Front Page Titles (by Subject) 10: Miscellaneous Criticisms of Free Banking - The Theory of Free Banking: Money Supply under Competitive Note Issue
The Online Library of Liberty
A project of Liberty Fund, Inc.
Search this Title:
10: Miscellaneous Criticisms of Free Banking - George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 
The Theory of Free Banking: Money Supply under Competitive Note Issue (Lanham, MD.: Rowman & Littlefield, 1988).
About Liberty Fund:
Liberty Fund, Inc. is a private, educational foundation established to encourage the study of the ideal of a society of free and responsible individuals.
This title has been put online with the permission of the author.
Fair use statement:
This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.
Miscellaneous Criticisms of Free Banking
The preceding chapters addressed the major, traditional criticisms of free banking. They showed that free banking is not inflationary, that it does not promote monetary disequilibrium, that it does not allow undesirable fluctuations in the value of money, that it is not otherwise unstable or especially subject to runs and panics, and that it does not use resources inefficiently.
But some criticisms of free banking still need to be discussed. Many lack substance, being products of conventional wisdom. Other, more sophisticated criticisms are that free banking encourages fraud, that it inhibits economic growth, that it is inconsistent with full employment, that note issue is a natural monopoly, that the production of money is a public good, that there are externalities in the production or consumption of money that cause its competitive supply to be deficient or excessive, and that a banking system needs a lender of last resort. Finally, some criticisms of free banking are based on considerations of expediency; they refer, not to any theoretical shortcoming of free banking, but to the claim that free banking is unpopular, politically unacceptable, or difficult to implement and hence impractical as a means of reform.
Criticisms from Conventional Wisdom
The first criticism we must consider, based on conventional wisdom, holds that free banking cannot be desirable because, were it desirable, it would have been adopted long ago; at least there would be no such widespread support for central banking as currently exists among theorists and policy makers.1 This poses a form of argument by authority, and would not merit attention were it not the major reason why free banking is not considered a serious alternative for monetary reform.
In response it must be said that the vast majority of economists, including monetary economists, have never given serious thought to the possibility of free banking: they take centralization for granted, not because they have compared it with free banking and found it superior, but because they are unfamiliar with free banking and because they prefer to study money and banking as they find them in economies today. Also, economists are prone to make the unwarranted assumption that legislation and institutions are generally sponsored by considerations of social welfare. The truth, as we have seen, is that many central banks are an outgrowth of monopoly banks of issue established by governments anxious to monetize their debt but not particularly interested in promoting monetary stability. Furthermore, in many places centralized banking prevailed only after a struggle, with respectable theorists participating on both sides.2
A related criticism holds that central banking has triumphed because free banking has historically failed to work. This claim, as chapter 1 showed, is simply false. Though episodes of free banking have been rare in history, where they occurred (as in Scotland, Sweden, China and, to a less complete extent, Canada) the evidence does not indicate that they were replaced because they were not functioning well. On the contrary, the record of these systems was quite favorable. The test they failed was political, not economic.
Banking in the United States in the first half of the 19th century is often cited as an instance of the failure of laissez faire. This, too, is incorrect: the free banks that are supposed to have performed so poorly throughout this era were not truly free at all.3 They are more accurately called “bond deposit” banks because of the special security needed for their note issues. State laws also prohibited them from forming branch networks that would have added to their stability and efficiency. Comparing the theoretical implications of these restrictions to the actual performance of America’s “free” banks shows the U.S. episode to be evidence, not of the shortcomings of free banking, but of the shortcomings of regulations.
Another common argument against free banking is that note issue is a government prerogative. Drawing a parallel with coinage, the argument claims that, because coinage has everywhere for centuries been a prerogative of government, the issue of currency should also be subject to government control. But the analogy to coinage is not persuasive. Even if governments must monopolize the production of coins it does not follow that they must monopolize currency. Otherwise one might with equal reason argue that the government should monopolize the production of checkable deposits and other financial assets, since these have as much in common with paper currency as it has with coin. Of course, very few theorists argue for nationalization of deposit banking. They see a crucial difference between deposits and bank notes. Still, it must be shown that the difference is crucial enough to warrant nationalization of one but not the other, and a mere analogy with coinage does not do this.
Even if the analogy of bank notes with coin were airtight, it would justify nationalization of currency production only if the government’s coinage prerogative were itself justified. Yet no convincing argument exists to show that private coinage is inefficient. Jevons’s argument for government coinage—one of the only attempts to give theoretical justification to this institution—which criticized Herbert Spencer’s defense of private coinage,4 is based on a misunderstanding of Gresham’s Law. Jevons (1882, 64-65) wrote that “if coining were left free, those who sold light coins at reduced prices would drive the best trade.” He failed to see that there is no more reason for sellers “of light coins at reduced prices” to be preferred to sellers of heavier coins at higher prices than there is for sellers of milk at 75¢ a quart to be preferred to those selling it at $1.50 a half-gallon. If consumers show a preference in such cases, it must be for size rather than quality. Such preferences have nothing to do with Gresham’s Law that “bad money will drive out good money,” to which Jevons tried to appeal. Indeed, it is only when light coins do not sell at reduced prices relative to heavy coins—that is, if their exchange rates are not allowed to reflect their lower metallic content—that Gresham’s Law takes effect. This would not happen in a free market where exchange rates reflect consumer preferences.
Empirical evidence also disputes the argument that governments must monopolize production of coin. As we observed in chapter 2, the first coins were produced by private mints rather than governments, and there is no evidence that government issues when they appeared were superior to private ones.5 Instead, the government prerogative in coinage required the use of force to outlaw private competitors whose issues the public preferred.
The coinage monopoly of the United States government has been challenged on several occasions. The gold coins of Templeton Reid of Georgia—which actually had a bullion value slightly above their face value—and the gold Bechtler coins of North Carolina—minted in the 1830s and still in circulation half a century later—competed successfully with coins produced by nearby Federal rivals, and the Bechtler coinage (over three million dollars worth) was for some time the favored money of the mid-Atlantic states.6 During the California gold rush at least fifteen private mints struck coins to satisfy a demand that would otherwise have gone unfulfilled due to the absence of any government mint. Some of them produced inferior coin, but those that did so fell rapidly into disrepute and were outcompeted by other firms such as Moffat & Co., Kellogg & Co., and Wass, Molitor & Co. The latter firms enjoyed excellent reputations (in addition to tacit government approval) even though private coinage had become a misdemeanor in California law after April 1850 (Adams 1913, xii).
