Free Banking 

At Marginal Revolution, Alex Tabarrok notes David Warsh’s claim, seconded by Paul Krugman, that “Friedrich Hayek is not an important figure in the history of macroeconomics.” Apparently Warsh and Krugman have no memory of the 20^th century. The big issue of the century in economic theory and economic policy, spanning macroeconomics and microeconomics, was the contest between central planning and markets. Hayek and Ludwig von Mises were by far the most prominent economists who argued long and loud that central planning was disastrous, not just because of the viciousness of communist dictatorships, but because even under ideal conditions it could not generate and use effectively the knowledge necessary to maintain modern standards of living. For a long time they were considered to be naive. As late as 1989, Paul Samuelson was still writing in his best-selling economics textbook, "The Soviet economy is proof that ... a socialist command economy can function and even thrive." About a hundred million people died proving that Karl Marx, his followers, and credulous souls inclined to give central planning the benefit of the doubt, such as Samuelson, were wrong, and that Mises and Hayek were right.

In comparison to the gigantic contest between central planning and markets, all the other economic issues of the century look insignificant. (Yes, even the Great Depression. How many Americans starved to death at the depth of the Depression in 1933? Not many. How many Ukrainians starved to death in the same year as a result of Joseph Stalin's drive to collectivize agriculture? Millions.) Even so, on a lower plane of significance, I think that Hayek’s revival of the idea of free banking will eventually be recognized as an important event in the history of macroeconomics. It took more than half a century for economists to acknowledge the importance of Hayek’s insights on central planning. It may take just as long with free banking.

At his Forbes blog, Ralph Benko calls attention to Nouriel Roubini’s rant against the gold standard. Roubini joins Paul Krugman (of course) and others in this unwise course. The gold standard is becoming a litmus test: haughty dismissal of it is a sign of a closed mind. Dismissal of the gold standard is especially bizarre today. In the 40 years since the abandonment of the last and weakest version of the gold standard, the Bretton Woods system, we have had dozens of episodes of high inflation in poor countries; much lower but still troublesome inflation in rich countries, wrung out of the system in the United States only by a wrenching recession; some highly disruptive episodes of deflation, notably in many rich countries during the Great Recession; and financial crises aplenty, with the prospect of more to come.

One of the main arguments against the gold standard is that smart central bankers can outperform a gold standard. The record of monetary policy around the world over the last 40 years that I have just summarized is not obviously superior to preceding eras. A large dose of humility about both our knowledge and our ability to implement what we know are in order.

The other main argument against the gold standard is that the Great Depression discredits it. If so, by the same token, the Great Recession discredits fiat money — a claim I doubt that any critic of the gold standard would accept.

A monetary system has a number of components, including (1) the monetary standard (the target for monetary policy); (2) the exchange rate regime; (3) the monetary authority (or, under free banking, the lack of a monopolistic authority); (4) the financial system other than the monetary authority; and (5) expectations about how the system works. Any component can make a big difference in how a monetary system works. One must examine all these components, and some other factors besides, to judge just what were the sources of the problems experienced during historical episodes such as the Great Depression or the Great Recession. Critics of the gold standard, even those who have a deeper knowledge of economic history than Roubini or Krugman, tend to lump many or all of the five components together. To do so, however, is as big a mistake as treating monetary policy in Sweden, the United States, and Venezuela over the last decade as essentially similar because all three countries are off the gold standard.

Michael Woodford of Columbia University is acknowledged as probably the most influential academic monetary economist today. His 2003 book Interest and Prices: Foundations of a Theory of Monetary Policy is his magnum opus. It is not a book for laymen, but it is one of the handful of books over the last 40 years that everyone who participates in academic debate on monetary economics needs to have read.

When introducing his theoretical framework, Woodford writes near the bottom of page 63, "I begin by considering price-level determination in an economy in which both goods markets and financial markets are completely frictionless: markets are pefectly competitive, prices adjust continuously to clear markets, and there exist markets in which state-contingent securities of any kind may be traded."

