Wrong Lessons from Canada's Private Currency, Part 2

Canadian banking system, Canadian Banker's Association, clearinghouses, private currency, fung
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(Editor's note: This is the second installment of a three-part article.)

Intervention or Private Initiative?

As I argued in my previous post addressing Fung et al.'s article on Canada's private banknote currency, the imperfections of that currency appear, on close inspection, far less substantial than Fung et al. suggest. Moreover, what blemishes there were didn't imply any market failure, or a need for more government regulation, for the simple reason that "imperfect" doesn't mean "inefficient." On the contrary: the facts suggest that heavy-handed government interventions, aimed at correcting the supposed imperfections more rapidly than bankers' own efforts might, would probably have done Canadians more harm than good.

By making those points, I don't mean to deny that the various reforms Fung et al. describe, culminating in the Bank Act of 1890, led to some genuine improvements. Yet even if they did, the reforms still don't imply any market failure, for the simple reason that those reforms appear, for the most part, to have been ones that Canada's private bankers themselves recommended and implemented, often in anticipation of legislation that enshrined them.

The specific reforms to which Fung et al. refer are:

  • The provision of the 1870 Bank Act imposing double liability on banks' shareholders[1];
  • That of the 1880 Act giving note holders a first lien on banks' assets; and
  • Those of the 1890 Act requiring banks to establish note-redemption agencies in "all of Canada's major commercial centers," together with a Bank Circulation Fund for the redemption of notes of failed banks, and also to provide for the payment of interest to holders of failed banks' notes as compensation for any settlement delay.

It's the importance Fung et al. assign to these reforms, in perfecting Canada's commercial banknote currency, as well as their belief that the reforms were compulsory, that informs their conclusion that "some intervention by government" will be called for if digital currencies are to be made safe and uniform.

But to what extent were those 19th century reforms truly compulsory, in the sense meaning that they had to be imposed upon Canada's bankers by government authorities?

Canadian Banking Charters and Welcome Reforms

To answer the question, one must consider that during the period in question each of Canada's commercial banks was chartered by means of a separate Act of Parliament. Furthermore their charters up to the time of Confederation had all been modeled on those of the first Bank of the United States and its very similar successor, and were as such correspondingly outmoded. As George Hague, a prominent Canadian banker and the first President of the Canadian Bankers' Association, explained in an 1897 address to Ottawa's Board of Trade, although many of the provisions Alexander Hamilton set down in drafting the first Federal bank's charter "indicated considerable financial knowledge, others exhibited a remarkable want of acquaintance with the function and scope of Joint Stock Banking. They indicated rather a 'feeling after' what was desirable, than an acquaintance with what had been found to be sound and practicable."

In other words, Canada's early bankers were saddled with charters containing various "curious and crude provisions…all indicating a great want of acquaintance with Banking as it was carried on in the countries where it had attained the highest development and was best understood, viz., England and Scotland."

But while the bankers might have urgently wished to revise some of the rules under which they operated, they couldn't do so on their own, for modifications to the provisions of their charters could only be effected through legislation, whether the bankers themselves welcomed the modifications or not.

In fact, Canadian bankers did welcome most of the reforms contained in the various Bank Acts, for the simple reason that they were themselves the principal authors of those reforms! According to Roeliff Breckenridge's The Canadian Banking System, 1817-1890 (p. 357), an authoritative work to which Fung et al. frequently refer, it was the bankers' own suggestions and efforts, inspired by their "desire to remove…the causes of public dissatisfaction," that paved the way to change.[2]

As for Parliament itself, according to George Foster, the MP who introduced the 1890 Act, by then at least it seemed determined "not to interfere violently with what  we may call the natural growth of the banking system in this country" (ibid., p. 358). Instead, by heeding the bankers' advice, it endeavored (to return to Breckenridge's own words) "by some slight strengthening, some little alteration, to keep and enhance the certain benefits of what they [Canadians] already possessed."

