Free Banking 

Two more cents from me on the topic, from Bloomberg's Echoes blog.

As Congress prepares once again to decide the fate of the penny, with deliberations to take place next week concerning whether to revive the WWII-era practice of striking pennies of steel, so as to at least avoid wasting more than a penny's worth of resources on each penny struck, penny (read: zinc) lobbyists--henceforth "pennysniffs"--have been busy making the case that messing around with the penny, especially by doing away with it but even by altering its metal (read: zinc) content, will hurt American consumers.

Of various bad arguments for keeping the penny--and all of them are bad to some degree--perhaps the worst is the one first promulgated by Zinc Lobby Penn State economics professor Raymond Lombra, and recently repeated by Eric Wen in The New Republic. It is that, if pennies are abolished, retailers will respond by rounding up to the nearest nickel, making everything cost more. Lombra calls it, ominously, a "rounding tax," presumably to win gullible conservatives over to his cause.

I'm tempted to stop typing now, and make this into a pop-econ quiz, the quiz question being: Why would any economist, or even any intelligent journalist, say anything so stupid? No, sorry, that's the second quiz question. The first is, Is this argument consistent with the most elementary principles of economics?

If you answered "no," congratulations! You have at least some grasp of how competitive market forces work, especially by recognizing how they would force rival retailers to come up with some alternative to merely "rounding up" prices in every instance, probably by rounding up some and lowering others, because under competition something called a "zero profit" condition holds, which is a fancy way of saying that if any firm in a competitive industry raises prices more than it has to to earn a normal return it will see its customers blazing a trail to some rival firm or firms smart enough to resist doing the same.

If you answered "yes," on the other hand, you too may have a future as a professional pennysniff, perhaps for Americans for Common Cents; alternatively you may qualify as a staff-writer for a neo-liberal monthly. But please have some consideration for others in choosing your vocation, and don't go 'round pretending to be an economist.

What determines the extent to which a bank can be trusted to honor its fixed-rate redemption commitments?

The answer that's at least implicit on most writings is that what matters is the nature of the assets backing a bank's IOUs, and especially the extent to which those assets consist of cash reserves. As a bank's reserves approach 100 percent of its outstanding demand liabilities, its ability to meet redemption requests improves, other things remaining equal; and if it actually maintains 100-percent reserves even a systemic run cannot force it to suspend. The case for currency boards, as more robust alternatives to central banks for preserving fixed exchange rates, rests entirely on this simple truth, which is also one of the arguments (but by no means the most important argument) offered by those who favor 100-percent reserve commercial banking over a fractional-reserve alternative.

But while the argument in question is valid so far as it goes, it overlooks a far more important determinant of the robustness of a bank's commitment to convertibility. For if history is any guide a bank's ability to fulfill its contractual obligations matters far less than its willingness to do so. And that willingness depends less upon the state of a bank's cash holdings than on its legal and economic status. Specifically it depends on whether the bank is so privileged as to be able to default on its promises without running the risk of being forced into liquidation, or that of being taken over by its creditors, or even that of losing much business.

A competitive and privately-owned bank, lacking any special privileges, can't default with impunity. It's outstanding liabilities are just that--liabilities--which means that it has to honor them or face legal consequences, including either its liquidation or a transfer of ownership. In earlier times a bank's owners might also have been liable to an extent exceeding the nominal value of there shares, and perhaps to the full extent of their personal wealth, with imprisonment the normal penalty for non-payment.

Moreover even if the owners of a competitive bank might somehow have escaped legal penalties for nonpayment of the bank's debts, they could hardly have avoided the market penalty consisting of the utter ruin of the bank's reputation, and the corresponding, wholesale loss of business to more reputable banks. There would still be no question of the bank's continuing to be a going concern.

For these reasons it is, of course, impossible to imagine a competitive bank "devaluing" its currency. The concept of "devaluation" is strictly applicable to banks having monopoly privileges, and particularly to monopoly banks of issue. By the same token, it is incorrect to equate a competitive issuer's commitment to redeem its notes at an unalterable rate as an instance of "price fixing": a competitive bank is no more free to "adjust" the rate at which it exchanges reserve money for its IOUs than a restaurant cloakroom is free to adjust the rate at which it exchanges coats and hats for claim tickets. It was only once governments awarded monopoly privileges to favored bankers, and then allowed those bankers to devalue their promises, or stop paying them altogether, and to do so with impunity, that what had once been solemn obligations to repay debts devolved into mere "price fixing."

