What is Free Banking?

A private banknote issued by the Erie and Kalamazoo Railroad Bank in 1853.

In order to understand a regulated banking system, you must have a conception of what the banking system would look like without government. Free banking may be something like pure capitalism: we’ve never actually seen it. However, we’ve never seen truly free trade either, but we have a conception of what it would look like, and how restrictions like tariffs affect it. To understand how the banking system works with regulation and central banks, you must have a basis for a theory of free banking. It isn’t about libertarianism and things being free for the sake of being free. It’s about knowing how the banking system is affected by regulation and central banks. If a monetary economist wants to preach about central bank policy, ask them about free banking. If they don’t understand what life would be like without central banks and regulations, they literally have no idea what they’re talking about.

In most people’s minds, there is no alternative to the government issuing currency and regulating banks the way they do. A common argument is that the financial system is just too important to leave to the whims of the private sector. This is the wrong thing to focus on. Food is pretty important. Trade is pretty important. Energy is pretty important. Health care is pretty important. It’s hard to envision a major sector of the economy that isn’t important and that we’d prefer not to have messed up. The better question is: does government involvement make the financial system work better?

Depositors currently have no risk up to the FDIC insurance limits. Unfortunately, taxpayers still do. Government schemes to “eliminate” risk in the banking system have resulted in taxpayers facing greater systemic losses. There have been multiple financial crises since the arrival of the Fed. Depositors are safe, but taxpayers are not. The idea that risk from the banking system has been eliminated due to deposit insurance, regulations, or the existence of the Fed is really just an illusion. And as long as the government wants to bailout financial institutions, the moral hazard created makes the “elimination” of risk even more laughable.

In free banking, the counterpart for deposit insurance is bank capital. You would put your money in a bank with a lot of capital. Any losses the bank suffers as a result of bad loans comes from that capital. If it over issues, it will suffer reserve losses and a liquidity problem which will constrain it quickly. If it makes bad loans, then its problem will be insolvency which will come out of capital first. Only after the capital is exhausted do the depositors and note holders bear losses. In free banking, there is a real onus on bank shareholders to protect their capital i.e. investment. Before the establishment of the Fed, it was common for banks to have capital in the amount of 30% their liabilities. Central banking eats away at bank capital because it’s a substitute for bank capital. The Fed acts as a lender of last resort, has an open discount window, and holds deposit credits. Plus the FDIC offers insurance. Owners of free banks have unlimited liability and they don’t want to lose their investment.

Free banking is a banking system without any special regulations. That is, where government treats banks like normal companies which make real goods and services. There would be no deposit insurance, lender of last resort, or legal restrictions on interest rates, portfolios, branch banking, and currency issuance. There might not be any special role for government in free banking other then the enforcement of contracts, which is vital to all economic endeavors. With a commodity monetary base like a gold or silver standard, the banks could do everything the government currently does. Banks that go insolvent would bear losses to depositors, but in a free banking system it would be easier to facilitate a takeover or merger which could mediate such losses. Also, the shareholders of the bank are the ones which often lose the most. They want to protect their capital position. Depositors would face a positive probability of losing their money, or part of it. But this only means people actually would have to do some due diligence on who to bank with. Currently, most people do nothing more than make sure the FDIC emblem is on the door (if that). You should spend more than two seconds on who you consider worthy to hold all of your money. It would be no different than researching cars or laptops as a consumer. You wouldn’t just blindly pick one and go for it devoid of any information about it. If you were shopping banks, you’d want to look at the bank’s capital position. You’d want to find out what notes issued by other banks and checks they are willing to take and consider current. You’d want to see what banks work with the clearinghouse and get a report from them. Consumer research and involvement would help limit the number of shoddy banks.

The Fed didn’t mark the beginning of government involvement in banking. Governments have always held a heavy hand. For one, branch banking used to be prohibited in the United States. Almost all banks were single office unit banks which remained true many decades after the Fed’s establishment in 1913. This lack of branch banking meant that single banks were subject to all of the market risks and shocks of one single community i.e. no diversification. It would be like an insurance company only issuing homeowner’s insurance on the Gulf Coast. Hurricane Katrina would wipe them out. As a bank, if you are allowed to open branches in different communities, cities, and regions, all of the sudden your depositors and debtors come from many industries with many different macro-economic environments. One shock wouldn’t necessarily put the bank under.

