The Theory of Freebanking:

Money Supply Under Competitive Note Issue

by George A. Selgin

Rowman and Littlefield, 1988

218 pages; ISBN 0-8476-7578-5

Reviewed by Eric Watt Forste

The advent of digital cash and secure private electronic transactions shows the way to an inevitably deregulated economic future. But again and again, proponents of the new technologies of private digital cash are confronted with the question “What will the new money be based on?” In a free marketplace, of course, the right answer to this question is “Whatever you want.” But the new technologies do raise more penetrating questions that get down to the root of monetary theory. What is money? How can we arrange for a marketplace that provides a stable money, free of either inflationary or deflationary instabilities?

Conventional answers to this question call either for the use of some centralized authority, with monopoly power over currency issue, or for the use of a commodity standard (and a one-to-one reserve ratio), the supply of which can only respond weakly to changes in the demand for money. Such weak response leads to price disequilibrium. The faults of centralized monopoly suppliers of currency are well-documented in history and theory. In the effort to sustain stable prices, a centralized authority can rely on either managerial discre-

tion or adherence to a fixed rule. Managerial discretion allows constant temptations of over-issue and inflation; fixed rules are incapable of responding to real changes in the demand for (or “velocity” of) money. Neither approach has led to a stable price structure free of crises. The monopoly in currency is also one more tool of the state in its efforts to control society and markets.

George Selgin’s book The Theory of Free Banking: Money Supply Under Competitive Note Issue is perhaps the first general overview

of a serious competitor to central-banking theory. Although unrestricted competitive fractional-reserve banking has been successfully practiced in the past, theoretical work in this area by economists, until now, has been specialized or isolated. Selgin combines a thorough survey of the economic literature with original work of his own to produce a sweeping account of the theory of free banking, and a solidly-based argument for its superiority to monopolized currency supply. Selgin’s case is that unrestricted competitive note issue on a fractional-reserve basis can provide a price structure more stable than can be provided by any monopolized system, and also (here’s the surprise for traditional libertarian monetary theorists) more stable than can be provided by a nonfiduciary commodity-money system such as that endorsed by Ludwig von Mises, or a fixed-supply fiat-

currency system such as endorsed by Milton Friedman.

Why should extropians care about stable money? Unstable money leads to unstable prices, which hamper long-term planning by individuals and firms and provide a less nurturing environment for investment in blue-sky technologies. Instability and unpredictability in the structure of prices is certainly one factor hampering current investment in research into nanotechnology, space development, artificial intelligence, and other very-long-term-payoff domains. Unstable money is far from being the only such factor; unpredictability of future regulations is probably far more discouraging than the threat of inflation. Nonetheless, if we look toward private digital banking to protect us from some of the ravages of the state, we should do what we can to make sure our future extropian currencies do at least as good a job as the U.S. dollar had done, preferably better. Of course, this discussion is oversimplified; some price changes, such as lower prices brought about by increases in real productivity, are desirable and do not hamper good planning and

Unstable money leads to unstable prices, which hamper long-term planning by individuals and firms and provide a less nurturing environment for investment in blue-sky technologies. Instability and unpredictability in the structure of prices is certainly one factor hampering current investment in research into nanotechnology, space development, artificial intelligence, and other very-long-term-payoff domains.

investment decisions. But price changes due to monetary disequilibrium are another story altogether, a thing to be avoided.

Ludwig von Mises and Milton Friedman were both well aware of the failures of monopolies with discretionary power over currency issue. For these reasons, von Mises disapproved of fiduciary substitution (the practice of issuing unbacked notes) entirely, and endorsed free banking only because it was his opinion that free competition would do away with fractional-reserve banking. Milton Friedman, working in a more regulatory climate, acquiesced to the monopolization of currency, but endorsed the use of strict rules governing monetary growth to bar the way to discretion and inflation. However, as Selgin points out, although both von Mises’ and Friedman’s approach are preferable to traditional central banking, each has its own

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potential price instabilities. A system without fractional reserves cannot respond to changes in the demand for currency balances. If people choose to hold more currency for longer periods of time (a “fall in the velocity” of money), then price deflation may ensue, and likewise if the “velocity” of money increases, price inflation may result from the decreased demand to hold money. Under a pure, full-reserve commodity money standard, these changes in demand fall directly upon the gold mines; banks can do nothing to alleviate them. Under a Chicago-school system of monetary growth at a fixed rate (possibly a zero rate), likewise, spontaneous changes in the demand for currency balances are unaccommodated by supply. Any change in demand that is unaccommodated by changes in supply must be accommodated by changes in the price structure; that means either inflation or deflation.

