Free Banking and Economic Development; D. Glasner

THEFREEMAN IDEASON LIBERTY Free Banking and EconomicDevelopment by David Glasner A b~ut five years ago I published a book, Free Banking and Monetary Reform, that proposed a radical reform of our mon etary system. Competing banks, I argued, should be free to supply any monetary instrument, including currency or bank not.es, while the government would perform the limited but vital function of establishing a currency unit (e.g., the dollar) in terms of which privately supplied monetary instru ments could be defined. And to ensure optimal stability of the purchasing power of the currency unit, I proposed a mechanism of indirect convertibility tied to a price (or, preferably, a wage) index. I have been disappointed but not sur prised to detect no groundswell of popular support either for free banking or for any of my specific proposals. I do not believe that this lack of enthusiasm betrays any short comings with free banking or my proposals.

What the indifference to free banking re flects is rather a salutary, "if it ain't broke, don't fix it" sort of conservatism. As long as inflation remains low and the banking sys tem is not collapsing, practical people will not undertake the effort required to effect Dr. Glasner, an economist with the Federal Trade Commission, is the author of Free Bank ing and Monetary Reform (Cambridge University Press, 1989) and the editor ofThe Encyclopedia of Business Cycles, Panics, Crises, and Depres sions (Garland, forthcoming 1995). The views expressed in this article do not necessarily reflect those of the Federal Trade Commission or of individual Commissioners. a reform of this magnitude. The potential benefit from such a reform is not big enough to outweigh the perceived risk in trading the monetary system we know for one we don't. 1 I have therefore concluded that my proposals for free banking are less relevant for the United States and other developed countries with stable monetary systems than for less developed and former Eastern Bloc countries now lacking the monetary stability necessary for economic develop ment. Without secure monetary institu tions, these countries have far less to lose than do advanced countries by experiment ing with free banking. Nor, for reasons that will become apparent, can less developed countries simply copy the monetary sys tems of the advanced ones. Free banking is, therefore, ideally suited for overcoming the systemic problems that now frustrate the attempts of less developed countries to achieve monetary stability.

To understand why free banking is so well suited to the circumstances of less devel oped and former Eastern Bloc countries, we must first consider how money and banking can contribute to economic development. The role of money is familiar and obvi ous-it is a medium of exchange. Money facilitates exchange by allowing us to trade without having to identify, as we do in barter transactions, a double coincidence of wants. Reducing barriers to trade promotes eco nomic progress by allowing resources to be shifted from less to more valued uses. Such 461 462 THE FREEMAN • JULY 1995 shifts create new opportunities and new demands for resources, triggering an up ward spiral of output and wealth. It is worth observing that the capacity of money to perform this extraordinarily valu able social function poses something of a puzzle. The existence of an instrument that serves only as a medium of exchange, pro viding no real services, seems to contradict the usual assumption of economists that self-interest motivates economic decisions.

Why do people accept money, which (de spite its social utility) has no direct use for them individually, in exchange for real com modities or services that do have direct use for them? The acceptability of money is sometimes attributed to an implicit under standing among people to act in the common good rather than pursue selfish goals or to a command by the sovereign imposed through legal-tender laws. But neither recognition of the common interest in having a medium of exchange nor laws commanding that an instrument be accepted as legal tender could make people use as money an instrument that they would not have otherwise, in their narrow self-interest, chosen so to use. Self-Interest and Exchange How then does self-interest cause anyone to accept a money that has no use except to be exchanged for something else? Whether it is in my self-interest to accept money in exchange for real goods and services de pends critically on whether I expect other people to accept money in exchange for real goods and services. If I expect other people to refuse money that I offer in exchange for their goods and .services, then my self interest is to refuse money in exchange, too.

But if I expect other people to accept money that I offer in exchange for their goods and services, then my self-interest may dictate accepting money in exchange for the goods and services that I supply, because doing so may allow me more easily to sell what I want to sell and more easily to buy what I want to buy than if I try to barter. The less confident I am that it will retain its value, the less willingI shall be to accept it in exchange. So whether money is acceptable is a matter of degree, not a simple yes or no question. 2 It is, at any rate, clear that money cannot function well as a medium of exchange unless people are confident that it will be acceptable at roughly its current value in the future. Whatever undermines people's con fidence or trust in the future value of money threatens its capacity to serve as a medium of exchange. The delicate web of mutually supporting expectations that allows a me dium of exchange to function can easily unravel or collapse if the trust underlying those expectations is eroded-or betrayed.

In primitive conditions, the medium-of exchange role of money can be performed without the aid of banks. Money could circulate hand-to-hand, either in the form of precious metals, coins, or currency (con vertible or fiat) issued by the state. How ever, the transfer of deposits within or between banks through checks (and now electronically) is an exceptionally efficient way to convey money in trade. To engage in monetary exchange through banks, peo ple must hold deposits with them. By hold ing bank deposits instead of some other form of money or wealth, people lend banks capital which the banks then lend to borrowers (who typically borrow to fi nance investment, not consumption). Thus, by providing a convenient way for the public to hold money and execute transactions, banks channel the savings represented by the public's deposits to investors. As inter mediaries between ultimate savers and ul timate borrowers, banks increase the return to savers from savings and reduce the cost to borrowers of borrowing, promoting eco nomic development within the areas they serve.

Creating and Maintaining Confidence Having considered how money and bank ing promote economic development, we can now ask which institutions will support a stable system of money and banking. Since money cannot function well as a medium of exchange unless people have confidence in FREE BANKING AND ECONOMIC DEVELOPMENT 463 its future value, the fundamental task of monetary institutions is to create and main tain that confidence. How can such confi dence be created and maintained? The an swer for a private supplier of money, i.e., a competitive bank, is very different from the answer for a state that supplies money. And it is on that difference that I am going to rest the case for free banking as the solution for chronic monetary instability in less devel oped and former Eastern Bloc countries. Why does it matter whether money is supplied privately or by the state? When a private bank creates money, it does so by issuing a special type of IOU against itself.

The IOU allows the owner of the IOU or anyone he assigns to demand its instant redemption in terms of a fixed amount of a specified asset. For example, when Citibank creates a demand deposit, it is promising to redeem that deposit in terms of an equiva lent amount of U.S. currency to the depos itor or to anyone to whom the depositor writes a check up to the amount of the deposit. 3 A bank's contractual obligation to redeem its IOUs on demand does not automatically create the confidence in their future value required for them to function as money. If the bank is widely expected to default on its IOUs, those IOUs, regardless of the bank's net worth or financial soundness, will not function as money, because IOUs that peo ple do not expect to be honored will be unacceptable in exchange. For a bank to create confidence that it will continue re deeming its IOUs, it must convince people that it would lose more by defaulting than it would gain. Whether people will trust banks with a substantial net worth to honor their contractual obligations depends in large part on the legal consequences of default for the bank. If the legal system under which banks operate strictly enforces contractual obligations and penalizes de fault, default will appear unlikely.