The Free Banking System

Economics Economics Questions
1

Could someone fully explain “free banking”? From my understanding, it is if the government sets no requirements on the reserve rate banks must hold. So theoretically, it could be zero or it could be 100%, depending on what the market chooses. The beauty of it is that individuals could purchase different rate plans. A 100% reserve plan would be the most expensive while a 0% reserve plan would be the cheapest. To me, this seems like a true free-market for money/loans.

Is any of that wrong? Am i missing anything? How is free banking different than the gold standard?

To me, the free banking system seems better than the gold standard. If I am not mistaken, under the gold standard the government would force banks to keep 100% reserve at all times. Why not allow the market to decide what reserve rate is best? Why not allow some people to make deposits backed 100%, and others to make deposits backed 50% or 10%? Someone on this forum (I forget who) said that a 100% reserve rate would be like buying a Rolls royce while a low percent rate would be like buying a honda. Is that a good metaphor? If so, then doesn’t the gold standard force all people to purchase rolls royces? Why not allow people to purchase honda’s if they wish?

If my understandings of the two systems are correct, I have a difficult time accepting the gold standard theory, but the free banking theory is very attractive to me.

2

It really all comes down to if you believe that selling warehouse receipts that are supposedly backed by a commodity (but aren’t because of the fractional reserve) is theft or not.

Both could (did) exist in a free banking system but the inflationary bank notes will (did) trade at a discount to the 100% backed notes according to the people’s perception on how inflationary the issuing bank is (was).

Nothing would stop you from trading your goods/labor for bank notes that are backed by a hope and a dream but others you try to trade them with would probably have different ideas on the true backing value of said notes.

The gold standard means that the money is backed by gold instead of nothing except the ‘full faith’ of government under the current fiat system.

Free banking means that the banking system is free from government interference unlike the central bank controlled cartel system we have today.

The old ‘free banking’ fractional reserve banks were very, very conservative about their inflationary policies because there was both no one to bail them out when the creditors came calling and they didn’t have the reserves to cover their notes and the chances of a bank run were extremely high once people starting feeling that they were even a tiny bit unstable – which is always the case under a fractional reserve system because the system is inherently unstable.

But you will find people who have no problems with the inflationary theft system that also claim to believe in Austrian economics.

3

By gold standard, we mean that the government should be forced to exchange its notes at a certain parity, not that it should force people to use gold. Austrians argue for a fully privatized banking system. Free banking and a commodity standard are two proposed systems. Remember, the only role of the government in either is to stay out. When applied to the government the gold standard just means what I said.

4

“Could someone fully explain “free banking”? From my understanding, it is if the government sets no requirements on the reserve rate banks must hold. So theoretically, it could be zero or it could be 100%, depending on what the market chooses. The beauty of it is that individuals could purchase different rate plans. A 100% reserve plan would be the most expensive while a 0% reserve plan would be the cheapest. To me, this seems like a true free-market for money/loans.”

This is a pretty good first pass at free banking. There is debate about whether Fractional Reserve banking is consistent with the libertarian property ethic, though. As an analogy, would a valid law rule out the voluntary contracting of an assassination on a non-aggressing third party, or should the market decide? An anarchist might argue that private market courts would validly rule against such contracts, because they are aggressive. So the reserve issue is not cut and dried. Rothbard is a good source for this side of the argument.

“Is any of that wrong? Am i missing anything? How is free banking different than the gold standard?”

A gold-coin standard is what the free market landed on by natural and non-coercive means. This is why the Austrians like it. It is considered to be honest free market commodity money, in contrast with fiat paper, which is worthless and put in place via threat of violence from the aggressive state. Free banking is merely a free market in banking - unregulated, unlegislated, no central bank or coercive banking cartel, no lender of last resort, no legal tender laws, and no banking holidays to protect the banks from bank-runs.

"To me, the free banking system seems better than the gold standard.”

This is too much like saying that cars seem to be better than roads. The two are not in conflict.

“If I am not mistaken, under the gold standard the government would force banks to keep 100% reserve at all times.”

