Authors

Economics

Why doesn’t Free Banking work now?

The most basic theory of (fractional-reserve) free banking concerns the supply of money and demand for money. At some times the public on net want to hold more of their assets as money, and at other times less. In the former case we say there has been a rise in demand for money holding, and in the latter case a fall in demand. If a fall in demand isn’t satisfied by a fall in supply, then prices will rise. That’s because people will spend their excess money holdings which will bid prices up. Similarly, if a rise in demand for money isn’t satisfied by a rise in supply then prices will fall. That happens because people will seek to increase their money holdings by keeping money they earn from income or sale of goods instead of spending it. The reduction in spending will cause prices to be bid down. The changes in price that come with a rise or fall in demand for money are costly.

Recently, I was involved in a discussion about free-banking. I’ll paraphrase my opponents arguments here ….

  • There is an excess demand for money.
  • So, profit could be made by issuing money. Any creation of money would be a loan to the issuer at a favourable interest rate.
  • Why then are businesses not creating money? Surely even though free banking isn’t legal this is a flaw in free banking theory? After all, we have laws against drug dealing and despite them drugs are readily available in many places.

It’s useful to explain the term “excess demand for money”. In economics there are often “excess” supplies and demands. If there is an “excess supply”, that means that at the current price sellers of a good are being left with surpluses. As a result those sellers are going to reduce the price soon, and/or make less of the product. Similarly, “excess demand” means that at the current price buyers want to buy more than sellers have, that means the opposite, sellers are going to raise their prices soon, if possible, and/or sell more. So, in the excess supply case the price is being bid down, and in the excess demand case it’s being bid up. By analogy an “excess demand for money” means that the price level is being bid up by a rise in demand for money that hasn’t been matched by supply.

The person I was arguing here asks a good question: if there is an excess demand for money why hasn’t more fiduciary media been created by banks during the recession?

I agree that at least during the earlier part of the recession, though perhaps not now, there was an excess demand for money. This was shown by the period of deflation. I’m sure some of the 100% reserve advocates on this site will disagree with me about that, or argue that the demand should not be met using fiduciary media. My purpose here isn’t to argue about that, but to describe why the money supply didn’t expand in this case.

To begin with, we have to consider what money is. When economists and ordinary people talk about money they mean the medium-of-exchange, today that means notes and coins for small transactions and transfers of bank balances for large transactions. Things like “Bitcoins” are not really money, they are at the most an attempt to create a new form of money and not so far a successful one. This by itself explains why it’s not possible to make an analogy to drug-dealing. For drug-dealing to be practical it’s only necessary that a buyer can meet with a drug vendor. But, for a form of “money” to be actual money it must be widely accepted by a great many traders who accept it as payment. That can’t possibly be done outside the view of the police.

Notes and coins are relatively unimportant in today’s economy. In many countries the state has monopoly privileges on issuing them. This isn’t always true. In some places, types of local money have been created by private groups such as charities and federations of local businesses. Banks are generally not able to issue notes as they once did; as far as I know this applies to the US, UK and Europe. As Toby Baxendale often points out, normal companies must “keep their short-term creditors whole”. They can only produce a banknote if they hold matching short-term liabilities, so they have little or no incentive to create money. In Scotland, which is one of the last places where banks can still issue notes, the quantity of those notes is controlled by the Bank of England.

The local currency movement seems to be growing, though it’s difficult to get good figures. The question may be asked: why didn’t local currency issuers create more money? I think the answer lies in the dominant network effects of state currency. Now state issued notes and coins are accepted everywhere and most customers use them there is little incentive for either normal people or businesses to support alternative currencies. George Selgin has described the many problems with local currencies here. There isn’t just one “stable equilibrium” here though, as Scotland shows, if other types of banknote are important enough and safe enough then vendors will support them. Past historical examples show that when banks and other businesses are allowed to compete in the currency market then privately issued note and coins are likely to arise.

