Wednesday, August 1, 2012

Two questions on free banking

Sometimes people assume I'm opposed, but I'm actually not strongly opposed - I definitely see it's benefits. I just worry about some of the risks. Two questions came to mind today about it:

1. Would it be feasible or desirable to have a central bank with central bank money in a free banking system? I don't really worry about the "wildcat" stuff - what I worry about with free banking is really that credit could contract across the banking sector. I've read some of Kevin Dowd's responses to Goodhart on that, and either he's not making a convincing argument against that concern, or I'm not understanding his argument (or, of course, both). But could you just address this by having a central bank that issues federal reserve notes the way we have now, with banknotes fluctuating against that (much like Keynes's proposed bancor)? I don't see how this would threaten the virtues of competing monies, and it would seem like it would address the concerns about sufficient elasticity.

2. This is more of a question than a suggestion: how does foreign exchange work in a free banking system? Are foreigners expected to keep up with all the competing monies? I can't imagine free banknotes really circulated as foreign exchange before (although perhaps they did). I imagine it was gold, right? If my suspicions of how free banking might hamper international trade are correct, that might be another reason to issue federal reserve notes alongside banknotes. Foreigners would be much more likely to take federal reserve notes, and internally banknotes would trade against federal reserve notes at varying rates. Does that sound right?


  1. By "Goodhart", are you referring to Charles Goodhart? And perhaps you ought to talk to David Glasner, as he has written a book on Free Banking before.

  2. Ad. 1. Selgin believes that free banking system would achieve monetary equlibrium because a rise (fall) in the demand for money would be lead to rise (fall) in the supply of money. Selgin, Horwitz, Garrison and other "non-internet austrians" believe that free banking system can achieve this because of the law of excess reserves. The assumption is of course that the only kind of money circulating in the economy are banknotes issued by the banks. When monetary base consists of gold coins this assumption is acceptable (because gold is heavier and bulkier, people prefer to hold paper banknotes that might even earn interest). On the other hand, when base money consists of paper notes issued by the Fed, one of the reasons to hold private banknotes disappears. So there is a risk that when demand for monetary base would rise banks would be unable to increase the money supply to avoid the fall in AD. I guess that central bank could try to offset such changes in demand via policy of NGDP targeting (yes I'm market monetarist), Selgin's proposal however is a little bit different. For him a central bank should make its notes big and bulky in order to discourage people from holding them. This way people would use only inside money (private banknotes) in their transactions, which according to the free banking theory is enough to keep AD stable (or on a stable path). Selgin first presented this idea in his book "The Theory of the Free Banking..." in one of the last chapters.

    Ad 2. In the free banking system (by definition) there are no restrictions in banking/money production business. Foreigners could than hold either monetary base (let's say those large, bulky Fed notes) or notes issued by the banking system. It is highly probable that due to the high information costs, foreigners would not like to hold notes issued by private less known banks. I believe that they would probably choose to demand notes issued by well known banks (Citi, JP Morgan etc.) or keep monetary base. I don't see how this would affect international trade.

    BTW, Daniel you've mentioned Keynes' Bankor proposal. I am embarrassed to admit I don't know a lot about this. Could you suggest a good article explaining his proposal? Also, you've mentioned Goodhart criticism and Dowd's response. Could you specify what articles are you talking about? I would be grateful for any information.

    1. I just refer to people as "internet Austrians" if they aren't actually economists. So Rothbard, Block, Murphy etc are all Austrians off the internet as well. Major Freedom & Bob Roddis are another story.

    2. I'm referring to Goodhart's The Evolution of Central Banks, and Dowd's review of it... I thought it was in something like the Cato Journal, but the only thing I can find is this:

      At the Scottish Journal of Political Economy. If this is not what I read, I'm sure he makes similar arguments.

      I don't have a single good source for you. I want to say I got most familiar with it in something Moggridge or Howson wrote on the continuity in his monetary thought. I was reading a bunch of their stuff for my 1920-21 paper. But it may not be in there. Zhou Xiaochuan's suggestion for SDRs (here: is the modern version of the proposal.

