Now that the blog is well launched and other contributors are writing posts, I generally will not directly reply to comments. I may reply indirectly in later posts, but I have enough else to do in my life that responding to blog comments is not my top priority. My silence does not mean agreement or disagreement with comments. I will continue to read comments, and I appreciate those who devote thought to writing them.
Free bankers have been fighting a war on two fronts. On one they face champions of central banking and managed money. On the other they struggle against advocates of 100-percent reserve banking. Although the second front is a lot smaller than the first, it’s far from being unimportant, in part because the battle there is being fought against people who generally favor free markets, who might have been expected to join rather than to oppose our cause.
They oppose it for a variety of reasons, one of which is their belief that, in a truly free-market setting, fractional reserve banking wouldn’t survive. Instead, they insist, 100-percent reserve banks would prevail. That they haven't is due, in their opinion, to a banking industry playing field slanted in favor of favor fractional-reserve banks, especially by either implicit or implicit deposit guarantees financed through forced levies upon all banks, and sometimes by taxation or inflation. In short, fractional-reserve banking has been nurtured by government subsidies.
Free bankers have tried responding to this argument by noting how fractional reserve banking has prevailed under every sort of bank regulatory regime, from the earliest beginnings of banking, not excepting regimes that involved very little regulation, like those of Scotland, Canada, and Sweden, and that lacked even a trace of government guarantees or other sorts of artificial support. But since some 100-percenters seem unmoved by this approach, I here take a different tack, which consists of pointing out that every significant 100-percent bank known to history was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions. Yet despite the special support they enjoyed, and their solemn commitments to refrain from lending coin deposited with them, they all eventually came a cropper. What’s more, it was these government-sponsored full-reserve banks, rather than their private-market fractional reserve counterparts, that were the progenitors of later central banks, starting with the Bank of England.
So far as records indicate, the very earliest banks were private institutions that began as sidelines to other businesses. The very first bankers may have been the trapezites or money-changers of ancient Athens, or their later Roman counterparts. But the earliest concerning which any details are known were the “banks of deposit” that arose during the 12th century in Italy, especially in Genoa and Venice, and the record clearly indicates that these banks were credit-granting institutions rather then mere coin warehouses. Indeed, it was almost inevitable that they should have been so, because in order to efficiently undertake to make payments by bank transfer, and so spare their clients the necessity of dealing with the shoddy coins then available, they were bound to promise to return on demand, not the very coins deposited with them, but coins of equal value, which in effect meant becoming debtors rather than bailees. Moreover, overdrafts were bound occasionally to result in credits in excess of cash reserves, while the interest to be earned from additional lending allowed bankers to reduce the fees they charged for their payment services, and even to occasionally pay interest on their “deposits.” In any event the lending was never concealed. In London goldsmith banking took a similar course, though not until the mid-17th century. In short, so far as records indicate, all of the earliest private banks operated on a fractional-reserve basis.
Banking in the medieval and renaissance period was a notoriously risky business, so despite typically holding reserves of roughly a third of their deposits private banks often failed. It was partly in response to these failures, and partly out of fiscal motives, that governments first began venturing into the banking business, by establishing so-called “public” banks, which though government-sponsored were otherwise supposed to operate according to what we might call “Rothbardian” principles, offering a combination of payment and metallic-money custodial services, but without engaging in any lending. The first such bank, Barcelona’s Taula de Canvi, was established in 1401 with the promise that it would be a safe place to store coin. In fact the government intended from the start to draw on its resources to fund the city’s debt, and merchants saw through the scheme. The government then responded by awarding the Taula a monopoly of demand deposits. Still many merchants refused to take the bait, which was just as well since the government eventually drew so heavily upon the Taula that it went bankrupt.
Although Venice’s first public bank, the Banco di Rialto established in 1587, was modeled after the Taula, it actually did operate on a 100-percent reserve basis for some time, and was for some years Venice’s only bank. But far from having out-competed fractional reserve rivals on a level playing field, the Rialto Bank had its operating expenses, including normal returns, covered by customs duties, and was only for that reason able to offer risk-free payment services in exchange for only modest fees. Still the bank’s days were numbered when a rival public bank, the Banco del Giro, was established in 1619, and was initially allowed to operate on a fractional reserve basis. The new bank absorbed its full-reserve rival in 1637, and thanks to continued government demands upon it never did manage to convert to a 100-percent reserve basis. On the contrary: it twice had to suspend payments, in each case for many years.
