Why Not a Free Market in Money?

Consider a bulls-eye, with concentric rings, ever-smaller as the center is approached.  As you move from the outermost circle toward the center, each ring represents a fuller representation of free markets.  The center circle- the bulls-eye is a completely free market: relationships defined by voluntary agreement, with the requisite condition that members within the society by-and-large respect the non-aggression principle. 

There are many that argue in support of free markets.  All have a place on this target – each has a ring.  Without pretending to be an exhaustive list, I will suggest that the outermost ring is for those who believe in free markets, with an exception made for imported goods – tariffs.  Somehow, goods made overseas are different than goods made domestically – never mind that in either case the delineation is an artificial line on a map.  To the individual buyer and seller, what difference does the location of the counter-party make?  If satisfaction is maximized, does it matter from where the satisfaction came?

The next ring toward the center is for those who understand the benefit of low (or non-existent) and uniform tariffs, but believe there is a role for central banking.  Monetary policy cannot be left to the market; it is too complex, they suggest. 

The next ring is for those who understand that money and credit should be produced by the market – no monopoly via central banking.  Gold with 100% reserves as the foundation for this free-market money is all that is necessary.

For some, this is the innermost ring – the bulls-eye.  I would like to examine this belief.

Over the last several years, I have dug deeper into my views of markets.  It was always easy for me to say that I believed I free markets, but what did this actually mean?  This effort has led me to a further study of Austrian economics – not as a serious student, but as an interested layman.

Within this most free-market of schools, one of many schisms is on the idea of free-banking.  I have spent considerable time on this topic, and have written several posts that directly or indirectly touch on this.

I have witnessed, via the internet, several debates on this subject – debates amongst those who acknowledge being within the Austrian camp.  On the one side is the unqualified free market; on the other is what I would call the conditional free market – the ring I described above, with free market money and credit backed by 100% gold reserves (or some similar derivation).

The internet is a wonderful tool to allow relationships to remain abstract and sterile.  Reading the viewpoints of those otherwise fully in the free market camp writing about a conditional free market in money seemed distant, somewhat clinical.

This abstraction was recently shattered for me, as I recently had the opportunity to discuss this topic in person with several people, all of whom to some degree fall into the free market camp – all Austrian-inclined.  I discovered that when the abstraction became a face, I would be shaken to my core.

How could individuals so pre-disposed to free markets not be accepting of a fully free market in money, banking, and credit?  I only read about this before; now I was staring it in the face.

This post is my attempt to summarize my views on an unconditional free market in money, banking and credit.  I will try not to repeat too much of what I have previously written (55 posts, as of this moment); I will link to earlier posts, when appropriate, for further detail and clarification.

Free Banking

I will start with a definition for free banking, taken from the Mises site:

Free Banking:

Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency (banknotes). In a free banking system, market forces control the supply of total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of "fiat" money issued by a central bank. In the strictest versions of free banking, however, there either is no role at all for a central bank, or the supply of central bank money is supposed to be permanently "frozen." There is, therefore, no agency capable of serving as a "lender of last resort" in the usually understood sense of the term. Nor is there any government insurance of banknotes or bank deposit accounts.

The concerns raised by those in the conditional free market camp regarding free banking include the possibility of credit expansion, expansion through fractional reserve practices.  Such expansion is inflationary and hence, destabilizing.  Further such a practice is fraudulent, as it suggests that two individuals have the same claim on the same asset at the same time.

Fractional Reserve Banking is Fraud

I will summarize my thoughts regarding the possibility of fraud first.  Fraud is one of those “I will know it when I see it” terms.  To me, if a product is represented as one thing, but in fact is another – and the false representation is done knowingly, this is fraud.  But even this is not so cut-and-dry.  Don’t cosmetics companies practice this regularly? 

To make a long story short, the deposit contract at a bank makes clear the practice of the bank – the bank is not holding your funds; your ability to receive withdrawal on demand is conditional.  Therefore, I find no fraud. 

“But wait,” the objection is raised, “the depositor believes his deposit is being held at the bank.  Surely this is an issue.”

People are want to believe many things – from Santa Claus to the fear that Muslims in a cave ten thousand miles away are within minutes of overrunning the United States.  Just because this is believed doesn’t make it so.

How is it possible that the bank is holding the depositor’s funds, and at the same time a) paying interest for the deposit and b) not charging a storage fee?  What possible business model can explain this?

The two posts that most directly touch on this issue are here and here.

Credit Expansion and Inflation

Now what of credit expansion, with the instability resulting in the boom and bust of inflation.  Both Mises and Rothbard have examined a market-based mechanism to check credit expansion; both have found such a mechanism to be quite effective.

