The law of national guaranteed banks in Argentina, 1887-1890: free-banking failure or regulatory failure?
Author | Cachanosky, Nicolas |
Empirical studies of historical cases of free banking have received renewed interest recently. Because financial crises have occurred when central banks have existed, a comparative analysis with free banking promises to be worthwhile. By reference or implication, the Law of National Guaranteed Banks in Argentina between 1887 and 1890 has been advanced as a case of free banking. An expression of this reading of events appears in the work of Gerardo della Paolera and Alan Taylor, who say that the Law of National Guaranteed Banks is "commonly referred to as the 'free banking law'" (2001, 240); a similar expression appears in the work of Vicente Vazquez-Presedo (1971, 37). (1) Kurt Schuler, in a volume on free banking, states: "Argentina's currency during its free banking period consisted of fiat government notes and bank notes nominally backed by gold government bonds, but in reality unbacked" (1992b, 29, emphasis added). (2) Roberto Cortes Condo says, when discussing the case of the national guaranteed banks, that the idea of "free banks" has antecedents in the United States (1989, 195-204). Lucas Llach maintains that "[l]egislation for a system of free banking had been an option since [President Bartolome] Mitre's times, favored by orthodox circles in Buenos Aires" (2007, 93, emphasis added). Pablo Gerchunoff, Fernando Rocchi, and Gaston Rossi maintain that President Juarez Celman (1886-90) found an opportunistic moment to embrace the theory of free banking that had been discussed during Mitre's presidency in the 1860s (2008, 84). (3)
A few exceptions to this general characterization of the Law of National Guaranteed Banks as free banking, however, can be found. Charles Hickson and John Turner (2004), for example, classify the Argentine case as one of a regulatory environment rather than free banking. (4) M. C. Gomez, in his article "Free Banking in Argentina" (1994), studies the period between 1810 and 1881 rather than the system of guaranteed banks. This earlier period might be labeled more properly an instance of free banking because it preceded the national government's heavy involvement in money and banking.
The Law of National Guaranteed Banks in Argentina lasted only four years, from 1887 to 1890. Some studies (Cortes Conde 1989, 212-16; della Paolera and Taylor 2001, 106-13) have related the guaranteed banks' failure to the Baring Crisis of 1890. (5) If the guaranteed banks did indeed help to cause the Baring Crisis, then it is even more important to determine whether the system of guaranteed banks was a free-banking system or a regulated-banking system. Was this event a historical case of free-market failure, or did the regulations of the financial reform bear responsibility for the banking crisis?
In this article, I examine the structure and incentives that the Law of National Guaranteed Banks imposed on the market and on policies, and I conclude that the financial crisis that occurred was a consequence of the regulations rather than of free-banking instabilities. I first discuss what we should understand by the term free banking. I then describe the historical context preceding the Law of National Guaranteed Banks, the law itself, and the mechanisms and incentives of the underlying banking market. Finally, I discuss the main differences among the various mechanisms of free banking and conclude that the Law of National Guaranteed banks represents a historical case of regulatory failure, not market failure.
What Is Free Banking?
Analysts disagree as to what should be understood as free banking. (6) Ignacio Briones and Hugh Rockoff (2005), for example, ask whether economists have reached a clear conclusion with regard to free-banking episodes. This ambiguity may exist because it is easier to say what should be absent in free banking than what particular form it should take. Free banking requires not simply the absence of a central bank, but also the absence of regulation. Nevertheless, a free market in money and banking can take different shapes. For example, Friedrich Hayek's 1976 proposal for currency competition (Hayek [1976] 2007) is not the same thing as free banking. What, then, makes a particular instance a case of free banking?
In free (laissez-faire) banking, all banks are allowed to issue their own notes, and freedom of entry into the banking industry prevails. There is no regulation of banking practices, such as reserve requirements, limitations of interest rates, and restrictions of branching. In addition, banks are free to choose whom they lend to; the law does not require them to lend to the government. Banks issue notes (inside money) against money proper (outside money) that their customers deposit. The contracts with their customers and other counterparties are enforced by law. In other words, the literature on free banking pertains to how the invisible hand would handle money and banking (Selgin 1988, chap. 1).
