Commercial Banking In a Free Society; S. Horwitz

Nonetheless, this need not completely discourage us from imagining what the·de tails of some aspects of a freer economy might look like. One way to go about this task is to look at the various ways a partic ular industry is unfree and imagine what removing those restrictions might do. In conjunction with such a thought experiment we might also look for historical examples where the industry in question was more free and explore the ways in which it oper.. ated and organized itself. The banking industry is especially suited for just this kind of analysis. If we want to know what commercial banking might look like in a free society, we need only turn to Steven Horwitz is Assistant Professor of Eco nomics and Flora Irene Eggleston Faculty Chair at St. Lawrence University in Canton, New York. contemporary regulation and the historical record to begin to piece together a coherent story. There are four major areas in which the freedom of American commercial banks is restricted. The first area is the set of pre rogatives taken away by this existence of government central banks, particularly the private issuance of currency. The second deals with restrictions on geographic loca tion, while the third concerns the relation ship between banks and non-bank firms.

Fourth, as a result of the first three, is mandatory deposit insurance. Central Banks and the Issuance of Currency In order for central banks to undertake the activities they, or their political overseers, have deemed necessary, they must acquire a monopoly over the production of cur rency. This restriction on the freedom of individual banks to create the kinds of financial instruments their customers might want has large and pervasive effects on the macroeconomy and the size of government more generally. Because" customers" must use the government-issued currency, they have noway of indicating their dissatisfac tion with its quality or value. This is what enables governments to use the banking system to raise revenue; if they create more 370 COMMERCIAL BANKING IN A FREE SOCIETY 371 currency, it will be accepted by someone somewhere. Central banks also have had a notorious time, even when the political incentives to inflate can be overcome, figuring out pre cisely what the right quantity of money should be. In a small version of what would face a comprehensive economic planner, central bankers attempt to estimate the demand for money and create the appropri ate amount in response. For the reasons so skillfully articulated by Mises and Hayek, there are enormous knowledge barriers to this kind of central planning, even in one industry.

In a free society one would expect banks to produce their own brands of currency which would compete for the business of money users. Although this may seem a bit strange, having lived in an economy with only one currency, it really is not that much different from where we are today. Firstly, banks already offer competing monies. A checking account at Chase Manhattan is a different brand of privately produced money from a checking account at Citibank. Check ing accounts are liabilities of the banks that create them, making them privately pro duced. They also differ in various ways: interest paid or not, rate of interest, fees charged, services offered, overdraft protec tion, and so on. Depositors choose among banks today based on the total package of products and services that accompany a checking account. One would expect the same if currency were competitively pro duced. More important, competition in currency production would give producers the incen tive to neither overproduce nor underpro duce currency, and therefore maintain its value. In order for banks to get their liabil ities (either currency or checking accounts) accepted, they would have to make them redeemable in some commodity (such as gold) or some other asset. Customers would not accept mere paper liabilities without some connection to an item which had value outside of the banking system.

As a result, any bank which overproduced would find customers returning unwanted currency which would lead to a fall in the bank's holding of the backing commodity, reducing its ability to create loans. Banks cannot afford to risk reserve shortages like this, so they would reduce their outstanding currency liabilities until those losses stopped. Banks that issued too little cur rency would see their reserves piling up and would be sacrificing the interest they could earn by making loans backed by those reserves. In a free society, the same market forces that create incentives to produce the correct quantity of shoes, toothbrushes, or eggs, would apply to currency. Because the banking system of a free society would get the supply of money generally right, it would also avoid the macroeconomic problems of inflation and deflation that have resulted from unfree central banking systems. Virtually every country on the planet has had some experience with privately pro duced currency. The historical evidence suggests that countries with less regulated currency production had fewer bank failures and more stable macroeconomies. The Scottish banking system of the late eigh teenth and early nineteenth centuries is a good example of the benefits of freedom, especially when compared with the substan tially less free English banking system of the time. The U.S. experience of the nineteenth century provides a good example of how problems can develop when even private currency production is overregulated. The recurring crises and panics of the period can be seen as unintended consequences of misguided bank regulations.