Banks were also heavily restricted on issuing currency in the US. Before the Federal Reserve, banks and mints were supplying money. Many banks could issue their own circulating notes. However, these notes weren’t distinct from one another in representing underlying monies. They all had similar claims to some underlying amount of gold. That is, if you were paid in a given bank’s notes, you could take the notes to that bank and ask for the underlying gold it represented. There was a uniform monetary standard but no monopoly bestowed on the private banks for the issuance of the paper representative of the monetary unit. Established banks were not allowed to issue currency when needed. The proposal of the Federal Reserve and its 12 branches came about to address currency shortages. The currency shortages only occurred because of the regulations. There was nothing special about the Fed except that it wasn’t subject to the same rules. While the Fed could address the shortages, they also gained the power to produce too much currency.

Prohibiting branch banking and restricting the issuance of currency alone caused all sorts of trouble for banks; the same troubles that were used to convince us we needed the Federal Reserve.

Banking has typically been a heavily regulated industry in countries that otherwise are fairly capitalistic and free market. The closest example of pure free banking that we know of was in Scotland from about 1750-1845. As it turned out, this is the time and place of the father of modern economics, Adam Smith.

Those Scottish banks showed that with private issuers of currency, there is a market restraint to over-supplying the monetary base. Of course increasing the monetary base with no respect to goods and services inflates the economy, devalues currency, and takes advantage of savers holding the currency. In free banking, if a bank made too many loans to its rivals, checks are drawn on those loans which are redeposited and cleared. The generous banks begin to run out of reserves. This puts a strict limit on money reserves as the form of deposits. When banks could issue their own notes, they were subject to the same discipline. If the bank made loans and the borrower took them in the form of the bank’s notes, those notes would ultimately be received mainly by rival banks that would send them back for redemption. Competition worked to constrain the amount of bank notes any individual bank could issue in the system. That doesn’t work if one bank has a monopoly on currency because its notes get treated like reserves by other banks. The central bank can expand without limitation and it encourages the other banks to expand as well. As we’ve seen with the Fed over the last few years, there seems to be no restraints on how far they’ll expand the money supply.

If a bank was becoming insolvent, there would be signals. The clearinghouse would catch on that a bank is lending too aggressively before anyone else. They’d throw the bank out and other banks would stop accepting their notes. In addition, a note is a financial asset which is traded on a secondary market. Here the note is priced by experts in the market, including other banks. Once there is a question about a bank’s solvency, its notes will go to a discount.

In the Scottish system, generally notes stayed at par and it was safe to deal with them.

Depositors would accept your notes if they believe you’ve been acting responsibly and only issuing an amount consistent with your long run survival. Individual banks can fail but the clearinghouse disciplines banks and keeps them from going overboard because they know what will happen if they lend too generously.

Many people believe free banking does not utilize fractional reserve banking. This is not the case. The typical Scottish bank held gold reserves of 1-2%, which evolved through trial and error. Everyone had the right to convert a Scottish bank note into gold but no one ever did it because of the faith in the system. Scots didn’t want to hold gold and if someone paid in a gold ginni they would get rid of it and deposit it into a good bank for paper.

In the event of Scottish bank runs, banks were liquidated and often a complete payout of deposit and note holders occurred. Recourse before liquidation was an “optional clause” Scottish banks put on their notes. It said that they reserve the right to suspend payment on demand of the notes and gold. If banks exercised this right, during the period of suspension the note holder was paid a high interest rate. In effect, notes converted into bonds. This clause wasn’t used often. It only occurred early in Scottish banking history when banks would try to gang up on upstart new rivals by piling up their notes and staging runs to force them out of business. This was called a note raid. The clause safeguarded themselves from raids by rival banks, but it was never used to protect against runs against their own customers.

If a bank was solvent but people were panicking with imperfect information, it would be advantageous for the bank to invoke the option clause and pay the high rate of interest. If a bank made bad loans and was insolvent, it wouldn’t pay to invoke the clause, and they’d just shut down.

You can have free banking with any monetary standard e.g. gold, silver, fiat dollar, etc. That must be defined.

You could actually keep the Fed if you wanted to maintain the fiat dollar. The Fed could be nothing more than a maintenance institution for maintaining a fixed stock of bank reserves. It would have no discretionary powers to add or subtract, wouldn’t be relied on for paper notes, and wouldn’t conduct monetary policy. All monetary accommodation would be done by the private sector. You could privatize the Fed clearing system. In free banking, you’d want to have flexible reserve ratios. The banking system would issue notes and expand private deposit credits in response to greater public needs.

Currently, the Fed monopolizes currency which gives it ultimate leverage over the whole money stock. If you shut down the Fed in our regulated system, you’d risk a mismatch of quantity of currency relative to demand. But if banks had complete freedom, you could shut the Fed down by freezing the monetary base, creating a fixed stock of reserves. The change in monetary needs by the public would then be accommodated by the private financial system.

