Wrong Lessons from Canada's Private Currency, Part 1

Canadian Banking System, Counterfeiting, Currency Competition, National Banking Era, Private Banknotes
Bank of Prince Edward Island, One Dollar. Credit to National Museum of American History. https://en.wikipedia.org/wiki/Prince_Edward_Island_dollar#/media/File:CAN-S1929c-Bank_of_Prince_Edward_Island-1_Dollar_(1877).jpg

I've referred often in these pages to the virtues of Canada's late-19th century currency system, with its heavy reliance upon circulating notes issued by several dozen commercial banks, most of which commanded extensive nationwide branch networks. I've also lamented the fact that so few monetary economists today, let alone members of the general public, seem aware of that arrangement, the superiority of which, both absolutely and compared to its U.S. counterpart, was once widely celebrated. For I'm certain that, if more people were aware of it, the scales might drop from their eyes, plainly revealing the gigantic blunder our nation (and most others) committed by entrusting the management of paper currency to a government-sponsored monopoly managed by bureaucrats.

So you might expect me to be jumping for joy after seeing this new Bank of Canada Staff Working Paper by Ben Fung, Scott Hendry, and Warren E. Weber, on "Canadian Bank Notes and Dominion Notes: Lessons for Digital Currencies."  But no such luck: instead, after reading it, I've been in a blue funk.

How come? Because, instead of drawing badly-needed attention to the substantial merits of Canada's private currency system, Messrs. Fung, Hendry, and Weber focus on its shortcomings, claiming that it suffered from serious flaws that only the government could fix. They then go on to argue that government intervention may also be needed to keep today's private digital currencies from displaying similar flaws. In short, according to them, Canada's experience, instead of casting doubt on the desirability of special government regulation of private currencies, supplies grist for regulators' mill.

Is their perspective compelling? I don't think so. As I plan to show, and as even a cautious reading of Fung et al.'s own assessment will suggest to persons familiar with other nations' experiences, the imperfections of Canada's private banknote currency were minor ones, especially in comparison to those of the concurrent U.S. arrangement. Nor is it even clear that they were genuine flaws, in the sense that implies market failure. The reforms that eventually eliminated the imperfections were, in any case, not imposed on Canada's commercial bankers against their wishes, but instigated by those bankers themselves. Finally, the suggested analogy between Canada's 19th-century banknotes and modern digital currencies, far from supplying solid grounds for supposing that unregulated digital currencies are likely to exhibit the same (real or presumed) shortcomings as their 19th-century Canadian counterparts, is so forced as to be utterly unconvincing. For all these reasons, those seeking to draw useful lessons from Canada's private currency experience will be well-advised to look for them elsewhere.

Because there's so much I feel compelled to say about Fung et al.'s paper, I've decided to devote several posts to it. In this one, I'll assess that paper's claims regarding the supposed shortcomings of Canada's private banknote currency. In the follow-ups, I'll address the claim that it took government regulations to perfect that currency, and their claim that Canada's experience with private banknotes points to the likely need for government intervention to correct inherent shortcomings of today's digital currencies. Finally, I'll share my thoughts regarding the real lessons to be learned from Canada's 19th-century currency system.

Supposed Shortcomings of Canada's Private Currency

Following Canada's Confederation in 1867, that country's paper currency consisted mainly of the circulating notes (or "bills," as the Canadians called them) of a couple dozen commercial banks, plus some government-issued paper money known as "Dominion" notes. Although Dominion notes were made legal tender, both they and bank notes were payable on demand in specie. Unlike the notes of U.S. national banks, which had to be secured by certain U.S. government bonds, Canadian bank notes were backed by their issuers' general assets. Canada's banks were also free, unlike their U.S. counterparts, to establish note-issuing branches anywhere in that country, and even beyond it (several had New York City branches). Nor were the banks required to maintain any specific amount of cash reserves. After 1871, banknotes were limited to denominations of $4 or more; and in 1880 that minimum was raised to $5. The banks' charters also limited their circulation to their paid-in capital; however that restriction didn't become binding until the outbreak of the U.S. Panic of 1907. In short, the supply of Canadian banknote currency came very close to being completely unregulated.

That lack of regulation, according to Fung et al., caused Canada's private banknote currency to go awry in several ways. It was, they say, subject to "considerable" counterfeiting.  And prior to the passage of the Bank Act of 1890 , it was also neither perfectly safe nor perfectly uniform. Bank failures sometimes exposed note holders to long delays in payment, if not to outright losses; and banknotes sometimes traded at a discount from their face values.


How serious were these imperfections? Although Fung et al. speak of "considerable" counterfeiting, the adjective merely means that, at one time or another, attempts were made to counterfeit most of them, and that now and then substantial amounts of counterfeits were produced. It doesn't follow that the counterfeits in question were capable of fooling experienced bank tellers (Fung et al. themselves recognize that many were of "poor quality") much less that they were a serious menace to legitimate banks of issue (if they were, the record is silent about it). Still, counterfeits had their victims, and as such were a blemish on the Canadian system's record.


Regarding banknotes' safety, Fung et al. note that, of 55 Canadian banks that operated at some time between 1867 and 1895, only three wound-up without paying their note holders in full. The Bank of Acadia, which failed in 1873, left most of its outstanding notes unpaid, whereas the Mechanics Bank of Montreal, which failed in 1879, and the Bank of Prince Edward Island, which failed in 1881, paid 57½ and 59½ cents on the dollar, respectively.

Considering the size of the banks that failed, as measured by their total note circulation, these already very modest losses appear even less significant. At the time of its failure, the Mechanics Bank of Montreal had only $168,132 in notes outstanding. The circulation of the Bank of Prince Edward Island, at $264,000, wasn't all that much greater. The Bank of Acadia, finally, was an outright fraud, for which no actual circulation figures exist. Assigning to its circulation the almost certainly too-generous value of $50,000, and allowing for a total circulation of all Canadian banks of about $25 million, the notes of the three failed banks made up less than 2 percent of the total. Not perfect, to be sure; but not bad at all.

Stepping back to take in a still bigger view, the Canadian banks' record looks even better: in all, between 1867 and the end of the century, the grand total of losses of all creditors of failed Canadian banks amounted to $2,000,000, which was less than 1 percent of the banks' obligations.

