By Stephen Slivinski
Selgin: I use the term to mean laissez-faire banking — banking without any special government regulations or restrictions. Like free trade, it’s an ideal concept. It doesn’t refer to any specific or actual banking system, although some, like Scotland’s in the early 19th century, came close.
My own ideal version of free banking would have no special requirements for note issuance. Private banks would be able to issue their own notes on the same basis as they create demand deposits. They would also be free to open branches and invest in all kinds of securities. Finally, there wouldn’t be any sort of implicit or explicit government guarantees, like deposit insurance.
Selgin: I think a distinction needs to be made between the banking regime on the one hand and the monetary base regime on the other. The way I envision free banking, it does not rely on a particular base regime. It’s true, as a matter of history, that if you had free banking from the get-go, you wouldn’t have central banks and you would almost certainly have a commodity money standard, probably gold. But one can conceive of free banking in a modern fiat money setting. What would make it free is that the central bank would not have a monopoly on issuing paper currency the way central banks do today almost everywhere.
A modern proposal for free banking that doesn’t radically alter the monetary base regime is one that freezes the monetary base, lets banks issue any sort of liabilities — including currency — and gets rid of deposit insurance. The central bank would still maintain the monetary base but, in principle, it would just be a question of making sure it mopped up old central bank notes and otherwise maintained a fixed stock of reserve credit for banks to settle with. In that case, you’d have free banking with a fiat money standard.
The fiat money we currently have is purely the product of central banks. I think it’s pretty clear that if we never had central banks, we wouldn’t have fiat money. Instead, we’d still have commodity money. I don’t think there were any evolutionary forces at work that would have weaned monetary systems off of established commodity standards, particularly gold and silver. What would have happened instead, and what was tending to happen while we still had those standards, was that the actual need for gold and silver as money would have fallen, thanks to financial innovations, to very trivial amounts.
In the Scottish free banking system, for example, actual gold coin reserve ratios had already fallen to as low as 1 percent to 2 percent of the banks’ outstanding demand liabilities by the 1820s. Most of the liabilities were banknotes back then — deposits weren’t so important. At any rate, the Scottish banks didn’t need a lot of gold, and the system was always finding new ways to economize on it. But the ultimate standard was still gold, and I think it would have remained so in the absence of government interference.
Selgin: The advantages of free banking are distinct from those of the gold standard or any commodity standard. That doesn’t mean that I think there is no advantage to a gold standard. As a matter of history, I think it’s a shame that the gold standard was dismantled. That dismantling really began in earnest during World War I, and the gold standard that was restored afterward was a jury-rigged and, ultimately, very unstable standard. But one can have a better banking system under free banking whether there is a gold standard or not. Fiat money would also work better with free banking than without it.
As for fractional reserve banking, I think it’s a wonderful institution and that it’s crazy to argue that we need to get rid of it to have a stable monetary regime. Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on its fraudulent nature or inherent instability are, frankly, making poor arguments. I don’t think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment.
The main thing to keep in mind is that a competitive bank of issue is one that can issue circulating currency but has no monopoly on doing so. So it isn’t in a position to print up its own reserves or to print anything that other banks can be counted on to treat as reserves. Free banks compete, as it were, on an even playing field in issuing paper IOUs, which are basically what banknotes are. They have to redeem those IOUs on a regular basis: The competition among different issuers means that their notes will be treated the same way that checks are treated by banks today. They will be accumulated for a day or so and then sent through the clearing system for collection. It’s this competition among issuers that assures that none of them has the power to lead the system into a general overexpansion.
That’s quite unlike the situation you have when you have a monopoly bank of issue. Even in the presence of a gold standard, when the privileged banks’ IOUs are themselves claims to gold, a monopoly bank of issue can expect other banks to treat its paper notes and its deposit credits, which are close substitutes, as reserve assets — that is, to treat them as if they were gold themselves. As a result of that tendency, which exists only because the recipient banks are deprived of the right to issue their own paper currency, the less privileged banks become dependent on the monopoly currency provider and, therefore treat its notes as reserve money. Now that monopoly bank has the power to generate more reserves for the whole system and it, in turn, is free of the discipline of the clearing mechanism. That’s where central banks’ power comes from. This is what allows central banks to promote a general overexpansion of credit and inflation.
What I just described is exactly the sort of thing that triggered many of the financial crises of the 19th century. The irony is that people now see these periodic crises, especially in England, as proving the need for a central bank and a lender of last resort. Walter Bagehot, on the other hand, recognized that the boom-and-bust cycles were a product of a monopoly in currency issuance.
