Last July I attended a summer program called "Alternative Money University" at the CATO Institute in Washington DC. The main theme of the course was to learn lessons from economic history, alternative monetary arrangements as well as alternative monetary theory. The course thus offered a rather unique approach to monetary economics that one might not get exposed to when doing a regular economics undergraduate or even graduate program, which all too often only contain "mainstream" ideas. I was one out of 30 students who got accepted for this summer school, which CATO organized for the first time. Not only was the summer school an amazing experience, but it was also fully funded by the CATO institute and I hereby would like to express my gratitude to George Selgin, the director of the Center for Monetary and Financial Alternatives at CATO, all the organizers of the event as well as the speakers who participated in the program.
The program included, amongst others, lectures by George Selgin on the history of banking and the Federal Reserve. Larry White was talking about free banking and cryptocurrencies. Scott Sumner and David Beckworth, on the other hand, were mostly focusing on modern Central Banking, the Great Recession, and the mistakes that were made by Central Bankers and other policy makers in response to the crisis.
Some thoughts on financial history and free banking:
In what follows, I will mostly focus on free banking as an alternative monetary regime, which was in some way the most interesting to me because my knowledge of this topic was somewhat more limited, and I suspect that the same is true even for some economists.
While most people simply assume the existence of a Central Bank as well as the fact that the government has a natural monopoly on printing money and issuing bank notes and currency, this state of things cannot by any means be described as the natural order of things. Instead, governments realized over time that they had an incentive to monopolize money and money creation. They therefore created Central Banks as to become the sole beneficiary of seigniorage, the profit the Central Bank makes by issuing costless fiat currency and investing the proceeds in interest rate bearing assets, usually government bonds. Of course, it should be noted here that the Central Bank cannot issue currency without limits as in the long-run the rate of inflation is almost correlated one to one with the rate of money growth.
The development of modern finance took place in early modern Europe a few centuries ago. The first modern banks emerged in Italy during the Renaissance era. Later on, the Netherlands and the UK took over and became the most financially developed countries in the world during the Age of Enlightenment (18th century). Modern bond markets, both for private bills of exchange as well as for government bonds, developed in the Netherlands and the UK just prior to the Industrial Revolution, and so did modern stock markets (Neal, 2015).
Some economists have made the argument that finance has significantly contributed to modern economic growth and that the Industrial Revolution would not have been possible without the development of modern financial markets (Neal, 2015). There is in my mind no doubt that there is some truth to that claim, given that any entrepreneurial activity, let that be just commercial trade or the development and production of some kind of good, requires some kind of financial funding and startup capital
That being said, financial markets are also occasionally prone to excessive euphoria. The first financial bubbles formed alongside the development of financial markets, one example being the South Sea Bubble of 1720 when a large number of companies, some of them fraudulent, attracted a large inflow of money on the promise for spectacular returns based on potential trade opportunities with the New World. Markets eventually crashed when the speculative frenzy ended (Kindleberger, 2000).
The financial system during that time looked fundamentally different from nowadays, as modern Central Banks did not exist yet. Bank notes were issued by commercial banks instead, one but by far not the only aspect of a free banking regime. Note that the Scottish pound, which is on par with the British pound and also accepted as currency in England, is still issued by three commercial banks in Scotland.
There is in the public some mysticism about banking and money creation, a lot of it coming from the modern monetary theory crowd (MMT), as those issues are in general not very well understood. According to some people, standard economic textbooks do not cover financial topics adequately. Mostly, the claim that banks can create credit out of thin air (which is basically true) is indeed sometimes swept under the rug, at least in Econ 101. Regardless, it does not really change what Keynes, Friedman, and Tobin have been teaching us about monetary economics, Central Banking, and the extent to which Central Banks can determine and influence aggregate demand and the aggregate price level (Tobin, 1969).
