This article was published in the Winter 1998-1999 issue of Formulations
by the Free Nation Foundation
Commercial Banking in a Free Society
by Steven Horwitz

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Central Banks and the Issuance of Currency
Interstate Banking
Glass-Steagall Restrictions
Private Deposit Insurance

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[This article is reprinted with the permission of The Foundation for Economic Education]

Although we can say a great deal about the institutions of a free society, and why they are desirable, speculating about the specific ways in which people will choose to organize themselves within such institutions is always a tricky matter. After all, the whole justification for the institutions of a free society is that only through its institutions can human beings discover progressively better ways of dealing with scarcity (of both goods and knowledge) and thus improve both our material and non-material welfare. Our ignorance of the details of a free society is precisely why having a free society is so important.

Nonetheless, this need not completely discourage us from imagining what the details of some aspects of a freer economy might look like. One way to go about this task is to look at the various ways a particular industry is unfree and imagine what removing those restrictions might do. In conjunction with such a thought experiment we might also look for historical examples where the industry in question was more free and explore the ways in which it operated and organized itself.

The banking industry is especially suited for just this kind of analysis. If we want to know what commercial banking might look like in a free society, we need only turn to contemporary regulation and the historical record to begin to piece together a coherent story.

There are four major areas in which the freedom of American commercial banks is restricted. The first area is the set of prerogatives taken away by the existence of government central banks, particularly the private issuance of currency. The second deals with restrictions on geographic location, while the third concerns the relationship between banks and non-bank firms. Fourth, as a result of the first three, is mandatory deposit insurance.

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Central Banks and the Issuance of Currency

In order for central banks to undertake the activities they, or their political overseers, have deemed necessary, they must acquire a monopoly over the production of currency. This restriction on the freedom of individual banks to create the kinds of financial instruments their customers might want has large and pervasive effects on the macroeconomy and the size of government more generally. Because "customers" must use the government-issued currency, they have no way of indicating their dissatisfaction with its quality or value. This is what enables governments to use the banking system to raise revenue; if they create more currency, it will be accepted by someone somewhere.

Central banks also have had a notorious time, even when the political incentives to inflate can be overcome, figuring out precisely what the right quantity of money should be. In a small version of what would face a comprehensive economic planner, central bankers attempt to estimate the demand for money and create the appropriate amount in response. For the reasons so skillfully articulated by Mises and Hayek, there are enormous knowledge barriers to this kind of central planning, even in one industry.

In a free society one would expect banks to produce their own brands of currency which would compete for the business of money users. Although this may seem a bit strange, having lived in an economy with only one currency, it really is not that much different from where we are today. Firstly, banks already offer competing monies. A checking account at Chase Manhattan is a different brand of privately produced money from a checking account at Citibank. Checking accounts are liabilities of the banks that create them, making them privately produced. They also differ in various ways: interest paid or not, rate of interest, fees charged, services offered, overdraft protection, and so on. Depositors choose among banks today based on the total package of products and services that accompany a checking account. One would expect the same if currency were competitively produced.

More important, competition in currency production would give producers the incentive to neither overproduce nor underproduce currency, and therefore maintain its value. In order for banks to get their liabilities (either currency or checking accounts) accepted, they would have to make them redeemable in some commodity (such as gold) or some other asset. Customers would not accept mere paper liabilities without some connection to an item which had value outside of the banking system.

As a result, any bank which overproduced would find customers returning unwanted currency which would lead to a fall in the bank's holding of the backing commodity, reducing its ability to create loans. Banks cannot afford to risk reserve shortages like this, so they would reduce their outstanding currency liabilities until those losses stopped. Banks that issued too little currency would see their reserves piling up and would be sacrificing the interest they could earn by making loans backed by those reserves. In a free society, the same market forces that create incentives to produce the correct quantity of shoes, toothbrushes, or eggs, would apply to currency. Because the banking system of a free society would get the supply of money generally right, it would also avoid the macroeconomic problems of inflation and deflation that have resulted from unfree central banking systems.

Virtually every country on the planet has had some experience with privately produced currency. The historical evidence suggests that countries with less regulated currency production had fewer bank failures and more stable macroeconomics. The Scottish banking system of the late eighteenth and early nineteenth centuries is a good example of the benefits of freedom, especially when compared with the substantially less free English banking system of the time. The U.S. experience of the nineteenth century provides a good example of how problems can develop when even private currency production is overregulated. The recurring crises and panics of the period can be seen as unintended consequences of misguided bank regulations.

In order to make their currency monopoly work, central banks have imposed other restrictions that would be absent in a free society. For example, central banks require banks to hold certain minimum levels of reserves. Normally these are higher than banks would otherwise hold and they usually do not earn any interest. Effectively they are a tax. In addition, reserve requirements prevent the public from having accurate information about bank portfolios. Banks that could afford to hold fewer reserves because they are safer are prevented from doing so, and banks who are riskier and might choose to hold higher reserve levels, especially in the absence of government mandated deposit insurance (see below), have no need to do so. In a free society, banks could pick the level of reserves they saw fit and would have to bear the consequences of holding too many or too few reserves.

