Quote of the Day: High Degree of Stability of Free Banking Systems

Another point that stands out [in a review of the empirical evidence] is the high degree of stability of free banking systems.  Overissues of currency were corrected rapidly by the banks’ clearing system operating on the basis of the commodity standard (White, 1984; Selgin, 1988).  There is evidence that interest rates were more stable under free banking, and the less regulated banking systems of Scotland and Canada were apparently better able to weather shocks than their more regulated counterparts in England and the USA.  There is also evidence that shocks tended to originate in the more regulated systems and spread to the less regulated ones, rather than the other way round.  Banks typically observed high capital ratios by modern standards and, in the absence of ‘official’ regulation, bank management was monitored by the market.  The evidence seems to confirm that banks that were not considered sufficiently sound would lose their market share, and competition for market share would force banks to maintain the margins of safety and soundness that their customers desired (see, for example,Kaufman, 1988).  But perhaps the most striking evidence is that, in the absence of any ‘official’ lender of last resort or deposit insurance, banks only rarely faced runs, and the runs that did occur were typically confined to small numbers of banks, and often only a single bank, which had suffered some shock (such as the revelation of loan losses) which led their customers to doubt their soundness.

(bold mine)

This quote is from Kevin Dowd‘s 1994 essay “Free Banking,” which can be found in chapter 59 of The Elgar Companion to Austrian Economics (Peter J. Boettke, ed., 1994; links added). This quote was originally published at the Café Hayek Blog

Video: Free Banking 101

From LearnLiberty.org (hat tip Zero Hedge) 

What would happen if we didn't have a central bank? Prof. Lawrence H. White explains that private banks would be able to circulate money by issuing notes and checks redeemable for coin. Trustworthy banks would make arrangements to accept each other's notes and checks. Banks would have better incentives than the federal government to ensure their currency retained its value, because if it didn't, people would bank elsewhere. By contrast, central banks controlled by the government are able to devalue currency as they see fit and can even quit redeeming notes for coins of real value if they want to do so. It sounds like social-science fiction, but there are numerous real-world examples in history of successful free-banking systems. In fact, central banks arose largely because governments wanted an institution willing and able to lend them money with easy terms, not because of any problem with the free-banking system. Free markets offer the most efficient system for allocating goods and services, and money is no exception. As failures among central banking systems mount, it is time to reconsider the alternative of free banking.

Tom Woods: Why the Greenbackers Are Wrong

One of the strident critics of the US Federal Reserve have been the Greenbackers. 

Greenbackers represent a left wing American political party backed by the ideology which embraces inflationism (hence “greenbacks” in reference to non-gold backed paper money) and who are opposed to the gold standard due to its deflationary outcome. Greenbackers desire the engagement of more money printing as a solution to social ills.

One of the Greenback movement’s most vocal spokesperson Atty. Ellen Brown has been repeatedly critiqued by Austrian economist Gary North.

At the 2013 Austrian Economic Research Conference, Austrian economist Thomas Woods points out of the basic economic errors of the Greenback’s ideology by dealing with money basics, which is why I posted his paper.

Here is a snip of Tom Woods’ paper:

One of Ron Paul’s great accomplishments is that the Federal Reserve faces more opposition today than ever before. Readers of this site will be familiar with the arguments: the Fed enjoys special government privileges; its interference with market interest rates gives rise to the boom-bust business cycle; it has undermined the value of the dollar; it creates moral hazard, since market participants know the money producer can bail them out; and it is unnecessary to and at odds with a free-market economy.

Unfortunately, not all Fed critics, even among Ron Paul supporters, approach the problem in this way. A subset of the end-the-Fed crowd opposes the Fed for peripheral or entirely wrongheaded reasons. For this group, the Fed is not inflating enough. (I have been told by one critic that our problem cannot be that too much money is being created, since he doesn’t know anyone who has too many Federal Reserve Notes.) Their other main complaints are (1) that the Fed is “privately owned” (the Fed’s problem evidently being that it isn’t socialistic enough), (2) that fiat money is just fine as long as it is issued by the people’s trusty representatives instead of by the Fed, and (3) that under the present system we are burdened with what they call “debt-based money”; their key monetary reform, in turn, involves moving to “debt-free money.” These critics have been called Greenbackers, a reference to fiat money used during the Civil War. (A fourth claim is that the Austrian School of economics, which Ron Paul promotes, is composed of shills for the banking system and the status quo; I have exploded this claim already – here, here, and here.)

