Monday, September 05, 2011

Book Review (#30 of 2011) The Theory of Free Banking

The Theory of Free Banking: Money Supply Under Competitive Note Issue by George Selgin (1988). Selgin is an economist at the University of Georgia who also contributes to the Free Banking blog where I found this book.

Selgin is eager to put to bed any prejudices against free banking by pointing out that many prominent theorists who had been skeptical of its merits never really studied what free banking really was nor had an all-encompassing theory to work from--until now. Selgin provides some historical background into various short-lived attempts at free banking and examines why they were short-lived.  He builds a theory of how currency and a system of fractional reserve banking without a central bank could arise in the hypothetical economy of Ruritania.  He then provides a critique of central banking and makes a proposal for how our current U.S. Federal Reserve system could be dismantled and free the banks to be like other businesses in a competitive marketplace.

Selgin is fighting battles on several fronts here-- with modern economists who take our current system as a given, with Rothbardians who believe fractional reserve banking is immoral, and with dead economists who did not properly grasp the history of free banking (or lack thereof).  Monetarists squabble about the best way to achieve monetary equilibrium and Selgin's theory presents a believable means to achieving it. I would say the bar for new ideas to be accepted here isn't that high-- since everything else we've tried has failed then why not try this?

I particularly liked the explanation of how in a world where banks are free to issue notes, arbitrage opportunities would eventually cause markets to arise that would cause all notes to be accepted at par. I also liked the practical explanation of how private insurance and reciprocal agreements between banks could prevent a system-wide bank run.

The two specific issues I found inadequately addressed in Selgin's theory are:
1. "Note dueling--aggressively buying large amounts of rival's notes and presenting them for redemption all at once." Selgin says that as all banks learned to keep high reserves, note dueling would cease to be advantageous and banks would eventually not do it. But, why would this not just as easily result in a Nash equilibrium where banks end up holding a large amount of reserves?  It seems to me that the Pareto-efficient outcome-- banks holding low reserves and trusting each other not to duel-- creates a real incentive for someone to cheat, leading to a standard Nash outcome.

2. Selgin believes that banks would want to compete with branded bank notes-- like Nike, Reebok, Adidas, but with currency.  It seems hard to see how this could lead to monetary equilibrium, as monopolistic competition causes a less-than-socially-optimal quantity to be produced, and at a higher price.

The simplicity of the theory is appealing, but another caveat is that it is looking at banks rather traditionally--abstract from what we now see in modern banking. Little attention is given to the assets the banks hold, presumably they are unregulated so can invest in anything. Presumably since there is no central bank increasing the money supply beyond equilibrium quantity there is no asset bubble & bust that would drive banks out of business.  I haven't worked it out in my own mind, but I'm not certain that monetary equilibrium can completely eliminate all asset market inefficiencies and quell the "animal spirits."

There is also little attention given to what happens if an economy, like the U.S., adopts the free banking model from its current central banking position. Is there a first-mover advantage or disadvantage in global capital markets?  Free banking also only works, of course, if all other markets are left relatively unregulated-- if government simply maintains its limited role prescribed by classical liberals. I think the last 30 years are evidence that if you deregulate piecemeal, you get serious distortions. Hence, free banking seems to be a Pareto-efficient outcome that is unobtainable given where we are today.  But that doesn't mean that a country like Estonia, who I think would be the best candidate, couldn't give it a shot.

In all, I give this book 4 stars out of 5.  I liked it, learned a good bit of monetary history from it.

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