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Free Banking

Free Banking. Lawrence H. White SREK 2014. oll.libertyfund.org/. http://www.iea.org.uk/. http://www.econlib.org/. Two views of money. Coins can be privately produced. Why then have governments monopolized coinage? To improve quality?. Silver content of European govt. coins, c1300-c1500.

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Free Banking

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  1. Free Banking Lawrence H. White SREK 2014

  2. oll.libertyfund.org/ http://www.iea.org.uk/ http://www.econlib.org/

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

  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 Assets Liabilities 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 BANCO di MEDICI Assets Liabilities coins in vault $40 owed to Alice $10 owed to Bob $10 loans, bills $160 owed to others $180 Advantages to the bank? Advantages to the customer?

  13. Bank‑issued currency

  14. Warehouse receipts do not resemble banknotes

  15. When is a fractional reserve feasible?

  16. Is a fractional reserve banknote like a lottery ticket?

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

  18. A money warehouse contract is legitimate. • A time deposit contract is legitimate. • A demand deposit contract is neither a money warehouse contract nor a time deposit. 4. Therefore, a demand deposit contract is not legitimate.

  19. A dog has four legs. • A cat has four legs. • A goat is neither a dog nor a cat. 4. Therefore, a goat does not have four legs.

  20. Banks will accept one another’s liabilities at par (face value) • Non-par means customer inconvenience • Profitable for banks to eliminate these inconveniences

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

  22. 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

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

  24. Why did we switch to fiat money? IOU NOTHING

  25. 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.

  26. Simplified free bank balance sheet Assets Liabilities + Equity ______________________________________ R reserves N 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

  27. 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 public’s desired N Assets Liabilities + Equity R L N D K

  28. What corrects a bank’s over-issue? • Reserve losses as notes return for redemption • “overissue”: the quantity of a bank’s currency in circulation exceeds the quantity demanded • given its optimizing expenditures on non-price competition • cause: either bank expands N, or Nd 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 Nd as the public adjusts toward its desired portfolio of assets • Adjustment of system-wide N as Nd falls or rises

  29. 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 paripassu 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.)

  30. 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 banking’s adjustment of N to Nd helps to stabilize aggregate spending • Hayek’s “money stream” • Policy implication: don’t restrict note-issue to a single institution. Allow free entry. James Wm. Gilbart, leader of British Free Banking School

  31. The problem of runs

  32. 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

  33. 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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