Bank Act of 1870: Liability

The significance of bankers' own desire for reform is admittedly not so evident in the case of the double liability provision of the Bank Act of 1870. But that's only because, despite what Fung et al. suggest, that measure wasn't all that significant. For some years before the 1870 Act was passed, most of Canada's bank shareholders were already subject to double liability in the event that a bank whose shares they owned failed. The sole exceptions were holders of shares in the Bank of British North America, whose liability was limited, and those of the Banque du Peuple, whose liability was unlimited. Since the Bank of British North America was actually exempted from the 1870 double liability provision, that measure did not actually subject existing Canadian bank shareholders to any increased liability at all!

Bank Act of 1880: Note Holders First Lien

The 1880 provision making banknotes a first lien on banks' assets was, on the other hand, a genuine innovation. But it was also one for which Canada's bankers were themselves responsible. As Breckenridge explains (p. 291-2), it was they who approached the then Minister of Finance, Sir Samuel Tilly, presenting him with various reform proposals, including their "plan to make the notes issued by a bank the first charge upon its assets in case of insolvency," which they believed would assure "the ultimate payment of all bank notes in full" despite occasional bank failures.

Bank Act of 1890: Note Redemption

The 1890 reform, finally, was also the bankers' idea. According to Breckenridge, in December 1888 one of them sent a circular letter to all the others, noting the complaints about banknotes not always being current, and outlining plans for keeping them at par "however far they might be from the place of issue." The circular also proposed the establishment of "a safety fund, contributed from all the banks, whereby to ensure prompt and full redemption to the holders of notes of a suspended bank."

What's more, most of the banks completed arrangements to carry out the circulars' first proposal within a year of its receipt, that is, before the new Bank Act was passed, making pairwise agreements to redeem each other's notes in their separate neighborhoods. According to Breckenridge, "this simple device quite prevented the discount for geographical reasons" (p. 321). The actual legislation, in other words, amounted to little more than an official endorsement of voluntary arrangements already in place when it passed.[3]

It was, presumably, with these facts in mind that L. Carroll Root (p. 323) bemoaned "the tendency  of United States financiers and statesmen to place extraordinary stress upon providing for elaborate redemption facilities," while noting that Canada's experience proved "that legislation in this regard was delightfully immaterial." U.S. experience, on the other hand, "demonstrated how completely a thoroughly good system which has developed without the aid of law has been petrified by attempting to assist it."

Government-Inspired Reforms

And what about those banking and currency reforms, whether merely proposed, or proposed and actually implemented, that really were the brainchildren of Canadian government officials? How sound were they, and how much good did they do when actually implemented?

The general answers are, not sound at all, and no good at all.  Although the schemes' proponents always claimed that they were aimed at improving the established  system's stability and uniformity, in truth their real purpose, like that of most government-inspired monetary reforms in those days, if not since, was to fill the government's coffers —  and never mind the other consequences! Also like most reform proposals then and long after, they tended to be influenced more by mere U.S. and British precedents, and occasionally without regard to those precedents' actual results, than by any consideration of the plans' merits in comparison to those of existing Canadian  arrangements.

If you doubt these claims, I hope that a quick review of the main government-inspired schemes will change your mind. These were:

  • Lord Sydenham's 1841 proposal to establish a monopoly bank of issue for the Province of Canada;
  • The Provincial Government's (so-called) Free Banking Act of 1850; and
  • The 1866 plan by which Provincial (later Dominion) notes were introduced.

Most of the governments' other initiatives were but variations on these three schemes.

Lord Sydenham's 1841 Monopoly Proposal

The reform originally proposed by Lord Sydenham, the first Governor-General of the Province of Canada (a merger of the earlier colonies of Upper and Lower Canada) was nothing less than an attempt to anticipate in Canada a stricter version of the system that Peel's Act established in England several years later. Like the latter arrangement, it was based on Lord Overstone's Currency School doctrines, with their insistence upon maintaining a rigid connection between the quantity of banknotes outstanding and their issuers' specie reserves. The specific plan was to establish a Provincial Bank of Issue with a fixed fiduciary note issue, beyond which it could issue notes only in exchange for bullion, and soon thereafter to discontinue other banks' powers of note issue.

