Free Banking

Free Banking: Theory, History, and a Laissez-Faire Model, by Larry Sechrest

This book, available as a free download from the Mises Institute, offers a thorough analysis and review of the free banking model.  As suggested by the sub-title, Sechrest covers the theory and history, as well as offering a comparison of the various free and relatively-free banking models.

Regular visitors to this site know that I favor a free-market in money and banking; this means a free-market: not conditional, not gold-backed, not 100% reserve – while these might emerge as options in a free-banking environment, I find no need to intervene beyond the cleansing work of the market.  It is in this distinction – free as opposed to conditionally free-banking – where I will focus in this review.  I will spend little time on the theory, as this primarily focusses on the comparison of free banking vs. central banking.  I will also not spend time on the history – the author offers an exposition of free banking in Scotland, where he offers a critique of White’s work, and free banking in America.

The book was originally written in 1993.  This edition is a reprinting, in 2008.  The preface to this edition offers some valuable insights.  It is here where I will begin.  In the preface, he calls attention to the work of several Austrian economists opposed to the free banking model, specifically regarding the requirement for holding 100% reserves:

This group is principally composed of certain Rothbardians associated with the Ludwig von Mises Institute, some of whom, by the way, I am pleased to think of as friends. It includes, among others, Walter Block, Jörg Guido Hülsmann, Hans-Hermann Hoppe, William Barnett II, and especially Jesús Huerta de Soto.  In what follows I will explain why I think their various condemnations of fractional reserve free banking (FRFB), despite their energetic efforts, remain unconvincing.

I too have found these efforts unconvincing; I expect I will find some common ground with Sechrest.  He begins with Huerta de Soto:

His massive 876-page treatise, Money, Bank Credit, and Economic Cycles (2006), is intended to be the final and decisive proof that fractional reserves are incompatible with a) a proper defense of private property rights, b) morality, and c) a stable economy. With painstaking effort he investigates legal theory, banking history, business cycles, and even variations in medieval theological doctrine. There is much to interest the curious reader, but a great deal is actually irrelevant to the author’s professed intent.  Further, one will repeatedly encounter, along with some careful scholarship, “straw man” arguments, nonsequiturs, and question-begging.

About a year or so ago I began reading this book by de Soto.  It was suggested to me as a definitive statement regarding the fraud of fractional reserve banking.  The version I have is 812 pages, before bibliography and end notes.  I got to page 66, then stopped – yes, sixty-six.  I haven’t picked it up since, until today for the purpose of this post.

Huerta de Soto begins well enough: in the preface to this edition, he explains well the reason for the bubble, the problems of central banking, etc.  He then suggests a cure, including a mandatory 100% reserve requirement on demand deposits and a return to the classic pure gold standard.  Of course, it is in this prescription where I disagree with de Soto, but then that is why I was reading his book – I wanted to understand the counter-position. 

Why only page 66?  The answer is found in Sechrest’s statement: “…a great deal is actually irrelevant to the author’s professed intent…. “straw man” arguments”

Much of de Soto’s discussion assumes that the deposit was a bailment.  But today’s deposit contract isn’t a bailment.  It is a loan.  Huerta de Soto suggests a loan must be for a stated time period – but why? 

Page after page, and often several times per page, the white space of my copy of the book is marked with my notes: What if the contract allows this?  Is this in violation of the contract?  Why can’t the contract rule?  This cannot last long without state backing, why not just focus on state backing?  What does the contract say? 

I decided I could read no further, the proper issues were not being addressed; the proper questions were not being answered.  Within 66 pages I seemed to recognize the flaw that Sechrest raised.  I set the book aside for a later time.  That time has not yet arrived.

Back to Sechrest:

In effect, Huerta de Soto defines demand deposits as a warehousing contract and then proceeds to provide many details on how that sort of contract has often been violated by banks.

But it doesn’t have to be a warehousing-type contract, does it?

Above all, Huerta de Soto refuses to even consider the possibility that banks’ customers may have been quite willing to face some risk exposure in exchange for the benefits of a) the receipt of interest on their deposits and b) having circulating inside money in the form of “payable to the bearer” banknotes (something 100 percent reserve banks are unable to provide, since they must charge security fees on all demand deposits).

This gets to one of the pillars upon which my conclusion about free banking rests, and more so, that (outside of government intervention) today’s fractional reserve banking is not fraudulent – how is it possible that a bank pays interest and does not charge for storage for deposits that supposedly are being held for the sake of the depositor?  Of course, it cannot be, and the contract is clear that it isn’t. 

Sechrest goes on to critique the work of Jörg Guido Hülsmann, in his article “Has Fractional-Reserve Banking Really Passed the Market Test?” (The Independent Review, Winter 2003).

Instead of continuing one by one through these proponents of 100% reserve banking, Sechrest approaches the themes common to the critics of fully free banking:

Found in both of these above mentioned essays, and most if not all, other defenses of 100 percent reserve banking are three problematic assertions. The first is the assumption that any departure from 100 percent reserves cannot be agreeable to the bank’s customers and thus constitutes an act of fraud on the part of the banker. As a result, all the historical episodes in which banks began as money warehouses but later acted as intermediaries holding fractional reserves are immediately interpreted as being rooted in criminality. The obvious alternative possibility, that fractional reserve holding might have naturally evolved as an improvement on warehousing is rejected out of hand.

