Free Banking

Lawrence H. WhiteSREK 2014

http://www.iea.org.uk/http://www.econlib.org/

oll.libertyfund.org/

Two views of money

Coins can be privately produced

• Why then have governments monopolized coinage? • To improve quality?

Silver content of European govt. coins, c1300-c1500

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

c1300 c1400 c1500

per

flo

rin

Castile Maravedi

Cologne Schilling

Flanders Groot

Austria Schilling

France Sou

Lubeck Schilling

Rome Soldo

Florence Soldo

Prague Groschen

Venice Soldo

Aragon Sueldo

England Shilling

Bank‑account money

• more portable• greater uniformity than

debased coins

1.

2.

Why did bank account balances become transferable?

1.

2.

Account of

1. Antonio -$1002. Bartolemo +$100

Account balance transfer

Account of

1. Antonio -$1002. Bartolemo +$100

Money Warehouse

Assets Liabilities

coins in vault $200 owed to Alice $10owed to Bob

$10 owed to others $180

Economical means of safe storage.

Is there a more economical alternative for payments?

Fractional-reserve Bank

Assets Liabilities

coins in vault $40 owed to Alice$10

owed to Bob $10

loans, bills $160 owed to others $180

Advantages to the bank?

Advantages to the customer?

BANCO di MEDICI

Bank‑issued currency

Warehouse receipts do notresemble banknotes

When is a fractional reserve feasible?

Is a fractional reserve banknote like a lottery ticket?

BANK

Is it inherently fraudulent to hold a fractional reserve ?

Why might a fully informed customer agree to fractional reserves?

1. A money warehouse contract is legitimate.

2. A time deposit contract is legitimate.

3. A demand deposit contract is neither a money warehouse contract nor a time deposit.

4. Therefore, a demand deposit contract is not legitimate.

1. A dog has four legs.

2. A cat has four legs.

3. A goat is neither a dognor a cat.

4. Therefore, a goat does not have four legs.

Banks will accept one another’s liabilities at par (face value)

• Non-par means customer inconvenience

• Profitable for banks to eliminate these inconveniences

Suffolk Bank (Boston), 1830s

Bank of Scotland Royal Bank of Scotland,est. 1727

Freely evolved banking systems

• Definitive money: specie (gold or silver coin)• Unit of account: specie unit• Retail CAMOEs: bank-issued currency and

transferable account balances– Bank-issued money denominated in the specie unit– widely accepted at par – All banks are linked into a unified clearing network

• Seen historically in banking systems that were free of significant legal restrictions

Scotland Canada Sweden New England

Historical free banking systems

… and 50+ more

Why did we switch to fiat money?

IOU NOTHING

Over the years, all the governments in the world, having discovered that gold is, like, rare, decided that it would be more convenient to back their money with something that is easier to come by, namely: nothing.

Simplified free bank balance sheet

Assets Liabilities + Equity

______________________________________

R reserves N notes in circulation

L loans and securities D deposits

K equity capital

A profit-seeking bank equates at the margin MR from loans = MR from reserve holding MR from loans = MC of liabilities to fund them MC of notes = MC of deposits

balance sheet constraint: R + L = N + D + K

Managing a free bank of issue

• Bank optimization determines N, D, R• Desired N and D are finite, because

redeemable notes (or deposits) cannot simply be circulated ad lib

• One thing to print up the notes; another to keep them in circulation

– Undemanded (excess) notes will return to be redeemed

– To cultivate a demand to hold its notes, the bank must incur provide costly services

– Thus rising MC limits profit-max size of public’s desired N

Assets Liabilities + Equity

R

L

N

D

K

What corrects a bank’s over-issue?

• Reserve losses as notes return for redemption• “overissue”: the quantity of a bank’s currency in

circulation exceeds the quantity demanded – given its optimizing expenditures on non-price competition– cause: either bank expands N, or Nd falls

• What corrects over-issue? – Not: Fullarton's (1845) flawed “law of the reflux” – Not: repayment of loans or “real bills”– Correct theory: actual N converges on desired Nd as the public

adjusts toward its desired portfolio of assets

• Adjustment of system-wide N as Nd falls or rises

Mises on market correction of N under free banking

“A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then -- apart from an extension of its clientele -- it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause.”

--Theory of Money and Credit, p. 347 (1980 ed.)

Competition vs. monopoly in note-issue

• Competition (many issuers) limits the danger of a large-scale overissue – Random money-supply errors will tend to

offset one another in the aggregate – Danger of large-scale overissue is greatest

when a single issuer has a 100% share of the circulation

• Free banking’s adjustment of N to Nd helps to stabilize aggregate spending– Hayek’s “money stream”

• Policy implication: don’t restrict note-issue to a single institution. Allow free entry.

James Wm. Gilbart, leader of British Free Banking School

The problem of runs

Run-prone bank account

• Greater expected payoff to redeeming sooner rather than later

1) debt claim

2) unconditionally redeemable on demand (first come, first served)

3) default likely on last claim served

Non-run-prone bank account

• Modify any one of these conditions:

1’) equity claim, like MMMF

2’) conditional redeemability, like a notice-of-withdrawal clause

3’) solvency assurances• adequate capital• diversified portfolio of safe assets • extended liability for shareholders• clearinghouse certification