Most economists consider money to be a special good
that should be controlled by the national government. But advocates of
free banking consider money a private good which, as any other good,
must meet the market test of acceptability. Let us consider the
advantages of free banking, and see how such a system might be
implemented in the United States.
Under free banking, no government agency would grant a
charter to allow a bank to operate. Banks would be free to begin
operations as they saw fit, just as other businesses. They could acquire
funds from any source: equity, deposits, bank-notes, or other
liabilities such as debentures; and pay whatever market conditions
dictated on these sources. They could then use these funds in the manner
most profitable to the bank as long as they avoided deception or fraud.
They would hold whatever reserve they wanted - cash, securities or
claims on a clearinghouse - wherever they wanted to hold it. Loans and
securities would not be subjected to interest controls, nor would
investment in any particular industry be mandated or forbidden. If so
desired, banks could even acquire equity positions in other firms. The
only role for government would be to prosecute fraud and enforce
contracts, including settling disputes in court. Banks would not be
subjected to government audits or made to pay any special taxes not
levied on other businesses.
Money did not originate through some governmental body
authorizing its use, but rather by the public and the market deciding
what was mutually acceptable. Free banks could continue to offer to
exchange their recognized and highly tradeable liabilities for the less
well-known and less marketable liabilities of others. Traditionally,
banks have persuaded the public to use bank-notes and checkable deposits
as money. The right to issue these notes and deposits was never a
government prerogative, but the common right of all (Breckenridge 1895,
p. 196). In the quasi-free-banking systems of the past, bank-notes and
deposits were normally convertible; that is, redeemable on demand in
some reserve asset that the bank could not create, such as gold or
silver. Central banks entered the picture and eventually monopolized the
issuance of currency, leaving deposit creation to commercial banks.
Since currency became an outside money which banks
could no longer issue, they could not exchange one liability for another
- deposits for bank-notes - as the public desired, but instead were
forced to use up reserves or borrow from the central bank to placate
public demand for currency. The ability to issue their own notes
permitted banks to ease public fears about bank runs and to reduce funds
tied up in till money, since un-issued bank-notes were not a liability
on the bank's balance sheet, but were instantly available. This was
especially helpful to Canadian and Scottish banks in minimizing the cost
of operating branch offices (Breckenridge, p. 387; Beckhart 1929, p.
377; White 1984, p. 40).
Banks in an unregulated system would be free to open
and close branches wherever they wanted. Branching allows banks to
diversify their loans geographically and industrially, since banks would
be in a position to acquire loan customers all over the country. An
increased need for banking services in a particular area of a nation is
met more readily by a new branch of an existing bank than by a new unit
bank, which requires new directors and managers. Furthermore, within a
given financial center, reserves can be moved among branches of one
institution more quickly and cheaply than among institutions.
Branching would not be required, of course, but would
face the test of the market. Experience from both Scotland and Canada
shows that unit banks found it difficult to compete with larger branch
banks and were frequently absorbed by them (Breckenridge, p. 146; White
1984, p. 3 6).
Many specialized thrift institutions, such as savings
banks, savings and loan associations, credit unions, and trust
companies, originated because commercial banks were legally barred from,
or voluntarily eschewed, a particular field of lending. Free banking
implies no restrictions on bank lending or investing; hence specialized
thrifts would be necessary only for loan categories systematically
shunned by banks.
Limit on Credit Expansion
Unlike the current arrangement, whereby the central
bank controls the ultimate expansion of the money supply through its
control of the money base, bank loan expansion under free banking would
be controlled by the exchange of notes and deposits through
clearinghouses. Banks that expanded their lending more rapidly than
others would face adverse clearings and would be forced to curtail their
lending unless they possessed more cash reserves than their rivals.
These reserve assets could be deposits in the clearinghouse, gold,
silver or some other "outside" money, such as Federal Reserve Notes
(FRNs), which would be frozen in supply as were Greenbacks after the
Civil War. If the Federal Reserve (Fed) were abolished, existing FRNs
could serve as base money in a free banking system.
