Arnold Kling  

George Selgin on Free Banking

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He talks with Russ Roberts, who asks skeptical questions.

Selgin thinks that one can have sound unregulated, uninsured banking without reserve requirements of 100 percent. He thinks that bank owners need to have significant capital at risk. Once upon a time, in fact, some banks did not have limited liability, meaning that if the bank could not meet its obligations the owners' personal wealth was at risk.


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COMMENTS (13 to date)
Grant writes:

While that was a fantastic podcast (I learned a lot - thanks!), I am not sure I'd say Russ asks skeptical questions. I'd love to hear a serious attempt to refute free banking.

Understanding free banking better helps me understand Keynesian economics better, and it makes me think the later may only model the special case of the nationalized monetary system.

PrestoPundit writes:

Imagine if Paulson and Bush had money on the line ...

Gary Rogers writes:

Another great podcast. You would think that after listening to these podcasts every week I would begin to accumulate some knowlege, but there is always so much more to learn.

I would like to see this put into practice someplace just to see if it works. It can't be any worse than the banking experience Iceland is going through. There are several small countries like Swizerland and the Caymen islands that already have become banking centers and there is room for more. Look at the opportunity right now for a gold standard currency that could compete in the world market against the soon to be worthless Dollars and Euros. That would be an experiment worth watching.

Bill Stepp writes:

When you say "unregulated," you seem to be assuming the absence of law. As a couple of bloggers have pointed out recently at other blogs, market discipline plus the rule of law is itself a form of regulation.
Free banking is the only monetary system that ensures the existence of sound money and monetary equilibrium, and that would put an end to cyclical booms and their inevitable busts.
The goals of central banking (price stability, etc.), are not technically feasible under such a system. Sound money and price stability are technically feasible under free banking, even if it's not politically possible.

I suppose John Lennon couldn't have sung about imagining no central bank or liquidity trap.

"Imagine there's no central bank...
I wonder if you can...."

Under free banking, the guys from Government Sachs would have to find something else to do instead of bothering the tax payers. But at least Lloyd Blankfein et al. could bank their bonuses.

And check out Krugman's NYT blog today where he thinks that lower i rates lead to more saving (he calls it hoarding)! 1 + 1 = 3.

shayne writes:

It strikes me that Selgin's free banking model is significantly already in effect and at work, if one considers global rather than national scales.

First, Selgin indicated a desire for the 'private' banks to have many branches - that a weakness in prior systems of free banking was that there were only single (central) banks. If one considers the U.S. central bank (the Fed) and the Federal Reserve member banks as 'branches', Selgin's weakness is addressed. Similarly with other national central banks and their member branches.

Second, Selgin professes that natural self-interest (risk of having other banks not honor demand notes from issuing banks) precludes, or applies natural disincentives to over-printing demand notes. Such is already the case with the central banks. The 'locally' (national) applied regulations, in terms of reserve requirements for member 'branches', merely represents the rules established by the 'main branch' to preserve the perception of demand note value to other national banks. Ditto other national 'main branch' rules/regulations - merely 'local' rules, in a global exchange sense.

Third, Selgin rather glosses over the transaction costs for all participants in a 'private' system when he indicates "all depositors have to do is research which 'private' banks are financially sound in order to determine where to deposit their money". The existing 'central' bank system dramatically reduces that transaction cost by virtue of both its rules/regulatory framework and by virtue of handling of foreign (other 'private' bank's) currency exchanges and pricing.

The central bank model is a monopoly, but only in a local/national sense. Given the freedom of international capital flows in current times, no real monopoly power exists. Anyone, anywhere can relatively freely either make deposits to or take equity stakes in any 'private' (national) banking system they choose.

Of course, the benefits of this 'free banking' model are seriously degraded if some sort of global central bank evolves out of the current financial mess. That seems to be the notion many are advocating.

Grant writes:

shayne,

Some differences that come to mind are:

1) Market banks are incentivized by the profit motive. Political banks are incentivized by political motives (probably a desire to monetize debt, pander to certain financial special interests and appeal to voters).

2) In a free banking system, any currency could be used. In a nationalized banking system, people can only use the currency of their nation.

3) Te incentives of free banking customers are to pick the most solvent possible bank for their deposits. The incentives of nationalized bank customers don't matter, since they must use their national banking system and clearing house for general consumer banking. The incentives of voters are aligned with political biases, and probably include a desire to insure their own deposits at the expense of everyone else. Any incentive to pick the most stable banking model would be quite weak.

shayne writes:

Hi Grant:

I'm not sure there is much discontinuity between our positions on this. I guess my point is that I see it only as a matter of scale - global versus national.

I'll confess my biases up front: I think Selgin's free banking model is quite compelling and offers numerous benefits. I merely think it's already in place and the benefits are already being realized if one thinks globally, rather than nationally. I find nothing at all compelling about reverting to a Gold (or other 'hard' asset) based currency. (Possibly because I own little or no Gold, and therefore if there was a transition I'd be left destitute.) Similarly, I see little or no benefit to establishment of a single, global currency under a single, globally controlling central bank.

To address your individual points above ...
1.) I'm not sure there is as much distinction between market and political forces (locally/nationally) as you are implying - with regard at least in the U.S. banking system. Political forces are merely institutionalized reflections of general market preferences. In the case of the U.S. central bank charter, it has the dual political mandates of controlling inflation (protecting the value of the demand notes it issues) and encouraging economic growth (making certain there are enough demand notes available to the 'local' economy to support/sustain demand.) How it fulfills those dual mandates is a matter of fluctuating 'local' market dynamics. The very same constraints/controls/mandates would be present under a fully free banking system, only less formalized. Each free banking element would necessarily and similarly have to answer to the demands of its service area constituents in both amount and integrity of its issues.