One of the last American private mints, Clark, Gruber & Co., operated between 1860 and 1862 and produced high-quality gold coins often superior to United States coins of like denomination. In its two years of existence, it produced approximately $3,000,000 of coin and threatened to rob the Federal mints of a substantial part of their market. To guard against this the government bought the mint out in 1863 for $25,000 (Watner 1976, 27-28). Two years later the Federal government passed a law prohibiting all private coinage.
Fraud and Counterfeiting
A more substantive argument against free banking is that it is prone to fraud. Thomas Tooke, in his History of Prices, endorsed the opinion of an anonymous American writer that “free trade in banking is synonymous with free trade in swindling” (Tooke 1840, 205).7 Milton Friedman, who has since modified his views on this subject, was only slightly more charitable in A Program for Monetary Stability. He claimed that bank note contracts “are peculiarly difficult to enforce”:
The very performance of its central function requires money to be generally acceptable and to pass from hand to hand. As a result, individuals may be led to enter into contracts with persons far removed in space and acquaintance, and a long period may elapse between the issue of a promise and the demand for its fulfilment. In fraud as in other activities, opportunities for profit are not likely to go unexploited. A fiduciary currency is therefore likely . . . to be overissued.8
To support his argument, Friedman referred to the occurance of fraud during the so-called “free banking” era in the U. S. We have already seen why many inferences concerning free banking drawn from this episode are inappropriate: American “free banks” were regulated bond-deposit banks, and bond-deposit requirements, rather than anything inherent in free banking, were responsible for the worst episodes of fraud.9
The substance of Friedman’s argument is also defective. It seems to say that because money (i.e., commodity money) must be generally acceptable, so must bank notes. It is true that banks, in order to stay in the business of note issue, must establish a fairly wide market for their notes, but no bank when it first begins business is presented with such a market as a given. Every bank must slowly construct a market for its notes by consistently honoring its promises. Some banks might establish their reliability in the businesses of lending and deposit administration, using this as a way of securing entry into the market for notes. In any event a bank is likely to have to make a considerable investment in brand-name capital before its notes can travel to persons “far removed in space and acquaintance” who will unhesitatingly accept them. The circumstances are not especially favorable to fraud. This is not to say that fraud will not take place, but only that there is no reason to believe that it will happen more regularly than in a system of deposit banks. Indeed, the danger of fraud is likely to be greatest under monopolized banking: a monopoly bank of issue can defraud its customers with impunity, especially if it is aided by a suspension of payment sanctioned by the government. History bears evidence to this time after time.
Connected to the idea that free banks will be prone to fraud is the belief that their notes, once issued, will circulate for long periods before being returned as clearings which will test the reliability of their issuer.10 This delay between issue and reflux is supposed to invite swindlers, who can use it as an opportunity to escape to some far-off hideaway.
This argument compounds the error of assuming that bank notes of uncertain reputation are readily put into circulation by suggesting that their acceptance will be so general that few persons will discriminate against them by exchanging them for liabilities of other banks. But passive acceptance is not likely to take place where note issue is competitive, even for the notes of well-established banks: diverse consumer preferences as regards notes from various issuers will cause the average circulation period for notes of any single issuer to be fairly short. In 1873 (when, due to the influence of the Bank Act, the Scottish system was undergoing substantial consolidation) the average period of circulation for a Scottish bank note was still only 10 or 11 days (Somers 1873, 161). It may have been even shorter at the height of the free-banking era, when Scotland had twice as many note-issuing institutions. If one considers the same degree of competition combined with modern means of communication and transport it is easy to see how the delay would be still shorter. In fact, for note issues in excess of demand there is no reason to assume a delay or float period exceeding the average float period for checks written in an unregulated system. The error of authors who assume that notes would behave differently may stem from improper generalization from the behavior of currency in a centralized system. The currency of a monopoly bank of issue will be returned to its source less frequently than currencies that are not high-powered money.
That competitively issued notes would have brief circulation periods also undermines the charge that free banking would promote counterfeiting, a particular form of fraudulant note issue. The likelihood of detection of counterfeit notes is inversely related to their average period of circulation. It rises with the frequency with which the notes pass under the specially trained eyes of tellers at the legitimate bank of issue. Counterfeiting should therefore be less lucrative and less tempting under free banking than under monopolized note issue. Experience confirms this. According to Emmanuel Coppieters, during the free-banking era Scottish bank notes, which had a short period of circulation, were rarely forged or counterfeited, whereas Bank of England notes—which circulated for long average periods or even indefinitely—were forged continually.11
A final argument concerning fraud claims that sellers of goods or services cannot possibly scrutinize all the notes offered to them in exchange, even though they are bound to accept notes that are not really familiar to them. This is supposed to invite overissue.12 This argument misconstrues the nature of the checks against overissue under free banking. Individuals do not need to keep informed of the reliability and solvency of all the diverse banks of issue whose notes might be offered to them. They only need to be convinced of the reliability and solvency of the bank with which they do most of their business, and to accept at par in addition to that bank’s notes only those notes that it will accept (for deposit or redemption) at par.13 Thus proximate responsibility for the testing or monitoring of note issues falls, not upon the public, but upon the rival issuers themselves. That no non-bank individual wishes to take on this task does not, therefore, mean that it is a public good which the private market would not supply.14
Restriction of Economic Growth and Full Employment
Another argument sometimes made against free banking is that it may restrict economic growth.15 F. Crouzet (1972, 46fn), in disputing the claims of Rondo Cameron, has claimed that this was the case in the Scottish system.16 But his claim has been convincingly answered by Munn in the latter’s study of the provincial banking companies (1981, 229-33). Even the halfhearted American experiment in “free banking”—with all its restrictions against branch banking and note issue—does not seem to have frustrated economic growth in any discernible way.17 New England, which for most of the first half of the 19th century had the least regulated banking system in the U.S., witnessed the greatest industrial progress. Sweden and Canada also prospered during the era when their banks were relatively unregulated and free to issue notes. Freedom of note issue seems, if anything, to promote economic growth.