Anyone conversant with English financial history knows that Peel's Act proved a failure there, the government having had to suspend it on three occasions within less than a quarter-century. But in England the measure could at least be said to have been intended to address the established arrangement's undeniable shortcomings, made dramatically evident in the severe Panic of 1825 and the somewhat less severe one of 1836. (By the way, Scotland, with its free banking system that Canada's bankers wisely strove to imitate — whenever the Canadian government let them — was quite unscathed by either panic.)

The Province of Canada, however, could offer no such justification for pursuing a similar reform. As Breckenridge (p. 111) points out, with a (I think quite justified) hint of indignation,

so far as the experience of either Upper or Lower Canada taught anything, it was that their bank note currency was satisfactory, worked well and was safe.  … What [Canadians] wanted, what in fact they had, was a bank note currency that would fluctuate in correspondence with the number and amount of transactions wherein it was used. Compared to this, the rigidity and inelasticity of a government issue were distinctly objectionable.

If Lord Sydenham's plan was hardly likely to give Canadians a currency superior to what they already had, what it was likely to do was help fill the Provisional government's depleted coffers. Talk of protecting note holders was, in fact, a sham; the government's real intent all along had been to create, in the shape of the proposed Provincial Bank, a ready market for Provincial  government debt, which was to make up three-quarters of the assets backing the proposed bank's notes (ibid., pp. 110-11).

The (So-Called) Free Banking Act of 1850

Turning to the reform of 1850, Warren Weber, one of the authors of the work I'm criticizing, but also a foremost authority on the shortcomings of the so-called "free banking" systems established by 17 U.S. state governments between 1837 and 1860, would presumably be among the first to recognize the seeds of folly lurking in any plan to superimpose a like system upon Canada's otherwise commendably safe and stable, if not quite perfect, monetary arrangements. As Daniel Sanchez explains in a recent review of the U.S. experiments, although a few worked reasonably well, others witnessed numerous bank failures, and still others were complete fiascos.

Yet importing the doubtful American arrangement, right down to its misleading name, is just what the Hon. William Hamilton Merritt did in  proposing the Free Banking Act of 1850 to the Provincial Government's Legislative Assembly. Once again, the proposed measure overlooked both the special circumstance — in this case, the corruption involved in the so-called "spoils system" for chartering banks — that had brought the U.S. free banking systems into being, and the very real shortcomings of those systems. Even in New York's case — one of the better ones, upon which Canada's legislation was most closely modeled — twenty-nine banks had failed within the system's first five years, forcing those holding their notes to settle for only 75¢ on each of their supposedly fully secured dollars (Breckenridge p. 137)!

Despite these facts, the government succeeded on this occasion in getting its proposal adopted. Fortunately, few banks were ever chartered under the Free Banking Act's provisions, and those that were found competing with their less-regulated rivals a hard slog. Eventually, in the colorful words of Horace White (p. 361), the chartered banks “crowded the free banks to the wall.” Although it lingered on for some years as a dead letter, Canada's Free Banking Act was finally repealed in 1866.

What drove Canadian government authorities to push such an ill-conceived and ill-fated measure through in the first place? Not, surely, a desire to "regulate private banking and the circulation of the notes of private bankers," much less "to protect the public from injury from private banks," as the law's preamble declared: the Free Banking Act didn't do, and couldn't possibly have done, any of these things. The measure's true purpose was, as usual, "to relieve, in part at least, the financial difficulties of the government, by widening the market for its securities" (Breckenridge, p. 137), which it did by asking banks formed under it to "deposit with the Receiver General provincial securities for not less than £25,000 ($100,000), par value, in pledge for their notes" (ibid., pp. 138-9).

