Free banking

From Liberpedia

Free banking is banking with competitive entry and note issue, without a state-granted monopoly. Banks remain bound to honour the obligations they actually promise.[1]

Historical use of the term

In the nineteenth-century United States, “free banking” laws permitted entry under general incorporation rules rather than requiring an individual legislative charter. Banks could nevertheless face restrictions on branching and on the assets eligible to back their notes. Selgin distinguishes these historical arrangements from the competitive note-issue system analysed in his theoretical model.[2]

Institutional evolution

Hülsmann distinguishes explaining how an institution could solve a problem from proving that the problem must produce that institution. He argues that an account of banking’s evolution does not establish fractional reserves as the necessary outcome of every unhampered market.[3]

Selgin introduces his imaginary Ruritanian banking system as a conjectural reconstruction, supported by historical illustrations. He describes successive stages as logical outgrowths, while acknowledging that actual innovation can involve dead ends and destruction of earlier arrangements.[4]

Contracts and reserves

Free entry does not settle the reserve ratio. Selgin and White defend the voluntary issue and acceptance of fractional-reserve claims, distinguishing redeemable bank debt from irredeemable fiat money. Their defence rests on contractual consent.[5]

Full-reserve custody and credit

Hülsmann’s full-reserve proposal separates custody from financial intermediation. Gold backing demand claims remains in storage, with customers paying for custody and payment services. Lending can still take place using money its owners have lent to intermediaries for a period; full reserves therefore do not eliminate credit.[6] Selgin and White likewise allow customers to choose fee-charging full-reserve custody. Their defense of fractional reserves concerns allowing an informed customer to choose an interest-bearing debt claim instead.[7]

Conditional redemption and contractual remedies

Selgin and White distinguish a debt contract from a warehouse receipt. In their account, failure to honor an unconditional redemption promise is a breach; fraud involves willful deception. Their defense of fractional reserves concerns terms that customers freely and knowingly accept.[8]

An option clause can instead specify a limited delay in redemption, with interest payable to the holder and repayment of face value in base money. Selgin and White give this interest two functions: compensating the holder for waiting and penalizing the bank for invoking the clause unnecessarily or keeping insufficient reserves. The arrangement therefore retains a redemption obligation rather than giving the bank an indefinite right to refuse payment.[9]

Hülsmann disputes whether such clauses and conversion into equity can remedy fractional-reserve banking. Time and real goods remain scarce, he argues, and agreement by customers cannot authorize inflationary costs imposed on outsiders. He also argues that circulating suspended claims or equity in place of money would fragment the monetary system.[10] Selgin and White’s separate discussion of third-party effects distinguishes changes in market value from infringements of property rights and acknowledges possible risk spillovers beyond the bank’s customers, while judging the benefits larger.[11]

Clearing and liquidity

Mises argues that redemption demands and interbank settlement restrain an expanding bank.[1] Rallo envisages competing private reserve centres, with discipline supplied by convertibility and the freedom to withdraw reserves or change providers.[12]

White distinguishes actual withdrawal patterns from contractual maturities. He also stresses that a bill payable in ninety days cannot provide cash immediately during a general run. Agreement on banking freedom therefore leaves substantial disagreement about prudent liquidity management.[13]

Net settlement

In Selgin’s conjectural account, banks can economize on reserves by offsetting their claims through a clearinghouse. In his three-bank example ($ denotes a commodity-money unit), A holds $20,000 of B’s notes, B holds $20,000 of C’s notes, and C holds $10,000 of A’s notes. The net positions are A +$10,000, B $0 and C −$10,000, so one $10,000 reserve transfer from C to A settles the balances.[14]

The example assumes par valuation and obligations available for settlement together. Redemption duties and the possibility of net reserve outflows remain.[15]

Holder preferences and adverse clearings

Selgin’s argument about one bank expanding against unchanged total note demand also depends on which issuers’ notes people prefer to hold. If holders retain preferred issues and spend unwanted ones, surplus notes tend to return to their issuer through clearing. Indifference between issuers can spread that return flow across banks and weaken the expanding bank’s reserve drain. Selgin argues that enough holders have preferences for particular issuers; his argument does not require every holder to be rigidly loyal to one bank.[16]

Money demand and reserve needs

Selgin distinguishes expansion by one bank from expansion by the whole system. In his model, a general rise in desired bank balances initially reduces payments and precautionary reserve needs, allowing a larger issue against the same reserves. Expansion beyond demand instead increases settlement risk even when expected net payments between banks balance.[17]

This argument depends on payment patterns. Selgin notes that fewer, larger payments can increase reserve needs even with an unchanged total value of payments.[17]

