Free banking

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Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency (banknotes). In a free banking system, market forces control the supply of total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of "fiat" money issued by a central bank. In the strictest versions of free banking, however, there either is no role at all for a central bank, or the supply of central bank money is supposed to be permanently "frozen." There is, therefore, no agency capable of serving as a "lender of last resort" in the usually understood sense of the term. Nor is there any government insurance of banknotes or bank deposit accounts.

Institutions of Free Banking

Free banking includes:

  1. Free entry of banking and fiduciary producers
  2. Freedom to issue banknotes (promissory notes issued by a bank payable to bearer on demand).
  3. Freedom to accept money on deposit to current account, and to pay and collect cheques for customers
  4. Freedom to borrow money on term deposit and other forms of secured and unsecured borrowing
  5. Freedom to lend money and otherwise invest the bank's assets
  6. Freedom to provide guarantees, documentary letters of credit, performance bonds and to incur other off balance sheet exposures.

Vera Smith's classic definition of free banking is:

"A régime where note-issuing banks are allowed to set up in the same way as any other type of business enterprise, so long as they comply with the general company law. The requirement for their establishment is not special conditional authorization from a Government authority, but the ability to raise sufficient capital, and public confidence, to gain acceptance for their notes and ensure the profitability of the undertaking. Under such a system all banks would not only be allowed the same rights, but would also be subjected to the same responsibilities as other business enterprises. If they failed to meet their obligations they would be declared bankrupt and put into liquidation, and their assets used to meet the claims of their creditors, in which case the shareholders would lose the whole or part of their capital, and the penalty for failure would be paid, at least for the most part, by those responsible for the policy of the bank. . . . No bank would have the right to call on the Government or on any other institution for special help in time of need. No bank would be able to give its notes forced currency by declaring them to be legal tender for all payments. . . . A central bank, on the other hand, being founded with the aid either direct or indirect of the Government, is able to fall back on the Government for protection from the disagreeable consequences of its acts. The central bank, which cannot meet its obligations, is allowed to suspend payment . . . while its notes are given forced currency." (Smith, Vera. [1936] 1990. The Rationale of Central Banking and the Free Banking Alternative. Minneapolis, Minn.: Liberty Fund., pp. 169–70)

Characteristics of Free Banking

Free banking theorists consider that free banking is characterized by:Script errorScript error[citation needed]

  1. Competitive issue of redeemable bearer currency instead of central bank notes monopoly. Historically this meant banknotes (promissory notes issued by a bank payable to bearer on demand) issued in the form of paper or metal tokens, but cryptography and modern communications technology mean that it can now take the form of electronic tokens, too.
  2. Mutual acceptance by banks of each other's notes at parScript errorScript error[citation needed], and indirect redemption of notes by banks through note exchanges.
  3. In the same way competitive provision of current account services, but cooperation, too, in clearing of inter-bank payments between such accounts through clearing houses and settlement banks.
  4. Development of short term credit markets to allow banks with excess reserves to invest them at interest, and banks in need of reserves to borrow funds short term.
  5. Development of, and bank investment in, marketable debt securities, providing investment opportunities that can be liquidated at short notice, and acting as collateral for short term inter-bank borrowing and lending.
  6. No government-enforced legal tender laws; that is, no legally enforced monopoly currency. Everybody is free to accept or refuse a trade in the currency they choose. A government central bank can still exist and can issue currency but its currency can only be mandatory for Government-related payments, like taxes.
  7. No central bank enforced fractional reserve ratio. Banks are free to vary their bank reserve ratio, or sell financial products with differing fractional reserves, and impose differing restrictions on withdrawal rules and adjust the interest rates offered on accounts, and even offer the option of full reserve banking services.

History

The Free Banking movement got its modern start with The Denationalization of Money, by Friedrich Hayek, who advocated that national governments stop claiming a monopoly on the issuing of currency, and allow private issuers like banks to voluntarily compete to do so.

In the 1980s, this expanded into an increasingly elaborate theory of free market money and banking, with proponents Lawrence White, George Selgin, and Charles Timberlake increasingly centering their writing and research around the concept, either regarding modern theory and application, or researching the history of spontaneously free banking.

History of Free Banks

Banking has been more regulated in some times and places than others, and some times and places it has hardly been regulated at all, giving some experiences of more or less free banking.