But to really appreciate how safe Canada's banks were, one needs to compare their performance to that of banks elsewhere — something Fung et al. don't bother to do. The contrast between Canadian bank's safety and that of their contemporary U.S. counterparts — the notes of which were, remember, fully backed by U.S. government bonds — is especially striking. According to Andrew Frame, between 1863 and 1896, 330 national banks failed.  Of $98,322,170 in accumulated claims against them, less than 64 percent had been paid by the end of the period, leaving $35,556,026 still due to creditors. Another 1,234 state banks also failed, leaving $I20,541,262 out of $220,629,988 in debts unpaid. In other words, the record of recoveries from U.S. bank failures taken as a whole was not much better than that of two of the Canadian system's three worst deadbeats! 

There was, however, as Fung et al. also point out, more to the imperfect safety of Canadian banknotes than these recovery statistics suggest, for in some cases in which holders of failed banks' notes were eventually paid in full, they had to wait for months, and in one instance more than two years, to be paid in full, or else had to settle for less by selling their notes at a discount. But here again, the extent of the losses involved mustn't be exaggerated. Of eight banks that failed other than those that never paid their notes in full, five had fewer than $50,000 in outstanding notes, and the circulation of one — the Bank of Liverpool — was just $3,368! Furthermore, according to George Hague (1825-1915), a long-time Canadian banker and author of several highly-regarded works on the history and workings of the Canadian system, the notes of failed banks "have generally maintained their value, or fallen only to a slight discount until finally paid." Payment also appears to have been made, in most cases, in a matter of a few months at most.

Fung et al. point, on the other hand, to two notorious cases — those of the Consolidated Bank of Canada (circulation $423,819), which suspended in 1879, and of the Maritime Bank of the Dominion of Canada (circulation $314,288), which did so in 1887. Some holders of the Consolidated's notes, they observe, submitted to discounts of 10-25 percent rather than wait for payment, while it took those who held notes of the Maritime Bank more than two years to be paid in full.

Concerning these exceptions, in one case — that of the Maritime Bank — the bank's liquidators were sued by the Receiver-General of the Province of New Brunswick, which was among its depositors. The Receiver-General claimed that, because it was a representative of the Imperial Government, the royal prerogative gave it priority over the banks' other creditors, including note holders. (This was, it bears noting, notwithstanding the 1880 statute giving bank note holders a first lien.) The suit set in motion a protracted  sequence of trials and appeals, culminating in a Supreme Court verdict in the provincial governments' favor. It's therefore not inaccurate to say that, if the Maritime bank's note-holders, who were eventually paid in full, suffered in the meantime, the fault was neither the bank's, nor its liquidator's, but that of Canadian government authorities themselves, who were more interested in pressing their own claims than in satisfying those of Canada's citizens at large.

The case of the Consolidated Bank of Canada was, on the other hand, a genuine, if singular, blot on the Canadian system's record, which led to the indictment, and nearly to the conviction, of several of the bank's officers for making a "willfully false and deceptive statement" regarding the bank's condition prior to its failure. (The gory details can be found here.) Eventually a broker paid $260,000 for the Consolidated's assets, which it reported as being worth over $3 million at the time of its suspension!


Finally, note discounts. It's true that, before 1890, the notes of perfectly solvent Canadian banks sometimes commanded less than their full face values at places remote from their sources. Unlike information concerning discounts on antebellum U.S. bank notes, which can be had from numerous "banknote reporters" published at the time, details concerning Canadian banknote discounts are relatively few and far between — a fact that itself suggests that the problem was not so severe. What few details there are also suggest that note discounts were modest. According to L. Carroll Root,  (p. 323), before 1890 notes from Nova Scotia and New Brunswick tended to pass at a "slight" discount in both Toronto and Montreal, while those of Toronto and Montreal tended to be discounted — again, slightly — in the Northwest only, while passing current in Toronto.

The Nirvana Fallacy

There's no denying that, whatever its merits, Canada's private currency was less than perfect. But so what? Imperfection alone is no proof of market failure. To assume otherwise is to subscribe to what Harold Demsetz famously named "the Nirvana fallacy":  the view that "implicitly presents the relevant policy choice as between an ideal norm and an existing 'imperfect' institutional arrangement," instead of recognizing that the relevant choice must be one between alternative realizable arrangements. More concretely and precisely, it's necessary to ask, not whether Canada's private banknote currency was "imperfect," but whether it was inefficient. Alas, that is something Fung et al. never do.

Was the Extent of Banknote Counterfeiting Inefficient?

Yet the imperfections of Canada's commercial banknote currency were certainly not such as might supply prima facie grounds for supposing that it was inefficient. Take counterfeiting. Yes, Canadian banknotes were counterfeited. But the same may be said for virtually every paper currency that has ever been issued, including every sort of official (that is, government or central-bank issued) paper currency. Experience shows, moreover, that even the most elaborate — and expensive — schemes for thwarting counterfeiters are incapable of deterring them. One need only consider the Fed's frequent, futile efforts to render its currency counterfeit-proof. Nor has the Bank of Canada been much luckier.

Indeed, if you're looking for troublesome high-tech counterfeits, the best place to look for them is, not among Canada's private banknotes, but among those paper currencies, including Canada's 19th-century Dominion notes and today's fiat monies, that qualify as legal tender. Counterfeits are usually detected by expert tellers working for legitimate currency issuers, rather than by ordinary members of the public. Counterfeit detection rates therefore depend on how often an issuer's currency returns to it for processing. Unlike commercial banknotes, which tend to circulate only for relatively short periods before being returned to their supposed source, legal tender currencies tend to circulate until they wear out, that is, for years rather than a few days. Consequently the risk of fakes, and good ones especially, being quickly detected is relatively low. And the more widely a legal tender currency circulates, the more safe it is to imitate, other things equal.

