Free Banking – Wishful Thinking

selginMy debt book is out!!

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.

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9 thoughts on “Free Banking – Wishful Thinking

  1. NeilW

    “But since it would be pegging its notes to other bank notes at par, if the other banks refused to follow suit the deficit-running bank would soon see its reserves of other banks’ notes drained away.”

    That wouldn’t be how it works. If you have a deposit at Bank A and you want to pay somebody at Bank B, then Bank B has to swap with you as the depositor in Bank A to allow the payment (i.e. Bank B takes your asset and increases the liability to the payee – balance sheet expansion).

    Unless the banks play ball with each other the payment system just collapses and stops working. And the way you get around that is to have a central clearing house that all subscribe to that levels out the daily imbalances and ensures clearing happens…

    To run a deficit the bank has to create a null asset – or revalue its loan book/collateral upwards. At which point there is the issue of how the bank distributes the new liabilities it has just created (presumably they just hand them out to the bankers that work for them – seignorage for banks).

    Always remember that notes are simply receipts for liabilities at a bank somewhere. Essentially they are a cheque. They are a receipt for money, not the money itself. And like cheques they have to clear once they get to a bank. In an electronic world the usual proposals don’t add up.

    Reply
    1. axdouglas Post author

      You’re right, of course, but that section was misguided in several ways, so I’ve taken it out. I wrote it too quickly. Your comment is still informative, though.

      Reply
  2. Georg Thomas

    Thanks for this masterful in nuce refutation of Free Banking. Even if one were to disagree on this or that point or eventually the entire argument, your post is most helpful in getting a comprehensive perspective on a possible criticism of Free Banking. Since my student days, 800 years ago, I have felt that money theory is incomplete and muddled and sooner or later given up again on my repeated returns to it, always for the same reason (it appearing incomplete and muddled). I am most grateful for lucid accounts such as yours. It is a pity your “The Philosophy of Debt” is so expensive (€ 151 at Amazon Germany). What other books would you recommend for someone willing to learn about money theory from scratch?

    Reply
      1. Georg Thomas

        Bob,

        Thanks for the excellent links. I am reading a hard copy version of Wray’s “MMT.” Nonetheless, it is useful to know I can refer to the online variant any time I am working with the computer. Romanchuk’s book looks very promising.

    1. axdouglas Post author

      Thanks very much for that kind comment. It’s very nice to read positive comments like that.

      Why is my book so expensive in Germany? In the UK the paperback is £30. Have you checked what it would cost to order directly from Routledge?: https://www.routledge.com/products/9781138929746

      Not that I’m pressuring you to buy my book!

      I can recommend Mark Peacock’s Introducing Money, which covers some of the same material as, say, Geoffrey Ingham, but perhaps in a more accessible way. Again, I expect it’ll be cheaper buying it directly from Routledge than going through Amazon Germany. There is a little bit on the theory of money in L. Randall Wray’s Modern Money Theory, but the primary focus there is macroeconomics more generally

      Then of course there’s the classic paper by Innes: https://www.community-exchange.org/docs/what%20is%20money.htm

      Reply
      1. Georg Thomas

        Alexander,

        Thanks ever so much for your tips and links. I have no idea why prices at Amazon Germany are so much higher? You are in good company: Bill Mitchell’s “Eurozone Dystopia” sells at € 170, up from € 150.

  3. Pingback: Fiat Currency is Backed by Public Services (And Basic Income Doesn’t Work) | Origin of Specious

  4. Nathanael

    Having studied the history of free banking in the United States in the 19th century, the situation was even whackier. The US declared both gold and silver to be payable for taxes with a fixed par ratio, and the result was horrible arbitrage operations between gold and silver. So the US stepped in to *completely control* the gold and silver markets (an expensive and complicated enterprise), effectively turning them into fiat currency.

    But the government still refused to issue fiat notes after the retirement of the Civil War Era Greenbacks due to problems with not-trading-at-par (the Greenbacks had traded below par relative to gold certificates and silver certificates even though they could be used to pay taxes). There wasn’t enough gold and silver to supply monetary needs and the government was afraid to issue non-backed certificates for reasons of legitimacy.

    SO, the banks started issuing notes all over the place, with varying amounts of backing. The notes traded at par *LOCALLY* but were discounted if you took them to a different city! The government officially agreed to accept all banknotes from “nationally chartered” banks for payment of taxes. This created a problem when the government held banknotes from insolvent banks and attempted to reclaim gold from those banks which wasn’t there. This led to the Office of the Comptroller of the Currency regulating the operation of the banks to make sure they kept enough reserves that the *government* could get gold when it turned its notes in…

    So effectively the entire banking system came under very tight government control. And *even so* it had financial panics and collapses rather routinely!

    Free banking just sucks, that’s all there is to it. People are way more comfortable with government-issued fiat money.

    Free banking appears spontaneously when the government *fails to issue enough fiat money*. It’s actually pretty much impossible to make it illegal. This is the essential origin of the “money market funds”, among other things: they are banks creating money because the government wasn’t supplying enough money to meet demand. The emergence of free banking is a *consequence* of an economy where the government is not supplying enough fiat money. It’s always undesirable (unless you’re a banker with a taste for risky gambles, in which case you can make a lot of money with free banking).

    Reply

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