On Free Banking, Monetary Rules, and Crusades

Canadian Banking System, Commodity Money, monetary rules, NGDP targeting, Scottish Free Banking
Modified image of crusaders from the film "Kingdom of Heaven," produced by Scott Free Productions and distributed by 20th Century Fox. https://thecinematicexperiance.files.wordpress.com/2015/01/kingdom-of-heaven-2.jpg

Crusaders2I often find myself described, not as a monetary economist, plain vanilla or otherwise, but as a "free banker," and (therefore) as someone who wants to "abolish" the Fed.  Yet I've also been accused of lacking consistency, and even of being an outright apologist for monetary central planning, because I also have some nice things to say about monetary rules in general, and about nominal spending rules in particular.

So, am I a free banker or not?  The short answer is…well, there isn't a short answer other than "it's complicated."

First of all, I don't much like being called a "free banker," or a free banking "advocate."  Yes, I have a soft spot for free banking; yes, I think that the Scottish and Canadian systems of yore, which approximated it most closely, performed a helluva lot better than their modern, centralized counterparts; and yes, I think more people should study those systems, and free banking more generally, so as to better appreciate the extent to which competitive market arrangements are capable of producing stable and efficient systems of money and banking.

Yet these beliefs of mine don't mean that I'm not interested in reforms that fall short of any sort of free-banking ideal.  Still less do they mean that I imagine that, were we to simply get rid of the Fed, root and branch, a set of currency-issuing private banks would rush in at once to fill the void. Nor do I suppose for a moment that allowing commercial banks to issue their own notes, and otherwise deregulating them, while leaving the Fed's current money-creating powers unchanged, would put an end to monetary instability.  Finally, despite having moved from the academy to Cato, I'm more interested in promoting a proper understanding of the economic implications of free banking than I am in leading a crusade of any sort.  (Then again, I'm confident that, if more people understood free banking, we'd have crusaders aplenty for it.)

But there's a more fundamental reason why partiality to free banking today doesn't automatically translate into a desire to annihilate central banks.  When banknotes were still redeemable claims to some "outside" money, like gold or silver coin, to favor free banking — that is, to favor having rival banks issue redeemable notes over having a single bank alone do so — was equivalent to being opposed to having a central bank.  In a metallic standard context, freedom of entry into the currency business sufficed to keep any one bank's actions from provoking a general expansion or contraction, because while a monopoly issuer might count on other banks treating its IOUs as cash reserves, a bank enjoying no monopoly privileges could expect rival issuers to treat its notes like so many checks, to be promptly presented to it for redemption.  Subjecting a formerly privileged bank of issue to competition therefore served, no less than abolishing it altogether might, to deprive the bank of its short-run ability to influence aggregate nominal magnitudes.  Were the bank to be abolished, on the other hand, other banks, perhaps including new entrants, could readily make up for its absence, because the economy's (metallic) monetary standard would remain intact.

The situation becomes quite different once metallic standards give way to fiat money.  In a fiat system free banking ceases to be a straightforward alternative to, or substitute for, central banking.  That's so because the monopoly bank of issue is now responsible, not just for issuing paper currency, but for supplying the economy's standard money.  There is, in other words, no monetary standard apart from that embodied in the central bank's liabilities.  A "standard" U.S. dollar today is no longer a quantity of silver or of gold; it is a one-dollar Federal Reserve Note, or a one-dollar credit on the Fed's books.  It follows that, to simply abolish the Fed, in the strict sense of liquidating it (that is, parceling-out its assets to its creditors, and destroying and retiring its paper liabilities),  would be tantamount to abolishing the U.S. dollar itself.  Though it's still possible, and perhaps even likely, that some sort of new new banking and currency system would arise, that development would have to be accompanied by the prior or concurrent development of a new monetary standard or standards — a potentially fraught proposition.  Some may well be willing to risk such a radical change; but no one could predict its results with any degree of confidence.