All this said, notes and coins are not as important today as they were.  Our principal form of money today is the bank balance. Bank balances are created by fractional reserve banks which are private institutions. Normal businesses can create accounts for their customers and often do. The accounting law mentioned above means that normal companies have no more incentive to create balances for general use than they do to create notes or coins. This leads to the question: why didn’t the banks create more current account balances? In my opinion this is the interesting question.

In many countries, banks must be part of the central banking system. I don’t know if it’s still possible in the US to run a commercial bank that isn’t a member of the Federal Reserve system, but even if it is there are great disadvantages to doing that. The central banks limit the amount of money that the commercial banks can create through regulatory requirements, such as the reserve requirement and capital requirements. But this doesn’t give an explanation; at present and throughout the crisis the banks have held much greater reserves than necessary. The banks are not limited by the reserve requirement at present. In fact, as many commentators have pointed out, if they were to loan more then the money supply would quickly explode.

The reason the banks did not expand the money supply in 2008-2010, and are not doing so greatly now, is that their finances are very fragile. Before the crisis, many of them in the US, UK and Europe, invested in CDOs and CLOs that went bad. There were losses on conventional property loans such as those in Ireland and on loans to other banks involved in these investments. Since banks need assets to back current account balances this is a major problem.

During the boom the protection of current account holders by state-supported deposit insurance schemes was important. The existence of these schemes weakened the interest bank customers would otherwise have had in picking a solvent bank. Northern Rock, for example, was a very risky share even quite a long time before it went bankrupt. But to the ordinary bank customer’s point of view, this risk was minimal because of deposit insurance. In retrospect, this helped “soften up” the banks ready for the onslaught of bad debt ahead.

I’m an advocate of the Austrian Business Cycle Theory and I think it provides the best explanation of the last boom and bust. The toxic assets on the balance sheets of banks are the result of misallocation of capital. Some is due to the secondary effects of the ensuing recession too. In my opinion, to ask for the commercial banking system to deal with this is too much. Commercial banks can’t know for certain when monetary expansion is going to cause a bust. The market interest rate doesn’t easily provide information about the stance of monetary policy. If there is creation of money beyond demand for it, then that doesn’t immediately manifest itself in noticeable price inflation. As a result, banks can’t protect themselves from ABCT busts.

I don’t want to rely too much on ABCT, though. Existing commercial banks suffer from a lack of good assets which prevents them from creating money. Why then don’t other businesses that own (or could access) safe assets start up commercial banks? The problem here is that the regulatory obstacles are large. In the US there are many regulatory bodies that must approve the creation of a bank. A Federal Reserve bank must obey Fed regulations, there are state banking regulations, FDIC regulations and regulations issued by the comptroller of the currency. There are also market issues, such as obtaining membership of transfer networks and creating a structure of branches. The problem any company faces is that they must fulfil their regulatory obligations before the recession is over and the opportunity disappears. Despite this, some have tried.  Wal-Mart have tried several times to acquire a US banking license, but they’ve failed. The most plausible explanation for this is that incumbent banks have leaned on the regulators to prevent Wal-Mart from entering the market. This is interesting because of what it shows about US monetary policy. Many have argued that the Federal Reserve can’t expand because the commercial banks won’t expand lending. To the extent that this is true, it concentrates too much on existing commercial banks. If new entrants were allowed into the market, they would not be in the dire financial situation that the existing banks are.  New entrants would be in a much better position to lend. If it were not for the bailouts, starting a new commercial bank would be simpler.  A business wishing to start a new bank could buy a bankrupt bank and use it’s branch network and access to transfer networks.

The bailouts have caused a strange situation to develop. The existing commercial banks are perhaps not Zombie banks in the technical sense – banks with less than zero net worth – but they are in such a precarious situation that they can’t make many new loans. What preoccupies them is the performance of existing loans. Had they not been bailed out so extensively at the beginning of the crisis, this wouldn’t have happened.