An individual bank could increase its reserves by a
lending policy more restrictive than that of its rivals. The expanding
bank would find its notes and deposits presented for redemption in
reserve money; the more restrictive bank would gain reserves, as a
smaller volume of its liabilities would be presented, by other banks,
for payment through the clearinghouse.
However, the reserve base in an entirely free banking
system could expand only if new reserve money entered from the outside.
Since no FRNs would ever again be printed, the only avenue open would be
an influx of gold or silver from other areas or from mining. But no
central bank could expand the money base at will, imparting monetary
disturbances to the economy.
Since no bank would be legally required to maintain any
specific reserves, each bank would hold only the amount of the reserve
assets indicated by its experience and liquidity preferences. Thus, if
all banks in the system were to expand their lending by the same
percentage, the check on them would not be adverse clearings, since each
would be receiving from every other roughly the same amount of notes and
deposits. Instead the expansion would be checked by each bank's desired
holding of reserves plus the public's desired ratio of base money to
notes and deposits. If the public trusted banks it would be unlikely to
convert notes and deposits to specie or FRNs, but such a conversion
would act as a brake on bank expansion.
White (1984, p. 44n) found that Scottish banks, during
the late 1700s and early 1800s, were able to reduce their average gold
reserves from 10 per cent and higher to 3.2 per cent as these banks
gained more public confidence. In any case, credit expansion is limited
in a free banking system, since the public will hold only a finite
amount of any issuer's distinctive notes and deposits. But under our
current system, there is no limit to expansion by the central bank,
because the supply of its monopoly money will create its own demand, as
the public has no choice but to hold whatever amount is created to
support a higher level of nominal income and prices (Yeager, p. 42).
Transition to a Free Banking System
The first step to achieve a free banking system is to
remove all legal obstacles to the production of "outside" base money
plus all restrictions on private banking. The legal impediments to the
production of outside money, according to White (1984a, pp. 297-98),
include: (1) a prohibition on the minting of private coins; (2) a sales
tax on the purchase of commodity monies; (3) a capital-gains tax on the
holding of non-dollar currencies; and (4) uncertainty regarding the
upholding by courts of the payment of a contract in anything but
dollars, even when gold is specified. Removal of these barriers would
signify that the field is open to any type of innovation that might seem
profitable to undertake.
Simultaneously, Congress would have to abolish the Fed,
freeing the existing supply of FRNs (the Bureau of Engraving can replace
worn bills). The Fed would dispose of its assets, after buying back its
stock from the member banks. Termination of the Fed could proceed as
follows: (1) cease open-market operations and discounting; (2) require
the Fed to buy back its stock from member banks by crediting their
reserve accounts; (3) send all government securities and gold
certificates to the Treasury for cancellation; (4) move the Treasury
account to the commercial banking system; (5) let foreign central banks
move their accounts wherever they wish; (6) phase out the Fed's
check-clearing system, perhaps over one year, as deregulated commercial
banks establish branches nationwide and assume the clearing function.
Private Banking. Equally important, however,
would be total deregulation of private banking, concurrent with
dismantling of the Fed. The immediate steps should be: (1) allow free
entry with no charter needed from any governmental agency; (2) grant
freedom to branch anywhere; (3) abolish reserve requirements; (4) remove
restrictions on the type of assets held; (5) abolish limits on interest
rates paid or charged; and (6) allow banks to issue distinctive
bank-notes or even fractional token coins.
The freedom to enter without charter should charter
should reduce the forced difference between banks and thrift
institutions. The unlimited branching will further erode this
distinction as mergers occur between banks and thrifts. In addition,
unrestricted branching will expedite the replacement of Fed
check-clearing with private clearing. Unlimited branching will also lead
to the end of correspondent relationships among banks and the holding of
inter-bank deposits, a feature peculiar to the unit banking system. When
allowed to branch, as in Canada and Scotland, banks hold insignificant
amounts of the liabilities of other banks, and are insulated from
contagious bank runs.