It is, moreover, precisely owing to this devolution of former promises to pay that fixed-rate convertibility schemes are now notoriously subject to "speculative attacks," that is, to runs based upon (sometimes self-fulfilling) fear of an impending devaluation. Notwithstanding the fantasies of Diamond and Dybvig, commercial-bank note redemption agreements were historically far less vulnerable to speculative attacks than modern pegged-exchange rate schemes overseen by central bankers, for the simple reason that commercial note-issuers who failed to keep their promises had a lot more to lose than their modern central-bank counterparts.

A particularly remarkable illustration of a private issuer's tenacity in this regard took place in Scotland during the 'Forty-Five, when, as Prince Charles was marching his way toward Edinburgh, both the Bank of Scotland and its rival, the Royal Bank, took the precaution of placing their cash reserves beyond trouble's reach in the city's relatively impregnable Castle. After the city itself was occupied, the Castle remained in the hands of Royalists, who harassed the enemy (and innocent civilians alike) by raking the streets below with round after round of grapeshot. Still that didn't prevent a white-flagged band from courting death to make its way to the Castle drawbridge one morning. The band consisted of the Royal Bank's cashier, three of its directors, its accountant, and a teller. They had come to get cash to pay notes returned to them from Glasgow the evening before.

Of course, despite the penalty of failure, commercial issuers did sometimes fail to keep their promises. But unlike central banks, which have often resorted to suspension or devaluation or both while still well-stocked with reserves, they never did so if they could help it; in any event the monetary standard survived individual issuers' misfortunes and misconduct. When, in contrast, a central bank is obliged, for any reason, to break its promises, it is necessarily obliged to alter its nation's monetary standard as well.

Considerations such as these explain why the proliferation of central banks would have doomed the gold standard even if wars and depression hadn't taken their distinct toll on it. For central banking tended to reduce that standard to a mere set of official gold price-fixing schemes, with their corresponding vulnerability to speculative attacks. By the same token, they also explain why persons wishing for a revival of the gold standard had better also wish for competitive rather than centralized paper currency.

Despite the bright light streaming into my office window, reminding me of the beautiful spring weather here in Athens, I managed to spend most of yesterday afternoon listening to the first installment of Ben Bernanke's 4-part lecture series on "The Federal Reserve and the Financial Crisis." The lecture took place on Tuesday evening at George Washington University. The other parts will be given on the 22nd, 27th, and 29th of this month.

In this opening lecture Bernanke offers a brief overview of the role of central banks, their general origins, the specific origins of the Federal Reserve System, and the Fed's early performance.

It would of course be silly to expect any sitting central banker, much less the head of the world's most important central bank, to deliver an entirely candid lecture on the origins of central banking. But then again, Ben Bernanke is no run-of-the-mill central banker: he is a former academic economist and economic historian, and one with very high standing in the profession. So one might expect him to at least avoid gross distortions of the historical record to which his less academically-minded counterparts might be expected to resort. But no: as the lecture lumbered on (for Chairman Bernanke's classroom demeanor is all too reminiscent of his demeanor when testifying to Congress), it became increasingly evident that the man lecturing at Duquès Hall was at least 99 and 44/100ths percent pure Federal Reserve spokesman.

So like any central banker, and unlike better academic economists, Bernanke consistently portrays inflation, business cycles, financial crises, and asset price "bubbles" as things that happen because...well, the point is that there is generally no "because." These things just happen; central banks, on the other hand, exist to prevent them from happening, or to "mitigate" them once they happen, or perhaps (as in the case of "bubbles") to simply tolerate them, because they can't do any better than that. That central banks' own policies might actually cause inflation, or contribute to the business cycle, or trigger crises, or blow-up asset bubbles--these are possibilities to which every economist worth his or her salt attaches some importance, if not overwhelming importance. But they are also possibilities that every true-blue central banker avoids like so many landmines. Are you old enough to remember that publicity shot of Arthur Burns holding a baseball bat and declaring that he was about to "knock inflation out of the economy"? That was Burns talking, not like a monetary economist, but like the Fed propagandist that he was. Bernanke talks the same way throughout much (though not quite all) of his lecture.

