The Free Banking Alternative
Lawrence H. White, University of Missouri—St. Louis
This year marks the thirtieth anniversary of Friedrich Hayek’s broadside The Denationalization of Money, first published in 1976 by the Institute of Economic Affairs in London. The world of monetary policy has changed dramatically since it was written. The inflation rate in the UK (as measured by the retail prices index, all items) hit 24.2% in 1975. In the US inflation peaked at 13.1% four years later. Hayek wondered why we didn’t have better quality money, and – being an economist – he thought about the institutional arrangements for producing money and the incentives the producer faces. It dawned on him that government monopoly was producing low-quality money just as it produces low-quality postal services. Free enterprise had been stopped from satisfying users of money the way free enterprise satisfies the users of other goods and services. Hayek hypothesized that a system of competing private monies would be better at providing high quality, at maintaining the value of money over time. If citizens were free to use alternative monies, he predicted that private monies would outperform central bank monies in purchasing-power stability and would dominate them in popularity.
Hayek’s somewhat visionary proposal to denationalize money may seem to have been a political failure. It was, one might think, so far beyond the pale of political respectable ideas for monetary reform as to be an irrelevant pipe dream. Further, the urgency of any major reform of our monetary and banking institutions seems much less today. Even without denationalization of money, inflation in the US is down from the double digits of the 1970s to low single digits today (although it’s up more than a couple of points compared to two years ago).
Actually, I think we should consider the possibility that inflation is down in large part because of the intellectual success of Hayek and other thinkers – most prominently Milton Friedman – in changing the climate of opinion about appropriate monetary policy. The change in opinion has not, however, produced a change in the monetary regime, the institutional arrangements we rely upon for supplying money.
We are still at the mercies of an unconstrained central bank issuing fiat money. My assigned topic is the “free banking alternative” to the Federal Reserve System. In a “free banking” or laissez faire regime, currency issue would return to commercial banks. Commercial banks would be regulated in their issue of deposits and currency only by contracts and market practices, not by legislated restrictions. There would be no central bank. The useful functions of the clearinghouse (clearing and settlement of currency and deposit transfers, enforcing membership standards for clearing banks through bank examinations, possibly last-resort lending) would be denationalized and returned to clearinghouse associations, privately owned and operated (presumably by member banks). Other current central bank roles (enforcing inefficient legal restrictions on banks, conducting monetary policy) would disappear.
What would determine and control the quantity of the basic money, the medium of redemption, in a free banking system? Friedman and Hayek proposed different reforms of the monetary regime. (Actually, over the course of his career, Hayek alone proposed a variety of reforms, as did Friedman.) Friedman (1969), in his “optimum quantity of money” proposal, famously suggested fastening a monetary policy rule on the central bank to mimic a competitive rate of return on government-issued money. Hayek (1976) proposed allowing actual free-market competition among private monies. Friedman later moved in Hayek’s direction (Friedman 1987, Friedman and Schwartz 1986), reconsidering his own earlier skepticism toward private currency, though for good reasons he did not embrace Hayek’s specific scenario of private fiat-type monies. My own view is that the most plausible free banking system is one resting on a commodity standard, particularly a silver or gold standard.
In the last thirty years we have also made progress in banking. The US banking system is no longer in crisis. You may remember that there were so many bank failures in the 1980s that the FDIC ran out of money and had to arrange a $90 billion credit line from the Treasury. It looked like we were in for a banking industry fiasco on the order of the $150 billion savings and loan industry fiasco. Unfortunately, it didn’t happen. I say “unfortunately” – tongue in cheek – because in 1991 I helped organize a conference on “The Crisis in American Banking”. The conference volume (White 1993a) came out two years later. Bad timing. The failure of a major US bank, say Citibank, really would have helped to spur my book sales. But by 1993 the banking industry was enjoying healthy profits. The main reasons for the turnaround were that nominal interest rates receded from their very high levels and that the spread between short rates at which banks borrow and the longer rates at which they lend (the “yield curve”) returned to normal width. The reason for the S&L and banking crises was basically the high nominal interest rates resulting from the inflationary monetary policy of the 1980s (together with some moral hazard from deposit guarantees). The reason for the return to normalcy was basically that the inflationary monetary policy abated, and by 1993 the recession that accompanied the transition to lower inflation had ended.
