All Commentary
Friday, August 9, 2013

The Origin of Specie, Pt. 2

The Case for Private Money and Free Banking

In my previous article, I outlined the argument for why money is not, contrary to popular opinion, a so-called “public good.” I also elaborated on why any positive externalities arguments against market-supplied money are likely to be overblown. 

In this installment, I’ll make the case for a private monetary regime. 

Readers will be interested to know that the following is not just academic speculation. Periods of laissez-faire money provision have existed and flourished throughout history. Examples include (but are not limited to) Scotland from roughly the mid-eighteenth to the mid-nineteenth century and Canada throughout its history up until the Great Depression. For readers interested in learning more, I recommend highly a 1994 article by George Selgin and Lawrence White, “How Would the Invisible Hand Handle Money?,” which appeared in the December issue of the Journal of Economic Literature.


Free Money, Free Banking

Laissez-faire money comes hand-in-hand with laissez-faire banking. In these “free banking” systems, money—the economy’s medium of exchange (and, in this case, also its medium of account)—is a commodity such as gold or silver. Banks store specie in their vaults and give specie depositors claims to their specie, either in the form of paper notes or interest-bearing accounts, redeemable on demand. The paper notes, which are promissory notes typically marked with the name of the bank and amount of specie owed, are what actually circulate as day-to-day money. Instead of carrying around specie, which can be pretty inconvenient, individuals carry around claims to specie, and this is what changes hands during a typical business day. Banks use the liabilities they issue to fund asset portfolios, and the yield spread between this portfolio and the interest it promises to deposit holders is the bank’s rate of profit.

Banks compete with each other in attracting and keeping depositors. This competition keeps banks honest, preventing them from issuing too large a quantity of liabilities to purchase for themselves real goods and services with claims that they are ultimately unable to honor. For example, if the Bank of Al issues too many notes, the Bank of Bob has an incentive to accept Bank of Bob and Bank of Al notes at its window. After collecting many Bank of Al notes, the Bank of Bob takes these notes to the Bank of Al and demands redemption. The Bank of Al, having overissued, cannot meet these claims and is forced to shut down. The prospect of this “note dueling” makes banks diligent in their activities and wary of other banks—exactly the attitude we want in any business engaged in healthy market competition.

Banks do not spend all their time planning to drive each other out of business, however. In fact, there is a significant degree of cooperation among banks in certain activities. I mentioned above that banks have an incentive to accept other banks’ notes for redemption in specie in an attempt to drive other banks out of business. But banks also have an incentive to accept other banks’ notes because doing so increases the demand for that bank’s notes. If the Bank of Chuck accepts the Bank of Dan’s notes, people will be more willing to trade for and hold the Bank of Chuck’s notes. This is because people will realize that, even if they find themselves in a situation where they have to (or merely find it profitable to) trade their Bank of Chuck notes for Bank of Dan notes, the Bank of Chuck will redeem Bank of Dan notes in specie. This logic holds for the Bank of Dan as well, along with all the banks in the banking system. 


The Clearinghouse

Recognizing the incentives for mutual acceptance, banks will naturally acquire large numbers of one another’s liabilities as a regular course of business. This fact drove the creation of one of the most important financial evolutions in banking history: the interbank clearinghouse. The interbank clearinghouse is where banks go to settle balances with each other. Instead of the Bank of Al clearing with the Bank of Bob, the Bank of Chuck, and the Bank of Dan individually, all four banks meet at a mutually agreed upon location and settle balances multilaterally, economizing significantly on transaction costs. Membership in the clearinghouse becomes a valuable capital asset for the banks, incentivizing honest business practices. The clearinghouse can also serve as a “bankers’ bank”, keeping detailed financial records of its members in order to maintain safe capital ratios and providing a convenient mechanism for securing short-term loans. This latter function is especially important, since it can be crucial in stopping nascent financial crises before they get out of control.   

Free-banking systems, as an unintended consequence of the profit-seeking behavior of the individual banks, also exhibit desirable macroeconomic properties. When individuals’ willingness to hold bank liabilities rises, banks notice that they are redeeming fewer liabilities for specie during a given business interval. This buildup of excess specie signals to banks that individuals are more willing than before to give the bank a loan—that is, to hold the banks’ liabilities in their portfolios. Banks thus issues more liabilities, preventing a change in individuals’ preferences for the composition of their asset portfolios from resulting in a downturn in economic activity. Conversely, when banks have issued too much—when banks notice their specie reserves are depleting too quickly—they call in loans and issue fewer liabilities, until their specie reserves are back to safe levels. Thus, a free-banking system (unlike the current system) tends naturally to avoid the excesses of boom and bust, creating an environment conducive to the long-term business planning necessary for economic growth.

Despite its many laudable features, free banking isn’t perfect. Some banks will inevitably make bad investments and fail from time to time. This may result in the failure of businesses that invested heavily in, or stored a large part of their cash reserves in, that bank. However, given the features outlined above, it is unlikely that the effects of this failure will propagate throughout the financial system to a degree large enough to cause a panic. In addition, any particular defect of free banking by itself is insufficient to rule out free banking’s desirability; it must be compared with the alternative systems before any verdict can be reached. 

As the recent global financial crisis has shown, current monetary arrangements that rely on central banks to manage the financial sector prudently are fraught with their own problems. For all its vaunted superiority, the historical record suggests that recessions are no less frequent or severe than they were before the rise of central banking. 

Theory and history show that free banking can be relied on to deliver sound money and economic stability. Once we free ourselves of our preconceived notions about why it “can’t work,” we see that a free market in money is just as desirable as a free market in any other commodity on which we rely.