Today, poor Bagehot must be spinning in his grave, because your average central bank apologist likes to cite him as having argued that every country should have its own central bank. That is a calumny. Bagehot in fact wrote very explicitly that he thought it would have been best had there never been a Bank of England, and if England instead had a competitive banking system like Scotland’s. In that case there would have been no need for any lender of last resort. In recommending that the Bank of England serve as such a lender, Bagehot wasn’t recommending a solution to problems inherent in unregulated banking. He was just trying to get an inherently flawed Bank of England to behave itself.
Selgin: The Scottish system was unique, and that’s because of politics. After the 1707 Treaty of Union, English authorities did not want Scotland to end up with an institution with the same power and prestige as the Bank of England. They more or less insisted that Scotland allow open entry into the note-issuing business. So the Bank of Scotland, chartered in 1695, was followed by the Royal Bank of Scotland, and then by other note-issuing banks, until Scotland had a couple of dozen banks of issue — some big, some small — all competing. In this way the English quite unintentionally gave Scotland the world’s most stable, most envied banking system, and one far superior to its own. For one thing, Scotland was relatively free of crises while England was buffeted by one crisis after another.
By the way, the same comparison can be made between the U.S. banking system and the Canadian banking system in the last half of the 19th century. Neither was a free banking system, but the Canadian system was freer in crucial respects, like allowing banks to issue notes without special collateral requirements and allowing nationwide branch banking. This greater freedom made the Canadian banking system the envy of U.S. commentators at the time.
Selgin: Banks were free in the late antebellum United States in one sense only. Originally, you could only start a bank with a special charter passed by a state legislature, so entry was restricted. In some cases, it was very severely restricted. There were some states and territories, especially in the West, that banned banking altogether and others that chartered only a single, privileged bank.
Starting in the late 1830s, in reaction to the corruption of the previous system, states – beginning with Michigan and New York – created so-called “free banking” laws that allowed banks to be established through something like a general act of incorporation. So, banking under these laws was free in the sense that there was greater freedom of entry.
But the banks weren’t free in the sense that they were free from special regulations. In every case, their notes had to be backed by specified bond collateral, and this requirement often had very bad consequences. In many states, banks were forced to buy assets that turned out to be junk, and this was a major cause of failure in these supposedly “free banking” systems. None of the banks could have branches, either. As is evident to everybody today, the lack of branch banking was a very important source of U.S. banking system weakness and fragility.
Selgin: Unlimited liability gives banks subject to it a greater effective capital cushion, with correspondingly greater guarantees to the holders of their notes. In that case, those note holders would be subject to losses only after the banks' owners had been deprived, not only of their equity interest in the banks, but also of their personal property. So unlimited liability constituted a really effective as well as incentive-compatible kind of insurance — much better than government deposit insurance. But it's important not to exaggerate the role of unlimited liability. In the Scottish system, for example, only some banks had unlimited liability — the older "chartered" banks didn't. The evidence doesn't by any means suggest that free banking can only work with unlimited liability. I don't think free banking theorists have taken any particular stand on how much liability is ideal. Rather, I think their view is that the choice is best left to the market.
Selgin: The standard view is that banking systems are inherently fragile and that they’ll be subject to frequent bank runs, which with fractional reserve banking will have very serious consequences. But there’s no good evidence for this view.
Two things need to be said. First, truly irrational and random runs on banks, out of pure ill-informed panic, are the exception. In most cases the runs turn out to be based on relatively accurate information about which banks are insolvent and which ones aren’t. In other words, so-called bank “contagions” tend to be very limited.
People point to the nationwide U.S. panic in late February 1933 as an exception. Yet that major run was triggered by two things. The first was the spread of bank holidays, which were foolish and unnecessary alternatives to partial suspensions. The other was a run on the dollar caused by the fear that FDR would devalue it upon taking office. Roosevelt’s failure to unequivocally deny any intent to devalue helped fuel the run. So a rush to convert paper dollars into gold caused the Federal Reserve Bank of New York, which felt the brunt of that rush, to call for a New York state bank holiday, which precipitated the national bank holiday. Of course if there’s fear of devaluation under a gold standard, people are going to run on the banks to get their hands on paper money, so as to convert the paper into gold. But that doesn’t imply distrust of the banking system.
