The Theory of Free Banking

[This is an old post that was lost when the first version of this blog was hacked back in 2011. I found it using the Wayback Machine, so I wanted to re-post it.]

The current financial crisis has inspired growing concern over the ability of the Federal Reserve to handle the money supply and juggle the number of objectives it has been tasked with.  While opinions vary wildly, including many who would like to see the Fed’s activities expanded, there has been an unprecedented growth in the movement to outright abolish the United States’s central bank.  Popular opinion has begun to shift against the Fed due to its inability to properly accomplish any of its general objectives, including stabilizing prices and fighting unemployment.  Furthermore, its role as a general supervisor of banking activity has come under close scrutiny, and it is beginning to be seen more as a cause of moral hazard more so than as an efficient oversight mechanism — (for worse) the state has been forced to jump into the role of regulator.

While recent events have ballooned anti-Fed sentiment, the intellectual movement against monopolized currency systems is not new.[1] The modern debate has been led by the Austrian school, and the theoretical argument has been sealed by Ludwig von Mises and Friedrich Hayek.  Both intellectuals went through great lengths to prove how industrial fluctuations — business cycles — are caused by currency monopolies,[2] guaranteed by means of government authority.  Unfortunately, the Austrian lesson fell on deaf ears.  For the majority of the economics profession, business cycles were caused by deficiencies in aggregate demand, whether caused by unbridled speculation or an insufficient quantity of money.  For these economists, the Federal Reserve became a key tool for the restoration of prosperity.

Friedrich Hayek’s 1974 Nobel Memorial Prize and the consequent publishing of two major monographs, Choice in Currency[3] and Denationalisation of Money[4], led to a major revival in interest in Austrian ideas during the mid-1970s. Hayek reminded those willing to listen that a monopolized currency regime was not the only choice, and that free banking is a theoretically established alternative.

Broadly speaking, two branches of the Austrian school have formed respective of the question of what a free banking industry would look like.  The first can be referred to as the “full reserve bankers”, believing that a bank’s supply of money substitute[5] should be fully backed by commodity money.  The second, usually considered opposed to the first, are commonly referred to as “free bankers” — even though it should be realized that both branches argue in favor of deregulated banking — and believe that an unregulated banking industry would practice fractional reserve banking, and that it is the central banking regime that corrupts the issue of fiduciary media.[6] The bevy of literature that represents both branches is too large to refer to in detail, but it suffices to say that the past forty years has seen a flourishing of theory on the issue.

The main literary representative of the free banking school is George Selgin’s The Theory of Free Banking, published in 1988.[7] It was inspired by earlier work written by Lawrence White, Kevin Dowd, and others.  In it, Selgin provides a very complete theory of banking in an unregulated, competitive industry.  While Selgin has not managed to persuade all his peers, and in fact there are powerful and equally as convincing arguments against fractional reserve banking theory, Selgin’s model deserves to be understood.

While the academics who lead the debate may know exactly what they are talking about, many of the interested followers have been left in the dark.  The present essay is an attempt to paraphrase the free banker’s argument, as presented in Selgin’s The Theory of Free Banking, in an effort to clarify just what exactly the “fractional reserve bankers” are supporting.

Free Banking Theory

Before delving into the meat and bones of George Selgin’s free banking model it is worth to first briefly explore the development of a banking system in a free society.[8] Preceding the development of banking banking is the emergence of a medium of exchange, which occurs as a result of the problematic nature of barter — it is difficult, transitioning towards the impossible, in a larger division of labor to consistently find others with what is called a “double coincidence of wants”.  Sooner or later, indirect barter will necessarily be adopted, where individual A exchanges his goods for another set of goods with which individual A will use to barter for what he actually wants, allowing him to primitively circumvent the lack of an initial double coincidence of wants.  Progressively, individuals find that there are certain goods that people generally want more than others, and ultimately the good that best fulfills the qualities of money emerges as the medium of exchange.[9]Historically, while many different types of goods have been used as money, the ones which ultimately emerged from an early period of trial and error have been metallic commodities, especially gold and silver.  For our purpose, we can assume that the medium of exchange of our free society is gold.  We can also assume that merchants begin to first mark, and then stamp, coins as a means of minimizing the necessity of weighing and assessing coins — competition forces merchants to strive towards reliability, minimizing the opportunity for fraud.

Banks develop from two major early roles.  Merchants who engage in long range exchanges find it convenient to have foreign-exchange brokers settle debts by means of ledger-account transfers.  Wealthy individuals who begin to form relatively large sums of commodity money begin to prefer to hold these stocks in much safer deposits.  Thus banks form as money warehouses and as institutions capable of settling debts between merchants.  While at first banks tend to lend only their own wealth, earned from the services provided to their clientele, they ultimately begin to loan out their customer’s deposits — initially, time deposits.  As explained below, ultimately banks may begin to lend out their customer’s demand deposits, usually offering interest on those accounts in return.