Selgin’s alternative is to allow individual banks to determine their own reserve requirements, issuing notes freely to meet their customers’ demand. His immediate task (to which he devotes most of the book) is to show that such note issue will respond to increases in demand without going beyond demand, and that such free note issue will likewise contract in response to decreased demand for holding currency balances. This is, of course, where things get complex. But it’s important to acknowledge that if the flexibility of free note issue on fractional reserves could be made to respond to demand (or “velocity”) and only to demand, it would lead to a more stable monetary equilibrium than any fixed rule for monetary growth.

Most of the objections to free banking have been based on the idea that there are no market forces to prevent concerted credit creation and resulting price inflation in a free banking system. Selgin’s counterargument is concise and elegant. He points out that demand for reserve currency (high-powered money, inside money, e.g. gold in the traditional commodity-based system) has two components. The first is the need for reserves to present for net clearings overall; this is already widely acknowledged in the literature, and is the reason why a free bank cannot overissue without the cooperation of its competitors overissuing at the same rate. But Selgin’s contribution is to point out that there is a component of reserve demand that is needed to meet daily clearings. If a bank in a stable market keeps its

note supply constant, its positive clearings will over time cancel out its negative clearings. Nevertheless, it needs reserves to cover those negative clearings when they happen. And if all banks expand in concert, the variance of those clearings will go up, which means that large daily negative clearings will happen more often than before the concerted expansion. Selgin explains how this component of reserve demand prevents a system of free banks from expanding as a whole beyond the limits of market demand. Of course, some expansion of this kind is possible; Selgin is discussing a fractional-reserve system, after all. But the expansion eventually meets market-imposed bounds, bounds which preserve monetary equilibrium and a beneficial environment for planning and investment.

One of the most entertaining parts of Selgin’s book is his Chapter Two, “The Evolution of a Free Banking System” in which he outlines the economic history of the fictitious country of Ruritania, to try and paint a picture of the sort of banking and monetary system we might have to-

Selgin’s Chapter Two is a beautiful exposition of spontaneous order (or of, as Adam Smith put it, “the invisible hand” at work).

Although Selgin’s focus is on filling a lacuna in recent economic literature by developing a solid theory of free banking, he acknowledges and draws upon the excellent recent work that has been done on the factual history of free and almost-free banking systems. In particular, he looks at the free banking systems in nineteenth-century Scotland, Canada, and Sweden, and the Suffolk Bank system of New England in the United States. In each case, he details the political processes that led to the transition from a system of plural, competitive note issue to a central-bank monopoly. Selgin is adept at using the historical records to test his theory. While “retrudiction” in economics has been widely abused, history remains the largest and readiest source of data for us to test our economic theories against, and Selgin’s many references into the economic and historical literature provide plenty of grist for the suspicious

While crypto mavens are busy explaining how these banks could function technologically, the theory of free banking explains how they could function economically. It provides an answer to the question “Under a digital cash system, what would the money be, exactly?”

day had not governments intervened to secure themselves a source of cheap and easy loans (and hidden taxes) from the printing press. The interesting development of this chapter is a system of clearinghouses, which fill many of the functions currently served by our governments’ central banks, but which have no monopoly on note issue. (Under the systems Selgin envisions, clearinghouses hardly ever issue notes for circulation at all.) The principal function of clearinghouses is multilateral exchange of notes and checks issued by the various banks, on a daily basis, and the settling of any left-over clearing balances from this exchange. It is the rapid turnover engendered by this system that gives individual competing banks signals about the relative supply and demand of currency so much faster than a central bank (without the information-generating process of competition to inform it) can gather such information.

reader to further investigate.