With so much to cover I don’t intend to get into (1) right now, but it should suffice to note that being created by an act of Congress, having your board’s personnel appointed by the U.S. president, and enjoying government-granted monopoly privileges without which you would be of no significance, are not the typical features of a “private” institution. I’ll address (2) and (3) throughout what follows.

The point of this discussion is to refute the principal falsehoods that circulate among Greenbackers: (a) that a gold standard (either 100 percent reserve or fractional reserve) or the Federal Reserve’s fiat money system yields an outcome in which outstanding loans cannot all be paid because there is “not enough money” to pay both the principal and the interest; (b) that if the banks are allowed to issue loans at interest they will eventually wind up with all the money; and that the only alternative is “debt-free” fiat paper money issued by government.

My answers will be as follows: (1) the claim that there is “not enough money” to pay both principal and interest is false, regardless of which of these monetary systems we are considering; and (2) even if “debt-free” money were the solution, the best producer of such money is the free market, not Nancy Pelosi or John McCain.

Read the rest here

This portion where Mr. Woods deals with the how the banking system would be regulated by economic forces in a free market environment is particularly worth quoting:

as with every other industry, profit regulates production. The production of money, like the production of all other goods, settles on a normal rate of return, and is not uniquely poised to shower participants in that industry with premium profits. As more firms enter the industry, the rising demand for the factors of production necessary to produce the money puts upward pressure on the prices of those factors. Meanwhile, the increase in money production itself puts downward pressure on the purchasing power of the money produced.

In other words, these twin pressures of (1) the increasing costliness of money production and (2) the decreasing value of the money thus produced (since the more money that exists, ceteris paribus, the lower its purchasing power) serve to regulate money production in the same way they regulate the production of all other goods in the economy.

Once the gold is mined, it needs to be converted into coins for general use, and subsequently stamped with some form of reliable certification indicating the weight and fineness of those coins. Private firms perform such certification for a wide variety of goods on the free market. This service is provided for newly coined money by mints.

Banking services would exist on the free market to the extent that people valued financial intermediation, as well as the various services, such as check-writing and the safekeeping of money, that banks provided.

China’s Blossoming Peer to Peer Credit Industry

More proof that markets abhor a vacuum.

While we seem to be getting mixed signals about the real credit conditions in China, where I suspect that lending growth has been happening among State Owned Enterprises (SoE) but may have been contracting in the private sector due to the overleverage in the shadow banking system (mostly from financial vehicles setup by regional authorities), many of the average Chinese seems to be exploring direct credit transactions via the internet: Peer to Peer lending.

From Bloomberg,

Peer-to-peer lending is taking off in China as traditional methods of private lending among family and acquaintances, part of the country’s unregulated $2.4 trillion shadow-banking system, move online. More than 2,000 websites have been set up nationwide since 2007, China National Radio reported in May. Loans brokered online increased 300-fold to 6 billion yuan in the first half of 2011, the latest figures available, from the full year total in 2007, the report said.

’Innovative Lending’

Akin to LendingClub.com or Prosper.com in the U.S., China’s peer-to-peer lenders let individuals invest a minimum of 50 yuan in projects ranging from small-business expansion to funding newlyweds’ honeymoons for as much as 23 percent interest, the highest rate allowed under Chinese law. While the returns are higher than parking the money in bank accounts earning 3 percent, they’re dwarfed by some underground shadow-banking investment yields that can go as high as 100 percent.

“This is an interesting and innovative lending platform with a lot of goodwill,” said Liao Qiang, a Beijing-based director for financial institutions at Standard & Poor’s.

Existing outside of regulators’ jurisdiction, online lending sites aren’t without risks. The China Banking Regulatory Commission in September issued a warning about web-based brokers, cautioning that their bad-loan ratio is “significantly higher” than that of banks -- without specifying the figure -- and that they can cross the line into illegality such as fraud, funding illegitimate businesses or money laundering.

A Beijing-based spokesman for the banking regulator said peer-to-peer lending isn’t under its official purview.

“There is no discipline at all,” Liao said, calling it a “short-lived fad” that won’t affect the role banks play in the economy. “There’s no enforcement should borrowers default.”