The Rothbardian anarcho-capitalist view is that even private courts would find currencies based on FR banknotes to be fraudulent. So the question is, would it be? If it would, then no libertarian should be in favor of currencies based on FR banknotes. The debate is in the ethical nature of paper currencies based on FR banknotes - not whether free banking is good or not.

“Why not allow the market to decide what reserve rate is best?”

This is fine, as long as the market provides private courts to determine if fraud has happened. From a certain perspective this can be seen as similar to “why not allow the market to decide what kinds of murder are best.”

“Why not allow some people to make deposits backed 100%, and others to make deposits backed 50% or 10%?”

There is no question that such transactions should be allowable. The question is, could receipts for 10% backed deposits possibly become universally accepted as money in a free and non-fraudulent market. If this is not possible, and yet such banknotes were indeed universally accepted nonetheless, would this necessarily imply a mass fraud taking place? If the answer is yes, then libertarianism rules it out.

“Someone on this forum (I forget who) said that a 100% reserve rate would be like buying a Rolls royce while a low percent rate would be like buying a honda. Is that a good metaphor?”

A better metaphor is someone sells you a house which you pay for and take title to, but don’t immediately move in to. Simultaneously, the same seller secretly lends title to the same house to someone else - who moves in. You both hold title to the same house, and since you have not moved in, you do not notice this. Is this fraud, or is it merely efficient use of your house?

“If so, then doesn’t the gold standard force all people to purchase rolls royces?”

It forces people to explicitly contract for either a storage arrangement of their money, or a credit arrangement - one or the other, but not both at the same time, since such an arrangement is deemed to be a logically impossible and purposefully deceptive arrangement.

“Why not allow people to purchase honda’s if they wish?”

So this analogy is not quite good enough.

“If my understandings of the two systems are correct, I have a difficult time accepting the gold standard theory, but the free banking theory is very attractive to me.”

I hope my answers introduce some of the possible ethical snags inherent in (even “free”) FR banking.

5

wgeary, you appear to be confusing two different concepts.

Concept 1 is the gold standard.

Concept 2 is free banking.

The gold standard means that the standard of legal tender (i.e. to give a good discharge of debt of money) is gold coin. Also known as the gold coin standard. Gold coin is standard money.

Free banking means that there is freedom to form banks that issue bank notes and conduct current accounts for their customers, pay and collect cheques, and can set their own financial policies such as for capitalisation and investment/lending. This is generally taken to include the freedom to set their own reserve ratio.

It is possible to have one without the other.

For example, England introduced a system of central banking with the Bank of England, formed in 1694, while the monetary standard was the gold standard. Bank of England banknotes were not legal tender, gold coins, were. In 1708 the Bank of England was granted a monopoly on the issue of banknotes in the metropolis, but the notes remained payable in standard money or currency, i.e. in gold coin.

Only later in were Bank of England notes made legal tender, although they were still payable in gold coin at the bank. At this point the gold standard can be said to have ceased, notwithstanding that the notes remained valued at par and redeemable in gold coin.

Later in 1797 the Bank of England defaulted on its notes, and the UK pound went to a discount. Country bankers and Scottish bankers also stopped paying their notes in gold coin, and paid them with Bank of England notes instead.

Later in 1821 the Bank of England started honouring its notes again, and the UK pound went back to par with gold.

During the ‘restriction period’ 1797-1821, the Scottish banking system remained free, with competing banks issuing notes and conducting current accounts for customers, paying and collecting cheques for customers, and free from any government regulation of their financial policies.

The Scottish monetary system 1821-1845 combined both free banking and the gold standard. The Australian monetary system 1788 to the 1890s also did – British and foeign gold coins formed the monetary standard, while all and sundry issued promissory notes for use as money, until from 1817 banks began to dominate the business of issuing notes for use as money. In 1822 the British halted local attempts to establish the Spanish dollar as colonial currencies, and required British pounds (gold coin) to be used, and a branch of the Royal Mint was established in Sydney in 1855. The banking and note issuing businesses were regulated and taxed in various ways, but financial policies of banks were never regulated, and restrictions on join stock banking were relaxed over time, leading to the development of strong, branched banks.

6

I think a free banking system would be great, first of all it would increase the competitivness of our banks, it would also rid the ability of special intrest groups to influence govt monetary policy…

7

Its not a matter of preference. Fractional reserve banking is accounting fraud.