It was partly for that reason (but also because their designs were no better than those of commercial banknotes) that circulating Dominion notes were no strangers to the forgers' wiles. Fung et al. themselves point out that $1 Toronto (Dominion) notes of 1870, and both $1 and $2 Montreal and Toronto notes of 1878, were "extensively counterfeited." (According to one numismatic reference work, counterfeit specimens of the $2 Dominion notes of 1878 actually outnumber genuine ones!) 1887 $2 notes were also counterfeited, though sources do not say how extensively. All this may not sound so bad, until you realize that, apart from very modest quantities of 25¢ shinplasters and (starting in 1882) $4 notes (useful for their equivalence to £1 sterling), $1 and $2 bills made up the bulk of Dominion notes that actually circulated, larger ones having been used only as bank reserves. ($5 Dominion notes did not make their first appearance until 1912.)

Nor is that all: the 1870 and 1878 $1 notes were the only $1 notes supplied before 1897, while the 1870, 1878, and 1887 $2 notes were the only $2 notes available until 1897. In short, to observe, as Fung et al. do, that the appearance of Dominion notes "did not improve the situation with regard to counterfeiting," is beating around the bush. The truth is that all pre-1897 Dominion notes were counterfeited, and most were counterfeited "extensively."

To treat the fact that Canada's private banknotes were counterfeited as a flaw, despite the even more aggressive and troublesome counterfeiting of their closest substitutes, Dominion notes, is a perfect example of the Nirvana fallacy at work.

Was Less than Perfect Note-holder Safety Inefficient?

The same may be said of Fung et al.'s claim that Canadian banknote currency was flawed because persons who held it sometimes suffered losses when banks whose notes they held failed. Although we tend today to take for granted that currency should be free of default risk, we do so in part because we're used to irredeemable fiat monies, which of course aren't IOUs at all; alternatively, they are, in the immortal words of former Federal Reserve Bank President John Exter, "IOU nothings." Still more precisely, fiat currencies, or most of them at any rate (including Federal Reserve Notes and modern Bank of Canada Notes), are free of default risk because their issuers have already defaulted. It's hard to break an already broken promise!

Things were, of course, different in the days of the gold standard. To their credit Fung et al. recognize this when, in discussing the characteristics of Dominion notes, they observe (p. 23) that "no fiduciary currency is 100 per cent safe." The question, then, is whether Canada's commercial banknotes were excessively risky compared to other fiduciary alternatives. Since no holder of Dominion notes suffered any loss until Canada went off the gold standard during the Great Depression, it's easy enough to conclude commercial banknotes were riskier. But it doesn't follow that they were excessively so, because the extra safety of Dominion notes came at a price, consisting of their exceptionally high specie backing.

Would the extra cost have been a price worth paying to spare Canadian banknote holders their relatively modest losses? I doubt it: according to George Hague, although the Canadian system exposed note holders to some risk of loss, it also "rendered the small amount of active capital possessed in a partially developed country available to the utmost extent possible." As anyone knows who has read Book II, Chapter II of The Wealth of Nations, or my own Cliff Notes version, available here and here, or Rondo Cameron's Banking in the Early Stages of Industrialization, maintaining such heavy specie reserves meant devoting fewer funds toward productive investment.

Still more do I doubt that it would have made sense to sacrifice the famous "elasticity" of Canada's commercial banknote currency — a feature that helped Canada to avoid U.S.-style currency panics — for the sake of giving banknote holders a little more security. Yet such a sacrifice is exactly what would have been required had Canada stuck to it's original plan to have Dominion notes, with their 100-percet marginal specie reserve requirement, supplant banknotes. I very much doubt it, though I cannot be certain. What I do know is that Fung et al. never bother to demonstrate that available alternatives to Canada's imperfect banknotes would actually have been better, let alone perfect.

Were Discounts on Solvent Banks' Notes Inefficient?

And how about those "slight" discounts to which notes of solvent banks were sometimes subject. Were they proof positive of market failure? Hardly. Just as banks that deal in foreign currency notes today must cover the costs involved in shipping those notes to and from their sources, early banks and banknote brokers had to be compensated for the cost of returning domestic banknotes to their (sometimes far-away) sources for redemption. In Canada, those costs were anything but trivial. Though Canada's combined provinces are geographically larger than the U.S., at the time of its first, 1871 census it had only 2,779 miles of railroad to the United States' 45,000 miles.  Nor was the first trans-Canada railroad  completed until 1885, some 16 years after the driving of the golden spike at Promontory Summit. Canada also had only about one-tenth as many people, most of whom lived far away from its cities. And "cities" is being generous. Only nine held more than 10,000 people, and only one (Montreal) had a population exceeding 100,000. Small wonder that banknotes found far from their sources were likely to be discounted!

Moreover the tendency, independent of any legislative interference, was for those discounts to decline over time, and often to vanish altogether, as banks expanded their branch networks (and also, in time, as they found it worthwhile to form clearinghouses). For according to Roeliff Morton Breckenridge, upon whom Fung et al. rely for much of their information concerning Canadian banknotes' lack of uniformity, it was only "the notes of a bank without a branch in the neighborhood [that] did not circulate at their par value in localities remote from where they were payable" (my emphasis).

That Canada's established banks at first hesitated to establish branches in any but the most settled and thriving communities was only reasonable. As George Hague explains, in the early days "restless, and even reckless, persons" outnumbered other sorts in Canada's less populous towns and villages, so that any branch located in them had to exercise great care to keep it's customers' savings from "being lost in foolish projects and hastily considered enterprises." Even so, according to Breckenridge (p. 354), the banks "rendered yeoman service…extending their field of operations as fast, probably, as the growth of the country warranted," so that, by the early1890s Canada's banks collectively had branches, or their headquarters, "in almost every community where there is accumulation, commerce, and credit."

If Canadian banks' branch networks didn't grow, and note discounts therefore didn't disappear, more rapidly than they did, the parsimonious explanation is, not that there was a market failure, but that a faster rate of expansion wouldn't have been economically worthwhile. Better to let people bear a discount on "foreign" banknotes now and then than waste resources by placing bank branches (let alone clearinghouses) where the risks are too great, much less where wolves still outnumbered people.