Banks have been creating credit for hundreds of years, and during the period of free banking in Scotland in the 18th century banks were also issuing private bank notes competitively. The fact that banks can issue notes does not by any means imply that they will do so without bounds, just like the fact that nowadays banks will not create credits without bounds (Selgin and White, 1987). Banks are constrained by the economic environment they face, and issuing additional credit or even bank notes is not free. The graph below displays the balance sheet of a bank under free banking. Assets must equal liabilities plus bank equity. On the asset side of the balance sheet you have reserves plus loans, the liability side consists of demand deposits as well as privately issued bank notes in circulation (plus equity capital).
Bank's balance sheet in a free banking regime
Just as for other companies, a profit-maximizing bank must ensure that its equi-marginal conditions hold. More specifically, the marginal benefit of lending must be equal to the marginal cost of financing via note issuance. Simultaneously, the marginal benefit of lending must also equal the marginal cost of financing via bank deposits.
While it is in a way very cheap to simply issue more notes and put them into circulation, a bank must make sure that the clients are also willing to hold the additional currency and keep them in circulation, thus effectively putting a number of constraints onto the bank that prevent it from over-issuance of bank notes. One costly way to increase the demand for one's banknotes is to attract more depositors. However, in the free banking world, there is a number of banks that are actively competing with each other, both in terms of attracting new deposits as well as in terms of issuing new currency. The banknotes that are privately issued by commercial banks thus compete with each other and circulate simultaneously, but should effectively be traded at par, unless regulatory constraints prevent the system from working (Gorton, 2012). The US is one example where commercial bank notes were not trading on par during the 19th century, this was to some extent the result of legislation that did not allow banks to branch out across states (Calomiris, 2006).
In a more or less competitive banking system, moral hazard should also be much less of an issue, especially if deposit insurance and the problem of "Too big to fail" are eliminated. Consumers would monitor their own bank deposits and switch to a competing bank if there is any sign of trouble, thus effectively imposing some market discipline on the system.
Of course, the argument that an unregulated banking system based on market discipline works rests on the assumption that both consumers and bankers are mostly rational and that many of the human tendencies that behavioral economics has described in recent years, human heuristics, pretty much cancel each other out in aggregate on the macroeconomic level. In other words, the efficient market hypothesis must be more or less true and the banking sector must also, for the most part, not exhibit any major information asymmetries, or other externalities that would require government involvement. However, if you believe instead like Minsky that financial markets are prone to instability and speculative behavior that is built into the system, a result of the human psyche to be overconfident and leverage up during the boom, only to become excessively pessimistic and deleverage during the bust, then unfettered financial markets combined with an unregulated banking system might not be such a good idea after all (Minsky, 1986). Paraphrasing Keynes, who actively speculated in financial markets and lost quite a bit of money at times: Markets can stay irrational longer than you can stay solvent (Keynes, 2018; Leijonhufvud, 1967).
Selgin and White have discussed how the period of free banking in Scotland during the 17th century was mostly characterized by financial stability (Selgin and White, 1987). It is not entirely clear to me though whether such a regime would also work in today's world of integrated financial markets and rapid capital flows across borders. Furthermore, we are as far away from the free banking world as one can possibly imagine. The financial crisis of 2007 has actually aggravated the "Too big too fail problem" as concentration in the US banking sector has actually increased over the last decade. Even more concerning, the Fed has significantly changed its "modus operandi" over the last 10 years as well. Given the problems Central Bankers faced when they hit the zero-lower bound in the aftermath of the financial crisis, they introduced a variety of tools that were outside the usual monetary tool box. While asset purchases of Treasuries and long-term government bonds are basically standard monetary policy operations, purchases of private sector bonds are not. These are credit easing policy tools, which can potentially have a distortionary effect on the economy. They do not operate by increasing aggregate demand in general via an injection of base money, but more or less act as a subsidy to one single sector, thus shifting resources from away from potentially more productive enterprises and undertakings. The same can be said for interest rates on reserves, which is a contractionary policy that at the same time is a direct transfer to the banking sector (see Selgin's blog posts at Alt-M on this topic).
