I think discussions on plurality of emission deserve a place back in money and banking classes, especially with regards to modern monetary challenges. In this video, Larry White gives a quick introduction to some of the features of free banking systems.
[T]he mischief takes a wide range. Those who have been accommodated with loans must pay, whatever their readiness or ability to do so. Further advances cannot be obtained. Other banks must call in their loans and refuse to extend credit in order to fortify themselves against the uneasiness and even terror of their own depositors. Confidence is destroyed. Enterprises are stopped. Business is brought to a standstill. Securities are enforced. Property is sacrificed, and disaster spreads from locality to locality. All these incidents of the banking business are matters of common knowledge and experience.
Court of Kansas. 1911. Schaake v. Dolley, 118 p. 80, 83 (Kansas denying a charter to a new bank because “the economy could not support another bank”).
Over at the Austrian Economics Center blog, Finbar Feehan-Fitzgerald has an entry on concurrent currencies, with special attention to Friedrich A. Hayek’s plan and Milton Friedman’s skeptical stance on it. Kurt Schuler over at freebanking.org provides further discussion.
In the words of Finbar Feehan-Fitzgerald, Friedman was skeptical because of the cost of switching currencies:
It was the view of Friedman, that network effects and/or switching costs would hamper the emergence of a new monetary system in general and prevent Hayek’s system from operating as desired in particular.
As evidence, he offers this passage from Friedman (1984, p.44):
Both German marks and Swiss francs have for many years maintained their purchasing power better, and with less fluctuations, than U.S. dollars. Many residents of the U.S. hold German marks and Swiss francs, or claims denominated in those currencies, as part of their portfolio of assets. But, with perhaps rare exceptions, only those who engage in trade with Germany or Switzerland, or travel to those countries, use the currencies as a medium of circulation.
It is true that Hayek and Friedman seem to have a different understanding of these costs. Take this passage from Hayek (1984, p. 30), the essay just before Friedman’s in the same book:
There is no doubt that it will take people some time to adjust themselves to such a new situation, but it is certain that it would not really take very long. When you watch what is happening in a major inflationary period, you see how ingenious people are in finding alternatives to an inflating currency which they are forced to use. I do not think it would take them long to learn to follow the quotations on the currency markets which would come into being, in order to inform themselves as to which currency they could trust to be a stable money and which not.
However, when reading this passage, it is good to keep in mind that Hayek had a fairly grim expectations of future monetary policies. It is particularly visible in this interview from 1975:
I’d say it’s almost a hopeless proposition for the government to pursue a sensible policy as long as the public is obsessed with the idea that there’s a cheap way of curing unemployment. As an economist I can only argue this is a mistake.
But as the people believe — and I think the great majority of people do believe — that the government has the power to eliminate unemployment quickly and lastingly, the government won’t be able to stop the inflationary process.
[…]
I’m fairly certain […] that attempts at so-called pump priming will probably sooner lead to acceleration of the price rise, rather than an increase in employment, and people ill demand control of the price rise. The government will clamp on controls and pump more money into circulation, which will have the disappointing effect of not creating much employment.
It seems that Hayek did not underestimate the costs of switching one currency to another with regards to their general acceptability, but that he was anticipating some sort of central bank engineered doomsday scenario that would have pushed these opportunity costs way down. I don’t believe it is fair to say that Hayek believed networks and switching costs were low, while Friedman thought they were high. Indeed, if you read a passage in Friedman (1984, p. 44) a few lines above the one cited by Finbar Feehan-Fitzgerald, Friedman himself admits that under much worse monetary management such costs might be rendered less important (emphasis mine);
I conjecture that, as with a private gold standard, even greater freedom for the issuance of competitive moneys would not in fact lead to the emergence of any such a widely used money in the U.S. (or other major countries) unless U.S. monetary management becomes far worse than it has been.
Again, p. 46:
There is little basis in experience for expecting any widely used private moneys to emerge in major countries unless governmental monetary management becomes far worse than it has been in the post-World War II period. And there is little basis in experience to expect any such extreme degeneration in monetary management except as the aftermath of a major military conflict.
