George Selgin on Free Banking 11/17/2008

Because National Bank notes had to be backed by government securities, as the government retired its post-Civil War debt it became exceedingly costly to supply currency, so the currency supply shrank even as the country grew rapidly, causing severe currency shortages and financial crises in the late 19th and early 20th centuries.

“as the government retired its debt in the post-civil war period it became exceedingly costly for them to supply currency so the currency supply shrank even as the country was growing very rapidly and that was the thing that set the stage for severe currency shortages and financial crises”

Legal-tender enforcement of debased money is a prisoner's dilemma whose equilibrium outcome is the circulation of bad money, as shown by French Revolution assignat laws that made it illegal for a merchant to ask which kind of money he would be paid before making a deal.

“during the French Revolution at one point having issued paper... that were supposed to be equivalent to gold coins... the government actually made it illegal for any merchant to inquire which sort of money he was going to be paid before making a deal... a simple prisoner's dilemma model will tell you what the equilibrium outcome of that's going to attract bad money”

Private coiners (such as Thomas Williams) issued copper coins that were initially heavier than Royal Mint equivalents, beautifully engraved to defeat counterfeiting, and redeemable on demand to balance supply and demand—producing money superior in all respects to the Royal Mint's and, via about 20 mints serving 200 issuers, solving the coin shortage.

“their coins initially were actually heavier than royal mint equivalents they were beautifully engraved and that's one reason why they defeated counterfeiting they were redeemable on demand and that helped maintain the balance of supply and demand... before long there were 20 different mints commissioned producing custom-made coins for about 200 different issuers around the country and they solve the shortage”

The right policy is to stabilize aggregate demand (total spending PY) while letting the price level fall when productivity improves and rise when it falls, because an improvement in productivity is a change in the relative price of output to input—so forcing a stable output price level requires inflating input prices, whereas letting output prices decline is better.

“if you stabilize M V you're stabilizing py but you're not necessarily stabilizing P itself if Y is changing... if you have an improvement in productivity... it's the relative price of output the input... if you stabilize the output price level you've got to inflate input prices it's better I argue that the output price level should just be allowed to decline if productivity is improving”

Gresham's law ('bad money drives out good') applies only where government has monopolized coinage and uses legal-tender laws to force inferior coins to circulate at par with superior ones; in a free market with no legal-tender laws merchants can price in or refuse bad coins, so the opposite prevails—good money drives out bad.

“they all refer to situations where there was no private coinage no free choice in coinage but instead a government that having monopolized coinage decided that it was going to basically dilute the quality of its coins... in a free market there's no tendency for that to happen at all because the merchant can say look this is my bottle... if you offer me anything else I'll either refuse it or I'll have to charge you more... under competition good money drives bad money up”

Historically, under free banking, different banks issued notes with their own names but all represented claims to the same underlying gold standard, creating a uniform monetary standard without a monopoly issuer of paper money.

“different banks issued one dollar notes and five dollar notes and ten dollar notes with their names on them but they were all similar claims to some underlying amount of gold... so there was a uniform monetary standard but you didn't have a monopoly of the issuer”

Bank capital is the free-banking counterpart to deposit insurance: losses from bad loans are absorbed first by shareholders' capital, and only after capital is exhausted do depositors and note holders suffer—so customers choose well-capitalized banks for safety.

“the front line of defense of the banks and the their counterpart to the deposit insurance that exists today in a free banking system is their capital... any losses it suffers as a result of bad loans comes out of that capital... only after the capital is exhausted do the deposit holders and note holders their losses”

Scottish free banking ended in 1845 due to the careless extension of England's Peel's Act to Scotland on the assumption that what was good for England suited Scotland too; the Act capped note issues and imposed 100% marginal reserve requirements, ultimately giving the Bank of England a currency monopoly without solving instability.