The literature usually considers gold as the outside money, with no restrictions on the issuance of money substitutes, such as banknotes, by private banks. A number of competitive banks may issue banknotes, but with money proper, the relation between banknotes is that of a parity, not an exchange rate. All banknotes are denominated in terms of the outside money (for examples, ounces of gold per dollar).
Although gold is the most common example of outside money, any other commodity being used as a medium of exchange can be the base for a free-banking system as long as the banks accept it. (7) Note-issuing banks may also accept more than one outside money, for example, gold and silver. However, because there are no regulations regarding the exchange rate between the two commodities, their exchange values float, and so Gresham's law does not hold.
Other proposed unregulated systems, such as Hayek's currency competition and the Greenfield-Yeager cashless system, do not fall into the free-banking category. In Hayek's plan, for example, banks issue their own fiat money with the promise to keep the purchasing power of their currency stable. But Hayekian banks issue outside money rather than inside money. Hayek was concerned about how to go from central banks that issue fiat currencies to a more competitive system wherein the alternative of going back to the gold standard is not feasible. In the Greenfield-Yeager cashless proposal, each issuer adheres to a common bundle as unit of account, but the redemption of liabilities is done in a different and more convenient bundle of goods. With the gold standard, the claims are denominated and redeemable in gold, and there is no separation between the price level of a bundle of commodities and a redeemable bundle. (8) Neither Hayek's currency competition nor the Greenfield-Yeager cashless system falls in the category of free banking because banks do not issue banknotes against what is used as money in the market.
When studying historical cases, however, hardly a pure case of free banking can be found. Historical cases usually mentioned, such as those of Scotland from 1716 to 1844 and Canada from 1867 to 1914, still have some differences from an ideal free-banking system. (9) Nonetheless, the incentives in the system may still be the same as those under free banking, where outside money is deposited in a bank that issues inside money or money substitutes. These issuer banks compete with each other to attract customers' savings and to act as intermediaries between suppliers and demanders of credit. If this structure is not present anymore--for example, if banks are forced to issue banknotes against government bonds rather than against outside money--the incentives and dynamics of the monetary institutions may change into something different from those associated with free banking.
The Situation Prior to the Law of National Guaranteed Banks
After Argentina's revolution against Spain in 1810, years were lost in conflicts as the provinces fell into wars and political disputes with each other. A strong rivalry took place between the Province of Buenos Aires (henceforth "Buenos Aires") and the other provinces for political and economic power. (10) The provinces--absent a definite national government, involved in armed conflicts, lacking domestic and international credit, with no room for further taxation, and without the same access to the resources from the Potosi mines--used their own official banks to print money as a way to finance their ventures. Furthermore, trade taxes tended to decline in the presence of crisis and civil wars, and the provincial governments' inability to get much revenue from this source constituted a major problem for them in those days.
The difference between Buenos Aires and the interior provinces was huge. Llach reports that by 1880 Buenos Aires, with 32 percent of the total population, had a budget that accounted for 58 percent of the combined budget of all fourteen provinces (2007, 12). Buenos Aires's budget was 11.2 pesos per capita; in the other provinces, the budget was 2.5 pesos per capita. Llach offers a few possible grounds for this important difference (2007, 14). The decline of Potosi, on which the interior was dependent, affected the provinces, and they shifted their economic center to Buenos Aires, but poor transportation infrastructure and internal trade taxes slowed their economic growth and development. Also, the civil wars damaged the interior more than they damaged Buenos Aires, and import penetration displaced local producers in the interior.
A firm national government and the end of internal wars finally came with President Bartolome Mitre (1862-68). (11) The Pacto de San Jose de Flores followed the battle of Cepeda in 1859 between Buenos Aires and the Argentina Confederation (formed by thirteen provinces). Under this agreement, Buenos Aires would join the nation as another province and sign the Constitution of 1853, but the possibility of constitutional reform remained open. In 1860, a...
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