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Dollar Based Free Banking: A Possible Road to Sound Money?

February 10, 2011

In The Theory of Free Banking (1988), George Selgin offers a monetary reform proposal to go from the actual monetary system based on a monopolistic control of money to a competitive banking system (pp. 164-172).

There are different reasons (economic, institutional, political, psychological, etc.) why the return to banking based in a commodity like gold could be unfeasible, or very hard to achieve. However, Selgin uses the idea to freeze the monetary base as a transition to free banking (FRB). It should be noted that FRB in itself does not require gold to be the base money in place, the fact that this is what historically happened does not mean that FRB could not do with other alternative as base money. FRB requires something working as money in the market so that competitive issuer banks can issue their notes as claims on demand against it. Then, it might be possible to move towards FRB with fiat dollars as base money.

There are two important differences in place with a gold based FRB. The first one is that the dollars are easy to use as medium as exchange, there is no practical advantage in using a banknote against gold in the case of dollars as base money. For this reason the reform should came along with measures to increase the transaction costs of using dollars as medium of exchange (changing its denomination, size and color are some of Selgin’s thoughts). It is possible, then, that the public becomes accustomed to use the banknotes rather than the paper dollars. While banknotes are used for transactions, dollars remain in deposit. The second one is that paper dollars do not have use value. As dollars loose participation in the market its value will converge to zero if other assets can take the role of unit of account. What started as a fiat based FRB could become a commodity based FRB. Should that commodity be gold or another one will be a result of market itself. In that case dollars could become the useful vehicle to go back to a commodity base FRB.

Banknotes, however, were issued redeemable on dollars, this means that at some point issuer banks should start to issue their notes against the new asset. But another alternative is that banks could entertain the idea of moving to issue their own fiat money rather than redeemable notes if their clients trust them that much. This would be a scenario of currency competition. In this case banks offer a promise of stable currency, but their notes are not claims on demand against commodity money; if they do not hold to their promise they lose their clients, but they do not breach a contract. If banks move to currency competition, it would be like abandoning a dollar-standard rather than the gold-standard. If the profits of a one-shot hyperinflation strategy are high enough, then banks may be tempted to turn into fiat money. Banks may get higher profits today even if that causes them to shut down tomorrow due to the loss of clients.

Is it possible, then, that banks will turn into currency competition? Or will this move by some banks cause other competitors to stay in FRB as a best response strategy? Either way, if currency competition turns out to be stable, then the result is a competitive sound money system. If, on the other hand, currency competition becomes unstable, then banks will have incentives to move back to a commodity based FRB and gain new customers. Although there are two possible alternatives, as long as government stays out of banking it will be the market the one providing sound money.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image by scottchan / FreeDigitalPhotos.net.

5 Comments

  1. dgcmagazine May 13, 2011 10:39 AM
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    This is a wonderful article and points to the banking possibilities for the next decade.
    I just have to ask why wait for the banks? With today's Internet software, private companies are issuing their own currencies and it is successful around the world. No bank needed. A company like Webmoney Transfer, that offers various currency wallets is wildly successful. Digital currency wallets are created to fit a geographic area such as a WMR ruble wallet, WME euro wallet and even a WMG gold wallet. The private company issues the digital currency and that is accepted by merchants or exchangeable into national currency. In the LOOM.cc digital currency, each person may issue their own "brand" of currency and others accept it based on their reputation. Again, some are backed by gold, some are not. If you trust the issuer use that currency, if not, issue your own. I trust Webmoney more than I would ever trust a bank. These systems offer payments as small as 1/4 of a cent, they are excellent for everyday commerce.

    Mark
    editor@dgcmagazine.com

  2. Nicolas Cachanosky February 16, 2011 10:01 PM
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    Hello Ronald,
    Sorry for me delay in getting back to you.
    After following your link I know understand better you commodity example.
    As I understand Friedman's comment about the bricks, I see him using it as an example more as an endorsement of a monetary proposal. Bricks are a very straightforward example because of its obvious similar shape to a "brick of gold." But the argument could be equally valid for any other (elastic) good other than bricks.
    There has to be a reason, then, for the market to have chosen gold rather than bricks as money. For example, if gold has a higher exchange value (and it's not extremely scarce) it may be a more practical commodity money.
    Thanks for your participation and make us think a little more about money issues.

  3. Nicolas Cachanosky February 10, 2011 3:53 PM
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    Hello Ronald,

    Gresham's Law says that bad money drives out good money *if* there's a *fix exchange rate* between them. If that's not the case then good money drives out good money. In FRB there's no interference by the government, so there's no fix exchange rate and bad money does not drive out good money.
    A short explanation of Gresham's Law can be found here: http://eh.net/encyclopedia/article/selgin.gresham

    In pure-fiat systems banks do not issue claims on demand against a commodity (i.e. gold) as happens in FRB. In FRB, if a bank fails to honor its notes it incurs in a breach of contract. This does not happen with pure-fiat money. For this reason banks may be tempted to devaluate its currency and get high profits today against a more stable currency and a stream of future income. This is a possibility in pure-fiat systems that is not present in FRB because the later cannot expand the supply of their notes if they don't increase their reserves of gold first. This may be considered as a strength of FRB with respect to pure-fiat systems.

    I'm not so sure about the commodity base you refer in your link. How would the government now what and how much of each different commodity to buy and sell at the specific time and place needed? What of the goods he has in stock are different to those he would need to sell some years from now? If I understand it correctly it seems that this system would affect relative prices by playing a role as a buyer or seller in the market, and this causes distortions in the market.

    Hope this helps,
    NC

    • Ronald Grey Jr. February 13, 2011 7:35 PM
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      Hello Nicolas,

      Thank you for your reply to my comment!

      Your link to the article about Gresham's Law and your comparison between pure-fiat systems and FRB do indeed help me further understand FRB.

      Regarding answers to your own questions about a commodity-reserve currency, it would be best for me leave that to Milton Friedman, who addressed those same topics in a 1951 article you can access at the following: http://bit.ly/fImAzy

      Thanks again for your consideration and guidance.

      Sincerely,
      Ronald Grey
      http://ronaldgrey.wordpress.com
      Competence & Character: #Grey2012

      P.S. What do you think of the idea Friedman endorses, beginning on p. 208 of the above-linked article, about using bricks as money? Please comment with your opinion here.

  4. Ronald Grey Jr. February 10, 2011 1:52 PM
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    @Nicolas Cachanosky:

    Thank you for this stimulating article that inspires two questions in particular:

    (1) How does FRB relate to the economic law stated by Sir Thomas Gresham, who said, "Bad money drives out good?"
    (2) In your expert opinion, do you think FRB is preferable to the commodity-reserve or pure-fiat systems for currency proposed by economist Milton Friedman? (Please see: http://wp.me/pZiAD-101 and http://wp.me/pZiAD-13h, respectively.)

    Thanks again for your consideration and guidance.

    Sincerely,
    Ronald Grey http://ronaldgrey.wordpress.com