If I have 50% fractional reserve that means that I own 50 ounces of gold but have outstanding notes worth 100 ounces of gold that I’m obligated to honor. My bank is insolvent, every note above 50 ounces of gold is a lie. If half of those people demand payment for their notes, the other half will never get their gold. They have been robbed.

Handing out two deeds of ownership to a single ounce of gold is just as criminal as selling my car to two different people. The difference is that it will take the holders of the gold deeds longer to discover the crime than it would the holders of the car deeds.

However, theft does not occur when the person finally discovers his property missing, but when the item is actually taken. The holders of the notes have been victimized the moment the 51st note enters circulation. The holder of notes have been deceived whether they know it or not.

In a free market some banks would try to continue to get away with creating more notes than they hold gold(or other backing), however the market treats these banks ruthlessly and they will eventually suffer bank runs. This is the reason we have a banking system rather than a market. Without the bank cartel achieving 10% reserve ratios would not be possible.

When fractional reserve banking disappears it will be because of the self regulating market and not any legal system, even free market.

8

For someone crying accounting fraud you seem to have no idea of accounting, things like assets and liabilities and capital.

Bankers who issue banknotes, i.e. promissory notes payable to bearer on demand intended to circulate as money, have non-reserve assets as well as reserve assets to offset their note liabilities. And a promissory note is a promise to pay money, not a promise to hold a particular asset portfolio or a pledge of security (although a promissory note may include a pledge of assets as security, typically they don’t). To pay their notes, bankers may need to sell assets such as interest bearing securities, or re-finance by issuing other securities, such as bonds. For example, suppose a banker with a capital of 20 Kg of gold, issues 100 Kg of banknotes and invests in 80Kg of marketable debt securities, and holds 40 Kg in reserves. So the banker’s balance sheet is:

Assets:

Reserves 40Kg

Marketable debt securities 80Kg

Total Assets 120Kg

Liabilities:

Notes issued 100Kg

Capital 20Kg

Total Liabilities + capital 120 Kg

If 50 Kg of notes are presented for payment, the banker could:

  1. Sell at least 10 Kg of marketable debt securities, or
  2. Issue at least 10 Kg of bonds or other borrowings, or
  3. Issue at least 10Kg in additional capital.
    It is only if the banker actually runs out of reserves or capital that he can be said to be insolvent.
9

Part of the debate centers on the validity of putting deposits from customers on the books at all. The argument is really that a deposit is not a liability, but rather it is owned by the customer placed with the bank for safe-keeping - a warehouse service. Therefore, the banknote is in reality a warehouse receipt, or a money substitute. Given that this warehouse receipt represents clear and present ownership of the actual money, it is not a liability of the bank, and is not available to the bank to lend out. Much like a warehouse cannot lend out the goods it stores for its customers. The issue that there is the vast amount of confusion that is implied in a bank subtly treating as a loan, what the customer tends to think of as a warehouse service. And when a money substitute is not a claim to present money, a misrepresentation of the nature of the money substitute is implied.

10

That was a fine example of accounting fraud…

I think it’s fair to say that quite a few people know how it works and base their ‘fraud’ charge on this knowledge.

Funny how the accountants could never convince people how this isn’t a fraudulent activity when there was a bank run and depositors lost their life savings.

11

The gold standard is where there is a law that says if you have a debt, like you owe someone 3 cows, you may give the person the equivalent amount in gold, and clear that debt. Or it can mean that your paper money can redeemed for gold.

The paper standard means that you can clear debt with pieces of paper.

People haven’t figured out how to turn lead into gold yet, but they can print paper with ease, this is why governments prefer paper money.

Fractional reserve demand deposits, means that you let the bank hold your money, but you can withdraw the money at any time, but the bank will also lend the money out itself, therefore there’s a chance that when you go to withdraw the money it may not be there.

The reserve ratio is how much money relative to the amount of demand deposit liabilities that the bank must hold onto, this is to help garuntee that bank will have enough money to redeem demand deposits, although anything short of 100% reserves isn’t 100% safe.

100% reserve banking means the bank puts the money in a safe or something and doesn’t loan it out, they should never fail to redeen deposits unless in the case of fraud.