The abolition of reserve requirements would permit
banks to escape the implicit tax with which they have been burdened
since the beginning of the National Bank System during the Civil War;
they could then earn profits on all of their assets, rather than about
90 per cent of them. A fixed percentage required reserve is the least
liquid asset a bank has. When banks are permitted to hold any amount of
reserve they want, their anticipated liquidity needs are the sole
determinant of the amount and location of those reserve.
As an example, before the Bank of Canada was founded in
1935, Canadian banks faced no reserve requirements but held as desired
reserve: outside money, call loans in New York and London, securities
and commercial paper, and deposits in foreign banks (Beckhart, p. 430).
Cash reserves were normally 10 per cent of total liabilities, but
fluctuated between 8 per cent and 15 per cent. Banks watched the balance
sheets of their rivals: the stronger ones kept the weaker in line by
refusing to take checks drawn on them or refusing to lend to them in a
crisis (Breckenridge, p. 433; Beckhart, p. 485). Most of the outside
money (specie and Dominion Notes) was kept at the financial centers; the
branches used mostly un-issued bank-notes as their till money. Since
un-issued bank-notes are costless, this economy measure helped subsidize
some of the branches in remote areas.
A similar situation could evolve in the U.S. under free
banking. The cash reserves of banks would probably consist of FRNs at
first, and then specie if the public displayed a preference for
convertible bank-notes and deposits. But secondary reserves would
undoubtedly be invested in short term securities (such as Treasury
bills, commercial paper, and bankers' acceptances) and call loans. No
longer could banks consider themselves liquid merely because they could
borrow outside money from a lender of last resort. Each would be
responsible for its own liquidity, and any burrowing would have to meet
the standards of the market.
It is also very important that banks again be allowed
to issue bank-notes if unregulated banking is to succeed. This enables
banks to exchange one liability for another - deposits for notes - at
the demand of the public, without disturbing the bank's reserves, or any
other asset. In addition, these bank-notes should be distinctive, not
uniform as were the National Bank-notes, and issued without pledging any
specific asset, such as government bonds. Distinctive bank-notes would
meet the daily test of convertibility: Each bank would be anxious to
issue its own notes; upon receiving notes issued by others, it would
return them to their issuers through a clearinghouse. To pay out the
notes of another bank would be acting as a broker without fee; to hold
them would be lending to the issuer without interest (Breckenridge, p.
407). Therefore, note exchanges act as a check on expansion just as
check clearings do.
Allowing an unrestricted issue of bank-notes, with no
requirement to pledge certain assets such as government bonds, permits
banks to supply the exact amount of currency that the public demands at
the instant they demand it. Panics and bank runs can be avoided if the
public is allowed to exchange one type of money-deposits for bank-notes
- when it wants. The panics of 1873, 1893, and 1907 in the U.S. resulted
when the public could not convert their deposits to currency (Canadian
depositors experienced no such difficulty). Many national banks in the
U.S. found it unprofitable to hold the 2 per cent government bonds that
were required to back their notes, thus were unable to issue enough
notes to satisfy the panicky demand for currency. When banks tried to
satisfy this demand by paying out their cash reserve (gold certificates,
greenbacks, and other Treasury currency), they depleted their required
reserves, and were forced to suspend payment.
Deposit Insurance. Another important step in
achieving free banking is terminating the Federal deposit insurance that
has existed since 1934. Deposit insurance was part of a system of strict
regulation designed to save the unit bank system during the credit
implosion of the early 1930s. It is rarely found in nations with a small
number of large branch banks, even though Canada adopted a plan in 1967.
But it is totally incompatible with free banking and thus would have to
be phased out.