The Provincial Note Act of 1866

The Provincial Note Act of 1866, finally, was another Provincial Government revenue gambit, this time motivated by the fact that $5 million in its floating debts were coming due, plus the fact that A.T. Galt, its acting Minister of Finance, lacked "the courage to borrow, at the market rate of interest, the necessary funds" to pay them (Breckenridge p. 178). Galt therefore argued that the government "should resume a portion of the rights which it had deputed to others, and meet the liabilities of the country with the currency which belonged to it" (ibid.) His specific proposal consisted of an act authorizing the Provincial government itself to issue up to $8 million in notes payable on demand in specie, and to reward banks for agreeing to retire their own notes and employ provincial notes instead.

Concerning Mr. Galt's claim that the right to issue currency "belonged" to the government, Beckenridge effectively rebuts it (pp. 196-7), observing instead that  "The right to issue promissory notes, payable on demand, for circulation of money was not originally a government or crown prerogative, either in Great Britain or its colonies," and that this same right "existed and was exercised both in Lower and Upper Canada before banks ever became a subject of [Canadian] legislation."  Breckenridge goes on to say that

Once it is recognized that the business of issuing notes for circulation, promising payment, and payable on demand, is essentially similar to any other business in instruments or forms of credit — once it is seen that, historically and practically, note issue is no more a prerogative of government than life insurance, receiving deposits at call, or drawing foreign exchange, the way is barred to many a fallacy and delusion. The cry that "the profits of the circulation should belong to the government," then appears no less ridiculous than the plaint, "the profits of the flour mills, the shoe factories, the building societies, should belong to the government" (ibid., p. 199).

To which I can only add, Hear, hear!

Well justified or not, Galt's project won the day. And what were its effects? Even from the government's own perspective, they were disappointing. The Bank of Montreal alone agreed to retire its own notes in exchange for the new Provincial ones — and did so only because that was its best hope of collecting on the $2,250,000 the government owed it at the time. As other banks refused to go along with the plan, the average amount of Provincial notes outstanding during the scheme's first year was just a little more than $3 million, which was hardly enough, if indeed it was enough, to cover the governments' costs of implementing it.

If the Provincial Notes Act let down the government, it proved positively destructive to the Canadian banking system. Although the Bank of Montreal itself gained by the fact that the government was no longer in  arrears with it, the Act also had the detrimental effect of placing the interests of that powerful institution "in antagonism to those of the other banks" (ibid., p. 183).

In particular, because the Montreal bank profited from any increase in the demand for Provincial notes, and those notes alone enjoyed legal tender status, it now stood to gain from any general loss of confidence in the banking system (ibid., p. 185). Consequently it became, not merely disinclined to offer its assistance to any of its rivals in need, but inclined to resort to stratagems, such as that of refusing to accept (as it had routinely done in the past) drafts on Montreal in lieu of legal tender in settlement of interbank dues (ibid., p. 182), calculated to embarrass them. It was (again, according to Breckenridge) owing to these and other such subtle effects of the Provincial Notes Act that Canada suffered one of its only (minor) banking panics, in 1868, among other "remoter" consequences (ibid., p. 194). For all these reasons Breckenridge finds himself concurring  with Sir Richard J. Cartwright's verdict, delivered in the Dominion House of Commons in December 1867. "A statute more offensive, or more deliberately mischievous, or more calculated to prejudice Upper Canada," Cartwright said, "was impossible to conceive (ibid.)."

