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Bank Deregulation and Monetary Order by George Selgin

Routledge • 1996 • 288 pages • $69.95

Parth Shah is an economics professor and president of the Center for Civil Society, New Delhi, India.

The classical gold standard is generally considered to be the only monetary system consistent with the principles of laissez faire. In that system, the currency issued by the government is convertible on demand into a specified amount of gold. The government’s ability to issue currency is limited by the amount of gold it possesses; there is less room for the hidden tax of inflation. The government, however, retains a monopoly on the issue of currency. F. A. Hayek’s pioneering essay, “Choice in Currency” (1976), offered an alternative of laissez-faire banking—a system of privately issued competing currencies. Since then, the novel alternative of free banking has attracted considerable attention from young Austrians.

George Selgin’s Bank Deregulation and Monetary Order reprints 12 of his recent articles (two coauthored with Larry White) that further support the proposition that money is not unlike other goods and can be best supplied by the market. Though the articles were written for an academic audience, they are accessible, with some effort, to any interested individual. They exemplify Selgin’s ability to write for academic and nonacademic audiences simultaneously.

The conventional view maintains that banking systems are inherently unstable and prone to crises, and therefore government regulation and control are essential. Selgin demonstrates that the conventional view is false, both theoretically and empirically. Historical evidence from several countries over a period of about 200 years suggests that “genuine banking crises have been rare in most well-studied fractional-reserve banking systems and entirely absent in several.” What explains, then, the conventional view of banking? This view, like most economic theories, is largely due to British and American economists whose judgments are colored by the banking histories of their own countries. Among the countries studied, “banking crises appear to have been a U.S. specialty, with England earning second place. A global historical perspective on banking, however, indicates a generally acceptable performance.”

For the period of 1793-1933, Selgin categorizes banking systems as relatively “unfree” (United States, England, France, Germany, and Italy) and relatively “free” (Canada, Scotland, Sweden, Australia, China, and South Africa). The “unfree” systems had “privileged” banks and/or restrictions on bank charters and currency issue. The “free” banking systems had multiple private issuers of currency convertible into specie. “Of forty-eight recorded crises, all but seven occurred in unfree systems.” “[B]anking crises,” Selgin concludes, “have been more frequent in heavily regulated banking systems than in relatively unregulated ones.”

Government regulation of banking through monopoly issue of currency, lender of last resort, deposit insurance, branching and asset restrictions, interest-rate ceilings, and other means has made this system less, not more, stable. Inherent instability of banking systems is used to justify restrictions, but their presence is actually responsible for the instability. The restrictions, then, are self-fulfilling—they create instability which in turn justifies their existence and even expansion. In opposition to the conventional “market failure” theory, Selgin proposes a “legal restrictions” theory of banking crises and instability. Even bank-lending manias are usually caused and sustained by restrictions on banking and not by excessive “confidence” or “optimism” or “animal spirits” as the folklore alleges. Selgin supports this contention theoretically by showing the effectiveness of the clearing mechanism under free banking, and historically by examining several alleged episodes of financial “bubbles.”

The infamous banking crisis of the 1930s, the cause of the Great Depression, corroborates Selgin’s legal-restrictions theory. In the first two years of the crisis, most of the failures were of “small-unit banks in agricultural regions.” Their failure, as those of 6,000 banks in the 1920s, was due to the fall in the relative price of agricultural products. If the United States had allowed nationwide branch banking, most of these “relative-price-induced” bank failures might have been avoided. Canada, which suffered the decline in agricultural prices but had branch banking, did not have a single bank failure in those two decades, except for one failure in 1923 involving fraud. Moreover, in response to the public’s increased demand for currency, Canadian banks were able to issue more notes in exchange for deposits, but the American banks could not increase their note supply without relaxation of the restrictions by the Fed. The troubles of agricultural banks could have been largely contained if only the United States had branch banking and freedom in note issue.

Banks’ inability to issue more notes prompted clearinghouses to seek permission of the Treasury “to issue clearinghouse certificates as substitutes for bank notes, as they had done during earlier crises. But they were refused permission on the grounds that such a private response was no longer needed: the Fed was capable of issuing ‘plenty of money that looks like real money.’ In the event, of course, the Fed’s response proved far from adequate.” The crisis of agricultural banks did not turn into a widespread panic until February 1933, when states began declaring bank holidays (Michigan on February 14, which led to the national bank holiday on March 6), and when rumors spread about the government’s plan to devalue the dollar. On top of it all, in mid-1932, a two-cent tax on checks was imposed, which further encouraged the public to withdraw currency from the banking system. A restrictionless banking system would surely have mitigated, if not prevented completely, the Great Depression.

Many advocates of free markets (Milton Friedman, for example) consider the central bank as generally evil but absolutely necessary for smooth and efficient working of the financial system. Surprisingly though, hardly any systematic, scholarly case has been offered to support the assumed necessity of the central bank. Its desirability is simply taken for granted. Charles Goodhart’s The Evolution of Central Banks, attempts a defense of central banks. Selgin provides a detailed and persuasive critique of Goodhart’s rationale for central banks as well as his interpretation of the theory and history of free banking.

Selgin points out, among other things, that central banks of the world did not evolve “naturally” because of the economies of scale in reserve holding and the need for a lender of last resort in fractional-reserve banking. They were contrived by the fiscal necessities of states and by “advantages endowed by legislation.” The economies of scale in reserve holding can otherwise be achieved by branch banking and non-bank clearinghouses. The need for a lender of last resort is actually created by the privileges (of note issue, access to capital and such) granted to particular banks, which weakened the other banks in the system and made them unnaturally dependent on the “privileged banks.”

Chapters 1, 2, 4, and 6 explain how, without state interventions, the banking system would have evolved by using Carl Menger’s theory of the evolution of money and his “conjectural historical” approach; how free banking adjusts the supply of money to its demand; and how it provides a substantially more stable monetary environment and less room for “money mischief.” For nonspecialists, these chapters offer a quick but thorough understanding of the workings of a free banking system and its advantages over central banking.

Selgin addresses an important ongoing debate among economists on “productivity norm” versus “price level stability norm” (Chapters 7 and 8). This debate applies to both free banks and central banks—how free banks would behave and how central banks should conduct their monetary policy. The central bank of New Zealand is now required by law to maintain stable prices or zero inflation. Stability of prices has become a dominant concern of many a central bank. The productivity norm, which Selgin prefers, suggests that prices be allowed to fall in response to increases in productivity of the economy. Selgin contends that as the supply of goods and services increases, the downward pressure on their prices should not be countered by expanding the money supply to keep them stable.

Suppose unexpected technological improvements in the production of some goods lowers their cost of production. That would, under competition, lead to a decline in the prices of those goods relative to other goods. Which norm requires changes in more prices? Under the productivity norm, prices of only those goods whose productivity has increased must fall; all other prices remain the same. Under the price level stability norm—which is identical to keeping a consumer price index constant—prices of all other goods must be raised relative to the prices of goods whose productivity has increased. Thus, the productivity norm, Selgin maintains, is superior to its commonly advocated alternative.

I am sure that this book will encourage the reader to further explore the crucial field of free banking—crucial to the evolution of a laissez-faire society.

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