"Free issue" systems

by Kurt Schuler October 29th, 2013 10:09 pm

As I mentioned in my previous post, Hong Kong had an unusual monetary system before returning to the currency board system in 1983. It was (retrospectively, perhaps) dubbed the "free issue" system and that seems as good a placeholder as any, though I welcome suggestions for a different name.

“Free issue” systems are those in which bank liabilities are not convertible into a commodity or foreign currency at a set rate, no party external to the commercial banking system such as a central bank issues a monetary base into which bank liabilities are convertible at a set rate (usually 1:1), and legal requirements compel people to use the local currency. The last characteristic sets them apart from all free banking systems, historical or imagined.

I have found only two historical cases of free issue systems: Hong Kong from 1974 to 1983 and Canada from 1914 to 1926 and again from 1929 to 1935. There are few discussions extant of free issue systems, and those I've seen are fragmentary. John Greenwood's book cited in my previous post is the only place I have seen a balance sheet treatment.

Here is how the Hong Kong system worked. Until 1972, the pound sterling was the anchor currency for the Hong Kong dollar at HK$16 = £1. Hong Kong’s three note-issuing banks were in effect agents of Hong Kong’s currency board, which was called the Exchange Fund. To issue notes, the banks had to give the Exchange Fund specified sterling assets, such as British Treasury bills, equal to the notes they wanted to issue. (If the banks took notes out of circulation, the Exchange Fund gave them back sterling assets of equal value.)

Hong Kong abandoned the pound sterling as the anchor currency during the upheaval that marked the breakup of the Bretton Woods monetary system. At first it switched to the U.S. dollar as the anchor, but the dollar too had problems, so in 1974 Hong Kong’s government floated the exchange rate. The Exchange Fund then began accepting Hong Kong dollar-denominated assets as backing for note issues alongside foreign assets. It converted much but not all of the Hong Kong dollar assets it received into foreign currency.

You can see the potential problem. The note-issuing banks could not influence the creation of British Treasury bills, but they could influence the creation of Hong Kong dollar assets. Buy a security issued by, say, China Light & Power (the local electric company), take it to the Exchange Fund as backing for issuing notes, use the new notes to buy another China Light & Power security, take it to the Exchange Fund as backing for issuing more notes, etc. In principle the monetary base could have become infinitely large. In practice it did not, mainly I suspect because hardly anybody understood how the system worked. It was also in the interest of the note-issuing banks not to barbecue their mortgage loans and other Hong Kong dollar-denominated financial assets with a hyperinflation.

(My example above is hypothetical. Until 1992 the Exchange Fund did not publish a financial statement and the government of Hong Kong rarely made public any information about it. We have rudimentary retrospective balance sheet information, but it would be worthwhile for somebody in Hong Kong or visiting Hong Kong to sift through the archives and write a paper describing the details of how the Exchange Fund worked during the free issue period.)

An essential element of a free issue system is some kind of requirement that people use the local currency, such as a forced-tender law. In a competitive currency system, an individual issuer issuing a currency with a floating exchange rate may create hyperinflation in its own currency, but people have the freedom to use other currencies instead. Damage to the economy will therefore be limited because few people will want to use a hyperinflating currency.

ADDENDUM: A commenter brings up the case of New Zealand, contemporaneous with that of Canada. Both countries later established central banks at about the same time as well.


Hong Kong's durable currency board

by Kurt Schuler October 28th, 2013 10:10 pm

Earlier this month Hong Kong passed a milestone: 30 years since it re-established a currency board system. The 99 years since the start of World War I have been quite turbulent in terms of monetary policy. Not many places have stuck with the same exchange rate, or, if on a floating rate, the same policy behind the float, for 30 years. The Bretton Woods system did not last so long. Nor has any floating rate system since that I know of stuck with monetary base targeting, inflation targeting, or some other readily identifiable policy for 30 years. And of course Hong Kong's system has lasted 30 years longer than nominal GDP targeting, given that the latter is still merely a proposal on paper.

