Austrian Finance, Central Banks and the Virtues of Free Banking

Scott Smith of The Daily Bell interviewed Professor George Selgin on "Austrian Finance, Central Banks and the Virtues of Free Banking" (April 18, 2010). It includes an excellent exchange about "100%-reserve" banking" versus "fractional" reserve banking in an Austrian economics setting. I tend to favor the argument advanced by both Selgin and White that unrestrained market forces in free banking would favor "fractional" reserve banking.

George A. Selgin is a professor of economics in the Terry College of Business at the University of Georgia, a senior fellow at the Cato Institute in Washington DC, and an associate editor of Econ Journal Watch. Selgin formerly taught at George Mason University, the University of Hong Kong, and West Virginia University. Selgin's principal research areas are monetary and banking theory, monetary history, and macroeconomics. He is one of the founders, along with Kevin Dowd and Lawrence H. White, of the Modern Free Banking School, which draws its inspiration from the writings of Friedrich Hayek on denationalization of money and choice in currency.

A central claim of the Free Banking School is that the effects of government intervention in monetary systems cannot be properly appreciated except with reference to a theory of monetary laissez-faire, analogous to the theory of free trade that informs the modern understanding of the effects of tariffs and other trade barriers. Selgin is also known for his research on coinage, including studies of Gresham's Law and of private minting of coins during Great Britain's Industrial Revolution, and for his advocacy of a "productivity norm" for monetary policy – a plan that would have policymakers target the growth-rate of nominal gross domestic product at a level that would allow the overall price level to decline along with goods' real (unit) costs of production.

From The Daily Bell After Thoughts:

George Selgin, along with his mentor Lawrence White, blazed an original trail in the late 20th century that virtually resuscitated the concept of free-banking. Free-banking is simply the idea that a bank (or any entity operating as a bank) is free to accept deposits and loan money beyond the deposits it has on hand. This banking methodology is known as fractional banking and evokes strong feelings within the free-market universe.

The United States economy was in a sense based on free-banking, even after the Civil War, and until the advent of the Federal Reserve in 1913. However, the US never offered an entirely free-banking economy – given the Constitutional definition of money-as-silver – and bank owners often found they could not be chartered without buying a good deal of municipal (local) debt.

Famous free-market economist Murray Rothbard has suggested that local American debt was often questionable and made bank balance sheets unstable – leading to bank runs. This gave American free-banking a bad name, leading to the appellation "wildcat" banking. Thus we could argue that untrammeled free-banking was never implemented in the US.

Where are we now? Today, in America and around the world, banks function with fiat-money fractional reserves, and Ben Bernanke has suggested doing away (recently), even, with those. The idea is that within a central bank money environment, banks are basically distribution centers for debt-based money and it does not matter whether they have additional "funds" within their coffers or not.

Bernanke's position in fact is simply a recognition that the banking system, not based on gold and silver money, is really only an imitation of what once existed. Today, the Fed and other banks could just as easily disburse paper and electronic money directly to businesses and consumers - but that would mean bypassing the banking system that is a main feature of modern societal power and control.

The current system obviously does not work very well. Free banking would be one solution. Yet free-banking - which Selgin and others believe has proved viable for long periods of time in the past, especially in Scotland, and less well in the US (to the degree that it was implemented) – remains a controversial subject.

Free banking arouses strong passions. Anti-free bankers have suggested than anything other than a 100 percent gold standard – when it comes to securing money in banks – would be something of a criminal endeavor, even in a free-market society. Beyond that, and regardless of the degree of criminality, the position of anti-free bankers remains that the marketplace itself would immediately reject a banking system that did not back deposits fully with precious metals.

The crux of the argument within free-market circles, therefore, is whether or not free-banking (fractional reserve banking) is (1) an acceptable behavior and (2) a practical one. Free-banking backers (and we are partial to free-banking) would respond that (1) the market should be allowed to decide whether free-banking is acceptable and (2) the practicality of free-banking has been proven by past episodes.

Ultimately, we don't believe that money is so complicated as people make it out to be. Money, historically, is gold and silver and governments (historically) have done anything and everything in their power to control money and to substitute paper and – now – electronic media in its place. But inevitably substitute money media is abused and inflated and history shows us that sooner or later gold and silver tend to circulate once again within the context of an honest money standard.

So here is the question. What would be a default standard in a truly free-market economy? We would suggest that one answer might be free-banking where anyone is able to offer a warehousing service for gold and silver and issue paper notes (receipts) that may be accepted at least locally as cash. Additionally, we would suggest individuals or entities doing the warehousing would be entitled to pursue fractional reserve banking so long as it was disclosed.

Is it wrong to let the market decide on what kind of banking works? Free-banking, fractional reserve banking, even central banking (or a variant thereof) all seem logical to us so long as they are pursued within a free-market context. It may even be that the marketplace would determine a 100% gold reserve to be ideal. But the point is, let the market decide. The problems begin when government steps in. Then distortions, bad-dealings and destructive inflation (and price-inflation) are inevitable when they do. In our opinion, a private marketplace for money would sort out these problems through competition and people's natural inclination to be prudent (for the most part) about their hard-earned money. See, maybe it's not so complicated after all.