In contrast, a free-banking reform that left the Fed's money-creating powers unchanged, while allowing private firms to issue dollar-denominated paper currency in competition with it, wouldn't make a big difference, even supposing that the new currency would be so attractive that no one bothered holding Federal Reserve notes at all.  The change wouldn't be entirely without significance.  For one thing, it would substantially reduce the Fed's, and therefore the Treasury's, seignorage revenue, converting it from producers' to consumers' surplus.  The reform would also relieve the Fed of the burden of providing for seasonal and cyclical changes in currency demand.  Finally, for reasons I've spelled-out in The Theory of Free Banking and elsewhere, the change could make for a more stable relationship between the quantity of base money and the volume of aggregate spending or NGDP.  But so long as paper currency consists either of Federal Reserve dollars themselves or of dollar-denominated private banknotes, a competitive banknote regime alone would not reduce, let alone undermine, the Fed's general ability to influence nominal magnitudes by buying or selling assets, and perhaps by other means.  Nominal values would be no less dependent than before on the size of the Fed's balance sheet, holding other determinants of the real demand for reserves (including interest rates on reserves and alternative assets) constant.  It follows that allowing other banks to issue currency would not rule out undesirable central-bank sponsored changes in spending, output, and the rate of inflation.

It follows from this that, so long as an economy relies on fiat money, the quantity of standard money itself, instead of being regulated by private market forces, has to be regulated by some other means.  That must either mean discretionary control by bureaucrats, or control by means of some sort of monetary rule.  The rule might itself replace the fiat standard with a revived commodity standard, by turning purely nominal official monetary liabilities into genuine claims to definite quantities of gold or silver.  But that is only one possibility among many — and an especially difficult one to pull off.  Most rules would instead preserve the standard money's "fiat" status.  And most would preserve the rumps, if nothing else, of established central banks.  Call it central banking, night-watchman style.

In short, although a century or more ago, free banking and monetary rules were rival ideas for guarding against abuses of discretionary monetary policy, today they are properly seen as complementary schemes, one for improving the performance of the banking system, the other for reforming the base-money regime.  Therefore there's no reason why one can't favor, and even crusade for, both.


  1. "One might reply that central banks’ many failures have been, not failures of central banking per se, but failures of discretionary central banking that might have been avoided by commitment to the right sort of monetary rules. But plausible as this view may appear, I believe it to be mistaken. For insofar as it takes the presence of a central bank for granted, the very idea that a choice exists between monetary rules and monetary discretion is misleading. The truth is rather that central banks are inherently discretionary institutions or, more precisely, that central bankers cannot resist exercising discretion. Like a married bachelor, a rule-bound central banker is a contradiction in terms, for both the background of central bankers and the incentives they confront, combined with the inescapable imperfections of even the most carefully crafted of monetary rules, will inevitably tempt them to tinker with the money stock."


    1. Admittedly, Will, there is at least a semantic inconsistency in my two statements, Much depends on how one defines a "monetary rule" and "central bank." In my forthcoming Cato paper (presented at last year's monetary conference) I distinguish between strictly enforced rules and others, and also between rules enforced by contract and ones enforced by design. A rule enforced by design would not provide much scope for rule breaking, Here again, semantics matter: is the publicly-designed arrangement that manages the stock of standard (fiat) money still a "central bank" is it does so using a computer program that can't easily be switched off or modified? I am thinking of that sort of rule when I speak of a "night-watchman" central bank–essentially, a central bank with no central bankers lurking around to muck things up! In the piece you refer to, I implicitly have in mind a monetary rule that is vulnerable to abuse because authorities can violate it.

      Semantics aside, the essential problem remains that, in a fiat system, you can't altogether abolish the central bank of issue without destroying the monetary standard itself. So, what to do?

      1. Thanks for clarifying, George. I am raising this issue because I often find myself at odds between advocating for an institutional reform (e.g., gold standard) and a policy reform (e.g., nominal income level targeting). The ideological stranglehold of central banking means the former is unlikely to be tried. The futility of central banking leaves little hope that the latter will be successfully implemented if tried.

        1. I agree. We want impersonal central banks that are in essence clever machines.

          1. Perhaps even clever machines that operate on a resilient, decentralized peer-to-peer network to achieve immutable consensus of transaction records.

