FREE BANKING: A PRIVATE ORDER, A PUBLIC GOOD
Can international monetary order be maintained with the provision of money under private institutions?
Abstract
Contemporary International Political Economy accepts that monetary order can only exist with the direct intervention of states and overlooks the possibility that firms, operating under a Free Banking system, can maintain monetary stability better than any central bank monopoly supported by the state. This paper proposes that the competitive 'Market Process' is economically superior to state planning authorities and concludes that private institutions can manage at least one function of state power: the provision of money.
Introduction
The evolution of our monetary system over the last three millennia reflects a tension between two conflicting forces. One is the competitive search for lowercost media of exchange; the other is the desire of the state to monopolise the supply of money. -David Glasner, 1990.
Money is not an 'invention' of the state, nor has its issuance been the exclusive domain of a central planning authority controlling the volume, the quality and the cost of its use. In the last century, debates in Britain, Europe and the US freely discussed the benefits of opening the provision of money to competition.[1] However, the general acceptance of central bank monopolies by economists and policy makers this century, extinguished intellectual debate regarding 'Free Banking'. Few dared to suggest the abandonment of state planning over the monetary system, for fear of being labelled as 'cranks'. Nevertheless, given the economic incompetence of central banks, the debates of the past have been rekindled since the publication of Hayek's Denationalisation of Money (1978) spurred many economists to challenge to the idea of state money. The re-emergence of the 'Free Banking School' and the validity of their arguments has become part of mainstream economic debate[2] yet, scholars of International Political Economy (IPE) have neglected to address it, or have simply dismissed it without having made adequate research in the field. This paper hopes to serve as an introduction to students of IPE about the theory of Free Banking and its repercussions on the dichotomy between states and markets in the international system.
To expand the debate on free banking and make a case against the monopoly provision of money by the state, this paper will 1) look at the relationship between states and money; 2) outline the negative economic effects of central banking; 3) establish the theoretical foundations of Free Banking and present relevant historical evidence; 4) address the most important counter-arguments; and 5) explain the function of the 'Market Process' and make a case for an international spontaneous banking order. However, before embarking on a theoretical exposition about states and markets, we must first define 'money' and its economic role.
Money
It is important to understand what money is before determining if it can be open to competition. To many, money only represents the 'legal tender' notes and coins used to purchase goods and services. Thus, money is classified as a physical token of exchange endorsed by government fiat. However, the real definition of money is more complicated as it can incorporate coins, notes, bank accounts and scores of monetary instruments. It is for this reason that the US Federal Reserve has more than forty definitions and the Bank of England's monetary aggregates vary from M0 to M5 and upwards.[3] Therefore, for the purposes of this paper, it is better to define money by its function, rather than its form and establish the crucial role it plays in the economy.
Primarily, money acts as a medium of exchange and from this property it also acts as a unit of account and a store of value.[4] Money evolved spontaneously to facilitate trade between individuals involving a wide variety of goods and services, because it was the most tradable and liquid of all commodities. As it was the most tradable good, it became the unit of account from which the value of all other goods in the market is known. Thus, it is the benchmark to which all commodities are measured against and establishes itself as the price index from which economic calculation is possible. Without it the market cannot coordinate itself and economic chaos ensues.
If the money used does not have a stable value it cannot be successful in coordinating the subjective preferences of individuals into an objective exchange mechanism.[5] Consequently, if money is to provide its optimal service to mankind it must have a stable value.[6] Thus, when comparing a monopolistic against a competitive system of money the litmus test will rest on its ability to maintain a stable value.
But why is a 'stable value' the desirable for economic calculation? The reason is that it helps to minimise the effects of unavoidable uncertainty, derived from the inability of individual men, or centralised authorities, to harness the decentralised knowledge of the market, or even predict the future with all available information.[7] So, through the price mechanism, which entrepreneurs use to allocate scarce resources, money is a vital source of information. As will be made clearer below, the firm in a competitive environment is the best institution available for reducing future uncertainty and delivering better information to the market; and it is part of the reason why the value of money is more efficiently maintained by firms -- especially in the international system where knowledge is more dispersed and transaction costs higher. Thus, stability is a prerequisite for the promotion of international commerce.
States and Money
The historical relationship between states and money has led to the politicisation of economic exchange. Although money was a spontaneous development in the evolution of capitalism, it was not long before monarchs and sovereign states attempted to control it for political aims. By controlling the supply of money, states could arrange interest-free debt finance and increase their purchasing power to fulfil the desires of political leaders and their supporters.
Originally, monopolistic privileges were granted to banks which helped to fund the state's war-making capacity.[8] "...Money was the prerequisite of institutionalised state-directed violence and therefore, of political authority itself".[9] Therefore, the key rationale for the establishment of central banks was based on the need for immediate war finance in a crisis: to repel invaders or conquer foes. The self preservation of states in the international system demanded it.