Expert opinion was no less damning concerning the later, 1869 government proposal to have Dominion notes, not only replace former Provincial notes, but completely supplant commercial bank notes. When this proposal was mooted, gold was still commanding a 30 percent premium relative to U.S. Notes (aka greenbacks), notwithstanding Lee's surrender at Appomattox several years earlier. With that circumstance in mind, the editor of the Canadian Journal of Commerce observed that

with the well defined experience of the past to guide us, besides having the example of the Unites States as a warning, it does seem almost a work of supererogation to argue the question of a government paper currency. To advocate it, except under very peculiar circumstances, implies either palpable ignorance of the plainest historical facts and the most widely admitted conclusions on the science of banking, or a strange, infatuous, and obstinate clinging to a mere theory, long after the world has thrown it aside as absurd. … [Government paper currency] is only justifiable when it is the last resort of an embarrassed Treasury, and when the national honor and existence are at stake, and even then experience shows that whenever it is adopted a long heritage of debt and high expenditures is entailed upon the country which sanctions or suffers it.

No wonder that Fung et al. don't find much evidence that Dominion notes "improved the performance of the Canadian monetary system." Unfortunately, they never consider the possibility that banknotes were in crucial respects superior to government paper money, as was indeed the case. I'll have more to say about that in the next, and final, post in this series.

But why resurrect all these ancient complaints about the Canadian government's interference with its (mostly) private monetary system? Because, if Fung et al. succeed in encouraging either the Canadian government or the Bank of Canada itself to regulate private digital currencies so as to "improve" them, Canadians had better brace themselves for another round of harmful (though perhaps fiscally convenient) currency reforms.

Continue Reading Wrong Lessons from Canada's Private Currency

_______________________________

[1] Although, in their "Non-Technical Summary" and elsewhere, Fung et al. credit the Bank Act of 1871, rather than that of 1870, with imposing double liability on Canadian bank shareholders, that is not correct. The 1871 Act involved only minor technical amendments to existing legislation, having been, as Breckenridge notes (pp. 261-2), chiefly "devoted to the re-enactment and consolidation of legislation with respect to banks already in force."

[2] In observing that Canada's bankers themselves bore primary responsibility for the various beneficial reforms that Fung et al. attribute to "government intervention," I don't by any means intend to suggest that any reform that some or all bankers themselves desire is bound to prove generally beneficial! In the United States, certainly, powerful bankers have been behind some of the very worst banking reforms, including the decision, following the Panic of 1907, to set-aside a Canadian-style currency and banking reform in favor of the establishment of a central bank.

[3] The bankers rejected, on the other hand, an alternative proposal that would have compelled them to copy the 1864 U.S. National Bank Act provision, discussed previously, by which every national bank had to receive at par the notes of all other national banks, on the perfectly valid grounds that "the duty of redemption ought to fall, not upon its competitors, but upon the bank which gains from the circulation" (Johnson p. 323). This is one of many examples — some others are discussed below — of how the Canadian government's own reform proposals tended to consist of thoughtless imitations of U.S. (or British) arrangements that were themselves, more often than not, severely flawed.

Besides reciprocal arrangements between pairs of banks, the establishment (again, voluntary) of bank clearinghouses also contributed to the efficiency of Canada's note redemption arrangements. Here Halifax and Montreal led the way by establishing clearinghouses in 1887 and 1889, respectively. Other clearinghouses were established, with the help of the newly-formed (and once again voluntary) Canadian Bankers' Association, in Toronto and Hamilton in 1891, in Winnipeg in 1893, and in St. John, New Brunswick, in 1896 (see Cannon, Clearing-Houses, p. 299). Yet it was not until after that Association was incorporated by Canada's Parliament in 1900 that it was authorized, by the Bank Act of 1900, to "establish in any place in Canada a clearing house for banks, and make rules and regulations for the operations of such clearing house [sic]." Here again, legislation merely sanctioned what private initiative had already accomplished.

  • Ray Lopez

    Selgin: "By making those points, I don't mean to deny that the various reforms Fung et al. describe, culminating in the Bank Act of 1890, led to some genuine improvements. Yet even if they did, the reforms still don't imply any market failure, for the simple reason that those reforms appear, for the most part, to have been ones that Canada's private bankers themselves recommended and implemented, often in anticipation of legislation that enshrined them."