In describing the historical origins of central banking, for instance, Bernanke makes no mention at all of the fiscal purpose of all of the earliest central banks--that is, of the fact that they were set up, not to combat inflation or crises or cycles but to provide financial relief to their sponsoring governments in return for monopoly privileges. He is thus able to steer clear of the thorny challenge of explaining just how it was that institutions established for function X happened to prove ideally suited for functions Y and Z, even though the latter functions never even entered the minds of the institutions' sponsors or designers!

By ignoring the true origins of early central banks, and of the Bank of England in particular, and simply asserting that the (immaculately conceived) Bank gradually figured-out its "true" purpose, especially by discovering that it could save the British economy now and then by serving as a Lender of Last Resort, Bernanke is able to overlook the important possibility that central banks' monopoly privileges--and their monopoly of paper currency especially--may have been a contributing cause of 19th-century financial instability. How currency monopoly contributed to instability is something I've explained elsewhere. More to the point, it is something that Walter Bagehot was perfectly clear about in his famous 1873 work, Lombard Street. Bernanke, in typical central-bank-apologist fashion, refers to Bagehot's work, but only to recite Bagehot's rules for last-resort lending. He thus allows all those innocent GWU students to suppose (as was surely his intent) that Bagehot considered central banking a jolly good thing. In fact, as anyone who actually reads Bagehot will see, he emphatically considered central banking--or what he called England's "one-reserve system" of banking--a very bad thing, best avoided in favor of a "natural" system, like Scotland's, in which numerous competing banks of issue are each responsible for maintaining their own cash reserves.

Besides ignoring the destabilizing effects of central banking--or of any system based on a currency monopoly--Bernanke carefully avoids any mention of the destabilizing effects of other sorts of misguided financial regulation. He thus attributes the greater frequency of banking crises in the post-Civil War U.S. than in England solely to the lack of a central bank in the former country, making one wish that some clever GWU student had interrupted him to observe that Canada and Scotland, despite also lacking central banks, each had far fewer crises than either the U.S. or England. Hearing Bernanke you would never guess that U.S. banks were generally denied the ability to branch, or that state chartered banks were prevented by a prohibitive federal tax from issuing their own notes, or that National banks found it increasingly difficult to issue their own notes owing to the high cost of government securities required (originally for fiscal reasons) as backing for their notes. Certainly you would not realize that economic historians have long recognized (see, for starters, here and here) how these regulations played a crucial part in pre-Fed U.S. financial instability. No: you would be left to assume that U.S. crises just...happened, or rather, that they happened "because" there was no central bank around to put a stop to them.

Because he entirely overlooks the role played by legal restrictions in destabilizing the pre-1914 U.S. financial system, Bernanke is bound to overlook as well the historically important "asset currency" reform movement that anticipated the post-1907 turn toward a central-bank based monetary reform. Instead of calling for yet more government intervention in the monetary system the earlier movement proposed a number of deregulatory solutions to periodic financial crises, including the repeal of Civil-War era currency-backing requirements and the dismantlement of barriers to nationwide branch banking. Canada's experience suggested that this deregulatory program might have worked very well. Unfortunately concerted opposition to branch banking, by both established "independent" bankers and Wall Street (which gained lots of correspondent business thanks to other banks' inability to have branches there) blocked this avenue of reform. Instead of mentioning any of this, Bernanke refers only to the alternative of relying upon private clearinghouses to handle panics, which he says "just wasn't sufficient." True enough. But the Fed, first of all (as Bernanke himself goes on to admit, and as Friedman and Schwartz argue at length), turned out be be an even less adequate solution than the clearinghouses had been; more importantly, the clearinghouses themselves, far from having been the sole or best alternative to a central bank, were but a poor second-best substitute for needed deregulation.

