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Let’s not ban private money

Posted By Kevin Dowd On May 10, 2014 @ 10:45 pm In Digital Money,Economic History,Free Banking | 13 Comments

[originally posted at the Institute for Economic Affairs on 6 May 2014]

In a recent Financial Times article Martin Wolf announced his conversion to the view that private banks should be stripped of their ability to create money. The proposal to end private money is an old idea that periodically resurfaces in the history of economic thought, typically during crises of confidence in mainstream economic thinking when the conventional wisdom becomes discredited. An early example was the early 19th century Currency School; they succeeded in implementing it in the form of the Bank Chart Act of 1844, which imposed a 100 per cent marginal reserve requirement on the note issue and effectively gave the Bank of England a monopoly of the note supply. Later versions included the Chicago Plan advocated by Irving Fisher and Henry Simons in the 1930s; and it has surfaced repeatedly in the recent financial crisis. These more modern versions boil down to monopolising the issue of bank deposits through a 100 per cent reserve requirement.

Its proponents make extraordinary claims for it: it would slash public debt, stabilise the financial system, make the banking system run-proof and make it much easier for the government to achieve price stability. If these claims seem too good to be true, it is because they are.

In essence, this proposal is just another instance of what Ronald Coase once derided as ‘blackboard economics’ – a scheme that works well on the blackboard, but does not actually work in the real world because the economy never works the way its proponents imagine it to.

The Bank Charter Act is a perfect example. The note issue restrictions of the Act were supposed to ensure banking stability based on the premise that the underlying cause of instability was an unstable private note supply. However, it soon became apparent these restrictions created additional instability of their own, as they suppressed the note issue elasticity that previously worked to calm markets. In subsequent years – 1847, 1857 and 1866 – crises erupted that were only resolved when these note issue restrictions were temporarily suspended. The Bank Charter Act was, thus, a failure.

A second problem with the proposal to prohibit private money is that it would seriously impact the credit system because it would entail a massive switch in bank assets from private lending to government securities. Bank lending to the private sector would go to zero and banks would then exist primarily to finance government. Mr. Wolf acknowledges the issue, but almost casually dismisses it on the grounds that ‘we’ could find new (non-bank) channels to finance investment, as if the problem were easily resolved. These new credit channels would take time to emerge, however, and in the meantime the provision of credit would be to a large extent stopped in its tracks. This amounts to hitting our already fragile credit system with a sledgehammer and would probably be enough to push the economy into a depression.

But perhaps the biggest problem with any proposals to prohibit private money is not practical but intellectual: they are based on a mistaken view of the causes of economic and financial instability. Major fluctuations are not caused by volatile behaviour on the part of the private sector, but by government or central bank interventions that have destabilised the economy again and again. The Currency School is a case in point; it overlooked the point that the main causes of instability were the erratic policies of the Bank of England and the restrictions under which other banks were forced to operate. As a result, they applied the wrong medicine which then didn’t work.

More recent government interventions have created further instability: the botched policies of the Federal Reserve were the key factors behind the length and severity of the Great Depression; deposit insurance and the lender of last resort have created major incentives for banks to take excessive risks; and erratic monetary policies have greatly destabilised the macroeconomy over much of the last century. As Milton Friedman observed back in 1960:

The failure of government to provide a stable monetary framework has…been a major if not the major factor accounting for our really severe inflations and depressions. Perhaps the most remarkable feature of the record is the adaptability and flexibility that the private sector has so frequently shown under such extreme provocation.

So let’s challenge the conventional wisdom by all means, but proposals to prohibit private money are based on a false diagnosis and go in the wrong direction. The problem is not the instability created by private money, but rather the instability created by government intervention into the monetary system. Government money is not the solution; it is the problem.

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