By page 64, though, a central bank somehow becomes part of this system of perfectly competitive markets. It is a perfect example of how limiting it is to know only the present. Free banking has a history centuries long: the first free banking system began in China apparently about 995, more than 600 years before the first central bank. More than 60 countries have had free banking. And yet, Woodford does not even pause for a page to consider what a banking system would look like without a central bank.

During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

In normal times, it is a fairly safe assumption that demand is roughly constant or changing predictably, but in abnormal times, it is a dangerous assumption. No high inflation occurred in any country that expanded the monetary base rapidly during the financial crisis. Evidently, demand expanded along with supply. In fact, Scott Sumner and other “market monetarists” think supply did not keep up with demand. Similarly, nobody should be perplexed if a case arises where the monetary base is constant or even falling but inflation is rising sharply. Absent a natural disaster or some other nonmonetary event, it is evidence that demand for the monetary base is falling but supply is not keeping pace.

In my first post on this blog I promised that I would address several questions in later posts. One of those questions I have not addressed until now is how writers on free banking should communicate our findings so that they receive the consideration they deserve.

For many years, it surprised me how closed the mainstream of economists was to new ideas and even to old ideas. The first case of competitive issue of notes occurred about 1,000 years ago, in China. Free banking has existed in more than 60 countries, including such major economies as the United States (in a qualified way – a subject for a later post), the United Kingdom, Brazil, India, and Italy. One would think that with such a deep and broad historical record, economists would be more curious about it. But to most economists, the past is a closed book.

There have been exceptions. The world has enough economists that some are interested in treading unfamiliar paths. If you got your ideas just from reading the standard textbooks in introductory economics or in money and banking, though, you would not know that central banking is more recent than a number of other monetary systems, including free banking; that it has not always been so widespread; and that its record regarding inflation and financial crises compares poorly to that of some other systems.

Despite the scholarly work that has been done on free banking; despite its having been advocated by Friedrich Hayek and Milton Friedman in the full maturity of their careers; despite the seriousness with which a few experts on central banking (for instance, Charles Goodhart) have treated free banking, it is not part of mainstream economics.

It is essential for established scholars who are interested in free banking to continue working on it, to demonstrate to youngsters wanting to become scholars that the topic is deep enough to spend a career exploring. I now think that while such scholarship is essential for free banking to become part of the mainstream one day, it will not the catalyst.

Instead, I think the catalyst will be the events in what one of my college professors called “the so-called real world.” Something will happen in electronic money, in economic policy, or to central banks that requires expanding the mainstream presentation of ideas to let free banking in. What has happened with the idea of nominal GDP targeting is a possible pattern. It had been discussed among economists since the 1980s, but what has pushed it into the public eye has been the determined efforts of one able blogger, Scott Sumner of Bentley University. His blog The Money Illusion became the focal point for a number of other intelligent bloggers to establish a small community that has debated the idea in detail, examining its strengths and weaknesses in a way that would have taken much longer before blogs. (A few of the bloggers who have written on nominal GDP have also written scholarly work on free banking.) Their presentation of the idea was so compelling that a number of big-name economists have also taken up the topic in newspaper articles. Among those who also write textbooks, I suspect that nominal GDP targeting will appear in the next editions. The old process, by which economics journals served as a filter and delayed  new ideas from spreading into textbooks for years, is changing drastically. Articles in economics journals used to be birth announcements for new ideas; now they are more like graduation announcements.

Central banking has undergone drastic changes during the last 100 years that are often unappreciated today. Before World War I, most central banks were partly or entirely privately owned. They were not expected to spur economic growth or smooth business cycles. Rather, they defined their goals more narrowly as adhering to the gold standard and earning modest profits for their shareholders in normal times. True, during wars they were expected to lend heavily to the government, temporarily suspending the gold standard if need be, and during financial crises they were expected to act as lenders of last resort to solvent but illiquid financial institutions. War between the major powers was viewed as improbable, though.

