The Illusion of free banking

A May 2014 Skepticlawyer post that I failed to cross-post to here slightly updated.

Reading Fragile by Design: The Political Origins of Banking Crises and Scarce Credit by Charles Calomiris and Stephen Haber is a rewarding experience, not only in what it says but in the thinking it stimulates. As one comes to appreciate how immense the damage done by central bankers has been--causing the Great Depression, Japan's "lost decades", the Great Recession, the Eurozone crisis--which, I should clarify, is not the subject matter of Fragile by Design, free banking (in the sense of a banking regime without a central bank) becomes more and more attractive.

Especially as there are two excellent examples of how successful free banking can be, both covered in some detail in Fragile by Design. The first is Scotland from the late C17th until the mid C19th, when the privileges of the Bank of England were (partially) extended into Scotland, and Canada from the 1860s to the creation of the Bank of Canada in 1934. In both cases, free banking generated stable, efficient banking systems able to provide high levels of credit to their economies.

Case closed therefore?

No, a monopoly in issuing banknotes is not a necessary feature of a stable banking regime.

Alas, no. Central banks are ubiquitous in modern economies and for a simple reason--no state is willing to forego the financing advantages having a central bank gives it. A tame banker is a boon during fiscal emergencies--this is why they were created, starting with the oldest, the Sveriges Riksbank (founded 1668, the fourth oldest bank still in existence), and the second oldest, the Bank of England (founded 1694, the ninth oldest bank still in existence).

In both the above cases of free banking (Canada and Scotland), the free banking regime operated under the shelter of a central-bank-financed state. In the case of Scotland, part of the United Kingdom from 1707 onwards but sharing a common monarch since 1603 (apart from the Interregnum, when they still shared a government), the English-cum-British war machine, debt-financed as necessary via the Bank of England since 1694, protected Scotland and its free banking system (as Calomiris & Haber point out). In the case of Canada, part of the British Empire, Canada and its free banking regime was protected by the Royal Navy, also debt-financed as necessary by the Bank of England since, well, 1694.

Royal Navy: financed through the Bank of England,
also protecting free banking Scotland.

So, both the flagship cases of successful free banking regimes are also examples of why they are so rare. It is possible to have a free banking regime--in a subordinate jurisdiction protected by a central bank debt-financed war machine.

Since states are not going to give up their central banks, the trick becomes to determine the best policy regime for a given central bank to operate under. NGDP level targeting--maintaining a smooth trend in aggregate spending/aggregate income--is the best on offer at the moment. As Lars Christensen points out, it would mean that the business cycle was entirely driven by supply shocks; as Scott Sumner points out, it would allow policy to largely leave things be; and, as the experience of Australia and Israel demonstrate, can lead to very flat business cycles even during other people's (demand-shock caused) Great Recessions. (Yes, technically, the Reserve Bank of Australia runs a broad inflation targeting policy regime, but it largely operates as an aggregate spending smoothing policy regime.)

So, free banking: lovely idea, not going to happen. And the standard examples of why it is a lovely policy idea also demonstrate why it is not going to happen (except in subordinate jurisdictions able to have their own banking arrangements protected by central bank debt-financed as necessary war machines).