Sunday , 20 April 2014

“Free Banking Era” ?

A common but incorrect view of banking in the United States is that it went through a period of unregulated “Laissez Faire” freedom in which persistent malinvestment of deposits led to a public demand for government regulations and the central bank. I intend to illustrate how banks of the United States have never been laissez faire, and in fact are a product of government interference from its onset.

Prior to the creation of a central bank, whether a bank could legally operate depended on local state laws. Some states outright banned the creation of banking institutions, while the ones that permitted banks imposed severe regulations. Even the creation of a bank required tremendous paperwork and authorization, limiting its creation to individuals who were extremely wealthy. These wealthy individuals were motivated to create banks both as a means to obtain capital to fund projects that they independently lacked, or to mitigate the risk of directly funding such endeavours. Despite these self-satisfying goals, early banks were in fact rather sound – bank failures were uncommon and were thus a large factor in the early development of the American economy.

Early banks were by no means laissez faire in its operation. States imposed three general requirements on all banks: Limitations on a bank’s ability to set up branches, minimum reserve requirements, and requirements that all banks purchase particular financial assets, such as bonds, as “collateral.”

In order to expand on these limitations, starting with why branches exist, it is necessary to step back and to discuss the operation and evaluation of particular banking goods and services:

Individuals each have their own preferences for the ideal money stock, and this preference is predicated on a variety of factors. Their understanding of available money supply in the economy, their own time preferences for various ends, comparisons to other individuals, fantasies, and expectations of the future are all possible variables. Of note is that no particular factor can be stated or defined a priori – each individual is different. This results in a difference in the demand for savings (money that is intended to be consumed later) and for more money (additional capital that is used toward means that one otherwise would not have access).

Banks facilitate these two general ends by offering incentives to savers to invest their money in exchange for future payout. It also offers these savings to borrowers. The compensation (interest rate) is charged as the bank’s compensation for the loss of the use of money – the bank could have invested the funds elsewhere.  Interest is thus the cost of borrowed money.

The purpose of a branch generally serves two main functions: first, it minimizes the travel time customers take to reach a service agent of the bank. This increases accessibility, and is intended to positively affect customer satisfaction (it affects psychic profit). Secondly, the bank combines the branch with a mechanism to manage consumer transactions in a centralized fashion. By decreasing the clearing time of financial transactions, consumers have quicker access to their accounts. To address the bank’s perceived risk(s), service fees and other regulations / fees were levied on the customers.

More branches also provided the benefit of allowing banks access to a wider geographic area, and thus potential access to different industries and greater number of customers. This diversification of investments assists in maintaining a bank’s profitability during economic downturns. Banks which were unable to diversify their investments were at the mercy of the economic factors in their immediate vicinity (whether geographic or industry). Of note, this is not a consequence of laissez faire / free banking – whether a bank was well diversified or not does not ensure a bank’s profitability during economic slumps: diversification is merely a strategy to remain profitable.

Diversification of Investments

In a free market, well diversified banks can stay profitable through economic downturns. However, smaller banks that are under-diversified lack such options.

However, these incentives to invest in setting up new branches were stymied by government regulations. Smaller, less diversified banks complained to the government that the introduction of new branches by competing banks would run them out of business. Setting up limitations on the number and geographic locations of branches only served to stunt the growth of more successful banks. First, it limited the diversity of a bank’s investments. By having territories, a bank was unable to increase its profitability through expansion, or to remain profitable despite localized depressions. Also, this delayed the expansion of banks / banking conglomerates into greater geographical areas. Providing interstate commercial services was made difficult by the state imposed necessity of working with multiple banks rather than through one or a handful of geographically large banking institutions.

Note: in a free market, a large bank only succeeds by continuously satisfying consumer preferences. A large bank is not necessarily a corrupt or cronyistic institution.

The state imposed requirement to purchase particular financial instruments was first introduced as a means to insulate a bank’s customers against malinvestments. However, in practice, such requirements were used to redirect consumer demand toward mercantilist ends.

Banks serve numerous functions in order to remain profitable. When a bank purchases assets or engages in a loan, the expectation is that the future value of these purchases will be profitable – a bank (rather, the individuals operating in its name, using the bank’s specialized collection of assets and capital) “acts” as individuals do. If the bank makes a mistake in its evaluation of the future, there exists in a free banking environment many consequences which act as a disincentive: reported losses to its shareholders and customers, inability to repay debts leading to restrictions on future operations, or even worse, total bankruptcy. More importantly, a bank that engages in mal-investment must deal with a market correction which leads to a distribution of its capital and assets to other individuals. In order to maximize return on capital purchased at too high a price, a bank liquidates at a lower clearing price. In order to repay debts, a bank might liquidate its assets at decreased prices. While bank panics and runs were not common, they serve a purpose – to distribute mismanaged capital away from those who made a poor decision.

To avoid such unwanted ends, banks seek only investments it believes will be profitable. However, state intervention in how a bank must invest prevents a bank from acting as it would have otherwise. One common investment imposed by the state is for banks to purchase railroad bonds as well as government bonds. The ability of government officials to force banks to purchase bonds and stocks of corporation creates an incentive for lobbyists representing such institutions to rent-seek. This creates an environment of crony capitalism, rather than free banking, as the banks and lending institutions are unable to veto such demands, and are made to purchase assets it might not have otherwise.

Aside from direct taxation, governments are able to create money to be spent by selling bonds – promissory instruments that are repaid with interest after a particular time period has expired. In a free market, anybody can purchase bonds – corporations and banks sell bonds as well as governments. However, by forcing the banks to purchase its bonds, a government potentially can increase its spending above what the free market would allow. This affects the incentives that government officials have toward the citizens – malinvestment of capital is more likely as the repercussions are distorted or non-existent. Also, forcing banks to purchase government bonds allowed the state to subsidize its expenses during wars – even before central banking, the state had found a way to divert spending towards its own ends. However, this form of direct compensation drastically affected bond prices – when the Civil War ended, the supply of bonds was reduced, leading to rapidly increasing prices when consumer demand for money increased – particular during boom periods such as crop harvest season.

Most importantly, it was in fact these and other government regulations that prevented banking corporations from avoiding poor asset purchases and diversifying its portfolios in order to remain profitable. By forcing banks into purchasing bonds and stocks from favoured corporations, bank panics and runs occurred more frequently as malinvestments led to bust cycles. This caused a public perception that banks were unable to operate satisfactorily.  Calls for more government measures and a central bank were made. The creation of a central bank allowed the state to set minimal reserve requirements to banking institutions by various means, which will be covered in the next article.

Additional reading:

Richard H. Timberlake, Monetary Policy in the United States (Chicago: University of Chicago Press, 1993)

Steven Horwitz, Competitive  Currencies, Legal Restrictions and the Origins of the Fed: Some Evidence from the Panic of 1907,  Southern Economic Journal 56, no. 4 (January 1990): 639–49

Steven Horwitz, Introduction to Monetary Policy - the basis of this essay, which serves to explain the topic of banking in USA in a more simplified format.

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About Pika Chan

Pika Chan
Michael Chan is a supporter of and proponent of Market Anarchism. Sometimes he writes articles on economics and reminds the liberty movement that the solution isn't the 'right' rules, but total, unabashed anti-statism.
  • Jared

    Thanks for this buddy, great read

    • PGies Chan

      :D