Moreover, the main problem Friedman has with plurality of emission is not so much network and switching costs or that stable purchasing-power is not enough to make a private currency attractive, but a technicality with Hayek’s plan (at least in the essay Finbar Feehan-Fitzgerald cites, for other reasons Friedman has opposed competing currencies see Selgin 2008). He believes private money will never be good money because the private sector cannot supply assets denominated in purchasing-power to back the notes. Indeed, Hayek’s model rests on the contention that “if people were wholly free to choose which money they wished to use in their daily transactions, it would soon appear that those did best who preferred a money with a stable purchasing-power” (Hayek 1984, p. 33). In Friedman’s view, only government can do this, and it would make Hayek’s money “in essence government, not private money” (p. 45).
In the words of Friedman (1984, p. 43):
I may say that I am all in favour of the changes in legislation he proposes which would give private banks the greatest latitude in the way of offering substitutes for money. But I do not predict the same outcome as he does. I am very much less optimistic than he is that such a system would lead to a money of of constant purchasing-power and of high quality. The fundamental problem is that in the present circumstances of the world there are no assets which banks could acquire to match purchasing-power obligations. Let a bank undertake to pay out money which will have a fixed purchasing-power, how can it be sure to guarantee that result? Only if it can match those liabilities with assets which can be assured of fixed purchasing power. That will be possible when and only when governments in turn issue purchasing-power securities.
Most of the essay is then dedicated to examples of plans aiming at stable purchasing-power assets that have failed.
While Finbar Feehan-Fitzgerald’s essay is a very interesting discussion of network effects and switching costs, and provides a wonderful application of these issues to the Somali case, I do believe it might be misrepresenting both Hayek’s view on the topic and Friedman’s skepticism of competing currencies.
——–
Friedman, Milton. 1984. “Currency Competition: A Sceptical View”. In Currency Competition and Monetary Union, ed. Pascal Salin, pp. 59-73. The Hague: Martinus Nijhoff.
Hayek, Friedrich A. June 1975. “Monex International Presents an Exclusive Interview With Nobel Laureate Dr. Friedrich A. von Hayek”. Gold & Silver Newsletter, p. 1-5. Monex International, Ltd.
Hayek, Friedrich A. 1984. “The Future Unit of Value”. In Currency Competition and Monetary Union, ed. Pascal Salin, pp. 29-42. The Hague: Martinus Nijhoff.
Selgin, George. 2008. “Milton Friedman and the Case against Currency Monopoly”. Cato Journal, Vol. 28, No. 2, pp. 287-301.
The Diamond-Dybvig framework assumes that the bank cannot distinguish between short-term agents that withdraw for effective consumption needs and long-term agents withdrawing because they self-fulfillingly anticipate a run. Mixed with the sequential service constraint, even if the bank invokes a suspension clause there is a risk that short term agents would be at the end of the queue, and seemingly starve to death. How does this assumption hold up in 21st century banking where we have algorithms to instantly detect unusual withdrawals, to protect depositors from fraud? Is it science-fiction to think those algorithms could be calibrated to trigger a variant of the suspension clause on panicky depositors exclusively?
I’m asking because in his 1993 paper George Selgin criticizes the bank suspension as portrayed in Diamond-Dybvig. While so-called “bank holidays” fit the Diamond-Dybvig suspension, some better conceived bank suspension policies were more partial in the sense that depositors could still use their checkbooks and banknotes to consume. They didn’t starve. But bank suspensions might also be more partial in other ways; convertibility might be suspended only for depositors that seem to be in panic. In fact, even thought it was aimed at predatory redemption “duels” rather than Diamond-Dybvig “panic” runs, the option clause of the Scottish free-banking experience was not always used as a blanket measure, applying systematically to all banknotes. In some instances of duels, bona fide customers could still convert their notes while the clause was invoked against other banks’ agents. Granted, it might be easier to tell a regular customer from a competing bank’s employee, than it is to tell apart a customer withdrawing for real needs from a customer that’s panicking, if only because competitors would present a much bigger volume of notes for redemption than your regular customers ever would. But with nowadays’ technology…?
Here’s something I wrote, up for comments. Here’s the abstract:
A 2000 paper by Philippe Aghion, Patrick Bolton, and Mathias Dewatripont off ers a model where what they describe as a free banking system is vulnerable to contagious bank runs through clearinghouse loans. The paper ignores key contributions to both free banking and financial history literature, such that the paper is of little relevance to the understanding of the stability of both free banking systems and clearinghouse arrangements. Our criticism concentrates on the institutions of banking absent or misrepresented. It is argued that it is not clear whether the paper even features banks.