Time deposits are when you deposit money and you cannot get it back for a certian amount of time, therefore the bank will have your money unless it’s creditors are having trouble paying the bank back.

Free banking means that the depositers, banks and borrowers, do whatever they want so long as no one defrauds anyone. When you loan money to your friends you are engaging in free banking.

Central banking is a system where if bank reserves are getting low, so that the bank may not be able to redeem deposits, the central bank will either print money and pump it into the economy(buy stuff with the new money, usually financial assets) until the reserves are reinflated to be able to cover obligations to depositors, or the central bank will lend money or money substitues to banks that need money. If a bank that borrows from a central bank is unable to pay back the central bank, the loss will usually be covered by the taxpayer. This way bank losses are socialized on the backs of dollar holders and taxpayers.

12

Count me as a free banking adherent who “claims to believe in Austrian economics.” It seems, though, that there might be 2 different positions falling under the 100% gold reserve title:

1-There should be laws requiring 100% gold reserves.

2-There should be an anarcho-capitalist system, and under that system, private courts would hold that fractional reserve banking is theft. Also, gold would be the commodity used as money.

It’s clear that Rothbard’s position is the latter, and the debate in Austrian circles is primarily between this position and the free banking position. The nice thing about arguing 2 vs. free banking is that it’s no longer a normative question - instead, it’s a question of predicting market outcomes. To me, it’s an open question whether or not there would be some courts, albeit very few, allowing things like out and out theft. So, it’s conceivable that one can believe that fractional reserves are fraud, and that fraud is bad, and that there would be some companies establishing justice systems that allow fractional reserve banking.

Now, Rothbard would object that systems that allow theft would have very few customers, and would rapidly go out of business. I tend to agree. However, I don’t agree that fractional reserve banking is fraud, and I believe that the companies which allow fractional reserve banking would do quite well.

Why do I argue that it isn’t fraud? Because every complaint of fraud that is made can be handled with a simple sign on the window of the bank. The complaint is, as far as I can tell, that my bank will offer withdrawal on demand, and will have more money in accounts than in the vault. This means, in theory, that more than 1 person has some sort of claim to each gold bar in my vault. To which I say - so what? Gold bars are interchangable. This idea that more than 1 person has a claim to a particular bar only works if it’s possible for you, as a customer at my bank, to identify what bar you have a claim to. You can’t. If 3 people order a sofa from Walmart, and they only have 2 sofas, they haven’t committed a fraud - and there’s no sofa that more than 1 person claims. Someone isn’t getting a sofa, though. So, in a run, it’s possible that someone won’t get anything - that’s why the bank pays interest, to pay you for that risk that you’re undertaking in depositing. That’s specified on the sign.

So far as I know, the 100% gold reserve folks don’t mind if I offer CDs, then loan out the money, keeping enough in reserve to deal with the possibility of early withdrawal. If you give me 100 ounces, and I promise to pay it back in a year, then I’m allowed to loan it out to someone who wants to borrow it for 11 months. The concern only arises with accounts where you can walk in anytime and take your money out with no penalty. The reason the CD isn’t an issue is because you signed a contract saying that you understood what a CD was. So we’ll make some similar waiver on the savings account. What’s the issue?

13

If I write on a bit of paper:

‘I David Hillary promise to pay Paul Smith 5 grams of gold coin on 10th June 2008, signed, D Hillary’ and give it to Paul

This is called a promissory note, and is David Hillary’s liability and Paul’s asset. I might have done as a trade for something worth 4.9 grams of gold today from Paul.

If I write:

‘I David Hillary promise to pay the bearer 5 grams of gold coin on 10th June 2008, signed, D Hillary’ and give it to Paul

Then Paul can give it to anyone he likes, and then that person, or the holder in due course, has a claim on me payable on 10th June 2008 for 5 grams of gold coin. This claim is a creditor claim, and I’m the debtor. These claims and obligations are recorded as ordinary assets and liabilities on the respective books of those issuing and holding them.

If I write:

‘I David Hillary promise to pay the bearer 5 grams of gold coin on demand, signed, D Hillary’ and give it to Paul

Then the instrument retains its character, however the holder can present it to me for payment at any time.