  1. Australia. In the late 19th century, banking in Australia was subject to little regulation. There were four large banks with over 100 branches each, that together had about half of the banking business, and branch banking and deposit banking were much more advanced than other more regulated countries such as the UK and USA. Banks accepted each other's notes at par. Interest margins were about 4% p.a. In the 1890s a land price crash caused the failure of many smaller banks and building societies. Bankruptcy legislation put in place at the time gave bank debtors generous terms they could restructure under, and most of the banks used this as a means to restructure their debts in their favor, even though they didn't really need to.
  2. Switzerland.[1] In the 19th Century several Swiss cantons deregulated banking, allowing free entry and issue of notes. Cantons retained jurisdiction over banking until the enactment of the Federal Banking Law of 1881. The centralisation of note issue reduced the problem of the existence of "a bewildering variety of notes of varying qualities ... at fluctuating exchange rates."[2]
  3. Scottish Free Banking.[3] This period lasted between 1716 and 1845. The Bank of Scotland, the original Scottish bank charter and The Royal Bank of Scotland, chartered by England, issued competitive currencies. This resulted in a "currency war" in 1727. The result was a cooperative equilibrium, where both banks agreed to accept rival banks' notes in the ordinary course of business. This area of study has been developed further by Lawrence H. White in his book Free Banking in Britain: Theory, Experience and Debate 1800-1845[4] This example has been contested by Murray Rothbard,[5] resulting in a reply by White.[6]
  4. United States.[7] Although the period from 1837 to 1864 in the U.S. is often referred to as the Free Banking Era, the term is something of a misnomer, for it refers not to a general system of "free" banking in the literal sense described previously, but rather to various state banking systems based on so-called "free banking" laws, which, though they made it unnecessary for new entrants to secure charters (each of which was subject to a vote by the state legislature), nonetheless restricted their undertakings in important ways. Most importantly, U.S. "free" banks were denied the right to establish branch networks, and had to "secure" their notes by purchasing and surrendering to state banking authorities certain securities those authorities deemed eligible for the purpose. The securities in many cases included bonds of the authorizing state governments themselves; and it has been determined that the depreciation of these very securities was the chief cause of "free bank" failures, and indeed of bank failures generally, during the period in question. The lack of branch banking, in turn, caused state-issued banknotes to be discounted at varying rates once they had traveled any considerable distance from their sources. In short, the shortcomings of banks and bank-supplied paper currency during the so-called "free banking era" in the U.S., far from establishing the need for special regulation of banks, testifies to the dangers of unwarranted or unwise regulation. Then, from 1863 to 1913, known as the National Banks Era, state-chartered banks were still operating under a free banking system. Some scholars have found that the system was mostly stable.[8]
  5. Sweden.[9] Sweden had two periods of free banking, 1830–60 and 1860-1902. Following a bank crisis in 1857, there was a rise in popular support for private banks and private money issuers (especially Stockholms Enskilda Bank, founded in 1856). A new bank law was adopted by parliament in 1864, deregulating the interest rate. The following decades marked the height of the Swedish free banking era. After 1874, no new private banks were founded. In 1901, issuing of private money was prohibited. Work on the Swedish free banking era has been done by Per Hortlund and Erik Lakomaa. Erik Lakomaa (The Quarterly Journal of Austrian Economics, Summer 2007), has demonstrated that the Swedish experiment in free banking was successful. It reduced booms and busts. Only one bank went bankrupt for 70 years, an event related to fraud and not to excessive lending as has happened wherever central banking has been practiced.

There is speculation that with electronic currencies free banking can evolve into anonymous internet banking. The implications of this for the monetary system are unknown, and much of the rigorous theory in this area has been abandoned for a "wait and see" attitude.

Advocates

See also

References

  1. Briones, Ignacio and Hugh Rockoff. "Do Economists Reach a Conclusion on Free-Banking Episodes?", Econ Journal Watch, Vol.2, No.2 (August 2005), pp.279-324.[1]
  2. The Central Bank and the Financial System, Charles Albert Eric Goodhart, p. 211.
  3. "Do Economists Reach a Conclusion on Free-Banking Episodes?". op. cit.
  4. Lawrence H. White, Free Banking in Britain: Theory, Experience and Debate 1800-1845, London: Institute of Economic Affairs, 1995, ISBN 0-255-36375-3.
  5. Rothbard, Murray The Myth of Free Banking in Scotland
  6. George Selgin and Lawrence H. White, In Defense of Fiduciary Media- or, We are Not Devo(lutionists) We are Miseasians, The Review of Austrian Economics, Vol. 9, No. 2, (1996):83-107 ISSN 0889-3047.
  7. Ibid
  8. Microeconomics of Banking, De Xavier Freixas, Jean-Charles Rochet, p. 261.
  9. "Do Economists Reach a Conclusion on Free-Banking Episodes?", op. cit.
  10. Free Banking Explained - The Progress Report November, 2008
  11. http://www.cato.org/pubs/pas/pa017.html
  12. http://www.richmondfed.org/publications/research/region_focus/2009/winter/full_interview.cfm
  • Ebenstein, Alan. Friedrich Hayek: A Biography. University of Chicago Press, 2003. Print.
  • Selgin, George. The Theory of Free Banking. Rowman & Littlefield Publishers, Inc., 1988. Print.
  • White, Lawrence. Competition and Currency: Essays on Free Banking and Money. New York University Press, 1992. Print.

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