      2. It isn't that I love fiat money. It's that I want to take necessary steps to secure it from abuse so that those who hold the stuff and rely on it as a medium of account won't be subject to avoidable hardship. Allowing "choice in currency" doesn't address the serious network problems that make switching out of an established money very difficult, even in hyperinflations. Making fiat dollars convertible into a commodity is a proposition fraught with difficulties, including the likelihood of immediate speculative runs on the issuers, owing to the fact that their promises are unlikely to command any confidence (history is hard to reverse, in short). If you can propose a better way to save the dollar, I am all ears! If you say you want a revolution, (and the dollar be damned), then you can count me out.

  2. I thought private banks issued currency when they made loans. Also, central banks have chosen winners and losers, and generally the economy of main street has lost. Seems like there should be sovereign rules against international central banks like the Fed mispricing risk. Mispricing risk should be a crime. Otherwise, the only way to juice the economy is through predatory lending? JMO.

    1. Quite true, Gary. But a "night-watchman" central bank would do no more than implement a monetary rule in a manner that would leave as small a footprint as possible on the economy. Free banking would help by minimizing the public's need for central bank created dollars.

  3. Excellent article. However, consider re-reading this article with the assumption–which is backed by data–that money is largely neutral. Does this change the analysis? Not necessarily that much, and it makes it all the more interesting.

    Also this sentence is clearly hyperbole: "Still less do they mean that I imagine that, were we to simply get rid
    of the Fed, root and branch, a set of currency-issuing private banks
    would rush in at once to fill the void" – nobody would want to barter for transactions, and clearly the seignorage revenue would be sufficient for some big bank to issue notes of some sort. It happened during the Great Recession with script so it would happen again if the Fed was eliminated.

    1. Ray, "rush" is the operative word. The problem is that a new standard would have to be established, and that the transition is likely to be quite chaotic. During the Great Depression, the dollar standard remained intact, even if much of the banking system didn't.

  4. "so long as an economy relies on fiat money, the quantity of standard
    money itself, instead of being regulated by private market forces, has
    to be regulated by some other means. "

    The problem is that so-called fiat money is not fiat money at all. It is careless reasoning to observe that Federal Reserve Notes are not convertible into the Fed's gold, and to conclude that FRN's are not backed by the Fed's assets.

    1. Mike, everyone uses the term "fiat money" to refer to the irredeemable "liabilities" of modern central banks. It is not lack of "backing" but the absence of convertibility into a fixed quantity of some commodity that distinguishes such standard money from other sorts. I do not believe that there is anything to be gained by refusing to use words as most others use them.

      And no one denies that the Fed's liabilities are "backed" by its assets in the simple sense that the assets are there, and that their nominal value exceeds that of the Fed's liabilities! So no one (or no economist of any standing) is guilty of the careless reasoning to which you refer.

      1. Consider the Bank of England's suspension of gold convertibility (but not bond convertibility) on Feb 26, 1797. Before that date, everyone believed that the value of the pound was determined by its backing. After that date, quantity theorists began to deny that backing determined the pound's value, and instead claimed that the pound was fiat money, that it was valued because it was limited in supply, and useful for trading.
        The trouble with this view is that it requires us to believe that the forces determining the value of the pound
        changed over time. No serious economist would deny that a newly created money,
        issued by a bank that has only just commenced business, must be valued
        according to its backing and convertibility. And yet quantity theorists insist
        that the paper pound, and all similar currencies, were and are valued because
        of a limitation of quantity, and not because of backing. Thus quantity
        theorists are forced to contend that the factors determining the value of the
        paper pound must have changed sometime between the Bank of England’s first
        issue of notes in 1694, and its suspension of convertibility in 1797. Against
        this unlikely scenario, I propose the more plausible alternative that the
        pound’s value was determined by backing both before and after the suspension of
        convertibility; that it was backing that mattered during normal business hours
        when the notes were convertible, that it was backing that mattered during the
        nights and weekends when the notes were temporarily inconvertible, and that it
        was still backing that mattered during the longer suspensions of convertibility
        such as the period from 1797-1821.

        1. A temporarily suspended liability is not the same as one for which there is no expectation of any future renewal of convertibility. I have elsewhere notices the difference. One is "credit money" in Mises' sense, the other fiat money.