Still, examples from history do not completely settle the issue. The real question is whether the amount of lending and investment financed by a free banking system would be greater or less than it ought to be to promote maximum sustainable economic growth. Most theorists agree that a banking system should utilize all voluntary savings made available to it, without creating credit in excess of voluntary savings which causes monetary disequilibrium.18 The limits of a banking system’s contribution to economic growth then become a function of its efficiency in attracting and investing private savings. We have already seen in the last part of chapter 4 that free note issue does not interfere with the efficiency of intermediation. We may conclude from this that free banks do not inhibit economic growth, either.19
Related to the issue of economic growth is that of full employment. Earlier it was shown that free banking maintains equilibrium in the market for inside money. For this to be regarded as inconsistent with full employment the latter must be supposed to require either deflation, meaning changes in the supply of inside money such as will result in sustained excess demand for it, or inflation, meaning changes in supply such as will result in sustained excess supply. No economists believe that full employment requires deflation. Some Keynesians do believe that it requires inflation. Their views have, however, been the object of mounting criticisms by economists of the Monetarist, New Classical (Rational Expectations), and Austrian schools.20 These theorists have pointed out that the alleged inflation-unemployment tradeoff to which many Keynesians refer assumes that firms or their employees suffer from long-run money illusion. Such a dubious assumption does not constitute a strong basis for rejecting free banking.21
Money Supply as Natural Monopoly
Another argument against free banking holds that the issue of currency is a natural monopoly.22 This implies that a single banking firm is more efficient in supplying the demand for currency than any combination of smaller firms. But once a firm achieves a monopoly of currency supply, its issues are not limited by adverse clearings, and it can exploit its monopoly of currency supply by overissuing. Therefore the monopoly bank has to be regulated, or a government-controlled bank has to be erected in its place.
Although a monopoly in currency supply allows the monopoly bank to escape adverse clearings in the short run, for such a monopoly to be “natural,” that is, for it to represent a stable market equilibrium, it must be able to maintain its notes in circulation more efficiently than rival firms in an environment of free entry where adverse clearings result in demands for its reserves. In other words, the average costs of maintaining notes in circulation, i.e., of building a market for currency holding by the public so that adverse clearings are avoided, must be declining with scale or at least subadditive.23 For a single bank to gain a monopoly of note issue it is not sufficient that banking involve substantial fixed costs, with relatively small marginal costs, from issuing additional notes. The bank must also take steps to improve the popularity of its notes relative to commodity money or relative to notes of other banks, or it must suffer the expense of redeeming them soon after their issue. If the costs to the bank of extending the market or of redemption rise rapidly enough at the margin,24 its average costs per unit of outstanding currency will rise above the minimum level long before the point at which it would saturate the market for currency. In this case the industry cannot be considered a natural monopoly, and no single firm will be able to avoid the consequences of rivals establishing their own circulations and returning its excess notes to it for redemption.
An error sometimes committed in considering the natural monopoly question is to assume that the only marginal costs of currency issue are the cost of paper and ink, which do not rise significantly at the margin and may even fall due to economies of large-scale purchasing. This implies that banks face an inexhaustible demand for their notes, or that they will not be asked to redeem them in base money. But, where notes are convertible, this can happen only if the issuer has a monopoly of currency supply to begin with—one based, for example, on special legislation prohibiting the entry of other note-issuing banks that might redeem their rival’s issues.25 To assume the existence of a monopoly in currency supply in order to explain its “natural” occurrence obviously begs the question.
Allowing that there are costs of maintaining a note circulation (including, but not limited to, marketing and liquidity costs) which individual firms must reckon with, the possibility of natural monopoly still exists, but its plausibility is much diminished. There is no strong a priori case for the view that competition in currency supply will lead to the emergence of a single bank of issue.
What, then, does the empirical evidence suggest? Simply this: that throughout the experience of both Europe and America the tendency under unrestricted entry has always been toward a plurality of note-issuing banks.26 The appearance of monopoly banks of issue in these areas has in every instance been due to legislation restraining rival issuers by limiting their issues, imposing special capitalization or geographical constraints upon them, setting up barriers to new entry, or overtly and directly forcing them out of the issue business altogether. Where such measures were not taken no obvious tendencies toward monopolization were seen.27
Even if the natural monopoly argument were valid it would not justify erecting barriers to entry in the note-issue business. If the issue of currency is indeed a natural monopoly the monopoly bank should be be able to employ its advantage in production (an advantage which it must maintain even as competitors threaten to return its issues for redemption) to discourage or outcompete any rival that might enter into competition with it.28 In the meantime, the potential entrants encourage the monopoly issuer to operate as efficiently as possible while standing ready to supplement its output in case it should fail to fulfill entirely the needs of the public.
To support their claim that currency production is a natural monopoly, which to them constitutes a rationale for limiting entry into the business of note issue, Michael Melvin (1984, 13-14) and Benjamin Klein (1978) argue that confidence building is more costly for private issuers than it is for government. Melvin writes that “the history of money production observed over the past 2,000 years is likely due to economic efficiency and not to 2,000 years of ignorance or coercion.” Despite what Melvin considers likely, the facts show that government monopolies in money production have everywhere been achieved by coercion: governments have outlawed private coinage, passed forced-tender laws, restricted private and incorporated banking, prohibited branch banking and note exchange, taxed bank notes out of existence, passed bond-deposit legislation, refused to enforce redemption contracts, and imposed exchange controls. All of these measures discouraged private, competitive production of money while encouraging production by governments. Most were undertaken to aid the monetization of government debt, which means they were undertaken precisely because confidence in governments was too low to allow them to obtain funds through normal channels.
