Saturday, August 22, 2015

Free Banking: How Good, and How Free?

A fixation of libertarians is banking without any government control, or free banking. Did it work? Can it work?

What if we could get the government off our necks and out of our pockets, reverting to a more blissful state of nature when human relations were voluntary and markets rendered, by their invisible hand, everything we need? That is the dream of libertarians, especially monetary libertarians, who yearn to go back to gold and back to a time when anyone could issue any kind of money they pleased.

It is difficult to take all this seriously, but let's try. We would have to put aside the myriad problems of the gold standard. The gold (and silver) standard did one thing very well in its day, which was to keep money similarly valued over long periods of time. A ducat was worth something reasonably similar for hundreds of years, as was a Pound Sterling, i.e. a pound of silver. The intrinsic scarcity of these metals, and the nature of mining that added to stocks in very rough proportion to human economic activity (at least when economic growth was very slow), made them natural stores of value, virtually universal among pre-industrial human societies.

Free banking has actually happened, apparently most purely in Scotland in the 1700's and 1800's, till the evil British put the Bank of England in charge of monetary policy for good, in 1844. In this system, banks competed by issuing notes on their stocks of gold. These notes constituted their funding for loans, and acted as currency. This was truly a fractional reserve system, where on a certain stock of gold, they could issue several times the value in notes, and expect that redemptions back to gold would be rare enough that they would not, in normal circumstances, face a "run" on those reserves. Their motivation, therefore, was to have their notes be as trusted as possible, and thus as long in circulation as possible, so that loans could be made in large amounts. This style of banking goes back a long way, back to the Venetians and probably beyond. The early US in the 1800's had a similar system, though free banking enthusiasts look askance because it was heavily regulated (and corrupted!) by the states, not to mention that it ended up being extremely unstable, with numerous runs, collapses, and depressions.

Free banking is not really free, in my estimation, but highly restricted in several respects. First is the gold standard. The only commonly and universally recognized form of money at the time was precious metal, for which the notes served merely as an IOU. But were everyone to wish to convert their notes to gold for safe-keeping in their mattresses, (say, if war beckoned), the system would fall apart instantly. So it was a sort of ponzi scheme from the start, as is, in fairness, most banking. The gold standard meant that many banks could operate simultaneously, recognize each other's notes, and clear each other's payments, (and have the motivation to do so), because ultimately, they knew they could settle in gold if the need arose. Crises arise, now as then, when one institution loses this trust, faces lack of credit from intermediaries and / or customers, and spirals immediately into liquidation.

Under what I would take as true libertarian principles, really free banking would be something quite different, where a bank could issue money based on any form of value at all, and compete in the marketplace of customer trust. Its reserves could be land, or timber, cows, or cockle shells. Perhaps this would reduce in practice to the old gold standard, or perhaps to the money of some well-run state far away, as many dollarized economies practice it today(!) In any case, the use of gold/silver would not be forced on the banks and their customers, but be their own choice of funding / backing.

The second restriction was the nature of the bank corporation, which had unlimited liability. Thus, unlike our own corporations, which can escape any adversity through bankruptcy, the owners (partners) of classical banks were on the hook if there was a run or over-lending and their gold stores ran out. The Scottish system had one spectacular failure, of the Ayrs Bank, which reportedly ended up with virtually no losses to the note holders because the partners were cleaned out. Obviously, this rested on a legal system that was willing to hold the partners to literal account, something that seems to be oddly lacking in the current business climate. Likewise, the legal system had to underpin the gold standard, recognizing its central role of value in economic life.

Additionally, arch-libertarian Murray Rothbard brought out a rather tart paper about how unfree the Scottish system actually was, since its banks evaded their gold redemption requirements with great determination, and relied instead on Bank of England notes for most redemptions, treating it as their central bank. It is actually an excellent article about banking in general, graced with terror over proto-Keynesian "rank inflationists".
"Professor Sydney Checkland points out that Scottish banks expanded and contracted credit in a lengthy series of boom-bust cycles, in particular in the years surrounding the crises of the 1760s, 1772, 1778, 1793, 1797, 1802-03, 1809-10, 1810-11, 1818-19, 1825-26, 1836-1837, 1839, and 1845—47. Apparently, the Scottish banks escaped none of the destabilizing, cycle-generating behavior of their English cousins."
"The Scottish system was one of continuous partial suspension of specie payments. No one really expected to be able to enter a Scots bank . . . with a large holding of notes and receive the equivalent immediately in gold or silver. They expected, rather, an argument, or even a rebuff. At best they would get a little specie and perhaps bills on London. If they made serious trouble, the matter would be noted and they would find the obtaining of credit more difficult in the future."
"Bailey overlooked the fundamental Ricardian truth that there is never any social value in increasing the supply of money, as well as the insight that bank credit entails a fraudulent issue of warehouse receipts to nonexistent goods."

Anyhow, given these important restrictions and traditions, the Scottish system was quite competitive and reasonably robust for its day, with a few large and many small banks. The one thing it didn't do was serve the state, which by time was becoming used, in England, to running the monetary system for purposes of both inflation control and its own funding, especially in war. As Rothbard notes, the Scottish system had led to credit gyrations and substantial inflation, issuing roughly fifty times as many notes as the underlying gold/silver. This allowed economic growth, but also was completely unsustainable in terms of a true gold standard.

In the end, we return to the questions that were current in the 1800's as modern banking began to take shape. Should fractional banking be allowed in any form, or should money be 100% backed by the precious metals of tradition? If fractional banking be allowed, how should the creation of money be controlled to prevent the incessant cycles of boom and bust which appeared inherent to the free system whereby banks printed paper money in response to business demand for credit? If fractional banking be not allowed, how could one accommodate economic growth when the supply of money failed to grow- that is, when one's mines (or Imperial thievery) failed to crank out as much new metal as proportionately required for growth in population and technology? Would everyone end up being "crucified on a cross of gold"?

The answer, obviously, is that neither a 100% gold standard, nor free, unregulated banking, are optimal. Given the world's current wealth of about $250 trillion, an ounce of gold would have to be worth $50,000 to back wealth at 100%, which seems not just unrealistic, but obscene and a threat to our natural environment, given the mining this price would entail. Historically, as economic growth far outstripped metal mining, central banks took over macroeconomic policy with regard to money creation, inflation & interest rate control, bank regulation, reserve requirements, and many other practices. Central banks have made their share of grievous errors, particularly in the Great Depression. But some lessons have been learned, and our latest brush with the pitfalls of ponzi banking was significantly less bad than the Great Depression.

Nor is a stable store of value over long periods of time the only point of having a monetary system. Rather, it should exist to increase prosperity and human well-being. Gold is still available, after all, to all and sundry who wish for that imperishable store of value. For the rest, modest and controlled inflation using an elastic supply of money, as a spur to productive investment and labor over pure saving / mattress-stuffing, may be a more desirable feature of an optimal monetary system, combined with active state management to maintain value over booms and busts in the business cycle.

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