Free Banking as an Alternative to the Federal Reserve

Free banking compared to Central Banking

Free banking is money that is issued by free-market private banks with minimal regulation and clear market rules in a competitive environment.

Free banking has worked throughout history, yet for ideologically derived and fiscal expansion reasons it is jettisoned for government-controlled money. The idea is a few intellectuals know better than the free market. We should trust the few intellectuals over our own wisdom.

Free Banking is the only method available for the prevention of the inherit expansion of credit.

Ludwig Von Mises, Human Action, p.440

Free banking in history

Banks historically back their currency with gold or silver. In this manor confidence in the currency was established. If you could transact in fiat backed by ‘thin air’ or a gold note what would you have more confidence in?

Not just confidence generally but that the note would retain its value. If something retains value and is known to be quality, people use it more and it functions better.

Trust is the currency of this game.

Jeff Probst Survivor

Similarly economics is a social science and experiment. You can not legislate trust it has to be earned. Econometricians forget that individual social aspect of economics is the micro-foundations for macroeconomics.

To attract deposits banks tried hard to establish credibility and trust. Think about your visa or master card. You feel confident that your card will stand by you if there is fraudulent activity. Or Amazon, it does out of its way to establish credibility. Google with search, puts trust at their priority, that the integrity of the results is optimized for user satisfaction.

Similarly, banks under free banking did everything they could to establish and keep their reputation.

Again think of your visa card and all the relationships this company has and agreements of trust. Similarly, banks made agreements so make sure people trusted the value of their currency. This was all before Google reviews and the nearly instantaneous transmission of information.

Therefore, banks became interchangeable much like visa cards today. Retailers will accept visa cards from Bank of America or your credit union as there is backing or trust and the profit motive. Banks could not hold inadequate reserves or take on risky strategies or risk-averse investors would quickly lose confidence in the currency. Therefore, this was not done historically.

  • Without this risky behavior, there would be no need for bailouts.

A government issuer can devalue and manipulate the vale of its currency for political ends or a deemed social engineering objective. Free banking could not do that or it would lose trust.

Example of the Federal Reserve’s performance

  • 1 US dollar in 1787 was worth $1.06.
  • In 1913 the Federal Reserve Bank was established and $1 dollar in 1913 is today worth .04 cents.

How can you argue with that? Not to mention something called the Great Depression.

Think of anything you buy. If you buy something of lower quality, that falls apart people do not want to continue to buy it or it does not function as it is supposed to well. I would rather buy and use something of quality. So it is with money. You want to hold and use money of quality. People today do not have a choice because of the government stronghold on money.

It is like under communism you had to buy your goods from the one state-owned store. In our society, it is all people know, so like under communism people have been economically conditioned to believe this is the reality. It took a generation in the post-communist countries to change their mentality.

  • The issue here is people do not have a choice in these most important commodity in the market.

The Federal Reserve has a monopoly on money. With any monopoly, the price is generally distorted. Even if the monopoly is well-intentioned and benevolent.

Money is no exception that the free market results in the most efficient outcome based on individual choices. This is in contrast to the Central Banks around the world printing money out of thin air to pay the governments spending and promises. Look at our debt today.

The Theoretical support for Free Banking

Resources on the Free Banking debate versus Central Bank

This is academic theory, not some battle cry to abolish the Fed. Respected non-conspiracy theorists advocate the return to free banking and sound money.

The following is an outline of the basic logic.

Definitions of concepts in monetary economics

Prices are inter-temporal information points. That is they coordinated demanders and suppliers of a good while also are considering the future. How much they want to consume of that good in time weighing all the possibilities now and in the future.

The information is about the supplier willingness to supply and demanders willingness to hold or use.

This coordination is done at a microeconomics individual level. For example, each person decided for themselves how much of that particular good they want to consume. Each person has a different utility preference to consume, for example, ice cream. However, in aggregate we can derive a demand curve.

Money is a commodity, which functions as a medium of exchange, store of value and a unit of account. It is the second half of every transaction. You barter something for money in every transaction.

Credit is a derivative of money and in a modern economy functions as the medium for purchasing power, what Mises called fiduciary media. Purchasing power is what expands and contracts and influences economic decisions.

Interest is the price of credit. That is an inter-temporal information point that tells us how much credit people want to consume now based on a future looking time horizon. This purchasing power can be for consumer or capital goods.

Capital are tools which enhance the production process. The wise use of capital will result in greater profitability. Entrepreneurs perform economic calculations based on market estimates and based their capital deepening on these economic calculations.

Therefore, if the price of money/credit is wrongly estimated by a central bank, even a smidgeon, it will cause market distortion. Especially in the capital markets where entrepreneurs are formulating long term plans.

This theory has roots with Carl Menger’s organic understanding of money, in the Knut Wicksell with a cumulative process of price movements and Ludwig Von Mises and Friedrich Hayek with distortions in the capital structure that cause a business cycle.

What do we mean by the wrong price of credit?

We mean specifically the interest rate, that is the rate controlled by the central bank for practical purpose the Fed funds rate does not coordinate the ex-ante investors and savers. I=S ex-post by definition. We are concerned with the ex-ante process of coordination. This forward-looking process that all humans have because of inflated frontal lobes.

If this price on credit is wrongly estimated we have a market distortion, much like rent controls or the government setting the price of gas at the pump. If there is too little of a supplied good, then there are shortages. There could be non-price rationing, like lines at the pump, and loss of consumer surplus. Similar and excess supply of good causes of waste in that market.

However, since money is the second half of every transaction, the way money works out its disequilibrium, is not in an individual market but in every market. Every market is a market for money.

Therefore, if the Federal Reserve sets the Interest rate too high or too low, the price of credit, then there is a severe issue that affects every individual.

In contrast, in free banking, the market sets the price of credit. In fact, for different risk profiles and lengths of the loans and asset compositions, there should be multiple rates of interest not just one rate of interest. The idea of one rate is that entrepreneurs will arbitrate all markets to this singular rate. In the Hayek Staffa debates on the 20th century, this point was brought out.

How does the Central Bank set the price of money?

The Central Bank uses a wholly empirically derived estimate called R-star, a proxy for the theoretical concept of the natural rate of interest. It is an economic estimate of the price of money that would bring money neutrality to all markets.

The historical evidence is the Federal Reserve has failed to do its job.

It is beyond the scope of this discussion to explain the econometric reasons why, but historically the based on the Great Depression to the Crisis of ’08 the central bank has not done a good job.

What about Free banking or even its cousin the Gold standard?

Prices were stable and the US reached its gilded age. This was in a time of great historical upheaval and the industrial revolution and when the information was arguably less perfect than it is today.

The historical date of growth, stability and the Gini coefficient argues the Federal Reserve has not done as good of a job as free banking or the classic gold standard.

Why do we have a Central Bank? The political reason, so we can finance endless overseas military acts (these are not wars as Congress did not declare war) which we do not win or other programs. Who pays for it? The working and middle class. Who benefits, the people who have access to credit and work on Wall Street. The fat cats on Wall Street have they earned their money in the same way as hard working entrepreneurs? The irony is this is not Marxist speak, rather, free-market ideas.

Could we eliminate the Federal Reserve and return to free banking? Yes if there the paradigm is overturned. Paradigms are overturned all the time. It would translate for the US a return to the free market and free choice.

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