Secondly, the tendency for banking systems to suffer failures, especially big clusters of failures, depends on the regulatory environment. Had we had nationwide branch banking all along in the United States, that alone would have allowed us to avoid many of the bank failures and problems we’ve experienced. So, the question that has to be asked is not whether heavily regulated and structurally weak banking systems in the past could have benefitted from a lender of last resort. Perhaps they could have. It’s whether the first-best solution is to get rid of the regulations that rendered these systems so artificially fragile in the first place. I don’t think that laissez-faire or free banking systems, or the closest approximations we have been able to study, have demonstrated the sort of fragility that suggests the need for a lender of last resort at all. In my opinion, a lender of last resort is a second-best solution to problems caused by misguided regulation of banking systems.
Freedom to issue notes is important too. When banks can’t issue their own notes, well, they need a lender of last resort to supply them with notes. If we told companies that manufacture shoes that henceforth they could only make shoes for left feet, lo and behold, there would be a need for an “emergency” source of shoes for right feet, which could be created by establishing a new government agency for the purpose. Eventually people would say, “Thank goodness for the Government Shoe Agency. How would anyone be able to walk otherwise?”
Selgin: There are. For example, banknotes can include so-called “option clauses.” Scottish banknotes bore such clauses before 1765, although the banks didn’t actually use them to preclude panics, as I’ll explain in a moment. With an option clause, a bank in effect reserves the right to stop redeeming its notes on demand, on the condition that it must pay interest on the notes during any period of suspension. So long as the interest rate is sufficiently high, option clauses are incentive compatible: They’ll only be invoked when so doing is in the noteholders’ own best interest. For example, if you had a completely irrational run on a solvent bank, the clause could kick in and prevent the panicking note holders from wrecking the bank. The very fact of the bank’s invoking the clause tells panicking customers that it’s solvent, because if it weren’t, it would make more sense for its owners to go ahead and wind it up.
But Scottish banks didn’t actually use option clause notes to prevent runs. Instead they had them to protect against note raids, where rival banks would pile up notes and then stage a raid to exhaust a bank’s reserves and put it out of business. Such raids occurred in the early days of Scottish banking. The option clause might have been used to protect against random panics, except that there weren’t any random panics. So in theory at least there is a contractual solution to such panics that could work very well.
Also, when you ban competitive note issue, you eliminate the one bank-issued demand liability for which there can be an active secondary market. Suppose you have a bank that’s insolvent, then expert market participants would discount its notes. Conversely, if the notes aren’t discounted, nobody has to worry. “Naive” bank customers could just check the market price of their notes to know whether they’d better run on their banks or not. So information from the secondary note market can prevent runs and panics from spreading randomly. If you shut down that market, as you do when you prohibit competition in note issue, you create a basis for bank-run contagions that wouldn’t exist otherwise.
Selgin: The big problem of small change — which is the title of a very good book by Thomas Sargent and François Velde — refers to the problem of trying to keep smaller denomination coins circulating alongside larger denomination coins. Say you have a gold standard. If the mint strikes only full-bodied gold coins, the smaller denominations will end up being too tiny. You actually have historical examples of very tiny coins being issued. But people lost them, and they were otherwise very inconvenient. So, what else can you do? You can switch to silver or copper, but then your large denomination coins would be huge. In practice, no one metal can be convenient for the full range of denominations people need.
Instead, you can have two kinds of metal circulating as coins — that’s called “bimetallism.” But bimetallism has its own problem. So long as the mint sticks to a single unit of account, its coining rates will imply a fixed relative price for the two metals. But that price is bound eventually to differ from the world relative price. When it does, the metal that’s relatively undervalued at the Mint will no longer be offered to it, and already-existing coins made from it will disappear from circulation unless they’re badly worn.
The other solution, and the one that was adopted everywhere, is to use “fiduciary” or “token” coins. Here, the metal isn’t the source of the coins’ value, which instead rests on a contrived scarcity or their convertibility into nonfiduciary money. The trouble with respect to such coins is that they can be a tempting object for counterfeiters.
This brings us to the British case. By the 1780s, it was estimated that more than 90 percent of the token copper coins in circulation in Great Britain were fake. And the real ones were in terrible condition. Merchants and factory owners could not get hold of enough decent coins for making change and paying workers. Of course, these problems were interrelated. The lack of decent official coins just made it easier for forgers to market counterfeit coins, while the extent of the counterfeiting discouraged the Royal Mint from producing more legitimate coins. At last, for several decades starting in 1775, the Mint decided not to produce any copper coins at all.
Great Britain also used silver coins as not-so-small small change, but because Great Britain’s official bimetallic ration caused silver to be undervalued at the Royal Mint throughout the 18th century, no silver was being brought to the Mint to be coined. In other words, from 1775 onward, the Royal Mint produced hardly any small change of any kind.