World War I struck like a thunderclap. Browse through old issues of the Commercial and Financial Chronicle, which in 1914 was the leading U.S. business publication, and you will see that in the month leading up to the war, European politics received little ink, as if the assassination of Archduke Franz Ferdinand were of no more world importance than the man who fired shots at the U.S. embassy in Sarajevo today. Then war came and within a week, more than half the world was embroiled in it, because Europe’s colonies were involved also.

By the war’s end, the central banks of the belligerent countries had created so much inflation to finance the war that returning to prewar exchange rates was either painful or impossible. Although the gold standard in principle remained the goal, the war had planted the idea that monetary policy could be “mobilized” in peacetime somewhat as it had been in wartime. The brief return of many countries to the gold standard in the late 1920s occurred in an intellectual climate where the standard no longer enjoyed its former unquestioned, and largely unquestioning, support. The Great Depression and World War II finished the job. By 1945, almost all central banks were government owned institutions whose primary goal was macroeconomic management, not profit seeking. There was a kind of gold standard — the Bretton Woods agreement had been signed and the signatories were working towards implementing it — but it was a gold standard in most cases hedged about by exchange controls, and without the depth of commitment of the pre-World War I gold standard. In the early 1970s that, too, ended.

As all readers who are at least middle-aged will remember, a generation of turbulence followed. Inflation in the rich countries in the 1970s, the Third World debt crisis of the 1980s, inflation in postcommunist countries and the emerging market financial crises of the 1990s. Finally, in the last decade, there were some quiet years, when it was plausible to think that the main practical problems of central banking been largely solved. Now it’s all up for grabs again.

I have been busy writing a paper that I will summarize in a later post, so I am only now making a belated reply to comments by David Glasner at his worthwhile blog, Uneasy Money, disputing my claim that central banking is a form of central planning. I will take one last shot at the subject for now because the idea that central banking is a form of central planning is a crucial part of free banking thought, and because I am amazed by Glasner’s view given that he once wrote a book on free banking,

Central planning need not extend to every economic activity. It is enough for the government to control key institutions, which Vladimir Lenin called “the commanding heights” of the economy. The monetary system is obviously one such institution. A monetary system that is not under government control is incompatible with central planning because it gives people a powerful and easy means of making decentralized exchanges that circumvent the plan.

As I wrote in a previous post, centrally planned economies have monobank systems, in which commercial banking is a government monopoly, whereas in more market-oriented economies, commercial banking is competitive. Even if a monetary system has competitive commercial banking, it remains true that central banking injects substantial elements of central planning. The whole point of central banking in the form in which it has existed since about World War I is to monopolize the monetary base; consciously use the monopoly to affect conditions throughout the economy; do so through a centralized, government institution; and prevent challenges to the monopoly that might end its power. None of these elements are present in a free banking system.

Glasner claims that in Hayek’s monograph Denationalisation of Money, “Hayek’s dismissal of central banking was crucially and explicitly dependent on an argument that private competitive banks would issue their own currencies defined in terms of units of their choosing not redeemable in terms of any outside asset not under the control of the issuing bank.” The monetary system Hayek discussed Denationalisation of Money was one of competing, bank-issued fiat currencies, but Hayek was also aware of the existence of competitive banking systems based on gold. Much earlier in his career he supervised Vera Smith’s dissertation, The Rationale of Central Banking, which discussed some historical episodes fitting that description. Hayek, like his teacher Ludwig von Mises, had an extraordinarily wide range of intellectual interests, of which monetary theory was only one. They did much, but left much still to be done by successors who were willing to focus on monetary theory alone. That helps explain why the building blocks of the idea that central banking is a form of central planning are present in Mises and Hayek, but not until Lawrence H. White and George Selgin in the 1980s did Austrian economists use the building blocks to construct a detailed argument.