Banking deregulation, though partial, has been a political success and an economic success. Deposit interest rates are now free, interstate branching is allowed, activity restrictions (the Glass-Steagall Act) have been partially relaxed. Computerized “sweeping” of account balances into has made reserve requirements effectively non-binding. The FDIC has been reformed, though deposit “insurance” remains arbitrarily “priced” because there is no competitive market. There remain regulations to repeal: the Community Reinvestment Act, the Home Mortgage Disclosure Act, and – if I may dream – the Federal Deposit Insurance Act. While I’m dreaming, I would also like to repeal the Federal Reserve Act and the National Banking Acts, which brings us back to monetary policy.
The most-discussed proposal these days for monetary policy reform is “inflation targeting”. Inflation targeting doesn’t abolish the central bank, and doesn’t even fasten a strict rule on it. But – seeing the glass as half-full rather than half-empty – it is a step toward a rule constraining the central bank, and constraining the central bank is a step toward doing without it.
Given that economists generally recognize the self-regulating properties of markets, why don’t more economists embrace the ideal of a market-based monetary system? Or to put it another way, Why do fewer economists support free banking than support free trade? Among market-friendly economists, few have even addressed the question. Money-and-banking textbooks, remarkably, almost never address the most fundamental question of monetary policy: why should government be involved in the monetary system in the first place? Economists who have remarked on the question have offered several rationales for rejecting reliance on market mechanisms in money. I think the rationales are mistaken, so their proponents might accuse me of misunderstanding, but I will try to describe them fairly.
I have elsewhere tried to catalog and critically analyze the technical arguments that economists have offered for considering money and banking to be “public goods” or sources of important “external effects” or subject to “natural monopoly”. The intuitive core of these arguments is the notion that money is not the ordinary kind of good that markets provide efficiently.
Economists favor free trade in other goods because they recognize that freely competitive markets coordinate the desires of producers and consumers. Free trade creates a recurring order: a market-clearing price is established every day. Guided by market prices, each producer specializes in that good or service where he has a comparative advantage. Driven by profit-seeking entrepreneurial efforts to buy where the price is low and sell where the price is high, the price system moves resources and products to their highest-valued uses. Some aspects of money, by contrast, have characteristics of a cumulative order, emerging from forces that build and select institutions over time. Israel Kirzner (1992) has cautioned us that an economist familiar with the beneficial logic of goods allocation need not believe that there is a similar beneficial logic of institutional evolution. The economist may grant that via the market process some commodity will spontaneously emerge as money, but worry that it may not be the right commodity. He may regard the monetary system, like the legal system, as part of the institutional framework of the market economy – a necessary precondition for rather than a result of successful markets. This approach is typically implicit in discussions of the “best design” for a “monetary constitution”.
Fortunately there is, in fact, a beneficial logic of institutional evolution in monetary arrangements. We can see its operation historically where governments did not interfere. Not only did a commonly accepted medium of exchange emerge without central design, but the choices made by money-users favored more suitable commodities (more durable, divisible, portable, uniform, and stable-valued) for the role of hand-to-hand medium over less suitable commodities. Payment products and institutions – coinage, transferable deposits (with fractional reserves), banknotes, clearinghouses – evolved through market forces to lower the costs of holding and using commodity-based money.
David Laidler (2005), in an thoughtful recent paper considering free banking, worries about natural monopoly in the banking industry on a commodity money standard: “the centralizing tendencies in reserve holding inherent in banking systems would undermine its competitiveness.” He writes:
Though it [the free-banking argument] makes a plausible case that such a system would be capable of providing a good measure of monetary stability, based on commodity convertibility kept in place by the self-interest of individual banks, the key role it assigns to the clearing system and the centralization of reserves there seems to imply that such arrangements are prone to a natural-monopoly problem. Access to the business of banking on a competitive footing would appear to depend upon access to the clearing system, and in an exercise in conjecture such as we are here pursuing, it is surely fair to ask whether some form of government intervention might not be called for to regulate the clearing house.
If Laidler’s conjecture – which I take to be that clearinghouse members will successfully act as a joint monopolist in pricing deposits and loans – were correct, it would at most call for a requirement that the clearinghouse not exclude potential members based on their pricing policies. But fortunately the conjecture is false. While history records attempts by private clearinghouses to form cartel agreements, it does not to my knowledge record their success in getting them to stick. When the Suffolk Bank of 1840s Boston – a profit-seeking bank that was also a clearinghouse for notes – charged monopoly prices for its clearing services, the banks that had been its clients organized their own cooperative arrangement, the Bank for Mutual Redemption. Even where there is only one clearinghouse, the market appears to be contestable.
