Herewith an eleven point introduction
to free banking, followed by an explanation as to where the flaws are.
I assume free banking is what one of
its main proponents, George Selgin, says it is. In this talk, he
says the following.
1. Free banking is a system in which
there is no central bank, and commercial banks provide the entire money supply.
2. The historical examples of free
banking (the main examples being in Scotland and Canada 100 to 200 years ago)
worked well, and they used gold or silver as the monetary base.
3. Once a central bank enters the
scene it starts issuing a fiat monetary base and can do so to an irresponsible
extent.
4. (10.00 mins) The notes or bills
issued by competing commercial banks were exchanged at par: i.e. a £5 note
issued by banks X,Y, & Z were all regarded as being worth £5 – except where
a bank was seen as being in trouble.
5. In the particular case of the US,
free banking did not work well because banks were limited to the geographical
location where they first set up: i.e. a bank which set up in San Francisco couldn’t
have a branch in New York. That meant that notes issued by the SF bank became
progressively less acceptable, the further they travelled from SF.
6. (14.45 minutes) Adam Smith noted
that in the early stages of the Scottish free bank system, those banks got
their reserves down to very low levels (about 1%). That had the advantage of
economising on the use of a real resource: gold. I.e. those holding such banks
notes were in effect funding productive investment (made by those borrowing from
those banks)
7. (17.10) Central banks in contrast,
do not invest in particularly productive stuff. They “invest” in government
debt, and junk bonds issued by commercial banks that are in trouble, and which
the central bank is bailing out or giving temporary liquidity support to.
8. (19.45) If we were to revert to
free banking, we’d get the above advantage: those holding privately issued
notes would be investing in productive investment, rather than central bank
“junk” investments. But central banks would still perform a kind of
macroeconomic function: controlling the size of the monetary base.
9. (20.45) If free banking were
re-introduced, central banks would no longer issue paper or metal money
(coins). That would be done by private banks.
10. An advantage of privately issued
notes is that given an increased demand by the public for notes (as happens at
Christmas time) private banks would just print extra notes and give them to
customers and debt those customers’ accounts. In contrast, under the existing
system, private banks have to give customers CENTRAL BANK issued notes, and
that inevitably drains the private bank’s reserves, and has in the past lead to
private bank liquidity problems.
11. Selgin claims that bank panics
are more down to incompetent management by central banks than to anything
private banks have done wrong.
What’s wrong with free banking?
First, the above point about physical
notes (No.10 above) is of limited relevance nowadays, given the diminishing use
of bank notes and increased use of plastic cards.
Second, since Selgin’s ideas on a
return to free banking involve retaining central banks, he does not actually
advocate a return to free banking as practiced in Scotland 100 to 200 years
ago.
Third, the political reality is that
the public DEMANDS a 100% safe form of money: a perfectly reasonable demand. That
is, most people are not too clued up as to the solvency of various private
banks.
Therefor government has to stand
behind the money issued by private banks and/or has to provide a form of 100%
safe money.
But the problem with government (i.e.
taxpayers) standing behind privately issued money is that that is by definition
a subsidy of private banks. Of course where a country has a large number of
small banks, that can be dealt with by self funding insurance scheme (FDIC in
the US). But in the case of large banks there are systemic risks, and those can
only be covered by taxpayers.
So what’s escape from that dilemma?
Well it’s easy. The “escape” has been set out by Profs Richard Werner
and Laurence Kotlikoff.
It’s to have government issue a form
of money for those who want 100% safety – but they get no interest. As to those who want to have their money earn
interest - and that can only be done by lending the money on or investing it -
that INEVITABLY involves risk, and it’s not the job of taxpayers to stand
behind that risk. So the relevant depositor/investors are on their own.
Conclusion.
A Kotlikoff system beats free banking
hands down.
With all due respect, Ralph, your summary of my claims is inaccurate in too many ways to cataloguein any detail. But to give your readers some sense of what I mean, in your first bullet points alone, you have me grossly misstating the dates of the Scottish and Canadian free-banking episodes, arguing as if central banks have always issued fiat money, and denying that private banknotes have _ever_ been discounted, even in the U.S.!
ReplyDeleteI have enough confidence both in my knowledge of the subject and in my abilities as a speaker to know that these claims reflect, not my own sloppiness, but your lack of attention. The same can be said for your characterization of my policy recommendations--e.g., the claim that I want to retain central banks, which is another grotesque misrepresentation of my views.
It goes without saying that your criticisms of my talk, and of free banking more generally, miss their mark.
George,
DeleteRe my having “grossly misstating the dates of the Scottish and Canadian free-banking episodes”, I said 100 to 200 years ago above (for the sake of brevity). In contrast, your talk said (starting at 2.30 mins) that the Scottish system existed between about 1750 and 1850, while the Canadian one lasted from the late 1800s to early 1900s. I suggest my “abbreviation” was fair enough.
Plus readers will be able to judge for themselves whether that abbreviation seriously affects the arguments for or against free banking. I think not.
Re central banks and fiat money, I accept that my point No 3 rather implies that central banks have always issued fiat money. Point taken: I should have worded that differently.
However, and first, that doesn’t have much bearing on the basic argument here, since central banks currently issue fiat money and have no intention of returning to gold. Second, while the Bank of England wasn’t SUPPOSED to issue fiat money in the 1800s, I seem to remember from Bagehot’s book, that in one or two of the panics in the 1800s, the surreptitiously DID issue it.
Next, re your claim that I denied that private bank notes had ever been discounted, I said no such thing above. Indeed, in point No 4 I said that notes were exchanged at par “except where a bank was seen as being in trouble.” That makes it clear that sometimes notes WERE discounted.
Next, you say that my claim that you want to “retain central banks” is a “grotesque misrepresentation of my views”. Well here are some actual passages from your talk (20.37 onwards) which make it clear that you very much see a role for central banks or some sort of central monetary authority if and when free banking is re-introduced:
“in that case, a switch to free banking does not solve the problem of overall money management. You'd still need to do something about regulating the supply of the basic money, still in the hands of a central authority..”
”the central bank would still be the source of reserves for the system and so it would still maintain the capacity to control the overall scale of money creation, and so control the rate of inflation or deflation, or could contribute to the business cycle through its manipulation of the reserve supply..”
“Free banking does not solve the problem of overall money management. You'd still need to do something about regulating the supply of the basic money, still in the hands of the central authorities.”