In order to make their currency monopoly work, central banks have imposed other restrictions that would be absent in a free society. For example, central banks require banks to hold certain minimum levels of reserves. Normally these are higher than banks would otherwise hold and they usu ally do not earn any interest. Effectively they are a tax. In addition, reserve require ments prevent the public from having accu rate information about bank portfolios. Banks that could afford to hold fewer re serves because they are safer are prevented from doing so, and banks who are riskier and 372 THE FREEMAN • JULY 1994 might choose to hold higher reserve levels, especially in the absence of government mandated deposit insurance (see below), have no need to do so. In a free society, banks could pick the level of reserves they saw fit and would have to bear the conse quences of holding too many or too few reserves.

More generally, a free society would not see central banks in the way they have developed in the nineteenth and twentieth centuries. There is nothing inherent in the evolution of banking that necessitates them, and their existence results from constitu tionally unconstrained politicians striving after a cheap source of revenue. Of course banks in a free society would likely develop interbank institutions such as clearing houses, but these would have no special government privileges and would be forced to compete for members and business. Interstate Banking A more general way of thinking about banking in a free society is that banks willbe subject to the same laws as other corpora tions. One example of how that is not true today is the issue of interstate banking. It is very difficult for many American banks to open up branches across state lines. Laws permitting interstate banking are made at the state level and they vary from state to state. Although most states have liberalized these laws to some extent in the last 10 or 20 years, full nationwide banking does not exist.

One result of this is that many banks are insufficiently diversified because they are too closely tied to industries specific to their state. When those industries falter, the banks fail with them. Banks that can spread their risks across different industries, by operating in different states, are less likely to fail. One bit of historical evidence for this contention ·comes from Canada. Canadian banks have historically been able to operate nationwide. While over 5,000 American banks failed in the 1920sand early '30s, only one Canadian bank did. Although a number of bank offices closed, only the one bank failed. This statistic is even more compelling when one considers that the variation in economic conditions between rural and ur ban Canada is greater than in the United States, posing a greater diversification chal lenge. In a free society, we could expect banks to operate wherever they pleased, just as other firms do now. The need for traveler's checks, or the hassle of finding a new bank after moving, would disappear as true na tionwide banking would make it far more likely that one's bank would have offices in more places. One consequence of this change would be a smaller number of larger sized banking organizations. However, as evidence from countries which permit na tionwide banking indicates, these larger banks would operate more offices per capita than smaller banks. This would both im prove access to banking for most people and enable banks to capture the cost efficiencies of large-scale production that are now closed off.

Glass-Steagall Restrictions One other set of regulations on contem porary American banks are so-called Glass Steagall restrictions. As part of the banking reform acts of the 1930s,a firm may not own both a commercial bank and a non-bank business. Firms like Sears that provide fi nancial services can only provide those services to non-commercial customers. These laws also prevent banks from selling insurance or underwriting securities. Many argued that such an intermixture of banking and commerce was·responsible for the nu merous bank failures of the early 1930s, so a regulatory wall was needed to separate banking from commerce. Subsequent re search has found this explanation of the bank failures to be incorrect and the justi fication for Glass-Steagall restrictions has been greatly weakened. Even the Clinton administration has recognized this and in cluded liberalization of these regulations, as well as those on branching, in its reform package.

In a free society we would expect to see REGULATION AND PRODUCTIVITY 373 financial supermarkets where one could ad dress all of one's financial needs (banking, insurance, investment) in one firm. There are obvious efficiencygains to producers in such a situation, as well as better service to consumers with one person or group over seeing their whole financial portfolios. Because of the activities of central banks and the various other regulations noted above, bank failures are a real worry in unfree banking systems. As 'a result, gov ernments have imposed mandatory deposit insurance in order to prevent the potential bank runs that their own regulations can trigger. If banks in a free society are unen cumbered by central banking and other regulations, we would expect the whole problem of bank runs to be far less signifi cant. Given this, any possible justification for government-mandated deposit insur ance disappears.