A Tale of Free Banking

Herewith we visit an imaginary future where free banking prevails. Government regulation of banks is a thing of the past. Banks have the freedom and the responsibility that they lacked under government regulation. In particular, private banks are free to print money, either literally, in the form of paper banknotes for the shrinking number of customers who want them, but in electronic form for most.

Print money? Horrors, you say! Fraud! Runaway inflation!

Not so fast. Come with me on a fantasy visit to the local branch of my bank, a future incarnation of Wells Fargo to be specific.

The first thing we notice is a display case showing a number of gold coins and a placard that says, “available here for 1,000 Wells Fargo Dollars each, now and forever.” I have in my wallet a number of Wells Fargo banknotes in various denominations. I could walk up to a teller and plunk down 1,000 of them and the smiling young lady would hand over one of these coins. More likely I would whip out my smartphone and hold it up to the near-field reader, validate my thumbprint, and complete the transaction without paper.

I have a few of these beautiful gold coins socked away at home but I don’t want any more today nor do I want to carry them around. Electronic money is ever so much safer and more convenient. Still, I am reassured by the knowledge that I could get the gold any time I wanted it. That is the basis for my confidence in this bank, not the FDIC sticker we used to see in the bank’s window.

Confidence? What about inflation? Wells Fargo can create as many of these dollars as they want, out of thin air. Without government regulation, who will stop them from creating and spending as many dollars as they want?

The market will stop them, that’s who.

In my scenario, Consumer Reports and a number of lesser known organizations track Wells Fargo and other banks. These organizations post daily figures online showing the number of Wells Fargo dollars (WF$) outstanding and the amount of gold holdings that the bank keeps in reserve to back these dollars. Premium subscribers, I imagine, can get an email alert any time a bank’s reserves fall below some specified levels. Large depositors will notify Wells Fargo of their intention to begin withdrawing deposits and/or demanding physical gold. Small depositors piggyback on the vigilance efforts of big depositors. They know it is not necessary for them to pester the bank when the big guys are doing it for everybody.

Wells Fargo practices fractional reserve banking. They cannot redeem all their banknote liabilities and demand deposit liabilities at the stated rate of one ounce of gold per thousand WF$. This situation is clearly outlined in the contract that depositors sign and is printed on their banknotes.

Let’s assume Wells Fargo backs just 40% of its banknotes and deposits with physical gold. How is this figure arrived at? By trial and error. Managers believe that if they let the reserve ratio slip much below 40% they will start getting flak from the monitoring websites and their big depositors. If they let it rise much above that figure their stockholders will begin complaining about missed profit opportunities.

Under fractional reserve banking, bank runs are possible. A bank run is a situation where a few depositors lose confidence in a bank and demand redemption of their deposits in gold or in notes of another bank. Seeing this, other depositors line up to get their money out, and if left unchecked, the bank is wiped out along with the depositors who were last in line. Bank runs are not a pretty sight.

Wells Fargo has a number of strategies for heading off a bank run. They have an agreement with the private clearing house of which they are a member that allows the bank to draw on a line of credit under certain circumstances. There is a clause, clearly indicated in the agreement with their depositors, allowing them to delay gold redemption for up to 60 days under special circumstances. They can reduce the supply of WF$ by calling in loans as permitted by loan agreements. Most important, though, is Wells Fargo’s reputation. Not once in their long history has Wells Fargo been subject to a bank run. Management is keenly aware of the value of their reputation and will move heaven and earth to preserve it.

To sum up, Wells Fargo’s ability to create unbacked money is limited by the public’s willingness to hold that money. The bank can respond to changes in the demand to hold WF$ whether those changes are seasonal in nature or secular.  They have strategies in place to head off runs should one appear imminent or actually begin.

What about competing banks, you may ask. Does Bank of America issue its own money? If so, there must be chaos with several different brands of money in the market. Are there floating exchange rates? Is a BofA$ worth WF$1.05 one day and WF$0.95 the next? What else but government regulation could put an end to such chaos?

The market, that’s what else.

Competing suppliers of all sorts of products have an incentive to adhere to standards even as they compete vigorously. If we were in a classroom right now I would point to the fluorescent lights overhead. The tubes are all four feet long and 1.5 inches in diameter, with standard connectors. They run on 110 volt 60 Hz AC current. Suppliers all adhere to this standard while competing vigorously with one another. If they don’t adhere to the standards people won’t buy their light bulbs.

So it is that competing banks in my fantasy world have all converged on a gold standard. They all adhere to the standard one ounce of gold per thousand dollars. (I trust it’s obvious that I just made up this number. Any number would do.)

Why gold? Gold has physical properties that have endeared it to people over the ages—durability, divisibility, scarcity to name a few. But other standards might have evolved such as a basket of commodities—gold, silver, copper, whatever.

You may raise another objection. All this gold sitting in vaults detracts from the supply available for jewelry, electronics, etc. That’s a real cost to these industries and their customers.

Yes, it is. It’s called the “resource cost” of commodity-backed money. To get a handle on this cost we must recognize that gold sitting in vaults is not really idle, but is actively providing a service. It is ensuring a stable monetary system immune from political meddling. How valuable is that? The market will balance the benefits of stability against the resource costs of a gold standard.

