Alt-M Ideas for an Alternative Monetary Future Fri, 31 Jul 2015 20:32:06 +0000 en-US hourly 1 Reserve Requirements Basel Style: The Liquidity Coverage Ratio Fri, 31 Jul 2015 18:03:38 +0000 Over the last couple of decades, reserve requirements all but vanished as a means of bank regulation and monetary control.  But now a new variation on reserve requirements is being introduced through the capital controls of the Basel Accords. Canada, the UK, Sweden, Australia, New Zealand, and Hong Kong have...

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Shawneetown bankOver the last couple of decades, reserve requirements all but vanished as a means of bank regulation and monetary control.  But now a new variation on reserve requirements is being introduced through the capital controls of the Basel Accords.

Canada, the UK, Sweden, Australia, New Zealand, and Hong Kong have all abolished traditional reserve requirements.  In many other countries, reserve requirements have become a dead letter.  In the U.S., for instance, the Fed under Alan Greenspan reduced all reserve requirements to zero except for transactions deposits (checking accounts), while permitting banks to evade reserve requirements on transactions balances by using sophisticated computer software to regularly “sweep” those balances into money market deposit accounts, which have no reserve requirement.  In 2011 Congress went a step further by allowing the Fed to eliminate all reserve requirements if it so desired. The Eurozone, for its part, began with a reserve requirement of only 2 percent, which was reduced to 1 percent in January 1999.

There were good reasons for this deregulatory trend.  Economists consider reserve requirements an implicit tax on banks, requiring them to hold non-interest earning assets, while central banks considered changes in such requirements too blunt an instrument for monetary control.  The Fed discovered the latter shortcoming when, in the midst of the Great Depression, having just gained control over the reserve requirements of national banks, it doubled them, contributing to recession of 1937.

Ostensibly designed to keep banks more liquid, reserve requirements can prevent them from drawing on their liquidity when it is most needed.  As Armen A. Alchian and William R. Allen point out in University Economics (1964): “To rely upon a reserve requirement for the meeting of cash-withdrawal demands of banks’ customers is analogous to trying to protect a community from fire by requiring that a large water tank be kept full at all times: the water is useless in case of emergency if it cannot be drawn from the tank.”

As reserve requirements became less fashionable, advocates of more stringent bank regulation resorted instead to risk-based capital requirements, as implemented through the international Basel Accords.  More recently the increasingly widespread practice of paying interest on bank reserves has also given central banks an alternative and less burdensome means for inducing banks to hold more reserves.

But in Basel III, agreed upon in 2010-2011, there appeared a new kind of liquidity requirement that mimics reserve requirements in many respects.  Known as the “Liquidity Coverage Ratio” or LCR, it requires banks to hold “high quality liquid assets” (HQLA) sufficient to cover potential net cash outflows over 30 days.  In September 2014 the Fed, the Comptroller, and the FDIC finalized the rule implementing the Liquidity Coverage Ratio.  The rule, which took effect at the beginning at 2015, must be fully complied with by January 2017.

Far from involving a simple ratio, as earlier reserve requirements did, the Liquidity Coverage Ratio is extremely complicated, filling 103 pages in the Federal Register.  The rule does not apply to small community banks but instead to banks with more than $250 billion of assets, with a modified rule applying to the holding companies of both banks and savings institutions.  The Fed also plans to impose a similar rule on non-bank financial institutions.  But because a variant of the rule applies to bank holding companies on a “consolidated basis,” the Liquidity Coverage Ratio already affects most major investment banks, which are owned by bank holding companies.

Unlike traditional reserve requirements, the Liquidity Coverage Ratio does not call for any minimum quantity of cash reserves.  Instead, it calls for a minimum quantity of various high quality liquid assets.  Weighting bank assets according to their maturity, marketability, and riskiness, the LCR even counts as high quality some forms of corporate debt at half of face value.  The LCR also differs in being applied, not just to bank deposits, but to nearly all bank liabilities, including large CDs, derivatives, and off-balance sheet loan commitments, according to their maturity.

In short, the Liquidity Coverage Ratio is designed to reduce maturity mismatches for large financial institutions in order to protect against the kind of panics in the repo and asset-backed commercial paper markets that occurred during the financial crisis of 2007-2008.  In any case, the rule will still require banks to hold more reserves or short-term Treasury securities than they otherwise might prefer.  Since the rule was under discussion by 2010, it could be another reason—along with interest on reserves and capital requirements—why U.S. banks have continued to hold more than 100-percent reserves behind M1 deposits.

Every time there is a financial crisis, the proposal to force banks to hold higher reserve ratios, if not 100-percent reserves, resurfaces.  During the Great Depression, this proposal went under the name of the Chicago Plan and even received support from Milton Friedman in his early writings.  The proposal was called “narrow banking” during the savings and loan crisis.  Since the recent crisis, it has been advocated in one form or another by such economists as Laurence Kotlikoff of the Boston University, John Cochrane of the University of Chicago, and Martin Wolf of the Financial Times. All of these proposals hinge on the government paying interest on bank reserves.

The new Liquidity Coverage Ratio in one sense is less restrictive than these proposals but in another is more so.  It is less restrictive in that it allows deposits to be covered by liquid securities other than cash equivalents, and in that sense is a bit reminiscent of the discredited real-bills doctrine that insisted the banks should make only short-term, self-liquidating loans.

But the Liquidity Coverage Ratio is more restrictive than conventional reserve requirements in so far as it applies to a much broader range of bank liabilities.  Unlike such requirements, it is striving to prevent banks from engaging in significant maturity transformation, which involves bundling and converting long-term securities into short-term securities.  That makes it closest in spirit to Cochrane’s reform proposal, which combines a 100-percent reserve requirement for deposits with a 100-percent capital requirement for all other bank liabilities.  Cochrane’s proposal really would eliminate all maturity mismatches; indeed, it would make all banks resemble combinations of safe-deposit businesses on the one hand and mutual funds or, for that matter, Islamic banks, on the other.

Will the Liquidity Coverage Ratio ultimately work? Although the question requires further thought and study, I doubt it.  Several monetary economists, considering the rule’s implementation in Europe (here and here), are more optimistic than I am, and a few even think that it will not be restrictive enough.  But they may be overlooking the long-term downsides.

As with so many past banking regulations, this one could ultimately end up being non-binding. Banks may find loopholes in the rule, or may innovate around it, and the rule’s very complexity and supposed flexibility is likely to make doing these things easier.  On the other hand, when the next financial crisis hits, by hobbling a bank’s discretionary control over its balance sheet, the rule may well exacerbate the crisis.  To the extent that the rule is binding, it changes the fundamental nature of banking in a way that may curtail efficient financial intermediation.  Whatever happens, it definitely increases the government’s central planning of the allocation of savings.  In the final analysis, it is another futile attempt to use prudential regulation to overcome the excessive risk taking resulting from the moral hazard created by deposit insurance and too-big-to-fail.

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There Was No Place Like Canada Wed, 29 Jul 2015 13:04:26 +0000 Speaking of myths about U.S. banking, another that tops my list is the myth that the Federal Reserve, or some sort of central-bank-type arrangement, was the best conceivable solution to the ills of the pre-1914 U.S. monetary system. I encountered that myth most recently in reading America's Bank, Roger Lowenstein's...

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Canada, banking system, currencySpeaking of myths about U.S. banking, another that tops my list is the myth that the Federal Reserve, or some sort of central-bank-type arrangement, was the best conceivable solution to the ills of the pre-1914 U.S. monetary system.

I encountered that myth most recently in reading America's Bank, Roger Lowenstein's forthcoming book on the Fed's origins, which I'm reviewing for Barron's.  Lowenstein's book is well-researched and entertainingly written.  But it also suffers from an all-too-common drawback:  Lowenstein takes for granted that those who favored having a U.S. central bank of some kind (whatever they called it and however they chose to disguise it) were well-informed and right-thinking, whereas those who didn't were either ignorant hicks or pawns of special interests.  He has, in other words, little patience with history's losers, whether they be people or ideas.  Like other "Whig" histories, his history of the Fed treats the past as an "inexorable march of progress towards enlightenment."

Don't get me wrong: I'm no Tory, and I certainly don't think that the pre-Fed U.S. monetary system was fine and dandy.  I know about the panics of 1884, 1893, and 1907.  I know how specie tended to pile-up in New York after every harvest season, and that by the time it got there not one but three banks were likely to reckon it, or make claims to it, as part of their reserves.  I also know how, when the harvest season returned, all those banks were likely to try and get their hands on the same gold, and how this made for tight money, if it didn't spark a full-scale panic.  Finally, I know that one way to avoid such panics, on paper at least, was to establish a central bank, or "federal" equivalent, capable of supplying banks with emergency cash when they needed it.

Yet I still think that the Fed was a lousy idea.  How come?  My reason isn't simply that the Fed turned out to be quite incapable of preventing financial crises, though that's certainly true.   It's that there was a much better way of fixing the pre-Fed system.  That alternative was perfectly obvious to many who struggled to reform the U.S. system in the years prior to the Fed's establishment.  It could hardly have been otherwise, since it was then almost literally staring them in the face.  But it should be equally obvious even today to anyone who delves into the underlying causes of the infirmities of the pre-Fed National Currency system.

What were these causes?  Essentially there were two.  First, ever since the Civil War state banks were prohibited from issuing circulating notes, while National banks could issue notes only to the extent that they backed them with specified U.S. government bonds.  Those bonds were getting harder to come by (by the 1890s National banks had already acquired almost all of them).  What's more, it didn't pay for National banks to acquire the costly securities just for the sake of meeting harvest-time currency needs, for that would mean incurring very high opportunity costs for the sake of having stacks of notes sitting idle in their vaults for most of the year.

The other, notorious cause of trouble was the fact that most U.S. banks, whether state or National, didn't have branch networks of any kind.  Instead, ours was for the most part a system of "unit" banks.  This was so mainly owing to laws that prohibited them from branching, even within their own states.  But even had branching been legal, the restrictions on banks' ability to issue notes would have made it less economical by substantially raising the cost of equipping bank branches with inventories of till money.[1]

That unit banking limited U.S. banks' ability to diversify their assets and liabilities, and thereby made the U.S. banking system much more fragile than it might have been, is (or ought to be) well-appreciated.  Unit banking also encouraged banks to deposit their idle reserves with "reserve city" correspondents, who in turn sent their own surplus cash to New York.  The National Banking Acts actually encouraged this practice by letting correspondent balances satisfy a portion of banks' legal reserve requirements.  The set-up kept money gainfully employed when it wasn't needed in the countryside; but it also made for a mad scramble when cash was needed back home.

