A Case for Free Banking
Free banking is a monetary system or arrangement that is free from special regulations that usually central banking systems undergo. This is not a new monetary standard, free banking as a concept has been around for a long time and has been implemented around the world in various time periods each with an interesting history and can give interesting insights for policymakers today and solutions for problems that our monetary system faces and in turn us citizens who are affected by monetary changes and fluctuations on a grand scale. United States monetary policy has been vigorously debated, discussed and analyzed throughout history mostly because the topic is a very nuanced but an empirical subject. Many problems within the US monetary system reveal the faulty foundation it is laid upon and handled year by year. Reverting to an older more stable process, while costly in the short run, will help us in the long run by avoiding an economic downturn and inappropriate handling of the money supply.
A more in-depth look at free banking reveals a relatively simple approach to fiscal protocol but before describing deregulation of banks we first must look at the current American system of central banking and the fractional reserve system that is used and its inherent flaws[MG1] [MG2] . Central banking is a monetary authority with monopolized granted privilege to control credit and money through production and distribution. Money produced and distributed by the central bank ttoday is a type of currency called Fiat currency. Fiat currency is a type of money that holds no intrinsic value compared to that of commodity money which is backed by a certain commodity, usually gold or silver. Fiat money’s value comes from the regulation and backing guarantee of the government. Central banks exist outside of the market and are an anticompetitive institution, America’s central bank known as the Federal Reserve is not a government agency and not legally owned by the government, but their practices are protected and enforced by law. Its legal monopoly status allows it to issue bank notes and cash while commercial banks cannot and can only issue things like checking deposits. Central banks set federal interest rates as well usually these interest rates are between banks which goes into the fractional reserve system that America also practices which will be described as well.
Now that I have gone over what a central bank is I will highlight some of its functions briefly. There are many functions to a central bank such as handling monetary policy but there are a few big things that it also does, such as manipulating the money supply which is the total amount of money in circulation at a time. The Fed does this through issuing currency and setting interest rates through rates and bonds so that they may keep the economy stable and achieve certain economic goals like full employment. The central bank also regulates other banks through capital requirements and reserve requirements, reserve requirements go into a fractional reserve system which means that only a fraction of bank deposits are kept on hand and backed by actual cash and are up for withdrawal. For example, if an individual deposit $100 into the bank, that bank cannot lend out the entire amount they deposited but also the bank does not have to keep the entire amount either. Usually, the Federal Reserve will set reserve requirements but usually its about 10%. Increasing the reserve requirement takes money out of the economy while decreasing does the opposite and puts money into it, the Fed does this for a multitude of reasons most of which have been highlighted already.
After describing how central banking and to a lesser extent fractional reserve banking functions we should look at some of the flaws. A glaring flaw to our system is that the Federal Reserve is not a government agency, it is essentially a nationalized industry that goes unchecked and has the authority to control, produce, and spend money where it sees fit to help our economy. While the fed does not help the government in its role of authority and its monopoly on force it does overstep its boundary of forbidding free individuals to make decisions for themselves. Money is a medium of exchange, it can range from gold to silver, to shells, or pieces of paper but all these commodities have one thing in common. That is, their value is decided and voluntarily agreed upon by individual’s who use these commodity’s to voluntarily exchange goods or services.
The currency in which we stand upon today is seemingly backed by the value of what the state says it is and we must take their word for it to put it simply. This is not a feasible practice for handling banking or even money, money is a finicky thing and can change depending on a multitude of factors such as the market environment, events happening in the world, time preferences for individual’s, etc. The government can change the money supply at whim depending on what they say is the right thing but as I stated money is a finicky thing and nobody knows exactly how it works so the government will change the money supply in an inappropriate manner. A good example of this is the Phillips Curve which asserts that unemployment and inflation have an inverse relationship to one another the central bank aims to hit economic goals through monetary policy such as reaching full employment or keeping inflation under control, or even pacing the economy at certain speed. It does this by keeping the curve in mind but is this curve really the best way to look at handling the economy from a monetary standpoint?
