Saturday, 2 May 2009

Interview with George Selgin

An interesting interview, from the winter 2009 issue of Region Focus from the The Federal Reserve Bank of Richmond, with George Selgin.

A couple of interesting question:
RF: Is a commodity standard necessary in your hypothesized free banking environment? Or, to put it another way, is “fiat money” incompatible with free banking?

Selgin: I think a distinction needs to be made between the banking regime on the one hand and the monetary base regime on the other. The way I envision free banking, it does not rely on a particular base regime. It’s true, as a matter of history, that if you had free banking from the get-go, you wouldn’t have central banks and you would almost certainly have a commodity money standard, probably gold. But one can conceive of free banking in a modern fiat money setting. What would make it free is that the central bank would not have a monopoly on issuing paper currency the way central banks do today almost everywhere.

A modern proposal for free banking that doesn’t radically alter the monetary base regime is one that freezes the monetary base, lets banks issue any sort of liabilities — including currency — and gets rid of deposit insurance. The central bank would still maintain the monetary base but, in principle, it would just be a question of making sure it mopped up old central bank notes and otherwise maintained a fixed stock of reserve credit for banks to settle with. In that case, you’d have free banking with a fiat money standard.

The fiat money we currently have is purely the product of central banks. I think it’s pretty clear that if we never had central banks, we wouldn’t have fiat money. Instead, we’d still have commodity money. I don’t think there were any evolutionary forces at work that would have weaned monetary systems off of established commodity standards, particularly gold and silver. What would have happened instead, and what was tending to happen while we still had those standards, was that the actual need for gold and silver as money would have fallen, thanks to financial innovations, to very trivial amounts.

In the Scottish free banking system, for example, actual gold coin reserve ratios had already fallen to as low as 1 percent to 2 percent of the banks’ outstanding demand liabilities by the 1820s. Most of the liabilities were banknotes back then — deposits weren’t so important. At any rate, the Scottish banks didn’t need a lot of gold, and the system was always finding new ways to economize on it. But the ultimate standard was still gold, and I think it would have remained so in the absence of government interference.
RF: Do you consider fractional reserve banking inherently problematic? Does free banking require a commodity standard so private banks don’t issue too much currency?

Selgin: The advantages of free banking are distinct from those of the gold standard or any commodity standard. That doesn’t mean that I think there is no advantage to a gold standard. As a matter of history, I think it’s a shame that the gold standard was dismantled. That dismantling really began in earnest during World War I, and the gold standard that was restored afterward was a jury-rigged and, ultimately, very unstable standard. But one can have a better banking system under free banking whether there is a gold standard or not. Fiat money would also work better with free banking than without it.

As for fractional reserve banking, I think it’s a wonderful institution and that it’s crazy to argue that we need to get rid of it to have a stable monetary regime. Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on its fraudulent nature or inherent instability are, frankly, making poor arguments. I don’t think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment.

The main thing to keep in mind is that a competitive bank of issue is one that can issue circulating currency but has no monopoly on doing so. So it isn’t in a position to print up its own reserves or to print anything that other banks can be counted on to treat as reserves. Free banks compete, as it were, on an even playing field in issuing paper IOUs, which are basically what banknotes are. They have to redeem those IOUs on a regular basis: The competition among different issuers means that their notes will be treated the same way that checks are treated by banks today. They will be accumulated for a day or so and then sent through the clearing system for collection. It’s this competition among issuers that assures that none of them has the power to lead the system into a general overexpansion.

That’s quite unlike the situation you have when you have a monopoly bank of issue. Even in the presence of a gold standard, when the privileged banks’ IOUs are themselves claims to gold, a monopoly bank of issue can expect other banks to treat its paper notes and its deposit credits, which are close substitutes, as reserve assets — that is, to treat them as if they were gold themselves. As a result of that tendency, which exists only because the recipient banks are deprived of the right to issue their own paper currency, the less privileged banks become dependent on the monopoly currency provider and, therefore treat its notes as reserve money. Now that monopoly bank has the power to generate more reserves for the whole system and it, in turn, is free of the discipline of the clearing mechanism. That’s where central banks’ power comes from. This is what allows central banks to promote a general overexpansion of credit and inflation.

What I just described is exactly the sort of thing that triggered many of the financial crises of the 19th century. The irony is that people now see these periodic crises, especially in England, as proving the need for a central bank and a lender of last resort. Walter Bagehot, on the other hand, recognized that the boom-and-bust cycles were a product of a monopoly in currency issuance.

Today, poor Bagehot must be spinning in his grave, because your average central bank apologist likes to cite him as having argued that every country should have its own central bank. That is a calumny. Bagehot in fact wrote very explicitly that he thought it would have been best had there never been a Bank of England, and if England instead had a competitive banking system like Scotland’s. In that case there would have been no need for any lender of last resort. In recommending that the Bank of England serve as such a lender, Bagehot wasn’t recommending a solution to problems inherent in unregulated banking. He was just trying to get an inherently flawed Bank of England to behave itself.

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