P2P lending will hardly be a short-lived fad, as they are in reality representative of free markets and of the deepening trend of the information age.

It’s bizarre how the mainstream talks about the paucity of discipline when today’s over-indebted shadow banking in China has mainly been fueled by reckless local government units in pursuit of political goals. China’s shadow banking industry consists of the investment trust industry, pawn shops, guarantors, underground banks and wealth management products.

Politicians and their apologists always try to shift the blame on markets the monsters which are, in reality, products of their self-creation.

Eventually P2P credit markets will get significant volume enough to challenge the conventional banking and financial industries, where the latter would seek interventions to curb competition. Don’t forget that conventional banking and governments will strive to uphold their symbiotic relationship which has been backed by the central bank.

Nonetheless, again China’s blossoming P2P credit markets are growing evidences of the deepening of the information age and of the parallel free markets (free banking?) that can be accessed, in case the conventional political- interdependent banking system undergoes a seizure (similar to Lehman episode of 2008). if not a collapse.

China’s Middle Class Support Demand for Gold

From Mineweb.com

The rise of China's middle-class is helping support demand for gold in the country. China, the largest producer of gold, is set to become the biggest consumer of the metal in 2012, with a significant proportion of luxury purchases in China veering towards gold accessories, bought by middle-class aspirational consumers.

By 2020, 25% of China's population is expected to be middle-class, creating great consumption demand. Diamond studded luxury items and gold watches are seeing `blow-out like demand' from wealthy shoppers in China, who are snapping up these expensive accessories to make a fashion statement, give as business gifts or just collect.

What also augurs well this year is that middle-class wealth is expected to spread to 600 million people in third-tier Chinese cities, with a sizeable percentage investing in gold or buying gold jewellery.

For a country whose gold production in the first four months of 2012 reached 109.6 tonnes, up 6.13% from the same period last year, passion for the yellow metal has scaled new heights.

Total retail sales of gold, silver and jewellery in China amounted to $2.82 billion in May, up 18.2% compared to the same period last year, according to the National Bureau of Statistics of China. Accumulative retail sales of the segment in the first five months of 2012 reached $14.6 billion, up 16.1% compared to the same period last year.

In May, the country's overall retail sales of consumer goods including gold, silver and jewellery totalled $262 billion, up 13.8% year-on-year at nominal growth rates. The real growth rate was 11%, data showed.

The jewellery sector in China has become a hot spot fuelled by surging investment demand for gold and precious stones. Jewellery retailers registered a 42% increase in sales last year, driven by consumers' taste for gold and gemstone-encrusted jewellery. Reports indicate that these jewellers are looking beyond traditional markets, eager to dig into the pockets of the newly rich middle-class in smaller cities.

For some time now, the country's growing middle-class has been pursuing a quality of lifestyle that includes appreciation for exquisite fine jewellery. And, retail jewellery chains are expanding to smaller cities and districts to keep up with demand.

Statists have always made the point that paper money has been the popular choice. But appeal to popularity premised on free lunch or Santa Claus politics cannot and will not supplant economic reality.

Today’s crisis have been manifestations of the unraveling of such unsustainable institutional arrangements.

Statists also say that people will have difficulty over adjusting or accepting to the return of gold as money. Maybe for the people of the West this may hold some substance. The intellectual elite may have successfully indoctrinated upon the public to accept the ideology that gold is a “barbaric metal” and where free lunch politics have promoted and embedded to their lifestyles the creed that “debt based spending is the path to prosperity” through government’s cartelized banking system.

But this certainly is far from reality for most of Asia such as China, India, Malaysia or Vietnam. The rate of growth of gold’s demand by China’s middle class looks like a testament to these.

In other words, should a global currency crisis emerge, then Asians are likely to reform their respective monetary system faster than that of the West. But that would be just a guess.

Yet it is unclear if prospective monetary reforms will include gold. But chances are increasing that gold may be part of it.

Global central banks have been accumulating gold at a faster rate led by Asia.

From Reuters.com

The Bank for International Settlements (BIS) noted in its June 2012 Quarterly Review that "central bank balance sheets in emerging Asia expanded rapidly over the past decade because of the unprecedented rise in foreign reserve assets" Reserves rose from $1.1 trillion to $6.4 trillion in 2011.

