Review: The Rationale of Central Banking and the Free Banking Alternative by Vera C. Smith

This is a rather old book, written in 1936. The author, Vera Smith, was a student of Hayek and wrote the book as her doctoral dissertation. Despite its age, I think the material is still very relevant. Given that central banks dominate the economies of the world - and have since the late 1800’s to early 1900’s - and since deviating from (now fiat) central banking is no longer even considered a realistic option, no serious discussion on the matter has taken place since the time this book was written anyway. The history of the move to central banking in western Europe and the United States, and the economic arguments that took place as part of that move, is the subject matter of this book.

The debate between those supporting state sponsored central banks and those supporting so-called “free banking” really boils down to who has the right to issue notes. In the age prior to pure fiat money (paper money unbacked by gold or anything else), notes were essentially warehouse receipts, or promises to pay, given out by banks. They have a face value, normally in gold, and should be redeemable for that amount of gold when presented to the bank. Central bank supporters believed that the state should control, either directly or indirectly, the note issue; free bankers believed that anyone should be allowed to issue notes, subject only to the same laws and regulations that apply to other businesses.

Here’s the brief economic “history”: Banks provided a warehousing service for gold, which was the “real” money. To those who deposited their gold at the bank they provided bank notes, which are “promises to pay” as explained above. Owing to the far greater convenience of using notes for day-to-day transactions, few people ever actually decided to redeem notes for the actual gold, so the notes themselves started to circulate as money. Because of this, the banks were able to make loans, in the form of notes, and thus put into circulation notes far in excess of the amount of gold they actually had in the vaults.

There was much debate about whether competing free banks would naturally have the necessary checks and balances to prevent individual banks from expanding their note issue out of step with the rest (note that there is always an economic incentive to issue more notes through loans if the risk of being caught without enough reserve can be tolerated). After reading this book, which is in no way antagonistic to free market ideas, I would conclude that competition in the issue of notes is by no means a guaranteed protection against over-issue of bank notes. Compelling cases were made that a more conservative bank could find itself in a position where it too must begin issuing more notes (lower loan rates) or else find itself in an untennable financial position. Refer to the book for more mathematical detail, but the essence of it is that even if a bank is accutely aware of an impending bust and bank run, the time delay between profitable over-issue of notes and the bust makes it difficult or impossible to stay conservative without losing out on significant profits or possibly being driven out of business altogether in the mean time.

The problem with continuous expansion like this, where there are far more notes in circulation than gold to back them, is that there is always the possibility of a bank run. When the bank run, or “panic,” takes place, a large fraction of note holders loses faith in the system and demands the gold supposedly backing their notes. If the banks miscalculated or pushed their luck too far (or were forced to take part in an expansion to stay in business), they would not have enough gold on hand and would have to suspend payment. Governments generally gave banks a certain grace period within which to resume payment of their obligations, after which they were forced to go into liquidation. Whether or not banks and their shareholders were granted limited liability was also a matter of debate. This book gave me the impression that limited liability was granted in most cases.

One point that was not covered in much detail (although it was mentioned that there were supporters) was the possibility of requiring 100% reserves, that is, disallowing any over-issue of notes relative to gold in the vaults. In more recent times, Murray Rothbard has advocated this position. It’s an interesting question to ponder just in principle; are you violating a contract if you knowingly put yourself in a position where you might not be able to meet your obligations? Or is it only a violation if you actually fail to meet your obligations? It seems clear that in the legal sphere as we know it today, I can sign contracts with people and there are only legal consequences when I actually default. At the personal level, suppose I promise to help two different people by picking them up if their cars break down. It’s possible that both of their cars will break down simultaneously; does that make my promises insincere or shady in some way?

Practically speaking though, I could believe that note issue by banks is a case where there is a strong incentive to push this “making of multiple promises” thing to the limit. Requiring 100% reserve seems like one way to nip it in the bud for sure. At the same time, it would really change the nature of banking. If banks can’t lend your money and promise it to you at the same time, then they can’t make any loans - at least not from normal acounts. The depositer would have to pay interest to the bank for the services it provides. Loans would need to be provided by means of things like bonds, where the “depositer” gives up the money for a prescribed period of time and/or knowingly takes a risk of not getting all the money back.