And of course, while theory and history are enjoyable, the point of studying these things is implementation: present and future practice. Given that we are currently running a dollar economy, how can we make a transition from the Federal Reserve system to a free-banking system without at the same time taking on the tremendous uproar of shifting to an entirely new unit of reserve currency? Selgin has a proposal here as well. There’s no particular reason why the bad old Federal Reserve Note cannot serve as the reserve currency for a free-banking system. First, we will need to remove the existing restrictions on branch banking and other liberal banking practices, and much of this deregulation is already underway. Second, we will need to remove the legal reserve minimums imposed on banks. This will need to be done carefully to avoid a large inflationary response. Most

EXTROPY #15 (7:2) 2nd-3rd Quarter 1995

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banks now, operating under a legal reserve minimum of, say, twenty percent, keep roughly twenty-five percent on hand. Only the extra five percent does any useful work at the clearinghouse. Selgin describes some complex (to me, but then, I’m not an economist) schemes of swapping the legally-mandated reserves for Treasury bills or other forms of non-high-powered money. At this point we would be ready for the third step; freezing the base money supply and allowing banks to issue their own currency notes. Now freezing the supply of base money is the same reform Milton Friedman has proposed, and as we noted, it would result in price disequilibrium to the same extent that the demand for currency varied. By combining this reform with the additional step of allowing banks to issue currency (subject to the market discipline of the clearinghouse), we can allow for equilibrium-preserving responses to changes in demand. To promote public acceptance of the new currency, high-powered (and fixed-supply) Federal Reserve Notes could be issued in larger, inconvenient sizes, printed in red ink, and in large denominations (with perhaps only odd small de-

nominations: we could see a return of the two-dollar bill, or even a three-dollar bill). Banks would of course be free to issue their currency in the size, appearance, and denominations desired by their customers, who would still continue to use standard change machines, ATMs, and cash drawers.

Once such reforms were in place, banks would then be free (with a little further deregulation) to offer interest-bearing accounts based on other currencies, on mutual-fund shares, or on commodities such as gold. The gold and silver notes of old could then stage their return, for those who were interested in using them. Another pleasant feature of free banking is that not only does it allow currency supply to vary with market demand, it also provides base currencies according to market demand. There would be no need for a sweeping, politically-unpopular “return to the gold standard” or adoption of a complex (and frightening, to some) stock-market based currency; instead, we could simply set the market free to determine its own most salable good.

Contemporaneous with these hoped-

for regulatory reforms, we can expect to see the technology of digital cash and cryptographic banking developing apace. While crypto mavens are busy explaining how these banks could function technologically, the theory of free banking explains how they could function economically. It provides an answer to the question “Under a digital cash system, what would the money be, exactly?” What the money would be, if we deregulate banking at the same rate as we develop the new technologies, is cryptographically-secure bearer claims on deposited goods. Whether those deposited goods are Federal Reserve Notes, troy ounces of gold, or shares in an index stock fund, would depend purely on what you wanted to deposit with a bank in exchange for bearer claims. Since I myself am a big fan of Harry Browne, I’d love to be able to bring some gold in for deposit at my local cryptobank, and accept my digicash in exchange just for the beauty of the thing. Those who prefer to deal in cash based on silver, or dollars, or pounds, or Swiss francs, or shares in the S&P 500, or whatever, would be free to do so. Which is just what we ought to expect from a market system.

PART 1 Transhumanist Philosophy

Max More, Robin Hanson,

William Wiser

PART 2 Extropy Institute, MI, Uploads

Max More, Robin Hanson, Abe Heward

PART 3 Indefinite Lifespan, Uploads

Max More, Robin Hanson,

Chris Heward, Tim Freeman

PART 4 Alcor Foundation and Cryonics

Max More, Regina Pancake,

Dan Spitzer, Tim Freeman

PART 5 Mood Modification and

Identity Choice

Dr. Ray Sahelian, Max More

PART 6 The WWW and Virtual Communities

Jeannine Parker, Coco Conn

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EXTROPY #15 (7:2) 2nd-3rd Quarter 1995