To be fair, Bernanke does eventually get 'round to offering a theory of crises. The theory is the one according to which a rumor spreads to the effect that some bank or banks may be in trouble, which is supposedly enough to trigger a "contagion" of fear that has everyone scrambling for their dough. Bernanke refers listeners to Frank Capra's movie "It's a Wonderful Life," as though it offered some sort of ground for taking the theory seriously, though admittedly he might have done worse by referring them to Diamond and Dybvig's (1983) even more factitious journal article. Either way, the impression left is one that ought to make any thinking person wonder how any bank ever managed to last for more than a few hours in those awful pre-deposit insurance days. That quite a few banks, and especially ones that could diversify through branching, did considerably better than that is of course a problem for the theory, though one Bernanke never mentions. (Neither, for that matter, do many monetary economists, most of whom seem to judge theories, not according to how well they stand up to the facts, but according to how many papers you can spin off from them.) In particular, he never mentions the fact that Canada had no bank failures at all during the 1930s, despite having had no central bank until 1935, and no deposit insurance until many decades later. Nor does he acknowledge research by George Kaufman, among others, showing that bank run "contagions" have actually been rare even in the relatively fragile U.S. banking system. (Although it resembled a system-wide contagion, the panic of late February 1933 was actually a speculative attack on the dollar spurred on by the fear that Roosevelt was going to devalue it--which of course he eventually did.) And although Bernanke shows a chart depicting high U.S. bank failure rates in the years prior to the Fed's establishment, he cuts it off so that no one can observe how those failure rates increased after 1914. Finally, Bernanke suggests that the Fed, acting in accordance with his theory, only offers last-resort aid to solvent ("Jimmy Stewart") banks, leaving others to fail, whereas in fact the record shows that, after the sorry experience of the Great Depression (when it let poor Jimmy fend for himself), the Fed went on to employ its last resort lending powers, not to rescue solvent banks (which for the most part no longer needed any help from it), but to bail out manifestly insolvent ones. All of these "overlooked" facts suggest that there is something not quite right about the suggestion that bank failure rates are highest when there is neither a central bank nor deposit insurance. But why complicate things? The story is a cinch to teach, and the Diamond-Dybvig model is so..."elegant." Besides, who wants to spoil the plot of "It's a Wonderful Life?"

Bernanke's discussion of the gold standard is perhaps the low point of a generally poor performance, consisting of little more than the usual catalog of anti-gold clichés: like most critics of the gold standard, Bernanke is evidently so convinced of its rottenness that it has never occurred to him to check whether the standard arguments against it have any merit. Thus he says, referring to an old Friedman essay, that the gold standard wastes resources. He neglects to tell his listeners (1) that for his calculations Friedman assumed 100% gold reserves, instead of the "paper thin" reserves that, according to Bernanke himself, where actually relied upon during the gold standard era; (2) that Friedman subsequently wrote an article on "The Resource Costs of Irredeemable Paper Money" in which he questioned his own, previous assumption that paper money was cheaper than gold; and (3) that the flow of resources to gold mining and processing is mainly a function of gold's relative price, and that that relative price has been higher since 1971 than it was during the classical gold standard era, thanks mainly to the heightened demand for gold as a hedge against fiat-money-based inflation. Indeed, the real price of gold is higher today than it has ever been except for a brief interval during the 1980s. So, Ben: while you chuckle about how silly it would be to embrace a monetary standard that tends to enrich foreign gold miners, perhaps you should consider how no monetary standard has done so more than the one you yourself have been managing!

Bernanke's claim that output was more volatile under the gold standard than it has been in recent decades is equally unsound. True: some old statistics support it; but those have been overturned by Christina Romer's more recent estimates, which show the standard deviation of real GNP since World War II to be only slightly lower than that for the pre-Fed period. (For a detailed and up-to-date comparison of pre-1914 and post-1945 U.S. economic volatility see my, Bill Lastrapes, and Larry White's forthcoming Journal of Macroeconomics paper, "Has the Fed Been a Failure?").

Nor is Bernanke on solid ground in suggesting that the gold standard was harmful because it resulted in gradual deflation for most of the gold-standard era. True, farmers wanted higher prices for their crops, if not general inflation to erode the value of their debts--when haven't they? But generally the deflation of the 19th century did no harm at all, because it was roughly consistent with productivity gains of the era, and so reflected falling unit production costs. As a self-proclaimed fan of Friedman and Schwartz, Bernanke ought to be aware of their own conclusion that the secular deflation he complains about was perfectly benign. Or else he should read Saul's The Myth of the Great the Great Depression, or Atkeson and Kehoe's more recent AER article, or my Less Than Zero. In short, he should inform himself of the fundamental difference between supply-drive and demand-driven deflation, instead of lumping them together, and lecture students accordingly.