Banknotes have historically and typically been structured as promissory notes issued by a bank and payable on demand to the bearer. In fact the typical banking transaction has been an exchange of credits – the customer’s credit for the bank’s credit. For example if Jack is in the business of selling garments to merchants, and he sells a load of garments to Tom, but Tom doesn’t want to pay right away. Tom writes Jack a promissory note engaging to pay for the goods in 60 days and gives it to Jack. Jack takes it to his bank, signs it himself as well, making him also liable, and exchanges it for a smaller amount of promissory notes issued by the bank, payable on demand. Jack can then either present the banknotes for payment in coin, if he wants coin, or hold them until he wants to spend his loan proceeds. Then, if the bank needs more reserves of coin, it can also sign the promissory note and sell it at a smaller discount. (Historically it was more common to use Bills of Exchange rather than Promissory Notes for this kind of thing, but legally there isn’t much difference). Anyway, the traditional banknote is unambiguously a promissory note. Check out any contemporary banknote issued by the Bank of England, Bank of Scotland, Royal Bank of Scotland, Clydesdale Bank, Bank of Ireland, First Trust Bank, Northern Bank, Ulster Bank, The Hongkong and Shanghai Banking Corporation Limited, Standard Chartered Bank (Hong Kong) Limited and the Bank of China (Hong Kong) Limited, and you’ll see the words ‘promises to pay the bearer on demand the sum of’ or equivalent.

Warehouse receipts do not include a promise to pay, but an engagement to store and redeliver.

Maintaining funds with a bank on current account, differs from holding banknotes in several ways.

The current account holder is the customer of the bank, for the purposes of the bank-customer contract and is entitled to several legal rights that do not apply to banknote holders. These include:

  1. the common law duty of secrecy on the part of the bank concerning the account balance and transactions going through the account and other matters concerning the customer’s information held by the bank,

  2. the obligation of the bank to pay the customer’s cheques drawn on the bank up to the customer’s available funds on the current account

  3. the obligation of the bank to account for the debits made to the customer’s account, and that the bank needs a mandate to draw from the customer’s account

  4. The bank’s obligation to promptly collect the cheques deposited to the credit of the customer’s account.

  5. The banks obligation not to close the customer’s account without reasonable notice, because cheques are outstanding in the ordinary course of business for several days.
    However, in respect to the financial and legal relationship involved, the same debtor-creditor relationship exists. The account balance records the financial position between the bank and the customer – when the account is in ‘credit’ the bank owes this amount to the customer, when it is in ‘debit’ or ‘overdraft’ the customer owes this amount to the bank. The true financial position can be obtained by combining all relevant accounts or obligations: the bank, for example, has a right to offset any amount it owes the customer by taking into account loans or other amounts the customer owes the bank. For example, if the bank grants a customer an overdraft of $1000 upon opening an account, and the customer deposits a cheque for $1000, and writes a cheque for $500 which is presented for payment at the bank immediately. The bank holds the deposited cheque as the customer’s agent while presenting it and awaiting its payment by the drawee bank – in other words, legally, the customer still owns the cheque, not the bank. Since the cheque isn’t yet cleared, the customer’s balance is $500 overdrawn. Suppose, now, that the customer is bankrupted, and the customer has debts of $5,000, and no other realisable property than the cheque deposited but not yet cleared. The bank, since it is in possession of the cheque, has a lien on the cheque. When the cheque is paid to the collecting bank as agent of the customer, the bank uses the proceeds first to discharge the overdraft, and then the remaining proceeds can be used by the bankruptcy trustee to provide other unsecured creditors with 10c in the dollar.

On the other hand, if the account is in credit, and it is the bank that becomes insolvent, the customers rank pari passu with other unsecured creditors such as banknote holders, time deposit holders, bondholders, suppliers etc.

An account with a bank, financially, is no different from an account with a non-bank, for example an account of a customer with a supplier – nothing more than a simple debtor-creditor relationship is involved concerning the balance of the account.