Far less well appreciated is how unit banking also contributed to the notorious "inelasticity" of the pre-Fed U.S. currency stock.  Before I explain why, I'd better first lay another myth to rest, which is the myth that complaints concerning the "inelasticity" of the pre-Fed currency stock were a hobbyhorse of persons who subscribed to the "real-bills" doctrine  — that is, the view that the currency supply could and should wax-and-wane in concert with the total quantity of "real bills" or short-term commercial paper presented to banks for discounting.

It's true that many persons who complained about the "inelastic" nature of the U.S. currency system, including many who were instrumental in designing (and later in managing) the Federal Reserve System, also subscribed to the real bills doctrine, and that that doctrine is mostly baloney.  But that doesn't mean that the alleged inelasticity of the U.S. currency stock was a mere bugbear.  The real demand for currency really did vary considerably, especially by rising a lot — sometimes by as much as 50 percent — during the harvest season, when migrant workers had to be paid to "move" the crops.  And U.S. banks really were unprepared to meet such increases in demand by issuing more notes, even if doing so was only a matter of swapping note liabilities for deposit liabilities, owing to the legal restrictions to which I've drawn attention.  In short, you don't have to have drunk the real-bills Kool-Aid to agree that the pre-Fed U.S. currency system wasn't capable of meeting the "needs of trade."

How, then, did unit banking contribute to the problem of an inelastic currency stock?  It did so by considerably raising the cost banks had to incur to redeem rival banks' notes, and thereby limiting the extent to which unwanted banknotes made it back to their issuers.  In a branch-banking system, note exchange and redemption are mostly a local, and therefore cheap, affair; add a few regional clearinghouses to handle items not settled locally, and you've got all that's needed to see to it that unwanted currency is rapidly removed from circulation.

In the U.S., on the other hand, banks had to bear substantial costs of sorting and shipping notes to their sources, or to distant  clearinghouses, which costs were made all the greater by the sheer number of National banks — tens of thousands, eventually — and resulting lack of economies of scale.  These factors would normally have caused National banks to accept the notes of distant rivals at discounts sufficient to cover anticipated redemption costs, as antebellum state banks had been in the habit of doing.  The authors of the 1863 and 1864 National Banking Acts were, however, determined to give the nation a "uniform" currency.  Consequently they stipulated that every National bank had to accept the notes of all other national banks at par.  That got rid of note discounts, sure enough.  But it also meant that National banknotes would no longer be actively and systematically redeemed.[2]  As I like to say, any fool can fix most any problem — so long as he ignores the others.

If my dog is limping, and I discover that she's got a pebble wedged between her paw pads, I don't think of calling for a team of stretcher bearers: I just pull the pebble out.  In the same way any reasonable person, knowing the underlying causes of the infirmities of the pre-Fed U.S. currency system, would first consider removing those causes.  And that was precisely what many advocates of currency reform tried to do before any dared to suggest anything like a U.S. central bank.  That is, they tried to get bills passed — there must have been at least a dozen of them — calling for some combination of (1) repeal of the bond-backing requirement for National banknotes; (2) allowing National banks to branch, and (3) restoring state banks' right to issue currency.  The restrictions on note issue had, after all, been put into effect for the sake of helping the Union government fund the Civil War — a purpose now long obsolete.  The restrictions on branching, on the other hand, were widely understood to be another deleterious consequence of the unfortunate decision to model the National Banking Acts after earlier, state "free banking" laws.

Might deregulation  alone, as was contemplated in such "asset currency" reform proposals (so-called because they would have allowed banks to issue notes backed by general assets, rather than by specific securities),  really have given the U.S. a perfectly sound and stable currency and banking system?  Yes.  How can I be so confident?  Because it would have given the U.S. a currency system like Canada's.  And Canada's system was, in fact, famously sound and famously stable.[3]

"Don't mention the war!"  is what Basil Fawlty tells his staff, out of concern for the sensibilities of his German guests.  (Basil himself nevertheless can't help referring to it again and again.)  "Don't mention Canada!" is what a Whig historian of the Fed must tell himself, assuming he knows what went on there, lest he should broach a topic that would muddle-up his otherwise tidy epic.  For to consider Canada is to realize that there was, in fact, no need at all for all the elaborate proposals, hearings, secret meetings, and political wheeling-and-dealing, that ultimately gave shape to the Federal Reserve Act, if all that was desired was to equip the United States with a currency system worthy of a nation already on its way to becoming an economic powerhouse.  Like Dorothy's ruby slippers, the solution to the United States' currency ills had been there all along.  Legislators had only to repeat to themselves, "There's no place like Canada," while taking steps that would tap obstructive legal restrictions out of the banking system.

Of course that didn't happen, thanks mainly to a combination of banking-industry opposition to branch banking and populist opposition —  spearheaded by William Jennings Bryan — to any sort of non-government currency.  "Asset currency" was, if you like, "politically impossible."

So reformers at length turned to the alternative of a central bank.  And how was that supposed to work?  Though buckets of ink have been spilled for the sake of offering all sorts of elaborate explanations of the "science" behind the Federal Reserve, the essence of that solution, once considered against the backdrop of the "asset currency" alternative, couldn't have been simpler.  It boils down to this:  instead of allowing already existing U.S. banks to branch and to issue notes backed by assets other than government bonds, the government would leave the old restrictions in place, while setting up a dozen new banks that would be uniquely exempt from those restrictions.  If National banks (or state banks, if they chose to join the new system) wanted currency, but lacked the necessary bonds, they still couldn't issue more of their own notes no matter what other assets they possessed.  But they might now take some of those other assets to the Fed, to exchange for Federal Reserve Notes.  The Fed was, in short, a sort of stretcher corps for banks lamed by earlier laws.

To an extent, the more centralized reform resembled an asset currency reform one step removed.  But there were two crucial differences.  First, by setting the "discount rate" at which they would exchange notes for commercial paper and other assets, the Federal Reserve Banks could either encourage or discourage other banks from acquiring their notes.  Second, because member banks could count not just gold and greenbacks but Fed liabilities as reserves, the Fed's discount rates influenced the overall availability of bank reserves and, hence, of money and credit.  These differences, far from having been innocuous, were, as we now realize, portentous.

Still the Fed did have one incontestable advantage over previous reform proposals. For it alone was politically possible.  It alone was a winning solution.

But the fact that the Fed won in 1913 doesn't mean that other, rejected options aren't worth recalling.  Still less does it warrant treating the Fed as sacrosanct.  History isn't finished.  Just a few years before the Federal Reserve Act was passed, most people still believed that Andrew Jackson had put paid once and for all to the idea of a U.S. central bank.  Today most people still consider the Federal Reserve Act the last word in scientific monetary control.  As for what most people will think tomorrow, well, that's partly up to us, isn't it?

[1] Although they typically appreciate the debilitating consequences of unit banking, many U.S. economists and economic historians appear unaware of the crucial role that freedom of note issue played historically in facilitating branch banking.  That banking systems involving relatively few restrictions on banks' ability to issue banknotes, like those of Scotland before 1845 and Canada until 1935, also had extremely well-developed branch networks, was no coincidence.

[2]  On the limited redemption of National banknotes and attempts to address it see Selgin and White, "Monetary Reform and the Redemption of National Bank Notes, 1863-1913."  Business History Review 68 (2) (Summer 1994).

[3] For a very good review of the features and performance of the Canadian system in its heyday, see R.M. Breckenridge, "The Canadian Banking System, 1817-1890," Publications of the American Economic Association, v. X (1895), pp. 1-476.  Not long ago, when I spoke favorably of Canada's system at a gathering of economic historians, one asked afterwards, rather superciliously, whether I realized how large Canada's economy had been back around 1913.   Apparently my interrogator thought that Canada's small size made its success irrelevant.  I can't see why.  Nor, evidently, could the many persons who proposed and lobbied for various asset currency proposals over the course of over a decade or so.

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Real and Pseudo Free Banking Thu, 23 Jul 2015 13:03:15 +0000 Like certain weeds and infectious diseases, some myths about banking seem beyond human powers of eradication. I was reminded of this recently by a Facebook correspondent’s reply to my recent post on “Hayek and Free Banking.” “We had free banking in the US from 1830 until 1862,” he wrote. “It didn't...

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wildcat bankingLike certain weeds and infectious diseases, some myths about banking seem beyond human powers of eradication.

I was reminded of this recently by a Facebook correspondent’s reply to my recent post on “Hayek and Free Banking.” “We had free banking in the US from 1830 until 1862,” he wrote. “It didn't work out too well.” “During the Wildcat Era,” he added, “banks were unregulated and failed by the hundreds.”

Imagine the effect my critic must have anticipated — the crushing blow his revelations would surely deal to my cherished beliefs.  Upon reading his words, my eyes widen; my jaw goes slack.  Can this really be so?, I ask myself?   I read the ominous sentences again, more slowly, sub-vocalizing.  Beads of sweat gather across my brow.  Then, pursing my lips, my eyes downcast, I turn my head, first left, then right, then left again.  If only I had known!  All these years…no one ever…I mean, how was I supposed…it never occurred to me… DARNITALL! Why didn’t I think of looking at the U.S. experience before shooting my mouth off about free banking?

Well, that isn't what happened.  "What cheek this fellow has!" was more like it.  (OK, it wasn't exactly that, either.)  Of course I’ve looked into the U.S. record.  So has Larry White.  And Kevin Dowd.  And every other dues-paying member of the Modern Free Banking School.  We’ve looked into it, and we’ve found nothing there to change our minds concerning the advantages of freedom in banking.

So what about all those "unregulated" wildcats?  First of all, there’s never been a time in U.S. history when banking was truly unregulated, or anything close.  Up until 1837, just getting permission to open a bank was a hard slog, when it wasn’t altogether impossible.  Here’s Richard Hildreth’s tongue-in-cheek description of how one went about becoming a banker back in 1837:

The first thing is, to get a charter.  One from the General Government, with exclusive privileges, and a clause prohibiting the grant of any other bank, is esteemed best of all.  But such a charter is a non-such not easy to be got.[1]

Next best is a State Bank, in which the state government takes a portion of the stock, with a clause, if possible, prohibiting the grant of any other bank within the state. But if such a bank is not to be had, a bare charter, without any exclusive privileges, should be thankfully accepted.

It is very desirable however, that no other bank should be permitted in the county, city, town or village, in which the new bank is established; and all existing banks, are to join together upon all occasions, in a solemn protest against the creation of any new banks, declaring with one voice, that the multiplication of small banks, — which, by way of emphasis, may be denounced, as “little peddling shaving shops,” — is ruinous to the country, produces a scarcity of money, &c. &c. &c.