Nor has confidence in government currencies been enhanced by their performance over time. The record of all has been one of eventual depreciation. Examples of government-issued currency out-competing privately issued ones without having to outlaw or otherwise restrict them are rare.29 Yet there have been numerous episodes in which private currencies have competed successfully with state issued ones. For instance, the American state-bank note issues of 1863-1865 competed successfully against greenbacks and against the government-bond based issues of nationally chartered banks. The government responded to this successful competition by imposing a prohibitive 10 percent tax on state bank notes. Another example is the plural note-issue episode of Sweden, in which private issues, despite barriers thrown in their way by the Swedish government, successfully challenged the note-issue monopoly of the Riksbank.30
If the reasoning of Klein and Melvin proves anything at all, it proves too much, because most of the costs expended by note-issuing private banks in gaining the confidence of potential customers are also expended by deposit banks: once a bank has established the reliability of its checkable deposits the additional costs of building confidence in its note-issues are not especially great. If governments are more efficient in building confidence, why restrict their prerogative to currency issue? Why not extend it to deposit banking as well? By the same token, why permit traveler’s checks to be competitively supplied if the government should be able to supply them at lower cost?
Yet another point against the natural monopoly argument is that, if it is valid, another argument used historically to justify government regulation and monopolization of currency supply must necessarily be false. This is the argument that free banking leads to a proliferation of banks of issue and to a bewildering variety of note brands. If the natural monopoly argument is correct, then multiplication of bank-note brands could not be a long-run consequence of free banking.
Finally, mention should be made of the view that money production is shown to be a natural monopoly by the fact that consumers benefit from having a common medium of exchange. This confuses two issues, one being whether the market tends to adopt a single unit of account (e.g., an ounce of gold or a pound of silver) and the other being whether the production or issue of material representatives of this standard unit is most efficiently undertaken by one or several firms. Our review of the evolution of money in chapter 2 made clear that adoption of a single standard monetary unit does not imply that production of money is a natural monopoly. The relation between the monetary unit and actual money—its material representatives—can be likened to that of a standard unit of length, such as the yard, and its material embodiment, the yardstick. The yard is a standard unit of measurement throughout the United States; one can call this a “natural monopoly” if one likes, but such a label would be irrelevant since yards are not objects of production or exchange, and what is not produced or exchanged cannot be produced or exchanged inefficiently, by a monopoly or otherwise. The same is true of other standards—such as shoe sizes and rules of spelling. Only when it comes to material embodiments of these standards, namely, yardsticks, shoes, and dictionaries—does the question of natural monopoly arise. In the case of money, it is evident that the existence of a gold standard does not mean that gold coin, and media convertible into gold coin, cannot be competitively produced. The mere fact that the market promotes the emergence of a single monetary standard does not give any validity whatsoever to the natural monopoly argument.
Public Good and Externality Arguments
Two more criticisms of free banking are closely related to the natural monopoly argument. One holds that inside money (and currency especially) is a public good because it exhibits either non-rivalrousness or nonexcludability in consumption, which make its private production in desired quantities unprofitable and hence impossible.31 The other holds that there are externalities in inside-money production because (a) producers do not bear all the costs of it, so that profit-maximizing competitive producers will issue more inside money than the amount that equates marginal social cost with marginal revenues; or (b) that benefits from inside-money issue are not fully reflected in bank earnings, so that competing issuers will underproduce.32
Is it true that inside money exhibits nonexcludability in consumption, so that some people may act as “free riders,” sharing in the benefits from money balances that others have made sacrifices to acquire? Is the use of inside money by any one person nonrivalrous, so that others beside him enjoy the yield of services accruing from his balance (but without reducing his own return)? The answer in both cases is no, because a particular sum of inside money renders its service—increased purchasing opportunities—only to those who actually possess it. Those who refuse to do without other forms of wealth or who do not abstain from consumption (by holding inside money instead of consuming a flow of services from goods) cannot take advantage of the benefits associated with inside money. Of course, the same cannot be said of the standard money unit (the unit of account). But we have already seen that this is irrelevant, since the money unit is not itself an object of production, and since, in any event, the market (rather than government) was responsible for the original emergence of widely used monetary standards.33
Are there, then, costs associated with the issue of inside money that are not borne by competitive suppliers and which therefore imply competitive overproduction? Some possibilities that come to mind are costs of monetary disequilibrium, price-level effects, and fallen confidence. We have already seen in chapters 3 through 9 that free banking promotes neither monetary disequilibrium nor confidence externalities. Moreover, if confidence externalities did arise under free banking they would not necessarily be Pareto-relevant: each bank has an incentive, under the circumstance, to support any solvent rival suffering a run. In this case the externality is appropriable, which means that it is not Pareto-relevant—that is, not a source of market failure—and hence not grounds for rejecting free banking.34 Those price-level effects that free banking would allow are also not Pareto-relevant, so they do not provide a rationale for regulation either.35
Another possible criticism of free banking comes from Milton Friedman’s “optimum quantity of money” argument.36 This holds that the benefits from money holding are maximized when the marginal gain from money holding (the nonpecuniary service yield from an addition to money balances) is just equal to the marginal social costs of producing money balances, which are assumed to be close to zero. But the private cost of adding to money balances is equal to the interest rate on alternative assets, which typically exceeds the near-zero social costs of money production. Under such conditions the public will hold a less than optimal quantity of money. As Friedman observes, the problem can be seen as involving external effects of money holding, since individuals must forego real resources to add to their balances, but produce a windfall gain to other money holders in doing so.
To induce the public to hold an optimal quantity of money, steps have to be taken to eliminate the discrepency between the equilibrium marginal service (liquidity) yield from holding money balances (L) and the social cost of producing such balances (assumed = 0). If rc is the rate of interest on alternative, non-money assets, the suboptimal solution is where L = rc > 0. On the other hand, money holdings will be optimal only if L = 0. The latter result can be achieved in two ways, either of which involves supplementing the nonpecuniary service yield on money holdings with some additional pecuniary return. In the solution recommended by Friedman the additional return takes the form of a capital gain on money holdings, based on a fully anticipated, steady rate of price deflation equal to the real rate of interest on capital . In equilibrium this gives
The other solution is to pay explicit interest to money holders (rm), with the level of prices assumed unchanging, equal to the rate of interest on capital (rc) minus any costs of administering and maintaining the money supply (here assumed = 0). In equilibrium this gives
L = rc - rm = 0.
In the first solution, the addition to real money balances is accomplished by “crying down prices” with a fixed nominal money supply. In the second, the increase consists of an addition to nominal money holdings, with prices unchanged.
