The current issue of the Cato Journal (volume 32, number 2) contains papers from the Cato Institute’s annual monetary conference in November. Among the contributors are many of the bloggers on this site: Kevin Dowd, Jerry O’Driscoll, George Selgin, Judy Shelton, Larry White, and me. My coauthor is Will McBride, who wrote a Ph.D. dissertation related to free banking.
Larry White is apparently too modest or too busy to mention here that he has a new book, The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years, so I will mention it for him. Free banking is not prominent in the book because because it has not been prominent in policy debates, despite the revival of the idea that Larry himself has led.
Larry’s book has been reviewed by Perry Mehrling. Mehrling is the author the author of a fine biography of the late Fischer Black, an unorthodox thinker who was one of the key figures in modern finance; he also has some connection to modern free banking theory, which perhaps I will discuss in a future post. Mehrling remarks that in contrast to Larry’s view that central banking is “just another example of government stepping in to do what free markets do better,” “I align myself with [Walter] Bagehot, who famously stated that ‘Money will not manage itself, and Lombard Street has a great deal of money to manage.’”
A couple of posts ago I remarked that the most important reason for studying the history of economic thought is that sometimes the present has forgotten what the past knew. Mehrling’s quotation from Walter Bagehot’s Lombard Street is a case in point. Bagehot wrote his book as a proposal for improving England’s central banking system, and it was within that context that he wrote the famous sentence that Mehrling quotes, at the end of the book’s first chapter. In the next chapter, though, Bagehot made it clear that he considered central banking a second-best system, and that under free banking, which he considered the best system, money does manage itself.
Another example I recently came across in which the past knew what the present had until recently forgotten concerns John Stuart Mill. His treatise Principles of Political Economy contains a chapter called “Of Credit, as a Substitute for Money.” Using modern terminology, much of what he is talking about in the chapter we would today call “shadow banking” – the extension of credit outside of banks, but in a way intended to provide high liquidity rather than being linked to particular trading relationships, as business do with trade credit. In particular, Mill briefly discusses bills of credit and promissory notes, and how they have sometimes circulated widely.
Mill provides a third example of how the the recent past knew what the present, in this case Mill himself, has forgotten. The first edition of Principles of Political Economy was published in 1848, and the last edition revised by Mill was published in 1870. By 1848 the debate on whether Britain should have free banking or central banking had been finished for several years, having been decided in favor of central [note: original post mistakenly said "free"] banking. Mill’s analysis of the subject is weak, basing itself on the supposed advantages of concentrating gold reserves in a single bank, and lacks the depth of analysis that had been attained by English monetary writers earlier in Mill's own adult life.
In his NY Times column Sunday, Paul Krugman tries, in vain, to construct a case for bank regulation in light of the problems at JP Morgan. As usual with Krugman, there’s much to disagree with, but I want to focus on his utterly ham-handed version of the history of US banking, which bears shockingly little resemblance to reality.
Krugman thinks he has the critics of regulation nailed with his take on US financial history:
Why, exactly, are banks special? Because history tells us that banking is and always has been subject to occasional destructive “panics,” which can wreak havoc with the economy as a whole. Current right-wing mythology has it that bad banking is always the result of government intervention, whether from the Federal Reserve or meddling liberals in Congress. In fact, however, Gilded Age America — a land with minimal government and no Fed — was subject to panics roughly once every six years. And some of these panics inflicted major economic losses. So what can be done? In the 1930s, after the mother of all banking panics, we arrived at a workable solution, involving both guarantees and oversight.
This passage is an utter abuse of history in several ways.
Most important, what Krugman calls the “right-wing mythology” is largely correct: government intervention is responsible for the systematic problems with the US banking system. That, however, is not the same as “bad banking.” Banks, like any other business, make mistakes all the time. Bad banking happens in free markets, but markets provide incentives and knowledge signals that help banks avoid and correct such mistakes. The question is not whether there is or isn’t “bad banking,” but which institutional environment minimizes and corrects it best. What doesn’t happen in free markets are the systematic mistakes that lead to panics and massive bank failures.
And that is where Krugman is most wrong. What he calls “Gilded Age America” was emphatically not a land of minimal government in banking. Yes there was no Fed (and no serious critic of regulation has blamed everything on the Fed), but the federal and state governments played a huge role in the banking industry and it was those regulations that were responsible for the pre-Fed panics. The two most relevant regulations were: 1) the prohibition on interstate banking, which created overly small and undiversified banks that were highly prone to failure; and 2) the requirement that federally chartered banks back their currency with purchases of US government bonds, which made it prohibitively expensive to issue more currency when the demand rose, leading to the currency shortages and resulting panics that culminated in the Panic of 1907.
These were not failures of a free market in banking. They were failures of government regulation. And those same restrictions on interstate banking, along with the failure of the Fed to do its job, were largely responsible for the massive failures of the 1930s. Banks during the Great Depression were hardly unregulated, and those bank failures happened after the creation of the Fed. Those banking problems were also failures of government regulation.
But Krugman has a much bigger puzzle to explain away: if free markets in banking are the problem, why did Canada, which, during this period, had a far less regulated banking system than the US, not experience the panics we did, and why did no Canadian banks fail during the Great Depression while around 9000 US banks did? If Krugman’s criticism of the “mythology” is correct, the Canadian banking system of that era should have been a basket case, but instead it was a model for the world precisely because it lacked the two most damaging government regulations present in the US. Canadian banks have always been free to operate nationwide and were, before 1934, able to issue their own currency free of bond collateral requirements. The very free market in Canadian banking dramatically out-performed the much more regulated US system.
So Professor Krugman, what say you? If the reason banks fail is because free markets in banking don’t work, how do you explain the lack of the problems you claim plague free markets in the much less regulated pre-1934 Canadian banking industry? The mythology, Professor, is your history, not mine.
Cross-posted from Coordination Problem.
Recently I talked to the French economist Philippe Nataf, who has written about France’s era of partly free banking in the early 19th century (in The Experience of Free Banking, edited by Kevin Dowd and published in 1992). He mentioned to me that Friedrich Hayek once told him that the work of the 19th-century French economist Charles Coquelin had been an important influence on Hayek’s business cycle theory. Hayek in fact said that he had kept Coquelin’s book at his desk during the period he was writing his business cycle work. Coquelin is almost unknown outside of France, but besides his work on business cycles, he was also the editor of a standard reference work of the period, the Dictionnaire de l'économie politique (at least partly translated into English) and an advocate of free banking. Nataf himself was so impressed with Coquelin that he called the small publishing firm he started Editions Charles Coquelin. Among its forthcoming publications is a French translation of Ludwig von Mises’s Theory of Money and Credit, commemorating the centenary this year of the original German-language edition.
For any readers who know French and are interested in the future as well as the past, I will take the opportunity here to mention Marcel Aucoin’s 1996 book Vers l'argent électronique: banques d'hier, d'aujourd'hui et de demain (Towards Electronic Money: Banks of Yesterday, Today, and Tomorrow) published by the Société Educative Financière Internationale in Canada. The book was by far the best thing on the subject when it appeared. I have not seen any more recent books on electronic money that I thought were appreciably better, though there are some that are more up to date in their discussion of technological developments.