In order to obtain a charter, it is necessary to be on good terms with the legislature applied to.  Obstinate opposers may be silenced by the promise of a certain number of shares in the stock, — which shares, if very obstinate, they must be allowed to keep without paying for.

This being properly prepared, a petition is to be presented to the legislature, representing that in the town of ——–, the public good requires the establishment of a bank. … The bank is to be asked for, solely on public grounds; not a whisper about the profits the petitioners expect to make by it.

If the petition is coolly received, it may be well to revise the private list of stock-holders, and to add the names of several of the legislators. …

If nothing better can be done, employ some influential politician to procure a charter for you, and buy him out at a premium.[2]

When Hildreth wrote, around 600 U.S. banks were in business. That may seem like plenty.  But the fact that the vast majority of these were in the northeast, and that hardly any had branches, meant that most U.S. communities still had no banks at all.  In most territories and states west of the Mississippi, becoming a banker wasn't just difficult: it was illegal.

1837 was also, however, the year in which Michigan passed a “free banking” law, becoming the first of thirteen states that would pass similar laws over the course of the next two decades.  The laws provided for something akin to a general incorporation procedure for banks, making it unnecessary for state legislators to vote on specific bank bills, and to that extent improved upon the former bank-by-bank charter or “spoils” system.  But despite the name, which suggested, if not completely unregulated banking,  at least the sort of lightly-regulated banking for which Scotland was then famous, the laws didn’t even come close to allowing American banks the freedoms that their  Scottish counterparts enjoyed.  Indeed, the restrictions imposed on U.S. "free" banks proved so onerous that the laws don't even appear to have achieved a substantial overall easing of entry into the banking business.[3]

Two rules, common to all U.S. free banking laws, were to have especially important consequences. The first denied U.S. “free” banks the right to establish branches—something their Scottish counterparts were famous for doing, and that even some chartered U.S. banks could and did do.  The other required them to secure their notes using specific securities, which were to be lodged for safekeeping with state banking authorities.  U.S. “free” banks were not free, in other words, to decide how to employ the funds represented by their notes, which were in those days a more important source of bank funding than bank deposits.  Such “bond deposit” requirements were also unknown in the Scottish system.

So U.S. “free” banks were hardly “unregulated.”  They did, however, “fail by the hundreds”– 2.42 hundred, to be precise, which was no small portion of the total.  The question is, why did so many American "free" banks fail?  Was it because they weren't regulated enough?  No sir: it was because they were over-regulated: the free banking laws of several states forced banks to invest in very risky securities — and especially in risky state government bonds — while the rule against branching limited their ability to diversify around this risk, especially by relying more on deposits than on notes.  It was owing to these restrictive components of U.S.-style free banking that scads of American free banks ended up going bust.

And that's not just one kooky free banker's opinion: it’s the opinion of every competent monetary historian who has looked into the matter.[4]  According to Matt Jaremski, whose 2010 Vanderbilt U. dissertation is the most careful study to date, the bond-deposit requirements of antebellum free-banking laws “seem to be the underlying cause of the free banking system’s [sic] high failure rate relative to the charter banking system.  While bond price declines were significantly correlated with free bank failures, they were not correlated with the failure rate of charter banks.”  Moreover, it wasn’t the general level of bond prices that mattered, but only the prices of specific securities that banks were legally obliged to purchase.

And “wildcat” banking?  It’s no coincidence that that expression appears to have first gained currency, so to speak, in Michigan in the 1830s, where it was used to refer to some of the more disreputable banks established under that state's original free banking law.[5]  That law proved such a fiasco that it was repealed just two years later, after inflicting heavy losses on innocent note holders.[6]  The law appears to have encouraged more than a few bankers to throw large quantities of their notes onto the market, while situating their banks as remotely as possible, the better to avoid pesky redemption requests.  But here, as with U.S. free bank failures generally, regulations were to blame.  It just so happened that the securities banks were encouraged to hold under Michigan’s law were especially lousy, consisting as they did “either of bonds and mortgages upon real estate within this state or in bonds executed by resident freeholders of the state.”[7]  Call it the Wild West version of Community Reinvestment.

Notwithstanding what happened in Michigan, and all the attention it received, “wildcat” banking, understood to mean banking of the fly-by-night sort, was actually quite rare.  In Wisconsin, Indiana, and Illinois, whose free banking laws also proved disastrous, it was unimportant, if not altogether unknown; even in Michigan itself it doesn't seem to have survived the first free-banking law.[8]  Indeed, the all-around record of U.S.-style free banking improved significantly as the Civil War approached.  Even banknote discounts — another consequence of unit banking that has been wrongly treated as a necessary consequence of having multiple banks of issue — had become almost trivial by the early 1860s.  According to my own research, someone who, in October 1863, was foolish enough to purchase every non-Confederate banknote in the country for its full face value, in order to sell the notes to a broker in either Chicago or New York, would have suffered a loss on that transaction of less than one percent of his or her investment.[9]  That's less than the cost merchants incur today when they accept credit cards, or what people typically pay to withdraw cash from an ATM that doesn't belong to their own bank.

The best reason I can think of for the persistence of the myth of rampant wildcat banking is simply that stories about it makes for more titillating reading than ones about the mass of less colorful, if no less unfortunate, free-bank failures.  Wildcat banking is to the history of banking what the O.K. Corral and Wild Bill Hickok are to the history of the far west.

Somewhat harder to account for is the fact that, in America at least, “free banking” has come to refer exclusively to the antebellum U.S. episodes (as well as to a similar — and mercifully short-lived — Canadian experiment).  The expression was, after all, appropriated by U.S. state legislators for the sake of its appealing connotations, after having been in use for some time overseas, where it and its equivalents (“la liberté des banques,” “bankfreiheit,” etc.) continued to stand for genuinely unregulated banking, or something close to it.  Sheer parochialism is, I'm afraid, partly to blame: many authorities on American banking, whether economists, historians, or economic historians, appear to be unfamiliar with European writings on free banking, or with the banking systems those writings regard as exemplary.

The limited interest that even some of the more painstaking authorities on U.S. style “free” banking have shown in free banking of the other sort seems to me a shame.  After all, what could be more informative than to compare, say, Michigan's experience with Scotland's, so as to gain a better understanding of the consequences of laissez-faire banking on the one hand and of certain departures from laissez faire on the other?  By failing, not only to make such comparisons,  but (in some cases) to even recognize non-U.S.-style free banking and the literature concerning it, such experts have unwittingly encouraged people to confuse U.S.-style "free banking" with the real McCoy.


[1] Thanks to Andrew Jackson’s efforts, the Charter of the 2nd Bank of the United States had been allowed to expire the year before.

[2] Richard Hildreth, The History of Banks (Boston: Hilliard, Gray & Company, 1837), pp. 97-8.

[3] See Kenneth Ng, “Free Banking Laws and Barriers to Entry in Banking, 1838-1860.”  Journal of Economic History 48 (4) (December 1988).  Since the Scottish system was itself essentially a "charter" system, entry into it was also strictly limited.  Limited entry was, indeed, the most important of several departures of pre-1845 Scottish banking was genuine laissez faire.

[4] See, among other works, Hugh Rockoff, The Free Banking Era: A Reexamination (New York: Arno press, 1975); Arthur J. Rolnick and Warren E. Weber, "The Causes of Free Bank Failures: A Detailed Examination,"  Journal of Monetary Economics 14 (3) (November 1984); Gerald P. Dwyer, "Wildcat Banking, Banking Panics, and Free Banking in the United States," Federal Reserve Bank of Atlanta Economic Review, December 1996; Howard Bodenhorn, State Banking in Early America: A New Economic History (New York: Oxford University Press, 2003); and Matthew S. Jaremski, "Free Banking: A Reassessment Using Bank-Level Data" (PhD Dissertation, Vanderbilt University, August 2010).

[5] Dwyer, p. 1.

[6] Michigan took another, more successful stab at free banking in 1857.

[7] Dwyer, p. 6.

[8] Ibid., pp. 9-10, and the studies mentioned therein.

[9] See my article, "The Suppression of State Banknotes." Economic Inquiry 38 (4) (October 2000).

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Hayek and Free Banking Sat, 18 Jul 2015 11:07:32 +0000 I owe a heckuva lot to Friedrich Hayek.  Had it not been for him, I might never have heard of "free banking," meaning the genuine article rather than the phony antebellum U.S. version.  Certainly I would never have found myself writing about it.  Nor, perhaps, would any other modern economist....

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free banking, Hayek, Scotland, currency competitionI owe a heckuva lot to Friedrich Hayek.  Had it not been for him, I might never have heard of "free banking," meaning the genuine article rather than the phony antebellum U.S. version.  Certainly I would never have found myself writing about it.  Nor, perhaps, would any other modern economist.

It was two pamphlets that Hayek published in the 1970s — first, Choice in Currency (1976) and then Denationalisation of Money  (1978) — that caused the scales to fall off of my eyes and of those of  some other economists, thereby encouraging us to reconsider the merits of  private and competitive currency systems.  That reconsideration in turn led to a revival of interest in former free banking episodes, including those of Scotland and Canada, which monetary economists had previously neglected or overlooked.  In short, were it not for Hayek, there'd be no such thing as a Modern Free Banking School.

Yet Hayek himself was no free banker.  For starters, his own vision of "choice in currency" had little if anything in common with historical free banking arrangements.  In those arrangements, banks dealt in established, precious-metal monetary units,  like the British pound and the American dollar, receiving deposits of metallic money, or claims to such, and offering in place their own readily-redeemable liabilities, including circulating banknotes.  In Hayek's scheme, in contrast, competing firms issue irredeemable paper notes, with each brand representing a distinct monetary unit.  Far from resembling ordinary commercial banks, Hayek's "banks" resemble so many modern central banks in that they issue a sort of "fiat" money.  But they differ from actual central banks in enjoying neither monopoly privileges nor the power to compel anyone to accept their products.1

Competition, Hayek claimed, would force private issuers of irredeemable currencies to maintain those currencies' purchasing power, or else go out of business.  An overexpanding free bank, in contrast, is disciplined, not by an eventual loss of reputation, but by the more immediate prospect of running out of cash reserves.  Hayek's claims have always been controversial, even among persons (myself among them) who are inclined to favor competitive currency arrangements over monopolistic ones.  It isn't clear that a Hayekian money issuer would ever manage to get its paper accepted, or that it would resist the temptation to hyperinflate if it did.2

But Hayek didn't merely differ from free bankers in proposing a form of currency competition distinct from free banking.  He expressly opposed  free banking.  Asked, during a 1945 radio interview, whether he considered the Federal Reserve System a step along "the road to serfdom," he unhesitatingly replied, "No.  That the monetary system must be under central control has never, to my mind, been denied by any sensible person."   And although by the 1970s he had come to believe it both possible and desirable to have a currency stock consisting of the irredeemable paper of numerous private firms, he also continued to maintain that, so long as government authorities supplied a nation's standard money, private firms should not be able to issue circulating paper claims denominated and redeemable in that money.

