Free Banking: A sensible option

[Tahuti]

Now, before I start off, I'm not a libertarian by any stretch of imagination. I wouldn't support any particular policy recommendation just because it is "moral", "respectful of property rights" or "pro-liberty". However, one particular policy recommendation associated with libertarians does seem so sensible on pragmatic ground that it deserves to be debated outside libertarian circles, namely, free banking.

In free banking, every commercial bank additionally has a function comparable to a country's central bank, and thus may issue its own currency, backed by the assets the bank owns (which doesn't have to be just gold and silver, but can also be, for example, resources and corporate stock), as well as by liabilities not denominated in the currency that is being issued.
This has the clear advantage that the collapse of one bank does no longer entail any systemic risk. After all, banks do not have to collapse any longer, as they can devalue their currency to match the total assets owned by the bank, and the other banks are for most part insulated from any negative effects such a devaluation may bring.

I can't see any disadvantage of such a system: Please prove me wrong. It seems almost too insane to be true.

 

[Ayatollah So]

Is there any legal obstacle to this? I'm kinda doubting it, because in my general vicinity in Michigan there is some kind of co-op scrip that (a few, very few) people are exchanging. Theoretically, it represents a claim on services from members of the co-op, or some such.

 

[Tahuti]

There is not so much an obstacle to it as that large commercial banks have a favourable position in that they are allowed to issue government money while virtually no one else isn't. After all, as observed by Gresham's law, bad money protected by law will always outcompete good money. Free banking would gain traction if banks wouldn't have the privilege to create central government money.

 

[Cutlass]

The US has had free banking. The result? Massive fraud, lost fortunes, inflationary and deflationary periods, a general economic rollercoaster. No good comes of this.

 

[Tahuti]

The US has had free banking. The result? Massive fraud, lost fortunes, inflationary and deflationary periods, a general economic rollercoaster. No good comes of this.

Note that during the free banking era, most states had laws that actually required banks to allow their money to be redeemable for gold, which was the main reason why many banks went down under. So the main problem seemed to be the gold standard and not free banking in itself. Sweden also had Free Banking, but no legally required gold standard, and indeed, free banking was quite successful there.

 

[Cutlass]

Some of the states may have required that. But had no way to enforce it. Just as no one would have a way to enforce value now. The problem is that there is no way to have transactions without knowing the value of the medium of transactions. And keeping track of 11,000 different moneys within the country on a minute by minute basis would be utterly impossible.

 

[Tahuti]

Some of the states may have required that. But had no way to enforce it. Just as no one would have a way to enforce value now. The problem is that there is no way to have transactions without knowing the value of the medium of transactions. And keeping track of 11,000 different moneys within the country on a minute by minute basis would be utterly impossible.

Sweden had like a dozen banks that issued their own currencies, that's quite manageble.

 

[Cutlass]

16,000 (including credit unions) > 12. There's a point at which problems that can be managed at a small scale can't be managed on a huge one.

 

[Tahuti]

Not all these banks necessarily have to issue currency that is also generally accepted as payment, should a system of free banking arise. Also, while not all problems can be solved and guarded against, one of the reasons why we would want to have a system of free banking is because most of the banking system would be insulated from the negative effects of an individual bank run.

 

[Cutlass]

Not really. The most irresponsible banks are the biggest ones. And he biggest ones are the size of 100s of the others.

 

[innonimatu]

In free banking, every commercial bank additionally has a function comparable to a country's central bank, and thus may issue its own currency, backed by the assets the bank owns (which doesn't have to be just gold and silver, but can also be, for example, resources and corporate stock), as well as by liabilities not denominated in the currency that is being issued.

That's not a function central bank. Central banks do issue currency, but they don't have to back it with anything. Except the expectation that some limit will be arbitrarily set and respected.

What you want here is a bit pointless to ask anyway: commercial banks already do what you propose in that they "issue money" in the form of new deposits when they create loans, and those are backed by "assets" (debts to the bank, which may in turn be guaranteed with something else). The only thing they no longer do (because it's unnecessary) is print some physical certificate (banknote or whatever) of that debt. That's what banknotes were when commercial banks issued money.

There was even another thing, presently going out of fashion, the endorse check, which was "money" created by private individuals backed by some asset (bank deposit) that could be traded. In function it served the purpose you seek here. And suffered the same fault: lack of trust by many possible receivers.

I can't see any disadvantage of such a system: Please prove me wrong. It seems almost too insane to be true.

One bank goes down; holders of securities (bank notes?) issued by other banks try to get rid of them in fear for the soundness of those other banks also; recipients will only accept them at a discount; uncertainly and economic deadlocks: this is precisely the "systemic risk" that supposedly required the exiting banks not to be allowed to fail.

 

[MagisterCultuum]

The US has never had anything close to true free banking.