Another interesting point related to the 100% reserve option is that requiring 100% reserves would cause a lot more energy and resources to be devoted to gold mining. With only 10% reserves, a given quantity of money can be maintained in circulation with only 10% as much gold required in the vaults. In this respect, unbacked fiat paper is actually desirable; we don’t want to create a economically inefficient incentive to waste resources digging up gold. Despite this, 100% reserves might still be a better option than runaway competition (or politicized government control).

A related matter mentioned in the book but never explored in detail is the matter of liability. It seems that many or most banks under quasi-free banking regimes had limited liability, so when the run came and they were liquidated, many note holders were left with worthless notes. Unlimited liability would seem to be a strong incentive for banks to be more conservative and would protect note holders in the process. Another possibility would be to require banks to carry insurance to cover their debts in the event that their reserves are depleted in a run. This is a problematic approach, however, since a large run would probably affect all the banks together leaving the insurer unable to pay.

The arguments in favor of central banking are several. First, the possibility of violent fluctuations in rates and boom/bust cycles is limited because possibly unstable competition is eliminated. It was pointed out in the book that free markets were heavily favored at the time of most of these debates; it was not questioned that market competition was desired in most fields of business. Detractors of free banking fairly pointed out that competition in note issue is not competition in the normal way. Issuing notes was a relatively costless activity, so unlike competition in other areas, it did not drive quality up and prices down.

Another argument against free banking was a practical one. With hundreds of banks issuing notes, how was the man on the street to know if a given note was from a suspect bank? It is generally preferable to have a common currency so that people aren’t required to be constantly aware of the reputations and status of numerous banks in order to be able to judge the value of their notes.

A third argument against free banking, or rather in favor of central banking, is that the central bank can act as “lender of last resort” during a panic. Since the central bank is essentially an arm of the government, the public will generally have much greater confidence in its notes and will not, in general, rush to convert these notes to gold. So when local banks (which keep their reserves at the central bank) can no longer meet their obligations, the central bank can always print more notes to stem the panic. What this argument is saying, I think, is that even if central bank notes are nominally gold backed, the public will almost never test this, so in practice the reserve ratio can be extremely low and nobody will ever notice.

There are, of course, strong arguments against central banking. As an arm of government, the central bank will likely be abused by the government (forced to loan the government money in exchange for its privilege) while at the same time being shielded by the government from the consequences of its actions. Examples of the latter include being allowed to suspend payment or go off the gold standard altogether.

While a central bank may not have competitive pressure to continuously expand, it also has little or no motivation not to. On what basis does it determine rate policy? It’s frightening to have such an important part of the economy determined by bureaucrats and politicians as opposed to market forces.

Although it was not discussed in the book, it’s worth bringing up the point that the model of notes and gold doesn’t really apply now that we are stuck with fiat money. In the U.S., dollars are the money. I think what this means is that to the bank, when you withraw cash dollars, it’s the same as if you were asking for gold back in the old days (you are depleting the bank reserves). A similar situation occurs with deposit accounts though; the bank can make loans by relying on people not cashing out their savings accounts.

Interestingly though, according to this book, there was never any real debate about free banking with respect to deposits. Everyone was okay with leaving that to the free market. Part of this might just be the symbolism associated with the printing of actual paper notes, but it turns out that there are strong economic arguments as well. When a bank makes a loan by writing a check or crediting an account, it can expect that the debtor will spend that money immediately, and unlike a loan made with notes, it can expect another bank to request payment almost immediately. Thus if a particular bank begins a rapid expansion out of step with the others, it can expect a drain on its cash reserves as the other banks return the checks for cash payment.

Banking may be a dry subject to many, but that’s unfortunate because it’s so important and has such a large impact on our lives. If you have the slightest interest in this subject I think this book is a great place to start. Since I’m such a free market advocate, this book was an eye opener in that it pointed out legitimate problems with unregulated free banking. Market forces may well not work in our best interest in this special case. I really would like to have seen a little more analysis of the 100% reserve option, however, since that may be all that is required to save free banking from its potential pitfalls.

This entry was posted on Friday, July 22nd, 2005 at 7:20 am and is filed under Book Reviews, Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.