Free Banking

Free Banking ( also free banking ) describes the ideal of a banking system in which banks the same ( state ) regulations are subject to other companies and any special state regulations, restrictions or privileges for companies in the banking sector exist .. Even under the laissez -faire advocates is only a minority for the realization of this ideal.

• 3.1 Further Developments after Kevin Dowd
• 3.2 Free Banking by Friedrich August Hayek

• 4.1 Scotland 1716-1844
• 4.2 United States 1837-1865
• 4.3 Other experiences

• 5.1 Consequences of government interest rate policy
• 5.2 consequences of state intervention for the stability

Overview

Today, banking is one of the most heavily regulated sectors of the economy. In the past there have been periods in which individual restrictions or privileges were not present in individual states or repealed, in which restrictions on free banking were thus lower than today. Perfect Bank freedom did not exist in these phases.

Representatives of a free banking often demand that central banks should not exist and everyone should have the right to issue banknotes unlimited and without any monetary coverage. In return, there are no legal tender, market participants, so do not be legally obliged to accept certain institutions have placed on the circulation of money as payment for goods and services.

This would in consistent implementation consisting mean the change from the today usually 2- tier banking system with public or quasi-public central banks to money supply and private commercial banks to supply to a one - tier banking system only from commercial banks with note issue. Theoretically also conceivable would be fundamentally the transition to a one - tier banking system consisting only of a central bank lending without commercial banks, but this in exact contrast to the approach of free banking.

This position is in economics in the minority. Trailer can be found especially in the environment of the Mont Pelerin Society, the Austrian School and followers of the economist Friedrich August von Hayek, Ludwig von Mises and Murray Rothbard. Mostly the opposite position is taken that the specifics of the credit system makes a banking regulation necessary. Currently and historically only a few economists advocate free banking theories. The reception of corresponding publications in specialized science is low.

Features

The following are the characteristics of the banking system will be explained as it has developed under free banking. As historical examples are rare and abstracts of historical features, this description is based primarily on theoretical considerations Line, but are consistent with historical evidence.

Competing currency provider

The banking system has evolved in a situation in which the common cash gold or silver coins were. Since the numbers of coins is inconvenient, people began to store their gold in people who already had to store larger amounts of about goldsmiths and the merchants. As acknowledgment goldsmiths gave out certificates that entitle the holder to withdraw a certain amount of gold to a goldsmith. Instead of gold coins, these certificates were common means of payment. Respectively, since only a small part of the deposited with a goldsmith gold was lifted, it was the goldsmith possible to issue more gold certificates than he could cover with gold. This process is now called the fractional reserve process. From this point the goldsmiths operated the business of a bank. For them, it was attractive to pay interest on the deposits, as they competed with each other to this. In addition, banks compete in the fact that the output of these certificates ( notes ) remain stable in value. The most convincing warranty for this was that the certificates could be converted into gold. This warranty gives the value of the notes was bound to the gold. Some representatives of free banking, such as J. G. Hülsmann, criticize that the fractional reserve process actually constitutes fraud and breach of contract arises when a bank of its obligation to exchange notes in gold, does not comply will not be punished enough. With the fractional reserve process inevitably there is an inherent risk of bank runs.

Clearing Systems

The business of a bank is limited by the acceptance issued by the Authority notes. Two banks can gain a competitive advantage by mutually undertake to accept the notes of the other bank, which also increases the overall acceptance. It turns out that the most practical way to organize the exchange of notes is to hold regular central clearing meeting, in which the banks will get back their notes and the differences are paid. A historical example is the New York Clearing House Association in the late 19th century. Clearing systems perform an important function, since they could cause by überemittiertes money, so money is not used as a means of payment and inflation or instability, is removed rapidly from the circulation.

Money markets

The liquidity of banks is subject to random fluctuations. This can indeed be largely offset by the bank sells assets, but remains a risk unexpectedly large fluctuations which can drive the bank into the illiquidity. This risk can be countered by banks that are short of liquidity in the short term borrow, in those who have surplus funds, money. In a currency beings with central banks can trust that this lends them the necessary funds. Since these funds can provide unlimited high available, it is the banks possible to lower their reserves to a level with which they would be unable to survive under free -banking (see also money market ).