Milton Friedman (1960, pp. 4-9) once argued that money is a “technical monopoly” in a different sense: competition would drive the value of money to zero, so a viable system needs a single issuer. There is some truth to that proposition with respect to fiat money. If we were to allow free entry into the issue of unbacked dollars – if everyone were free to counterfeit dollar bills, in other words – that “competition” would drive the value of the dollar note down to the cost of its paper and ink. But the proposition doesn’t apply to commodity money. The performance of a silver standard (say) is enhanced and not impaired by competition among many silver mines, many silver coin mints, and many issuers of silver-redeemable notes and deposits. The fact that the issue of fiat money may be in some sense a natural monopoly good can’t be a rationale for preferring government-produced fiat money over market-produced commodity money. (It only rationalizes the position that if we rely upon a fiat money, we shouldn’t let it be counterfeited.) Such a preference must lie elsewhere.
A common argument for a fiat standard over a commodity standard is that a fiat standard incurs smaller resource costs. I have argued elsewhere (White 1999, ch. 2) that Milton Friedman’s oft-cited estimate of the resource cost of maintaining commodity reserves (2.5% of national income), because it assumes 100% reserves against all bank deposits, exaggerates the cost of a free-banking commodity standard by a factor of 50. A more reasonable estimate places the cost at about the estimated deadweight cost of a 4% inflation rate. Wherever fiat money inflation rates would average above 4%, then, the resource costs of a commodity standard are the less expensive option.
Two further points about gold. (1) Economizing on resource costs was not the reason the United States left the gold standard. The US left in stages – at the initiatives of Presidents Franklin Roosevelt and Richard Nixon – in order to free the Federal Reserve System from the constraint on its money creation entailed by its obligation to redeem dollars for gold. (2) As Laidler (2005) notes, one can favor free banking without embracing a return to gold. Some recent proposals for free banking rest on basket-of-goods standards (without holding of physical reserves), or – as Friedman has now favored for many years – a continuation of the fiat dollar but a permanent fixing of its quantity. I will say a bit more about that proposal below.
Probably the main obstacle to free banking opinion is the set of views holding that a central bank is necessary and desirable. I don’t want to accuse anyone of anything more than intellectual error, but perhaps that view is promoted by the fact that central banks subsidize monetary policy research. The Federal Reserve System employs over 400 research economists on its staff, and subsidizes hundreds of academic economists each year as visiting scholars and consultants. Tariffs employ many fewer economists and have many fewer defenders.
Nonetheless the myths about historical record of free banking have become less prevalent. David Laidler (2005) offers the following verdict:
An extensive literature reexamined various episodes in monetary history, and … established beyond reasonable doubt that a great deal of what economists had previously thought they knew about certain crucial facts of monetary history was at least as much the result of viewing them through the prism of conventional views about the inherent instability of systems unfortunate enough to lack central banks as it was of a dispassionate weighing of the evidence.
That is, historical episodes of free banking didn’t have the problems that the advocates of central banking have supposed. Based on a variety of free banking case studies, I have previously summarized the historical record of in three lessons: Freedom to issue banknotes does not cause inflation of the money supply or of prices. Unrestricted competition among banks does not destabilize the banking system. Banking is not a natural monopoly.
Reviewing the Scottish experience with free banking, Randall Kroszner (1997) has helpfully enumerated further lessons that may surprise those who take the present-day status quo for granted:
- Competition is compatible with prudence and coordination
- Feasibility of sophisticated note and deposit contracts
- Importance of free entry to promote innovation
- Branching and portfolio diversification can substitute for deposit insurance
- “Extended” liability can substitute for deposit insurance
- “Option clause” and equity-like contracts can substitute for deposit insurance.
Kroszner notes that his argument “amounts to a conjecture that, as a general matter, market mechanisms, left to themselves, are capable of creating a stable monetary system unaided by the activities of government, beyond those aimed at providing a legal framework of well-defined property rights buttressed by sanctions against theft and fraud.” The fact that Kroszner could be appointed to the Federal Reserve Board of Governors after expressing this conjecture is perhaps more evidence that the economics profession is no longer so convinced that free banking is crazy.
Contemporary evidence on the workability of unregulated banking (at least deposit banking) can be gained by looking at its closest current approximation, the offshore banking market. Offshore banks in place like the Cayman Islands and the Bahamas are nearly unregulated by their host islands: no deposit insurance, no capital requirements, no interest rate ceilings, no portfolio restrictions, no community reinvestment quotas. There have been no crises. Because they are uninsured, offshore banks – which are mostly subsidiaries of well-known American and European banks – must behave prudently to attract depositors. And they do.
That a central bank is necessary and desirable is a prejudice, not a lesson taught by the actual historical record. So why are there still fewer free bankers than free traders? Laidler comments: “What really consigned [free banking ideas] to the fringes of intellectual respectability was the development of a consensus that monetary policy was an essential tool of a generally interventionist macroeconomic policy.” Here there is room for optimism, because the consensus is not what it once was. It is safe to say that economists as a group have given up much of their former wishful thinking about usefulness of clever monetary policy.