Harald Uhlig, an economist at the University of Chicago would disagree “One may be tempted to say: this is so, despite the empirical evidence accumulated over the last four decades. Do we know what the empirical evidence says? Are we “discovering” the empirical evidence that fits our view of the world that was established long ago? Are we looking at the data with glasses tinted by our theoretical prejudices? Have we been ignoring the empirical evidence all along? Or has the empirical evidence perhaps always been there, as a number of macro-econometricians forcefully argue?” (Uhlig 11). What Dr. Uhlig is saying that even though the Philips curve is a highly questionable model that has been disproven through various means of modern evidence the Phillips curve still prevails and sticks around and is a leading model and equation for the government to enforce the monetary policy. The relationships of data found in the Phillips curve between 1948-1959 and then again in 1959-1970 are not stable if policy seeks to manipulate this relationship if used. Indeed, it has been shown that exploiting the use of the Phillips curve results in little correlation that the model asserts. For now, Dr. Uhlig says “The Phillips curve now appears to be flat, judging by the data from 1992 to 2008. The current mainstream view is that the central bank has succeeded in stabilizing inflation, whereas something else is moving unemployment.” (Uhlig 11)
A model that is highly questionable in its accuracy that is being used by a nationalized bank that has monopolistic privilege when dealing with monetary policy is a concerning situation for us individuals. This is concerning mostly because our money is our property and by letting the state regulate and mishandle how our money functions to coerce us into using more inferior capital. So, what is our alternative that offers a far more tight and constrained system that in turn benefits our market and all citizens who inevitably use money in their everyday lives? Free banking as I said is a relatively older concept that existed marginally in the US from 1830-1860. While the American model was still very much regulated there are important insights to be gained from the era. An important look into other free banking models such as the Scottish model proves very interesting insights showing that free banking can work as a system. Free banks inherently regulate each other by competing with one another offer a better service to a possible individual who would want to open an account with them or use their bank notes. Randall Koszner points this out in his research paper “Competitive rivalry thus had the salubrious effect of forcing rivals to maintain reasonable reserve ratios.” (Kroszner 7). The consumer demands for reasonable banks practices and even a healthier amount of capital i.e. a more reliable note.
As I distinguished earlier, nobody knows exactly how money should function and what the objectively best option for money is. But the inherent problem with a central banking system is essentially the fact that the central bank assumes that it knows exactly what the market demands and what consumers want. So, it implements policy that thinks will help but this has an inverse effect, it has a possibility of tanking economies of weakening it. For example, The Great Recession of 2007 has origins in government regulation and specifically the Federal Reserves action within the financial system. As Larry White states in his write regarding a free banking system and how it would have prevented or at least restrained the boom and bust. “The Fed sowed the seeds of the bust 2007-08, by over expanding credit, keeping interest rates too low for too long. The Fed made these mistakes despite our having been assured that it had learned from past errors and that the art of central banking had all but been perfected.” (White 497). Even though the Fed had made copious amounts of errors in the past nothing changed, and it led to one of the worst recessions in recent history for America and these slip ups of one agency that isn’t even legally owned by our government comes at the expense of us the citizens. Free banking would have slip ups sure, but it wouldn’t be at the expense of everyone, taking the entire market down with one toxic financial firm or bank going bankrupt.
US monetary policy as we have explored is a flawed, unreliable, and warped system that unveils the even more flawed, unreliable, and warped foundation it is built on. Implementing a free banking system will be costly in the short run due to the confusion and the market readjusting but it will benefit us in the long run because of the healthier productivity that a free banking system reaps. Jeffery Herbener has an excellent take on this as he wrote about Ludwig von Mises’ view on a healthy monetary system as Mises said “We know the determinants of the value of money, or think we know them. But we are not in a position to bend them to our will.” (Herbener 69). We cannot simply bend the market and therefore something like money to our will simply because we assume we know what the best outcome is for doing so, we must let freedom of choice and entry as well as open competitive markets exist because all these things foster economic growth and allow for individuals to pursue their own interests and goals.
Works Cited
Herbener, Jeffrey M. “Ludwig Von Mises on the Gold Standard and Free Banking.” Quarterly Journal of Austrian Economics, vol. 5, no. 1, Spring 2002, p. 67. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6992789&site=eds-live&authtype=sso&custid=s8992667.
Kroszner, Randall. “Free Banking: The Scottish Experience as a Model for Emerging Economies.” Policy Research Working Papers, 1995, doi:10.1596/1813-9450-1536.
Uhlig, Harald. “Economics and Reality.” MF Working Paper Series, July 2011, pp. 1–31. No. 2011-006, doi:10.3386/w16416.
White, Lawrence H. “A Gold Standard with Free Banking Would Have Restrained the Boom and Bust.” CATO Journal, vol. 31, no. 3, Fall 2011, pp. 497–504. EBSCOhost, search.ebscohost.com/login.aspx?direct=true&db=buh&AN=67075492&site=eds-live&authtype=sso&custid=s8992667.
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