A century ago, Hong Kong had free banking. Banks issued notes redeemable in silver, which was the monetary standard of China. In the early part of the Great Depression, China's adherence to silver saved it from the mistaken policies that the Federal Reserve and the Bank of France in particular were transmitting internationally through gold. Then, though, the United States began buying large amounts of silver as one of the ill-considered special-interest sops of the New Deal. China's exchange rate appreciated, exports drooped, and the Chinese government decided to abandon the silver standard de facto in 1934 and officially in 1935. Hong Kong followed China off in 1935. Rather than simply change the exchange rate anchor and allow free banking to continue, the government of Hong Kong created a currency board to go with the change to the pound sterling as the new anchor. Unlike currency boards elsewhere, though, Hong Kong's Exchange Fund, as it was called, did not monopolize note issue directly. Rather, the note-issuing banks continued to issue, but they were reduced to agents of the Exchange Fund and with wrinkle the system operated on currency board lines. (Three banks issue notes today: HSSBC, Standard Chartered, and Bank of China.)

Hong Kong floated the exchange rate and thereby abandoned the currency board system in 1972, during the volatility of the collapse of the Bretton Woods system. Because the government was not really aware of what it was doing, Hong Kong wound up with a curious and historically rare system that had neither an exchange rate nor a monetary base of limited quantity as an anchor. In principle, the note-issuing banks could have created assets without limit and raised the monetary base as they did so. This poorly understood arrangement was weak, but about the only person who understood its weakness was John Greenwood, an economist at the Hong Kong office of the mutual fund company GT Management (Asia) Ltd. Greenwood wrote a number of articles in the company publication, the Asian Monetary Monitor, and elsewhere criticizing the existing system. He propose that to fix it, Hong Kong return to a currency board or adopt central banking. He did not get much of a hearing until a political crisis struck. When Britain and China were negotiating over Hong Kong's future after the 99-year British lease on most of the territory in the colony expired in 1997, a Chinese official bellicosely suggested that China might take Hong Kong back before then. A currency panic ensued, with some merchants refusing to sell goods except for foreign currency. Hong Kong's government suddenly became willing to listen to Greenwood, who briefed them on his proposals. The government opted to return to a currency board, with the U.S. dollar as the anchor.

The system has since stood repeated tests, including the East Asian currency crisis of 1997-98 and the world financial crisis of 2008-09. Even so, the government of Hong Kong has repeatedly instituted measures to depart in some measure from the robust simplicity of an orthodox currency board, only to move back towards orthodoxy when the chips are down. (For my views on this pattern in 1998 and my suggestion of one solution, see here; here is an even earlier paper by Steve Hanke on a similar theme.)

I became interested in currency boards in late 1988 while doing research on the history of free banking and seeing seeing how many free banking systems had had currency boards as a step to central banking. At the time there were only a few people who knew much about currency boards. Fortunately, I had the chance to learn a lot about them from John Greenwood during an internship the next summer. That led me to wonder whether it might be possible to go in the other direction and use currency boards as a step to free banking. It hasn't happened, but I think it has contributed to an awareness that there are choices other than central banking.

John Greenwood's criticisms of Hong Kong's monetary system before the 1983 crisis, his proposals for change, and his analysis of the post-1983 system have been collected in a book that is essential for those who want to understand how Hong Kong's somewhat idiosyncratic monetary system works. Another worthwhile book on the subject is by Tony Latter, a government official in Hong Kong during the crisis. Greenwood's is one of the few cases in monetary policy combining a diagnosis that proved to be correct with a cure that proved to be highly beneficial, both well before the fact. In recognition of his services to Hong Kong, the British government later granted him the honor of an OBE.


How free banking ended in India

by Kurt Schuler October 20th, 2013 4:41 pm

Under British rule, banks in India initially issued notes competitively. That changed because of James Wilson. Wilson is best known today as the founder of the Economist magazine, but he was a man of many accomplishments, including being a successful factory owner; a founder of one of the corporate ancestors to today's Standard Chartered Bank; and member of Parliament. One of his daughters married Walter Bagehot, who would later become the third editor of the Economist and who wrote a fine appreciation after his father-in-law's death.

In 1857 and 1858 the Sepoy Rebellion against the British East India Company nearly overthrew British rule in India. In response, the British government took over the rule of India from the company. It inherited a fiscal mess. The rebellion had reduced tax revenues while requiring a large increase in expenses for its suppression. The British government needed somebody to straighten out India's government finances, and it picked Wilson because during his time as a member of Parliament he had worked capably in bodies dealing with Indian affairs and finance. Wilson was appointed Financial Member (like minister of finance) in the Indian colonial government and sailed to Calcutta, then the capital of India, in 1859.