The most explicit, later statement of Hayek's views on free banking occurs in a lecture he gave at a conference in New Orleans in 1977, just as Denationalisation of Money was in press:

We have indeed given government, and for fairly good reasons, the exclusive right to issue gold coins.  And after we had given the government that right, I think it was equally understandable that we also gave the government the control over any money or any claims, paper claims, for coins or money of that definition.  That people other than the government are not allowed to issue dollars if the government issues dollars is a perfectly reasonable arrangement, even if it has not turned out to be completely beneficial.  And I am not suggesting that other people should be entitled to issue dollars.  All the discussion in the past about free banking was really about the idea that not only the government  or government institutions but others should also be able to issue dollar notes.  That, of course, would not work.4

Actually, governments monopolized the coining of gold and other metals, not for any good reasons, but because doing so gave them the opportunity to manipulate precious-metal standards in pursuit of narrow fiscal ends.  But it is the last sentence of this quote that's most surprising, for what Hayek declares "unworkable" is an arrangement that worked quite successfully in many places, including Canada, where it survived well into Hayek's own lifetime.   Canada's banking and currency system had in fact been remarkably stable, altogether avoiding the crises by which the U.S. was afflicted in the decades leading to the Fed's establishment, and weathering the Great Depression far better than the U.S. system did despite having lacked a central bank until after that episode's nadir.5

That Hayek should have written as if he was quite unaware of the Canadian experience or, for that matter, of the still more famous Scottish free banking episode  is extremely puzzling.  It was Hayek, after all, who supervised, and signed off on, Vera Smith's 1935 doctoral dissertation on "The Rationale of Central Banking" (subsequently published by P.S. King & Son, and reprinted by LibertyPress) in which she discusses both the Canadian and the Scottish episodes, as well as some other free banking episodes, in unmistakably favorable terms.

Had Hayek forgotten his own PhD student's work, if not some of his own early research?  Had he simply changed his mind, reverting to conventional wisdom after a brief interval during which he had entertained a more favorable view of free banking?  Or had he never accepted Free Banking School arguments?

Larry White, who drew attention to Hayek's anti free-banking stance some years ago in a History of Political Economy article entitled, "Why Didn't Hayek Favor Laissez Faire in Banking?," favors the third hypothesis, tracing Hayek's position to his unwavering belief that a free banking system would manage the stock of bank money in a procyclical manner.  Whereas for Mises, who did favor free banking,6 a cyclical boom was most likely to be set off by a central bank, for Hayek it is the competitive commercial banks that are most likely to overissue.  Unlike Mises, Hayek subscribed to the popular view that banks might expand credit without limit so long as they expanded in unison, and that they would in fact be inclined to overexpand, while allowing their reserve ratios to decline, in response to cyclical increases in the demand for loans.

But Hayek was mistaken.  The popular view, according to which banks can expand credit all they like so long as they expand it in unison, incorrectly equates a bank's demand for reserves with its net demand for such — that is, with its need for reserves to cover expected or deterministic outflows. This overlooks banks' need for  "precautionary" reserves, or reserves that serve to protect against an undue risk of stochastic or random reserves losses.  Even a well-coordinated, industry-wide expansion of bank credit will involve some increase in banks' collective demand for precautionary reserves.  For that reason such a coordinated expansion isn't sustainable unless it's accompanied by an increase in the nominal quantity of bank reserves.  That is why, if one examines the record of so-called bank lending "manias," one finds that they typically involve, not a substantial decline in bank reserve ratios, but a substantial increase in the nominal quantity of bank reserves.

Whether Hayek was right to reject free banking or not, and tempting as it may be for fans of free banking to claim him as one of their own,  doing so would hardly be doing justice to that great economist.  We may credit him for inspiring us all; but we mustn't otherwise associate him with opinions that, rightly or wrongly, he flatly rejected.


Addendum (July 22, 2015): Over at Mises Wire, Joe Salerno points to some passages in my post that he considers misleading or wrong.  I've corrected one indisputable error — my suggestion that Vera Smith's book includes a discussion of Canadian free banking — by crossing-out the offending words.


[1] The modern cybercurrency market, consisting of Bitcoin and its many less well-known rivals ("altcoins") offers something close to a real-world counterpart of Hayek's scheme.

[2] For criticisms of Hayek's scheme, and others like it, see George Selgin and Lawrence H. White, "How Would the Invisible Hand Handle Money?," Journal of Economic Literature 32 (4) (December 1994), and Lawrence H. White, The Theory of Monetary Institutions, Part XII, "Competitive Supply of Fiat-Type Money" (New York: Blackwell, 1999).

[3] Hayek on Hayek: An Autobiographical Dialogue, ed. Stephen Kresge and Leif Wenar (Chicago: University of Chicago Press, 1994), p. 116; quoted in White, "Why Didn't Hayek Favor Laissez Faire in Banking?, p. 763 n12.

[4] F. A. Hayek, "Toward a Free Market Monetary System." Journal of Libertarian Studies 5 (1) (Fall 1979).  Whether Hayek, like Friedman before him, imagines that private banks' circulating paper dollars would be indistinguishable from the fiat dollars issued by the central authority, is unclear from this passage.  If so, he committed the crude error of equating free banking with counterfeiting.

[5] On Canada's decision, despite its monetary system's good record,  to establish a central bank in 1935, see Bordo and Redish.

[6] See Lawrence H. White, "Mises on Free Banking and Fractional Reserves," in John W. Robbins and Mark Spangler, eds., A Man of Principle: Essays in Honor of Hans F. Sennholz (Grove City: Grove City College Press).

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A Conversation on Bitcoin Thu, 16 Jul 2015 23:53:20 +0000   (Last month, the Chilean webzine El Libero interviewed Larry White about Bitcoin and other cryptocurrency topics.  Here is the English translation of Larry's conversation with Juan Pablo Couyoumdjian.)   1.  Bitcoin is a class of “crypto-currency,” but what, exactly, are these crypto-currencies?  How do they emerge?  And why? LHW:...

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Bitcoin, cryptocurrency, Chile, Ripple


(Last month, the Chilean webzine El Libero interviewed Larry White about Bitcoin and other cryptocurrency topics.  Here is the English translation of Larry's conversation with Juan Pablo Couyoumdjian.)


1.  Bitcoin is a class of “crypto-currency,” but what, exactly, are these crypto-currencies?  How do they emerge?  And why?

LHW: Cryptocurrencies — Bitcoin and its competitors — are digital assets, secured by cryptography, that can be circulated from peer to peer like currency.

Like government fiat money, they are not redeemable at a fixed rate for any commodity or other money.  Unlike government fiat money, there is no issuer with discretion to increase the quantity at any time.  In the case of Bitcoin, the number of Bitcoin units is programmed to increase at slow and known rate.  In the case of Ripple, the top competitor, all the Ripple units to be made were made at the start.

Bitcoin originated (and remains) as a public-interest non-profit project by a programmer (who's identity is not known) who wanted to create a tamper-proof private non-state currency.  Some other cryptocurrencies arose similarly, by other groups of programmers who introduced improved designs (faster, more robust, more user privacy).  Once Bitcoin rose to prominence and considerable market value at the end of 2013 (the total value of all Bitcoins currently held is about US$3.4 billion), private for-profit competitors like Ripple and BitShares and Nxt came along with advanced designs and full-time development and promotion teams.

2.  These currencies are not only used as mediums of exchange, but also represent a sort of speculative investment, am I correct?  Is this what leads to their price-swings?  In effect, their “price” reflects their purchasing power, doesn’t it?

LHW: Bitcoin can be used at a number of websites, and at some brick-and-mortar businesses, to buy goods and services.  Payment processing companies like Bitpay are making it easier for shops to take Bitcoin.  But as far as I can tell, most transactions in Bitcoin and other cryptocurrencies are inter-currency speculative trades: US dollars for Bitcoins, Bitcoins for dollars, Chinese yuan for Bitcoins, Bitcoins for other cryptocurrencies, Dollars for Ripples, and so on.

Because the quantity of Bitcoin does not respond to the rise and fall of demand for Bitcoin, the price varies.  That is indeed why the price of Bitcoin has been volatile.  Although the price has retreated from its December 2013 peak, today’s market value is more than double that of two years ago.

3.  What type of regulation do these markets in digital currencies require?  What is the current international experience in this sense?

LHW: The most important regulation is by competition.  The cryptocurrency issuers provide openly all the information the public needs to trust them.  The source code of Bitcoin’s program (and that for other cryptocoins) is available online, as is the “public ledger” that records transactions.  Anyone can check to see that the quantity of coins in circulation is exactly what the program calls for.

The exchanges where cryptocurrencies are bought and sold (led by Bitstamp, Coinbase, Cryptsy, and Kraken) compete on fees, convenience, and security.  Concern about security has improved since hackers stole millions of dollars’ worth of BTC from the mismanaged exchange Mt. Gox, which was then the third largest, in February 2014.

I don’t see that the markets would benefit from legal restrictions imposed by governments.  Although the imposition of legal restrictions is often called “regulation,” it almost never actually makes markets more regular.  Cryptocurrency markets are still evolving.  They need freedom to discover and pursue the most beneficial technologies.

Restrictions vary across countries.  The United States’ government has begun burdening cryptocurrency providers, both Bitcoin exchanges and proprietary cryptocurrency issuers like Ripple, with anti-privacy rules.  The US government insists that any business exchanging cryptocurrency with US customers must be licensed as a “money services business” on the grounds that it could be used for funds transmission and thereby (like a bank) for “money laundering.”  To comply, a business has to collect identity data on its users (“know your customer” rules) and report “suspicious” transactions to the government.  Ripple recently paid a heavy fine for not complying promptly enough.

4.  You have been a long-time scholar of alternative monetary institutions.  To what extent does this development represent a new market innovation in the monetary field?

LHW: The traditional form of private money, as discussed in my first book, Free Banking in Britain (1984), consisted of banknotes and transferable account balances, which are IOUs (debt claims) for the bank that issues them, redeemable at a fixed rate in a more basic money like gold or silver.

Bitcoins and other cryptocurrencies are not IOUs.  I call them IOU-nothings.  This is something entirely new.  Instead of a value guarantee, backed by a contractual commitment to give the holder a certain amount of basic money on demand, Bitcoin offers a quantity guarantee.  The holder knows its value can’t be hyper-inflated away because the number of Bitcoins is governed by a secure program.  The assurance is similar to that provided by the numbering of artists’ prints.