The question is, does a free-banking system succeed in promoting optimal money holding by either of these means? The answer is that it succeeds in part, but perhaps not entirely. Only inside money is held in a mature free-banking system, and a large fraction of this money is deposit money. Free banks are driven to pay competitive rates of interest on such deposits, which prevents the deposits from being held in suboptimal quantities.37 This leaves the possibility that bank notes will be held in suboptimal quantities. The problem here is that payment of interest on notes is likely to be impossible because of the high transaction costs involved. Free banks might resort to clever means for getting around this, which would entirely solve the suboptimality problem.38 But suppose they cannot. Then the private cost of holding bank notes would exceed the social costs, and free banks would, in Harry Johnson’s words, “tend to produce a socially nonoptimum overalloction of resources to the provision of deposit money and underallocation of resources to the provision of currency for holding.”
In short, there would be a suboptimal quantity of bank notes, but the loss from this would be partly offset by a supra optimal quantity of deposits. The only net loss would be that stemming from any inelasticity of substitution between deposits and notes. According to Johnson (1973a, 142) this net loss “would probably be a negligible fraction of national income.”
Could government intervention do better? Insofar as the desired solution is payment of interest on holdings of currency, the answer must clearly be no, for government faces the same obstacles in doing this as do private issuers of bank notes. Indeed the government, or its central bank, is less likely to attempt interest payments on currency than private note issuers, since its monopoly privilege places it under less pressure to do so. This is illustrated by the current practice of the some central banks (including the Federal Reserve) of not paying interest on reserve holdings of commercial banks, even though paying interest on reserves is relatively easy compared to paying interest on currency held by the public.
So if any improvement is to be had from the government it must come through a policy of price deflation. Here, too, the revenue or seignorage-maximizing interests of a monopoly supplier of currency run counter to the policy in question. Putting this consideration aside, what gains can be expected from a policy of price deflation aimed at promoting an optimal use of currency? One possibility is that the cost, per real unit of money balances, of increasing aggregate holdings by crying down prices is lower than the cost of doing so by increasing the nominal supply of interest-bearing money units. This would make a central-bank administered deflationary policy superior to free banking even if the latter could pay interest to holders of bank notes. William Gramm (1974) has shown, however, that there is no justification for such a view. Starting with the assumption of a fractional-reserve banking system, Gramm argues, in essence, that the costs associated with creation of real money balances are proportionate to the real value of bank reserves multiplied by the rate of interest. Assuming that the reserve ratio (= m/M, where m is the nominal quantity of the reserve commodity and M is the nominal supply of bank money) is constant, an increase in the real supply of money requires either 1) an increase in M with a proportionate increase in m or 2) a lowering of P with both M and m held constant. In either case, the change in total (opportunity) costs associated with the production and maintenance of the additional real balances is the same. If this cost is represented by the formula rpm, where r is the rate of interest and p is the value of the reserve commodity (= 1/P), then in the former case rpm rises because of an increase in m, whereas in the latter case it rises by the same amount because of an increase in p. Thus Gramm concludes that there is no cost advantage to be had by crying down prices instead of increasing the money supply by means of an increase in the nominal quantity of money.
In fact Gramm’s assumption of a constant reserve ratio, which is crucial to his result, is itself question begging: as we have seen, an increase in the nominal supply of bank money that accommodates an increase in demand under free banking does not require a proportionate increase in the nominal quantity of bank reserves. The circumstance is one that would permit the free-banking reserve ratio to fall. Thus Gramm’s analysis overstates the costs of private production of money balances under laissez faire. It must also be admitted, however, that it is equally unrealistic to assume a constant reserve ratio for the case where M is constant but P is allowed to fall: a fall in the price-level reduces the nominal volume of bank transactions while simultaneously increasing the relative value of commodity money. This would give banks an excess supply of reserves, which would be aggravated by increased production of the money commodity combined with a reduced nonmonetary demand for it. Thus, crying down prices in the face of an increased demand for money balances does not, in a commodity-standard system, really achieve equilibrium in the market for money balances, for although the public may become satisfied with its nominal holdings of bank money, the banks find themselves holding excess reserves.39 Furthermore, there is no way, in a closed system, for these excess reserves to be eliminated except by an increase in bank loans and investments which leads to an increased nominal quantity of bank money and to an increase in the price level sufficient to restore the volume of bank transactions (plus the level of industrial demand for the money commodity) to where there no longer is any surplus of commodity money.
Thus we may conclude that the maximum potential advantage to be expected from a policy of deflation to promote currency holding would be no greater than the small social cost under free banking from consumers’ holding too many deposits and too few bank notes. Yet even this small advantage is unlikely to be achieved in practice, since it would be more than offset by the significant external diseconomies involved in any deflationary process. As S. C. Tsiang notes, these diseconomies would include “impairment of the efficiency of the financial market in channeling savings toward investment” and other consequences of monetary disequilibrium.40
These arguments have been dealt with cursorily here, because most of them have been critically treated elsewhere,41 and also because many of them are rather inappropriate when applied to inside money, which is after all not a commodity “produced” in the usual sense of the term but a vehicle of credit representing outside money lent to banks at call. In the case of such credit instruments the overriding consideration should be whether the supply of them agrees with the public’s demand for them at a given level of nominal income. The public goods and externality arguments are significant only insofar as they imply over- or underproduction in terms of this criterion. Since, as we have seen, the amount of inside money issued by a free banking system tends to conform to the demand for inside money, to say that a free bank will not produce a desirable amount of inside money is tantamount to saying that the demand for money is too intense or too meager, implying over- or underconsumption of inside money balances. The only argument that could possibly justify such a complaint is the one just discussed concerning the alleged nonoptimality of money holding under laissez faire. As we have seen, it is not convincing when applied to a free-banking system.
Alleged Need for a “Lender of Last Resort”
A final alleged shortcoming of free banking is its lack of a “lender of last resort.” Some remarks have been made about this in earlier parts of this study.42 The present section recapitulates and expands upon some of them.