Currency composition and reserves

Selgin isolates changes in money’s form while holding total money demand constant. If banks issue accepted notes with the same reserve needs as deposits, deposit-to-note exchanges need not drain reserves. Own unissued notes cannot settle debts to other banks.[18]

When deposit banks instead pay out a central issuer’s currency, their reserves fall. In Selgin’s fixed-reserve-ratio model, a $100 currency increase requires $90 of additional base money at a 10% reserve ratio to keep total money unchanged. The formula, ΔB = (1 − r)ΔC, assumes that commodity money does not circulate among the public.[19]

Bank runs and panics

Selgin distinguishes a currency run, seeking banknotes for payments, from a redemption run, seeking the ultimate settlement asset. Issuing more notes cannot satisfy holders who distrust the bank itself. A solvent bank can still face distress through hurried asset sales. Other banks may lend during an isolated run; a system-wide panic can leave too few unaffected lenders.[20]

Selgin favours an information-based explanation of panics and argues that traded note prices could reveal bank-specific risk.[21] A rival model by Diamond and Dybvig permits runs driven by depositors’ expectations that others will withdraw. Its consumers learn privately whether they need goods early, while invested goods yield more if left to mature. A demand-deposit contract promises a fixed early payment and serves withdrawals in order of arrival. When that promise exceeds the assets’ early-liquidation value, a run can be an equilibrium without new evidence of bad investments.[22]

Diamond and Dybvig also examine a contract permitting suspension after a specified volume of withdrawals. When the fraction needing early consumption is known and fixed, a suitably chosen limit removes the incentive for patient depositors to run. When that fraction is uncertain, suspension can prevent runs but may deny payment to consumers who really need it; under their sequential-service constraint, uninsured bank contracts cannot achieve the full-information risk-sharing optimum.[23]

Their deposit-insurance result depends on a specific fiscal power. The government can tax depositors after they withdraw and base the tax on total withdrawals; a bank subject to sequential service cannot revise earlier payments in this way. With an optimal tax, the guarantee implements the full-information optimum by making waiting preferable for patient depositors. The authors warn that this result assumes unconstrained tax policy: distortionary financing can reduce the gain, and sufficiently perverse taxation can make insurance worse than no insurance.[24]

In the simpler case of known, fixed withdrawal needs, a credible guarantee prevents runs and remains unused in equilibrium. This is why insurance is costless in that particular case of the model.[25]

The formal model uses riskless investment and treats the single bank as the financial intermediary industry; withdrawals represent net withdrawals from that system. In their conclusion, the authors discuss how insurance could affect managers’ choice of portfolio risk. Risky assets, moral hazard and the design of regulation remain questions for an extended model.[26]

A lender of last resort can reproduce the insurance allocation in the riskless case if it uses the same taxes and transfers. With risky assets, however, the authors identify a tension: an unconditional rescue commitment can encourage banks to take correlated risks, while uncertainty over rescue lending can leave room for runs. They suggest structuring deposit insurance so that a failed bank’s owners and managers still bear penalties.[26]

Dispute over unavoidable failure

Hülsmann argues that expected rescue by other banks encourages reserve reduction, until a sufficiently large failure produces a system-wide crisis. He treats this as a source of necessary failure under fractional reserves, and disputes whether uncertain clearing and liquidity costs can discipline expansion.[27]

Selgin describes emergency interbank lending as a profitable response to an isolated run when the troubled bank offers adequate collateral; he also acknowledges that a general panic can leave too few unaffected lenders to help.[28] In their broader 1996 defense, Selgin and White make lending against demandable funding conditional on estimating how long claims will remain outstanding. They recognize that this empirical estimation can go wrong.[29]

In his second discussion of contractual remedies, Hülsmann allows that pooling reserves can meet larger isolated redemption demands. However, he argues that banks then expand credit and reduce reserve ratios until the same problem returns on a larger scale. He applies this objection to branch banking, private clearinghouses and government central banks alike, predicting eventual abandonment of redemption and further inflation or regulation.[30]

Costs and natural monopoly

Selgin argues that cheap paper and printing do not establish that note issue is a natural monopoly. Relevant costs include building acceptance and meeting redemption demands. A natural-monopoly claim concerns whether one issuer can serve the market at lower total cost than several; the benefits of a common unit of account do not by themselves establish that result.[31]

Reserve costs and resource use

Hülsmann argues that the opportunity cost of holding reserves does not make them wasteful: holders can value the services they provide. He accepts that payment innovations can economize on labor and other resources, but argues that reducing reserve ratios merely expands fiduciary claims and redistributes purchasing power.[32]