          Anyway, there is no point going around this same merry-go-round. You and I must agree to disagree about the role of "backing" in fiat monetary systems.

          1. Modern government paper money clearly does not fit in the category of "no expectation of any future renewal of convertibility". Since all central banks hold assets, there is a reasonable expectation of future redemption of some kind, even if only for taxes due or loan repayments to the central bank. The right way to describe modern paper money is "backed but not gold-convertible".
            Once this is recognized, we can see that if, for example, the fed issues 10% more dollars, it will also get 10% more assets, and the value of the dollar will not change.

            Thus there is no need for you compromise your free banking principles and claim that "the quantity of standard money …has to be regulated". The value of standard money is preserved by the issuer's assets, not by government regulation.

  5. I wish it were so simple as you suggest, W. Ferrell The fact is that, like it or not, we are all stuck for the indefinite future with fiat money Allowing freedom of choice alone will not cause a quick, spontaneous transition to anything else, except perhaps in those cases where existing fiat monies are in the throes of hyperinflation. Even then, people are more likely to turn to some other fiat money (e.g., to dollarize) than to establish a new commodity-based alternative.

    In the meantime, the question remains: what can be done to make these fiat monies as tolerable as possible to the persons who must resign themselves to using them? Schemes that, while taken fiat money as given, attempt to secure them against discretionary manipulation by subjecting them to automatic regulation of some kind, are one solution. Call such schemes fascism if you insist. They at least have the virtue of being actual reforms, as opposed to mere libertarian grandstanding.

    1. I agree that central banking is a form of central planning, though I'm not prepared to call it "fascism" (I do not like to see such words robbed of their force by being applied too indiscriminately). As for academic reasoning, I believe that the Fed's power does in fact depends on support from academics and other experts. Were enough such to favor clipping its wings, I'm pretty sure that it would lead to some desirable reform.

      1. ACORN was not central to the banking crisis and even the housing bubble. If you think we should trust big banks more than government I suggest you are a little misguided.

  6. If we were lucky enough to live in a fantasy world where there was a broad based movement to get away from central banking, to decentralize the planning of the money and credit industries, I think there would still be an important place for central banks: As a tool of credit mobilization. Similarly to how you retain an army in peace time, central banks would have to stay around, too. We would need to develop rules and practices to keep them as dormant and harmless as possible, as we have with armies, when they are not in use, but the role they have to play during a wartime fiscal emergency is key and has been for the 300 years they've existed.

    After all, that was the initial role of the Bank of England: as a major source of credit for the British government. And that role was central to the growing military dominance of the UK in the 18th and 19th centuries. Even a libertarian country must have the tools available to mobilize the nation's resources, if just in a war of self-defense. The challenge is how you keep those tools from doing harm when they are not being used. The frequent foreign adventures of the modern US military highlight the height of this challenge, which also makes it difficult to imagine a world where we could have a peacetime free banking system paired to a potentially powerful central bank that could mobilize the financial resources of the country in time of need. The temptation to use it in less serious situations would be very great.

    A rigid monetary rule that can be broken under very particular conditions relating to a broad national consensus and agreement by a large portion of a national legislature is as good a place to start as any, though. If a monetary rule can establish credibility, furthermore, its actual long run influence on the broader economy can become less and less. The challenge is getting monetary authorities to stick to the rule and establish that credibility in the first place.

    Either way, wonderful to see you understand the importance of moderation in radicalism. No matter how radical your opinions, goals, or dreams, you need to understand that moderation is a virtue in itself. Never get too drunk on your own ambitions and all that.

    1. Thanks, MichaelM. I don't see my position as moderating my radicalism, so much as establishing the most effective means for achieving monetary stability. If I thought more radical means capable of doing better, I wouldn't hesitate to say so. I just don't see free banking today as a device for "taming" the dollar standard. That's quite apart from any consideration of its likelihood of being adopted. In fact, I believe that, if adopted, it would leave part of the reform job unfinished.

      Concerning the general points you make about the long-run benefits of having a monetary rule, I wholeheartedly agree.

