Luke

Criticisms of Free Banking

Criticisms from Conventional Wisdom

The first main argument which is made against free banking is, if free banking is desirable, why has it not been adopted and why would economist and policy makers worldwide have such strong support for central banking? This argument can be easily combated by noting the lack of serious thought or a fair chance to succeed, do not prove it would not work. Historical evidence shows that when implemented, such as in Sweden, Scotland and China, it failed politically not because of lack of function.

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Also, it can not be seen as a failture to the free banking system from the early 19th century in the United States when “free banking” was not free banking at all. During this era, it was more approapriatly called “bond deposit” banking, and the tight regulations which prohibited banks from forming branch networks to help stability and efficiently was what ultimately led to the failure of these “free” banks at the time.

Fraud and Counterfeiting

The criticism that free banking was more supseptable to fraud was started by Thomas Tooke and continued by Milton Friedman.

Friedman stated in A Program for Monetary Stability:

The very performance of its central function requires money to be generally acceptable and to pass from hand to hand. As a result, individuals may be led to enter into contracts with persons far removed in space and acquaintance, and a long period may elapse between the issue of a promise and the demand for its fulfillment. In fraud, as in other activities, opportunities for profit are not likely to go unexploited. A fiduciary currency is therefore likely…. to be overissued.

http://www.bankofcanada.ca/en/banknotes/graphs/photos/counterfeit/2001-04_20notes/20_security.gif

Friedman used examples from the so-called “free banking” period in early 19th century when fraudulant notes where being highly used, but like we mentioned earlier, the regulated bond-deposit requirements were to fault for fraud rather then anything inherent to free banking. The other main argument for free banking's acceptability to fraud, comes from belief that the long period of time during which bank notes are in circulation will lead to higher counterfit rate, which is true, but the assumption this is more prevalent in free banks is false. For example, when looking at Scotland, during the height of the Free Banking system, around 1870’s, they had very short periods of circulation of their bank notes and thus, low amount of forged notes.

Restriction of Economic Growth and Full Employment

A particular agrument was made by looking at the implementation of free banking system in Scotland, where Rondo Cameron claimed that it restricted economic growth. Although the arguement against the lack of economic growth during this time in Scotland can not denied, by looking at other examples, it seen that the one does not always cause the other.

In certain other examples, not only did free banking not hinder economic growth, such as in Sweden and Canada, during the brief periods in which their banks were relatively free and unregulated, and even New England, which was the least regulated of the banks in the U.S in the early 1800’s, but it seemed to, if anything, prosper under this system.

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History does not necessarily answer the underlying question of whether the amount of lending and investment financed by a free banking system would be sufficient to promote maximum sustainable economic growth.

As for full employment, some Keynesians believe that to achieve full employment it requiries inflation and thus would free banking, without a central bank and no inflation, be able to achieve and maintain full employment.

Public Good and Externality Arguments

There are two main criticisms of free banking concerning public good and externality and they are:

1. Inside money is a public good because it exhibits either nonrivalrousness or nonexcludability in consumption, which make its private production in desired quantities unprofitable

2. There are externalities in inside money production because (a) producers do not bear all the costs of it (b) benefits from inside money issue are not fully reflected in bank earnings, so that competing issuers will underproduce

Alleged Need for a "Lender of Last Resort"

It is argued that because of the lack of a central bank and thus a last resort option if other banks experience a run due to lack of confidence in their notes, free banking woudl ultimatily fail. To back up this argument, The Bank of England in the 19th century is used as an example for the need of a central bank. The Bank of England, with restrictions on note issuing power of the other banks, became the sole significant repository for the system and created notes acceptable for clearings at all other banks. Thus, if smaller banks experienced a run, The Bank of England could issue notes to settle clearings for that bank.

This theory for the need for the “lender of last resort” does not take into account that if the other banks had no restrictions on issuing their own notes, they could swap note liablies for deposit liabilies, still leaving reserves untouched.

This would not work if bank customers lost confidence in the individual bank’s notes because a threat of a redemption run could not be solved with offers of their own notes. It is seen historically though, that runs in systems with branch banking are very rare due to the ability stun runs by assistance from branches of the affected banks.