The most famous of the public 100-percent reserve banks, the Bank of Amsterdam, is also the one most often cited as proof of the viability of that form of banking. But here again, a close look suggests that the proof is no proof at all. For starters, in establishing the Bank of Amsterdam in 1609, the Dutch government also banned the city’s private “proto-bankers”—the analogues of Venice’s medieval money changers and London’s 17th-century goldsmiths—essentially giving the public bank a monopoly of non-coin payment services. The government also required that all bills of exchange worth 600 guilders or more be settled on the new bank’s books. Finally, rather than being true demand deposits, readily convertible into coin at no penalty, deposits at the Wisselbank could be converted into cash only for fees of up to 2.5% of withdrawn amounts, thus allowing it to cover its expenses while also earning a tidy profit without having to make any loans.
Yet, notwithstanding the widespread contrary belief and its solemn promise to “store” all deposits lodged with it, the Bank of Amsterdam did make loans. It did so, first of all, by allowing overdrafts. More importantly, it eventually did so, to a far greater extent, by making advances to the municipal government and to the Dutch East India Company. During the 1650s, for example, the city of Amsterdam borrowed a whopping 2 million guilders, which it never repaid; and after 1684 loans persistently amounted to 20 percent or more of the Bank’s total assets. Finally, in 1790, the failure of the bank’s heavy (and, as usual, clandestine) loans to the then-struggling East India Company forced it, in effect, to devalue most of its deposits by 10 percent, while altogether refusing to repay any of less than 2,500 guilders. At last, when the French invaded Amsterdam and got hold of the Bank’s books, these revealed that its reserves had fallen to less than 25 percent of its liabilities, with the Dutch East India Company alone owing it a grand total of 11 million guilders. Release of the last statistic at once caused the Bank’s famous bullion “receipts,” which were (since an 1683 reform) the only Bank liabilities that could actually be redeemed, to fall to a 16 percent discount.
The passing of the Bank of Amsterdam marked the end of governments' attempts to establish, or to pretend to establish, 100-percent reserve banks, and therefore marked the end of all significant instances of that sort of banking. Yet it was far from being the end of government involvement in the banking business, for the early “public” banks, and the Bank of Amsterdam especially—thanks in part to the myth of it’s always having been solid—were the direct inspiration for another breed of government-sponsored banks, the prototype of which was the Bank of England. Where that development has taken us is too well known to be worth restating here. But let it not be forgotten that it all started with the cry that the public ought not to have to deal with fractional-reserve banks.
A recent article in Econ Journal Watch surveying the favorite dead and living economists of 299 respondents caught my eye. It is also tangentially relevant to Brad’s question about the free banking classics. As you would have expected, Adam Smith was the respondents’ favorite economist before the 20th century, while John Maynard Keyes was the favorite dead economist of the 20th century.
Smith was the founder of modern economics in the sense that his Inquiry into the Nature and Causes of the Wealth of Nations made such an impression that thereafter it was impossible to ignore economic reasoning in debates about human society. Smith was also perhaps the first prominent advocate of free banking. In the last paragraph of book II, chapter 2 of the Wealth of Nations, he claimed that “If bankers are restrained from issuing any circulating bank notes, or notes payable to the bearer, for less than a certain sum, and if they are subjected to the obligation of an immediate and unconditional payment of such bank notes as soon as presented, their trade may, with safety to the public, be rendered in all other respects perfectly free.” In a later post I will return to the reasons for Smith’s proviso regarding small-denomination notes, but for now the important point is that he thought of regulation as the exception in banking, not the rule.
It surprised me that Henry Thornton got no votes. Thornton is not as well known as Smith, but he almost deserves to be. His 1802 Enquiry into the Nature and Effects of the Paper Credit of Great Britain (link is to a 1935 reprint edited by Friedrich Hayek) is, as its title suggests, a kind of reply to Smith’s book. Thornton can be said to be the (neglected) founder of macroeconomics. He integrated ideas on money, banking, interest rates, and business cycles with insight that had no equal for a century, and consequently he was too far ahead of his time to be properly appreciated. One aspect of Thornton’s criticism of Smith is that Thornton advocated central banking. His argument included ideas that were independently rediscovered 70 years later by Walter Bagehot, whose 1873 book Lombard Street is considered the intellectual foundation of modern central banking. Bagehot seems to have been unaware that he was on a path Thornton had already blazed. The same applies to Knut Wicksell and his rediscovery of the idea of the natural rate of interest a century after Thornton. Thornton remains worth reading today. Economists today know much more about many individual topics than Thornton did, but I think we have not yet surpassed him in integrating those ideas into a coherent macroeconomic theory.