      Finally, on central banks and credit mobilization: I think the argument anachronistic for most modern economies. Well-developed markets for government securities(such as were unknown in the early history of central banks) make it perfectly possible for governments to mobilize immense amounts of credit, provided they are willing to pay a price. Central banks in this case serve no purpose other thank to allow governments to engage in inflationary finance, that is, to steel instead of borrowing. Note that inflationary finance itself was no part of the Bank of England's original rationale.

      1. Vis the existence of deep, hungry markets for government debt in the modern day: That actually may be so. Still, all that argument does is make the separate nature of the central bank a questionable idea. The essential functions that aid in credit mobilization could very well just be an organ of the Treasury.

        I do, however, disagree about inflationary finance. At least in the modern day (when we're a lot more comfortable with the idea of inflation than Anglos in the 18th and 19th centuries were, as you know better than most!), inflationary finance is perfectly legitimate, or at least as perfectly legitimate as any taxation. That's all inflation is, when the seniorage is accruing to the government: A tax on cash balances.

        Inflationary finance is a significant portion of how the US paid for the Revolution, for example. Of course, it did so with no real central bank (the Bank of North America not being a real central bank and not being founded until the war was almost over, anyway), so this isn't really an argument for the continued existence of a central bank, either. Again, the Treasury itself is more than capable of all this.

        So, I suppose I'm not really trying to argue for the continued existence of a central bank so much as the continued existence of some kind of organization that can perform some of the roles central banks are supposed to perform. If that organization is subordinate to the Treasury, I don't think I'd be too bothered. That might actually be a good way to get commitment to some kind of rule, going. Treasury sub-departments can be bound by the Constitution in a way that an independent organization like the Federal Reserve cannot.

        Either way, just speculating.

        As to the first part of your response, I guess all I'm trying to say is that a dash of realism and pragmatism is a breath of fresh air in a sphere of interest (monetary reform) that is absolutely dominated by quacks. I've always had a lot of respect for you, at least since I started reading your work and the work of your colleagues in free banking scholarship years ago as a hobby. It's good to see that respect isn't badly placed 🙂

  7. Honorable Mr. Selgin, thank for your article. I have one question, what is you position about market monetarism? I heard that the market monetarists (Scott Sumner, etc) are not libertarians, but they positively refers to the free banking work (e.g., Glasner)? Can you also called yourself market monetarist?

    1. Well, I don't call myself a market monetarist. But then again, I don't call myself a libertarian, either. My ideas on money and banking rest on my understanding of economics–and the fact that I think stability and efficiency better than instability and inefficiency–and not ideology. I insist on this because I dislike the idea that people imagine that I treat economics as a handmaiden to some ideological views I hold.

      I share at least one fundamental belief with market monetarists, to wit: that a well-working monetary system is one that functions to preserve a stable flow of aggregate spending. However, I can't claim to have been won over to this belief by market monetarists, since I have taken it for granted since long before the MM movement got started.

  8. "It follows that, to simply abolish the Fed, in the strict sense of liquidating it (that is, parceling-out its assets to its creditors, and destroying and retiring its paper liabilities), would be tantamount to abolishing the U.S. dollar itself."

    I would only say that it is not the U.S. dollar we would be abolishing, it would be the Federal Reserve Note/dollar we would be abolishing, assuming the Fed were abolished. De-tethering, on the other hand, the Fed from the U.S. government would enable the Fed to continue to issue their base money and truly establish the independence they now falsely claim. The U.S. government would then be free to issue U.S. dollars and compete alongside the Federal Reserve. Of course, both could easily be placed in competition with multitudes of other domestic suppliers of "money", not to mention foreign producers.

    If you get to the heart of my, and many other's, complaint against the Fed and the current public-private structure, is it's very thinly disguised institution of privilege and political favoritism on the back's of those not not so privileged and favored. The American people are not clay, nor lab rats, to be experimented on, nor tiny morsels to be devoured. Under the current regime, the vast majority of real Americans are damaged by the Fed. That same institution, de-coupled from the U.S. government, under a truly independent regime, has the potential to be nothing short of a godsend to U.S. and foreign producers and consumers.

Comments are closed.