Option clauses

Since the banking system as a whole is not in a position to fulfill all payment obligations at the same time, the situation may arise in which the money markets have dried up, ie also to unusually high rates of interest, no one is willing to lend the banks money. Then a collapse of the financial system is conceivable. Banks can avoid this risk by changing the payment obligations of the notes. Instead of the obligation, the notes at any time to exchange them for coins, they may reserve the right to suspend the payment for a pre- specified period of time and to pay compensation for an interest. The exact terms will be chosen so that the banks this option clauses will apply only in cases of emergency, as the notes would otherwise not be accepted. The interest rate would be set lying around than x % above the average of money market interest rates of the last y months, so as to ensure that it is usually cheaper for the bank to raise funds in the money markets liquidity, as trigger the option clauses.

In times of crisis, however, the interest rate on the money markets may go so far that it is cheaper for the banks to suspend payment, when to charge the money markets. You can even suspend the payment and on-lend the money and so help to overcome the shortage of liquidity. Most importantly, however, is that the option clauses eliminate the risk of bank runs, resulting from the self-fulfilling expectation arise, such was imminent. If a bank without option clauses suffers a cash storm, investors get nothing, the demand as last redemption of their notes. For a bank with an option clause, the available money is divided, however, on anyone who has requested redemption. Therefore, the advantage to redeem the first, the marks omitted. Notes with option clauses were to be found in Scotland from 1730 to 1765.

Speculative Free banking concepts

In the free- banking theory, there were various speculations as to the financial system would develop without government influence. J. G. Hülsmann doubts that the fractional reserve process is compatible with property rights. The fractional reserve process had a negative impact, it would lead to inflation and implore the risk of bank runs up. According to Hülsmann any money would be in an economy without government influences commodity money, because money has no value beyond the monetary use is fraught with the risk of total loss in value.

Further development by Kevin Dowd

Kevin Dowd describes a development that could take the financial system, starting from the fractional reserve system. In a first step notes would increasingly not redeemed against gold, but against other investments such claims on other banks or companies. The public would accept that, as long as the investment vehicles offered were accepted stable in value and as a means of payment. They would prefer that even the gold, because they are easier to handle. The banks have initially the advantage that it is cheaper media such redemption ( redemption medium) to store than gold. More importantly, that the banks can buy the repayment media to broader markets and it is possible for them and their grades to pay higher prices than parity with the price of gold. With its notes to buy less gold than corresponds to the nominal value is the banks are contractually prohibited, as they have to keep the value of the notes to the gold stable. The probability that it rises can buy new repayment media on the Märken what the banks allows the reserve ratio back down. For the economy as a whole, such a move is positive, since the financial system no longer needs to respond with the raising of interest rates on large-scale recovery claims, which would have a negative economic impact.

In a second step, the obligation to exchange notes against gold are replaced by the obligation to exchange notes against financial instruments with the same value of gold. Such a commitment can the banks meet in which they intervene in the gold market or cheaper the futures market for gold. When a bank issues more notes as held by other would (money überemittiert ), which will reduce the value of the notes; it also the exchange ratio of notes and gold will eventually be affected. By suitable shops on the gold markets, the bank would have the exchange ratio stabilizing. Through such operations, the number of outstanding notes is (ie liabilities of the Bank ) is reduced at the same time they would have to sell assets to finance the business. The überemittierten funds are therefore taken off the market. Banks are no longer tenable to rely on gold reserves, but only need sufficient liquid assets.

In a third step, the role of gold replaced by a commodity or a basket with a value less volatile in relation to other goods, as it is the case with gold. Since the banking assets of the value of all kinds of goods depend on the liabilities, however, are listed in gold, they formed by a standard with fluctuating purchasing power risk. Therefore, it is to replace it useful for the standard. A stable standard has positive effects because the price signals are reliable and misallocations can also be avoided for the general public.

Free banking by Friedrich August Hayek

Even Hayek has speculated on free banking. His idea, he describes in Dena Transportation unreality of money '. Unlike Dowd Hayek assumes that banks enter into any contractual obligations to stabilize the value of issued notes. It would be sufficient that the public rejects currencies from banks, which it is not possible to keep the exchange rate stable. Banks must maintain the value of money to stay in business. The method by which they pursue this goal differs from that Dowd has proposed. Since it is the banks can buy back its currency at market value, and they are not set to a value standard, it makes sense for them to compensate for the obligations arising from the notes by assets whose value at which the notes is proportional. Would be suitable short term loans. To regulate the value of the notes, the banks would expand the availability of short term loans or limit, much as do the central banks today. In this way, the banks would avoid the risks that arise because the value of assets and liabilities may fluctuate with each other.