“the rather careless extension of legislation initially adopted for England to Scotland based on the assumption that what was good for England was necessarily good for Scotland... they capped their note issues with and made them subject to hundred percent marginal reserve requirements... that ended up giving the Bank of England ultimately a complete monopoly of currency and it didn't solve the problem”

During the late-18th-century Industrial Revolution, the Royal Mint produced essentially no silver and almost no copper coins despite rapidly growing demand, creating a severe small-coin shortage that threatened industrialization by leaving industrialists unable to pay workers and merchants unable to make change.

“The Royal Mint... was essentially producing no silver coins in the last quarter of the 18th century and practically no copper coins in other words you have growing demand and close to zero output and the result is a chain shortage... it really threatened to undo a big part of the process of industrialization”

The private coinage episode ended because issuers progressed to silver and finally a small amount of private gold coins, prompting the government and the threatened Royal Mint to declare private coinage illegal as an encroachment on the sovereign prerogative of coinage.

“finally a guy issued gold coins private gold coins not very many that last step finally got the government to say no this is too much of an encroachment of our prerogative of coinage... the Royal Mint by this time had long recognized that it was in deep trouble... so they too were aggressive in fighting for their prerogative to be restored and what ultimately happened is the private coinage was declared illegal”

The Scottish 'option clause' let banks suspend note redemption while paying note holders the maximum legal 5% interest during suspension, converting the note into a small bond; it developed to defend against rival banks staging note 'raids,' and was an incentive-compatible device never actually used against customer runs.

“the option or optional clause that banks put on their notes... we reserve the right in certain situations to suspend payment on demand of the notes and gold but if we exercise this right then during the period of suspension we have to pay what was then the maximum allowed rate of interest to 5%... the option clause developed as a way for banks to safeguard themselves against raids by rival banks”

The option clause is incentive-compatible: if correctly designed with the right interest rate, it only pays a bank to invoke it (rather than wind up) when the bank is actually solvent but facing an irrational panic; an insolvent bank with bad loans gains nothing from invoking it and simply shuts down—so it creates no moral hazard.

“if the only time it would pay for a bank to invoke the option clause instead of winding up... would be if in fact it was solvent it didn't have a lot of bad loans people were panicking even though nothing was wrong... if on the other hand a bank has been profligate and has made a lot of bad loans and really is insolvent... it doesn't pay to invoke the clause you simply shut down so it's an incentive compatible arrangement”

Maintaining a fairly stable level of total spending is key to dampening the business cycle, and a free banking system does this automatically because the money stock grows when velocity falls and shrinks when velocity rises.

“maintaining a fairly stable level of spending is very important for dampening the business cycle how do you do that well what you do is you want to make sure the money stock grows when velocity of money goes down and shrinks when velocity goes up well that's just what happens in a free banking system”

When public demand to hold money rises and velocity falls (people draw fewer checks, pass on fewer notes), free banks actually tend to issue more money because their demand for reserves is a function of payment flow through the clearing system; thus changes in velocity get offset by changes in the private money stock.

“there would be a tendency for the banks to actually issue more money... because that their demand for reserves is a function of the flow of payments through the clearing system so with that when that flow goes down... by by loaning more... changes in velocity get offset by changes in the private money stock”

Under competitive note issuance, an individual bank that over-issues faces a reserve drain: notes it issues are received and returned for redemption by rival banks, draining its reserves, which strictly limits how much currency any single bank can create—the same discipline that constrains deposit creation today via check-clearing.

“if a bank made loans and the borrower's took them in the form of the bank's own notes and went out and spent them the notes would be ultimately received mainly by rival banks who would send them back for redemption... so competition worked to constrain the amount of currency or bank notes any individual bank in a competitive system could issue”

The belief that a good banking system is one where customers never face losses is fundamentally rotten; allowing banks to fail and customers to take losses is necessary, because removing that risk leads eventually to a system dominated by lousy banks.

“the idea that you know the only good banking system is a system where bank customers the holders of bank liabilities never have to worry about taking losses that idea is just a fundamentally rotten idea”

A monopoly note issuer escapes the reserve-drain discipline because its notes get treated like reserves by other banks even under a gold standard, allowing it to expand with impunity and encouraging all other banks to expand as well.

