Although we can say a great deal about the institutions
of a free society, and why they are desirable, speculating about the
specific ways in which people will choose to organize themselves within
such institutions is always a tricky matter. After all, the whole
justification for the institutions of a free society is that only
through its institutions can human beings discover progressively better
ways of dealing with scarcity (of both goods and knowledge) and thus
improve both our material and non-material welfare. Our ignorance of the
details of a free society is precisely why having a free society is so
important.
Nonetheless, this need not completely discourage us
from imagining what the details of some aspects of a freer economy might
look like. One way to go about this task is to look at the various ways
a particular industry is unfree and imagine what removing those
restrictions might do. In conjunction with such a thought experiment we
might also look for historical examples where the industry in question
was more free and explore the ways in which it operated and organized
itself.
The banking industry is especially suited for just this
kind of analysis. If we want to know what commercial banking might look
like in a free society, we need only turn to contemporary regulation and
the historical record to begin to piece together a coherent story.
There are four major areas in which the freedom of
American commercial banks is restricted. The first area is the set of
prerogatives taken away by this existence of government central banks,
particularly the private issuance of currency. The second deals with
restrictions on geographic location, while the third concerns the
relationship between banks and non-bank firms. Fourth, as a result of
the first three, is mandatory deposit insurance.
Central Banks and the Issuance of Currency
In order for central banks to undertake the activities
they, or their political overseers, have deemed necessary, they must
acquire a monopoly over the production of currency. This restriction on
the freedom of individual banks to create the kinds of financial
instruments their customers might want has large and pervasive effects
on the macro-economy and the size of government more generally. Because
"customers" must use the government-issued currency, they have no way of
indicating their dissatisfaction with its quality or value. This is what
enables governments to use the banking system to raise revenue; if they
create more currency, it will be accepted by someone somewhere.
Central banks also have had a notorious time, even when
the political incentives to inflate can be overcome, figuring out
precisely what the right quantity of money should be. In a small version
of what would face a comprehensive economic planner, central bankers
attempt to estimate the demand for money and create the appropriate
amount in response. For the reasons so skillfully articulated by Mises
and Hayek, there are enormous knowledge barriers to this kind of central
planning, even in one industry.
In a free society one would expect banks to produce
their own brands of currency which would compete for the business of
money users. Although this may seem a bit strange, having lived in an
economy with only one currency, it really is not that much different
from where we are today. Firstly, banks already offer competing monies.
A checking account at Chase Manhattan is a different brand of privately
produced money from a checking account at Citibank. Checking accounts
are liabilities of the banks that create them, making them privately
produced. They also differ in various ways: interest paid or not, rate
of interest, fees charged, services offered, overdraft protection, and
so on. Depositors choose among banks today based on the total package of
products and services that accompany a checking account. One would
expect the same if currency were competitively produced.
More important, competition in currency production
would give producers the incentive to neither overproduce nor
under-produce currency, and therefore maintain its value. In order for
banks to get their liabilities (either currency or checking accounts)
accepted, they would have to make them redeemable in some commodity
(such as gold) or some other asset. Customers would not accept mere
paper liabilities without some connection to an item which had value
outside of the banking system.
As a result, any bank which overproduced would find
customers returning unwanted currency which would lead to a fall in the
bank's holding of the backing commodity, reducing its ability to create
loans. Banks cannot afford to risk reserve shortages like this, so they
would reduce their outstanding currency liabilities until those losses
stopped. Banks that issued too little currency would see their reserves
piling up and would be sacrificing the interest they could earn by
making loans backed by those reserves. In a free society, the same
market forces that create incentives to produce the correct quantity of
shoes, toothbrushes, or eggs, would apply to currency. Because the
banking system of a free society would get the supply of money generally
right, it would also avoid the macroeconomic problems of inflation and
deflation that have resulted from unfree central banking systems.
Virtually every country on the planet has had some
experience with privately produced currency. The historical evidence
suggests that countries with less regulated currency production had
fewer bank failures and more stable macro-economies. The Scottish
banking system of the late eighteenth and early nineteenth centuries is
a good example of the benefits of freedom, especially when compared with
the substantially less free English banking system of the time. The U.S.
experience of the nineteenth century provides a good example of how
problems can develop when even private currency production is
over-regulated. The recurring crises and panics of the period can be
seen as unintended consequences of misguided bank regulations.
In order to make their currency monopoly work, central
banks have imposed other restrictions that would be absent in a free
society. For example, central banks require banks to hold certain
minimum levels of reserves. Normally these are higher than banks would
otherwise hold and they usually do not earn any interest. Effectively
they are a tax. In addition, reserve requirements prevent the public
from having accurate information about bank portfolios. Banks that could
afford to hold fewer reserves because they are safer are prevented from
doing so, and banks who are riskier and might choose to hold higher
reserve levels, especially in the absence of government mandated deposit
insurance (see below), have no need to do so. In a free society, banks
could pick the level of reserves they saw fit and would have to bear the
consequences of holding too many or too few reserves.