Although he admits later in his lecture (in his sole acknowledgement of central bankers' capacity to do harm) that the Federal Reserve was itself to blame for the excessive monetary tightening of the early 1930s, in his discussion of the gold standard Bernanke repeats the canard that the Fed's hands were tied by that standard. The facts show otherwise: Federal Reserve rules required 40% gold backing of outstanding Federal Reserve notes. But the Fed wasn’t constrained by this requirement, which it had statutory authority to suspend at any time for an indefinite period. More importantly, during the first stages of the Great (monetary) Contraction, the Fed had plenty of gold and was actually accumulating more of it. By August 1931, it's gold holdings had risen to $3.5 billion (from $3.1 billion in 1929), which was 81% of its then-outstanding notes, or more than twice its required holdings. And although Fed gold holdings then started to decline, by March 1933, which is to say the very nadir of the monetary contraction, the Fed still held over than $1 billion in excess gold reserves. In short, at no point of the Great Contraction was the Fed prevented from further expanding the monetary base by a lack of required gold cover.

Finally, Bernanke repeats the tired old claim that the gold standard is no good because gold supply shocks will cause the value of money to fluctuate. It is of course easy to show that gold will be inferior on this score to an ideally managed fiat standard. But so what? The question is, how do the price movements under gold compare to those under actual fiat standards? Has Bernanke compared the post-Sutter's Mill inflation to that of, say, the Fed's first five years, or the 1970s? Has he compared the average annual inflation rate during the so-called "price revolution" of the 16th century--a result of massive gold imports from the New-World--to the average U.S. rate during his own tenure as Fed chairman? If he bothered to do so, I dare say he'd clam up about those terrible gold supply shocks.

Speaking of the Fed's first years, I myself chuckled at hearing Bernanke say, matter of factly, that "The Fed was established in 1914, and for while life was not so bad," as if the Fed did a dandy job until 1930 or so. No mention of the high inflation before 1921--as high as 40%, on an annualized basis, during some quarters; no mention of the record numbers of bank failures throughout the 1914-1930 period; no mention of the sharp recession of 1920-21; and no mention of any possible contribution by the Fed to the stock market boom (or "bubble," as Bernanke would have it) of the 1920s. Rather less amusing was his quotation of that "famous statement by Andrew Mellon" about liquidating stocks etc.: poor Mellon never said it, in fact: the words were Hoover's, and were intended as parody. But why waste a perfectly good straw man? Besides, those lazy GWU students will never check.

It's true that Bernanke's whitewashing of the Fed isn't quite complete: he devotes considerable time to explaining how it "blew it" during the Great Depression. But the admission is intended to be anything but fatal to the case for central banking. On the contrary: the depression was a crucial learning experience. Since then, the Fed, we are assured, has gotten its act together. Well, O.K.: there are still be a few bugs to be worked out. But never mind: some future Fed Chairman will manage to spin them away.

Was the subject assigned to me for my "Tea Lecture" to congressional staffers last week. The lecture is one of a series being sponsored by Ron Paul's office. The true story of the Fed's origins needs to be more widely known, so please do pass it on!

That's the sort of title I wanted City A.M., a free-market-oriented London financial daily, to give to this opinion piece arguing that "the gold standard" wasn't to blame for the Great Depression. Anything to get British readers' attention. But no dice: I guess they thought it a little too cheeky.

And here is an article by Barron's Gene Epstein, portraying me as a sort of Gran Poobah of anti-Fed "heretics" (and failing to mention, alas, either Bill Lastrapes or Larry White, co-authors of the forthcoming J. Macro paper referred to in the article). The comments are worth reading, if only to see evidence of the "don't trouble me with facts" attitude so many people have when it comes to staking out positions on matters of monetary policy.

For those who prefer a brief summary, or just like watching stuff on their computer, here is the video of my November Cato Monetary Conference presentation.

It seems that various pro-gold utterances in the course of the Republican primaries have provoked critics of the gold standard to circle their wagons and start shooting. But while the sheer volume of shots fired has been impressive, the shooters' aim has been lousy.

That goes for this recent volley from EconBrowser's James Hamilton, in which Professor Hamilton observes, among other things, that

The pre-Fed era was characterized by frequent episodes such as the Panic of 1857, Panic of 1873, Panic of 1893, Panic of 1896, and Panic of 1907 in which even the safest borrowers would suddenly find themselves needing to pay a very high rate of interest. Those events were associated with significant financial failures and business contraction. After establishment of the Federal Reserve, the U.S. short-term interest rate became much more stable and exhibited none of the sudden spiking behavior that used to be so common.

All of this, according to Professor Hamilton, was the fault of the gold standard.

