The modern free banking school: a review.

AuthorGedeon, Shirley J.

Why can't there be competition to government-produced fiat money? Why accept Federal Reserve notes as base money but not the notes issued by foreign countries or multinational banks? Do we really need central bank money as the currency for payment settlements among banks? Why have the central bank? If it can neither reduce the likelihood and severity of banking crises nor regulate the supply of credit money, then the modern free banking (MFB) school [Dowd 1993; Glasner 1989; Hayek 1976, 1978; Horwitz 1992; Selgin 1988; White 1989; Scigin and White 1994] asks us to consider a regime without one. The MFB school not only challenges the notion that central banks are necessary to avert banking crises, but argues that as lenders of first resort, banks contribute to banking system instability. This school holds that a central bank is not an economic necessity, but a political creation that can weaken the discipline that the competitive market imposes on banks. Key to the argument is the role of currency monopoly. A central bank monopoly, in the issue of currency, coupled with the government's requirement that this monopoly currency form the legal reserves of the banking system create conditions for moral hazard problems. This is mainly because the quid pro quo for the monopoly rights in currency issue is lender-of-last resort responsibilities. The MFB school argues that central bank protection to those banks that have overextended themselves weakens discipline; therefore, banking crises are more likely to occur under central bank regimes than under free banking ones. It is competition among banks in their search for deposits and the pressure banks place on each other to maintain the convertibility of their bank notes that will limit the total issue of inside money (notes and demand deposits) to just the amount that the public wants to hold.

Historically, Post Keynesian literature has dealt with the importance of central banking. Beginning perhaps with Minsky's [1957] discussion of the dialectical interaction between monetary policy and money market evolution, this literature has argued that the logic of capitalist accumulation implies an endogenous money supply and this - the endogeneity of the money supply - calls for a lender of last resort. Firms and banks create money credit when needed. But speculation is not easily recognized and when the system pushes itself to its realization limits, a sudden rush for liquidity can create extreme market disturbances. At this point, the central bank can be helpful.(1)

But this is an era of electronic payments systems, floating exchange rates, a national banking, and lightening speed adaptation of money market institutions to unstable conditions. Competition determines the value of currencies worldwide, so why not domestically? The MFB school not only questions why the state/central bank monopoly should alone earn seignorage income (the interest saving that the government earns through its issue of non-interest-bearing debt in the form of U.S. dollars), but pushes to ask why private multinational bank currency issues should not be encouraged to compete with the dollar, D-mark, and yen.

The MFB school is replete with answers and policy recommendations, many of which most JEI readers would reject out-of-hand. However, attention to the issues that free banking raises can help to clarify and push forward discussion about the security of a monetary system built on banks that issue private credit money and do so freely worldwide.

The Modern Free Banking School

According to Lawrence White, the most fundamental question of monetary policy "is whether government has any legitimate role to play in producing, or regulating the private production of, monetary assets" [1989, 48]. With this in mind, we examine the arguments made in defense of the deregulation of money, inside and out.

The MFB school makes the argument that overissue of notes or demand deposits will not occur under a laissez-faire monetary regime as long as convertibility of bank liabilities into base money is guaranteed by each bank and the total amount of base money is fixed in supply. The original version of this argument is the law of reflux, which claims that competitively issued currency cannot be overissued to such an extent as to cause inflation [Skaggs 1991, 457]. The base could be gold, silver, or some stock of fiat money permanently frozen; the stock of base money serves as the banking system's reserves.

The free banking system has been formalized by Selgin and White [1994, 1722-23] in the following way:

The stock of base money, B, is equal to the stock of bank reserves, R, while the money stock, M, is equal to bank deposits, D, plus outstanding notes, N.

(1) B = R

(2) M = D + N

equilibrium occurs where actual reserves = desired reserves

(3) R = r(D + N)

where r is the desired reserve ratio, R/M

Equations 1-3 can be rewritten as:

(4) M/B = 1/r.

Equation (4) is the free banking money multiplier. Note that unlike the textbook money multiplier, Equation (4[prime]),

(4[prime]) M/B = (1 + c)/(r + c)

an increase in desired currency holdings by the public, c = C/D, will not contract the money supply.

This is an important result. A free bank is assumed to be indifferent to issuing its own bank notes (currency) or deposit liabilities. A demand for currency would imply a desire on the part of the public to convert bank-issued demand deposits into bank-issued currency. Since the free bank creates its own currency, this amounts to simply reducing outstanding deposit liabilities and increasing outstanding currency liabilities without affecting total liabilities. This is in contrast to the traditional scenerio under central banking where attempts by the public to draw currency from its deposit accounts causes reserve drains on the bank and forces them to contract assets or petition the central bank for additional reserves. Simply stated, in the free banking system the banks are not forced into a dialogue with the central bank when there is a significant shift by the public toward holding currency because the banks can adjust their own portfolios and create their own currency according to market demand.

But what stops private issue banks from overissuing their currency or deposit liabilities? Since there are no statutory reserve requirements, why not push the reserve ratio to zero? The argument against the likelihood of monetary overissue is dubbed the "principle of adverse clearings." It is actually a reformulation of the nineteenth century law of reflux discussed by both Adam Smith and John Fullarton [Fullarton 1844]. The argument is that the market process itself will discipline banks so that they will not be tempted to overissue liabilities. By paying a competitive interest rate on deposits, and mindful of the spread between loan revenue and liability costs, each bank will reach an equilibrium point where the marginal revenue of an additional loan equals its marginal cost of servicing its liabilities [Glasner 1989, 66].(2)

Any bank trying to increase its market share by issuing more of its bank notes may find that this tactic backfires. To increase market share, a bank would have to buy assets (make loans) more cheaply than competitors as well as buy liabilities more highly priced (offer higher rates on demand deposits) than competitors. This squeezes profit margins. Even if willing to tolerate a lower profit margin, excessive bank note issue can still harm a bank. Individuals holding more dollars than desired-whether their "home" bank's Citibank dollars or that issued from some other bank, like Philadelphia First dollars - will deposit them in their demand deposits to earn interest. Banks would have to pay interest on these deposits. The bank that overissued notes would be disciplined by the banking community as a whole in two ways. The first would be when its notes were returned in inter-bank clearing and its reserves lost in the process; the second when repeated overissue forced the banking community to practice note-brand discrimination and refuse to accept the...

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