More generally, a free society would not see central
banks in the way they have developed in the nineteenth and twentieth
centuries. There is nothing inherent in the evolution of banking that
necessitates them, and their existence results from constitutionally
unconstrained politicians striving after a cheap source of revenue. Of
course banks in a free society would likely develop inter-bank
institutions such as clearinghouses, but these would have no special
government privileges and would be forced to compete for members and
business.
Interstate Banking
A more general way of thinking about banking in a free
society is that banks will be subject to the same laws as other
corporations. One example of how that is not true today is the issue of
interstate banking. It is very difficult for many American banks to open
up branches across state lines. Laws permitting interstate banking are
made at the state level and they vary from state to state. Although most
states have liberalized these laws to some extent in the last 10 or 20
years, full nationwide banking does not exist.
One result of this is that many banks are
insufficiently diversified because they are too closely tied to
industries specific to their state. When those industries falter, the
banks fail with them. Banks that can spread their risks across different
industries, by operating in different states, are less likely to fail.
One bit of historical evidence for this contention comes from Canada.
Canadian banks have historically been able to operate nationwide. While
over 5,000 American banks failed in the 1920s and early '30s, only one
Canadian bank did. Although a number of bank offices closed, only the
one bank failed. This statistic is even more compelling when one
considers that the variation in economic conditions between rural and
urban Canada is greater than in the United States, posing a greater
diversification challenge.
In a free society, we could expect banks to operate
wherever they pleased, just as other firms do now. The need for
traveler's checks, or the hassle of finding a new bank after moving,
would disappear as true nationwide banking would make it far more likely
that one's bank would have offices in more places. One consequence of
this change would be a smaller number of larger-sized banking
organizations. However, as evidence from countries which permit
nationwide banking indicates, these larger banks would operate more
offices per capita than smaller banks. This would both improve access to
banking for most people and enable banks to capture the cost
efficiencies of large-scale production that are now closed off.
Glass-Steagall Restrictions
One other set of regulations on contemporary American
banks are so-called Glass-Steagall restrictions. As part of the banking
reform acts of the 1930s, a firm may not own both a commercial bank and
a non-bank business. Firms like Sears that provide financial services
can only provide those services to non-commercial customers. These laws
also prevent banks from selling insurance or underwriting securities.
Many argued that such an intermixture of banking and commerce was
responsible for the numerous bank failures of the early 1930s, so a
regulatory wall was needed to separate banking from commerce. Subsequent
research has found this explanation of the bank failures to be incorrect
and the justification for Glass-Steagall restrictions has been greatly
weakened. Even the Clinton administration has recognized this and
included liberalization of these regulations, as well as those on
branching, in its reform package.
In a free society we would expect to see financial
supermarkets where one could address all of one's financial needs
(banking, insurance, investment) in one firm. There are obvious
efficiency gains to producers in such a situation, as well as better
service to consumers with one person or group overseeing their whole
financial portfolios.
Because of the activities of central banks and the
various other regulations noted above, bank failures are a real worry in
unfree banking systems. As a result, governments have imposed mandatory
deposit insurance in order to prevent the potential bank runs that their
own regulations can trigger. If banks in a free society are unencumbered
by central banking and other regulations, we would expect the whole
problem of bank runs to be far less significant. Given this, any
possible justification for government-mandated deposit insurance
disappears.
Private Deposit Insurance
Banks in a free society might choose to purchase
privately supplied deposit insurance as a way to reassure customers.
They might also enter into inter-bank mutual aid agreements, or be
insured through clearinghouses. Historically, banks have used these and
other methods to convey trust to customers. Before deposit insurance
banks would advertise their balance sheets and list the members of their
boards of directors. Providing this kind of information was a way to
establish their trustworthiness to actual and potential depositors. With
deposit insurance, banks need not do this. It is reasonable to expect
that banks in a free society will use these ways, and discover new and
imaginative ones, of creating the trust on which all banking systems
rest.
Banks in a free society will be literally nothing
special. What makes banking so unfree today is that banks are treated
differently from other business enterprises. The rule of law that would
characterize a free society would demand that banks be treated no
differently than other firms. If they are fraudulent or use force, then
they need to face the consequences. Otherwise, any sort of voluntary
arrangement banks make with customers will be allowed. The result will
not only be a more free banking system, but a more efficient, safe, and
productive one.
At the time of the original publication, Steven
Horwitz was Assistant Professor of Economics and Flora Irene Eggleston
Faculty Chair at St. Lawrence University in Canton, New York.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
July 1994, Vol. 44, No. 7.
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