      I think Jonathan Catalan was posting on one of Joe Stiglitz's books and mentioned that it was discussed there. You might want to do a search at his blog.

  3. BTW, Daniel please think about changing the theme of your blog (I mean graphic design etc, not content). The current one is not very easy to read (especially the comment section).

    1. I will agree with you in that I find that the font and boldness of the text for the comments to be somewhat harsh on the eyes.

  4. Michal Gamrot describes Selgin's views on central banking well. Some FRFBers have agreed to central banking if the central bank simply keeps the quantity of money constant. If a central bank intervenes, well that means you don't have free-banking. The excess-reserves theory can't be expected to work and MV won't be stabilised. At least not unless the central bank acts like a commercial bank.

    Credit contracting across the banking system could be caused because many banks are bankrupt or close to it. In that case I think a quick few bankruptcies is preferable to years of bailouts and a non-functional system for a long period of time. I agree that the quantity of money can be threatened from the asset side. I'm not sure how important that is in practice though. In practice most bank liabilities are akin to bonds or savings accounts, the rest are money-like. The quantity of money-like liabilities can rise even if the total falls because of bad assets (this happened in the UK during the recession).

    On the second point it's important to start by saying that the idea of free-banking is that FRFB currencies do *not* float against the base currency; they have the same value. In practice it's rare that private currencies are discounted, generally they are exchanged at face or there is bank run on the issuer. In America private currencies were sometimes discounted for strange reasons to do with bank location and bank regulations that will probably never be repeated.

    If one country adopts free banking then citizens of other countries are likely to sometimes demand base money. But, banks can arrange to supply that just as they did in the gold standard era. They won't necessarily always demand base money (as Michal mentions) if they believe the bank to be sound. I don't think it would be that different to the current situation.

    1. I also got the impression that Daniel thought the value of private banknotes floats against the unit of account in which they are denominated. But this is clearly wrong, since arbitrage would lead to "fixed" exchange rate between banknotes and monetary base.

    2. I know they exchange at the same value, but there's not a lot of variation in willingness to hold the money? I was under the impression that there was, and that for that reason a lot of notes didn't trade across state lines as often, etc. - and that made me curious about the implications for international trade. If they are really all viewed about the same it obviously isn't going to be much of an issue internationally either.

      re: "If one country adopts free banking then citizens of other countries are likely to sometimes demand base money. But, banks can arrange to supply that just as they did in the gold standard era."

      Right - that was more what I was thinking of. Is it reasonable to worry that this might hamper globalization.

    3. "I know they exchange at the same value, but there's not a lot of variation in willingness to hold the money? I was under the impression that there was, and that for that reason a lot of notes didn't trade across state lines as often, etc"

      In some US states branch banking was banned, in other places inter-state banking was severely restricted. In some states banks had to invest a certain amount of capital in the state's bonds. This meant that banking and banknotes tended to be more local. The willingness to hold certain banknotes was local because the banks were. Also, for the same reason, in the US there were discounts on banknotes because the creditworthiness of remote banks could not be well known, and it was difficult to tell fake notes from real ones. In Scotland where there were no limits on branch banking the banks that issued significant amounts of notes were generally national.

      I don't think there's any reason to think that banknotes would turn out much different to how bank accounts are now. Generally a bank transfer can be made between any bank account and any other. Though in some places where a specific bank doesn't operate it may not be much use having an account at it.

      Notes may end up being more regional than bank accounts, but these days who cares about that? As a data point on this, as you may know Scotland and Northern Ireland have private banknotes even though they don't have free banking. In Scotland all types of Scottish banknotes are generally accepted everywhere. Similarly, in Northern Ireland all types of Northern Irish banknotes are generally accepted everywhere. But, Scottish banknotes are only sometimes accepted in Northern Ireland and only sometimes accepted in England.

      "Right - that was more what I was thinking of. Is it reasonable to worry that this might hamper globalization."

      How is it any different to the current situation? If I transfer pounds to you what do you think happens, our banks won't just accept bank balances, they will redeem base money or perhaps exchange assets.