Thornton was a man of overflowing talents. He was a banker in the City of London, a member of the British Parliament, and the major financier of the movement to abolish the slave trade in the British Empire. (The 2006 movie Amazing Grace, about the abolitionist movement, has Thornton, played by Nicholas Farrell, in a number of scenes.) His involvement in the abolitionist movement sprang from his deep religious faith: he was an important member of the Evangelical movement of the Church of England. Several books of his religious writings and prayers, published after his death, have remained almost continuously available in print, unlike his economic writings.
Moving on to the 20th century, it surprised me that Ludwig von Mises received so few votes in the poll. The big economic question of the century was whether central planning worked better than the market economy. It was such a big question that roughly 100 million souls perished in China, Russia, and other communist countries proving that the answer was “no.” Mises’s book Socialism (1922), written at a still early stage of the debate, proved to be magnificently right. He should have received more recognition for being 70 years ahead of mainstream opinion. Mises placed 14th in the poll, whereas his student Friedrich Hayek was fourth. In later posts I will have more to say about Mises’s views on free banking and other aspects of monetary theory.
My Free Banking posts will not be focused on the monetary policy aspects of ‘free banking,’ but rather on the other aspects of what I would call a ‘free-er banking’ environment going forward. I plan to focus not only on these non-monetary policy activities of central banks, but also those of the other government actors (Ministries of Finance/Treasury Departments, deposit insurers, supervisors) that have intervened in the banking markets the past century in the US and elsewhere.
About five years ago I completed research on the functions that central banks engage in. This required reviewing about 120 central bank laws from around the world. The more familiar functions are so called ‘core’ functions, which most central banks undertake:
- Monetary policy
- Foreign exchange and reserve management
- Lender of last resort
- Supervision and regulation of commercial banks
- Payment and settlement systems oversight and participation
- Currency and coin management
- Fiscal agent
But central banks also get involved in a myriad of other, ‘non-core’ functions beyond those above:
- Non-bank financial institution supervision
- Management of deposit insurance systems
- Unified supervisor of financial institutions
- Resolution and liquidation of failing banks
- Financial intelligence unit for anti-money laundering
- Credit bureau
- Mortgage or housing activity
- Open bank assistance (bailouts)
- Agricultural related activity
- Small and medium enterprise loans
- Development banking
- Financial institutions development funding
- Loans to non-banks (bailouts)
- Export credit
- Ownership of a bank or state bank activity
- Consumer protection
Although much of the focus of the Free Banking blog will likely be on monetary aspects of central banks and alternatives to central bank money, I will spend my time focused on the other issues cited above. For example, I have spent much of the past two and a half years, both through research and four lawsuits under the Freedom of Information Act, trying to figure out precisely why the Board of Governors and New York Fed felt compelled to bail out Bear Stearns and AIG (but not Lehman); why the FDIC voted to bail out Wachovia, Citigroup, Bank of America and most large banks through the FDIC Debt Guarantee Program (aka TLGP—Temporary Liquidity Guarantee Program); and why the FHFA and Treasury felt compelled to bail out Fannie Mae and Freddie Mac. I have researched the history of these powers and hope to contrast how these bailouts worked during the most recent crisis as compared to early periods of financial turmoil such as the Panic of 1907 and back to earlier crises in the pre-Federal Reserve era. Although some of these periods may not be during the ‘free’ banking period that most people on this blog speak of, it was before the creation of a central bank in the US, which was certainly a ‘freer’ banking period prior to the massive interventions that went with the combination of the birth of the Federal Reserve, the Depression era legislative changes and up through the more recent crises during the 1980s and early 1990s and the ongoing implementation of Dodd-Frank.
I also expect to share some of my experiences on these issues working with central banks and financial agencies outside of the US, which is how I have spent my professional time the past twelve years.
