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Free Banking Lawrence H. White SREK 2014.

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Presentation on theme: "Free Banking Lawrence H. White SREK 2014."— Presentation transcript:

1 Free Banking Lawrence H. White SREK 2014


3 Two views of money

4 Coins can be privately produced Why then have governments monopolized coinage? To improve quality?

5 Silver content of European govt. coins, c1300-c1500

6 Bank account money more portable greater uniformity than debased coins

7 1. 2. Why did bank account balances become transferable?

8 1. 2. Account of 1. Antonio -$100 2. Bartolemo +$100

9 Account balance transfer

10 Account of 1. Antonio -$100 2. Bartolemo +$100

11 Money Warehouse AssetsLiabilities coins in vault $200 owed to Alice $10 owed to Bob $10 owed to others $180 Economical means of safe storage. Is there a more economical alternative for payments?

12 Fractional-reserve Bank AssetsLiabilities coins in vault$40owed to Alice$10 owed to Bob $10 loans, bills $160owed to others $180 Advantages to the bank? Advantages to the customer? BANCO di MEDICI

13 Bank issued currency


15 Warehouse receipts do not resemble banknotes

16 When is a fractional reserve feasible?

17 Is a fractional reserve banknote like a lottery ticket?

18 BANK Is it inherently fraudulent to hold a fractional reserve ? Why might a fully informed customer agree to fractional reserves?

19 1.A money warehouse contract is legitimate. 2.A time deposit contract is legitimate. 3.A demand deposit contract is neither a money warehouse contract nor a time deposit. 4. Therefore, a demand deposit contract is not legitimate.

20 1.A dog has four legs. 2.A cat has four legs. 3.A goat is neither a dog nor a cat. 4. Therefore, a goat does not have four legs.

21 Banks will accept one anothers liabilities at par (face value) Non-par means customer inconvenience Profitable for banks to eliminate these inconveniences

22 Suffolk Bank (Boston), 1830s Bank of Scotland Royal Bank of Scotland, est. 1727

23 Freely evolved banking systems Definitive money: specie (gold or silver coin) Unit of account: specie unit Retail CAMOEs: bank-issued currency and transferable account balances –Bank-issued money denominated in the specie unit –widely accepted at par –All banks are linked into a unified clearing network Seen historically in banking systems that were free of significant legal restrictions

24 Scotland Canada Sweden New England Historical free banking systems … and 50+ more

25 Why did we switch to fiat money? IOU NOTHING

26 Over the years, all the governments in the world, having discovered that gold is, like, rare, decided that it would be more convenient to back their money with something that is easier to come by, namely: nothing.

27 Simplified free bank balance sheet AssetsLiabilities + Equity ______________________________________ R reservesN notes in circulation L loans and securities D deposits K equity capital A profit-seeking bank equates at the margin MR from loans = MR from reserve holding MR from loans = MC of liabilities to fund them MC of notes = MC of deposits balance sheet constraint: R + L = N + D + K

28 Managing a free bank of issue Bank optimization determines N, D, R Desired N and D are finite, because redeemable notes (or deposits) cannot simply be circulated ad lib One thing to print up the notes; another to keep them in circulation –Undemanded (excess) notes will return to be redeemed –To cultivate a demand to hold its notes, the bank must incur provide costly services –Thus rising MC limits profit-max size of publics desired N Assets Liabilities + Equity RLRL NDKNDK

29 What corrects a banks over-issue? Reserve losses as notes return for redemption overissue: the quantity of a banks currency in circulation exceeds the quantity demanded –given its optimizing expenditures on non-price competition –cause: either bank expands N, or N d falls What corrects over-issue? –Not: Fullarton's (1845) flawed law of the reflux –Not: repayment of loans or real bills –Correct theory: actual N converges on desired N d as the public adjusts toward its desired portfolio of assets Adjustment of system-wide N as N d falls or rises

30 Mises on market correction of N under free banking A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then -- apart from an extension of its clientele -- it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus the banks may be seen to pay a certain amount of regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they help to stabilize the objective exchange value of money. To this extent, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended one of the phenomena of the market, even if it has also completely misapprehended its cause. --Theory of Money and Credit, p. 347 (1980 ed.)

31 Competition vs. monopoly in note-issue Competition (many issuers) limits the danger of a large-scale overissue –Random money-supply errors will tend to offset one another in the aggregate –Danger of large-scale overissue is greatest when a single issuer has a 100% share of the circulation Free bankings adjustment of N to N d helps to stabilize aggregate spending –Hayeks money stream Policy implication: dont restrict note-issue to a single institution. Allow free entry. James Wm. Gilbart, leader of British Free Banking School

32 The problem of runs

33 Run-prone bank account Greater expected payoff to redeeming sooner rather than later 1) debt claim 2) unconditionally redeemable on demand (first come, first served) 3) default likely on last claim served

34 Non-run-prone bank account Modify any one of these conditions: 1) equity claim, like MMMF 2) conditional redeemability, like a notice- of-withdrawal clause 3) solvency assurances adequate capital diversified portfolio of safe assets extended liability for shareholders clearinghouse certification

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