    So the private market anticipates and reacts to government regulations, is that the lesson here? OK, that's exactly what modern American 'liberals' say. So much for Adam Smith's self-correcting invisible hand! Perhaps money will always be a creature of the state then? The alternative explanation is that banks 'saw the writing on the wall' and imposed self-regulation to ward off action by the state for a while. Ideally the marketplace (customers) would decide if private banks are worth putting their money into, without the need for these regulations, but that also presupposes a savvy consumer, which modern behavioral economics (and modern American liberals) tell us is a scarce species.

    I'll also point out that private free banks changed the law of their charters on the fly on occasion: during runs, they would suspend the automatic right of customers to make immediate withdrawals on demand deposits, until the panic subsided, contrary to their charter. But it's understandable to do so, and actually the government regulated banks do the same thing (aka a 'bank holiday').

    Selgin: "Because, if Fung et al. succeed in encouraging either the Canadian government or the Bank of Canada itself to regulate private digital currencies so as to "improve" them, Canadians had better brace themselves for another round of harmful (though perhaps fiscally convenient) currency reforms." – is this a segue to Bitcoin? Keep in mind the Chinese, who are driving Bitcoin for money laundering purposes due to financial repression there, were told by their government a week ago that Bitcoin is to be regulated just like paper money. Same as it ever was, government meddles with the private sector.

    (PS-I am a fan of George and of private free banks).

    (PPS–in the US South, I know a Depression era person who lost everything in a bank there in the early 1930s, got a 'first lien' on real estate property, and supposedly got rich many times over, many years later, when said property went up in value, so the story goes.)

    • George Selgin

      Ray, as I explain, the bankers themselves came up with the reform recommendations in question. They didn't "anticipate and react to" government proposals. They may have imagined that the government would intervene if they didn't do anything, but I don't think there is even much evidence for that. Not enough, anyway, to warrant the conclusion that the bankers weren't inclined to address the problems in question on their own, to the extent that the law allowed them to do so.

      My next post in the series will address Fung et al.'s claims regarding the need for government regulation of digital currencies, by which they mean, not just bitcoin, but other types as well..

      • Ray Lopez

        Ok thanks for that amplification George, I look forward to part III.

  • Matt Stiles

    Fascinating stuff. Thanks, George!

    • George Selgin

      You're very welcome, Matt. Thanks for the kind words.

  • Mattyoung

    Canada, at the time, was also completing the telegraph connections across all the districts. They even had American western union with monopoly control, until the railroads competed. All this happening at the time of the free banker period. Bankers, (after farmers) regionally, certainly were the first to swap the book with their fellow bankers over the telegraph. The provincial governments never could have kept up.

    As an aside, farmers often are the first to use information technology in trade and bankers second. In the USA, pre-depression, farmers mastered short wave and were broadcasting commodity prices. Their bankers soon caught on. I have a hard time imagining that anything other than telegraph would be dominating the development of banking in the period. It drops currency jitter from two weeks on a train to a few minutes on the telegraph key.

    • George Selgin

      Thanks for these interesting observations, Mattyoung. The farmers' role is especially noteworthy. I'm sure our good friend Todd Walker will agree enthusiastically.

      • Mattyoung

        Can I mention another?
        In 1928 Hoover organized then federal role in splitting up the spectrum for broadcast. Radio,at the time, was a known quantity, but the broadcasters were wildcatters, in the same sense of free banking. A lot of famous live shows were appearing via phonograph to radio, it was popular. The eastern broadcasters, wildcat, legal, and lightly regulated were locally big.

        The big eastern locals were part of Hoover effort to organize the spectrum. So, naturally, within a year we had national broadcasters, due to the aggregation. And we get national advertisers, and the national advertisers all had outlets, the modest general store, right there on main street; with a few parking spaces. You can imagine what happened to downtown America on the day they advertised the new appliances, "rush to your local outlet".

  • Warren

    —"demonstrated how completely a thoroughly good system which has
    developed without the aid of law has been petrified by attempting to
    assist it."—

    So much of government is explained by this quote.