Mises addressed this in Human Action, chapter 17, section 12:

Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular - one is tempted to say normal - feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.

Mises accepts the possibility of a slow inflation.  He also sees in this the only check to prevent inflation to become systemic.

Mises goes further, critical of the 100% gold standard:

But even if the 100 per cent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.

Does Mises not indicate here that a 100% standard would require government interference?  Whether he does or not, I will say it: a 100% standard cannot be achieved in a free market.  It will require government interference.  And, by definition, a government-forced standard can never be as stable as a market-enforced standard.  It certainly cannot be as free-market as a free-market standard.

Mises also suggests, almost word-for-word, the definition of free banking: “to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.”

What of Rothbard?  He addresses free banking in The Mystery of Banking, chapter VIII:

Fortunately, the market does provide a superb, day-to-day grinding type of severe restraint on credit expansion under free banking.  It operates even while confidence in banks by their customers is as buoyant as ever. It does not depend, therefore, on a psychological loss of faith in the banks.  This vital restraint is simply the limited clientele of each bank.  In short, the Rothbard Bank (or the Jones Bank) is constrained, first, by the fear of a bank run (loss of confidence in the bank by its own customers); but it is also, and even more effectively, constrained by the very fact that, in the free market, the clientele of the Rothbard Bank is extremely limited.  The day-to-day constraint on banks under free banking is the fact that nonclients will, by definition, call upon the bank for redemption.

As does Mises before him, Rothbard finds in free banking a perfectly capable check on credit expansion.

If markets prove perfectly capable of regulating a fully free market, why on earth do otherwise free market proponents reject the market as the regulating force?  Why make the free market conditional?  This is truly baffling to me – in fact stunning when I was confronted with the reality of faces (as opposed to the unreality of the internet).

To go further.  Hans Sennholz has written a wonderful book, entitled “Money and Freedom.”  There are so many valuable insights in this book, for example:

Currencies are sound, not as they are managed, but as they are free.  This essay urges reconstruction of the monetary order on the foundation of freedom.  It differs from all other reform proposals in both the simplicity and audacity of its objective: only freedom.

In a monetary order without legal tender and a money monopoly, there could be no inflation.  Printing and issuing new money would not raise the prices of goods and services, but would merely lower the exchange rate of the issue in terms of other competing moneys.  Good money would drive out bad money.

He recognizes that inflation will be kept in check via competition.  He sees a world where currencies will compete, with the good driving out the bad (and the exchange rate between the two advertising the market’s acceptance of either form).  How can he see this world unless he accepts that there will be different qualities of money?  They cannot all be 100% gold backed and still retain this feature, can they?

Sennholz offers his plan for monetary reform:

1)      Mint gold and silver coins denominated only by weight and purity.

2)      Repeal legal tender laws and permit specific performance of payments.

3)      Permit financial institutions to issue private notes, and permit banks to accept deposits denominated in foreign currencies and weights of gold and silver.

4)      Permit free entry into banking.

5)      Permit interstate banking.

6)      End mandatory membership in the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and any other agency or cartel.

7)      Prevent tax discrimination against all forms of money.

My list would not be nearly as long – allow free markets in money, credit and banking.  That’s all.  However, I will note that Sennholz does not require (nor can he, given his views on competing currencies) that currencies must be 100% gold-backed – or 100% backed by anything.

Finally, I turn to one other author, Faustino Ballvé and his book “Essentials of Economics.”  Chapter 5 examines money and credit:

In this way money accumulates in banks, and as depositors do not normally need to have all their money at their immediate disposal, banks pay them interest (with certain exceptions), the amount being smaller in the case of demand deposits, which can be withdrawn by the depositor at any time without prior notice, and larger in the case of time deposits, which are not payable before a definite date.  Keeping on hand only what is needed to provide for anticipated withdrawals, the banks lend the surplus, charging the borrowers a higher rate of interest in order to earn a profit and cover their risk…..

Here Ballvé broaches the subject of fractional reserve banking.  He does not state the nature of the contract between depositor and bank.  However he mentions without a hint of concern the idea that even demand deposits are to be loaned out.

I will argue that only the contract should define what is and isn’t permissible to the banker.

Conclusion

Free markets are fully capable of regulating the market for banking, money, and credit – on this Mises and Rothbard fully agree.  Yet many Austrians – the most free-market of the free-market schools of economics – can only go as far as the conditional free market – claiming that there should be free markets with 100% gold backing (or something similar).

Why conditional?  Mises and Rothbard suggest that free markets are fully capable of doing the heavy lifting.  What is so scary about free markets?