Wilson proposed spending cuts, tax increases, reforms in budgeting procedures, and a government monopoly of note issue. Wilson’s case for a government monopoly of note issue was that (a) notes enabled a considerable saving of cost over using coins; (b) the government would reap a large part of such savings; (c) the savings for all would be largest if the notes were legal tender; (d) it would be inappropriate for bank-issued notes to be legal tender; (e) government notes could be issued according to procedures that would make them secure, in fact more so than bank-issued notes; (f) a uniform, reliable, legal tender currency would contribute to government revenue both by promoting faster economic growth and by generating seigniorage; and (g) issuing notes was not a necessary part of the business of banks.

Earlier in his career, in the book Capital, Currency, and Banking, Wilson had defended freedom of note issue in Scotland, but had also stated the view that  issuing notes was not a necessary part of the business of banks. In India at the time he proposed a government monopoly, note issue was quite small compared to coinage in circulation and notes were little used outside the three main centers of British administration--Calcutta, Madras, and Bombay. Wilson evidently considered that the benefits of a government monopoly of note issue were preponderant in the Indian case.

Wilson died, apparently of a tropical ailment, in 1860 and was buried in Calcutta. His unmarked grave was rediscovered nearly a century and a half later by an Indian tax official with an interest in history. Wilson's successor as Financial Member adopted Wilson's proposal in slightly modified form in Act 19 of 1861 and note issue became a government monopoly in India starting March 1, 1862.


Mises-Grinder combo

by Kurt Schuler October 20th, 2013 1:44 pm

Two of my recent posts were about Ludwig von Mises and Walter Grinder. Walter knew Mises toward the end of Mises's life, and he sent me a short e-mail reminiscing about taking afternoon tea in Mises's apartment, with Walter's wife and Margit von Mises. Walter wrote,  "It was pure heaven" to talk to Mises in such a setting and to hear from him what life had been like in Europe before World War I, when (as John Maynard Keynes also famously wrote) the forces of history all seemed to be moving in the direction of peace, freedom, and economic progress.

Walter modestly did not mention a remembrance he himself wrote less than a year after Mises died. I just came across it yesterday. It is noteworthy in particular for these prophetic sentences:

In fact, signs around us make it seem likely that Mises' influence will be stronger in years to come than it ever was during his lifetime. Both the present frightening objective conditions and the current subjective malaise make it clear that Ludwig von Mises' ideas are more desperately needed now than at any time since the Great Depression of the 1930's. One thing is certain, if the international market system as it has developed over the past 200 years is to survive, then the ideas of Mises must be understood and implemented. The alternative is far too horribly regressive to contemplate.

Right, right, right, and right. Mises's influence has grown. The 1970s were the high-water mark of the spread of centrally planned economies. The international market system survived by moving back toward (though obviously not all the way to) the ideas Mises championed. And the alternative was horrible, which is why the collapse of central planning was so complete.

I have aroused the ire of some readers of this blog by criticizing certain aspects of Mises's work. He was a great economist, but he didn't get everything right. Nobody does. It does more to honor Mises to revise the parts of his thought that seem in error than to preserve them unchanged, which will only mummify the Austrian School.


About that Nobel-influenced investment advice

by Kurt Schuler October 16th, 2013 2:48 pm

The award of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel to Eugene Fama (along with Robert Shiller and Lars Peter Hansen) has prompted a number of economists and finance professionals to note that Fama's work on the efficient market hypothesis underlies the buy-and-hold-the-market strategies embodied in a number of mutual funds, of which the Vanguard Index 500 has long been the flagship. We have been treated to another round of stories about how hard it is to beat the market. Fine. Let's remember the principle of the margin, though. The efficient market hypothesis assumes that there exists a fairly numerous group of people trying to spot potential arbitrage opportunities and to take advantage of them. Index funds and active investors act as checks on each other. If everybody is a passive index investor, there are opportunities for analysts to generate insights that nobody else is generating and to use them as the basis for profitable trades. If everybody is an active trader, given how many people do not have new insights to generate, some (most?) are better off giving up the small chance of sustained above-average returns for the certainty of lower fees. The underlying point to remember is that market efficiency is not something that happens automatically. It is the result of ceaseless activity by many people. Some of them are bright enough to beat the market, not by holding every stock on the market but by specializing in certain segments. The Forbes 400 list has quite a few hedge fund operators on it. As I interpret the implications of the efficient markets hypothesis for investing, it is that some people can beat the market consistently because they really do have superior insight. Warren Buffett was not just lucky; he reads financial statements with the enthusiasm that other people reserve for pulp novels. Most of us are better off riding on the efforts of others, though, just as we are better off not doing our own plumbing or our own songwriting. And if you are reading this now rather than plowing through corporate financial statements, you are very likely part of that great majority.