Furthermore we can expect resource costs to decline slowly as confidence in the banking system increases and people are comfortable with declining reserve ratios. Wells Fargo may find that a 30% reserve ratio rather 40% will be enough to maintain confidence. Other things equal, this development would boost profits temporarily, but those profits would soon be competed away, to the benefit of depositors and the economy as a whole.

Let’s go back to bank runs. Aren’t they something horrible, to be avoided at all costs?

Actually an occasional bank run is something to be celebrated. Not for those involved, of course, but to remind depositors and bank managers alike that they need to be careful. The same is true of the recent Radio Shack bankruptcy. Bad news for stockholders, suppliers and employees but an opportunity for competitors to learn from this bankruptcy.

Under my free banking scenario, depositors must take some responsibility for their actions. That doesn’t mean they have to become professional examiners. They just have to take some care to check with Consumer Reports or other rating organizations before signing on with a bank.

Have I sketched out a perfect situation? There’s no such thing as perfection in human affairs but I submit that this situation would be vastly superior to what we have now, where the Federal Reserve’s policy of printing money to finance government deficits will end badly. Furthermore, relatively free banking has existed in the past and worked well. To learn more, start with Larry White’s “Free Banking in Britain.”

20 thoughts on “A Tale of Free Banking

  1. There is no such thing as a bank ‘free of government regulation’. Ever since human societies have moved out of the hunter-gatherer stage of development states or state-like entities have always enforced contract rights, the most important of which have been debt contracts. To be put to practical use, any tale of free banking worth reading should define the role of the state.

    And you still can’t prevent a banking cartel like the present one from forming. When a financial crisis occurs (as they inevitably will and have since the very birth of capitalism and the institution of banking) some market player will have a great incentive to step in as a lender of last resort. The belief that market forces will be sufficient to keep the largest market participants from colluding to maximize monopoly power is superstition at best. Nothing has really stopped them before, and perfect competition is nearly impossible to achieve on a large scale–when Australia tried free banking in the 19th century the whole banking sector collapsed in spectacular fashion in the 1890s as ponzi finance and a speculative frenzy on real estate caught up to it.

    But I agree that currently the interests of the banking sector and the interests of the organizations that compose the real economy are out of alignment; just disagree that market forces alone will magically re-align them. That smacks of the utopian thinking you get from Marxists.

    • There is no such thing as a bank ‘free of government regulation’.

      Sure there is. Gibson even referenced one such work in his post.

      The rest of your “points” are made in the same kind of bad faith as your first one, and I’m not sure they’re worth debunking.

    • Did you actually read the research about free banking he posted with any attention to what, exactly, enforced the system of private property under which it occurred? By the researchers’ own admission, debt contracts were enforced by the British national government and the Scottish regional government throughout the free banking period; if debtors wouldn’t pay up, the banks didn’t go after them with privately hired mercenaries–they would bring them to court and the legal system would determine the dispute’s outcome. You could argue the system was more *loosely* regulated; but ‘free from government regulation’? That is nonsense, unless you want to argue that the courts and the system of law in Britain at the time never really existed and all evidence of their existence is being fabricated by the Illuminati–and we’d need to see some evidence of that conspiracy to give it credibility.

      Indeed, the Free Banking period in Britain–and, again, White is really talking about Scotland, where the banking system was actually merely a satellite of the larger British financial system being run out of London–substantiates the points I made, to which you provided no rebuttal. By 1752, Scotland’s three ‘public banks’–The Bank of Scotland, the Royal Bank of Scotland, and the British Linen Company–had formed a cartel that provided lender of last resort functions. Before that, the Bank of England provided that function, as Scotland was not an independent nation after 1707. So the whole period merely serves as proof for my point that market forces cannot stop cartels from forming; indeed, at times they may encourage them. After all, a banker can only make a decent living by lending responsibly with long-term tangible capital formation in mind; the interest payments he gets out of such lending will ever be ho-hum. To expand their income from average/’ho-hum’ to something more, they need monopoly power and a ponzi finance scheme–cartelization and the limitation of competition is ultimately just good for business, and so inevitable. Only under a free banking system there would be no mechanism to constrain the cartel’s bad habits whatsoever.

    • I didn’t realize that court-enforced contracts equaled government regulation of the banking industry…

    • Brandon–

      The courts are a part of the government. The legal parameters of the court system are derived from law, and the law is implemented by the state. The state determines what contracts the courts do and do not enforce, and thereby regulates the institution of finance. The principle question is *how* this should be done, not *whether* this should be done.

    • That’s a nice logical progression you’ve got going on there. This is especially good:

      The state determines what contracts the courts do and do not enforce, and thereby regulates the institution of finance.

      Pure brilliance! Tell me something: do you see anything wrong with this? Anything at all?

    • Not really, since it’s the truth. Only legal contracts will be enforced, and what is legal is determined by the government. (Ideally, however, the government is democratic not totalitarian and so this determination is by extension expressing the will of the general populace) That is how financial institutions are regulated. A banking system ‘free of government regulation’ is like a game of poker with no rules, or a square that is also a circle.

