On Free Banking, Monetary Rules, and Crusades

I often find myself described, not as a monetary economist, plain vanilla or otherwise, but as a “free banker,” and (therefore) as someone who wants to “abolish” the Fed.  Yet I’ve also been accused of lacking consistency, and even of being an outright apologist for monetary central planning, because I also have some nice things to say about monetary rules in general, and about nominal spending rules in particular.

So, am I a free banker or not?  The short answer is…well, there isn’t a short answer other than “it’s complicated.”

First of all, I don’t much like being called a “free banker,” or a free banking “advocate.”  Yes, I have a soft spot for free banking; yes, I think that the Scottish and Canadian systems of yore, which approximated most closely, performed a helluva lot better than their modern, centralized counterparts; and yes, I think more people should study those systems, and free banking more generally, so as to better appreciate the extent to which competitive market arrangements are capable of producing stable and efficient systems of money and banking.

Yet these beliefs of mine don’t mean that I’m not interested in reforms that fall short of any sort of some free-banking ideal.  Still less do they mean that I imagine that, were we to simply get rid of the Fed, root and branch, a set of currency-issuing private banks would rush in at once to fill the void. Nor do I suppose for a moment that allowing commercial banks to issue their own notes, and otherwise deregulating them, while leaving the Fed’s current money-creating powers unchanged, would put an end to monetary instability.  Finally, despite having moved from the academy to Cato, I’m more interested in promoting a proper understanding of the economic implications of free banking than I am in leading a crusade of any sort.  (Then again, I’m confident that, if more people understood free banking, we’d have crusaders aplenty for it.)

But there’s a more fundamental reason why partiality to free banking today doesn’t automatically translate into a desire to annihilate central banks.  When banknotes were still redeemable claims to some “outside” money, like gold or silver coin, to favor free banking — that is, to favor having rival banks issue redeemable notes over having a single bank alone do so — was equivalent to being opposed to having a central bank.  In a metallic standard context, freedom of entry into the currency business sufficed to keep any one bank’s actions from provoking a general expansion or contraction, because while a monopoly issuer might count on other banks treating its IOUs as cash reserves, a bank enjoying no monopoly privileges could expect rival issuers to treat its notes like so many checks, to be promptly presented to it for redemption.  Subjecting a formerly privileged bank of issue to competition therefore served, no less than abolishing it altogether might, to deprive the bank of its short-run ability to influence aggregate nominal magnitudes.  Were the bank to be abolished, on the other hand, other banks, perhaps including new entrants, could readily make up for its absence, because the economy’s (metallic) monetary standard would remain intact.

The situation becomes quite different once metallic standards give way to fiat money.  In a fiat system free banking ceases to be a straightforward alternative to, or substitute for, central banking.  That’s so because the monopoly bank of issue is now responsible, not just for issuing paper currency, but for supplying the economy’s standard money.  There is, in other words, no monetary standard apart from that embodied in the central bank’s liabilities.  A “standard” U.S. dollar today is no longer a quantity of silver or of gold; it is a one-dollar Federal Reserve Note, or a one-dollar credit on the Fed’s books.  It follows that, to simply abolish the Fed, in the strict sense of liquidating it (that is, parceling-out its assets to its creditors, and destroying and retiring its paper liabilities),  would be tantamount to abolishing the U.S. dollar itself.  Though it’s still possible, and perhaps even likely, that some sort of new new banking and currency system would arise, that development would have to be accompanied by the prior or concurrent development of a new monetary standard or standards — a potentially fraught proposition.  Some may well be willing to risk such a radical change; but no one could predict its results with any degree of confidence.

In contrast, a free-banking reform that left the Fed’s money-creating powers unchanged, while allowing private firms to issue dollar-denominated paper currency in competition with it, wouldn’t make a big difference, even supposing that the new currency would be so attractive that no one bothered holding Federal Reserve notes at all.  The change wouldn’t be entirely without significance.  For one thing, it would substantially reduce the Fed’s, and therefore the Treasury’s, seignorage revenue, converting it from producers’ to consumers’ surplus.  The reform would also relieve the Fed of the burden of providing for seasonal and cyclical changes in currency demand.  Finally, for reasons I’ve spelled-out in The Theory of Free Banking and elsewhere, the change could make for a more stable relationship between the quantity of base money and the volume of aggregate spending or NGDP.  But so long as paper currency consists either of Federal Reserve dollars themselves or of dollar-denominated private banknotes, a competitive banknote regime alone would not reduce, let alone undermine, the Fed’s general ability to influence nominal magnitudes by buying or selling assets, and perhaps by other means.  Nominal values would be no less dependent than before on the size of the Fed’s balance sheet, holding other determinants of the real demand for reserves (including interest rates on reserves and alternative assets) constant.  It follows that allowing other banks to issue currency would not rule out undesirable central-bank sponsored changes in spending, output, and the rate of inflation.

It follows from this that, so long as an economy relies on fiat money, the quantity of standard money itself, instead of being regulated by private market forces, has to be regulated by some other means.  That must either mean discretionary control by bureaucrats, or control by means of some sort of monetary rule.  The rule might itself replace the fiat standard with a revived commodity standard, by turning purely nominal official monetary liabilities into genuine claims to definite quantities of gold or silver.  But that is only one possibility among many — and an especially difficult one to pull off.  Most rules would instead preserve the standard money’s “fiat” status.  And most would preserve the rumps, if nothing else, of established central banks.  Call it central banking, night-watchman style.

In short, although a century or more ago, free banking and monetary rules were rival ideas for guarding against abuses of discretionary monetary policy, today they are properly seen as complementary schemes, one for improving the performance of the banking system, the other for reforming the base-money regime.  Therefore there’s no reason why one can’t favor, and even crusade for, both.

[Cross-posted from Alt-M.org]