ADDENDUM: As John Bogle of Vanguard has remarked, he was unaware of Fama's work when he developed index funds at Vanguard. Bogle's motivations were the high fees and lack of diversification he saw in existing financial products; he thought he could do better, and he did. I was aware of this, hence I did not say that Fama influenced Vanguard. It's an interesting case of how an insightful businessman and an insightful academic reached the same result by different routes.


For Walter

by George Selgin October 14th, 2013 10:48 pm


Dear Walter,

I meant to have this message to you appear with the other tributes Kurt posted on Saturday.  But thanks to a busy week in Madrid followed by a trip to Manhattan to tape a Stossel show segment, I sent it in a day late.  As it still hasn't been added to the others,* and I hate for you to think that I forgot your birthday, I'm posting it myself.

As I reflected upon how I first came to know you, I realized that had it not been for that encounter, my life would have been utterly different than it has been.  And I don’t merely mean that you changed my life in the sort of way that a Brazilian butterfly might change the weather in Texas.  Your influence was as certain as it was decisive.

It must have been in the late spring of 1981 that I came across that tiny ad in Reason.  It was from this place I’d never heard of called the Institute for Humane Studies, and it offered summer research grants.  I’d just begun working on a paper inspired by Hayek’s Denationalisation of Money, which I’d read earlier that spring, so I decided to apply.   I got the money, which was great.  But I also got to know you, which was far better.

You gave me all sorts of advice on the project, in letters and occasionally on the phone (of course we didn't have email back then).   It was all good, but I’m especially grateful for your having alerted me to the work of a UCLA grad student on the Scottish free banking episode.  His name was Larry White. You sent me drafts of Larry’s chapters, and I instantly became a Larry White fan.  Soon I was corresponding with him, asking all sorts of questions.  I remember one in particular.  It was, “Where do you plan to teach?”  I’d already decided to be his student.  That’s how I ended up at NYU.

Of course you and I stayed in touch, eventually meeting at the old IHS headquarters in Menlo Park—I think that was when Hans Eicholz showed up on his motorcycle, in full leather kit; he made me wonder whether I was tough enough to be a classical liberal!  When I’d finished my NYU coursework, you invited me to come back as an intern.  I leapt at the opportunity, thinking it would be a great one for writing my dissertation.

As it happened, from 9 to 5 you guys mostly had me slaving away on IHS stuff—planning seminars and organizing the contact list, among other things.  But from 7 until 9 every morning, and again from 6PM til midnight, I worked on “The Theory of Free Banking,” half the time at the (late, lamented) Printer’s Ink at Stanford, and half at the Prolific Oven in Palo Alto.  (Do you remember those half-moon cookies they had?  Mmm!)

Despite the hours the writing went better than I could have hoped.  And that was also mainly your doing, because every morning around 10:30 we walked over to Pete’s for coffee (Major Dickason’s—I still have the mug I bought there, white ceramic with red-brim), and then sat on a nearby park bench to discuss my progress over it.  So every idea I put into the dissertation—and plenty that, thank goodness, I didn’t put in—got a dry run.  If every doctoral student had someone like you to talk to, there’d be a lot fewer ABDs hanging around.

IHS and I moved to George Mason at the same time—I even got you guys to transport my little Honda Passport for me, only to end up ditching it after an Alexandria policeman politely informed me that Virginia, unlike California back then, insisted on my insuring it, acquiring a special motorcycle license, and wearing a helmet.  Miserable tyrants!   But at least I had a teaching job, which meant that, instead of just serving as a factotum at them, you actually let me lecture at IHS seminars.  I did that until 1995, when, along with all the old-guard faculty, I quit in protest over your leaving the Institute.  I know you didn’t want us to do that--the Institute always came first with you--but you shouldn’t blame us: so far as we were concerned, you were the Institute!   And though the place now has oodles more $$$ to toss around, I don’t imagine that it will ever replicate the  unique brand of intellectual inspiration and encouragement that you were able to give to students like me.  If classical liberal scholarship is thriving now, that’s in no small way thanks to you.

Happy Birthday,  ol’ buddy.   And many more.


*It has since been added, minus the picture (October 15, 2013).


Jansen on Voluntary Virtues Show

by Bradley Jansen October 14th, 2013 8:36 pm

Yours truly was a guest on an internet show tonight on the Fed and central banking.