Herewith my comment, minus the typos sullying the hurriedly-composed original as posted on Professor Hamilton's page:

Though I generally respect Professor Hamilton's opinions, and do not count myself among advocates of a return to the gold standard, I must say I find the argument he offers here quite disappointing, not the least because it manifests an extreme case of small sample bias of the sort that Professor Hamilton, of all people, might be expected to guard against.

To put the matter bluntly, the pre-Fed financial panics to which the U.S. economy was exposed, along with the general (and especially seasonal) volatility of interest rates during the pre-Fed era, had little if anything to do with the gold standard, as might readily be seen by considering gold-standard countries other than the U.S., and especially (because of its proximity) Canada.

It is notorious, to economic historians at any rate, that both the volatility of U.S. interest rates and the crises to which the U.S. economy was periodically exposed were by products of the "inalestic" nature of the currency system put into place during the Civil War, which (owing to wartime fiscal demands) linked the stock of national bank notes to the outstanding nominal stock of U.S. government securities, while depriving state banks altogether of their right to issue notes. After the war the Treasury enjoyed persistent surpluses, which it used to retire its debt. The transactions costs of acquiring national bank notes from the Comptroller in exchange for requisite bond collateral also made short-run adjustments to the currency stock uneconomical.

In consequence of these circumstances, the U.S. currency stock shrank by 50% between 1880 and 1890, while lacking any capacity for seasonal or cyclical adjustment. This "inelastic" quality of the U.S. currency stock was generally understood to be a major cause both of seasonal and cyclical interest rate volatility and of occasional "currency panics." This was, indeed, the understanding of the Fed's founders themselves, who far from claiming that the Fed was needed to defy tendencies stemming from the operation of "the gold standard," regarded its task as one of allowing that standard to work properly despite the deficiencies of national currency system.

If the gold standard, rather than specific U.S. banking and currency regulations, had been the source of trouble, other gold standard countries should have suffered from the same volatility of intertest rates and periodic crises as the U.S. Canada certainly should have, given its high degree of integration with the U.S., which exposed it to similar shocks, including similar gold flows. Instead, Canada was relatively crisis free, and its interest rates were relatively quite "smooth." The difference wasn't gold: it was Canadian currency and banking regulations, which among other things allowed Canada's currency stock to exhibit both secular growth during the last decades of the 19th century, and a lovely "sawtooth" pattern of seasonal adjustment coinciding with harvest-related peaks and troughs in currency demand.

Canada's relative stability was so notorous back then that many attempts were made in the years prior to 1913 to reform our currency and banking system along Canadian lines. Unfortunately they all failed, largely owing to opposition by the combined forces of Wall Street and the unit bankers' lobby. The Fed was the compromise solution adopted instead--and a very defective one, as events were to prove.

I'm tempted to complain as well about Professor Hamilton's failure to distinguish between the unsustainability of that house of cards, the gold exchange standard, and that of a traditional gold standard, and about his failure to note the lengths central banks went to during the 20s to defy the normal workings of the gold standard, by sterilizing gold inflows and so forth, in furthering my claim that he has generally failed properly to identify (I use the word advisedly) the adverse consequences of "the gold standard," as distinct from those of contemporaneous institutions, but I fear that to go on longer would perhaps be to abuse my privilege of commenting at all.

Free bankers like to claim Walter Bagehot, the British essayist and former (and most famous) editor-in-chief of The Economist, as one of their own. And they well ought to, for there can be no disputing the fact that Lombard Street, Bagehot's celebrated "description of the [London] money market," treats the concentration of cash reserves in the Bank of England as the Achilles heel of the British financial system, while in turn regarding that concentration as the unintended and "unnatural" consequence of the Old Lady's accumulation of monopoly privileges:

I shall have failed in my purpose if I have not proved that the system of entrusting all our reserves to a single board, like that of the Bank directors, is very anomolous; that it is very dangerous; that its bad consequences though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.

But it will be said--What would be better? What other system could there be? We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system--that which would have sprung up if Government had let banking alone--is that of many banks of equal or not altogether unequal size. In all other trades competition brings traders to a rough approximate equality... There is no tendency to a monarchy in the cotton world; nor, where banking has been left free, is there any tendency to a monarchy in banking either...no single bank permanently obtains an unquestioned predominance. None of them gets so much before the others that the others voluntarily place their reserves in its keeping (pp. 66-7, my emphasis).