For a long time we had extremely tight branching restrictions. Banks were often confined to one town, unable to diversify their holdings in order to mitigate local disasters like crop failures.

 

[innonimatu]

What? No! The US had free banking, at lest on the western states. Anyone could set up a bank in some of those states, banks were operated under state supervision, which was in many cases inexistent. The amazing thing is that bank notes were even accepted (at a discount) in places far away from the bank.
Those who received the more unusual notes eventually had to check big catalogues just to find out where to send the banknotes for exchange. Sometimes it turned out that the bank no longer existed! And forgers must have had their golden age.

 

[Tahuti]

That's not a function central bank. Central banks do issue currency, but they don't have to back it with anything. Except the expectation that some limit will be arbitrarily set and respected.

Central banks regulate a national currency. Why can't commercial banks issue their own currency and be responsible for its regulation as well. In a way, I'm sort of asking for the ability to compete with central banks in regulating your own currency. Self-regulation will never work when its not their own currency, but when it is, it just might.

What you want here is a bit pointless to ask anyway: commercial banks already do what you propose in that they "issue money"

But the money they issue is central bank money, not their own money. Hence the danger when one bank goes down: All banks are actually the same and are all pillars supporting eachother. Once a pillar goes down, the whole structure goes with it.

In the status quo, BANK A and BANK B all issue dollars of CENTRAL BANK A they belong to, while in free banking, BANK A issues BANK A dollars and BANK B issues BANK B dollars. If BANK A faces a bank run, it can devaluate its currency against owned assets and while suffering its own confidence crisis, wouldn't collapse and would also insulate most other banks from its effects.

 

[Cutlass]

Self-regulation will never work when it is their own currency, because you know, self-regulation never works. Period.

 

[Terxpahseyton]

Never?
State property horayy

 

[Cutlass]

If self regulation was viable the government wouldn't be regulating in the first place. What people tend to overlook is that, at least in the US, regulation is a last resort only after everything else has failed. So any area that is regulated, we already know that self regulation has failed. So given that we know that it has failed, what has changed to make it appear that it would work in the future?

 

[potatokiosk]

Why would I want to have to deal with lots of different currencies circulating in one country with fluctuating exchange rates and prices instead of the simplicity of just having one currency? No thanks, I think I'll pass on "free banking".

 

[Tahuti]

If self regulation was viable the government wouldn't be regulating in the first place. What people tend to overlook is that, at least in the US, regulation is a last resort only after everything else has failed. So any area that is regulated, we already know that self regulation has failed. So given that we know that it has failed, what has changed to make it appear that it would work in the future?

Self regulation is perhaps the wrong wording. At the heart of the crisis, were banks that were regulating a currency that wasn't their own, and could not be held accountable if it all failed.

Why would I want to have to deal with lots of different currencies circulating in one country with fluctuating exchange rates and prices instead of the simplicity of just having one currency?

Why would I want to have to deal with lots of different potatoes available in one country with fluctuating degrees of quality and prices instead of the simplicity of just having one kind of potato?

On the more serious note, because the "simplicity" of one currency is simply more prone to systemic risks. Also, if there is free banking between multiple countries, it also has the advantages of having one currency as within the chains of supply, suppliers are not necessarily forced to switch currency.

 

[innonimatu]

On the more serious note, because the "simplicity" of one currency is simply more prone to systemic risks. Also, if there is free banking between multiple countries, it also has the advantages of having one currency as within the chains of supply, suppliers are not necessarily forced to switch currency.

Theoretically the technical/economic consequences of this "systemic risk" would it unfold are no more than the devolution from national currencies to ad-hoc currencies, and corresponding reduction of trade volume due to uncertainty and higher costs of transaction. Those also happen to be inherent "features" of a free banking system. Thus a free banking system would be inferior to regulated banking, a less refined state of evolution.
It's not this simple in practice because both systems enable periods of credit expansion (where trade increases) and periods of crisis (when it collapses). Hard to actually make comparisons...

Broadly speaking, "free banking" benefits risk-takers (who want easy loans) and goes against the interests of rent-seekers (or, simply, savers - who want their principal guaranteed and financial capital to be expensive to get). That's why in the history of your country it was always the western, frontier states, that demanded free banking, and the eastern states that opposed it. And earlier it had been the british crown who wanted money somehow regulated, and the colonies that wanted to create their currency as necessary.

Free banking's main "problem", defaults and their losses to savers/lenders, is also one of its two attractions (the other being easier credit), though few will admit it.
Wealthy societies tend to be dominated by wealthy interests, which will obviously oppose "free banking": that dilutes their comparative power as gatekeepers of financial capital. Fast developing and less stratified societies have more people demanding easy loans because they have more people who believe they have opportunities to use such capital productively, and if that is the case can indeed benefit greatly from free banking, regardless of the frauds and defaults that may happen.