9 comments to Why doesn’t Free Banking work now?

  • I suggest the reason private sector banks don’t issue money when there an excess demand for money is that when these banks create money, the net paper assets of the population does not increase. That is, these banks create money when someone takes out a loan. E.g. if I take out a loan for £X I am better off in that I have £X of money I didn’t have before. But I am indebted to the bank to the tune of £X. So I’m no better off in a strict balance sheet sense. Obviously if I can make constructive use of the money, I’ll probably end up better off, but that’s by the by.

    It’s often said that private sector banks “lend money into existence”. For example as Martin Wolf put it in the FT last year, “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.”

    Here is another quote. “When a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit….” – Robert Anderson, Secretary of the U.S. Treasury, U.S. News and World Report, August 31, 1959.

    Central bank money (i.e. monetary base) is different. If the BoE just prints money and government spends it into the economy, there is no corresponding private sector liability. There is IN THEORY a corresponding liability: those £20 notes say something like “I, Uncle Mervyn of the Bank of England promise to pay the bearer £20 on demand”. But of course Uncle Mervyn has no intention of giving anyone anything in exchange for £20 notes – wicked man.

    • Robert Thorpe Robert Thorpe

      suggest the reason private sector banks don’t issue money when there an excess demand for money is that when these banks create money, the net paper assets of the population does not increase. That is, these banks create money when someone takes out a loan. E.g. if I take out a loan for £X I am better off in that I have £X of money I didn’t have before. But I am indebted to the bank to the tune of £X. So I’m no better off in a strict balance sheet sense. Obviously if I can make constructive use of the money, I’ll probably end up better off, but that’s by the by.

      I don’t follow your logic. Certainly, when commercial banks create money the net assets of the nation do not increase, that’s true. But that doesn’t explain why they don’t create money does it?

      The point about money demand is that in a period of uncertainty many people will wish to hold money rather than other assets. That means there is a demand for money. Now, since banks can supply that demand the question is: why aren’t they doing that since they could profit from it?

      It’s often said that private sector banks “lend money into existence”. For example as Martin Wolf put it in the FT last year, “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.”

      Banks create money from debt, that’s not nothing, as has been pointed out at length in these comments recently.

      Martin Wolf was quite right to criticise the quality of that debt during the boom. There’s a great deal that can be done about the quality of debt that is being monetized. The principle of basing money on debt is still sound.

      “When a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit….” – Robert Anderson, Secretary of the U.S. Treasury, U.S. News and World Report, August 31, 1959.

      Yes, a bank balance is the amount a bank owes it’s customer. So, if it lends £1000 to him it makes a contract for that, then puts an entry for £1000 in his bank account. He owes the bank £1000 (the loan) and they owe him £1000 (the current account). Robert Anderson omits to mention the next step, which is crucial. The borrower then *withdraws from the account* because the only reason to borrow money is to use it. When he withdraws he is redeeming, the bank must convert the £1000 balance into base money.

      If the BoE just prints money and government spends it into the economy, there is no corresponding private sector liability.

      In the central bank systems we have today the central bank owns government bonds which it monetizes. These assets, the government bonds, are supported by tax revenues, they are the private sector liability.

      That’s by the by though.

      I don’t understand this MMTer obbession with outside money. In the short run it doesn’t matter if money comes from debt or if it’s fiat money. Creating money is creating money. What is special about pure fiat money that makes it more stimulative than other sorts?

  • “To begin with, we have to consider what money is. When economists and ordinary people talk about money they mean the medium-of-exchange, today that means notes and coins for small transactions and transfers of bank balances for large transactions”

    The problem is economists largely do NOT mean the medium-of-exchange…

    “Our principal form of money today is the bank balance.”

    One of the new, but very many, definitions of money.

    “Bank balances are created by fractional reserve banks which are private institutions.

    ***Yes, but….***

    “Normal businesses can create accounts for their customers and often do.”