Hayek emphasized that central banks can achieve a permanent excess return because they can borrow at an interest rate of zero ( compare seigniorage ). One can illustrate this as follows: For an individual cash management and investment are separate acts, but not for the economy as a whole, for all funds that do not serve the consumer, represent savings. A central bank can draw on the savings that arise when someone stocks based on a currency by expanding the money supply and thus devalues ​​the savings. ( The relationship between money and the value of money is described by the quantity theory of money). A central bank that holds the value of its currency constant, the money supply can only expand if the demand for stocks is growing with this currency. The savings that form the holder of the currency correspond exactly to the funds that are new, the central bank in circulation and for which they can buy plants. Grasping the holder back on their savings and build from their currency holdings, the central bank must buy back the same extent funds. In this sense, the holder of the central bank have lent their savings. Hayek feared that the excess returns lead to political desires.

Past experiences

Scotland 1716-1844

In Scotland there were 1716-1844, a period less restrictions on free banking, private bank notes brought into circulation in the banks on the basis of a gold standard. The banking system was dominated by the Bank of Scotland, Royal Bank of Scotland and the British Linen Bank, which were equipped by the Scottish Parliament with the privilege of limited liability. Competing banks only received a permit to bring their own banknotes in circulation, if the shareholder is willing declared to stick with their private assets in full to the bank's liabilities.

Between individual banks score duels were fought occasionally. In this case, a bank accumulated over a long period of time, the marks of a competitor and then calls at a stroke their redemption with the aim to drive the competitors into insolvency and thus to gain market share. For the system as a whole, this behavior is beneficial because excess liquidity is taken off the market and it works disciplining the individual banks.

1730 had the Bank of Scotland for such a duel to close temporarily. As a result, they paid their scores with option clauses to be better protected against such attacks. That was the first time in history that such clauses have survived. The Bank of Scotland took the right to repayment to postpone by six months if they paid an indemnity of six pence per pound (equivalent to one years interest rate of 5 %). The other big banks did not adopt this innovation initially. Nevertheless, circulated notes with and without option clauses at par to each other. This shows that option clauses have been accepted by the public, even if alternatives were available. During this time, the banking business was new and it took some time to gain experience, how many reserves were necessary, was how to deal with liquidity problems and as with the competition. So it took until 1771 until a clearing system was set up.

In the 1760s there was a liquidity crisis. The interest in London rose strongly - at times the interest rate differential was 4-5 %. As a consequence flowed from gold from Scotland, which threatened the liquidity of the banks. These look for ways to protect themselves. 1762 all banks option clauses were introduced. In addition, the volume of credit were reduced and raised interest rates on deposits. After a brief recovery, the crisis flared up again in 1763 as an Amsterdam bank collapsed and began a flight across Europe into gold, which was again increase interest rates in London. In March 1764, both the Bank of Scotland and the Royal Bank turned to their option clauses. They also painted the lending together and further increased the interest on investments. The public was very dissatisfied with these measures and urged the legislature to intervene. 1765 a law was passed forbidding the grades below a nominal value of one pound and option clauses. The public perception was that the option clauses destabilized the monetary value. However, it can be speculated that the Scottish economy in crisis suffered an external deflationary shock. The connection between the note value and value of gold was interrupted by the use of option clauses, so that in the sizes of notes of the value of goods for personal consumption did not grow. The option Klausen would then parried the external shock.

Rondo Cameron noted that in the free banking period, the growth of Scotland turned out cheaper than in England or France. It applies economic historians as successful.

The economist and political philosopher Murray Rothbard doubted that it has acted in Scotland 1716-1844 to a free banking period. Between 1797 and 1821, the Scottish banks refused to repay outstanding notes and deposits in specie, which was illegal under Scottish law, but by the backing of the British government was possible. The Scottish banks did not rely on their own gold reserves, but relied on the help of England.

Rothbard rejects the thesis that the Scottish banking system was superior to the English. Although there were fewer bank failures in Scotland than in England, but is relevant to the national economy is limited in inflationary expansion of the money supply. There would have been no advantage as the Scottish banks expanded the credit amount cyclically and contracted.