Selgin and White locate a resource saving in the reduced production of monetary metal when bank claims partly replace it. Their argument concerns labor and capital that would otherwise be devoted to additional monetary gold, separately from gold produced for nonmonetary uses. They combine this with the claim that informed users can prefer the interest and services offered by fractional-reserve banks.[33]

Feedback and monetary policy

Selgin argues that producing notes or account entries cheaply does not tell an issuer how much money people want to hold. He treats clearing and redemption costs as feedback that helps competing banks revise their issues before general price movements become visible. He examines price indices, interest rates and fixed money-growth rules as alternative guides for a central issuer. This comparison abstracts from commodity-redemption constraints.[34]

Hülsmann disputes the informational superiority claimed for fractional-reserve banking. He argues that issuing claims beyond available reserves misleads holders about the goods they can command.[35]

Selgin’s reform proposal

Selgin’s 1988 plan combines competitive banknote issue with a later freeze of the monetary base. The freeze would follow the adoption of private notes for ordinary payments, with clearing based on existing dollars or warehouse claims on them. He also proposes converting statutorily required reserves into Treasury bills when removing reserve requirements, to limit the resulting scope for credit expansion.[36]

The plan assumes public acceptance of private notes and continued use of base dollars for settlement. Selgin also leaves users free to adopt another monetary standard.[37]

Objections and choice of standard

Hülsmann argues that abolishing central banking cannot avoid choosing a monetary constitution: the final reform itself favors particular arrangements. Rejecting a neutral appeal to competition, he advocates a gold standard with 100 percent reserves.[38]

White’s 1981 essay had itself raised a related transition problem: linking a new standard to the dollar makes unbiased competition among potential successors difficult. He also identified government favoritism among currencies in its fiscal dealings as a problem requiring a solution.[39]

Selgin’s 1988 transition proposal includes deliberate measures to encourage private-note adoption, such as making base-dollar notes less convenient in size or denomination, before freezing the base and ending the Federal Reserve’s money creation.[40] However, he makes continued dollar settlement dependent on public acceptance. He explicitly allows another asset to replace base dollars, which would then lose all value because they have no nonmonetary demand. The proposed institutional change leaves the future standard open rather than guaranteeing the dollar’s survival.[41]

Competition within and between standards

White’s 1989 chapter considers how initially separate private currencies might adopt a common parity. A bank accepting rivals’ irredeemable notes at par without a settlement obligation could be forced to accumulate an expanding rival’s issue. His proposed joint arrangement therefore requires each member to settle in a common medium at a fixed rate; he suggests Treasury bills or another low-risk earning asset as possible settlement media.[42]

White expressly limits this mechanism: adverse clearing can restrain a relatively expansive issuer, but does not by itself check growth common to every issuer. For chronic inflation he relies instead on actual or potential competition from alternative standards, while acknowledging that the transition affects which standard is likely to prevail for some time.[43] Selgin’s 1988 reform specifies a different constraint on the settlement base: its nominal stock would be frozen after private-note adoption, with users still free to replace it.[36][41]

Limits and research questions

Writing in 1988, Selgin acknowledges bad loans, bank failures and imperfect adjustment of bank money. He identifies the allocation of loanable funds, international use of base money and clearing without outside-money reserves among questions for further research.[44]