We can agree that central banks are run by intelligent people who have good intentions. We can debate whether there is some element of natural monopoly in money that means certain tasks are better done by a central planner than by competitive markets. (If it really is a natural monopoly, why does the law need to forbid competitors?) It should be evident, though, that central banking is indeed a kind of central planning.

As a child, I watched The Jetsons, a 1960s cartoon comedy series that followed the lives of an American family in a high-tech future. Nearly 50 years later, when I thought that future would have arrived, robot maids do not do our cooking and housecleaning, we do not work three-day weeks, and our cars do not fly through the air. There are ways in which our world closely resembles the world of The Jetsons, though: we can communicate easily all over the world, by text, voice, or video; and we can retrieve information and music almost instantly from vast storehouses.

Steve Jobs helped to make those futuristic dreams a reality, not just for a few people, but increasingly for everybody. Asian peasants and African cattle herders have cell phones; in a decade they will have knockoffs of the iPad as well. I am writing these words on an Apple Power Mac G5. It is both the most powerful and the cheapest computer I have ever owned. I paid $50 to buy it as surplus from a company that was upgrading its computers last year. The G5 was a technological marvel when Steve Jobs introduced it in 2003, but it is worth little more than scrap metal today. That is a breathtaking pace of progress.

The future of free banking is inextricably linked to the computers, cell phones, and other personal electronic devices that Steve Jobs did so much to envision, develop, and popularize. If there is a way to bypass central banking, it will use the networks of these devices, as some people are already trying to do. Rest in peace, Steve Jobs.

Banks present a tempting target for taxation because that’s where the money is. As with other forms of corporate taxation, though, who pays the tax to the government and who ultimately pays it can be two different things. This point is both so elementary and so important that if you hear somebody claim that the solution to raising more government revenue is to tax corporations rather than people, you can dismiss him as an ignoramus. Failing to understand it shows an inability to do what the economist Thomas Sowell calls “thinking beyond Step 1.” Step 1 is the levying of the tax. The further steps, which involve thinking about what happens next, are what Sowell considers to be the essence of the economic way of thinking.

Somebody, literally some body, has to pay the tax. That somebody is a combination of the customers, employees, suppliers, and shareholders of the corporation. A tax on bank profits, for instance, reduces the amount that banks can pay to depositors, bank tellers, furniture makers who supply bank offices, shareholders, etc.

If you don’t find the argument convincing, think about a tax on gasoline. The gasoline does not pay the tax because it is inanimate. Oil companies collect the tax, but the people who pay most of it are drivers, every time they fill up the tank. Or think about a property tax. As anyone who owns a house knows, the property itself does not pay the tax; the property owner does. If he rents out the property, it becomes a charge he tries to recover from renters.

There are only three logical reasons to tax corporations. One is that because of the way the tax code is written, some income that would otherwise be taxed as individual income escapes taxation by being sheltered by the corporate form. In that case, the best way to address the problem is to reform the tax code. The second reason to tax corporations is that it is more efficient, since there are many fewer corporations than there are individual taxpayers. Before the rise of the welfare state, this reason might have made sense. To generate the huge amounts of money necessary to run the welfare state, though, governments create tax collection agencies to keep tabs on the finances of millions of individuals. The final reason to tax corporations is to hide the effects from people who can’t reason beyond Step 1. I think this is the dominant reason for taxing corporations, including banks.

It has not been discussed so far in this blog what modern free banks might look like. Partly that is because several of us who blog here have the same picture in mind. It would be good for the rest of you to know what it is and decide what you think of it.

What activities would banks be allowed to engage in? Anything they wanted. In particular, they would be allowed to combine banking with commerce, so if Wal-Mart or Facebook wanted to start a bank or if a bank wanted by them, it could. If banks wanted to combine banking with brokerage or insurance, they could. In practice, some combinations of commercial banking with other lines of businesses would be common and others would not. I would not expect any bank-restaurant combinations, for example, because the businesses are so dissimilar. Even much closer combinations such as bank-plus-hedge fund might be rare because the businesses are not as alike as many people think.

