The illusion of free banking

By Lorenzo

Reading Fragile by Design: The Political Origins of Banking Crises and Scarce Credit by Charles Calomiris and Stephen Haber continues to stimulate. As one comes to appreciate how immense the damage done by central bankers has been–causing the Great Depression, Japan’s “lost decades”, the Great Recession, the Eurozone crisis–[which, I should clarify, is not the subject matter of Fragile by Designfree banking (in the sense of a banking regime without a central bank) becomes more and more attractive.

Especially as there are two excellent examples of how successful free banking can be, both covered in some detail in Fragile by Design. The first is Scotland from the late C17th until the mid C19th, when the privileges of the Bank of England were (partially) extended into Scotland, and Canada from the 1860s to the creation of the Bank of Canada in 1934. In both cases, free banking generated stable, efficient banking systems able to provide high levels of credit to their economies.

No, a monopoly in issuing banknotes is not a necessary feature of a stable banking regime.

Case closed therefore? Alas, no. Central banks are ubiquitous in modern economies and for a simple reason–no state is willing to forego the financing advantages having a central bank gives it. A tame banker is a boon during fiscal emergencies–this is why they were created, starting with the oldest, the Sveriges Riksbank (founded 1668, the fourth oldest bank still in existence), and the second oldest, the Bank of England (founded 1694, the ninth oldest bank still in existence).

In both the above cases of free banking (Canada and Scotland), the free banking regime operated under the shelter of a central-bank-financed state. In the case of Scotland, part of the United Kingdom from 1707 onwards but sharing a common monarch since 1603 (apart from the Interregnum, when they still shared a government), the English-cum-British war machine, debt-financed as necessary via the Bank of England since 1694, protected Scotland and its free banking system (as Calomiris & Haber point out). In the case of Canada, part of the British Empire, Canada and its free banking regime was protected by the Royal Navy, also debt-financed as necessary by the Bank of England since, well, 1694.

Royal Navy: financed through the Bank of England, also protecting free banking Scotland.

So, both the flagship cases of successful free banking regimes are also examples of why they are so rare. It is possible to have a free banking regime–in a subordinate jurisdiction protected by a central bank debt-financed war machine.

Since states are not going to give up their central banks, the trick becomes to determine the best policy regime for a given central bank to operate under. NGDP level targeting–maintaining a smooth trend in aggregate spending/aggregate income–is the best on offer at the moment.  As Lars Christensen points out, it would mean that the business cycle was entirely driven by supply shocks; as Scott Sumner points out, it would allow policy to largely leave things be; and, as the experience of Australia and Israel demonstrate, can lead to very flat business cycles even during other people’s (demand-shock caused) Great Recessions.  (Yes, technically, the Reserve Bank of Australia runs a broad inflation targeting policy regime, but it largely operates as an aggregate spending smoothing policy regime.)

So, free banking: lovely idea, not going to happen. And the standard examples of why it is a lovely policy idea also demonstrate why it is not going to happen (except in subordinate jurisdictions able to have their own banking arrangements protected by central bank debt-financed as necessary war machines).


  1. Herding cats
    Posted May 13, 2014 at 7:04 pm | Permalink

    Um, all this is reminiscent of Cher, with legs, astride a large calibre weapon – “If i could turn back time”.

    damn, i blew it in 1964.
    Became a student of experience and life – not a banker in Zurich. Meh.

  2. Ross
    Posted May 14, 2014 at 7:24 pm | Permalink

    Banking is a special activity because the money they create from nothing represents our productivity.

    The private US Federal Reserve has been creating over $100 billion per month since 2008.The USA has a shrinking economy but the share and derivative markets are growing with the inflationary money. This is a bubble that will burst.

    Now inflationary money which our private banks create depreciates our spending power and savings. This inflationary money is created as debt so we are paying the banks to depreciate our money.

    Private banks should only be allowed to loan out money that already exists. The fractional reserve system of banking needs to be scrapped.

  3. Posted May 15, 2014 at 8:31 am | Permalink

    [email protected] All banking systems use fractional reserve banking. Not all banking systems have crises (periodic or otherwise). Therefore, fractional reserve banking is not the problem.

    Read Fragile by Design for more details.

    The US Federal Reserve has consistently undershot its 2%pa inflation target, which is clearly operating as more of a ceiling. The TIPS spread suggests the market is expecting continuing low inflation. If you think you are cleverer than the market, be my guest and invest accordingly. But the TIPS spread has consistently been a better predictor than the inflation hysterics.

  4. Ross
    Posted May 15, 2014 at 2:43 pm | Permalink

    Lorenzo, they do not include the money that inflates the share market and derivatives in their inflation figures. When this money leaves the phoney world of derivative gambling, hyper inflation or stag flation will happen.

    The US Fed has created from nothing $16 trillion to bail out banks, money for weapons, socialised medicine etc and called it all debt that the US people must repay. There are 50 million people on food stamps of which half work and Obama cuts back on food stamps. The US economy is not recovering.

    They are pretending to cut back on money printing { QE } but this is not happening because Wall St is addicted to money printing while the real economy shrinks.

    The US $ will lose its reserve status .China and Russia will soon announce their currencies will be backed by gold while the US $ goes down the toilet.

    Private banks should not be allowed to create money from nothing as debt, because this represents the growth of the whole economy which everyone should share in. Why should a few take what is not theirs ?

  5. Posted May 15, 2014 at 3:29 pm | Permalink

    [email protected] Inflation figures do have problems, but not the one’s you think it has. One can look at NGDP growth, and see even more clearly the relative tightness of monetary policy.

    The low interest rates are also another indicator of tight monetary policy. Since low interest rates include low inflation expectations.

    There is also no sign of the US$ losing its reserve status–one indicator of that being that US bonds continue to be in demand, despite the very low interest rates they are paying.