“that doesn't work if you give one bank a monopoly because it's notes get treated like reserves by other banks even if there's a gold standard that happens and so it can expand with impunity it just encourages all the other banks to expand as well”

A bank note, unlike a deposit account, is a financial asset traded in a secondary market and priced by expert market makers, so any doubt about a bank's solvency causes its notes to trade at a discount immediately—giving note holders faster warning signals than a car buyer gets about product quality.

“a note is a financial asset... and it's traded in the secondary market unlike individual bank accounts for which there's no secondary market... the minute there's any doubt... its notes are going to go to a discount and you will know that because you won't be able to trade them currently”

Free banking is fractional reserve banking; in Scotland circa 1820 typical banks held gold reserves of only one to two percent because public faith was so high that almost no one redeemed notes—people actually preferred to deposit gold guineas in exchange for trusted bank paper.

“the typical Scottish bank held gold reserves of one to two percent... nobody ever did it though that's why the reserves were so low such was the faith in the Scottish banks... the first thing anyone in Scotland would do if someone paid him a golf Guinea was to get rid of it quick by depositing this pesky coin in a good Scottish bank”

Government schemes to eliminate depositor risk produce a less safe banking system overall: depositors stop facing losses but taxpayers face them instead, and those losses become greater and systemic rather than localized.

“every government scheme for trying to do away with that aspect of banking has has ultimately served to give rise to a less less safe banking system where it's true that depositors as such don't face losses but then taxpayers face them instead and those losses become greater”

The establishment of a lender of last resort and deposit insurance erodes bank capital because both are substitutes for capital in the eyes of depositors, which is why bank capital must now be regulated whereas before the Fed banks commonly held capital equal to 30% of liabilities.

“it was common before the establishment of the Fed for banks to have you know capital that was 30% of their liabilities the establishment of central banking tends to eat away at bank capital because it's a substitute in the eyes of depositors if you have a lender of last resort you don't need a capital”

Free banking can operate on any monetary standard (gold, silver, or even a fiat dollar created by a central bank), so free banking by itself does not specify a particular pattern for the total money supply.

“you can have free banking with any... you can have it on a gold standard a silver standard you could have a Fiat dollar free banking system... in that case the free banking conceived that way doesn't specify any particular pattern for the total money supply”

Central banking politicizes the money supply, creating circumstances where competing interest groups (such as debtors who benefit from inflation) lobby for inflation or deflation; once money is politicized it becomes harder to return to a neutral system because beneficiaries resist losing their favors.

“central banking politicizes the money supply... it creates a circumstance where competing interest groups lobby for inflation or deflation... once you've politicized things you've made it harder to go back to a system that cannot grant the interest groups benefiting from the present policies the favors that they're getting”

In free banking, a private clearinghouse acts as a banker's club that detects banks lending too aggressively before the public does, expelling them and prompting other banks to refuse their notes—as happened to the Ayr Bank in Adam Smith's day, which collapsed quickly with losses borne mainly by its shareholders.

“if a bank gets a reputation for for lending too aggressively the Clearing House which could would itself be private in a free banking system will probably catch on before anyone else it's a kind of a banker's Club and they'll throw that bank out... the air bank one of the Scottish banks pursued an easy money policy... the air bank completely collapsed in fairly short order”

Two specific pre-Fed regulations—the lack of branch banking (forcing single-office unit banks) and heavy restrictions on banks' ability to issue currency—caused much of the financial chaos that later served as the rationale for creating the Fed.

“I would pick on the lack of branch banking almost all banks were single office unit banks... and banks were heavily restricted in their ability to issue currency... those two regulations alone created all kinds of trouble with the pre fed monetary system and I think can largely take the blame for the crises that ultimately served as a rationale for the feds establishment”

In a free banking system, customers face two screening decisions—which bank to entrust with their money, and which other banks' notes their bank accepts—so a bank's willingness to accept another's notes signals that bank's safety, and banks not in good standing get weeded out of the system.

