What is free banking all about?

There has been some hot and stirring debate on free banking in the blogosphere.

Ueasymoney blog sums up the debate and provides links on who said what on the topic. For those interested in history of money and banking, studying free banking is a must as this is how it all started. Adam Smith wrote on free banking in his wealth of nations tome. Also read this website where leading free bajmking scholars are writing some really fab and interesting stuff.

There are two schools of free banking — Currency school led by Hume and Banking school led by Smith:

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Hmm..

Further the post points how earlier banking liabilities were mainly currencies and now deposits as well. This is interesting.  When did deposits become part of banking system?

The author believes in the Smithean banking school and says Friedman’s monetary targeting idea was a bad one:

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

This angle is hardly covered anywhere. We are just told that mon targeting failed as central banks found it difficult to measure the money supply.

There is a lot of discussion in the comments as well on free banking. Really exciting. Again what a pity that none of this is really taught. All these ideas matter greatly in shaping our banking and monetary policy. Infact, nothing else matters if one knows the history really well.

Have to read up on free banking issues. India would have had some version of free banking as well before RBI came up in 1935. How the entire thing ran and whether it followed currency or banking school should be an interesting thing to look at..

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