USA 1837-1865

In 1837, the federal government pulled out of the back legislation regarding banks, the responsibility for the legal framework for the banking industry was entirely up to the members states. Some of them passed laws which allowed banks to bring their own banknotes in circulation.

The bank freedom, however, was still significantly limited. Often, banks were required by law to use bonds as collateral for the States that are in circulation notes. The loss in value of such bonds led to the bankruptcy of many banks.

Other experiences

Australia had a financial system with extremely few regulations in 19.Jh. In the 1890s a property crash caused the failure of several banks. This could restructure and open again later.

In Canada from 1817 to 1935 was a free- banking system before. Even in the Great Depression there were no bank failures. 1935, a central bank was founded in the hope of being able to fend off inflation of the money supply depression.

In Sweden in 1824 the monopoly of the Riksbank to issue notes, abolished and only from 1897 to 1904 again. Various economic historian Lars Sandberg and Ögren of the opinion that the development of an advanced banking system explains the economic success of Sweden before the First World War.

Over the liberal revolutions in the first half of the 19th century in Switzerland, the banking system was deregulated. So allowed several cantons the banks putting out their own notes. This meant that there were three types of note -issuing banks: commercial, cantonal, led by the cantonal governments, and local, which included both individuals and communities. The cantonal banks had some privileges such as tax and fee waivers and full value for tax payments. 1881, the private note issuance was banned and banks were forced to accept foreign notes at par. Thus, the need to differentiate between individual notes, greatly reduced, and over emission was the result. In the 1890s, the banking system was further centralizes and 1907 established a central bank with monopoly money.

1860 Chile passed a law that allowed everyone to enter the banking business and the issuance of private notes. In practice, this law was undermined by privileges to banks financing the government deficit. Her grades were adopted by the State at par value, which offered them a strong competitive advantage. These banks had the incentive to monetize the public debt to finance that is, loans to the State by expanding the money supply. This convertibility was undermined, which in 1878 led to a financial crisis, during which the convertibility was all set. Began in 1879 the state itself to issue inconvertible notes, as legal tender. 1880 convertibility was introduced again but remain useless because the banks nachkamen their exchange duties with the legal tender. 1895 Chile returned back to the gold standard, by exchanging their own notes against gold. 1898, the issue of notes was eventually re-monopolized. Despite these problems, the banking business was expanded in the free banking period. This phase coincided with a period of strong economic growth.

Consequences of state intervention for the financial system

Government intervention in the financial system run by free -banking theories to destabilize the financial system and long-term reduction in the purchasing power of the currency. The reduction of interest on money through monetary policy entails, according to the monetary overinvestment theory to artificial booms that have turn sharp economic downturns result.

Consequences of government interest rate policy

According developed by Friedrich August von Hayek business cycle theory results in a free market, the equilibrium interest rate from the rates of time preference of savers and the realizable at a given interest rate investment opportunities. According to the theory allow monetary policy measures a decrease in the interest rate below the market price. This in turn causes entrepreneurs to expand their activities by realizing investments that would previously have been unprofitable. However, as the additional supply would not be connected in loans with an additional supply of available for capital goods, run the additional demand for factors of production to rising prices of the factors that are scarce, about wages or raw materials.

Will the rising factor prices passed on to customers, these miss their target time preference, they would have consumed less than intended in relation to their savings. They would reduce their savings and thus trigger an economic crisis since the same economic performance can not be maintained because of the lower savings and investment volume. If companies succeed not to pass on the rising input prices, some investments are unprofitable and must be stopped, which also leads to an economic crisis.

Competing economic theories sometimes lead to different results. A consensus on what causes business cycles, does not exist among economists.

Consequences of state intervention for the stability

According to Free banking theories by certain government interventions in the financial system undermine its stability.

Historically, early examples of such interventions are granting privileges to individual banks that offer in return the state preferential access to credit. Such privileges are typically monopoly rights on the issue of banknotes. Prevent monopoly rights that competing currency provider and the subsequent characteristics emerge a free finance. The quality of published by the monopoly supplier of money will be worse than money in a free market. This manifests itself, Kevin Dowd According, in an over- issuance of money, pulls the inflation itself. Another effect is that other banks will not hold their reserves as notes of the monopoly bank and in gold, as it was cheaper and was expected by the public. This means that on the national gold reserves are centralized at the monopoly bank and it must accept " the monetary system Warden " the role of.