“what notes of other banks and checks is my bank willing to take does it consider current... the notes that your bank is willing to take it regards those banks is safe you can accept those notes as well... banks that weren't in good standing with most or all other banks quickly got... weeded out of the system”

Rules like the Taylor rule fail because they use the price level as a proximate signal of whether there is too much or too little money, which is misleading; what matters for dampening the cycle is stabilizing total spending (MV = PY), not stabilizing the price level per se.

“the Taylor rule look at the price level as a proximate signal of whether there's too much money or too little and it's can be very very misleading notice what I said was necessary for dampening the cycle with stability of total spending not stability of the price level per se”

U.S. banks lost their right to issue notes in two Civil War stages: state banks were taxed out of note issuance, while federally chartered National Banks could only issue notes if backed more than fully by U.S. government securities—a design meant to finance the war, not to improve the monetary system.

“during the Civil War the state chartered banks... where deprived of their right to issue notes by... a stiff tax... another kind of Bank was established the National Bank's under a federal Charter... they could only issue notes if they backed them more than fully in face value terms with US government Security's the idea of course was to help finance the Civil War”

Many Scottish banks had unlimited liability exposing shareholders' personal wealth, but even limited-liability ones held very large capital; what restrained free banks from opportunism was that bank owners had a great deal of their own wealth at stake.

“a lot of Scottish banks though not all of them not the biggest ones but many had unlimited liabilities so their shareholders personal wealth was exposed... the reason Scottish banks and other free banks don't act irresponsibly is because the owners of the pynx have a lot at stake and they don't want to lose it”

In the Scottish free banking system until 1845, total losses suffered by banknote holders were miniscule compared to the losses borne mostly by taxpayers from bank failures in modern central-banking times.

“the total losses suffered by holders of Scottish banknotes including those who held Eyre banknotes we're really quite miniscule compared to losses that have been borne mostly by taxpayers as a result of bank failures in modern times”

Banks in a free banking system can do everything central banks/governments do in the monetary system except contribute to crises, which government agencies are particularly good at doing.

“the banks can do everything that the government does now accept accept contribute to crises which is something that government agencies are particularly good at doing”

The 'banking is too important to be left to the private sector' argument is weak because almost everything important (trade, food, agriculture) is left to markets; the real question is whether government involvement makes the sector work better.

“lots of things are really important trade is important food is important agriculture it's hard to think of a major sector of the economy that's not important... banking is not unique in that respect the question for it is the same as with any other section it is whether the government's involvement makes makes it work better or not”

Free banking means banking conducted without special regulations, treated like any other industry producing real goods, requiring no special government role beyond ordinary contract enforcement, especially under a commodity monetary base like a gold standard.

“free banking means a banking without any special regulations that is banking conducted as it might be if governments treated banks the way they treat companies that make shoes or widgets”

Government interference with money and banking long predates the Federal Reserve and other central banks; the U.S. government wielded a heavy hand in banking well before 1913.

“the creation of the Federal Reserve in this country and the establishment of other central banks elsewhere did not mark the beginning of government interference with banks”

A bank not subject to reserve requirements and able to supply both currency and deposits can expand more the more slowly people spend its money; in the limiting case where nobody ever writes checks, a bank could expand forever because it would never lose reserves.

“think of a bank where nobody writes checks for a while... in that case that bank could expand forever because no one's ever writing a check so it's never going to lose a dollar of reserves... how much a bank an issue... depends on how rapidly people are spending its money”

The Fed was essentially just 12 banks set up to issue currency when laws prevented national and state banks from doing so; there was nothing magic about it—the same problem could be solved by simply letting existing banks issue currency.

“if you look at what the Fed was it was basically that set up 12 banks that can issue currency when the laws would prevent the national banks and state banks from doing it there wasn't anything magic about it”

If a free bank ran out of gold in a panic it would shut down and be liquidated, but note and deposit holders often received a complete payout after some delay from the bank's assets and capital, which is why Scotland's overall loss figures were very modest despite occasional individual failures.

“the bank would then be liquidated and it would be a question of what its assets including and capital where we're worth and often there would be after some delay a complete payout of the deposit in note holders and that's why the loss figures for Scotland overall were very modest”