The current monetary system, especially in the US but also in Europe, is thus the exact opposite of what market monetarists or free banking advocates have in mind. Market concentration in the banking sector is abnormally high and the federal government subsidizes large banks with an implicit bailout guarantee because "Too big to fail" is even more of an issue nowadays than it was 10 years ago. Furthermore, deposit insurance leads to a moral hazard problem as depositors do not have to actively monitor their banks, which can assume additional risks in a world where the state or the Central Bank is the lender of last resort. Finally, instead of pursuing monetary policy, the Fed is also in the business of paying interest on reserves and making credit policy, which has distortionary effects on the economy by potentially misallocating resources.
So where do we go from here?
I am very skeptical that we will ever experience and return to something that will resemble a free banking system. Regardless, we can and should strive to go in that direction. As a starter, the banking system should be made more competitive. Eliminating too big to fail subsidies and allowing free entry would be a good start. Furthermore, the Fed should end its credit policies and go towards a system where monetary policy is the main and only objective.
Scott Sumner (2012) has argued repeatedly that the Fed's particular target, and even more importantly, its toolkit is somewhat flawed. The fixation on interest rates is outright dangerous, given that most people are confused about this particular issue and equate low interest rates with easy money. However, interest rates are a very poor and misleading measure for the stance of monetary policy. The so-called natural rate of interest, which is consistent with economic and price stability in the long-run, is unobservable, and even ex-post, our measures of the natural rate are quite unreliable.
Ultimately, the best indicator for the stance of monetary policy is inflation and/or the rate of nominal GDP growth. The Fed should therefore move towards a system where they ensure a nominal GDP level target consistent with a NGDP growth rate of maybe 4 to 5% per year (Sumner, 2012). They could achieve this target with one particular policy tool: Open market operations that increase or decrease the amount of base money in the system by agreeing to buy and sell NGDP futures in unlimited amounts as to hit the nominal GDP target. The base money supplied by the Fed then simultaneously serves as reserves for the banking system. Market prices in the NGDP futures market are used as an indicator of whether the economy is growing at the target rate and also as an indicator for how much base money is demanded by the banking system. The Fed would then simply adjust the supply of base money in accordance with shifts in demand, thus eliminating more or less any discretionary policies and putting monetary policy on autopilot, a framework that has been advocated by Scott Sumner (2015).
The history of free banking as an alternative monetary regime, suggestions for reforming the current operating framework of the Federal Reserve, current Fed policy, as well as other monetary topics were all discussed during Cato's Alternative Money University. Of particular notice last year was also James Bullard's discussion of cryptocurrencies. However, the entire week's program was far too extensive to summarize in one long or even several shorter blogposts. I hope that future students at Cato will love the program as much as I do.
- Calomiris, Charles W. US bank deregulation in historical perspective. Cambridge University Press, 2006.
- Gorton, Gary. Misunderstanding financial crises: Why we don't see them coming. Oxford University Press, 2012.
- Keynes, John Maynard. The general theory of employment, interest, and money. Springer, 2018.
- Kindleberger, Charles P. "Manias, panics, and crashes: a history of financial crises." The Scriblerian and the Kit-Cats 32, no. 2 (2000): 379.
- Leijonhufvud, Axel. "Keynes and the Keynesians: A suggested interpretation." The American Economic Review 57, no. 2 (1967): 401-410.
- Minsky, Hyman P. "Stabilizing an Unstable Economy: The Lessons for Industry, Finance and Government." (1986).
- Neal, Larry. A concise history of international finance: From Babylon to Bernanke. Cambridge University Press, 2015.
- Selgin, George A., and Lawrence H. White. "The evolution of a free banking system." Economic Inquiry 25, no. 3 (1987): 439-457.
- Sumner, Scott. "The case for nominal GDP targeting." Mercatus Research (2012).
- Sumner, Scott. "Nominal GDP futures targeting." Journal of Financial Stability 17 (2015): 65-75.
- Tobin, James. "A general equilibrium approach to monetary theory." Journal of money, credit and banking 1, no. 1 (1969): 15-29.