Monday, 28 October 2013

The flaws in free banking.

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.

A Kotlikoff system beats free banking hands down.


  1. 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.!

    I 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.

    1. George,

      Re 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.”


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