See also

References

  1. ↑ 1.0 1.1 Ludwig von Mises, Human Action, XVII.12, The Limitation on the Issuance of Fiduciary Media.
  2. ↑ George Selgin, The Theory of Free Banking (1988), chapter 1, pp. 12–15; Federal Reserve Bank of Minneapolis, “A History of Central Banking in the United States”, section “Free” Banks: 1837–1863.
  3. ↑ Hülsmann, Free Banking and the Free Bankers, pp. 17–20 and notes 23–25, journal text.
  4. ↑ George Selgin, The Theory of Free Banking (1988), chapter 2, pp. 16–17.
  5. ↑ George Selgin and Lawrence H. White, In Defense of Fiduciary Media—or, We are Not Devo(lutionists), We are Misesians!, 1996.
  6. ↑ Hülsmann, Free Banking and the Free Bankers, pp. 7–9 and 13–14, journal text.
  7. ↑ Selgin and White, In Defense of Fiduciary Media, pp. 87–88, journal text.
  8. ↑ George Selgin and Lawrence H. White, “In Defense of Fiduciary Media—or, We Are Not Devo(lutionists), We Are Misesians!”, The Review of Austrian Economics 9(2), 1996, pp. 87–89 and note 7.
  9. ↑ Selgin and White, In Defense of Fiduciary Media, pp. 89–92, journal text.
  10. ↑ Jörg Guido Hülsmann, “Free Banking and the Free Bankers”, The Review of Austrian Economics 9(1), 1996, pp. 42–45.
  11. ↑ Selgin and White, In Defense of Fiduciary Media, pp. 92–94, journal text.
  12. ↑ Juan Ramón Rallo, Free or privileged banking: the true dichotomy, 26 June 2013.
  13. ↑ Lawrence H. White, The Real Bills Doctrine: A Short Response, 13 October 2015.
  14. ↑ George Selgin, The Theory of Free Banking (1988), chapter 2, pp. 26–27 and notes 24–25, p. 180.
  15. ↑ Selgin, The Theory of Free Banking, chapter 2, pp. 31–32.
  16. ↑ George Selgin, The Theory of Free Banking (1988), chapter 3, pp. 41–46 and notes 8–13, p. 182.
  17. ↑ 17.0 17.1 George Selgin, The Theory of Free Banking (1988), chapters 5–6, pp. 64–85, especially pp. 72–77 and 80–82.
  18. ↑ George Selgin, The Theory of Free Banking (1988), chapter 8, pp. 108–114 and notes 1, 9–11, pp. 189–190.
  19. ↑ Selgin, The Theory of Free Banking, chapter 8, pp. 113–118 and 124–125; note 18, p. 190. Here B is base money, C is currency held by the public and r is the ratio of reserves to bank liabilities.
  20. ↑ George Selgin, The Theory of Free Banking (1988), chapter 9, pp. 133–137.
  21. ↑ Selgin, The Theory of Free Banking, chapter 9, pp. 137–139 and notes 15, 24–26, p. 193.
  22. ↑ Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983, section II, pp. 405–410; doi:10.1086/261155.
  23. ↑ Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983, sections III–IV, pp. 410–413; doi:10.1086/261155.
  24. ↑ Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983, section V, pp. 413–415; doi:10.1086/261155.
  25. ↑ Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983, section V, p. 416; doi:10.1086/261155.
  26. ↑ 26.0 26.1 Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy 91(3), 1983, section VI, pp. 416–417; doi:10.1086/261155.
  27. ↑ Jörg Guido Hülsmann, “Free Banking and the Free Bankers”, The Review of Austrian Economics 9(1), 1996, pp. 38–41.
  28. ↑ George Selgin, The Theory of Free Banking (1988), chapter 9, pp. 136–138.
  29. ↑ George Selgin and Lawrence H. White, “In Defense of Fiduciary Media—or, We Are Not Devo(lutionists), We Are Misesians!”, The Review of Austrian Economics 9(2), 1996, p. 103 and note 27; the introduction on p. 83 states that Hülsmann’s article appeared too recently for a direct reply.
  30. ↑ Hülsmann, Free Banking and the Free Bankers, pp. 45–47, journal text.
  31. ↑ George Selgin, The Theory of Free Banking (1988), chapter 10, pp. 150–154, especially pp. 151 and 153–154; note 23, p. 196.
  32. ↑ Hülsmann, Free Banking and the Free Bankers, pp. 10–13 and notes 12–14, journal text.
  33. ↑ Selgin and White, In Defense of Fiduciary Media, pp. 98–99 and notes 21–22, journal text.
  34. ↑ George Selgin, The Theory of Free Banking (1988), chapter 7, pp. 89–97 and 102–106.
  35. ↑ Jörg Guido Hülsmann, “Free Banking and the Free Bankers”, The Review of Austrian Economics 9(1), 1996, pp. 30–33.
  36. ↑ 36.0 36.1 George Selgin, The Theory of Free Banking (1988), chapter 11, pp. 168–170 and note 10, p. 198.
  37. ↑ Selgin, The Theory of Free Banking, chapter 11, pp. 169–171.
  38. ↑ Jörg Guido Hülsmann, “Free Banking and the Free Bankers”, The Review of Austrian Economics 9(1), 1996, pp. 51–53 and notes 93–101.
  39. ↑ Lawrence H. White, “Gold, Dollars, and Private Currencies”, Policy Report, June 1981; reproduced in the Congressional Record, 18 June 1981, pp. 13059–13061 (PDF 44–46). This is the 1981 essay, rather than the 1989 book edition.
  40. ↑ Selgin, The Theory of Free Banking, chapter 11, pp. 169–170, facsimile.
  41. ↑ 41.0 41.1 Selgin, The Theory of Free Banking, chapter 11, p. 171, facsimile.
  42. ↑ Lawrence H. White, “Gold, Dollars, and Private Currencies”, in Competition and Currency: Essays on Free Banking and Money (New York University Press, 1989), pp. 133–134 and notes 14–16 on p. 136, publisher-authorized preview.
  43. ↑ White, Competition and Currency, pp. 134–135, publisher-authorized preview.
  44. ↑ George Selgin, The Theory of Free Banking (1988), Conclusion, pp. 174–175.
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