Free Banking for Zimbabwe

This article appeared in the December 2007 issue of Globe Asia.

Since March 2007, Zimbabwe has been in the midst of a hyperinflation (a rateof inflation per month that exceeds 50%). This phenomenon is rather rare.Indeed, prior to Zimbabwe, there had only been 29 hyperinflations.

Zimbabwe's hyperinflation is destroying the economy,pushing more of its inhabitants into poverty andforcing millions of Zimbabweans to emigrate. Since1997, inflation has surged by 1,030,217%, while livingstandards (as measured by real GDP per capita) have fallen by35%. In addition, hyperinflation has robbed people of their savingsand financial institutions of their capital via negative realinterest rates. This form of theft occurs, in large part, because thelaws and regulations governing financial institutions (pensionfunds, insurance companies, building societies, and banks) forcethem to either purchase government treasury bills that yield onlya small fraction of the current inflation rate or to make depositsat the Reserve Bank of Zimbabwe that pay no interest.

Not surprisingly, the value of the Zimbabwe dollar has beenwiped out. The accompanying figure tells the devastating story—one that is ominously following the same plot as that taken by the mark during the great German hyperinflation of the 1920s.If all that destruction hasn't been painful enough, worse isyet to come. Private sector economists expect Zimbabwe's GDPto fall by 12% in 2007, and the International Monetary Fundprojects that year-on-year inflation could exceed 100,000% byyear-end.

As I conclude in my recent book, Zimbabwe: Hyperinflationto Growth, the most rapid and reliable way to stop hyperinflationin Zimbabwe is to replace central banking with a new monetaryregime. This would signal a clean break with the practices thathave created hyperinflation and give Zimbabweans reliable assurancethat inflation will henceforth remain relatively low.

One monetary regime that would stop Zimbabwe's hyperinflationis free banking. Under this system, private banks issuenotes (paper money) and other liabilities with minimal regulation.A completely free banking system has no central bank, nolender of last resort, no reserve requirements, and no legal restrictionson bank portfolios, interest rates, or branch banking.Free banking systems have existed in nearly 60 countries duringthe 1800s and early 1900s.

Zimbabwe had free banking from the time the first bank wasestablished in 1892 until the government replaced free bankingwith a currency board in 1940. Zimbabwe's free banking wasamong the least restricted that ever existed. At the time, thecountry had only two commercial banks, the Standard Bank ofSouth Africa and the Bank of Africa (later part of Barclays Bank).They issued notes denominated in pounds, and kept their privatelyissued pounds equal to the pound sterling—except duringthe First World War and for a few years afterwards, when the localpound floated along with the South African pound (the predecessorto the rand) against the pound sterling. Free bankingended in Zimbabwe not because it performed poorly, but becausethe government desired the profit from issuing notes.

Although free banking might be unfamiliar, the principles ofcompetition that underlie it are not,because they are already at work indeposit banking. We do not usuallythink of deposits from differentbanks as being different types ofcurrency, but in effect they are—atleast, they are different brands of acommon unit of account. By holdinga deposit at one bank ratherthan others, a depositor is choosingthat bank's management, portfolio,and services over those of its competitors.

Free banking extends competitionfrom deposits to notes. Inpractice, multiple brands of noteshave generally not created problemsfor free banking systems anymore than multiple brands of depositscreate problems in centralbanking or other systems.

In a system of fully free banking, the field includes anyone(domestic or foreign) who meets the requirements common toother businesses (registering a place of business, stating who theofficers are, listing the shareholders periodically, and publishingfinancial statements if the company is not a private partnership).Competition weeds out firms that are less astute at deliveringwhat consumers want. Abundant experience indicates that depositorswant assurance that they are placing their funds with afinancially solid bank.

That is why the tendency almost everywhere is for a few largebut highly competitive banks to dominate the market, thoughleaving niches for small banks to serve specialized clienteles. Aswith deposit banking, then, historical experience suggests thateventually or perhaps even immediately, note issuance will bedominated by a small number of large banks.

Under free banking, banks would have the liberty to issue depositsand circulate notes in any currency—the US dollar, SouthAfrican rand, gold, etc. In past free banking systems, they haveconverged on a single unit of account, typically gold or a foreigncurrency. In Zimbabwe it is quite possible they would convergeon the South African rand. However, free banking leaves it forbanks and customers to discover what works best for them; itdoes not presume that the government already knows the answers.

Comparing exchange rates of Zimbabwe (2005) and  Germany (1921)

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C.