Another type of destabilizing regulations exist in those that limit the organizational form of banks. So a law was enacted by the British Parliament in 1708 that forbade banks to include more than six occupants. Banks of this size were too small to withstand major shocks. Since the depositors knew this, any disruption in the financial markets led to bank runs.

Kevin Dowd argues that states tend to exert pressure on banks in times of crisis, in order to obtain low-interest loans. These loans weakened the banks and so increased the instability of the financial system.

To combat the instability of the financial system, there are further procedures. Often, as a statutory deposit guarantee is installed. This can indeed avert runs against individual banks, however, leads to moral hazard: For the banks, it is better to take high risks, since the costs are assessed in the event of a failure by the public. Voluntary deposit insurance does not hit this problem because banks will only participate in them, if it is ensured by imposing conditions that the risk of failure of another bank is not too big.

Device a bank in payment difficulties they may face the policy argue that valuable assets could be preserved if it had allowed her to temporarily suspend the payment. These interventions lead to moral hazard. In some cases, the payments remained permanently, such as the disposal of Nixon in 1971; this is the introduction of a paper money system.

State intervention in the business policies of banks lead to a reduction in the efficiency of capital markets. Furthermore, it is possible that the desired results are not achieved. Reasons for the latter can not be taken into account, for example, financial innovation or incompetence in the regulators.

Objections to free banking

After the Diamond - Dybvig Model Features of the financial industry lead to a market failure that exists in a fundamental instability. Consequence of this market failure are bank runs. An attempt to design state intervention, which eliminate the possibility of such runs in the model. However, Kevin Dowd According to these government interventions can only be successful, if not subject to the assumptions of the model for regular agents (isolation) for the state. So if there are ways to eliminate the risk of runs, they can, according to the proponents of free banking, also of market actors are used. An intervention of the state so it was not necessary. In addition, proponents of free banking assume that there is no inherent instability of the banking. If there were, there could be no decades of crisis- free free- banking periods, a statement that is contrary to the historical evidence. Empirical studies could not confirm that the financial system would be unstable under free banking, some of them put the opposite hand.

An often been applied criticism is that it was the banking business to a natural monopoly. Such a situation occurs when the entire market of an industry can be covered by one service at a lower cost than if the market would be divided among several providers. Possible sources of such economies of scale on the one hand, the reserve management, on the other hand, the diversification of risks. The positive scale effects of reserve requirements come about because the amount of payments that are required for a given probability, only the root of the scaled amount of outstanding receivables. So it happens that with a larger amount of outstanding receivables, a greater proportion of the deposited capital can be profitably invested. The economies of scale that are based on the reserve requirements, but disappear relatively quickly, as the following example shows: Suppose at an applied euros the reserve holdings must be exactly one Euro, then you need after root law in a hundred euros invested ten serve as a reserve. The replacement costs are then already be saved by 90%. At € 10,000 already 99% were saved, greater savings are hardly worth mentioning.

Douglas W. Diamond was able to show that larger banks have lower costs to monitor their loan portfolio. However, these advantages disappear even in the limit of large banks. It is therefore doubtful whether these economies of scale are sufficient to justify a natural monopoly. Empirical studies have shown that in banking, although economies of scale are present, but no tendency to a natural monopoly. A bank could only achieve a monopoly position, if they had received appropriate privileges.

Some critics represented continues to consider issuers would bring in the open competition as long as extra money in circulation until it was virtually worthless because the material to the issuer causing very little cost in circulation bringing additional money. However, there is under free banking no obligation to accept any money issuers as payment for goods and services. According to Friedrich von Hayek is under free banking the demand for money of a particular issuer depends on whether it is able to keep the value of money constant. If an issuer increases the money supply at a constant demand for the light emitted from him money, the value of money decreases. Market participants lose confidence in the issuers refuse to accept money from the issuer and soft on competitive money.

Some critics maintain free banking is not useful, because the transaction costs would be reduced if all subjects an economy use the same unit of account. This is not guaranteed under free banking. Proponents, this critique is not to be valid, as would evolve standards on a private basis. Such a standard would only be undermined if individual market participants alternative units of account might offer more advantages than the standard. In such a situation, however, it did not make sense to make a legally binding standard.