There are private options to government deposit
insurance that should be explored. One such option could lie with the
individual depositor. If uneasy about banking, this person could
approach an insurance company about insuring his deposit. The insurer
could diversify its risk by covering accounts up to a specified maximum
in any particular bank, and then asking future clients to deposit in
other banks where the insurer is covering smaller deposit volumes.
Another option lies with the banks themselves. They
could alleviate public concern over safety by offering low-interest
accounts with preferred claims on bank assets in case of liquidation.
Another alternative, similar to the existing tax-and-loan account, would
be to offer low-interest accounts backed by pledged securities. Other
depositors would receive market rates but would have no special
protection.
Bank-notes vs. Deposits. Holding private
bank-notes rather than government fiat money would be a new experience
for the current generation. Many may be reluctant to accept "funny
money" at first, especially since holders of bank-notes, unlike
depositors, may not be customers of the issuing bank, but merely
recipients of its notes in the course of business.
But banks could overcome the aversion to private
bank-notes in several ways. Banks could assume the risk for counterfeit
notes. Scottish banks honored forgeries presented over the counter by
innocent persons, but not those accepted by other banks and returned
through clearings. This put the burden on rival banks to be on the alert
for counterfeit notes. At any rate, counterfeiting is much more tempting
in a fiat-money system than in a free-banking system, in which the notes
return quickly to the issuer (White 1984, p. 40). Banks could also offer
to pay interest on any note not immediately redeemed in base money on
demand.
Free banks could voluntarily offer multiple liability
for stockholders if such proved reassuring to depositors and
note-holders. Scottish banks operated with unlimited liability for their
owners; Canadian banks and National banks in the U.S. formerly imposed
double liability on their stockholders. The market might compel smaller,
newer banks, but not large, well-established institutions, to impose
multiple liability.
Banks could offer a mutual note guarantee exemplified
by the Bank Circulation Redemption Fund (BCRF) that protected Canadian
bank-notes from 1891 until they were replaced by Bank of Canada
currency. Banks contributed to a fund to redeem the notes of any failed
bank, which notes were to earn interest until redeemed (Beckhart, p.
302). While this measure was successful in that the notes of even weak
banks circulated at par all over the country, it put the depositor in a
position inferior to that of the note-holder. In addition, this was not
a voluntary arrangement but was mandated by the Bank Act of 1891. But in
Scotland, when the Ayr Bank failed, other banks voluntarily advertised
that they would accept Ayr notes, thereby bolstering confidence and
gaining customers (White 1984, p. 32). A similar offer under free
banking could include depositors as well as note-holders.
A Temporary Lender of Last Resort
When a free banking system is established, reliance on
a governmental lender of last resort should be avoided even on a
temporary basis. With the Fed abolished, it might be tempting to permit
banks to borrow fiat money from the Treasury for a few years during the
phasing out of the FDIC. Canadian banks were allowed to borrow Dominion
Notes from the Minister of Finance in 1914 as a wartime measure, but
this practice was not terminated when the war ended in 1918; it
continued until the Bank of Canada began in 1935. Canada did not return
to the gold standard until 1926, but this borrowing of base money from
the government was incompatible with the gold standard, and the latter
was abandoned in 1929 (Curtis 1932, p. 322).
A government lender of last resort is also incompatible
with a free banking system, wherein each bank is to be responsible for
its own liquidity. Free banks can borrow from one another at market
rates, but a lender of last resort is needed only when one bank holds
all of the outside money, as did the Bank of England during the 1800s
(White 1984, p. 145). Under free banking, no bank would incur
liabilities in some money that it could not issue.
Coinage. In addition to bank-notes, private
banks would also be responsible for new coins: full-bodied coins for
reserves, and fractional, token coins for making change. The market
gradually developed coins to expedite the assessment of the value of
varying amounts of commodity money. Governments intervened to monopolize
coinage to extract a profit for themselves. Coinage could have remained
private, with inferior coins circulating at a discount (Selgin &
White 1985, pp. 4-5). Private mints, faced with existing and potential
competition, would have much less incentive to debase coins than would a
state with a monopoly on coinage.