Mike Shanklin is an independent freedom advocate and founder of VoluntaryVirtues.com, a website dedicated towards advancing free markets, property rights, and individual freedom. Voluntary Virtues advances freedom through educational interviews, narration videos, public speechs, and updates on current events.

The webcast is available here:


Operation Twist-the-Truth

by George Selgin October 14th, 2013 2:07 pm

That's the title of a paper I'm writing for this year's Cato Monetary Conference (the subtitle is "How the Federal Reserve Misrepresents Monetary History"). For it, I'd be very grateful to anyone who can point me to examples (the more egregious the better) of untrue or misleading statements regarding U.S. monetary history in general, and the Fed's performance in particular, in official Fed publications or in lectures and speeches by Federal Reserve officials.



Walter Grinder turns 75

by Kurt Schuler October 12th, 2013 6:02 am

Walter E. Grinder turns 75 years old today. He has been an important mentor to several of the contributors to the Free Banking blog and many other people interested in Austrian economics, spontaneous order in human society, classical liberalism, and modern libertarianism. Tributes to Walter are appearing here and on other sites today; send us a link if you see one on another site. Happy birthday, Walter! (Thanks to Chuck Moulton for setting up the pages listed below.)


Fortieth anniversary of Ludwig von Mises's death

by Kurt Schuler October 10th, 2013 11:53 am

Ludwig von Mises died 40 years ago today at the age of 92 in a hospital in New York.  To me, he was the most important economist of the 20th century because he addressed the most important economic issue of the century: capitalism versus socialism. His essay "Economic Calculation in the Socialist Commonwealth" (1920) and his book Socialism (1922) staked out a controversial position on the feasibility of complete central planning. Mises claimed that it was impossible for any society that wanted more than a primitive standard of living. The centrally planned economies that have existed have proved him right: they have had extensive but not complete central planning.  Complete central planning involves the abolition of money. The two countries that have tried it, the Soviet Union from 1920-1921 and Cambodia under the Khmer Rouge, found that the result was a rapid descent towards economic backwardness. Centrally planned economies therefore have grudgingly had to allow a sphere for individual initiative in exchange to correct in part the mistakes of the planners, and so they have had money, though it has been bad money. As the late Don Lavoie stressed in Rivalry and Central Planning (1984), a book that builds on Mises's ideas, "actually existing socialism" after the Soviet Union's attempted abolition of money marked a retreat from complete central planning. (Sorry, no link to Lavoie's book because it's out of print. You can find expensive used copies online, or go to the library.)

At the time of Mises's death, the reputation of capitalism was near its lowest ebb since the Great Depression. Inflation was starting to become a problem in the advanced capitalist countries. In the remainder of the 1970s, central planning  spread to South Vietnam, Cambodia, Laos, Ethiopia, Angola, Mozambique, Nicaragua, and Afghanistan. It looked as though the Third World countries were moving closer to the Second World than to the First World.

And yet, cracks were appearing in the socialist façade. The first volume of Aleksandr Solzhenitsyn's The Gulag Archipelago was published in 1973. In 1978, local government officials and 18 Chinese farmers made a secret agreement to spur individual initiative in production through a partial de faco privatization of communal farmland. The success of this and other such arrangements elsewhere became the foundation of China's momentous official turn toward (though not all the way to) capitalism under Deng Xiaoping. Poland's Solidarity movement formed in 1980. By 20 years after Mises's death, socialism had collapsed, retreating to small redoubts in Cuba and North Korea.

The underlying lesson of Mises's thought on socialism has nonetheless failed to penetrate deeply into economic policy making. Few people regard the collapse of extensive central planning as an argument against piecemeal central planning in monetary policy, transportation, education, health care, and other areas (including toilet paper in one country).

Mises did his major work on monetary theory before his work on socialism, and in my view his subsequent writings, especially Human Action, did not meld the two bodies of work as successfully as they might have. If Mises had done everything himself, though, there would be nothing left for us. The body of writing on free banking that has arisen since Mises's death has at its foundation an application of Mises's socialist calculation argument. George Selgin's book The Theory of Free Banking has done the most to make application explicit.

For more on Mises, the place to go is of course the Ludwig von Mises Institute, which has done a great service by putting online the works of the man himself as well as many writings by other members of the Austrian School and thinkers who have influenced the school. ADDENDUM: Liberty Fund also has a lot of Mises's writings.

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