How would banks be regulated? There would be no special regulations on banking, and in particular no minimum capital requirements or requirements that assets be invested in specific ways unless the bank itself promised to do so. There would continue to be some special features of law that apply to banking, just as there are some special features that that apply to other industries (fishing, trucking, warehousing, retailing, etc.) because of industry-specific features. In banking, two such features might be requirements to ensure that financial statements state certain assets and liabilities in detail to give an accurate picture of the business, and a bankruptcy regime that, one would hope, improves on the cumbersome procedures currently in place in most countries.

Advocates of free banking see no need for special regulations because they think bankruptcy would provide the ultimate check on imprudent behavior, as it does in other industries. Whether that would be the case in reality, or whether on the contrary governments would still treat some financial institutions as too big to fail, is a hugely important question that is a subject for another time.

What liability arrangements would banks have? Banks would have the choice of operating under limited liability of stockholders, unlimited liability, or combination arrangements where some shareholders would have limited liability and others would have unlimited liability. As long as the liability arrangement was clear to people who did business with the banks, there would be no special need to force banks to follow a uniform arrangement. Today, almost all banks have limited liability. Until the mid 1800s, limited liability was a privilege granted only to select companies, often in return for bribes or other favors. Then the principle became established that limited liability should be a matter of choice for stockholders. Partnerships with unlimited liability do persist, though, such as the venerable English bank Coutts and Company and many hedge funds.

What would be the monetary base? One possibility is the current fiat monetary base, frozen, as Milton Friedman proposed in an essay in a 1984 book called To Promote Prosperity. Under this proposal, banks would be free to issue notes, so over time, Federal Reserve notes would likely go out of circulation as currency and be used mainly by banks as reserves.

Another possibility is a return to gold. The gold standard has received much scorn from economists who don’t understand that the gold standard under free banking works differently from the gold standard under central banking.

Other possibilities seem far less likely. Banks could adopt a standard based on some unit not currently in use, such as the economic value of a frequent flyer mile or a British thermal unit or a basket of goods. Or they could issue currencies not tied in any set way to a good, as central banks to now and as Friedrich Hayek imagined in his pamphlet Denationalisation of Money. In a system of Hayekian banks there would be nothing corresponding to the monetary base as it now exists. No such arrangement has ever existed in any historical free banking system.

These are my educated guesses based on historical experience. Advocates of free banking would be content to allow whatever arrangements emerge through competition, and not to push the monetary system towards in one direction or other through restrictions. If people wanted to use gold, or frequent flyer miles, or adopt a Hayekian system of competing fiat currencies, it would vain for economists to protest that they were wrong to do so. It would be like saying that people are wrong to want to speak English instead of the supposedly more “rational” Esperanto (or even the truly more rational Interlingua [see page 307 of this for a speech in Interlingua by Leland Yeager, who has also written on laissez faire banking]).

Would there be fractional reserve banks or 100% reserve banks? In principle, both side by side. In practice, I know of no past banking system where the two have long coexisted. Fractional reserve banking has always outcompeted 100% reserve banking. By 100% reserve banking which I mean an arrangement where the bank holds assets for clients as a kind of warehouse and does not grant credit.

What about coins? Like the business of issuing notes, the business of issuing coins would be open to all comers. Banks might issue competing brands of coins; they might issue a common coinage through a cooperative arrangement; or they might leave coinage to other issuers. Coins might have substantial value as metal, or, as I think more likely, they might be mere tokens. Historically, where people trusted in the financial system, coins having substantial value as metal tended to be reduced to minor importance as currency over time because it is inconvenient to carry a lot of metal around in purses and cash registers. The tokens might not be redeemable in notes and deposits, or, as I think more likely, they might be. Again, historically tokens that were redeemable typically found greater acceptance than those that were not.