Now, this was no small matter. Britons needed small silver and copper coins for all payments under a guinea. Banknotes didn’t help, because the smallest until 1797 were for five pounds sterling. This was at a time when the average British worker was lucky to get 10 shillings, or half of one pound sterling, per week. So, retail exchange, wage payments — any transactions among the poor — there was no decent, official money for any of it. At the same time, the Industrial Revolution was gearing up. But that revolution depended crucially on the growth of retail exchange and the expansion of the factory system. It depended, in other words, on precisely the sort of exchange media that the government was no longer supplying. So the small-change shortage threatened to slow down the process of British industrialization.
Yet the British government, instead of trying to fix the problem, threw its hands up at it, leaving it to private merchants and industrialists to figure out a solution, which they did, ultimately, by minting and issuing their own coins.
Selgin: This private coinage episode, which is the subject of my book, was not a small thing. It was not a sideshow. In the course of 10 years, from 1787 to 1797, private coiners issued half again as many copper coins — in tons as well as in value terms — as the Royal Mint had issued throughout the previous half century. Later, the private coiners would issue silver coins too. So, for a big chunk of the early Industrial Revolution, the greatest part of the exchange medium used to sustain that revolution came from the private sector.
Very few people know this story. What’s more, it was only thanks to lessons learned from Great Britain’s private coiners, both concerning how to make coins and how to administer the coining system, that the British government and other governments were finally able to get their official coinage arrangements in sufficient order to allow them to provide for the coinage needs of industrial economies. Yet governments still aren’t very good at doing this. To this day there continue to be serious coin shortages around the world. Argentina has been in the grips of one for years. As long as we insist on letting government monopolize coinage, we can expect such shortages to occur.
That’s where Sargent and Velde go wrong in their book. They insist on treating the small-change problem as being due either to government authorities not having the right theory about how small change should be supplied or to their not having the right equipment with which to implement the theory. They never really consider what one might call the “public choice” problems behind change shortages, including the perverse incentives involved in a bureaucratic and centralized mechanism for supplying coins. If you look carefully at the British story, the problem there was very clearly not a lack of sound theory or a lack of adequate equipment. Most of Great Britain’s private or “commercial” coins were made using ordinary screw presses and were designed, issued, and administered by people who never lost a moment’s thought to any theory, new or otherwise.
Selgin: The private mints weren’t all equally reputable, in fact. Some catered to what we might call the “high end” of the market, supplying coins of the highest quality to very reputable issuers. Others, though, specialized in so-called ‘anonymous” tokens, or in spurious tokens aimed at fooling gullible collectors. Caveat emptor was the rule. But there is no question that the mass of circulating tokens was of a quality decidedly superior to that of the Royal Mint’s copper coins. The proof is that, by the mid-1790s, familiar commercial coins circulated at their face values, while their official counterparts were routinely refused, or were accepted only at a 50 percent discount. This was the case, moreover, even though official copper coins were legal tender for transactions up to six pence, whereas commercial coins weren’t, strictly speaking, legal at all.
Yes, part of it was reputation, and there was also an advertising component to the quality. You had both private mints and private coin issuers, so there was a division of labor. Ultimately, you had 20 different private mints that were serving hundreds of private issuers who would order custom-made coins from them. What caused them to care about how well their coins were made? Well, these coins were IOUs. If you were an issuer, the last thing you needed was for somebody to make perfect copies that would expose you to uncontrollable liabilities. So issuers had a powerful incentive to insist that the mints they used hired excellent engravers and used quality dyes. If one mint wouldn’t do it, an issuer could simply take his business down the street.
But there was another incentive at play also. The coins’ engravings, which were diverse and often quite beautiful, served to advertise the issuing firms at a time when print advertising wasn’t very important. So good PR was another reason for using nice dyes.
Selgin: The real lesson I want to get across with the book is that we should take private production and issuance of circulating money more seriously than we do. There is a great deal of misunderstanding about the historical record and particularly a great deal of myth that has grown out of the ancient and medieval dogma that kings and princes alone should be trusted to coin money. That dogma, which somehow managed to survive episode after episode of royal debasement, lies at the foundation of the entire modern superstructure of state control of money. Through their unthinking failure to question governments’ coinage “prerogative,” economists set a precedent that made it all too easy for them to excuse governments’ subsequent monopolization of paper currency, which in turn paved the way to fiat money, unlimited government guarantees, and the prevailing international monetary chaos.