More generally, a free society would not see central banks in the way they have developed in the nineteenth and twentieth centuries. There is nothing inherent in the evolution of banking that necessitates them, and their existence results from constitutionally unconstrained politicians striving after a cheap source of revenue. Of course banks in a free society would likely develop interbank institutions such as clearinghouses, but these would have no special government privileges and would be forced to compete for members and business.

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Interstate Banking

A more general way of thinking about banking in a free society is that banks will be subject to the same laws as other corporations. One example of how that is not true today is the issue of interstate banking. It is very difficult for many American banks to open up branches across state lines. Laws permitting interstate banking are made at the state level and they vary from state to state. Although most states have liberalized these laws to some extent in the last 10 or 20 years, full nationwide banking does not exist.

One result of this is that many banks are insufficiently diversified because they are too closely tied to industries specific to their state. When those industries falter, the banks fail with them. Banks that can spread their risks across different industries, by operating in different states, are less likely to fail. One bit of historical evidence for this contention comes from Canada. Canadian banks have historically been able to operate nationwide. While over 5,000 American banks failed in the 1920s and early '30s, only one Canadian bank did. Although a number of bank offices closed, only the one bank failed. This statistic is even more compelling when one considers that the variation in economic conditions between rural and urban Canada is greater than in the United States, posing a greater diversification challenge.

In a free society, we could expect banks to operate wherever they pleased, just as other firms do now. The need for traveler's checks, or the hassle of finding a new bank after moving, would disappear as true nationwide banking would make it far more likely that one's bank would have offices in more places. One consequence of this change would be a smaller number of larger-sized banking organizations. However, as evidence from countries which permit nationwide banking indicates, these larger banks would operate more offices per capita than smaller banks. This would both improve access to banking for most people and enable banks to capture the cost efficiencies of large-scale production that are now closed off.

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Glass-Steagall Restrictions

One other set of regulations on contemporary American banks are so-called Glass-Steagall restrictions. As part of the banking reform acts of the 1930s, a firm may not own both a commercial bank and a non-bank business. Firms like Sears that provide financial services can only provide those services to non-commercial customers. These laws also prevent banks from selling insurance or underwriting securities. Many argued that such an intermixture of banking and commerce was responsible for the numerous bank failures of the early 1930s, so a regulatory wall was needed to separate banking from commerce. Subsequent research has found this explanation of the bank failures to be incorrect and the justification for Glass-Steagall restrictions has been greatly weakened. Even the Clinton administration has recognized this and included liberalization of these regulations, as well as those on branching, in its reform package.

In a free society we would expect to see financial supermarkets where one could address all of one's financial needs (banking, insurance, investment) in one firm. There are obvious efficiency gains to producers in such a situation, as well as better service to consumers with one person or group overseeing their whole financial portfolios.

Because of the activities of central banks and the various other regulations noted above, bank failures are a real worry in unfree banking systems. As a result, governments have imposed mandatory deposit insurance in order to prevent the potential bank runs that their own regulations can trigger. If banks in a free society are unencumbered by central banking and other regulations, we would expect the whole problem of bank runs to be far less significant. Given this, any possible justification for government-mandated deposit insurance disappears.

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Private Deposit Insurance

Banks in a free society might choose to purchase privately supplied deposit insurance as a way to reassure customers. They might also enter into interbank mutual aid agreements, or be insured through clearinghouses. Historically, banks have used these and other methods to convey trust to customers. Before deposit insurance banks would advertise their balance sheets and list the members of their boards of directors. Providing this kind of information was a way to establish their trustworthiness to actual and potential depositors. With deposit insurance, banks need not do this. It is reasonable to expect that banks in a free society will use these ways, and discover new and imaginative ones, of creating the trust on which all banking systems rest.

Banks in a free society will be literally nothing special. What makes banking so unfree today is that banks are treated differently from other business enterprises. The rule of law that would characterize a free society would demand that banks be treated no differently than other firms. If they are fraudulent or use force, then they need to face the consequences. Otherwise, any sort of voluntary arrangement banks make with customers will be allowed. The result will not only be a more free banking system, but a more efficient, safe, and productive one. D

[Editor's note:  See the review of  Steven Horowitz's Monetary Evolution, Free Banking, and Economic Order which we carried in Formulations, Vol II, No.2 (Winter 1994-95).  You can find this review which was written by Eric-Charles Banfield in the web archive.]

Steven Horwitz is an associate professor of economics at St. Lawrence University in Canton, NY. He is the author of Monetary Evolution, Free Banking, and Economic Order (Westview, 1992) as well as numerous articles on Austrian economics, monetary theory and US financial history. He also has a book on Austrian macroeconomics forthcoming from Routledge. He has a special interest in the economics of monetary deregulation. Steve is the book review editor of The Review of Austrian Economics and a member of the board of advisors of Critical Review. For more on Steve and his research, see his website:


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