Together with the changing role of banks, these financial institutions begin to progress towards the invention of the bank note.  Initially, banks offer promissory notes transferable by endorsement and nonnegotiable checks.  These evolve into negotiable notes and checks, and bank-issued paper notes become money substitute, circulating in the market as a legitimate substitute to gold coin.  From here on out, bank notes may be referred to as “inside money” and gold money as “outside money”.  Money substitute begins to replace outside money with greater frequency due to its advantages, including bulk and weight.  The greater circulation of inside money also eventually forces competing banks, through the profit motive, to accept competing notes, creating the need for inter-bank clearings, which leads to the development of clearinghouses.  Clearinghouses serve the purpose of allowing multilateral clearings of debt between multiple banks, further reducing the necessary quantity of commodity money held in reserve by individual banks.  Clearinghouses eventually take on greater responsibility, as the banking system evolves, including becoming credit information bureaus — archiving information on particular bank clients who may have poor credit histories, and sharing this information between banks — and as a limited banks of last resort, lending to individual banks in times of crisis.

Here we begin to see one way by which banks may begin practicing fractional reserve banking.  The greater demand for inside money as a substitute for outside money decreases demand for outside money in circulation.  We begin to witness a greater use of bank notes and a greater amount of gold money sitting idle in bank warehouses.  This surplus of commodity money allows banks to export gold or sell it for nonmonetary use, causing many of the circulating bank notes to become fiduciary media.  In Selgin’s model of free banking, this method of outside money substitution becomes the principle cause behind falling reserve ratios, as banks find it profitable to sell their gold reserves — the fall in demand for outside money allows them to do so without repercussion, with banks and clearinghouses maintaining only enough gold to clear debts and meet obligations with their customers. This does not entail the creation of more money.  At this point, the quantity of money in circulation remains the same, as gold is taken out of circulation in exchange for bank notes — any increases in the supply of money are caused by an increase in the quantity of gold used as a medium of exchange.

It is important to realize that in a free banking industry we would see the emergence of competing currencies, with banks issuing their own notes and striving to establish methods by which the consumer can tell their note apart from others.  Given this competition, it is within the banks’s interest to guarantee the reliability of their note, especially in terms of the possibility of fraud (counterfeiting).

If we assume that for some period of time the replacement of outside for inside money has completed in accordance with consumer demand, we can begin to investigate possible changes in the supply of fiduciary media.  Banks profit by increasing their holdings of interest-earning assets, which it does by either increasing clientele or by losing reserves.  Banks are liable to a liquidity cost, where the bank must maintain sufficient reserves to meet obligations, and to costs related to their effort to maintain demand for their liabilities (interest offered on deposits, for example).  The former cost is represented by the principle of adverse clearings, guaranteeing that banks which over-issue fiduciary media will see an increase in returning liabilities (or immediately payable obligations) forcing them to reduce the quantity of outstanding fiduciary media.  The principle of adverse clearings depends on the following assumptions,

  1. Bank notes issued in surplus of the demand for that particular note will result in the expenditure of the surplus notes;
  2. The majority of spent surplus notes will end up in possession of competing banks;
  3. Banks return rivals’s notes for redemption;
  4. The majority of notes entering the clearing mechanism are of the over-issued kind.[10]

Individuals tend to demand a certain amount of money, meaning that they hold a given quantity of money as a means of making expenditures in the short-term.  Notes received in excess of that demanded are spent, and, perhaps not immediately deposited, remain in circulation for a short amount of time.  Ultimately, merchants will deposit bank notes in surplus of that necessary to make change — checkable deposits are more convenient than loose bank notes and earn interest.  Banks which hold rivals’s bank notes will return these for redemption in inter-bank clearings.

The fourth assumption is more difficult to defend and ultimately relies on the concept of note-brand discrimination.  It is within a bank’s interest to give their clients reason to holdtheir notes and instead spend their rivals’s notes.  Bank notes represent an interest-rate free loan to the bank, and thus banks look forward to maximizing the amount of time that loan remains in effect.  Furthermore, without such discrimination excess creation of fiduciary media by one bank will result in the bearing of a larger portion of the returning liabilities by non-expansionary banks.  The principle of adverse clearings does not require perfect or absolute note-brand discrimination, only that customers commonly discriminate between bank notes.  We can see, though, that there are multiple reasons why banks would attempt to incite such discrimination, as it is within their financial interests to do so.[11]

Knowing that an individual bank’s ability to issue fiduciary media is strictly governed by the amount of liabilities the bank has to clear at any given moment in time, we can deduce that the opportunity to issue more fiduciary media arises only when the quantity of returning liabilities falls.  This opportunity presents itself when the demand for money rises.  Imagine that the aggregate quantity of money held increases, reducing the quantity of money in circulation for a certain period in time.  For certain banks — those which notes are being held —, this leads to a fall in the amount of liabilities returning for redemption, or a fall in the volume of obligations that bank must meet at that moment in time (a “decline in the rate of turnover of inside money”[12]).  This temporary fall in returning liabilities allows relevant banks to increase the volume of outstanding liabilities by issuing fiduciary media through the loan market.  Free bankers illustrate this principle through the notion of a money equilibrium, or by what they refer to as — indirectly — meeting the demand for money.