I will leave out the second and third assertions, as I do not fully understand the subjects presented.  However, in this first it seems plausible – and I certainly can see the practice being developed in a free market – that depositors could be willing to take some minor risk in exchange for some interest return and avoidance of storage fees. 

Next, from the Forward by Kevin Dowd:

Free banking is – or at least ought to be – one of the key economic issues of our time…. Unlike some disasters, monetary instability is entirely avoidable, but to avoid it, we need to make sure the monetary system is built on the right foundations….

The right foundation, I insist, is one derived in the market - unconditional.

…central planning does not, and cannot, work.

A requirement of 100% reserve banking, with or without gold as the backing, is an intrusion in the free market.  It requires central planning.

Sechrest defines free banking:

Free banking’s most obvious features are (1) the absence of any central monetary authority and (2) the issuance of notes as well as deposit account by individual private banks.

…a “pure” free banking system (which has never existed) would be one in which there were (1) no governmental restrictions on entry or exit by firms into and out of banking, (2) no restrictions (other than enforcement of valid contracts) on the issue of notes as well as deposit accounts by financial insitutuions, (3) no central bank acts as an ex ante lender of last resort, (4) no governmental deposit insurance, (5) no statutory reserve requirements, (6) no minimum capital requirements, (7) no restrictions on branching, (8) no restrictions regarding the kinds of activities in which a bank might engage, such as the underwriting of corporate stock or bond issues, and (9) no interest rate controls.  In short, free banking means the total deregulation of the banking industry.  It is the thorough application of the principles of laissez faire to the one realm of economic activity where even the most “free market” economists have assumed such principles cannot be applied: money and banking.

The only statement I emphasize in bold in this entire post is the one above.  Why do free market advocates not advocate for the free market?  I described in my earlier post on this subject the struggle I had when confronted with such positions in person as opposed to solely in this virtual world.  Yes, it is stunning for me.

I move ahead to Chapter 7.  In this chapter, Sechrest examines what he describes as the Rothbard-Mises (RM) approach:

Rothbard adopts this position [fractional reserve banking as fraud] because he insists that banknotes and deposit credits are (or should be) warehouse receipts, both legally and economically.  That is, he perceives the proper role of banks to be that of warehouse than financial intermediary.  The act of depositing funds in a commercial bank and receiving in return either banknotes or a deposit credit is not, to Rothbard, a credit transaction.  The depositor is not loaning his or her funds to the banker, but merely hiring the banker’s vault as a place of safekeeping for valuable assets.  Rothbard declares that depositing money in a bank should be perfectly analogous to storing one’s furniture in a warehouse.  In other words, the banker should be dealt with as a bailee rather than as a debtor.

I will admit, I have not read much of Mises directly.  I am not familiar with Mises taking this same view – perhaps a reader can point me to where.  I am familiar with Mises’ view on unconditional free banking.  He seems to consider it a valid proposition.

However, as to Rothbard: This is what I do not understand in Rothbard’s position and those who hold to it.  My question is simple: Why?  Why must deposits be considered as warehouse receipts?  Why must a bank only act as a warehouse?  Why cant the deposit receipt be for a loan instead of a warehouse receipt?

Why?  I am yet to find a satisfactory answer.  Anywhere.

…the RM model does not honor consumer preferences.  Choices as to reserve ratios, redemption contracts, and the nature of base money should be left to the unconstrained interaction between banks and their customers if one claims to be proposing a truly free market approach to banking.  The RM model declares that to have a nonfraudulent banking system, one must have a specie base, 100 percent reserves and immediate redemption upon demand.

Why?  Can’t one who wants such a contract – specie based, fully reserved and immediate redemption – not contract for this if desired? Can those who desire something else not contract for something else?  Why must all be required to contract for this?

Sechrest continues:

The bank run plays a special role according to Rothbard.  Unlike the overwhelming majority of economists, he views bank runs favorably.  They function as a constraint on inflationary monetary expansion under free banking.

While I cannot say that I view bank runs “favorably,” on the whole I agree with this statement regarding Rothbard’s position.  It is the threat of a bank run that provides the discipline to banking.  A market based discipline, one that is elusive, if not impossible to achieve via requirements such as 100% reserves.  Such requirements, possible only through government intervention, can and will be just as easily circumvented by government intervention.

Finally (at least for my purposes), Sechrest addresses the assumption that free banking and inflation go hand in hand:

This belief appears to be based on the premises that (1) consumers are willing to use any banknotes that are issued; that is, they are indiscriminate; (2) there are no mechanisms within free banking that would constrain the over issue of notes….

He notes that inflation was not a concern during the relatively free-banking era in America.  Suffice it to say, both Mises and Rothbard have written convincingly (to me at least) that the market is the best regulator of inflation.  Sechrest adds his voice to this:

…to propose that consumers would voluntarily use any currency that had depreciated in value (purchasing power) is to suppose that consumers would not act in their own self-interest.

He goes on to suggest that keeping the notes in circulation is of value to the bank.  To do this, the bank’s reputation is important.  Depreciating notes are not reputation-enhancing!

In the end, I return to where I began.  I find no reason for conditional free-banking, beyond normal contract law.  Sechrest’s work adds further foundation to my view, and corroborates my criticism of the view that banking must be based on 100% reserves.