The gains from other schemes for keeping banknotes current might likewise fall short of the schemes' cost. Consider what transpired in the U.S. There, a "uniform" currency was first established in 1864. But by what means, and at what price? The deed was done, first, by stamping-out the notes of state-authorized banks (a step that itself almost certainly did more harm than good), and, second, by including a clause (section 32) in the 1864 National Bank Act stipulating that every national bank must "take and receive at par, for any debt or liability to it" the notes of all other national banks.[1] That of course meant that the banks could no longer afford to sort, mail, and return notes of rival banks to their sources for payment, as they would normally have been inclined to do. But, hey! The Draconian measure did after all give us a "uniform" currency, so what difference did it make whether the banks liked it or not?

Plenty, actually. Remarking on the routine redemption of Canada's commercial banknotes, Sir Byron Walker, the General Manager of the Canadian Bank of Commerce and a V.P. of the Canadian Bankers' Association, speaking at a bankers' gathering in Chicago in 1893, observed that

This great feature in our system as compared with the National Banking System, is generally overlooked, but it is because of this daily actual redemption that we have never had any serious inflation of our currency, if indeed there has ever been any inflation at all (p. 14).

You see, a currency that was scarcely ever sent back to its sources for redemption bore the characteristics, not of ordinary, low-powered banknotes, but of a high-powered fiat money. The national banks might therefore have been tempted to issue them without restraint, had they not been simultaneously burdened by bond-backing requirements and, until 1875, a limit on their aggregate note issues.

U.S. authorities, who wished to remove that aggregate limit, were fully aware of the problem, and sought to correct it by establishing, in 1874, a national banknote redemption Bureau in Washington. Unfortunately that solution never worked very well: for the most part, banks only sent the Bureau tattered, worn, and soiled notes that they couldn't get rid of otherwise.  It was, as Larry White and I have explained elsewhere, partly owing to the Bureau's inadequacy, which informed legislators' reluctance to relax bond-collateral constraints limiting national banks' capacity to issue more notes, that the U.S. found itself saddled, for the rest of the century and beyond, with an utterly inelastic currency system, and consequent, recurring crises.

Might U.S. citizens have been better-off, after all, putting up with the occasional banknote discount?[2] To anyone conversant with the sad history of late 19th-century U.S. panics, the question answers itself. Once again, imperfect doesn't always mean inefficient.

Continue Reading Wrong Lessons from Canada's Private Currency


[1] Fung et al. (p. 30) mistakenly claim that it was only after the establishment of the Washington note redemption bureau in 1874 that "notes of the various national banks exchanged at par." For the real purpose — and inadequacy — of that bureau, keep reading.

[2]  When I say "occasional," I mean it: as shown in my paper on state banknotes also linked to above, by the autumn of 1863, or not long before the reforms that were to establish a uniform U.S. currency, the aggregate discount on state banknotes (excluding notes of banks in the Confederacy, which were then no longer trading in Northern markets) was trifling. Had one purchased all the notes in question at face value, and then sold them to brokers in either Chicago or New York for what the brokers were paying in those markets, the loss would have amounted to less than one percent, even reckoning any note that brokers listed as unknown or uncertain as worthless.

  • joebhed

    Dr. Selgin,
    Thanks for this, as usual.
    Can you help me understand this …..
    "" ……… plus some government-issued paper money known as "Dominion" notes.
    Although Dominion notes were made legal tender, both they and bank notes
    were payable on demand in specie.""

    So, were these "Dominion Notes" like U.S. Greenbacks in the sense that they were issued 'debt-free' by that government, only difference being their specie convertibility.?
    Any good historical references …. legal tender CA statutes?

    • George Selgin

      "they were issued 'debt-free' by that government," Sorry, joebhed, but I have no idea what this means. Redeemable government paper money is a sort of non-interest bearing debt. And greenbacks (meaning U.S. Notes first issued during the Civil War), though not redeemable before 1879, were themselves redeemable in gold after that.

      • joebhed

        Thanks, Dr. Selgin,

        Sorry for that confusion, but I was not asking for the type of paper issuance, being redeemable as the Dominions were, and the Greenbacks were not, at issuance.

        Your response about government-issued redeemable paper money
        being a ‘sort of non interest bearing debt’ …. leaves me at the ‘sort of’ point
        as far as being debt goes. Being redeemable seems to me a separate matter.

        I didn’t think the Greenbacks were any kind of debt. The authorizing statutes say that no debt will be issued – at least originally, when the GBs were spent into existence … and those two faces of being spent-into-existence’ and without associated debt, is what I meant by ‘debt-free money’.

        All paper money issued by Treasury spending it into existence, without associated debt, is what I call permanent, debt-free, public money.

        Greenbacks had those qualities, and my inquiry was whether the 'Dominions' issued at that time had those qualities as well.
        Sorry, I didn’t mean to confuse the discussion of your article.


        • George Selgin

          Greenbacks were debt ultimately to be paid in gold. Until resumption,those who held them made an interest-free loans, equal to the nominal gold value of the notes, to the Union government.

          For that matter, all redeemable currency is debt of some kind. It is an IOU, and an IOU is a debt!

  • Great piece, great lessons. Thanks George!

    • George Selgin

      Thank you, Milton.

  • JP Koning

    Great post, George.

    What is the history of clearing houses in Canada?

    Weber et al seem to imply that national clearing only began in 1890 with the passage of government regulation. ie: "Neither Canadian nor U.S. banks on their own established any mechanism for nation-wide clearing or redemption which would have also served to eliminate such discounts."

    As far as you know, did Canadian banks set up local clearing houses for notes prior to 1890? Did Canada have its own Suffolk system?

    • George Selgin

      Hi JP; I'm glad you like it so far. I will talk about the clearinghouse in Part 2; short answer: the bankers took the initiative, establishing the first ones in tge 1880s. Legislation played no essential role either then or as more were established in the 90s.

  • The political reality is that privately issued money (in note form of book-keeping form) without state backing is a non-starter. It may have been OK in the 1870s. It lasted till the 1930s when (in the US) ordinary depositors lost about $6bn (according to Irving Fisher). But the experience of the 1930s means that nowadays, voters just demand a 100% safe form of money. No ifs, no buts. And only the state can provide that safety.