This quote, which I earlier posted, attributed to Janos Feteke (who I think was the deputy governor of the National Bank of Hungary) looks apropos to the surging demand of gold from China’s middle class and to the micro versus macro debate on the return of the gold standard,

There are about three hundred economists in the world who are against gold, and they think that gold is a barbarous relic - and they might be right. Unfortunately, there are three billion inhabitants of the world who believe in gold.

What truly matters is to get monetary system out of government's hands or to depoliticize or denationalize (Hayek) money and allow for competition in banking (free banking), where gold standard may or may not be the accepted standard. Nevertheless sound money based on free markets.

Essays on Proposed Monetary Reforms

I am supposed to take my day off today.

But I stumbled upon a gem of collection of wonderful essays on proposed monetary reforms from my favorites: Ron Paul, James Grant, Gerald O’ Driscoll, George Selgin, Lawrence White, Judy Shelton, Roger Garrison, Kevin Dowd, Kurt Schuler and more.

Read them at Cato Institute Journal called Monetary Reform in the Wake of Crisis (Volume 32 Number 2), a forum which was held in November of last year.

Read some of the statements by Ron Paul, Ben Steill (CFR), Allan Meltzer (Carnegie Mellon University), Lawrence White (George Mason University), Gerald O’Driscoll (Cato Institute) and Robert Zoellick, Jr. (World Bank) at the forum here

Gold Standard Years: Era of Relative Stability

Author and Bloomberg columnist Amity Shlaes defends the performance of the gold standard from mainstream critics.

The record of gold’s performance in all economies over the past century is not all “terrible.” Especially not in relation to areas that concern us today: growth, inflation or the frequency of bank crises. The problem here may lie not with the gold bugs but with those who work so hard to isolate them.

Gold’s Real Record

Conveniently enough, the gold record happens to have been assembled recently by a highly credentialed team at the Bank of England. In a December 2011 bank report, the authors Oliver Bush, Katie Farrant and Michelle Wright review three eras: the period of a traditional gold standard (1870-1913); the period of a gold-standard variant, the Bretton Woods gold-exchange standard (1948 to 1972); and a period of flexible exchange rates (1972-2008).

The report then looks at annual real growth per capita worldwide, over many nations. Such growth, they find, was stronger in the recent non-gold-standard modern period, averaging an annual increase of 1.8 percent per capita, than in the classical gold-standard period before 1913, when real per- capita gross domestic product increased 1.3 percent annually. Give a point to the gold disdainers.

But the authors also find that in the gold exchange standard years of 1948 to 1972 the world averaged annual per- capita growth of 2.8 percent, higher than the recent gold-free era. The gold exchange standard is a variant of the gold standard. That outcome doesn’t tell you we must go back to the gold exchange standard yesterday. But it does suggest that figuring out how the standard worked might prove a worthy, or at least not a ridiculous, endeavor.

Gold shone in other ways. In a gold-standard regime, money is backed by gold, so it’s impossible, or at least more difficult, for governments to inflate. Naturally the gold standard and Bretton Woods years therefore enjoyed lower rates of inflation compared with the most recent era. The gold standard endures a reputation for causing more banking crises than other monetary regimes. The Bank of England paper suggests gold stabilizes banks: The incidence of banking crises in the non-gold-standard period is higher than the incidence in the two gold periods.

“Overall the gold standard appeared to perform reasonably well against its financial stability and allocative efficiency objectives,” wrote Bush, Farrant and Wright.

Stable Markets

Markets and countries enjoyed relative stability in gold- standard years, and capital in those years flowed to worthy growth-generating projects. The main sacrifice in gold regimes that the authors identify is that governments lose authority to micromanage domestic economies. But given governments’ records, that may not be such a bad thing, either.

The gold standard essentially distilled or detached money from politics, by placing tethers on the spending abilities of politicians.

And this has been the key reason why politicians, their allies and captured institutions everywhere have worked fervently and in complicity to mangle or contort gold’s relatively better track record and or even discreetly attempted to expunge gold’s role from the pages of history books.

As the champion of sound money Professor Ludwig von Mises once wrote,

The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit's purchasing power independent of the policies of governments and political parties. Furthermore, it prevents rulers from eluding the financial and budgetary prerogatives of the representative assemblies. Parliamentary control of finances works only if the government is not in a position to provide for unauthorized expenditures by increasing the circulating amount of fiat money. Viewed in this light, the gold standard appears as an indispensable implement of the body of constitutional guarantees that make the system of representative government function.