For testimony, here is how Ben Bernanke and Frederic Mishkin (1997, p. 104) explain economists’ attraction to inflation targeting:
Developments in macroeconomic theory also played some role in the growing popularity of the inflation targeting approach. These familiar developments included reduced confidence in activist, countercyclical monetary policy; the widespread acceptance of the view that there is no long-run tradeoff between output (or unemployment) and inflation, so that monetary policy affects only prices in the long run; theoretical arguments for the value of precommitment and credibility in monetary policy (Kydland and Prescott, 1977; Calvo, 1978; Barro and Gordon, 1983); and an increasing acceptance of the proposition that low inflation promotes long-run economic growth and efficiency.
A free-banking system, guided by impersonal market forces and anchored by convertibility (a gold standard or something like it), would bar the activist “counter-cyclical” policy that, despite the best of intentions, has done more to exacerbate than to dampen business cycles. It would lower inflation by eliminating its source in central bank monetary expansion. Free banking would foster macroeconomic stability in both senses, as Laidler nicely puts it, “not because anyone would set such a goal, but because the self-interested behavior of the individual banks would generate it.”
If it seems utopian to think that any national government would give up its central bank, note that many already have. Twelve nations in Europe use a single currency, the euro, whose quantity is outside any one country’s control. (Granted, it is controlled by a multinational central bank.) More counties in central and eastern Europe are eager to give up their own monetary policies and join the arrangement. A similar common currency arrangement, to be launched in 2010, is being planned among six countries of the Persian Gulf. In Latin America, Ecuador and Costa Rica have joined Panama in adopting an external currency, the US dollar.
The most likely candidates for adopting free banking are naturally those nations that have made the biggest botch of monetary policy (countries with a history of hyperinflation), and new nations – say, a Quebec that has seceded from Canada – whose fiat money lacks credibility. As David Glasner (1995) summarizes the argument:
A private issuer of inside money has more credibility than a sovereign issuer of inside money, because people generally understand that a sovereign has less to lose than a private bank by reneging on a convertibility commitment. A defaulting bank forfeits its assets to its creditors while a devaluing sovereign forfeits only its reputation.
To which I would add: a monopoly central bank has far less concern for its reputation than does a private commercial bank in a competitive environment. Concern for reputation will deter the private bank from pursuing policies inconsistent with its convertibility commitment, because otherwise it will lose its customers. By contrast, even a major blow to its reputation won’t lose the central bank its captive clientele. The central bank can devalue with impunity. As Glasner notes: “even a currency board cannot prevent a government from devaluing if that is what the government decides to do.”
The argument for the necessity of a central bank most often invokes the need for an official lender of last resort. In a recent letter to Greg Mankiw, Milton Friedman (Mankiw 2006) writes:
Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.
Even better would be to abolish the Fed and mandate the Treasury to keep highpowered money at a constant numerical level.
The call for freezing the monetary base and abolishing the Fed is consistent with what Friedman has been saying since 1984. Regarding the base freeze proposal, Mankiw (2006) immediately raises the lender-of-last resort objection:
I would have thought that the experience of the 1930s argues against such a rule. If I recall correctly, most of the decline in the monetary aggregates during that period was attributable not to high-powered money but to inside money and the money multiplier. If we abolished the Fed and kept high-powered money constant, it seems that a similar set of events could potentially unfold.
Mankiw is correct that inside money (bank deposits) and the money multiplier declined sharply in the 1930s. Why did it decline, and could a repeat of the disaster occur if we abolish the Fed? It is well known that the proximate cause was bank runs and fear of more bank runs. Fearful of bank runs, the public withdrew base money from banks to hoard at home, reducing the volume of bank reserves available to support deposits. The banks cautiously held larger reserve ratios, creating fewer deposits per dollar of remaining bank reserves. But why were there runs? It is not widely appreciated that the underlying reason for the bank runs was geographic and note-issue restrictions that make US banks unnecessarily fragile. There were no bank runs in Canada, which had neither restriction. Fortunately, the US no longer has the geographic restrictions. It still has note-issue restrictions, but would not have them under free banking.
Friedman’s brief letter neglects to mention an important adjunct to his base-freeze proposal, which is that an increase in the public’s demand to hold currency could be accommodated by letting commercial banks freely issue currency redeemable for base money (see Friedman 1987). With well-diversified banks freely supplying currency, there is no reason for a collapse of the money multiplier to occur.
References
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