    • George Selgin

      Ralph, I'm offering a lesson in history, and I'm countering an attempt to use that same history to rationalize regulating modern digital currencies. So, tell the Bank of Canada to stop writing about old Canadian banknotes, if you must tell anyone.

      But really, you shouldn't. Your complaint is actually against history itself, which you naively imagine to be of no merit if the episode being discussed can't be replicated!

      Finally, I must remind you that the duty of any responsible economist is, not to stick a finger in the air to determine which way the politics are blowing, and then to express himself in favor of whatever that direction is, or more generally to treat whatever "is" as equivalent to what must be. It is our duty to speak of facts and logic, and to say what is efficient and what may not be, and to express views on desirable reforms, regardless of whether they may or may not be achievable. Let politicians and politics make the latter determination; doing so is their dirty work. Any economist who spares politicians the trouble, not only compromises his own and his professions integrity, but by so doing doesn't merely define, but actually reduces, the potential for desirable change.

      In short, you are a politician; I'm not. I understand your need to practice "the art of compromise." But my profession carries quite different responsibilities than yours. Let's not confuse the two!

    • Mattyoung

      100% currency guarantee by the state means all transactions must use the government tax dollar. The guarantee is that my dollar will always have convertibility into goods. The guarantee has enforcement costs, hence there is a wedge that separates out sets of transactions that are more efficiently bartered. Real estate trades denominated in fuzzy market numbers are a case in point.

      So the pledge is only maybe 97%, three times out of a hundred you find an item that your could have bought, but there was a transaction hassle and you skipped it. I am optimistic, but it is still 3%, Call it pricing uncertainty, but it is necessarily less than 100% because the currency participates in a discovery process that never really terminates. In fact the problem is much worse when government never acknowledges insurance failures, they keep the guarantee by extending their debt structure beyond any supportable basis.

      • “100% currency guarantee by the state means all transactions must use the government tax dollar.” News to me. Almost every country nowadays has “100% currency guarantee by the state” in the sense in which I used the phrase above: that’s a system whereby the state guarantees money in private banks (e.g. via the FDIC). And as to money in state run savings banks (e.g. National Savings and Investments in the UK) that is also 100% safe, or as near 100% safe as is possible in this world.

        However that guarantee most certainly does not mean “all transactions must use the government tax dollar”. People in the US are free to engage in barter if they want. They are free to use Bitcoins. They can use Russian Rouples if they really want.

    • jandr0

      [It lasted till the 1930s when (in the US) ordinary depositors lost about $6bn (according to Irving Fisher).]

      And you, I suspect DELIBERATELY, avoid addressing the politicians', governments', and banker cronies' roles in the situation, to therefore "present" a cut-down cardboard caricature version of the complete truth. Your obvious rhetorical ploy is clear to see.

      Some people would be nice and call what you did lying by omission. I, however, prefer to call it downright deceitful.

      [But the experience of the 1930s means that nowadays, voters just demand a 100% safe form of money.]

      I am a registered voter, and I do not demand that. No ifs, no buts.

      I am forced by legal tender laws to use fiat money. No ifs, no buts.

      I do, however, demand a money that doesn't get continually inflated to lower and lower value. Yet I don't get that. I get a state/government ordering to better do as they say, or else.

      Your whole "reasoning" falls flat.

      Statists gonna state.

      • Janro0,

        I’ll waste some of my time answering your stupid points.

        As to your claim that I “deliberately” didn’t address “politicians', governments', and banker cronies' roles in the situation..”, quite true: I didn’t. I simply pointed the indisputable fact that private banks left to their own devices have a tendency to promise depositors the latters’ money is safe, when it quite clearly isn't, as was demonstrated in the 1930s. As to exactly who was to blame for that debacle, I’m sure you are right in saying that politicians and “bankers’ cronies” had a lot to do with it. But bankers themselves were far from blameless. Or are you under the illusion that Wall Street bankers are scrupulously honest? If so, you’re living in la-la land: they’ve had to pay $300billion in fines and out of court settlements in recent years. Perhaps you didn’t know that.

        Or are you suggesting that bankers were all totally honest in the 1930s, and that it’s only recently that they’ve turned into far and away the country’s biggest criminals (at least going by the size of the fines they’ve had to pay)?

        Next and re you claim that you personally do not want a form of 100% safe money, that point is irrelevant: it in no way disproves my claim that MOST people (and probably about 98% at a guess) DO WANT a 100% safe form of money.

        Next, you say “I am forced by legal tender laws to use fiat money.” Well the only alternative to fiat money is some form of COMMODITY based money, like gold. So you personally want to return to the gold standard? Fine: problem is that most economists and ordinary people don’t. Sorry, but we live in a democracy.

        Next, you say “I do, however, demand a money that doesn't get continually inflated to lower and lower value.” The big problem there is that most economists and ordinary people are happy with the 2% inflation target: i.e. they are happy with a currency THAT DOES LOSE a small percentage of its value every year.

        You seem to be under the illusion that your personal preferences should take precedence over the wishes of the majority.

        • Ray Lopez

          Yeah seems that Ralph Musgrave has the better argument here. While I do like stable prices, the majority has gotten used to fiat money and unstable prices that yo-yo. It will be hard for them to go back to a gold standard, even though that would make prices stable. Keep in mind these things: (1) we live in a democracy, as Ralph says, and people in the First World really do like Big Brother (as Winston Smith learned to) (2) money is largely short-term neutral, so who cares about stable prices? Prices are indexed to inflation by and large (hyperinflation is a different matter but so far we've avoided that in the First World), (3) we don't have financial repression in the USA, EU anymore, since the late 1970s, (Japan is a bit different) so governments must behave with printing money or they will get a slap from voters and/or interest rates will go up in normal times (the long term govt deficits are a problem, agreed, but so far Debt-to-GDP is below 120% that Rogoff et al once claimed is a red flag). That said, I'm in favor of: (1) a Au / Ag backed dollar (or basket of goods backed), (2) no or very little deposit insurance, (3) private banking, (4) to abolish FNE (Fannie Mae), (5) to abolish the deduction of homeowners interest payments and the like, and a cut in all government services especially the military and raising of taxes to close the budget deficit. So I'm not a typical "liberal" either. But I don't see big swings in prices having any real effect either (money is neutral). Heck, on that last point, look at the huge swings in oil prices over the last ten years and nobody is claiming, save a few lunatics, that they had any real effect on the economy.