14

Even if gold bars are interchangable it is irrellevent. Money, gold, is a present good- it is held only due to uncertainty and if that condition did not hold it would not exist. So when 3 people put a gold bar each into a demand deposit and the bank lends one out you have 4 claims to 3 present goods which undermines the concept of property itself. Further however, the fact that one gold bar appears in two peoples asset column this presents problems to other firms who now believe that two gold bars exist whereas only one does. Your Walmart example is a disanaology since the purchase of the sofas represents the purchase of a future good not a present one and so the problem of fraud does not arise.

I strongly suggest you read Against Fiduciary Media by Hoppe.

15

Respect for property, justice and reason, and the existence of free markets are entirely tangled together. None comes without the others and this is unavoidable. The question is, do we advocate free markets or not. If we do, as a given, then we must also advocate respect for justice and property. So one question we can ask is are there contracts that two people can voluntarily agree to enter which are in fact invalid because they represent impossible agreements, or property violations. I think we know the answer to this is yes. So the next question we can ask is do fractional reserve contracts represent such a situation.

Several prominent Austrians have argued it does. To name a few, Hoppe, Hulsmann, Rothbard and Huerta de Soto. Others have almost argued that fractional reserve systems should banned including Mises, Salerno, and Herbener. Each of these have argued that fractional reserve banking is purely an artifact of state intervention in the banking industry and that a free market in banking would virtually eliminate the use of banknotes and deposit credit, thereby making it impossible for a free market fractional reserve currency to occur.

The issue is that paper with such conditions do not constitute money substitutes and the vast majority of people who understand their nature won’t accept them as such. This is a praxeological fact that follows from the nature of money. This fact is also demonstrated in history. So the problem is in understanding the true motivation behind such a confusing scam: to present a banknote as a money substitute that will only be acceptable if it is seen as a money substitute, but which in fact is categorically not a money substitute. That is the issue.

16

There are many ways to enter into a credit transaction, we have no dispute there. However, money and credit are two different things. People naturally wish to hold cash and receive payment in cash. When people think they are holding and transacting in cash, when they are in fact holding and transacting in IOU’s, there is a problem. When an entire economy is based on a currency of IOU’s, we know there is fraud. This is because IOU’s are not money and they are not money substitutes. Prices are not given in terms of credit. They are always given in today’s money - a present good.

17

Money is not the same as legal tender.

Legal tender means an legally good settlement of debt of money, where no particular means of settlement has been pre-specified. This may also be properly called ‘current money’ or ‘currency.’

Money is a good used for the purpose of indirect exchange. Such goods may or may not be legal tender.

Claims on banks such as banknotes and cheque account balances can function as money, a means of indirect exchange, while not being legal tender. Such claims on banks must be payable in the form of legal tender on demand in order for people to use them as money.

Thus a free market monetary system may be chacterised by two forms of money: manufactured commodity money (metallic coins in standard sizes and forms) and bank issued money (banknotes and balances of cheque accounts), the former as legal tender and the latter as practical and economical forms of holding wealth in money form.

18

Perhaps if people were allowed to price this into the equation when conducting trades it wouldn’t be a problem. “All debts public and private” with an implied “at face value” makes this impossible.

Strangely enough this does happen with gasoline and diesel, the cash and credit price usually have a 6 to 10 cent differential in favor of cash (or debit).

—edit to reply to Mr. Hillary who’s mighty quick—

That’s why banknotes traded at less than face value, at approximately the perceived amount of reserves backing them.

19

No one would hold a callable security if its market value is less than its face value: they’d call it and get the face value.

The whole point of banknotes and cheque accounts is that they’re callable for legal tender on demand and valued at par, and acceptible to many merchants and other banks at par. For this to occur the issuing banks need to be strong and creditworthy and service their redemption demands quickly and efficiently. Quality competition between banks brings the average bank up to very high credit quality and service levels.

20

Commodity coin money is money. Bank issued warehouse receipts for money are money certificates or money substitutes. Both are theoretically valid forms of money in a free market, and neither requires legal tender laws. Legal tender laws are state interferences in the market made necessary by the issuing of unbacked banknotes which begin to trade at a discount because of increased fears of irredeemability due to bank insolvency… due to the habit of keeping only a fractional reserve. The existence of legal tender laws is a clear indicator that there is not a free market in banking an money.