    • No, check it out. Even if we take your statements at face value (they are factually incorrect, but for this exercise we’ll assume that they’re not), it does not follow that because the courts decide which contracts to enforce and which to not enforce that government regulates finance.

      That’s a leap in logic I can only attribute to dogma.

    • The definition of regulation is hardly dogma. A regulation is a legal norm that shapes conduct. (Merriam-Webster’s primary definition of the term: “an official rule or law that says how something should be done.”) To ‘regulate’ something means (and again we’ll use Merriam-Webster here) “to make rules or laws that control (something)” or “to bring (something) under the control of authority” or “to set or adjust the amount, degree, or rate of (something)” The conduct of financial institutions is shaped and determined by the legal norms under which they operate. As the nomenclature implies, legal norms are established by law, and law is created by the government and implemented and enforced through the court system and through the state’s authority and use of force. So, despite your protestations to the contrary, going by conventional definitions, the financial sector is indeed ever and always regulated by the government.

      Are you really arguing that if, for example, tomorrow the government decides that the courts will not recognize any debt contract with an interest rate exceeding 5% as legally enforceable, the latter action would *not* constitute regulation of the financial system? Because that would not cohere at all with the definition of ‘regulation’ or ‘regulate’.

    • You are still flunking logic 101.

      First you state that regulation is a legal norm (false) and then you provide a definition that debunks your definition (an official rule is not a norm). The rest of your “argument” is made in equally bad faith.

      I can’t argue with your imagination.

    • There is no meaningful distinction between legal norms and laws. At best you can try to needlessly split hairs and argue that ‘a legal norm’ refers specifically to a mandatory rule of behavior established within the institution of law and ‘a law’ refers specifically to the legislative edict that formally codifies such rules, but such hair-splitting isn’t doing any argumentative work, since in that formulation each constructs and is a derivative of the other. And you cannot quibble with the dictionary definition of ‘regulation’ and ‘regulate’, and those definitions make it clear that the behavior of financial institutions is necessarily regulated by the state. What else determines what is and is not a lawful contract? How do such determinations -not- control the behavior of the financial sector through rules and laws? How do they -not- bring financial institutions under the control of an authority? Because the latter two are the main dictionary definitions of what it means to ‘regulate’.

      Also, the notion that a citation from Merriam Webster’s Dictionary is a figment of my imagination is rather nonsensical, especially when you can go to their website and see that I merely transcribed the definitions they provided. And are you intentionally attempting to be ironic when you don’t bother with providing any substantive rebuttal to my arguments in your posts and then claim *I* am arguing in bad faith?

    • Sorry dude, but the only place a legal system doubles as a regulatory body for the banking sector of an economy is in your imagination.

      Unicorns and fairy dust.

  2. Fantasizing about an alternative reality is good and even necessary. If we don’t, we are in a rut and we stay wedded to bad ways of doing things. I want to hear more about his, including from Diale. By the way, Diale, isn’t it true that there must have been unregulated banks at some time in history? Wouldn’t states have to have something to regulate before they started regulating? Or where all banks at all time founded by states?

    • Jacques–

      Think of it this way: a bank is not a bank unless it traffics in debt contracts. Otherwise it’s just a clearing house or a storage facility. Debt contracts have always been enforced by states or state-like entities since humans got out of the hunter-gatherer stage of their development. So all banks at all times have indeed been predicated on the state’s use of force, and thus on some degree of regulation by the state. (note, however, that states come in all shapes and sizes–large, miniscule, totalitarian, democratic, etc.)

      The issues of finance have never been “no state regulation” vs “state regulation” issues but issues about what *kind* of state regulation is best. Even Adam Smith wasn’t an anarchist. So to speculate about the benefits or drawbacks of a free banking system, you shouldn’t hand-wave away the role of the state, which is kind of what happens here when we begin with “Government regulation is a thing of the past.”

      The story would appear far less quixotic if instead this hand-waving was replaced with a specific designation for the role of the state, one that might be achievable. And if it included a discussion of the problem of imperfect competition (or rather that there is no guarantee of perfect competition in any given market, even under a laissez faire government) and the possibility of an informal lender of last resort being established in place of a central bank and resurrecting moral hazard. IMO, the less utopian and more practical the proposed alternatives to what we have are, the more incisive they are. (which is one reason that I find the history of actual attempts at free banking more interesting than theories of free banking–they put the benefits and tradeoffs on full display and genuinely get you to think about whether and how a free banking system might work in some undefined future)

    • And I’d add briefly that the author does deserve kudos for including a link to one such history.

  3. […] about something now and then. But even I was surprised (and not at all displeased) to discover that at least one person besides me–Warren Gibson–fantasizes about…free banking! Better yet, he's invited anyone who wishes to stroll down fantasy lane with him to witness his […]

  4. […] about something now and then. But even I was surprised (and not at all displeased) to discover that at least one person besides me–Warren Gibson–fantasizes about…free banking! Better yet, he’s invited anyone who wishes to stroll down fantasy lane with him to witness […]

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