    One can always claim that one’s theory will be vindicated in the future, because there is no information from the future, so it can be portrayed how one likes. (See Marx, K.) I prefer to base my analysis on the empirics informed by theory, not ignored by it.

    And no one is going to go onto the gold standard, as no one is going to make the economy hostage to the wild gyrations of the gold price. (And yes, I understand that, if large enough economies go onto the gold standard, it generally has a stabilising effect on the gold price, but not enough of one.)

    The US’s current debt problems are not as severe as they were in, say, 1945 and nowhere near as severe as the UK’s in 1821 (when public debt peaked at 262% of GDP). The US economy is in a low growth period, but it is not shrinking.

    And the US inflation rate will continue to be whatever the US Federal Reserve decides it will be. (As is true of the inflation rates of Japan and the BoJ, the UK and the BoE, the Eurozone and the ECB and Australia and the RBA, etc.)

    The problem is most of those central banks do not take any responsibility for income expectations. Until they change their policy regimes to do so, full recovery is unlikely. Meanwhile, the Australian economy barrels on because the RBA does, at least implicitly, take such responsibility.

  6. Posted May 15, 2014 at 3:31 pm | Permalink

    [email protected] I would also point out that the successful Scottish and Canadian free banking regimes included fractional reserve banking. Ensuring enough access to credit is necessary for strong and continuing economic growth. The trick is in the risk management, which the US system handles badly because it is regulated to do so.

  7. Ross
    Posted May 15, 2014 at 9:19 pm | Permalink

    Lorenzo the US banking used to have the Glass Steagall Act to regulate the excesses of the derivative market and protect our shares and deposits. Bill Clinton eliminated this Act in1998.

    The too big to fail banks have just bought more derivatives and made the bubble enormous.

    Our banking system used to be regulated by the Commonwealth and RBA. Now they please themselves. APRA is answerable to the private Bank of International Settlements and so is the RBA. Our Govt has almost no control over monetary policy.

    Our big four banks have derivative exposure of $22 trillion with assets of $ 3.6 trillion. Their assets are our mortgages and our real estate is 40 % over valued.

    I’m reading that China and Russia will soon announce they have 40,000 tons of gold between them and will back their currencies with it. The USA cannot continue to print money to pay off their debts and the rest of the world will soon put an end to it.

    The market is bigger than all the weapons on the planet unless of course the USA has a hissy fit and decides to blow up the planet so nobody wins.

  8. kvd
    Posted May 16, 2014 at 4:27 pm | Permalink

    Ross, I used to read the CEC news releases as well – just to keep myself informed of the looney fringe. But it got boring, and increasingly dissociated from reality. On the derivatives market, I can see references to the Wikileaks Party, and the BarnabyIsRight website. Can you provide an alternate source?

    Anyway I’m wondering where your ‘Russia, China, 40,000 tons’ comes from – given a simple Google search marks this as by some fellow called “Jim Willie” who says it was “stolen by the West”?

  9. Ross
    Posted May 16, 2014 at 6:21 pm | Permalink

    kvd it is not only the CEC but also Dr Paul Craig Roberts the ex- assistant secretary to the US Treasury, Gerald Celente of Trends Journal, Max Keiser, Prof Michel Chossovdosky of Global, Prof William K Black a US regulator who once had the power to jail these criminals.

    Instead of attacking the messenger you should address the logic which I’ve presented.

  10. kvd
    Posted May 17, 2014 at 6:24 am | Permalink

    Ross, the Glass Steagall Act to regulate the excesses of the derivative market is not my understanding. I thought it was more aimed at providing a legal barricade between traditional banking activity and the wilder excesses of derivatives markets. I support that distinction.

    Regarding our ‘big 4’ the latest estimate I can find puts a figure of $13Tn on their derivatives – but I am not sure if this is a net potential or a simple gross value of outstanding positions. Lorenzo might know, but the distinction is fairly significant.

    On your “40,000 tons of gold” comment I thought all I had asked for was a cite for this information – given that this is an order of magnitude over any previous discussion I can find of gold reserves for those countries – or in fact any country.

    As for your “jail these criminals” and “blow up the planet” comments – I regard them as way over the top, and unsuitable for any rational consideration of your logic.

  11. Posted May 18, 2014 at 7:35 am | Permalink

    [email protected] The problem was not derivatives per se, still less the repeal of Glass-Seagall, but that the reaching for the Too Big To Fail subsidy interacted with “good citizenship” criteria and the Community Reinvestment act to massively undermine mortgage standards across the entire housing finance market in the US along with prudential regulation which failed to remotely keep up with the changes.

    Really, read Fragile by Design, chapters 7 & 8.

    The rest is, as far as I can see, complete nonsense.

  12. Graham Bell
    Posted May 27, 2014 at 11:38 am | Permalink

    Sorry to be picky but the biggest problem, i.m.h.o., is not whether a system of exchange, savings and investment is run by a central bank or by a free-wheeling bank but of how to control the effects of human frailty – that is, irrational greed, megalomania, incredible stupidity, herd mentality and cadaver-obedience, gullibility, the wilful ignoring of warnings, fraud, the failure to adapt to a new situation, delusions of omniscience, alcoholism and drug befuddlement, moral cowardice, the failure to grasp once-in-a-lifetime opportunities, lack of planning, infatuation with new toys and fads, staleness and sheer laziness. Once we can protect buyers and sellers, savers and investors, rich and poor alike against the worst of those effects of human frailty I have listed, then we can look at forms and structures.

  13. Posted May 27, 2014 at 6:10 pm | Permalink

    [email protected] Ah, but the Canadian and Scottish cases suggest it is possible to deal with the frailties of human nature fairly well. That is the point about their free banking systems being stable and effective.

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