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 Wernerand 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.

Conclusion.

A Kotlikoff system beats free banking hands down.