But with a quantity that does not respond to demand, the price of Bitcoin (in US dollars or Chinese yuan) must do all the responding to changes in demand.  This makes the price of Bitcoin quite volatile.  We don’t know yet whether this price volatility will stop cryptocurrencies from catching on as a commonly used means of payment.

5.  Price stability has been said to be a fundamental element of any free society.  What is, according to your view, the best way to achieve such stability?

LHW: I think this question isn’t rightly posed.  In my view a free society means that people can use whatever kind of currency they prefer.  We shouldn’t pre-judge that they prefer a currency that produces a stable price level.

Other things equal, most people prefer a currency that better holds its value, but that doesn’t mean that government should try to stabilize the price level.  Instead it means that most people are likely to prefer a currency that gains value, over one that merely holds its value roughly unchanged.  Historically, the best money we’ve had for holding its value was the classical gold standard in countries without a central bank.  Where money was privately provided by multiple private banks, all legally bound to honor their contracts, no one bank could declare the suspension of gold redeemability.

Central banks are notorious for breaking their promises to keep a fixed rate between the local currency and gold, or between the local currency and some external currency.  And nobody can sue them for breach of contract, because they have sovereign immunity.  So the best way to achieve a monetary system where people have the kind of money they want, I would say, is one where there is free competition among currency issuers.  A system of free banking. I would expect the currency banks issue to be redeemable for gold, or dollars, or Swiss francs, or something else, depending on historical context.  Or I might be wrong, and something like Bitcoin might emerge as the most popular money.

6.  What do you think about Chile’s “monetary constitution”?  Chile has achieved monetary stability through an independent Central Bank; do you feel this is a robust institutional design?

LHW: In recent decades Chile has had lower inflation than its neighbors, especially Argentina, which is good for Chileans.  But I don’t know how robust the “monetary constitution” will prove itself to be when a fiscal emergency arises.

I note that peso banknotes have many zeroes on them, which suggests that inflation was a problem not too long ago.  The independence of any central bank is always limited by the fact that the bank is a creature of the government, which can take back the independence at any time.  In a fiscal emergency, especially under fiat money systems, formerly independent central banks tend to lose their independence and begin printing money to pay the government’s bills, more money than is consistent with low inflation.  Is your current government dedicated to fiscal prudence?


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"Deprived" My Foot Sat, 11 Jul 2015 11:17:29 +0000 I don't know about you, but I'm tired of hearing  that  Greece is being "deprived of fresh Euros" by the ECB, or by the European Commission, or that those bodies are "moving toward cutting off its money supply."  That's to say nothing of the Greek government's suggestion that Greece is...

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Greece, Euro, ECBI don't know about you, but I'm tired of hearing  that  Greece is being "deprived of fresh Euros" by the ECB, or by the European Commission, or that those bodies are "moving toward cutting off its money supply."  That's to say nothing of the Greek government's suggestion that Greece is being "blackmailed" by these authorities.

Such talk seems to suggest that Eurozone members are like so many helpless hatchlings, their outstretched beaks agape in anticipation of the ECB's regular and solicitous regurgitations of liquid sustenance.

At the risk of belaboring the obvious, I'd like to take a stab at putting this misguided metaphor to rest.

Consider for a moment, then, how two other Balkan states — Kosovo and Montenegro — manage to get hold of the euros they need to support their economies.  Although the euro is their official currency, neither is part of the Eurozone, and neither has had a formal agreement of any sort with ECB such as could allow it to count on being able to borrow euros from that institution, strings or no strings, in a pinch.

Yet neither territory complains  of being "deprived" of euros by European authorities, much less of being "blackmailed" by them.  Nor do Panama, Ecuador, and El Salvador — all dollarized Latin American nations — complain that the Fed isn't sufficiently forthcoming with dollars.  (Panama did once have reason to complain of blackmail, when the U.S. blocked paper dollar shipments there as part of its effort to topple Manuel Noriega.  But that was a special case.)  If the ECB and the Fed won't deal directly with these countries, on any terms, how do they manage to get their hands on the euros or dollars they need to keep their banking systems and their economies functioning, if not  thriving?

The answer is that both the euroized states of the Balkans and the dollarized ones of Latin America  have no choice but to get hold of euros and dollars the old fashioned way: by earning them.  That means that, to add to their stock of currency, they must bring in, through exports, remittances, and tourism, more euros or dollars than they spend on exports, remittances, and tourism, or else they must get foreigners to invest more in their country than they themselves invest abroad.  In other words, euros flow into Kosovo and Montenegro when they have a surplus balance of payments, and flow out when they have a deficit.  The same goes for Panama and dollars.  Ditto, for that matter, for Alaska and dollars.  In still other words, these states import their currency, and must pay for it, in the same way that they and other states import automobiles, and have to pay for those.

In principle, Greece could have imported all the euros it needed, without having to get them directly from the ECB, provided it exported enough goods, or attracted enough foreign capital, to end up with a sufficiently large balance of payments surplus.  For some years, while newlywed Eurozone members were still enjoying their long honeymoon, Greece did just that, relying mainly on foreign capital inflows to stay flush.  The trouble is that the flows in question consisted largely of revenue earned on sales of Greek government debt, and that the Greek government, instead of employing that revenue productively, so as to be able to collect taxes sufficient to keep its credit afloat, used the money it borrowed to further fatten an already bloated public sector.  The subprime crisis, to be sure, confronted Greece — along with much of the rest of the world — with tight money.  But with the help of a more responsible government Greece might eventually have gotten through its debt crisis, as Spain and other formerly debt-crippled Eurozone members have managed to do.  European authorities, it's true, contributed to Greece's spending spree, by giving Greece's creditors reason to assume that they'd never let any eurozone state default and that they'd never let the eurozone shrink.  Those authorities may also be faulted for not recognizing the futility of their attempts to make a Greek bailout conditional upon severe austerity measures.  Still, the Greek government is ultimately to blame for having borrowed, and then squandered, so much.

Now Greece, its credit in shambles, is on the verge of collapse.  For some time now it has had to depend on direct ECB support of its monetary system, and unless Greece's latest reform proposal is accepted by the EU, that support will run out.  Yet it blames its predicament, not on its own government's profligacy, and not on its resulting inability to raise the euros it needed to stay solvent through the normal operations of international exchange, but on the strings the ECB and other lenders have attached to their offers of emergency funds.

Stuff and nonsense.  When an entire multi-national currency area runs short of money, it is presumably some central bank's fault.  But when one country alone runs short, the blame rests squarely on that country's own misguided policies.

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Remove Lew, Not Hamilton Fri, 10 Jul 2015 19:09:16 +0000 On June 17th, Treasury Secretary Jack Lew shocked many, including former Chairman of the Federal Reserve Ben Bernanke, when he proclaimed that Alexander Hamilton (1755-1804) – the first and foremost Treasury Secretary – would be demoted and share the ten-dollar bill with a yet unnamed woman.  Undaunted by wide-spread criticism,...

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Jack Lew, Alexander Hamilton, $10 BillOn June 17th, Treasury Secretary Jack Lew shocked many, including former Chairman of the Federal Reserve Ben Bernanke, when he proclaimed that Alexander Hamilton (1755-1804) – the first and foremost Treasury Secretary – would be demoted and share the ten-dollar bill with a yet unnamed woman.  Undaunted by wide-spread criticism, Secretary Lew continued to press his case at an event at the Brookings Institution on July 8th.  Asked about the ten-dollar bill’s selection, Secretary Lew insipidly claimed that the ten-dollar bill was the “next up” for redesign to help combat forgery.  The diminution of Hamilton, for whatever reason, is simply indefensible.

Just how great was Hamilton?  A recent scholarly book by Robert E. Wright and David J. Cowen, Financial Founding Fathers: The Men Who Made America Rich, begins its pantheon of greats with a chapter on Alexander Hamilton.  It is aptly titled “The Creator.”

After the Constitution was ratified and George Washington was elected President, the new federal government lacked credibility.  Public finances hung like a threatening cloud over the government. Recall that paper money and debt were innovations of the colonial era, and that, once the Revolutionary War began, Americans used these innovations to the maximum.  As a result, the United States was born in a sea of debt.  A majority of the public favored a debt default.  Alexander Hamilton, acting as Washington’s Secretary of the Treasury, was firmly against default.  As a matter of principle, he argued that the sanctity of contracts was the foundation of all morality.  And as a practical matter, Hamilton argued that good government depended on its ability to fulfill its promises.

Hamilton won the argument and set about digging the country out of its financial debacle.  Among other things, Hamilton was – what would today be called – a first-class financial engineer.  He established a federal sinking fund to finance the Revolutionary War debt.  He also engineered a large debt swap in which the debts of individual states were assumed by the newly created federal government.  By August 1791, federal bonds sold above par in Europe, and by 1795, all foreign debts had been paid off.  Hamilton’s solution for America’s debt problem provided the country with a credibility and confidence shock.

Doesn’t the 76th Secretary of Treasury have better things to do than to diminish the presence of our 1st and most distinguished Secretary of Treasury?

[Cross-posted from Cato At Liberty]

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How Not to Stress Test: UK Edition Thu, 09 Jul 2015 19:01:29 +0000 Anyone who follows the  stress tests conducted by the Fed and various European banking authorities can’t help poking fun at them.  After all, it’s hard to repress a chuckle when, time and again, a bank passes one of these tests with flying colors only to end up failing not long...

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Bank of England, stress tests, inflation, capital requirementsAnyone who follows the  stress tests conducted by the Fed and various European banking authorities can’t help poking fun at them.  After all, it’s hard to repress a chuckle when, time and again, a bank passes one of these tests with flying colors only to end up failing not long afterwards.  Whether it’s Iceland in 2008, Ireland in 2010, or Cyprus in 2013, the story is the same: all three national banking systems collapsed shortly after being signed off as safe following regulatory stress tests.

When putting banks to such a test, a central bank or other banking authority starts by imagining one or more "stressful" scenarios to which banks might be exposed, uses a bunch of models to determine how those scenarios will affect the banks’ capital adequacy (that is, their ratio of capital to assets), and then passes or fails banks depending on whether their capital remains adequate at the end of the test.

The Bank of England reported the results of its first set of annual stress tests in December.  Its message was a reassuring one: the UK banks are safe.  Unfortunately, there's no good reason to trust that assessment than there was to trust the others, for the Bank of England's stress tests are also deeply flawed, in ways that, besides obscuring the significant vulnerability of the UK banking system, actually tend to accentuate it.