2.) The assumption that within a national system "people can only use the currency of their nation" isn't valid. In many economies, foreign currency is highly tradable/usable in lieu of local/national currency. Even in the U.S., along the northern border, U.S. merchants readily accept Canadian currency in exchange for goods. However, doing so adds transaction costs. Using foreign currency isn't necessarily illegal, it's merely inconvenient and induces higher transaction costs.

3.) Again, there is no gross discontinuity between market participants' incentives and those of the central bank - at least in the U.S. banking system. Also, given the freedom of capital flows, there is no "must use their national banking system and clearing house for general consumer banking" - it is simply more convenient and less costly to do so, by virtue of the alignment between participant and banking constituents.

I recognize not all nations' central bank rules are as closely aligned with market participants' incentives and desires as are those of the U.S. But many 'local' central bank systems are changing to more closely align policies with service demand in order to attract capital. I applaud that trend. And I suspect it is precisely the incentives/benefits of the current global free banking system Selgin describes that is driving the trend.

Grant writes:

Shayne,

Congress also has a mandate to obey the Constitution, which it frequently ignores. Central banks are created and regulated by political forces which ultimately respond to voters (the median voter, as Bryan would say). There has been a wealth of material presented on this blog showing how people are more rational and informed in their capacity as consumers than they are as voters.

I don't think it is any mistake that the most successful central banks seem to be somewhat politically isolated. As you say, the Fed seems to operate under decent incentives, especially compared to some other poorer nations. However, politics is not out the picture completely. I believe the Fed's mandate, while generally effective, is nowhere near as strong an incentive as the profit motive (which would literally drive it out of business if not followed). I think we should also consider ourselves lucky that the Fed generally behaves decently.

I do not believe politics has the incentives or ability to really experiment with different banking models, at least not nearly as quickly as markets do. I should admit my bias here: I've always thought that many critiques of free financial markets assumed that free market institutions would not be wildly different. I've always found it hard to believe that if complete freedom of association was allowed, individuals would be unable to create stable financial institutions.

On the issue of foreign currencies, I believe you are correct. I was thinking of the regulations involved in accepting foreign payments, but thinking about it further, I believe these only cover payments coming from outside the nation (regardless of currency). I think its worth noting that a free banking system would likely ease the pain involved in some types of payment processing, because current nationalized clearing houses (like the Fed's ACH network) don't seem to have much incentive to play with others easily.

Also, I think its worth mentioning that nationalized banking systems have no way of responding to economies of scale. That is, a central bank covers its nation, regardless of whether or not it would be more efficient if it were larger or smaller.

I also don't think free banking requires commodity money, though I admit I haven't read anything but armchair theorizing on that issue.

shayne writes:

Grant:

Gotcha. It is a compelling model in several respects. I'm just having trouble overcoming my perception that it would have a net impact of increasing my transaction costs for most of my transactions.

As an aside (and at risk of annoying Caplan), I don't assume any difference in rationality of actors in voting versus consuming, or anything else for that matter.

Grant writes:

Shayne,

I think the cost of some financial transactions (e.g., making purchases with a credit card, or sending money overseas) might be reduced with free banking. On the other hand, I totally agree with you that on the whole, transaction costs will probably increase. Contracts and general purchases would likely be made more complicated (if we hold electronic money as equal, though it may not be with more competition in ACHs). However, I see this as a net gain, because its moving the burden of decisions to people who are better equipped and incentivized to make them: the consumers of bank services.

shayne writes:

I concur with your first statement. But it's already in place and delivering the benefits. My primary credit card is issued by HSBC, incorporated in the UK. I lived in the UK for a couple of years about 30 years ago, but I'm back in the good old U.S. of A. now.

Grant writes:

If anyone is still reading this, I've got a question. Some people say we are currently in a liquidity trap. Is a liquidity trap possible under free banking?

Peter writes:

In case anybody is still reading (just listened to the podcast for the first time):

The liquidity trap occurs when the central bank loses its power to increase the money supply. In normal times the central bank's power to control the money supply depends on their being demand for money. By lending at less than the market rate of interest money is put into the economy, since commercial banks will borrow at this lower rate and then lend it on to its customers. By (less frequently!) borrowing at a higher than market rate money is sucked out of the economy. If real demand collapses so will nominal demand. The bank can lower its rate of interest as much as it likes; commercial banks still won't borrow (or they might, but just in order to mend their balance sheets. I guess something like this is happening at the moment).

I am not sure whether this situation could happen under free banking. I really think the whole concept of a liquidity trap is moot in a free banking situation. As explained, a liquidity trap is the failure to stimulate aggregate demand through low interest rates. Stimulating aggregate demand is not something that a free bank has in its mission statement.

Most importantly, I think liquidity traps would be even more infrequent and rare in a free banking world than they are in the current one. The reason is that under free banking increases in the money supply is 'demand led', i.e. the money supply is increased in response to real demand increases (the alternative is a fall in the price level or increase in the velocity of money; according to the fisher equation). Under central banking the central bank pushes money into the economy. Under central banking the bar (interest rates) is lowered for investment projects. You are more likely to have more investment, some of which will be unwise or speculative. This will cause a boom which may then be followed by a bust, when the investment agenda has been exhausted, and some financial recovery is required from failed projects. Since boom and busts are likely to be more infrequent under free banking, so will be the liquidity trap.

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