      The "globalization" situation could be helped significantly by free banking if many countries pick the same monetary base - e.g. gold. If that were to happen then there would be a fixed exchange rate between those countries, assuming there were no legal tricks.

  5. In both cases, the question is about trade offs with no obvious answer prima facie. So, in the first case, are the moral hazard caused by central banking and the reduced incentive to be a "conservative" bank, i.e. one who resists boom-profits to reap bust-profits, worth a certain guaranteed expansion of credit and elasticity of note issue? History can offer only limited guide due to the lack of ideal cases. Free banking has generally been quite rare and limited, and central banking has also been restricted by politics, since they were always political creatures. Goodhart's claim that central banks evolved naturally really means that he thinks that what makes central banking a good idea is implied in the flaws in a free banking system. It doesn't mean natural in the same sense as the "system of natural liberty." Note that the Bank of England, for example, resisted acknowledging its responsibility as the lender of last resort despite its privileged position, claiming that it should only behave like a typical commercial bank, for decades until Bagehot set things straight.

    Similarly, in the second case, are the benefits of only having to deal with one source of note issue worth the cost of no or privileged competition? Hard to say. (although I would also expect foreigners to generally prefer the central bank's notes)

    This is coming from someone who's been working on a book about such topics. Why economists find central banking desirable (and why a minority still don't) is maybe the first question I had about economics that wasn't immediately answerable. Since quite a few learned men didn't seem to know the answer, I thought it might be a fruitful subject to pursue. And indeed it is a subject ripe for further exploration, as I will argue (after I've established my market niche, of course). Hopefully it'll be my first work to be published--so I'm not exactly Mr. Authority here, but you could consider me an apprentice nearing his journeyman stage.

    1. Very interesting - I'd love to hear more about the project as it progresses.

      How far along are you? I'd also be interested in hearing what your first foray into writing a book is like. It's something I'd like to do some day, but the very idea seems daunting.

    2. Still working on the outline, but if things go according to schedule I should be done with the outline at about the end of August, give or take (probably give) a week or so. Maybe two weeks.

      Writing a book is very interesting, and yes, it's quite daunting. Projecting from current trends, my outline should be about 500 pages by the time it's finished--and that's just the gathering of relevant materials, before my own input is even added. Right now keeping everything organized is proving to be quite the headache. Furthermore, I only seem to find more things to read. I never learn anything that means I have to read one LESS book. So that's ~500 pages with current materials. I already am planning to read at least two more books, and maybe one to two dozen more articles, depending on how long my sanity lasts. So...maybe three weeks.

      Add that to my regular job as an aeronautical engineer in the army. Well, I'm training to become one, but that doesn't make it easier. Fortunately they take my tendency to zone out as a sign of some great hidden intelligence which thus far has managed to evade all tests. They'll be in for quite a surprise when a plane, or whatever the final test is, and it promptly explodes about two seconds after takeoff. Wait, I'm in the army, I'll probably get arrested for typing that. Or you will, for having the comment on your blog.

      Four weeks. Eh, call it six to eight weeks and shipping and handling are free.

  6. I think a potential answer to point #1 is contained in Hayek's "Denationalization of Money". Currency issuers would explicitly commit to keep the value of their currency stable and this would provide an incentive for people to hold that currency. Hayek suggests this could be done by "targeting" a bundle of commodities (currency issues could compete to provide the bundle most attractive to the users and could vary the bundle over time to keep it relevant.) So if (as Daniel fears) there was a tendency to reduce lending in a period of falling demand for money then currency issuers would address this by printing more money to buy assets and thus stabilize its value. If all currency issuers did the same then this would in effect operate as an AD stabilizer in the economy.

    Hayek's model appears to be different from Selgin's. It is not based upon a commodity such as gold but on whatever the issuers chose to measure its value against - and different currencies would choose different things.

    In answer to Daniel's second point: Foreign exchange would likely be a meaningless concept under free banking and competing currency since it would be up to individuals what currency to accept with no "official" curency in a give region. Under Hayek's vision of competing currencies there would need to be currency exchanges to establish the relative values of the different currencies in circulation.


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