For starters, the tests are based on a "risk-weighted asset" metric, which depends on models that underestimate banks’ risks.  Worse still, these models are eminently gameable, and banks have every incentive to game them, since doing so can reduce their capital requirements and allow them to distribute greater false profits.

Abundant research—from the Bank of England itself, among other authorities—has convincingly established that lower risk-weighted asset scores do not necessarily mean lower risk.  In fact, the risks are often greater; they just happen to be among those that are invisible to the risk measure.  We saw precisely this problem in 2008–2009, when UK banks appeared to be well capitalized using risk-weighted asset metrics, but actually turned out to be massively undercapitalized when the financial crisis hit.

These points alone ought to be enough to discredit the Bank of England’s stress tests.   Still, there are a plenty of other problems  to consider.

First, the Bank’s stress tests are based on just a single scenario.  This approach cannot possibly give us confidence that the banking system is safe against all the other possible scenarios that were not considered.  Indeed, the Bank acknowledged the need to consider multiple scenarios in one of its preliminary discussion papers, but then inexplicably ignored its own advice and opted for a single scenario in its final report.

Second, the Bank describes its stress tests as ‘extremely tough,’ but in reality its scenario is a mild one: GDP growth falls to -3.2 percent before bouncing back, inflation rises to peak at 6.5 percent, long term gilts peak just below 6 percent, and unemployment hits 12 percent.  This is not particularly stressful by historical standards, and also pales in comparison to the Eurozone’s recent (and on-going) strife.  The Bank of England scenario also has only a mild impact on bank capital and profitability—and if a stress scenario doesn’t actually stress the banking system, what is the point of the exercise?

Third, the Bank uses a very low "pass" standard—a 4.5 percent minimum ratio of capital to risk-weighted assets.  This is lower than the 5.5 percent ratio that the European Central Bank used in its widely discredited 2014 stress tests, and is well below the capital requirements coming through under Basel III.  Had the Bank carried out a test using these Basel minimums, the UK banking system would have failed.  Same exercise, higher safety standard, opposite result.

Fourth, the Bank also failed to carry out any tests based on leverage—the ratio of capital to total, unweighted assets—which offers a much less gameable measure of a bank’s financial health.  Even an undemanding such test, based on the Bank’s required minimum leverage ratio of 3 percent, would have revealed how weak the UK banking system really was.  Of course, many experts recommend a minimum leverage ratio of 15 percent or more, at least five times larger than the leverage test that the Bank failed to conduct—or, at least, to report.  Had the Bank based its stress tests on this measure, December’s comforting financial headlines would have been very different indeed.

Fifth, stress tests impose a single view of risk on the banking system—one based on the same flawed models, with the same blind spots.  This creates systemic instability: if the stress test’s view of risk turns out to be wrong, all the banks subject to it are likely to run into trouble at the same time.

Finally, stress tests have all the credibility of a Soviet election.  Even if the central bank discovers there are major problems in the banking system, it will be loathe to publicly admit to them.  Doing so would undermine confidence and also lead to awkward questions about the central bank’s own supervisory competence.

The bottom line is this: official stress tests are like a lookout who has trouble seeing big, white icebergs.  If you wouldn't travel on a liner with such a lookout, you shouldn't trust the results of  stress tests that cover every risk to a nation's banking system—except the sort that might sink it.

(This post is based on Kevin Dowd’s recent in-depth report for the Adam Smith Institute, “No Stress: The Flaws in the Bank of England’s Stress Testing Programme,” in which he critically assesses the stress tests conducted by the Bank of England and other central banks.)

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Alt-M Redux: Incredible Commitments: Why the Euro is Destroying both Europe and Itself Thu, 02 Jul 2015 14:13:46 +0000 (Every now and then, it seems worthwhile to re-post a seemingly pertinent item from our archives.  Thus the ongoing Greek crisis inspires me to air once more a post I wrote in 2012 concerning the flaws of Europe's currency system that had already begun to set the stage for the events of...

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Euro, Eurozone, ECB, European Union(Every now and then, it seems worthwhile to re-post a seemingly pertinent item from our archives.  Thus the ongoing Greek crisis inspires me to air once more a post I wrote in 2012 concerning the flaws of Europe's currency system that had already begun to set the stage for the events of the last few days.  And so, here is the first item in our new "Alt-M Redux" series.)


Except for omitted section headings what follows is the full text of the paper [since published in The Cato Journal] I presented last week [September 2012] at the Mont Pelerin Society General Meeting in Prague. As the paper had to be completed on time for a May deadline, it could not take into account subsequent developments. Fortunately those developments have mainly been entirely consistent with the paper's general thrust.

Otmar Issing, a former ECB chief economist and Executive Board member, also took part in my session.  Although Mr. Issing's paper and public remarks put a much more favorable spin on the Euro's prospects for survival than my own, I believe — as I remarked during the session — that the only substantial disagreement between us concerned the conditions in which it would be appropriate to pronounce the Euro "dead."  In brief, while Mr. Issing for his part appears to regard the merest heartbeat from Frankfurt as a sign of vitality, I say that, heartbeat or no heartbeat, the Euro is for all intents and purposes already brain-dead.


When the merits of a European Monetary Union were first being debated, many skeptics fell into one of two camps.  The first camp consisted of “Keynesians” (for example, Eichengreen and Bayoumi 1997; Salvatore 1997) who, referring to the theory of optimal currencies areas, doubted that Europe constituted such an area, and believed that the proposed monetary union would eventually fall victim to country-specific (“idiosyncratic”) shocks: unemployment and other burdens stemming from such shocks would, these critics argued, eventually force the monetary authority to either abandon its commitment to price-level stability in order to offer relief to adversely-affected members, or cause the members to abandon the union so as to be able to re-align their exchange rates.

The other camp was comprised of “Hayekians” who, drawing upon theories of international currency competition, claimed that monetary unification, by reducing the extent of such competition, would give rise to a relatively high seignorage-maximizing Eurozone inflation rate, and thereby result in a level of actual Eurozone inflation that was bound to disappoint the monetary union’s more inflation-phobic members.[1]  It was in light of such reasoning that British Prime Minister John Major made his alternative proposal for a parallel European currency—the so-called “hard ecu”— to supplement rather than supplant the British Pound and other established European currencies.

Today the euro is indeed failing.  But its failure has in large part been the result of fundamental shortcomings other than those pointed out by either of these prominent camps of early euroskeptics.  Rather than merely being wrenched apart by pressure from idiosyncratic shocks, or by disappointments stemming from the ECB’s temptation to profit from its monopoly status, the euro is unraveling because commitments upon which its ultimate success depended—commitments that had to be credible if it was to work as intended—have instead proven to be perfectly or almost perfectly incredible.  The euro, in other words, was built upon a set of promises that the authorities concerned were unable to keep.  Orthodox theory—theory that is neither particularly “Keynesian” nor particularly “Hayekian” in flavor, suffices to explain—admittedly, with the help of hindsight—why the promises in question could not possibly have been kept so long as the EMU’s members enjoyed substantial fiscal sovereignty.  The combination of effectively unconstrained fiscal sovereignty and a lack of credible commitments to avoid both centralized debt monetization and outright member-state bailouts created a perfect storm of perverse incentives.

The theory in question builds upon Kydland and Prescott’s (1977) well-known treatment of the time-inconsistency problem that confronts ordinary central banks.  That analysis, it bears observing, takes for its starting point a benevolent (social-welfare maximizing) though discretionary central bank, while making no reference to region-specific shocks or imperfect factor mobility.  Greg Mankiw (2006) offers the following summary of the standard time-inconsistency problem:

Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment.  According to the Phillips curve, the tradeoff between inflation and unemployment depends on expected inflation.  The Fed would prefer everyone to expect low inflation so that it will face a favorable tradeoff.  To reduce expected inflation, the Fed might announce that low inflation is the paramount goal of monetary policy.

But an announcement of a policy of low inflation is by itself not credible.  Once households and firms have formed their expectations of inflation and set wages and prices accordingly, the Fed has an incentive to renege on its announcement and implement expansionary monetary policy to reduce unemployment.  People understand the Fed's incentive to renege and therefore do not believe the announcement in the first place.

Monetary policy will also tend to be time-inconsistent when unanticipated inflation is capable of lowering the real value of outstanding nominal debts, thereby reducing the government’s fiscal burden.  In this case the central bank has an incentive to announce a low inflation target so as to achieve a favorable inflation-taxation trade-off.  Once again, were the central bank able to establish low inflation expectations, it would have an incentive to exploit those expectations so as to reduce the debt burden.  Consequently the announced, low inflation target is not credible.

In the context of a monetary union whose members enjoy unlimited fiscal sovereignty, the usual time-inconsistency problem is compounded by a free-rider problem, with far more serious consequences.  Here, as Chari and Kehoe (2007, 2008) have shown, a discretionary monetary authority’s optimal (benevolent) policy consists of setting “high inflation rates when the inherited debt levels of the member states are high and low inflation rates when they are low” (Chari and Kehoe 2007, p. 2400).  Assuming that costs of inflation are borne equally by the member states, the ability to free ride off of other members of the union causes member states to be become more indebted than they would in a cooperative equilibrium, thereby bringing about an excessively high rate of inflation.  Moreover, the free-rider problem gets worse as the number of countries gets larger, with the non-cooperative inflation rate rising, other things equal, as union membership increases (Chari and Kehoe 2008).  The incentive to free ride will, finally, be especially great for relatively small participants, and for participants with relatively high debts ratios, other things being equal, for these participants will be capable of externalizing a relatively large share of the cost of any deficits they incur.

Observe that, although the suboptimal outcomes predicted here—excessive government deficits and higher inflation—resemble those predicted by Hayek and his followers, the causal mechanism is much different.  For here a benevolent authority, concerned only with maximizing social welfare, is led inadvertently to engage in undesirable levels of debt monetization.  Were there no externalities, or were the authority capable of committing to policy invariant to the extent of union indebtedness, the problem would not arise.

Chari and Kehoe first establish the presence of a “free rider” problem for the case in which national fiscal authorities issue nominal debt only to lenders who live outside the monetary union to which they belong (2007, p. 2400); they then go on to show that the problem holds as well in the case where governments borrow from within the union.  The latter case, however, raises the additional possibility that union members can hold the union hostage, and thereby ultimately undermine it, by threatening either to default on their debt or to quit the union if it does not ease their debt burden by means of higher inflation or outright transfers (bailouts) or both.  In the words of Thomas Mayer (2010, p. 51), if heavily-indebted member countries “pose a threat to Eurozone financial stability, they can blackmail their partners into open-ended transfers to cover both fiscal and external deficits.  Or they can press the ECB to buy up and monetize their debts so as to avoid default.”