    But for goods and services they have, not for money… A business fronts its customer goods and services, but never fronts a customer money. An employee fronts an employer goods and services, but never money.

    The the problem again is that slippery definition of money, when we are talking about something else. A contract? Except as Mr. Baxendale notes, it fails the contract test.

    It seems if we keep the definition of money classical, and apply the contract test to these other arrangements, we might gain some light on the subject. No?

  • Chris Cresci

    The reason why we do not have free banking now is because most banks do not want to issue their own currency due to the increasing marginal costs associated with issuing money. Instead, most banks leverage their deposit bases to support their investment activities. To print money would require a massive retrenchment in their most profitable lines of business, as every note created at no cost would be a new batch of liabilities should these notes be redeemed.

    • Robert Thorpe Rob Thorpe

      Chris,

      Notes an coins, currency, is only a very small part of money today. Money today means bank balances, principally. Banks don’t issue hand-to-hand currency because they can’t legally do that. It would be profitable if they did because it represents an interest free loan to the bank, and an opportunity to advertise.

      We don’t have free-banking in bank accounts for the reasons I mention in the article.

      • Chris Cresci

        Rob-

        One of the positive aspects of Free Banking is the countercyclical nature of money issuance. Therefore it makes no sense to say that money issues represent an “interest free” loan to the bank. Maybe there is no “interest” per se, however, this is beside the point as the interest is not the main cost to the issuer. The costs are the increasing variable costs (e.g. increased risk of a bank run) associated with each new issue. This means that issuing money has a limit to the amount of profits it can generate. Investing money borrowed using deposited funds as collateral is much more profitable and is pro-cyclical. Most companies are concerned with allocating resources towards the most profitable endeavours. To create a climate where banks would voluntarily print money would require all of these more profitable ventures to be closed to banks.

        As to the legal question, given the fact that issuing money is not the most profitable use of banks’ capital even if issuing money were legal banks would still not issue money. Not only is it not the best use of their capital, but issuing money works against their current business model. Credit card processors, on the other hand, would find issuing money profitable and, at the same time, within the scope of their business model. Even with the illegality of issuing money, we can use gift cards and traveller’s cheques as a proxy. How many banks issue traveller’s cheques, gift cards or other legal issues of money substitutes (credit cards are simply personal loans)? Not many (if any). It is not because the banks lack the resources to do this. Rather, it has nothing to do with their business model, which, currently, is to amass deposits, use them as collateral to borrow from the central bank and lend the funds borrowed from the central bank out again or invest them. Wal-mart on the other hand could issue money as its primary business model is to increase market share within the sphere of retailing through low prices. If they wanted to create a currency that would be in keeping with their business model as they could use their money issuance to create customer loyalty and increase store traffic.

        • Robert Thorpe Rob Thorpe

          One of the positive aspects of Free Banking is the countercyclical nature of money issuance. Therefore it makes no sense to say that money issues represent an “interest free” loan to the bank.

          The countercyclical nature of money issue doesn’t have anything directly to do with the interest issue. When I say that the issue of notes and coins is “interest free” what I mean is that the bank receives an interest free loan from the holder of that currency. I don’t mean that the bank has no other costs.

          Maybe there is no “interest” per se, however, this is beside the point as the interest is not the main cost to the issuer. The costs are the increasing variable costs (e.g. increased risk of a bank run) associated with each new issue.

          Certainly the bank must hold reserves to serve redemptions, it must also print money and distribute money. I’m not persuaded though that these things are enormous barriers. In the 19th century banks issued both notes and in some cases coinage, even though at that time the costs of raw materials was much higher. Notes and coins also represent a great advertising opportunity.

          This means that issuing money has a limit to the amount of profits it can generate.

          Agreed.

          Investing money borrowed using deposited funds as collateral is much more profitable and is pro-cyclical. Most companies are concerned with allocating resources towards the most profitable endeavours. To create a climate where banks would voluntarily print money would require all of these more profitable ventures to be closed to banks.