To be sure, Bagehot did not suggest doing away with the Bank of England, or depriving it of its special privileges, for the state of public opinion was such, he believed, that doing so would only invite "useless ridicule." Instead, he offered his now-celebrated plea for last-resort lending: instead of merely looking after its bottom line, he argued, the Bank of England had to face up to its special obligation to safeguard the British financial system during periods of financial distress. It could best do this by lending freely, at high rates, on good securities. Bagehot's famous argument for last resort lending, it cannot be said often enough, was a second-best way to deal with the problem of financial crises. The first-best way was free banking. That apologists for central banking are often ignorant of this aspect of Bagehot's thought--that so many regard Bagehot's prescription for last-resort lending as an argument, and perhaps the strongest argument, for having central banks--only makes it all the more desirable to be able to insist that Bagehot was, in fact, on our side of the free-vs.-central banking debate.

But tempting as it is to claim that Bagehot was a free banker, the truth is more complicated than that. For although in 1873 Bagehot regarded the opinion that "banking is a trade, and only a trade" to be a "sound economical doctrine" which the British government forgot "when by privileges and monopolies, it made a single bank predominant over all others, and established the one-reserve system," some years before he'd championed the very opposite view. The occasion for this was Bagehot's 1848 review of three works--James Wilson's Capital, Currency, and Banking, Robert Torrens' Principles and Practical Operation of Sir R. Peel's Bill, and Thomas Tooke's History of Prices--responding to the passage of the Bank Charter Act of 1844, better known today Peel's Act. That Act had drawn a curtain across the stage upon which British monetary policy debates had played out over the course of the previous quarter century, by endorsing the views of the British Currency School, which favored a rule-bound currency monopoly, as against those of both the Banking and the Free Banking schools, with their distinct arguments to the effect that paper currency could best be left to regulate itself. Tooke and John Fullarton were the leading figures of the Banking School, while Torrens and Wilson (the founding editor of The Economist) tended to favor Free Banking.

As his review makes abundantly clear, Bagehot's sympathies at this time lay entirely with the Currency School and Peel's Act--a measure that was, according to him, "clearly an approach to the principle of a Government monopoly of paper money"--and against the view that "banking is a trade, and only a trade," best regulated by competition. "A sentiment of dislike to the interference of Government," he wrote, though "useful and healthy when confined to its legitimate function," is also "very susceptible to hurtful exaggeration." Those opposed to government regulation of currency were, in Bagehot's opinion, guilty of just such hurtful exaggeration: they failed to appreciate the necessity of "confining to Government both the coining of the precious metals, and, as far as possible, the utterance of money destitute of intrinsic value" instead of leaving them subject to "the disturbing agency of individual selfishness."

I pass over quickly Bagehot's arguments favoring a government monopoly of coining, for they are all-too-typical of the simple-minded balderdash that takes the place of sound argument when reason becomes the slave of preconceived opinion. A specimen will suffice: allowing that "the chief utility of competition is its quality of reducing the cost of production to the minimum which Nature admits of," thereby "supplying human wants at the least possible sacrifice of labour and capital," Bagehot goes on to observe that "improvements in the process of coining brought about by the competition of individual coiners would have a different and less beneficial effect. What is wanted in money is fixity of value." Bagehot imagines, in other words, that with respect to coins "cheaper" could only mean "lighter" (or more debased)--as if a private mint-master might out-compete rivals merely by seeing to it that his are the most substandard coins of all! In light of such reasoning we need not hesitate to concur with Bagehot's opinion "that all the grounds for entrusting the Government with a monopoly of coining money hold with increased force for giving them a monopoly of the issue of paper money." That they could not possibly hold with reduced force settles the matter.

Concerning paper money Bagehot is at least right in rejecting the Banking School's fallacious "Law of Reflux," according to which banks are prevented from over-issuing currency so long as they stick to making (short-term) loans, because then unwanted notes will be speedily returned to banks as loan repayments--as if banks' were "constrained" by such repayments rather than encouraged by them to lend some more. (The Free Banking School argument, in contrast, was that under competition a bank's excessive issues would be returned to it, not by borrowers repaying their loans, but by rival banks seeking settlement in gold, which does constrain lending.) But he spouts more nonsense in suggesting that the occasional failure of English "country" banks "reduces to a nullity the legal obligation to give coin in exchange for notes," which obligation is admitted by proponents of free trade in banking to be essential for the safe and beneficial employment of banknotes. Surely the fact that issuing banks occasionally failed was proof, not of the "nullity" of the legal obligation in question, but of its reality: it is, on the contrary, precisely when a suspending bank is suffered to remain a going concern, instead of being wound-up, that its erstwhile obligation to secure the convertibility of its notes is rendered nugatory. In the history of English banking only one bank ever enjoyed such immunity from failure, and that bank was the Bank of England.