To prevent runs on their banks during times of crisis, states introduced 'legal tender' laws; making their notes the exclusive means for the payment of taxes and giving such money the special power not to be refused by any creditor. This privilege allowed the central bank to preserve specie stocks by releasing it from maintaining convertibility because, unlike other banks, it can force the nation to accept its money. Open competition in the provision of money would compromise state revenue. Thus, competing banks had to be eliminated, or restricted, to prevent the public from exercising its right to lose confidence in the state bank and redeem notes for specie.
In their urgent need for money, states have several means for exploiting their monopoly: 1) generate a flow of seignorage by imposing charges at the mint, 2) extract wealth from holders of its money and debt by unexpectedly devaluing the currency or, 3) by causing unanticipated inflation with a sudden monetary expansion. All the manipulations above can yield large and immediate short-lived returns.[10]
Nevertheless, the situation outlined above has changed in two ways: 1) the ability of states to reap maximum seignorage has been eroded and 2) the nature of modern warfare no longer requires a monetary monopoly to pay for self-defence.
First, the real value of the monetary base (the sum of currency held by the public and the reserves held by the banking system) has fallen as financial regulatory reform has produced alternatives to government currency and regulated deposits. These changes have produced three effects:
• It has reduced the maximum onetime wealth transfers the government could extract.
• It has reduced the maximum steady flow of seignorage that the monopoly can generate.
• It has reduced the rate of inflation that would yield that maximum seignorage revenue.[11]
Secondly, financial innovation, particularly in sovereign debt, allows states to borrow money more efficiently from international capital markets; taking advantage of the services of private banks to repackage debt and sell it under the most attractive terms possible. So, in order to borrow, a state can use money markets to attract investors around the world, rather than just within its limited jurisdiction.
Furthermore, the nature of war has changed as technology and international defensive structures have become more complex and interdependent, thereby eliminating the need for a state monetary monopoly. Different military components and resources are decentralised across the globe, so no single state can wage a modern conventional war for long without relying on other states. International defence agreements like NATO also ensure that resources and military units are pooled to defend member states, reducing the burden of unilateral action and decreasing the threat of external aggression. Also, small scale conflicts do not require immediate financing and current military expenditures can be met within present government budgets. Clearly the maintenance of a standing army requires taxation, but it does not justify the monopoly of money.
Finally, for military powers, nuclear weapons have become the ultimate form of deterrent; and since the weapons to be used in a nuclear conflict must be prepared in advance, the monopoly is not well suited for paying for those weapons either. Nuclear technology has radically altered the necessity for immediate war finance.
If one can agree that the changes above have altered the justification for a monetary monopoly, then one must consider the Free Banking alternative. However, before doing that, this paper will lay down the short-comings of central banking.
The Defects of Central Banking
Although the control of money by states was justified by war, it is during peace that central banks cause the greatest amount of distortion in economic activity. In brief, central banking is a system in which one bank has "complete or residuary" monopoly in note issue, controlling the bulk of circulation and the total amount of currency and credit.[12] Being the 'guardian' of the system, as a lender-of-last-resort, it protects specie or note reserves, forcing the state's money upon the public in times of crisis, with legal tender laws.
Contrary to some beliefs, a central bank is not the 'natural' product of banking development. The historical evidence points to the fact that government interference either inadvertently gave one bank a privileged position, using entry barriers and regulation, as with the Bank of England prior to 1844, or simply granted a monopoly to a single bank by edict, with the explicit desire to control the money supply for political ends.[13] Nevertheless, Goodhart argues that central banks are "natural" because "the natural process of centralisation of inter-bank deposits, tends to lead to a banks 'club', which needs an independent arbiter".[14] But even by his own account, the centralising forces were not the 'natural' product of laissez faire. Centralisation followed from state regulation on the banking system, particularly through monopoly note issue and the restriction of branch banking and joint-stock ownership.
Looking at the historical accounts, as this paper will do in following sections, there is no evidence of 'market failure' in the Free Banking system that emerged centuries ago. A central authority was imposed on private banks, not to correct 'failures', but to finance government debt. Yet, even if market failures exist, they are dwarfed by the size of 'government failure' in the provision of money.
The Knowledge Problem
"The Bank of England and other central banks have a record of losses comparable to those of the worst managed nationalised trading companies".[15] This failure stems from the inability of a central authority to make successful economic calculations because it cannot gather enough information to coordinate the market. It is the pivotal contention of this paper that without the 'Market Process', dispersed information and knowledge cannot be channelled to a central body for effective policy making. This leads to greater transaction costs by generating uncertainty in both domestic and international markets. It is for this reason that state planning fails in both theory and practice and central banks cannot deliver a currency of stable value.[16]
Although many economists like Milton Friedman, extol the virtues of competition in goods and services, they make money an exception, entrusting a central planning authority to direct it towards its most efficient needs. The question then is, how can it determine the quantity and price (interest rate) of money when it is separated from the market process? To calculate actions, central banks have adopted a macroeconomic approach that relies on aggregate measurements of money (M0 - M5), prices (inflation) and production (GDP). As David Simpson argues in The End of Macroeconomics, the theories supporting central bank policies have failed to provide the necessary information because they
...make unwarranted assertions about the stability of empirical relationships between aggregates, assume their unchanging composition, abstract from essential elements of economic activity, and use concepts out of context.[17]