The “threat” to monetary stability can develop in several ways.  First, foreign commercial banks may hold substantial quantities of the debt of the hostage-taking country, so that its decision to default would threaten the rest of the zone with a financial crisis.  Second, the central monetary authority may itself hold substantial amounts of the troubled member’s debt, and so may also need to be recapitalized, at other participant countries’ expense, in the event of a default.  Alternatively, the bad debts would have to be reduced by means of more aggressive monetization and consequent, higher inflation (ibid., p. 52).  In either case, the decision to avoid the danger in question by instead supporting member governments in fiscal difficulties will tend to undermine public support for the monetary union while increasing the likelihood of further ransom demands.

Philip Bagus (2012) explains the particular course by which Greece was able to take the European Monetary Union hostage.  Banks throughout the Eurozone, he says, bought Greek bonds in part because they knew that either the ECB or other Eurozone central banks would accept the collateral for loans.  Thus a Greek default threatened, first, to do severe damage to Europe’s commercial banks, and then to damage the ECB insofar as it found itself holding Greek bonds taken as collateral for loans to troubled European banks.

In short, in a monetary union sovereign governments, like certain banks in single-nation central banking arrangements, can make themselves “too big to fail,” or rather “too big to default.”  As Pedro Schwartz (2004, p. 136-9) noted some years before the Greek crisis: “[I]t is clear that the EU will not let any member state go bankrupt.  The market therefore is sure that rogue states will be baled [sic] out, and so are the rogue states themselves.  This moral hazard would increase the risk margin on a member state’s public debt and if pushed too could lead to an Argentinian sort of disaster.”

Indeed, the moral hazard problem as it confronts a monetary union is all the worse precisely because sovereign governments, unlike commercial banks, can default without failing, that is, without ceasing to be going concerns.  This ability makes their ransom demands all the more effective, by making the implied threats more credible.  A commercial bank that tries to threaten a national central bank using the prospect of its own failure is like a suicide bomber, whereas a nation that tries to threaten a monetary union is more like a conventional kidnapper, who threatens to harm his innocent victim rather than himself.

The free-rider and hostage-taking problems present in a monetary union that combines discretionary monetary policy with unrestricted national fiscal sovereignty has led some experts to speak of a new “Impossible Trinity” or “Trilemma," complementing the “classical” Trilemma long recognized in discussions of alternative international monetary regimes.  The original Trilemma refers to the fact that, a country cannot pursue an independent monetary policy while both adhering to a fixed exchange rate and dispensing with capital controls.  According to Hanno Beck and Aloys Prinz (2012), in the context of a monetary union it is impossible for authorities to adhere to all three of the following commitments: 1) Monetary Independence, including a commitment on the part of the monetary authority to avoid either excessive inflation or the monetization of sovereign debts; 2) No bailouts, meaning no outright loans or grants to national governments in danger of defaulting; and 3) Fiscal Sovereignty, meaning a commitment to refrain from interfering with member nations’ freedom to resort to debt financing.

As we’ve seen, so long as unlimited fiscal sovereignty prevails, member states can find themselves in a position to take the monetary union hostage, forcing the central authorities to renege on one or both of heir other commitments.  It follows that either the principle of fiscal sovereignty must be abandoned in favor of something like an outright fiscal union, or that the union must abandon its commitment to either independent monetary policy or the no-bailout clause, exposing the union to the consequences of unconstrained fiscal free riding, with all the regrettable consequences that must entail.

Nor is the EMU’s experience the first to bear out these claims.  Having reviewed the lessons taught by previous monetary unions, in a work published between the signing of the Masstricht Treaty and the actual launching of the euro, Vanthoor (1996, p. 133) concluded that

monetary union is only sustainable and irreversible if it is embodied in a political union, in which competences beyond the monetary sphere are also transferred to a supranational body.  In this respect, the Maastricht Treaty provides insufficient guarantees, as budgetary policy as well as other kinds of policy…remain the province of national governments.

The euro’s flawed design, and the poor incentives created by it, have not merely caused the scheme itself to fail, but have done extensive damage to the European economy.  Philip Bagus (2012) supplies an excellent summary of its more regrettable consequences.  “To make an understatement,” he writes,

the costs of the Eurosystem are high.  They include an inflationary, self-destructing monetary system, a shot in the arm for governments, growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.

The euro, Bagus adds, has allowed European governments generally, and those of the peripheral nations in particular,

to maintain uncompetitive economic structures such as inflexible labor markets, huge welfare systems, and huge public sectors … Multiple sovereign-debt crises have in turn triggered a tendency toward centralization of power in Brussels [bringing us] ever closer to a more explicit transfer union.

In particular,

The Greek government used the lower interest rate to build a public adventure park.  Italy delayed necessary privatizations.  Spain expanded the public sector and built a housing bubble.  Ireland added to their housing bubble a financial bubble.  These distortions were partially caused by the EMU interest-rate convergence and the expansionary policies of the ECB.

In light of all of these ill consequences, Bagus concludes, “the project of the euro is not worth saving. The sooner it ends, the better.”  In other words, given the other consequences stemming from the euro’s poor design, it is just as well that that design is also causing the euro to self-destruct.

But perhaps the gravest of all consequences of the euro’s demise is also the most ironic, to wit: the harm done to inter-European relations.  Instead of cementing European unity, as its proponents claimed it would do, the euro is bearing-out Martin Feldstein’s (1997) prediction that it would ultimately supply grounds for new inter-European squabbles, culminating in the emergence of a new and vehement nationalism, all too reminiscent of the nationalism that twice set Europe aflame during the previous century.  As John Kornblum (2011), the U.S. Ambassador to Germany from 1997-2001, wrote last September, with the outbreak of the Greek crisis, “[t]he polite tone cultivated for decades by E.U. partners” has given way to “a tirade of insults”:

Germans have called the Greeks lazy, corrupt and just plain stupid.  The news media in Germany gleefully point out Greek billionaires who pay no taxes, workers who retire at 50 and harbors filled with the yachts of the idle rich. German politicians have suggested that Greece sell some islands to repay its debt.  In return, Greeks have pulled out the Nazi card, claiming that the Germans owe them billions in wartime reparations.

Rather than being specifically related to conditions in Greece this outcome, Kornblum observes, has its roots in the euro’s basic design:

Rather than being kept free of politics, as was originally intended, management of the currency has become a political football knocked back and forth by the growing resentments between richer and poorer Europeans.  The poorer countries reject the austerity measures necessary to meet German standards.  The Germans refuse to take the steps necessary to build a true economic community.  The result is a standoff…. [I]f the euro hadn’t been implemented as a political project in a Europe not ready for a common currency, experts could probably clean up such a situation fairly fast.  But now, they can’t.  Because in the end, such decisions are still about the war.


In examining the cause of the euro’s failure, it may seem that I’ve only succeeded in raising a different question, namely, how, did the euro manage to survive for so long?

The answer hinges on the fact that the credibility of various commitments made at the time of the euro’s launching was not something that could be ascertained in advance.  Instead, it had to be discovered.  In particular, the public had to discover whether European authorities had avoided the “Impossible Trilemma” discussed above, by strictly limiting participants’ fiscal independence.

That such limits were necessary if the common currency was not to fall victim to the “free rider” problem was recognized by several authorities before the euro’s actual establishment (e.g. Goodhart 1995, p. 467).  Indeed, it was generally understood that the EU would not allow any of its member states to go bankrupt, and that special steps would therefore have to be taken to guard against members’ tendency to free-ride on the union.

In principle, the time-inconsistency problem that sets the stage for free riding in a monetary union could itself have been avoided by means of a credible commitment to an independent ECB, unresponsive to European fiscal crises.  Such credibility might have been achieved by means of explicit rules, with corresponding incentive-compatible sanctions, or it might have been the result of a reputation for independence established over time.  But neither solutions was actually realized. As Chari and Kehoe (2007, p. 2401) observe, “notwithstanding the solemnly expressed intend to make price stability the monetary authority’s primary goal, in practice, monetary policy is set sequentially by majority rule.  In such a situation, the time inconsistency problem in monetary policy is potentially severe, and as our analysis shows, debt constraints are desirable.”

The euro’s capacity for escaping the Trilemma, and hence for long-run survival, therefore had to depend entirely on meaningful constraints placed upon member states indebtedness.  For a time the 1997 Stability and Growth Pact appeared to impose such constraints: the Pact appeared to provide for either the prevention or the timely correction of “excessive” government deficits (that is, deficits exceeding 3% of national GNP) or their rapid correction, thereby ruling-out “even the slightest possibility that a fiscal crisis in one country affect the entire Eurozone” (Mayer 2010, p. 49).  But it was not long before the Pact began crumbling.  The first fissures appeared in 2003, when France and Germany both exceeded the 3% target, and ECOFIN failed to impose sanctions on either.  By the outbreak of the current crisis, the Pact had ceased to be credible (Mayer 2010, p. 50).  Though fiscal restrictions remained in effect de jure, the de facto situation was one of unlimited fiscal sovereignty. That change meant, in effect, that either the ECB’s independence or the no-bailout commitment or both would have to give way, as both have indeed done.

Once any of the commitments essential to a monetary union’s success has lost its credibility, that credibility cannot be easily or quickly restored.  In light of this truth the EU’s decision, earlier this year, to sanction Hungary for its excessive deficits, seems an exercise in futility—an attempt, as it were, to close the stable door after the PIGS have bolted.

What, then, are some possible solutions?  Most recent proposals for saving the EMU—resort to Eurobonds, the establishment of a “European Monetary Fund,” raising the ECB’s inflation target—fail to address the free-rider problem that is the root cause of the current crisis.  Indeed, they appear likely to aggravate the problem by formally acknowledging collective responsibilities that were until now formally (though unconvincingly) repudiated.

In truth there are but two ways in which the EMU can be made viable without sacrificing monetary stability.  These are (1) the establishment of a genuine European Fiscal Union, that is, outright rejection of the principle of fiscal sovereignty that has thus far tended to undermine both the ECB‘s independence and the EU’s “no bailout” commitment or (2) replacement of the present politically “constructed” monetary union with a “spontaneous” or “voluntary” one based on the principle of free currency competition.  As Pedro Schwartz (2004, p. 190) explained several years ago,

There are two types of monetary union.  The first is based on a single money imposed by central authorities.  Such a monetary union requires centralized political authority… The other form of ‘monetary union’ arises from the free choice of individuals predominantly using one out of a range of alternative currencies.  The latter model does not require centralized political authority and is a better model for ensuring that monetary discipline is maintained.