  • Ray Lopez

    Do I dare go toe-to-toe with the great Free Banking scholar George Selgin? Fools go where angels fear to tread? Yes I do. (Long post follows, not sure if Discus will allow it)

    Firstly, compare and contrast why Canada's free banks (historically) succeeded when others failed: national branches in Canada vs US local branches. Unlike US "local" banks, Canadian banks did not fail in the Great Depression (Kevin Dowd: "Total losses to depositors and noteholders during the whole period up to the establishment of a central bank in 1935 were probably less than $30 million (cf. Beckhart 1929:337), far less per capita than in the United States. No Canadian banks failed from 1923 to 1985, while the United States suffered thousands of failures during the 1920s and 1930s"). This 'allow national branch banking' is a function of law, of policy, as Fung et al. implicitly state (for the wrong reasons perhaps).

    Below are my notes from Prof. Timberlake's tome on monetary policy ("Monetary Policy in the United States: An Intellectual and Institutional History" by Richard H. Timberlake
    (I think George once took over Timberlake's position at Georgia Tech).

    "New York was the first state to make the switch to free banking in 1838, and the reason for the switch was unambiguous: citizens who had been closed out of credit markets voted with a political party that promised to break the oligopoly that had controlled bank chartering. From the 1810s to the late 1830s, bank chartering in New York was controlled by the Albany Regency, a political machine run by Martin Van Buren. Also known as the Holy Alliance, … its political philosophy was best expressed by one of its leading members, New York governor William Marcy, who coined the phrase “To the victors belong the spoils.” Bank charters were granted only to friends of the Regency, in exchange for which the legislators received various bribes, …The Regency’s hold on bank chartering came to an end when the state’s voting laws were amended in 1826, allowing universal male suffrage. Within a decade, the Regency lost its control of the state legislature, and in 1838, in the wake of the panic, the dominant Whig Party enacted America’s first free-banking law. By 1841, New Yorkers had established 43 free banks, with a total capital of $10.7 million. By 1849, the number of free banks had mushroomed to 111, with $16.8 million in paid-in capital. By 1859 there were 274 free banks with paid-in capital of $100.6 million.36 Other states soon followed New York’s lead. By the early 1860s, 21 states had adopted some variant of the New York law …

    The banking experience of the South followed a different path from that of the North and Midwest after 1837. Unlike the North, where both free banks and specially chartered banks were prohibited from branching, most Southern states allowed banks to branch within the state. These fundamental differences made Northern banks much less stable than those in the South.45 The Northern banking system was composed of a large number of geographically isolated unit banks that were subject to substantial risk of loss on their loans as the result of severe local shocks (such as declines in crop prices). These smaller banks, operating in a more fragmented system, also found it more difficult to coordinate their responses to banking-system crises. They therefore faced a higher risk of failure. In the South, a small number of large and geographically overlapping branching banks were better diversified and better able to communicate and coordinate their responses during panics, making markets in each other’s liabilities and agreeing to avoid disruptive withdrawals of cash from one another. The large numbers of banks in Northern banking systems also presented greater challenges for the interbank clearing of notes and deposits."

    Secondly, did free banking in Canada ever really exist? See these passages from “Free banking in Canada" by Kurt Schuler, Chapter 4 from “The Experience of Free Banking” edited by Kevin Dowd (1992) and then "Fragile By Design” by Charles Calomiris et al. (Calomiris, Charles W., Haber, Stephen H.) (2014). (Schuler): "Branch banking was just one of the typical features of free banking that the Canadian system spontaneously evolved in its early years….In 1850, the Province of Canada imported bond-collateral banking, inappropriately called ‘free banking’, from the United States. Bond-collateral banks had to buy specified government bonds as a requirement for issuing notes. Their note issues could not exceed their holdings of the bonds. The provincial government hoped that bond-collateral banking would increase demand for its bonds, which were a drug on the market. Only five bond-collateral banks were ever founded, and none achieved prominence. The bond-collateral and chartered banking systems existed side by side. No chartered bank joined the bond-collateral system because the bond-collateral requirement and the prohibition (later eliminated) on establishing branches did not nearly offset the advantages of a lower minimum capital requirement. 3 The bond-collateral banks all failed or became chartered banks by the end of the decade, and the legislature repealed the bond-collateral law in 1866 (Breckenridge 1894:103–17). … THE HEYDAY OF FREE BANKING, 1867–1914" and then in the latter (Caloramis): The special charters granted to Canadian branching banks were decried by populist interests from the beginning, and that opposition grew over time.24 A serious challenge was mounted in 1850, when an agrarian populist movement that favored unit banking pushed for legislation to create a free-banking system modeled on that of New York State. One benefit, from the point of view of the Canadian government, was that this proposal would create a mechanism for state finance: the free banks would have to back their currency issues with high-grade securities, which is to say with government bond issues. That is, like free banks in the United States, the banks would receive a charter in exchange for a loan to the government. The law allowing the founding of free banks was passed. In addition, banks that did not join the new unit free-banking system were required to pay a 1 percent tax on their note issues. Crucially, however, there was not sufficient support in the legislature to abolish the original branch-banking system. Moreover, despite the tax on their notes, branching banks did not convert to the new system. The result was that very few banks were actually founded under the free-bank system, and only two managed to survive for more than a brief period. The provisions of the free-banking act pertaining to note issues were therefore repealed in 1866, and the act as a whole was repealed in 1880."

    In conclusion, I think / hope George and I are in violent agreement: private industry is in a partnership with the government, and if the government allows for robust free banking, such as allowing interstate economies of scale, then free banking can flourish, otherwise not. But arguably there's never been a period, except perhaps in the medieval ages, where true free banking, divorced from the state and the state's laws, flourished.

    • George Selgin

      Ray, this is a real load of….misunderstanding. Genuine "free banking" means just what the name suggests, that banks are free from any extraordinary government regulation. Pretend that, because anything free banks do they do because government policy allows it, and then state that what they do is "really" something other than a mere exercise of their freedom, may be the worst example of Orwellian spin I've head in the last few years–and I've been in Washington all that time!