          To issue notes a bank invests in reserves, in return it receives loans from customers. This is profitable so long as the costs of printing, distributing and keeping reserves are greater than the profits from advertising and obtaining the loan from currency holders.

          I don’t believe that banks always have more profitable uses for capital. If you look at the financial pages in newspapers you’ll find quite a lot of banks that have low profits. The regularly low level of the inter-bank lending rate demonstrates this. If banks had many profit opportunities then why would they invest at such poor rates?

          But, even if a bank *does* have a long list of profitable uses for capital then that doesn’t mean the bank will abandon issuing currency because doing so is cash-flow generating. Suppose that: * I own a bank and I have an opportunity to invest £70 million in high-profit ventures.
          * I have £50 million in capital that I own outright (not borrowed from customers). I consider excess and ready for investing.
          * The bank could issue notes. It estimates that £20M in notes could be issued at a cost of £5M in reserves and £1M in direct costs.

          I could profit by investing £50M direct in the highest profit opportunities. But, why should I settle for that? I can use leverage through issuing money. The bank could issue notes and thereby invest £64M instead of £50M. If the bank can make more than £1M plus the interest on £5M from the extra £14M then it’s worthwhile.

          As to the legal question, given the fact that issuing money is not the most profitable use of banks’ capital even if issuing money were legal banks would still not issue money.

          In Scotland where banks are still permitted to issue money they do issue it, it’s the same in Northern Ireland.

          Not only is it not the best use of their capital, but issuing money works against their current business model.

          Why?

          Credit card processors, on the other hand, would find issuing money profitable and, at the same time, within the scope of their business model.

          Maybe? But if they do then they’re becoming banks aren’t they.

          Even with the illegality of issuing money, we can use gift cards and traveller’s cheques as a proxy. How many banks issue traveller’s cheques, gift cards or other legal issues of money substitutes (credit cards are simply personal loans)? Not many (if any).

          How would a bank issue a gift card? I can imagine how romantic it would be to give my loved one a gift card from Ulster bank. I can imagine myself saying “Think of it, you can buy anything you like in Ulster bank” :). I think if a bank issued a gift card they would pretty quickly be prosecuted for issuing money.

          Rather, it has nothing to do with their business model, which, currently, is to amass deposits, use them as collateral to borrow from the central bank and lend the funds borrowed from the central bank out again or invest them.

          Deposits cannot be used as collateral because deposits are a liability not an asset. Loans can be used as collateral though. In this present crisis, as far as I know, commercial banks have often used their loans as collateral at the central bank to borrow more reserves.

          Wal-mart on the other hand could issue money as its primary business model is to increase market share within the sphere of retailing through low prices. If they wanted to create a currency that would be in keeping with their business model as they could use their money issuance to create customer loyalty and increase store traffic.

          That’s true. But I don’t accept that current account banking and issuing currency have become as separated as you claim. Remember that when you go to an ATM and withdraw state currency that is redemption from the banks’ point of view. If a bank issues it’s own currency then that isn’t redemption. In that case redemption only occurs when:
          * a customer requests base money, or
          * when a bank transfer is used, or
          * when the note arrives at another bank which requests redemption.

          That means that the bank benefits greatly if it can get customers to use it’s own currency.

          Anyway, all that said, I’m not so interested in currency. Bank balances are the important form of money today.

          • Chris Cresci

            Rob-

            My main point here is that the issuance of redeemable currency and fractional reserve lending are incompatible from a risk analysis perspective and as part of a business model. Whether this issue takes the form of bank notes or denominated account balances is irrelevant. The leverage a bank would be able to employ after issuing its own currency would be vastly more limited than it is today. If the market price of the note being held drops below its redemption value or there is a sell-off of that currency the bank that issued said currency is finished and possibly the currency as well. If, on the other hand, the issue is irredeemable and not issued by a depository institution the risks to the issuer are much less severe. While some might say that there is more moral hazard in this case, competition would be able to create a swift correction in the price either through speculation or issuer repurchases.