In theory, an increase in fiduciary media as a result of a rise in demand for money does not constitute a rise in the quantity of money in circulation.  The individual who increases his cash balances decreases the quantity of money in circulation for the amount of time in which he fails to allot that bank note towards present expenditure.  In a world of where equilibrium is attainable — an ideal, non-existent world — the amount of money issued by banks would equal the amount of money temporarily removed from circulation.  In reality, we can expect minor fluctuations in the quantity of money in circulation, as banks either under-issue or over-issue in response to a fall in the rate of turnover of liabilities.

Understanding that the demand for money fluctuates on an individual by individual basis, as the demand for money is decided by the individual market agent, the ability to issue fiduciary media as a result in the increase in the demand for money ultimately rests on the rule of large numbers.  In other words, there is a difference in the time that an individual may temporarily increase his cash holdings and the time allotted for the repayment of a newly issued loan.  The individual may decrease his cash holdings within a matter of days, while the new loan may have been issued for a period of months, or even years.  To cope with this disconnect, banks rely on the fact that the actions of independent market agents will largely offset each other.  For example, one individual may decrease his cash holdings while another individual increases his.

Of the two forces which operate to create fiduciary media, a fall in demand for outside money and a rise in demand for inside money, the former is likely to be the most important.  Given that changes in the demand for money between individuals are expected to offset each other, it could be argued that theoretically the aggregate demand for money should remain stable — the opportunities for individual banks to expand credit would be very slight and very temporary, with a long-run trend of a stable volume of outstanding liabilities.  Empirically, while after the 1970s the velocity of money (loosely related to the demand for money — a rise in demand for money usually translates into a fall in its velocity) has lost some stability, it usually had a historic tendency of remaining stable during periods of economic growth.[13] The issue of fiduciary media in response to changes in cash balances, therefore, would be extremely limited.

Short Macroeconomic Note

Given the nature of the free banking model, or of “meeting the demand for money”, free bankers also tend to support the theory of monetary (dis)equilibrium.  Roughly speaking, monetary equilibrium theory suggests that discoordination between demand for and supply of money can cause macroeconomic fluctuations, or the business cycle.  At the very least, a radical rise in the demand for money without an equal increase in the supply of money can exacerbate these industrial fluctuations, as it forces prices to adjust to changes in the quantity of money in circulation — it forces prices to fall, initially and temporarily pricing certain goods off the market and making some businesses unprofitable.  Some see the ability to increase money in the face of a rise in demand for money as a means of avoiding that painful downward readjustment of prices.[14]

Do changes in the demand for money cause business cycles?  It has been found that changes in the velocity of money usually follow changes in the supply of money, not vice versa.[15] In other words, the demand for money faces extreme increases only as a resultof monetary disturbances.  This is in line with Austrian business cycle theory, as the Austrians rightly attribute monetary disturbances to previous periods of severe intertemporal disequilibrium — usually caused by sustained over-issue of fiduciary media, which is a product of a monopolized currency system.  An increase in demand for money can be considered a secondary consequence of the causal factor behind industrial fluctuations, and that is malinvestment caused by intertemporal disequilibrium.[16] The dramatic fall in the quantity of money is caused by a credit contraction set off by necessary bankruptcies and the consequent radical reduction of outstanding bank liabilities.

Can an increase in the supply of money offset an otherwise necessary readjustment of prices?  For the sake of simplicity, let us assume an aggregate increase in demand for money that reduces spending towards industries A, B, and C.  This necessitates a fall in the prices of industries A, B, and C’s outputs, and therefore changes spending patterns on those same industries’s inputs (those industries now spend less on whatever capital goods were used for production of their own goods).  As a result of an increase in demand for money, banks issue an equal amount of money through the loanable funds market.  Will this prevent the readjustment of prices taking place as a result in consumer preference?  In order for this answer to be ‘yes’, all newly created money would have to be spent on exactly the same things the original money was bound to be spent on; in our example, all new money would have to be spent on industries A, B, and C, in exactly the same proportions as that sum of money would otherwise have been spent in lieu of an increase in demand for money.