In the internet boom of the 1990s, there was a rush of new alternative payment systems or currencies (Paypal being the most successful). Forbes even ran a great cover story on this issue Politics for the Really Cool. For whatever combination of reasons (the tech being too far ahead of the curve, regulators being over-zealous, outdated laws ill-suited for innovation, etc), the movement petered out. Until recently, that is.
Bitcoin is a grassroots nonprofit project that seeks to fashion a new currency out of little more than cryptography, networking and open-source software, and Andresen is the closest thing the project has to a director. Bitcoin is not, he explains, just a new way to digitally spend dollars, pounds and yen. That's been tried before. Remember Beenz and Flooz?
Bitcoin is different: It wholly replaces state-backed currencies with a digital version that's tougher to forge, cuts across international boundaries, can be stored on your hard drive instead of in a bank, and--perhaps most importantly to many of Bitcoin's users--isn't subject to the inflationary whim of whatever Federal Reserve chief decides to print more money.
Slate is there now talking about Bitcoin with an article My Money Is Cooler Than Yours.
The currency has a few advantages. For criminals, libertarians, and privacy freaks, the Bitcoin system allows for complete anonymity and privacy. Once a transaction is completed, there is no central server with information for the government to subpoena. (If you buy Bitcoins on an exchange, of course, that transaction would have a record.)
The start-up faces formidable competition. Square’s goal is to replace cash registers and point-of-sale terminals and the companies that make them, like Verifone. Square is also taking on the many start-ups that offer cellphone loyalty cards, like Foursquare, and competing with Google, Apple, PayPal and major credit card companies and banks to provide mobile payments.
Jerry Brito adds that Bitcoin or other digital currencies could fill a void for politicized institutions that interfere with payment systems (and infringe on human rights) such as donating to Wikileaks or paying for your online gambling.
The Washington Post followed up with a story the next day that began:
Bitcoin. Oh, man, where to begin. Its Hype-O-Meter got cranked to 11 this week, and breathless histrionics are everywhere. Death and Taxes called this new currency “a seismic event“; Adam Cohen says it’s nothing but a giant scam; Jason Calacanis calls it “the most dangerous project we’ve ever seen“; and they’re all completely wrong. It’s interesting, and innovative, and down the line it might even be important … but in many crucial ways, Bitcoin is nothing new.
I think that this story got it right. The real opportunity for alternative monies will come where the demand is greatest. One of those places is the developing world with central banks that are often more politicized than in developed countries. Zimbabwe, which has been flirting with a return to a gold standard since 2009 and is revisiting the idea of a gold-backed Zim dollar, would be a prime example. Explains the Washington Post story:
Meanwhile, mobile electronic payments are taking off in a big way all over sub-Saharan Africa. It isn’t much of a stretch to imagine Zimbabwe in ten years’ time—or a whole group of developing nations with a history of crippling inflation—adopting a new currency that is independent, incorruptible, and anti-inflationary by design. In short, something a whole lot like Bitcoin. No, it isn’t the future, but it just may point the way.
Of course I pointed this all out in my talk at the Mises Institute's Austrian Scholars Conference panel on how to transition to sound money. There I highlighted the observation of Randy Kroszner's paper on the Scottish free banking experience as a model for developing countries. I think his analogy is a sound one that the conditions in many developing countries today are similar to those in Scotland during its free banking experience.
With the Federal Reserve monetizing our budget deficits, there is already increasing talk of the dollar losing its global reserve currency status. Some speculated the euro might challenge it, but those economies face their own problems. Others envision a basket of currencies or commodities. The most likely threat there was from the International Monetary Fund's Special Drawing Rights, but the SDRs have lost their sex appeal with the disgraced IMF leader in the tabloids.
The real challenge to the hegemony of the US dollar might just come from the likes of a Bitcoin.
Happy days are, make that, stagflation is here again. So says Ronald McKinnon in a Wall Street Journal column. Stagflation was memorialized by the 1970s experience of high inflation and economic stagnation. The Stanford professor says it's rearing its ugly head again.
He lays out the cause:
Although many forces buffet the U.S. economy, the near-zero interest rate policy of the Federal Reserve is the prime contributor to the current bout with stagflation.