      Yet that's exactly what you do in pointing out, for instance, that "allow[ing] national branch banking' is a function of law, of policy." True,in the same way that, say, allowing people to speak freely without lining them up and shooting them "is a function of law, of policy." Very well then: freedom is a function of law, of policy. Whoever claimed otherwise!!

      My dear friend Dick Timberlake actually retired to make room for me at UGA, bless his big heart!

      And Dick is a huge fan of GENUINE free banking. (As he also reads Alt-M, I hope he may say so here!) All that stuff about antebellum U.S. "free banking" laws, and Canada's (that is, the Canadian government's) idiotic and disastrous attempt to copy the same (to which I plan to refer in my next post in this series), is a great waste of effort on your part. I've written a million times, if I have once (see https://www.alt-m.org/2015/07/23/real-pseudo-free-banking/
      for starters), about the difference between those silly U.S. arrangements, which had "free" in their name but didn't allow much real freedom to banks (they prohibited branching, and let banks issue notes only on certain securities) and the real free banking deal, which is what Canada had after Confederation and also what Scotland and some other places (but never the U.S.) had. There was scarcely any important regulation in those systems–there was some, but minor; and it is not hard to figure out what difference it did or didn't make.

      Sorry, my friend, but you cannot school me so easily on this topic. You'd be better off trying to do so, in any case, after first determining what I already know about it that you don't!

      • Ray Lopez

        Well! Well I never… Well I guess I stand corrected then. I will await for your next article and see if I can find some holes in it. Until then, adios amigo!

        • George Selgin

          Whether free banking existed in some pristine form is irrelevant–things are rarely as pristine in the world as in theory. But the Canadian and Scottish systems were close enough.

          We don't insist that we have no empirical evidence bearing on the theory of free trade because we cannot locate instances of pristine free trade. So, lets be consistent here!

          Bringing in the holocaust is a low comment. What is worst, Nazi gold deposits, protected by Swiss bankers, or a Nazi-like government being able to look into everyone's financial privacy? I don't have an answer–and neither, I suspect, do you!

          Now, can we talk about banking, please?

          • Ray Lopez

            OK George, but I will point out you yourself have implied (from my reading of your work) that Canada itself did not have a good or pristine or perfect or whatever you want to call it free banking system. I look forward to part II of your essay.

          • George Selgin

            I also pointed out that the imperfections were minor, and probably not market failures. Thus not "imperfections" at all in a policy-relevant sense.

            As this was the WHOLE GIST of my post, I must again complain about your sloppy reading. Why it is so bad it has me writing in capital letters, which is something I absolutely despise!

        • Andrew_FL

          " If this happens with FL "sunshine" laws"

          Incident Mr. Lopez described happened in 1926. Florida's earliest "Sunshine Law" dates to 1967-an act which concerned public meetings, not banking statistics or anything remotely like it. What crankery.

          • George Selgin

            Yes. Some people play loose with the facts. Ray lets them run away altogether.

  • Warren

    —–between 1863 and 1896, 330 national banks failed. Of $98,322,170 in
    accumulated claims against them, less than 64 percent had been paid by
    the end of the period, leaving $35,556,026 still due to creditors.
    Another 1,234 state banks also failed, leaving $I20,541,262 out of
    $220,629,988 in debts unpaid. In other words, the record of recoveries
    from U.S. bank failures taken as a whole was not much better than that of two of the Canadian system's three worst deadbeats! —–

    —-Had one purchased all the notes in question at face value, and then
    sold them to brokers in either Chicago or New York for what the brokers
    were paying in those markets, the loss would have amounted to less than one percent, even reckoning any note that brokers listed as unknown or uncertain as worthless.—

    So there were so many notes outstanding that even calculating the losses mentioned in the first section I quoted the overall losses to note-holders was still less than 1%?

    And weren't losses to note-holders in Scotland also less than 1%?

    There seems to be a bit of a pattern.

    And like in Scotland, did solvent Canadian banks buy up notes from failed banks to assuage the public about the strength of the banking system as a whole?

    • George Selgin

      "So there were so many notes outstanding that even calculating the losses
      mentioned in the first section I quoted the overall losses to
      note-holders was still less than 1%?" You confuse here losses from discounts on notes solvent banks (because they were in far off markets and had to be shipped for redemption) from accumulated losses of creditors to failed banks–and entirely different thing! I tried to be clear about the distinction, even treating the two topics under separate subheadings. But anyway, they aren't the same, so there's no paradox here.

      Scottish note holder losses from bank failures were indeed also very low. I believe far less than 1%. There was no discounting of solvent bank notes there that I'm aware if.

      • Warren

        Okay, I thought I was missing something. Thanks.

        • George Selgin

          No problem: it's a long and complicated subject.

  • Mattyoung

    Go through the arguments presented here and come to a conclusion: currency risk in that Canadian system was bound. Bound because you could eventually get to a clearing house. Bound because notes got priced at a discount, a good signal. And bound because there was free entry and exit of banks. Losses get noticed, and priced, early, before they balloon.

    One way to look at this, monetary zones have only so much currency insurance available, it is a limited resource, and debtors need to amortize more often when the insurance cupboard is bear.

  • Ray Lopez

    Thought experiment for you readers: imagine a world where money is neutral. You know what that means: printing money has no real effect. If you double the money supply, only prices will double, but there's no sticky prices and no money illusion so real output is unaffected. That is my prior, just assume it for this experiment (and BTW the data seems to show this, but let's shelf this topic for now).