Inflation, however, is not mechanical.  There is no mechanism which guarantees that new money will be spent in the same way as money held would have otherwise been spent.  The fact is that the new fiduciary media is likely to go to entirely different individuals, and thus preferences are likely to be entirely different.  The price readjustment will continue to occur, but the new money will allow different individuals to bid up prices by spending on industries D and E.

Is this inherently destabilizing?  If it was, then capitalism would be inherently unstable on account of the fact that individuals are constantly changing preferences — this is the source of dynamism on the market, and the entire reason why entrepreneurs can constantly profit by anticipating or best responding to these changes in preference.  Some industries face a fall in demand for their products, and others a rise; this is the nature of the market.

The attempt to vindicate monetary equilibrium theory by applying it to free banking is ultimately harmful to the accuracy of the theory behind the latter.  It confuses the microeconomic tenets of banking operations in a free market and the more controversial concept of monetary disequilibrium.  Free banking cannot stop changes in the structure of production — the changes are a natural part of an economy.

The Time Has Come

How a free banking industry would develop is a hotly contested issue.  George Selgin’s model is not universally accepted, and in fact has been the target of much criticism.  These criticisms are worthy of review, although given space limitations the present essay can only make brief reference to them (a short list of criticisms can be found on Economic Thought: “Fractional Reserve Banking Debate”).  Issues such as that of fraud and of the potential inherent instability of fractional reserve banking have been brought up.

However, this disagreement should not be an impediment to the deregulation of the banking industry.  The beauty of both the fractional reserve banking model and the full reserve banking model is that they both can naturally grow out of a free market.  In other words, it is ultimately up to the market (the consumer) to decide whether preference lies with full reserves or fractional reserves.  If the latter is a stable form of banking then it is likely to be adopted, and if it is not stable then consumers will opt for banks which maintain full reserves.

What is clear is that the existing state of affairs, or that of a monopolized currency system and a cartelized banking industry, is a major source of macroeconomic instability.  Both the theoretical and empirical evidence suggest that the time has come to replace it with a much more stable form of banking, and the same evidence convincingly argues that this is a product of freedom and deregulation.  We are not arguing for some deregulation, or deregulation in favor of the banking class, rather full fledge deregulation which places the entrepreneur (the banker, in our case) at the mercy of the market (the consumer).  Only then can we enjoy the fruits of a stable, sustainable economy.

[1] For a review of the early literature on central and free banking see: Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative (Indianapolis, Indiana: Liberty Fund, 1990).

[2] For Mises and Hayek, the market represents a network of relationships of exchange between individuals of a society — the division of labor — coordinated through the pricing process; Jonathan M. Finegold Catalán, “The Foremost Austrian Contribution to Economic Science.”  Government intervention in this pricing process represents sources of severe discoordination, while intervention in the supply of money causes substantial intertemporal discoordination between savings and investment, leading to malinvestment and industrial fluctuations.

[3] Friedrich Hayek, Choice in Currency (Auburn, Alabama: Ludwig von Mises Institute, 2009).

[4] Friedrich Hayek, Denationalisation of Money: The Argument Refined (London, United Kingdom: Institute of Economic Affairs, 1990).

[5] Whereas money refers to the actual commodity which makes up whatever medium of exchange is being employed — commonly gold —, money substitute is “a perfectly secure claim to an equivalent sum”.  For example, a paper note represents a claim to a given sum of commodity money, and thus is a money substitute.  Ludwig von Mises, The Theory of Money and Credit (Indianapolis, Indiana: Liberty Fund, 1980), pp. 63–67.

[6] Fiduciary media is money substitute not backed by commodity money.  Ibid., p. 155, 525–526.

[7] George Selgin, The Theory of Free Banking (Totowa, New Jersey: Rowman & Littlefield, 1988).

[8] What is briefly explained in the present essay is devoted an entire chapter in Selgin’s book; ibid., pp. 16–34.

[9] Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 257–262; Ludwig von Mises, Human Action (Auburn, Alabama: Ludwig von Mises Institute, 1998), pp. 405–407; Murray Rothbard, Man, Economy, and State with Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2009), pp. 187–195.

[10] Selgin (1990), pp. 40–42.

[11] Selgin offers a convincing case for note-brand discrimination; ibid., pp. 42–47.

[12] Ibid., p. 67.

[13] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, New Jersey: Princeton University Press, 1963), p. 592.

[14] For an introduction to monetary (dis)equilibrium theory, see Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997).  Also, see George Selgin, Bank Deregulation and Monetary Order (London, United Kingdom: Routledge, 1996), pp. 142–162.

[15] Roger W. Garrison, Time and Money (London, United Kingdom: Routledge, 2001), p. 234.

[16] Murray Rothbard, in fact, makes this argument in his explanation of the causes of the 1929 business cycle which set off the Great Depression.  See Murray Rothbard, America’s Great Depression (Auburn, Alabama: Ludwig von Mises Institute, 2000), p. 15.


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