Many people believe the Fed has tamed the business cycle through the modern banking system. This perceived end of economic volatility has been coined “The Great Moderation.” Recently, on the surface, this seems like a reasonable point of view. We’ve had sustained growth with only very brief and shallow recessions in the early 90s and early 2000s after the dot com bubble. The only problem is that this ignores the expansive monetary policy, artificially low interest rates, and easy money policies in the credit markets. This inflated a real estate bubble that served as the ultimate prolonged economic stimulus. People had tens of thousands if not hundreds of thousands of dollars to pull out of their homes like an ATM. What looked like a period of stability over the last two decades was really only setting the stage for a financial crisis and the Great Recession. We have also paid the price in inflation, the invisible tax.

The belief has been as long as the Fed hits an inflation target of around 2-4%, they can maintain moderate business cycles. Business cycles are basically the swing in overall spending, or aggregate demand. If there is too much spending, you’ll have unsustainable growth and an inevitable correction, as we’ve seen with the housing bubble. If there is a collapse of spending, you’ll see a recession and high unemployment. The only way to dampen the business cycle is to maintain a level of spending. The Fed pumps money into the system when the velocity of money declines to hit their inflation target. The velocity of money is how fast money exchanges hands and works through the economy. The Fed will suck money out of the system when velocity goes up to hopefully curb inflation and hit their target. The only problem is they make mistakes. Free banking accomplishes this naturally as a response to public needs in real time. If the velocity of money declines, free banks would tend to issue more money. Their demand for reserves is a function of a flow of payments through the clearing system. When that flow goes down, they can bring it back up again by lending more.

The price level is only an approximate signal as to whether there’s too much or too little money in the economy. Again, you need stability in total spending, not the price level. Total spending and price levels are only more or less equivalent if you hold the productivity of the economy constant. Of course productivity is anything but constant. Consider the equation of exchange:

M (money in circulation) * V (velocity) = P (avg. price level) * Y (output)

Output can change as a result of productivity, so there’s a relative price that has to change. Output price level should be allowed to decline if productivity is improving. Remember: we hope for productivity gains. That is a good thing. The Fed’s inflation targeting doesn’t really account for this.

The economy only gets more and more complex. Take some time and try to wrap your head around derivatives and you’ll figure that out in a hurry. This is all the more reason to decentralize. It doesn’t seem to me that the government has improved the function of the financial system. Financial institutions need to be allowed to fail. They can’t be insulated from their risk any longer. In a free banking system, customers would have to take an active role in identifying the healthiest banks to do business with. Price levels in the economy would be allowed to decline if that’s what productivity or market fundamentals called for.

My feeling is that the large financial institutions in this recent crisis were not too big to fail, but they may have been too interconnected. If one investment bank spent six to twelve months in bankruptcy court, other major banks that had loans, credit default swaps, and investments with the insolvent bank may have ran into trouble. But in a crisis situation, couldn’t we find an orderly and efficient way to liquidate a bank? The FDIC shuts down failed banks over a weekend on a regular basis. Maybe the government should be working on efficient liquidations of private firms.

Instead, we have banks with the same toxic debt as before, and a Federal Reserve balance sheet loaded with bad debt. In return we get an exploding money supply without respect to productivity in the economy. Deflation isn’t always bad. Housing needs to deflate. We overbuilt and consumers are over-leveraged. Deflation can actually promote stability if the rate of deflation stays in line with the rate of productivity growth.

There is a chance you’d lose your money in a free banking system. But, there is also a chance there will be a financial crisis under centralized control. If banks are not allowed to fail and customers take losses, you can end up with only lousy banks, or at least a propensity for them. As we’re experiencing now, so many banks in our system have yet to liquidate toxic debt, the cause of their solvency problems. The Fed injecting liquidity into struggling banks or buying the assets outright doesn’t clear those bad assets from the system. The costs of modern financial crises have been far greater than anything the Scottish free banking experiment ever encountered. The inability for taxpayers to actually control where bailout funds go and how effectively they’re spent is a big problem as well. The political economy and special interests control that flow, which don’t always correspond to the best interests of taxpayers.

Free banking will likely never happen in the United States, but it would be nice if more people talked about it. The system is a viable alternative with some attractive features. The problem is that many people see no alternative to government when it comes to regulating the banking system and monopolizing currency. Here’s hoping this most recent financial crisis will spark some concerns.

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A special thanks to George Selgin. His work helped educate me about free banking.

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