    Now please answer this: how did the Spanish Empire of the 15th though 19th centuries create wealth from the New World gold and silver (and I think it was mostly Ag) mined? It was through seigniorage (https://en.wikipedia.org/wiki/Seigniorage). But can you create wealth through seigniorage if money is neutral? I think the answer is you can create it by leveraging the fact that people collectively value gold as a medium of exchange (and store of value, unit of account, and cosmetic reasons) but only if it is scarce. You are taking money from society in exchange for something they value, but not creating new wealth. How much money are you taking? Since people don't know how much gold the Spanish Empire has found, they cannot assume that gold is now as cheap as water, so the seigniorage will be some positive value between the cost of mining the gold (almost zero, using slave labor) and the value to society, even given that money is neutral and prices will instantaneously adjust to any inflation. Of course the Spanish Empire sellers of gold will also lose some value of their gold due to the inflation, but the seigniorage profit will be positive and comprise the value that society has in having extra gold. In addition, if an economy is expanding, the 'unit of account' properties of money will also benefit that gold be sought by society, as more gold means stable prices in an expanding economy, as opposed to falling prices or rising prices. But keep in mind my thought experiment assumes money neutrality, so please don't answer with a monetarist answer if possible. I'm not entirely sure if "unit of account" might be deemed a real (i.e. money non-neutrality) argument; I'll wait to see if anybody answers.

    Incidentally, despite Spanish gold from the time of Columbus, real wages in Spain and Europe, due to the Black Death, actually fell from the 14th century to the 19th century. So in a sense, the Spanish empire's gold was a tax on the population, and did not produce any real growth or real wealth. The obverse of the Spanish thought experience above is if a rich billionaire burns up their money in a potlatch: the only nominal effect in a money neutral world is prices should fall a bit for everybody, but there is no real negative effect. BTW Scott Sumner was supposed to be doing a article on this, but I've not heard from him so I pose the question here, it is relevant to free banking as well.

    • George Selgin

      Tell me, Ray: what do you suppose the average annual rate of inflation was during the so-called European "price revolution" following the New World gold discoveries.

      And after answering that, tell me, if you please, how the Black Death can possibly have cause real wages to decline? Better still, cite me a source indicating that they did.

      Then, if you still wish to ask them, I'll considering answering your questions (or some of them–time is limited).

      • Ray Lopez

        (1) annual rate of inflation during the price revolution was low, but due to New World Au/Ag, was relatively high by medieval standards. You know better than I the exact number, but I would guess it's about 1% to 3% except maybe during the frequent Spanish defaults

        (2) the Black Death caused a jump in real wages in the EU (viz, one-third of the pop died), but afterwards, until the early to mid-19th C, a general steady decline in real wages per capita (total GDP increased because the population increased, Malthus style). Sources below, besides Clark's book. Don't let me cut into your real work George…

        http://www.academia.edu/253833/The_Decline_of_Spain_1500_1850_Conjectural_Estimates – This article attempts to quantify the decline of Spain over the period 1500-1850. In contrast to earlier estimates that focus almost exclusively on Castilian agriculture, we look at trends in urbanisation and construct new measures of agricultural and aggregate output at both regional and national levels. A distinctive long-run behaviour is found across Spanish regions that rejects the identification between Castile and Spain. Per capita income grew in the sixteenth and early nineteenth centuries, while contraction and stagnation occurred in the seventeenth and eighteenth centuries. In the long run, output per head did not improve until the early nineteenth century

        – The results obtained thus far fit plausibly with the general picture of European economic evolution during these 350 years [~1500-1800]. Portugal experienced a low rate of structural change, a rapid growth in population and kept a stable urbanization rate. Nevertheless, gross domestic product grew about 2.5 times, mostly sustained by agricultural output. A sustained long run fall in welfare per person reflected the 30% reduction in GDP per capita, which over the entire period only had one 50-year period of growth (1700-1750). The contribution of non-agricultural economic activity (including the colonial sector) to GDP showed considerably variation. At times it played a substantial role, but never a consistent or lasting one. Like most of Europe, agricultural productivity declined, in this case by about the same amount as GDP per capita.

        • George Selgin

          The avg. price revolution inflation a.p.r. was about 1.2%.

          The Black Death _raised_ real wages, of course. Real wages later fell in Europe, but the Black Death had nothing to do with it, except by ceasing to be a factor keeping wage rates up!

          To suggest that the Black Death lowered real wages based on the fact that (a) it happened and (b) real wages eventually declined, though much later, is the worst sort of post-hoc fallacy. Employing such reasoning in one's arguments, along with many other doubtful suppositions, makes fruitful debate darn difficult!

          • Ray Lopez

            Ok George, you got me but we are in violent agreement. I said: "Incidentally, despite Spanish gold from the time of Columbus, real wages in Spain and Europe, due to the Black Death, actually fell from the 14th century to the 19th century." and you nailed me on the ambiguity of "due to", sorry, I should have been more clear. Black Death raised real wages, which then fell after population began to catch up again.

            PS – OT, guest reader request: please blog on seigniorage in an economy where money is neutral (money non-neutrality would complicate the analysis I believe). In my mind's eye I have it all figured out: it's the rocket equation from physics (or the train that's leaking cargo from the wagons, and thus accelerating, same thing), the more gold that is sold, the less it is worth (in real terms) until some point where you, the state (or seigniorage owner) reach diminishing returns. and MC = MR (or well before then the market might switch to a store of value that is more scarce, like diamonds). This also has applications in private money: at what point do you lose customers if you, the private bank, back your fiat money with only an infinitesimal amount of precious metal? It should be well before 0.0001%, but what is that lower bound? Historically how much did free banks keep in reserves? 10% sounds familiar? Maybe that will be a clue.

  • Warren

    I wonder why folks in the US let the unit banking regs hinder them. I mean, if you've got the money to open one unit bank why not open another? Sure you would have to give them different names and maybe the ownership group would have to be slightly different but logistically it doesn't seem all that hard.

    You'd have the First Bank of Smith County and the First Bank of Jones County, and Reed County and so forth. All nominally unit banks but tied together behind the scenes and all trading their notes at par. In fact they might even issue similar notes, the only difference being the name of the bank.

    • George Selgin

      Unit banks that were independent firms couldn't operate like one big bank, even if owned in common, for too many reasons to explain here.

      But think about it, Warren. Is it likely that the battles to bring down barriers to branching, fought bitterly over the course of the better part of two centuries, went on because no one had thought of your easy solution?

  • w nieder

    Mr Selgin, a most brilliant and informative article.

    I must admit the subject is Greek to me (I do not understand the some of the mechanics), nevertheless, a fascinating read and instructional.

    I look forward to remainder of this series and will archive your thesis.