To appreciate the significance of the lender of last resort doctrine to the theory of free banking, one must understand, first, its historical origin and, second, precisely what it is that a lender of last resort is (or was originally) supposed to lend. The doctrine originated in the English banking crises of the 19th century; its principal architects were Henry Thornton and Walter Bagehot.43 It was designed to resolve problems peculiar to a system where one note-issuing bank had (limited) monopoly privileges. The existence of such privileges, which involved restrictions on the note-issue powers of other banks, caused the Bank of England to become a supplier of high-powered money: since paper currency by the 19th century had already begun to surpass coin as a preferred medium of exchange, banks unable to issue their own notes, including all banks within a 65 mile radius from the center of London except the Bank of England, were willing to hold Bank of England notes in place of specie reserves. Thus Bank of England notes were used to settle clearings among other banks, and the Bank became the sole significant repository for the system’s specie.
These circumstances allowed the Bank of England considerable leeway in its issues of inside money. Its issues, unlike those of other banks, were not limited by internal adverse clearings. The principal check against the Bank’s overissues was a drain of reserves to foreign countries sponsored by the price-specie-flow mechanism. So the Bank of England was in a sensitive position: if it overissued, it lost specie abroad, which eventually necessitated either contraction or suspension of payments. If it underissued, it made the conversion of deposits to notes at other English banks impossible. The Bank Act, in attempting to thwart overissue, also made note shortages more likely. It placed absolute limits on other banks’ authorized note issues, while at the same time prohibiting the Bank of England from adding to its note issues without also increasing its specie reserves by the same amount. Bagehot, in arguing that the Bank of England should function as a lender of last resort, was reacting to this. He recommended that the Bank be allowed to increase its circulation to meet “internal drains” of high-powered money from the reserves of other banks, which drains were mainly caused by depositors’ desire to obtain hand-to-hand media. Like the currency drains in America under the National Banking System, they were not due to any desire on the part of depositors to withdraw outside money per se. The dependence of other banks upon the Bank of England in such drains was entirely due to their inability to issue notes of their own, which placed them at the mercy of their privileged rival. Had it not been for restrictions on their rights to issue notes, the less-privileged banks could have met their depositors’ requests by simply swapping their own note liabilities for what had formerly been their deposit liabilities, leaving their reserves untouched. They would not have had any need for a “lender of last resort.”
This is not to deny that the classical developers of the lender of last resort doctrine spoke mainly of the need for central banks to supply ultimate money of redemption to distressed banks whose customers had lost confidence in them. A bank threatened with a redemption run cannot satisfy its panic-stricken clients by offering them its own notes.44 Nevertheless, there is reason for regarding currency runs as of more fundamental importance than redemption runs, as redemption runs seem often to have been set off by the failure of certain banks to meet currency runs. As Bagehot observed (1874, 265-66), panic was especially likely to result if, by its refusal of assistance during a currency run, the Bank of England caused “the failure of a first-rate joint stock bank in London.” The London joint-stock banks had substantial deposit liabilities, and their power to issue notes was, even before 1844, nil. During the “autumnal drain” of currency they were especially dependent upon the resources of the Bank of England.
Crucial to the present argument is Jevons’s finding that, in the course of the autumnal drain, public holdings of coin and bank notes—including notes issued by the “country” banks—moved together.45 There was not a rush for gold or Bank of England notes as such, but rather a rush for all types of currency. The pressure upon the Bank of England came when banks had exhausted their own authorized note issues together with available reserves of high-powered money. The facts confirm that panics were themselves a consequence of restrictions upon free note issue. The situation was similar to the one faced by banks in the United States during the post-Civil War era, except for the difference in note-issue restrictions in the two systems.46
In short, monopolization of note issue is simultaneously the source of the special powers of central banks and the source of difficulties that central banks are supposed to correct. The Bank of England became a last resort source of currency for the simple reason that the first resort, competitive note issue, was outlawed.
Of course, redemption runs need not always be precipitated by prior currency shortages. So a question still remains as to whether central banks can prevent such autonomous runs.47 Here it must be remembered that restrictions upon note issue also led to the centralization of gold reserves—the “one-reserve” system criticized by Bagehot. Gold actually became somewhat less accessible as a result of monopolized note issue than it might have been if banks issued notes competitively. Still, the Bank of England possessed a genuine advantage over free banking, since its issues could be used to settle clearings among other banks. This made it possible for the Bank of England to use its excess reserves to make emergency loans to other banks so that they could in turn satisfy the redemption demands of the public. Another advantage the Bank of England had was that its notes were often less susceptible to a general decline in confidence.
On the other side of the ledger we must consider the following: (a) under free banking redemption runs would be rare, so that the advantages to be had by having a central bank are not necessarily great; (b) special methods for dealing with runs could also be had in a free banking system; and (c) the welfare losses from over- and underissue are likely to outweigh the potential gains from having a central bank. Concerning (a), it was shown in chapter 9 that information externalities which might give rise to a rash of bank runs are less likely to arise under free banking than under central banking. Runs that begin at a small number of bank offices can also be contained there by assistance from other branches of the affected banks. Historically, there have been relatively few bank panics in countries with branch banking as compared with those where branching has been restricted. We have already noted the cases of Sweden, which had no bank failures at all during its era of competitive note issue, Canada, which had fewer bank runs or failures than the U.S. in the decades before 1935 (when it set up a central bank), and Scotland, which had isolated bank failures but no bank panics for the entire span of its free-banking episode.48
Even where branch banking is absent, a bank in need of temporary assistance can, if it is the victim of an isolated run, usually obtain it at a price. Rival banks—barring an implausible conspiracy—will lend to it so long as they are satisfied that it is solvent. It is generally agreed that central banks should employ a similar criterion.49 Notwithstanding this there is the obvious risk that a central bank, especially if it is a public institution not restricted by considerations of profit (or an issuer of fiat money having little to lose by making bad loans), will offer to assist truly insolvent banks whose misfortunes are due to poor management. This generates a moral hazard, encouraging bankers to take unwarranted risks, which in turn increases the probability of future failures.50
Some writers have argued that the existence of government deposit insurance, by providing an independent source of relief to deposit holders and by reducing the likelihood of runs leading to full-scale panic, renders the lender of last resort function of central banks unnecessary.51 If the argument is correct, it applies with even greater force to a system of private bank-liability insurance, which may also reduce the risk of moral hazard by charging insurance premiums reflecting the quality of individual bank asset portfolios.
