Free banking versus full reserve banking.

Free banking is a system under which central banks play a minimal role or don’t exist, and under which anyone can set up a bank and issue their own bank notes.

For the great and the good, particularly those on the political left, that’s anathema. They’ll claim the state (i.e. the great and good) knows best, and should regulate banks. That’s “great and good” as in “we lot who have made a complete mess of regulating banks over the last ten years and brought you the credit crunch, the subsequent austerity, etc”.

Moreover as George Selgin and other free banking advocates have shown, the historical record of free banking is good: it involved relatively little inflation and few bank failures, credit crunches, etc.

However, there is a crucial weakness in free banking, namely that the occasional bank failure DID OCCUR in free banking regimes, and the political reality is that the population nowadays just wont stand for ordinary depositors losing their money in the event of a bank failure. From which it looks like state sponsored deposit insurance is here to stay. 

 

But therein lie problems, as follows.

1. State sponsored deposit insurance for free banking is almost a contradiction in terms: i.e. the whole idea of free banking is that the state plays no role in banking. As this advocate of free banking put it, “Government deposit insurance does not fit into a free banking system.”

So free bankers and full reserve bankers agree that state sponsored insurance is unacceptable.

2. State sponsored deposit insurance is a subsidy of banking. (Granted there does not need to be any subsidy element in the case of insurance for SMALL BANKS (as is the case with FDIC). But in the case of SYSTEMIC FAILURE, and larger banks, only the state can do a rescue, and that equals a too big to fail subsidy.) And a state funded TBTF subsidy contradicts the basic idea behind free banking.

3. State sponsored or not, deposit insurance is pretty much a nonsense anyway. Reason is thus.

There is a big range of different ways of saving (e.g. investing in a property to let, investing in the stock exchange – which itself offers a huge range of different investments all with varying levels of risk, etc, etc.)  Now what’s the point of going for a risky investment and then insuring against the risk? That makes no sense – unless of course you’ve spotted some mug who charges an artificially low premium.

And that’s very much what is involved in state sponsored risk insurance! That is, if your risky investment goes wrong the taxpayer coughs up. (At least that’s the case with systemic failure rather than the failure of a small bank.) What more can you ask for? Heads I win, tails the taxpayer loses. You’d have to be stupid to turn down an offer like that. But of course that arrangement is not in the interests of the country as a whole.

So clearly the latter “deposit insurance / subsidy” nonsense needs removing. And there is a simple way of doing it: full reserve. 

Full reserve.

Under full reserve, depositors who want 100% safety can have it, but no risks are taken with their money. In contrast, those who want their money invested carry the risk.

And that very much answers one of the main criticisms of central banks made by free bankers, namely that central banks are the CAUSE of banking problems, moral hazard in particular. E.g. see paragraph headed “What about deposit insurance” here.

So free bankers ought to welcome full reserve banking in that under full reserve, taxpayer exposure is minimal.

Should commercial banks do stimulus?

The only remaining significant different between full reserve and free banking is that under full reserve, the commercial bank SYSTEM cannot expand the aggregate amount of money: only the state and central bank can do that.

In effect, commercial banks cannot do stimulus under full reserve (or at least one form of stimulus). Now given that everyone looks to government and central bank to do stimulus when needed, why let commercial banks do it as well? That’s duplication of effort.

Moreover, the commercial bank system is just brilliant at effecting stimulus just when it’s NOT NEEDED: that is commercial banks lend MORE during an asset price bubble and exacerbate the bubble. (E.g. see chart here showing the rapid expansion in the UK of commercial bank money/loans relative to the monetary base in the three years before the crisis.)

Thus barring commercial banks from effecting stimulus (a la full reserve) is a thoroughly good idea.

Conclusion.

Full reserve banking beats free banking.