Thirteen years is a very long delay for a comment, but I was not able to find anything addressing this paper, and since it is still cited in almost every literature review on systemic risk, I thought it deserved a comment. Suffice to say, I don’t think think free banking can be dismissed in 6 pages, without giving a proper definition and citing any work on the subject matter.
My usual collaborators in our department seem to be abroad or on vacation this week, so please think of this as a crowdsourced seminar and please do leave a comment.
“Practically all the discussion on the relative merits of a centralised monopolistic banking system and a system of competitive banks all possessing equal rights to trade, took a place in a period of some forty to fifty years in the nineteenth century, since when it has never been reopened. In that period, however, the subject was one of the most keenly debated of its time. This is especially true of France, and indeed the period of about twenty years during which French thinkers occupied themselves with this problem is perhaps the most productive of any in French economic literature, both from the point of view of output and from the standpoint of its quality in comparison with that of other countries in the same years.”
Smith, Vera C. (1936) 1990. The Rationale of Central Banking and the Free Banking Alternative. Reprint, Indianapolis: Liberty Fund.
A widely held belief in the United States and the world financial community is that the default of major debtors-whether companies or municipalities or sovereign countries-could lead to bank failures that would precipitate a financial crisis. The remedy proposed by those propagating this view is that major debtors therefore must be rescued from the threat of bankruptcy to avert the projected dire consequences for banks and for the stability of the financial system. I shall argue that (a) a debtor whose affairs have been mismanaged should be liquidated or reorganized under new management; (b) default by major debtors need not result in bank failures; (c) if defaults do result in bank failures, so long as the security of the private sector’s deposits is assured, no financial crisis will ensue. The bugaboo of financial crisis has been created to divert attention from the true remedies that the present financial situation demands.
Schwartz, Anna J. (1987) “Real and Pseudo-Financial Crises,” in Schwartz, Anna J. (ed.) Money in Historical Perspective, University of Chicago Press, p. 271-288.
Most papers on the random withdrawal theory of bank runs suggest that bank runs are not only self-fulfilling prophecies, that alone is bad enough, but that once the run is motion nothing can stop it. This has serious implications, if bank runs are self-fulfilling prophecies that can’t be stopped then you would expect that there would be a lot of bank failures that are only due to bank runs. You’d expect there would be contagious bank runs. Especially during the National Banking era, which was rife with banking panics. This table suggests otherwise.
Source: p. 183 of U.S. Comptroller of the Currency. Annual Report Vol. 1 1920. Washington, D.C.: U.S. Government Printing Office.
Out of 594 bank failures during the National banking era, only 9 had bank runs as their primary cause. Out of those 9, two were banks closed in anticipation of runs. Out of the remaining 7 bank failures, 6 were eventually restored to solvency by the receivership, so I’m going to assume the losses weren’t that important. Only 4 bank failures out of those 9 occured before the advent of the Federal Reserve, including one case where the bank was closed prior to the run, and the bank that was not restored to solvency by the receivership.
Other bank failures might have been sped up by bank runs, but it was not the primary cause of failure. This means that the run, while certainly costly, might have been salutary and closed down the bank before its managers could enlarge losses. It also suggests that bank runs are, in most cases at least, not self-fulfilling prophecies, and that partial “verification” runs can occur.
So, what this means is that, over the whole National Banking Era, we only have only one potential case of contagious bank run leading to an unsalvable bank failure. I say potential and not definitive, because it might be the case that the failure was, after all, more a result of predation than a result of the bank run. What I mean by that is that it is pretty much always in the interest of other banks, and clearinghouses, to come to the rescue of banks in difficulty, because they can profit from those situations. It wouldn’t be surprising to me that what appears to be the only national bank failure due to contagious bank runs, is actually a case of other banks letting it die so that it can acquire its assets at a discount.
More research is obviously necessary on all of this, especially on the outcome of the receiverships.
Source: page 90 of O’Connor, J. F. T. 1938. The Banking Crisis and Recovery under the Roosevelt Administration. Chicago: Callaghan and Co.
Economics and Other Petty Things 