The Free Banking Alternative; D. Wells and L.S. Scruggs

98 and it allowed all these institutions to borrow from the Federal Reserve. It is apparent that Congress did not intend to unleash the forces of com petition on the financial system. If this had been Congress' intention, it would have phased out, rather than increased, deposit insurance and would have left the amount and lo cation of reserve holding to the in dividual institutions. The purpose of this paper is to ex plain how a completely free banking system would operate. Under free banking, all financial institutions are subject only to the general laws of incorporation and against fraud. They would not be restrained by the rules of a central bank and not be audited by any government agency, nor be protected by any government deposit guarantee. The first part of this paper hypothesizes how individTHE FREE BANKING ALTERNATIVE 99 ual banks would thrive in this com petitive environment, while the sec ond part shows how the most serious problem this economy faces-infla tion-can be controlled without any government agency doing the controlling.

The Individual Financial Institution in a Free Banking Environment In a free banking system, any firm can enter the banking business by acquiring funds in any non-fraudu- ' lent manner and can put those funds to any legal use it wants. A bank may attract funds by offering bank notes (currency) or deposits convert ible on demand to specie (gold or sil ver coin). The bank's success would depend upon its gaining public con fidence for holding its banknotes and other bank liabilities, and on the probability that it can use its funds profitably. No bank would have any special privileges, like those cur rently enjoyed by central banks, such as a monopoly of the note issue or the protection of a legal tender law, giv ing its notes forced currency. There would be no government agency or central bank on which the bank could rely as a lender of last resort; it would have to borrow in the pri vate market at a rate consistent with the risk involved.

Under free banking, both notes and deposits would be promises to pay on demand some generally accepted medium, such as gold or sil ver.I The particular combination of notes and deposits issued in lending by each bank would be determined solely by public preference. The bank would be indifferent between the two, but the total amount of sight li abilities would by limited by its re serves of specie. No government reg ulation would specify that a bank had to hold certain assets, such as low-yielding government bonds, as backing for its banknotes, as was the case under the National Bank Act. Not only free entry, but freedom of exit is a necessary condition of free banking. Banks unable to redeem their demand obligations, and una ble to obtain private credit, would be forced to liquidate. This market pressure, along with the knowledge that there is no central bank acting as a lender of last resort, would force banks to act prudently.

Without a central bank, the check clearing process would be privately operated at its true cost, to the mu tual benefit of banks and the public. Any cost reductions resulting from innovations would, by force of com petition-, be passed along to the pub lic. Banks would have total freedom to branch anywhere. They would ex tend their operations nationwide, as have banks in Canada, England and other countries. The unit bank system was not a natural development but a result of restrictive legislation. The unit bank 100 THE FREEMAN February system led to correspondent bank ing, not only for holding reserves, but also for performance of services which small unit banks found too ex pensive to undertake individually. In the United States, these reserves tended to accumulate in financial centers, where they were subject to the fluctuations of speculative mar kets. But with a branch banking sys tem, even if a remote bank's re serves did find their way to financial centers, they would be held at a branch of the remote bank, which would retain total control over the funds. Each bank's own liability structure would determine how these funds were invested and in what maturities, in order to main tain adequate liquidity. With no need for a correspondent relation ship, nonbank corporations could have a single banking connection nationwide as in Canada.

Branch Banking Evidence from the depression clearly shows that branch banking was safer than unit banking, but that safety increased with the wid ening of the geographical area over which a bank could branch. Without branching, few banks could grow to a size large enough to handle the more desirable accounts. One study showed that 80 percent of the bank closings were in unit bank states, 2 and furthermore, that two-thirds of the branch banks that did fail were those that were restricted to a city.3 Canadian branch banks gained mil lions of dollars of American deposits, especially in border cities like Wind sor, Ontario. Another study on California bank ing in the depression demonstrated that the diversity of California's economy, accompanied by statewide branching, enabled that state to achieve one of the lowest bank fail ure rates in the country. Again, the two small branch bank systems that failed in that state were those that restricted branches to one city.4 This study also pointed out that the strong branch banking system in California also strengthened that state's unit banks by competitive example. 5 Under a free banking system, it might be possible for a well-run unit bank to prosper, but it would have to do so without the currently avail able privilege of issuing govern ment-guaranteed liabilities. The FDIC coverage is probably respon sible for making the deposits of many small banks acceptable at par whereas they might not be so ac ceptable in a free market.

The specialized financial institu tion would be unlikely to exist for very long under free banking. In vestment banking was part of com mercial banking until forcibly sep arated by the Banking Act of 1933. Many activities of one-bank holding companies are merely tactics for cir1985 THE FREE BANKING ALTERNATIVE 101 cumventing laws which restrict banks to a narrow line of business. Thrifts, such as savings and loans, mutual savings banks, and credit unions, may have developed because banks were not interested in some particular lines of lending at first, but whenever those activities be came profitable, it would have been the natural course of events for thrifts and banks to have merged. The public would be much better served by a more diversified finan cial institution than by a single·· purpose lender. A legally imposed distinction between deposit-type in stitutions does not serve the public well, because it leads to further gov ernment assistance to these single purpose lenders, such as Regulation Q, the Federal Home Loan Banks, the FSLIC and the NCUA. None of this intervention is costless: funds are channeled into areas that oth erwise would not receive them ex cept at higher interest rates, while other erstwhile borrowers are crowded out of the capital market.