The new Trilemma is a Trilemma for imposed monetary unions only: it is only such an imposed monetary union that calls for a corresponding fiscal union.  When participation in a monetary union is voluntary, there can be no question of participants taking advantage of their fiscal autonomy to hold the union as a whole hostage.  Consider, for example, the monetary union consisting of the United States, its trust territories, and those independent nations that have chosen to either officially or unofficially dollarize, such as Ecuador.  The Federal Reserve and the U.S. government played no essential part in Ecuador’s decision to join the U.S. dollar zone, and take no responsibility at all for macroeconomic conditions there.  They would presumably be able to regard Ecuador’s decision to leave the dollar zone with the same equanimity or indifference with which they reacted to its decision to adopt the dollar in the first place.  Although it’s true that the extent of participation in the dollar zone might serve as an indication of the dollars’ relative soundness, a foreign country’s decision to quit the dollar zone poses no serious threat to the integrity of the dollar or to the prosperity of either the U.S. or any other dollarized economy.  In short, in a regime of free currency choice, monetary authorities can gain nothing by letting their currencies deteriorate further for the sake of addressing the macroeconomic problems of particular dollarized countries.  Doing so would only tend to further undermine the dollar’s popularity.

Such considerations appear, in light of experience, to vindicate former Hayekian proposals for a “hard” ecu or parallel European currency that would (initially at least) have supplemented, instead of replacing, Europe’s established national currencies.  In retrospect, as Pedro Schwartz (ibid., pp. 183-4) has observed, we have every reason to regret missing the chance of having the euro as a parallel rather than an imposed currency:

If the EU had accepted the British proposal of a “parallel ecu,” rules guaranteeing the stability of the common currency and its independence from European governments would have been a part of the offer to users of the money by the European bank.  There would have been no need for constitutional rules to be made (and broken) by member states, and no need for a Growth and Stability Pact, since the euro would not have been seen as a possible instrument of state finance.

There is, of course, no turning back the clock.  But should the euro begin to disintegrate, the occasion, for all the disruption and damage it must cause, will at least renew the prospect for implementing the Hayekian alternative.  That, to be sure, is a rather meager bit of silver by which to line a very large, dark cloud.  Yet the ability to choose freely among competing currencies remains Europeans’ best hope for a monetary regime that is both stable and sustainable


1. “[T]hough I strongly sympathize with the desire to complete the economic unification of
Western Europe by completely freeing the flow of money between them, I have grave doubts about
doing so by creating a new European currency managed by any sort of supra-national authority. Quite apart from the extreme unlikelihood that the member countries would agree on the policy to be pursued in practice by a common monetary authority (and the practical inevitability of some countries getting a worse currency than they have now), it seems highly unlikely that it would be better administered than the present national currencies” (Hayek 1978).


Bagus, Philip. 2012. “The Eurozone: A Moral-Hazard Morass.” Mises Daily, April 17

Beck, Hanno, and Aloys Prinz. 2012. “The Trilemma of a Monetary Union: Another Impossible
Trinity.” Intereconomics 1

Chari, Varadarajan V., and Patrick J. Kehoe. 2007. “On the need for fiscal constraints in a
Monetary union.” Journal of Monetary Economics 54: 2399-2408.

__________. 2008. “Time Inconsistency and Free-Riding in a Monetary Union.” Journal of
Money, Credit, and Banking
40 (7) (October): 1329-55.

De Grawe, Paul, and Wim Moesen. 2009. “Common Euro Bonds: Necessary, Wise or to be
Avoided?” Intereconomics (May/June): 132-138.

Eichengreen, Barry and Tamin Bayoumi. 1997. “Shocking Aspects of European Monetary
Unification,” in Barry Eichengreen, ed., European Monetary Unification: Theory, Practice, and Analysis. The MIT Press, Cambridge Mass., pp. 73-109.

Feldstein, Martin. 1997. “EMU and International Conflict.” Foreign Affairs,

Goodhart, C.A.E. 1995. “The Political Economy of Monetary Union.” In P. B. Kennan, ed., The
Macroeconomics of the Open Economy
. Princeton: Princeton University Press, pp.

Gros, Daniel, and Thomas Meyer. 2010. “Towards a Euro(pean) Monetary Fund.” CEPS Policy
202 (February).

Hayek, Friedrich. 1978. Denationalisation of Money – The Argument Refined. Hobart Paper
Special No. 70, 2nd ed. London: Institute for Economic Affairs.

Kornblum, John. 2011. “”Without the euro, would Europe have turned to war?” The Washington
, September 24 (updated).

Kydland, Finn E., and Edward C. Prescott. 1977. “Rules Rather than Discretion: The
Inconsistency of Optimal Plans.” Journal of Political Economy 85 (3) (June): 473-92.

Mankiw, Greg. 2006. “Time Inconsistency.” Greg Mankiw’s Blog, April 19,

Mayer, Thomas. 2010. “What more do European governments need to do to save the Eurozone
in the medium run?” In Richard Baldwin, Daniel Gross, and Luc Laeven, eds., Completing the Eurozone Rescue: What More Needs to be Done? London: Centre for Economic Policy Research, pp. 49-53.

Salvatore, Dominick. 1997. “The Common Unresolved Problem with the EMS and EMU.”
American Economic Review 87(2): 224-226.

Schwartz, Pedro. 2004. The Euro as Politics. London: Institute of Economic Affairs, Research
Monograph 48.

Vanthoor, W. F. V. 1996. European Monetary Union since 1848: A Political and Historical
. Cheltenham: Edward Elgar.

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Why free-banking? Wed, 01 Jul 2015 14:39:04 +0000 The need for and convenience of a central bank are usually taken for granted.  To say that a central bank is a good institution and, therefore, needed, is not enough.  Unfortunately, the assumption that central banks are necessary seems to weigh more heavily than the facts that suggest otherwise. Good...

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Ayr Bank, Scotland, Australia, central bankingThe need for and convenience of a central bank are usually taken for granted.  To say that a central bank is a good institution and, therefore, needed, is not enough.  Unfortunately, the assumption that central banks are necessary seems to weigh more heavily than the facts that suggest otherwise.

Good and bad are relative terms.  With respect to what then is a central bank good?  Some might say to the absence of a central bank- or more specifically, to the presence of a free banking regime.

Historical records, however, show that free banking outperforms central banks in most, if not all, of the cases.

A free banking regime is such where the market for money and banking is free of specific regulation (save, of course, illegal activities such as the violation of third party property rights.)  Let me be clear. The absence of a central bank is not equivalent to free banking.  The absence of regulation is equivalent to free banking.  This is why to think of the pre-Fed era in the United States as a case of free banking shows a superficial understanding of what an unregulated –free– market is.

The literature on free banking is vast.  Let me just give a brief description and comment on a couple of illustrative historical cases.  First, under free banking, each bank is free to issue their own convertible banknotes.  Convertible to what?  To whatever functions as base money in the economy. Historically, this has been gold, but this does not need to be the case.  It could be, like Selgin describes in his Theory of Free Banking, that the Federal Reserve shuts down the FOMC and that the USD becomes the base money to which private convertible banknotes are convertible.  Whether or not the USD will eventually be replaced by gold, silver, or any other asset is up to the market process to sort out.

Second, because all banknotes are convertible to the same base money, there is no multiplicity of units of account.  Under this regime, there should be no fear of confusion about the multiplicity of prices.  If today you travel to Hong Kong, Ireland, or Scotland, you’ll see a strong presence of private money in circulation, but you won’t see multiplicity of units of account.  It could be said that the US banking system is not the most developed and flexible of the developed world.  On the contrary, the heavy regulation imposed on this market suggests that lot of improvement is possible and needed.

Third, the stability of the system comes from banks competing with each other for deposits and therefore for base money.  Surely, mathematical models showing how banking without central banks are instable can be developed.  With the right assumptions, it is possible to shows anything in a mathematical model.  Free banking shows a remarkably good performance, despite the claims that many academic models try to make.

Let me now comment on two examples that show that bank failures are not the same as bank runs. This would likely be the case under a fiat currency regime managed by central banks, but free banking works under a different regime and therefore with different incentives.  The outcome is a different performance.

Consider first free banking in Scotland (1716 – 1844).  In 1772 the “Ayr” bank collapsed, bringing other smaller banks down with it.  As spectacular as the Ayr Bank failure might have been, the Scottish free banking system did not suffer a bank run.  What happened?  The Ayr Bank was doing what any efficient bank would not do: aggressively increasing the issue of their convertible banknotes.  With the increase in circulation of convertible banknotes, the Ayr Bank started to lose reserves until it went bankrupt.  What about the other small banks?  These smaller banks were also doing what an efficient bank should not do.  These small banks invested their reserves in the Ayr Bank.  Why was there no bank run?  Succinctly, because the reserves that the Ayr Bank was losing were being transferred to other more efficiently managed banks.  This is the market outcome of over-expanding credit- no central authority is needed for this to take place.  The result is an increase in the market share of efficient banks at the expense of inefficient banks.  Isn’t that the outcome we want for any market- for efficient firms to displace inefficient firms?

The second case I want to mention is the economic crisis in Australia in 1890 under a free banking regime.  Australia was under free banking between 1830 and 1959.  The first thing to keep in mind is that the 1890 crisis in Australia was the result of Bank of England credit expansion being channeled to Australia.  The result was a bubble in land prices (sound familiar?)  When this process of credit expansion is reverted (in part to the Baring Crisis that was born from Argentina’s default) some banks experience solvency problems, other did not.  Those banks that saw the bubble and adjusted their portfolios where ready to buy the portfolio of the failing banks that did not see the crisis coming (again, sound familiar?)

Namely, the crisis was ready to be reverted.  But the U.K. government thought it knew better and made things worse (I can keep asking if it sounds familiar, but at this point the parallelism is quite obvious.)  The government committed two important mistakes.  First, it forced a bank holiday on banks that were in good standing and wanted to keep their doors open to their customers.  The result?  The market could not sort out which banks were solvent and which were not.  Second, it allowed failed banks to re-open their doors free of their previous liabilities, but this generosity was not extended to efficient banks.  The result was a bank run against efficient banks towards inefficient banks.  It should be patent that this was not a free banking failure, but just another case of regulation failure in one of the more complex and delicate markets.

If one looks at historical facts, rather than just let be guided by pre-conceived ideas, the need and superiority of central banking next to alternative monetary regimes is thrown into serious doubt. Surely, free banking is long gone and gold, which was used as base money under these cases, is not money anymore.

Why then look at free banking?  I can mention at least two reasons: (1) To do away with the almost ideological position that a central bank is needed.  This position, or assumption, needs to be questioned rather than taken as fact if we want to come up with innovative alternatives to our monetary regime.  (2) Even if the old free banking system based on gold standard is not feasible, it certainly helps us to come up with reform that can improve the status-quo.

[Cross-posted from Sound Money Project]

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