            Banks would also find it difficult to add value to using money without harming their own bottom line. The reason for this is that the activities at banks mainly revolve around deposits and loans. What incentive does a store have to accept the currency of a certain bank? If the store has an account at that bank there they might be able to work something out. But the store is in the business of increasing sales at the lowest possible cost, so the bank might not be able to offer increased traffic or a similar inducement. On the other hand a credit card company can give that store a discount on their per transaction fees and can give the user of the money a discount of some sort like miles or cash back. In any case, they can leverage their customer base and acceptance, while banks will find it very difficult to do the same and keep their level of profitability.

            • Robert Thorpe Rob Thorpe

              My main point here is that the issuance of redeemable currency and fractional reserve lending are incompatible from a risk analysis perspective and as part of a business model. Whether this issue takes the form of bank notes or denominated account balances is irrelevant.

              So, you’re not just talking about notes then, you’re talking about current account balances too?

              The leverage a bank would be able to employ after issuing its own currency would be vastly more limited than it is today

              By “leverage” do you mean that ratio of shareholders equity to total assets? In that case you’re right, but if you mean the ratio of reserves to other assets then I disagree. As George Selgin has showed in his books, even centuries ago banks operated with very low reserve ratios. With modern technology and planning to move base money around they could probably operate with even less.

              If the market price of the note being held drops below its redemption value or there is a sell-off of that currency the bank that issued said currency is finished and possibly the currency as well.

              Yes, but the question is: under what conditions will this happen? The answer is that the bank must make one of two mistakes. A bank could underestimate the demand for redemptions, this is unlikely though. Whatever 100% reserve supporters may say the demand for redemptions isn’t highly variable. Secondly, and more importantly the bank may mismanage it’s loans and end up bankrupt. That will trigger a run if it doesn’t trigger legal bankruptcy first.

              If, on the other hand, the issue is irredeemable and not issued by a depository institution the risks to the issuer are much less severe.

              How can a commercial bank issue irredeemable currency?

              In order to be useful to a bank customer a note or balance must be a guarantee of a payment of some kind. Why would anyone accept it otherwise? Any customer who deposits a sum of base money has no guarantee of getting anything back.

              I don’t think that customer pressure really helps much here. At any time a bank may simply take all of the capital it has and pay them to it’s shareholders. If there is no guarantee of redemption then it has no responsibility to it’s customers whatsoever. As soon as the net present value of future income from acting as bank falls below the net present value of the assets the bank has then it’s the responsibility of the board to transfer all assets to the shareholders and give the customers nothing. If this actually happened I’d be quite happy that such stupid customers were conned out of their assets, they would have deserved it.

              Also, how is transfer of money supposed to happen between banks? How can that happen without conversion to base money?

              Banks would also find it difficult to add value to using money without harming their own bottom line. The reason for this is that the activities at banks mainly revolve around deposits and loans. What incentive does a store have to accept the currency of a certain bank? If the store has an account at that bank there they might be able to work something out. But the store is in the business of increasing sales at the lowest possible cost, so the bank might not be able to offer increased traffic or a similar inducement. On the other hand a credit card company can give that store a discount on their per transaction fees and can give the user of the money a discount of some sort like miles or cash back. In any case, they can leverage their customer base and acceptance, while banks will find it very difficult to do the same and keep their level of profitability.

              In the eras of free-banking that we know of banks issued fiduciary media that was redeemable in base money. I see no reason to think that if free-banking were reintroduced that they would do anything radically different now. If irredeemable money is a much better solution then why wasn’t it used in the past?

              You may be right that credit card companies will be better positioned to issue notes and coins, but that’s a minor issue.

Leave a Reply

 

 

 

You can use these HTML tags

<a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

Please leave an intelligent and civil reply in your own name.