Establishment of a free banking system requires that
the Treasury cease minting its token coins, just as the Fed must stop
issuing currency. However, the Treasury could be allowed one last profit
by selling all its gold at Ft. Knox at market prices, ending any
conceivable government role in money creation. This seems easier than
the Timberlake (1984, p. 189) proposal to give everyone in the country
an equal share. The existing quantity of Treasury coins would be frozen,
joining the existing FRNs as part of the base, and still used as a
medium of exchange. Banks, however, would issue new fractional coins, as
well as bank-notes. Professor Hayek has hypothesized that local
merchants might collaborate to sell through banks a set of uniform coins
or tokens to be used in vending machines, perhaps replacing metallic
coins with plastic ones bearing electronic markings discernible to cash
registers and slot machines (Hayek 1978, p. 48n). If the many U.S.
railroads could agree on a standard gauge for tracks, banks and
retailers can agree on a substitute for Treasury coins.
Possible Concerns over Free Banking
To those who have experienced only a government
monopoly of base money, and central bank manipulation of that base, free
banking may seem too radical, even though the inflationary record of
central banking must inspire a search for alternatives. If money
creation were divorced from the government, politicians would have to
pay for their spending with taxes or real borrowing, but not by
government monetization of deficits.
Critics may fear free banking would be deflationary, as
the money base could grow only through additions to the gold or silver
stock, since the FRN quantity would be frozen. But this ignores the
possibilities of financial innovations to economize on base money,
higher money turnover rates, and increasing confidence in the ability of
banks to honor redemptions by the public. One Scottish bank in the early
1800s was able to operate with specie reserves of only 0.5 per cent of
assets, revealing that the public may not demand specie when assured of
its availability (White 1984, p. 141). Each competitive issuer can
observe the demand for his money and adjust the supply thereto, a task
no monopoly issuer can accomplish. Each bank must balance the desires of
its depositors, who fear a depreciating money, with those of its
borrowers, who would object to an appreciating money. But free banking
does promise to end the inflationary bias that has crept into most wage
negotiations and other long-term contracting. It is a system that would
be consistent with more flexibility of prices and wages.
Other qualms about free banking may afflict bankers
themselves who have spent their entire careers in a regulated
environment. Older bankers may resist the adjustment; but younger,
perhaps better educated ones might find a new, unregulated setting to be
a stimulating challenge. Many large retailers and brokerage houses
already have in place nationwide offices from which a new type of
banking business may be conducted. The field may become dominated by
those who were not bankers prior to free banking.
Because the U.S. system currently has no nationwide
banks, as other countries do, growth in the number of banks to a
competitive level may take longer than it would under unlimited
branching. However, the system is not burdened with governmentally
encouraged banking cartels that would stifle competition, and most
interest ceilings have been abolished. But American banks are still
subjected to governmental insuring and auditing, practices incompatible
with free banking. Fortunately, no private U.S. bank is a government
pet, like the Bank of Montreal (BOM) or the Bank of England (BOE). No
American bank would be the government's fiscal agent: Over 11,000 banks
currently hold tax-and-loan accounts of the Treasury; if the Treasury
closed its account at the Fed, no single private institution would play
the role of the BOM or BOE. Vis-á-vis the banking system, the U.S.
government would be neutral, having no independent Treasury funds to
deposit at various times, as was the case before 1914.
Finally, free banking is most likely the system that
would have emerged from normal market forces, had governments not
interfered with banks and money by imposing specific bond-holding for
note issue, mandating fixed percentage reserve requirements, forbidding
branching across state lines, and creating a central bank to expedite
inflationary governmental finance.
At the time of the original publication, Dr. Wells
taught in the Department of Economics and Dr. Scruggs in the
Department of Finance at Memphis State University, Memphis, Tennessee
This article was based on a paper presented to the Southwestern
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Reprinted with permission from The
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July 1986, Vol. 36, No. 7.
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