Under free banking, some of the strongest competition for existing banks may be provided by large re tailers, brokerage firms and credit card companies. Sears and Roebuck, Merrill-Lynch, and American Ex press already have in place nation wide offices from which to conduct a banking business. Automatic teller machines could give a depositor in stant cash anywhere in the country. The one-bank holding company has already been responsible for combin ing banking with other financial ser vices, so free banking would only re move the artificial restraints. The Market Decides The market would eventually de cide which of the many new services offered by banks would be profitable, but the chief beneficiary would be the consumer. Not only actual com petition but potential competition from new entrants would work more to the consumer's advantage than most of the "performance" laws that were specifically designed for con sumer protection. Under free bank ing, there would be no legal require ments for "truth in lending," "equal credit opportunity," or "community reinvestment," and no restrictions on debt collection practices. These performance standards add substan tial reporting and regulatory costs, which are at least partially passed on to the consumer. 6 Compared to a single governmen tally issued currency, private bank notes might present a greater temp tation to counterfeit. Counterfeiting was prevalent before the Civil War when there were so many different banknotes being used. However, a single government currency does not guarantee a counterfeit-free econ omy either: today's overdrafts and forged checks are analogous to the antebellum counterfeiting of state 102 THE FREEMAN February banknotes. Furthermore, modern communication technology would strongly discourage counterfeiting.

At any rate, insurance companies can underwrite any losses the public may suffer, as they do now for stolen or forged credit cards. With different banknotes being used, some company or group of re tailers might sell fractional coins to be used for small purchases and plastic tokens with electronic mark ings to be used in vending machines. 7 How Free Banking Would Prevent Inflation Deregulation of bank money alone will not give us an environment free of inflation unless there is some way to stop the unlimited creation of the money base by the central bank. When gold or silver is the base into which all banknotes and deposits are convertible, there is a limit on the money supply, because this base can not be created at will as fiat money can be issued by a central bank. 8 Central banks, being politically sen sitive, use their monopoly of the money base to help organized sectors at the expense of the general public, often under the guise of lowering in terest rates. It was recognized long ago that free banking restricted credit expansion, whereas central banks were tools for creating an easy-moneyenvironment. 9 The imposition of a money-growth rule on a central bank is not the cure for inflation. Congress has never shown any inclination to impose a fiat-money growth rule as mon etarists have advocated, and the Fed could not be trusted to follow it,judg ing from experience with gold re serve requirements. In 1913, the Fed was ordered to hold gold equal to 40 percent of its note liabilities and to 35 percent of member bank reserve deposits. Every time the limit was reached, these requirements were either suspended (1933), reduced (1945), or abolished (1965 & 1968).

Emergency currencies without gold backing were issued in the depres sion and in World War II. Prudent Practices Encouraged By contrast, commercial banks in a free banking system could never go off gold as could a privileged central bank with legal-tender banknotes. A private bank would be forced into liquidation if it could not convert its sight liabilities into specie. How ever, there is another limit to over expansion in a free banking system besides exhaustion of gold reserves, and that is the reflux of banknotes. Each bank would only payout its own notes over the counter, because unlike the notes in the National Banking System, these notes would be distinctive. Therefore, a bank that expanded its lending beyond pru dent limits would have its notes and deposits presented for payment faster than those of its rivals. If a 1985 THE FREE BANKING ALTERNATIVE 103 bank wanted to protect its "brand name capital," it would have to cur tail its lending or face the possibility of its notes circulating at a discount.

The marginal cost of printing bank notes may be zero, but the marginal cost of keeping them in circulation clearly is not zero. Central banks could try and com pete with private banknotes, but the public would only hold the central bank's notes if they retained their value relative to the private notes. However, the central bank could not monetize government deficits at will, nor bail out any bank or industry in trouble, because an oversupply of notes would result in depreciation. One might envision the Fed and pri vate banks competing through ad vertising the way the u.s. Postal Service and private package carriers do now. I The Source of Money -FOOTNOTESIVera C. Smith, The Rationale of Central Banking (London: P. S. King & Son, 1936),p. 149. 2Gaines T. Cartinhour, "Branch Banks ver sus Unit Banks," Annals of the American Academy of Political and Social Science 171 (January 1934): 36.

3Ibid., p. 37. 4John P. Wernette, "Branch Banking in Cal ifornia and Bank Failures," Quarterly Journal of Economics 46 (February 1932): 371. 5Ibid. 6Catherine England, The Case for Bank De regulation, (Washington: The Heritage Foun dation, 1982), p. 24. 7F. A. Hayek, Denationalization of Money The Argument Refined, 2nd ed. (London: The Institute of Economic Affairs, 1978), p. 48n. 8Lawrence H. White, "Competitive Money, Inside and Out," Cato Journal 3 (Spring 1983): 296. 9Ludwig von Mises, Human Action: A Trea tise on Economics (New Haven: Yale Univer sity Press, 1949), pp. 443-44. IDEAS ON LIBERTY UNLESS the creation and issue of money is withdrawn from the State and restored to the private banking system, I believe that parliamentary government and democracy will become impossible to maintain. John Maynard Keynes, in Essays in Persuasion, referring to the fa mous statement of Lenin as to the best way to destroy the capitalist system, wrote: "Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch its currency. This process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one in a million is able to diagnose."

The strange thing is that it appears never to have occurred to Lord Keynes that, under a free economy, it is impossible to debauch the currency. GEORGE WINDER, 1958 Ernest G. Ross The Deficit Connection FROM the man-in-the-street, to econ omists, to politicians, to academics, near ly everyone seems worried about federal deficits. During Presidential campaigning, Walter Mondale called deficits "a travesty"; in more reserved tones, Ronald Reagan called deficits "a problem." Distinguished professors write grave tracts warning of deficit re percussions "in the out years" (Le., in the longer run). In an informal tel evision tabulation of my own, in a single week over 100 interviewees and speakers from different walks of life were quoted making disparaging comments about deficits. That deficits seem destined to be Mr. Ross is an Oregon commentator and writer es pecially concerned with new developments in human freedom.