The mainstream may deny it, but the way governments, through central banks, have been rapidly and intensely emaciating (or put bluntly destroying) their currencies, we shouldn’t discount that prospective reforms to the current US dollar standard system could partly include the return of gold, or that gold may play a bigger role in the monetary system.

Former World Bank President Robert Zoellick suggested this in 2010, but he may have been pressured by some quarters that prompted for a swift abdication of his earlier position.

Nevertheless the only way to bring back stability is to depoliticize money. This could be attained by first removing the monopoly privileges of government over money and by allowing for currency competition. So markets will determine whether gold will reassume its role or whether other forms of currency systems will emerge.

Reply To A Free Banking Critic: People’s Actions Represent Choices From Alternatives

A critic of free banking, asks

How much of the world’s problems are due to

Fiat money? Bailouts, Subsidies? Deregulation? Government deficits?

I’d say,

First, laws or policies shapes people’s behaviour

Second, people act for a purpose.

If a go to a burger store, I don’t usually ask how much of the burger I ordered consisted of

Mayonnaise, Tomato, Hamburger patty, Salt, Mustard, bread etc...

My purchase of a burger in that particular store represented my action out of the following possible alternatives:

-I am hungry (need to eat),

-I just want to eat (perhaps want to try out this new store),

-I am in a meeting

-I’ll buy it for someone else

Or etc...

In short, I acted on a ‘bundled’ product as a result of my choice from the above set of alternatives

As Ludwig von Mises explained (bold emphasis mine)

Action does not measure utility or value; it chooses between alternatives. There is no abstract problem of total utility or total value. There is no ratiocinative operation which could lead from the valuation of a definite quantity or number of things to the determination of the value of a greater or smaller quantity or number. There is no means of calculating the total value of a supply if only the values of its parts are known. There is no means of establishing the value of a part of a supply if only the value of the total supply is known. There are in the sphere of values and valuations no arithmetical operations; there is no such thing as a calculation of values. The valuation of the total stock of two things can differ from the valuation of parts of these stocks.

The simple message is that people’s actions are intertwined with the presented alternatives from where we make choices. One cannot draw the “valuation of a definite quantity or number of things”.

We cannot isolate one variable from the other. People’s actions are responses to an ever dynamic “bundled” environment shaped by laws, markets, culture, environment, etc...

So applied to central banking, for every transaction we make, half of it represents money issued by the government.

Thus if the central bank decides to inflate, people’s alternatives will be shaped by the changing state of the purchasing power of money. So it will be a feedback loop which spreads or ripples to most of human activity or the society covered by such policies.

As argued here, the central bank, inflationism, government deficits, welfare state, bailouts and political privileges can be seen as a holistic interconnected network of political economic arrangement. But you can’t isolate one from the other because these factors are sustained upon by each other.

And that’s also why the alter ego to inflation is usually price control. Because people’s response will likely be met by populist political policies which tries to mitigate the short term predicaments.

If people’s action can be isolated, then hyperinflation won’t result to societal devastation. And we would probably be still under the Roman empire.

The above is an example of an intellectual strawman. The logic tries to argue from an intellectual state, but in reality represents irrelevance to actual human conditions.

Finally it is further a non sequitur to say “no system is perfect” as an excuse to argue for central banks. It is NOT about being perfect, it is about being the most efficient.

Professor Ludwig von Mises has seen through such red herring...

The analogy with the state of perfection is obvious. The fully satisfied individual is purposeless, he does not act, he has no incentive to think, he spends his days in leisurely enjoyment of life. Whether such a fairy-like existence is desirable may be left undecided. It is certain that living men can never attain such a state of perfection and equilibrium.

It is no less certain that, sorely tried by the imperfections of real life, people will dream of such a thorough fulfillment of all their wishes. This explains the sources of the emotional praise of equilibrium and condemnation of disequilibrium.

We can chose to live in a perpetual state of (social utopianism) fantasy, or we can act to improve our lives based on economic reality.

Video: Lawrence White On Free Banking, Gold Standard and Central Banking

GMU Professor Dr. Lawrence White speaking at a monetary conference at the Cato Institute deals with free banking, the Gold Standard Banking and Central Banking. (hat tip: Tom Palmer)