Concerning category (b), free banks could receive last-resort aid in the form of clearinghouse certificates and loan certificates, which are a short-lived form of emergency high-powered money. They might also resort to “option clauses” of the sort employed in Scotland for a short period during the free-banking era. Such clauses would provide a safety outlet for banks in case of a liquidity crisis, reducing the likelihood of runs by allowing a contractual suspension of payment. This would give banks time to contract their balance sheets. It would also be much more equitable than any non-contractual suspensions of payment, since bank customers would need to agree to the option clause arrangement ahead of time and since it would pay them interest in proportion to the duration of any suspension.
All these considerations militate against the view that central banking is superior to free banking for minimizing the harmful effects from bank runs and failures. Along with them we must reckon the additional burdens that central banks are likely to introduce—category (c) above—which have been alluded to frequently in the present study. They are the burdens of inflation and deflation, absolute as well as relative, with their damaging effects upon economic activity. The ability of central banks to aid other banks in distress—even where the distress is not due to previous central-bank misconduct—should only count as an advantage if there is reason to believe that it will be exercised at the right time and place. That central banks do not suffer when they bail out banks that really should be allowed to fail adds another dimension to the “knowledge problem” they confront, giving further reason to suspect that they will not behave properly.
Although opposed to the Bank of England’s monopoly in principle Bagehot (1874, 69) saw no point in trying to dismantle it: for better or worse, it had become an object of veneration. To oppose it was, in his view, to invite “useless ridicule.” Moreover, he observed, it would take years before a new, safer banking system could grow.
Considerations such as these are no less weighty today. Indeed, despite their poor performance, support for central banks has grown along with the belief that they combat the inherent instability of decentralized banking. Furthermore, the transitional costs of adopting free banking seem greater than ever, since modern banking systems, based on fiat monies and floating exchange rates, appear further removed from the theoretical ideal of free banking than any of their 19th-century predecessors.
The popularity of central banking today rests, however, on the public’s insufficient awareness of the advantages of free banking. Far from requiring theorists to dismiss the topic as a “dead issue,”52 the situation calls for them to perform their principal duty, which is to inform people about things that are not already obvious to them. Of course a theoretical possibility, once brought to the attention of the public, may be ignored or rejected; but it is irresponsible for theorists to write off an idea because they see little prospect of its ready acceptance. Issues do not die; they are just neglected!
That political decision makers are especially prone to ignore radical alternatives is also no reason to quell discussion of them. As an English statesman and writer once observed, that politicians are mainly concerned with “tasks of the hour” is “all the more reason why as many other people as possible should busy themselves in helping prepare opinion for the practical application of unfamiliar but weighty and promising suggestions, by constant and ready discussion of them upon their merits.”53
The matter of transition costs cannot be so tersely dealt with. Real doubts must exist concerning whether there is any way to convert existing banking arrangements so as to make them perform in the manner described in the theory of free banking. The only way to dispel such doubts is to offer an actual plan, showing how the conversion might be achieved without difficulties or costs so great as to render the plan unacceptable. This task is undertaken in the next chapter.
[1.] The criticisms discussed in this section are so much a part of received doctrine that it is unnecessary to cite particular occurrences of them in the literature.
[2.] The French case is conspicuous in this respect. It is discussed in the introduction and also in Nataf (1983). On the free vs. central banking debate in England see L. White (1984d, chapters 3-4). For debates in other nations see V. Smith (1936).
[3.] See the works by Rockoff and Rolnick and Weber cited in chapter 1.
[4.] Spencer’s argument for private coinage appears in his Social Statics (1896, 225-28).
[5.] See above, chapter 2, and also George MacDonald (1916, 7).
[6.] In the 1920s Bechtler dollars were still being accepted at par by North Carolina banks. See Woolridge (1970, 65) and Griffen (1929). Chapter 3 of Woolridge’s book is an excellent and entertaining survey of private issues of token (fractional) coinage in the U.S. For a good review of private coinage of fullweighted coins in the U.S. see Brian Summers (1976, 436-40).
[7.] It is noteworthy that in the 2nd. ed. of his Inquiry into the Currency Principle (1844) Tooke wrote that de facto convertibility into gold “together with unlimited competition as to issue” is sufficient to prevent an excessive issue of paper currency (155). He also pointed with approval to the example of Scotland (156). On the change in Tooke’s views on free banking, see Arie Arnon (1984).
[8.] Milton Friedman (1959, 6-7). In a more recent article (Friedman and Schwartz, 1986) Friedman reconsiders this and other arguments offered in his earlier work. He and Anna J. Schwartz write that under current conditions “The possibility—and reality—of fraud . . . seems unlikely to be more serious for hand-to-hand currency than for deposits” (51). They conclude that there is “no reason currently to prohibit banks from issuing hand-to-hand currency” (52). However they regard the possibility as a “dead issue” since it has no support from “banks or other groups.”
[9.] See the references cited in chapter 1.
[10.] Besides the passage from Friedman cited previously, see Robert G. King (1983, 136).
[11.] Emmanuel Coppieters (1955, 64-65), cited in L. White (1984d, 40). It is also relevant that the Scottish banks had a policy of accepting counterfeit money at par, in order to encourage its discovery and to assist the capture of its producers. This also eliminated any possibility of losses to note holders arising from this kind of fraud.
The average period of circulation of a Federal Reserve dollar from the time of its issue to the time of its return to a Federal Reserve bank is approximately 17 months. (See the Federal Reserve Bank of Atlanta, Fundamental Facts About U.S. Money.) The average period of circulation of twenty-dollar bills—which are most frequently counterfeited—is considerably longer. Approximately one-fifth of all exposed counterfeit currency is discovered at the Federal Reserve banks. (Source: Personal communication, Federal Reserve Bank of Richmond.)
[12.] Thus for example King (1983, 136) writes that “holders of circulating notes are unlikely to closely monitor the activities of a note issuer because notes represent a small fraction of an individual’s wealth and are held only for a brief period.” This, he says, will lead to banks “printing more notes than can be redeemed by securities” thereby “inflicting capital losses on noteholders if simultaneous redemption occurs.” This statement has several flaws in addition to the general criticism made in the text above. First of all, the reference to “simultaneous redemption” is gratuitous, since this would obviously lead to “capital losses” even in fractional-reserve banking systems lacking competitive note issue. Also, overissue is not a matter of “printing” too many notes but rather one of putting too many into circulation by making excess loans and investments. Finally, the passage implies that notes that can be “redeemed by securities” of their issuer do not represent an overissue. This is meaningless since almost any issue of notes by a bank involves a like purchase of securities.