What, then, was the actual, eventual consequence of granting to that bank a monopoly of England's paper currency? Was it to render the convertibility of that currency more secure than it would have been had the privilege continued to be shared among numerous banks, each of which was capable of failing? On the contrary: it was to altogether do away with even the limited degree of security that that currency once offered.

So far we have a nice distinction between the early Bagehot, champion of currency monopoly and of the "one-reserve" system that goes hand-in-hand with such monopoly, and the later Bagehot, champion of free banking and a "natural" multiple-reserve system. But the distinction isn't quite so clear-cut as all that, for toward the end of his review Bagehot recognizes the "unnatural" character of the English banking system, with its "excessive preponderance of the Bank of England over the other establishments," comparing it unfavorably to the Scottish system. But Bagehot's criticism of the English system falls well short of any implied endorsement of "free trade in banking." Instead, he merely complains that, in concentrating so much power in the hands of a single firm, legislation had rendered England's economy excessively vulnerable to poor decisions by that firm's directors. That misguided legislation went well beyond that--that it set the stage for crises that even the wisest Bank directors were powerless to prevent--was a conclusion he would come to only after an interval of many years.

What caused Bagehot's thinking to change? The unworkability of Peel's Act in practice--the Act's provisions had to be set-aside on three occasions before 1873--undoubtedly had something to do with it. But there is another, intriguing possibility. Bagehot became personally acquainted with James Wilson, whose pro-free banking views he'd once taken to task, in 1857. The two men then became quite close: so close, in fact, that Wilson gave Bagehot his daughter's hand in 1858, and made him the director of The Economist upon departing for India in the autumn of 1859. (Bagehot became editor-in-chief upon Wilson's death in India the following July.) It's tempting to assume that Wilson accomplished in person what he'd not done in print, by bringing his son-in-law and successor into the free-banking fold. The hypothesis is, I think, worthy of a fuller inquiry.*

*That Wilson did discuss the currency question with Bagehot isn't in doubt. In his Memoir of the Right Honourable James Wilson Bagehot observed that "to those who knew Mr. Wilson well, no subject is more connected with his memory: he was so fond of expounding it, that its very technicalities are, in the minds of some, associated with his voice and image." (Added February 10, 2012.)

Yeah, I know: it's been so long since I posted here that you'd have a right to wonder whether I decided to quit economics and enter a monastery, or had simply dropped dead.

In fact I've done neither, though I've had reason enough to be tempted by each of those alternative prospects. You see, we are hiring several new faculty here at UGA, and that has meant being almost constantly engaged in either interviewing or hearing presentations by prospective new faculty members, or attending meetings concerning the merits of various candidates. Add a full teaching load, a heavy travel schedule, and the fact that I am employed by one of those unenlightened econ departments that doesn't give a toss about blogging, but does insist on having its faculty publish articles in refereed journals that are so spectacularly famous that even some business school deans have heard of them, and you will perhaps be willing to forgive my absence from this forum.

So in my precious spare time between seminars and all that I've been working on some articles, which I am now pleased to share with my fellow free banking enthusiasts. The first is this article, prepared for an upcoming Liberty Fund colloquium revisiting In Search of A Monetary Constitution, a classic 1962 collection edited by Leland Yeager and including contributions by Rothbard, Buchanan, and Friedman, among other notables.

Here's the abstract:

"This paper considers reform possibilities posed by a type of base money that has heretofore been overlooked in the literature on monetary economics. I call this sort of money 'quasi-commodity money' because it shares features with both commodity money and fiat money, as these are usually defined, without fitting the conventional definition of either; examples of such money are Bitcoin and the 'Swiss dinars' that served as the currency of northern Iraq for over a decade. I argue that the attributes of quasi-commodity money are such as might supply the basis for a monetary regime that does not require oversight by any monetary authority, yet is capable of providing for all such changes in the money stock as may be needed to achieve a high degree of macroeconomic stability."

Comments and suggested improvements are, of course, very welcome.

Got to run: I hear the bell's chiming.