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Robust Convertibility

What determines the extent to which a bank can be trusted to honor its fixed-rate redemption commitments?

The answer that's at least implicit on most writings is that what matters is the nature of the assets backing a bank's IOUs, and especially the extent to which those assets consist of cash reserves. As a bank's reserves approach 100 percent of its outstanding demand liabilities, its ability to meet redemption requests improves, other things remaining equal; and if it actually maintains 100-percent reserves even a systemic run cannot force it to suspend. The case for currency boards, as more robust alternatives to central banks for preserving fixed exchange rates, rests entirely on this simple truth, which is also one of the arguments (but by no means the most important argument) offered by those who favor 100-percent reserve commercial banking over a fractional-reserve alternative.

But while the argument in question is valid so far as it goes, it overlooks a far more important determinant of the robustness of a bank's commitment to convertibility. For if history is any guide a bank's ability to fulfill its contractual obligations matters far less than its willingness to do so. And that willingness depends less upon the state of a bank's cash holdings than on its legal and economic status. Specifically it depends on whether the bank is so privileged as to be able to default on its promises without running the risk of being forced into liquidation, or that of being taken over by its creditors, or even that of losing much business.

A competitive and privately-owned bank, lacking any special privileges, can't default with impunity. It's outstanding liabilities are just that–liabilities–which means that it has to honor them or face legal consequences, including either its liquidation or a transfer of ownership. In earlier times a bank's owners might also have been liable to an extent exceeding the nominal value of there shares, and perhaps to the full extent of their personal wealth, with imprisonment the normal penalty for non-payment.

Moreover even if the owners of a competitive bank might somehow have escaped legal penalties for nonpayment of the bank's debts, they could hardly have avoided the market penalty consisting of the utter ruin of the bank's reputation, and the corresponding, wholesale loss of business to more reputable banks. There would still be no question of the bank's continuing to be a going concern.

For these reasons it is, of course, impossible to imagine a competitive bank "devaluing" its currency. The concept of "devaluation" is strictly applicable to banks having monopoly privileges, and particularly to monopoly banks of issue. By the same token, it is incorrect to equate a competitive issuer's commitment to redeem its notes at an unalterable rate as an instance of "price fixing": a competitive bank is no more free to "adjust" the rate at which it exchanges reserve money for its IOUs than a restaurant cloakroom is free to adjust the rate at which it exchanges coats and hats for claim tickets. It was only once governments awarded monopoly privileges to favored bankers, and then allowed those bankers to devalue their promises, or stop paying them altogether, and to do so with impunity, that what had once been solemn obligations to repay debts devolved into mere "price fixing."

It is, moreover, precisely owing to this devolution of former promises to pay that fixed-rate convertibility schemes are now notoriously subject to "speculative attacks," that is, to runs based upon (sometimes self-fulfilling) fear of an impending devaluation. Notwithstanding the fantasies of Diamond and Dybvig, commercial-bank note redemption agreements were historically far less vulnerable to speculative attacks than modern pegged-exchange rate schemes overseen by central bankers, for the simple reason that commercial note-issuers who failed to keep their promises had a lot more to lose than their modern central-bank counterparts.

A particularly remarkable illustration of a private issuer's tenacity in this regard took place in Scotland during the 'Forty-Five, when, as Prince Charles was marching his way toward Edinburgh, both the Bank of Scotland and its rival, the Royal Bank, took the precaution of placing their cash reserves beyond trouble's reach in the city's relatively impregnable Castle. After the city itself was occupied, the Castle remained in the hands of Royalists, who harassed the enemy (and innocent civilians alike) by raking the streets below with round after round of grapeshot. Still that didn't prevent a white-flagged band from courting death to make its way to the Castle drawbridge one morning. The band consisted of the Royal Bank's cashier, three of its directors, its accountant, and a teller. They had come to get cash to pay notes returned to them from Glasgow the evening before.

Of course, despite the penalty of failure, commercial issuers did sometimes fail to keep their promises. But unlike central banks, which have often resorted to suspension or devaluation or both while still well-stocked with reserves, they never did so if they could help it; in any event the monetary standard survived individual issuers' misfortunes and misconduct. When, in contrast, a central bank is obliged, for any reason, to break its promises, it is necessarily obliged to alter its nation's monetary standard as well.

Considerations such as these explain why the proliferation of central banks would have doomed the gold standard even if wars and depression hadn't taken their distinct toll on it. For central banking tended to reduce that standard to a mere set of official gold price-fixing schemes, with their corresponding vulnerability to speculative attacks. By the same token, they also explain why persons wishing for a revival of the gold standard had better also wish for competitive rather than centralized paper currency.