[13.] Individuals could entirely reject other notes, or they could agree to accept the notes at a discount (as they did in the U.S. in the 19th century, when merchants had “note reporters”), depending upon the extent of their distrust of them. Either practice would discourage attempts to put untrustworthy notes into circulation.
[14.] In contradiction to King (1983, 136).
[15.] See for example Allan H. Meltzer (1983, 109-10), and the reference to Crouzet below.
[16.] According to Cameron (1967, 94ff) the Scottish economy grew more rapidly during the century prior to 1844 than the English economy during the same period. Adam Smith, among others, argued that free banking made a significant contribution to Scotland’s economic growth. See L. White (1984d, 24).
[17.] See Hugh Rockoff (1974, 141-67).
[18.] Schumpeter, however, in his Theory of Economic Development (1983), argues that entrepreneurial activity depends on banks’ issues of “abnormal credit” giving rise to forced savings. Schumpeter was influenced by the real-bills doctrine, and so he associated abnormal credit and forced savings with bank issues not based on commodity bills. Conversely, he regarded credit based on commodity bills as sufficient only for maintaining an economy in a stationary state. Neither proposition is correct: there is no definite limit to the amount of credit that can be granted on the basis of the supply of commodity bills, since the latter supply is itself a nominal magnitude influenced by the terms of bank lending. Thus credit based on “real bills” may finance entrepreneurial ventures away from the stationary state, including some that inflict forced saving on the public. On the other hand, credit based on assets other than commodity bills (which may also finance economic development) need not give rise to forced savings, so long as it is based on increased abstinence of holders of inside money. It follows that economic development can take place whether or not banks restrict their lending to commodity bills, and it can also take place without forced savings.
[19.] Returning once again to the example of Scotland, as of 1872 (after the free-banking era, but at a time when Scotland still had 10 competing banks of issue) per-capita loanable funds administered by the Scottish banks exceeded per-capita funds granted by banks in England, and this without any evidence of credit creation (Somers 1873, 86-87). This supports the argument in chapter 9 that free banking systems are more efficient in the administration of loanable funds than centralized banking systems.
[20.] See for example Milton Friedman (1975); Robert E. Lucas, Jr. and Thomas J. Sargent (1978); and F. A. Hayek (1975a, 15-29).
[21.] A good discussion of the proper role of monetary policy in preventing unemployment appears in Lloyd Mints (1950, 15-51).
[22.] The best example of this argument is Michael Melvin (1984). See also Benjamin Klein (1978, esp. 76-78). Other examples can be found in Roland Vaubel (1984a, 45ff).
[23.] On the distinction between subadditivity of costs and decreasing average costs see William W. Sharkey (1982, 7).
[24.] It is reasonable to assume, as a general rule, that the costs of market-building increase as the boundaries of the market extend further from the source of issued notes.
[25.] It also requires that the economy be a closed one in which there is zero demand for commodity money by the public.
[26.] Africa, Asia, and South America are not considered because relatively little is known about their banking history.
[27.] This is not to say that there were not also measures taken that had the effect of artificially limiting the extent of consolidation of banking and note issue. Most obvious of these were laws preventing branch banking, such as have long existed in the United States.
In view of this, Melvin’s claim (1984, 9) that “We observe government produced money, not because of barriers to entry, but because government produced money is socially efficient” is questionable. Of course any institution that survives must be “socially efficient” in some broad sense; but the persistence of a government monopoly does not prove that it has been more effective than competition in satisfying consumer wants. The historical evidence suggests other reasons for government involvement in this area.
[28.] But see Sharkey for exceptions.
[29.] One exception is reported by Tuh-Yueh Lee (1952). Lee writes that “the currency notes issued by the Bank of China [originally established as the Chinese Government Bank in 1904 and renamed after the Revolution of 1911] begot such confidence and were held in such high esteem that even the farmers who traditionally demanded solid cash (silver dollars) came to accept [the notes] in payment for their products although they still obstinately declined the issues of any other bank.”
[30.] See above, chapter 1.
[31.] Examples of the use of these arguments against free banking are given in Vaubel (1984a, 28-45). Although most of these examples refer explicitly to outside money only, many imply that the arguments in question also apply to redeemable bank notes.
[32.] Analytically, the “nonrivalrousness in consumption” (public good) and “positive externality” (underproduction) arguments are not really distinct; their separation here is based on convention rather than logic.
[33.] See above, chapter 1.
[34.] See Vaubel (1984a, 32).
[35.] See chapter 9.
[36.] Milton Friedman (1969). See also Paul A. Samuelson (1969).
[37.] See Harry G. Johnson (1973b, 91-92).
[38.] One possibility is discussed below in chapter 11.
[39.] Recall our statement of the conditions of long-run equilibrium in a fractional-reserve banking system, given in chapter 2.
[40.] S. C. Tsiang (1969). See also the discussion of consequences of monetary disequilibrium above, chapter 4.
[41.] See Vaubel (1984a).
[42.] See above, chapters 8 and 9.
[43.] See Thomas M. Humphrey (1975); and Thomas M. Humphrey and Robert E. Keleher (1984).
[44.] Recall the distinction drawn in chapter 9 between a redemption run and a currency run.
[45.] Jevons (1884, 171 and 186, Table 6). “Country” banks included both private and joint-stock banks located outside of the 65-mile radius marking and Bank of England’s region of note-issue monopoly.
[46.] On currency supply under the National Banking System see above, chapter 8.
[47.] This topic was dealt with in the third section of chapter 9.
[48.] There was a run for a few days in Scotland following the collapse of the Ayr Bank.
[49.] See for example Hawtrey (1932, 228 and 259).
[50.] Bailouts that reduce potential losses to bank shareholders and management also encourage a happy-go-lucky attitude in consumers of bank services.
[51.] See for example Friedman and Schwartz (1963, 440-41).
[52.] As Friedman and Schwartz (1986, 52) do.
[53.] John Viscount Morley (1898, 98).