I tried to present a chapter of it to the Political Economy department at King’s College, London yesterday. There was a good discussion. Something came up in the discussion that often comes up when I talk about money and banking: the idea of free banking. Instead of trying to use currency creation by the State to serve the public purpose, why not let the market decide by privatising currency – letting different private agents create currencies and compete to get them used by the public?
The idea was promoted famously by Hayek in The Denationalisation of Money. It was developed by George Selgin, in a book of which I was reminded after my presentation. Instead of having one national currency issued by the State, you have lots of competing currencies issued by private banks. People can choose which currencies, from which banks, they’d like to borrow and spend.
Selgin’s book includes a incomplete and inaccurate history of free banking. It neglects to mention how tax payments worked in the various systems of free banking it discusses. As a rule, whatever the State demands for tax payments – whether a privileged commodity or the stamped certificate of a favoured issuer – will function as the only 100% certain means of settlement among banks. Banks will likely redeem their notes for it at par on demand. At least they will make a semblance of undertaking to do so. Where there is tax there is fiat money. By ignoring the mechanics of tax payments – what G.F. Knapp called ‘epicentric’ payments – Selgin blinds himself to the fiat money systems that were secretly at work in his chosen historical periods. It matters very little, by comparison, whether banks were issuing their own liabilities or simply reissuing liabilities of the State.
Never mind the historical examples. Don’t Hayek, Selgin, and others at least give a description of something we could have, in place of our fiat money system? Possibly – until it began to make any difference whatsoever.
Suppose you have a free banking system. So banks are effectively currency issuers and settle payments on their own balance sheets rather than on the central bank’s balance sheet. They also peg to each others’ liabilities at par
If the government accepts only one bank’s notes for tax payments, then everybody will demand that bank’s notes. Tax payments are the least negotiable payments of all. The other banks will then have to settle payments with the favoured bank’s liabilities. The favoured bank will effectively become a central bank.
Alternatively, suppose that to preserve neutrality the government accepts tax payments in all the banks’ notes. Now it wants to run a deficit. It has to borrow from the banks. But suppose it doesn’t like the terms any of them offer. The solution is simple. The government just threatens not to accept the banks’ notes in tax payments unless they give it the terms it wants. Now their currencies have become fiat currency overnight. The government effectively issues their currency, since it can force them to make loans whenever it wants, on whatever terms it wants, in whatever amounts it wants. All it has to do is threaten to unplug them from the tax payment system, in which case their currencies become second-class currencies that can’t keep anyone out of jail.
Free banking will therefore last until the very first situation in which the banks’ policies run up against the government’s purposes. At that point it will revert, instantly, to a fiat currency system. The whole thing is a long detour to get back to where we started.