But Fed officials claim that higher commodity prices don't presage a return of inflation. McKinnon disagrees:
For more than two years, the Fed has chosen to keep short-term interest rates on dollar assets close to zero and—over the past year—applied downward pressure on long rates through the so-called quantitative easing measures to increase purchases of Treasury bonds. The result has been a flood of hot money (i.e., volatile financial flows that are subject to reversals) from the New York financial markets into emerging markets on the dollar's periphery—particularly in Asia and Latin America, where natural rates of interest are much higher.
He continues to put the blame at the Fed's feet:
So the proximate cause of the rise in U.S. prices is inflation in emerging markets, but its true origin is in Washington. . . Since July 2008, the stock of so-called base money in the U.S. banking system has virtually tripled.
Shadowstats has a hyperinflation report out (pdf) with more facts and figures. Judge for yourself. McKinnon concludes:
The stagflation of the 1970s was brought on by unduly easy U.S. monetary policy in conjunction with attempts to "talk" the dollar down, leading to massive outflows of hot money that destabilized the monetary systems of America's trading partners. Although today's stagflation is not identical, the similarities are striking.
Brad asked about the free banking book classics. What I had already planned to write, below, partly answers his question.
Current thinking about free banking began with Friedrich Hayek’s 1976 pamphlet Denationalisation of Money (link is to an expanded version first issued in 1978 and reprinted in 1990). Until then, the idea of free banking had received no sustained attention from economists since the 1800s. Hayek’s timing was good: he wrote at a time of accelerating inflation in many Western countries, and his 1974 Nobel Memorial Prize in economics gave him a certain celebrity. Denationalisation of Money brought belated attention to a 1936 book by one of Hayek's students, Vera Smith (after marriage, known as Vera Lutz). Smith's book, The Rationale of Central Banking, remains essential reading on free banking.
The next big step forward in developing the idea of free banking was Lawrence H. White’s 1984 book Free Banking in Britain (link is to the 1995/2008 second edition). Whereas Hayek’s approach was mainly theoretical, White explained how the Scottish system of free banking had enjoyed practical success for more than a century, until ended by law in 1845. White’s book was a mixture of economic theory, economic history, and history of thought.
Most subsequent writing on free banking has been a development of themes that were in Hayek or White. Here are what I consider the most important ideas on free banking that have been well known for at least 15 years among those of us interested in the subject -- the "what's old" that I mentioned in my previous post.
- There is a sophisticated theoretical case to be made for free banking as the monetary system that best promotes monetary equilibrium. (George Selgin is the key thinker here with his 1988 Theory of Free Banking; Steve Horwitz has also done work on the topic.)
- Central banking is subject to the criticisms of centralized economic planning that Ludwig von Mises and Hayek made in the 1920s and 1930s, which other economists acknowledged as valid when communism collapsed in the late 20th century. Mainstream monetary theory indirectly addresses the criticism by claiming that money is a natural monopoly, but to my knowledge it has not tried to rebut the Mises-Hayek arguments head on.
- Free banking systems existed in dozens of countries until the early 1900s, and most seem to have worked successfully – much better in some ways than the central banking systems that replaced them. (An essay of mine in a book edited by Kevin Dowd, The Experience of Free Banking, is no classic, but it remains the best short overview of the subject. Unlike the other works I have linked to, it is unfortunately quite expensive.)
- Historical cases of free banking were typically associated with a gold or silver standard. A contemporary free banking system might operate on a different kind of monetary standard. Theorizing on this topic necessarily involves some leaps of imagination.
Welcome everyone to the free banking blog. I'm very excited about the stellar cast we have, and I hope this space will become a clearing house for information from different scholars and groups. In addition, as it grows, this page should become a great resource of information. With that in mind, I'm looking for suggestions for a reading list on the subject.
Similarly, what are links to other groups that should be added to page?
My hope for this blog is that it will help answer several questions about free banking and related topics, namely:
- What’s old: What have we known for a while?
- What’s new: What have we recently found?
- What’s left: What do we still need to discover?
- How do we communicate our findings so that they receive the consideration they deserve?
- To the extent the ideas we discuss can make the world a better place, what are the steps for achieving them?
I will use my next several posts to set out some of my views on these topics.
From time to time, I will also do my part to add links and supplementary material to help make this blog an excellent first stop for anybody interested in free banking.