I wrote Good Money to challenge the oldest and most fundamental belief behind modern governments’ control of money, by looking at a rare case where government didn’t issue coins, but the private sector did. Contrary to what people assume, the episode it suggests that the private sector alone is fit to coin money.
Selgin: I think the view that currency boards represent a step toward free banking, perhaps even a big step, is partly due to the tendency to equate free banking with the lack of a central bank. I’m not saying that tendency is wrong, but it’s a little bit misleading. There are ways of getting rid of central banks that may still leave commercial banks far from free, and currency boards are an example.
My perspective on currency boards is somewhat different. I agree that currency boards and dollarization can help us move toward free banking, but they do so by eliminating vested interests that tend to be among the most powerful opponents of granting greater freedom to banks. Once you dollarize, for example, whose concern is it domestically to prevent local banks from issuing their own currency? The currency profits — the seigniorage — are all going to another country. Allowing private institutions to supply currency would convert at least some of it to domestic consumers’ surplus. There’s no central bank to capture the seigniorage itself, and the treasury, which might otherwise look to a central bank to buy its debt, is now more likely to gain by encouraging than by standing in the way of currency privatization. So what dollarization and currency boards do is to get rid of at least some of the bureaucratic support for restrictions on commercial banks. In that sense, they represent a movement toward free banking.
Selgin: I agree entirely with those who blame the Fed for fueling the subprime housing boom by holding interest rates at such low levels for the early part of this decade. I think that was a very irresponsible policy. It was so even according to a conventional sort of Taylor rule, which, in my opinion, would itself have been too easy. Elsewhere I’ve defended the view that, in periods of growing productivity, central banks ought to allow some deflation — that is, monetary policy ought to be tighter than a standard Taylor rule would have it be. If you view the Fed’s actual policy in light of this argument, then the policy was very expansionary. Taylor’s own simulations suggest that if his rule had been followed, the housing boom would have been something like two-thirds as big. If the “productivity norm” I favor had been followed instead, the boom would have been much smaller still.
Still, it’s a mistake to blame the Fed alone for the crisis. And, to some extent, one wants to pity the Fed because the truth is that central banks cannot get the money supply right. They are trying to centrally plan it and they do not have adequate information to go by. They could do better than they have done, I think, by adopting the right rules. But they are fundamentally flawed institutions.
In any event, the Fed provided fuel for the fire, but the fuel was being directed into the mortgage market, and specifically into the subprime market, by an array of other government policies all aimed at increasing homeownership, especially among less creditworthy persons, and at helping the construction industry. The story is more complicated than that, of course, but these are the essential points.
Selgin: Financial innovations tend to take us in the direction of free banking. Such innovations have already privatized the greater part of national money stocks, and will keep doing so in the absence of a wholesale nationalization of banks. It’s only currency and coin that private firms have long been prevented from supplying.
So long as private currency remains illegal, and even if it doesn’t, further financial innovation will tend to make us less and less dependent on any sort of paper currency or coins. Smart cards, debit cards, that sort of thing, have already made some inroads. And global pressures tend to favor the loosening of other kinds of bank regulations. There is, however, one kind of regulation that is growing instead of retreating and that market forces can’t or won’t resist, namely, government guarantees. Here things have been going the wrong way for a long time. The spread of deposit insurance and other explicit guarantees has been obvious enough. Everyone thinks you can’t possibly have a stable banking system without deposit insurance, as if it weren’t the case that only one country had deposit insurance nationally before 1967 and only two countries for a while after that. I think the spread of deposit insurance has been very unfortunate, and that the spread of implicit government guarantees has been still more unfortunate, because implicit guarantees really have no limits.
Thanks to government guarantees, moral hazard is the big problem in banking today. We’ve got branch banking in the United States, finally. We’ve got many good private substitutes for government currency. We’ve gotten rid of other restrictive regulations like Glass-Steagall. Banks have a lot of freedom now that they didn’t have in the 1940s and that, so far as I’m concerned, is a good thing. But, tragically, back in the 1930s, when the government was busy saddling banks with regulations that would prove counterproductive, which it justified using false claims about banks’ excessive risk-taking, it also saddled banks with deposit insurance, thereby encouraging them to take excessive risks.
I don’t know how we’re going to get away from deposit insurance and guarantees, but as long as we have them and expand them, we can look forward to bigger and bigger crises. So to me, the biggest banking reform we need — bigger than allowing banks to issue their own notes, bigger than allowing private mints to spring up — is to roll back federal guarantees to the banking industry. Unfortunately, doing that may prove to be an even bigger challenge politically than trying to privatize all the world’s paper money and coin.