0:36 Intro. What is free banking? Banking without any special regulations, conducted as it might be if government treated banks as they treated shoes or widgets or anything that is a real good. Government has regulated banks heavily in all countries. What role for government in free bank? No special role other than enforcement of contracts. If you had a commodity monetary base such as gold or silver, there might not be any need for special regulation. Most people's reaction is: Banking is too important to be left to the private sector. Lots of things are really important: trade, food, agriculture; hard to think of any sector of the economy that is not important. Does government involvement make it work better or not? Pre-1913, before the Federal Reserve, though not free banking, relatively free. Fraught with bank runs that we thought the Fed has learned to smooth (though rethinking lately). Several instances approximated the ideal of free banking. Most important thing is that creation of the Federal Reserve did not mark the beginning of government interference with money and banks. In the United States, government has wielded a very heavy hand. Before the establishment of the Fed, lack of branch banking--which remained true for many decades after the establishment of the Fed; and banks were restricted in their ability to issue currency. Those two regulations created all kinds of trouble with the pre-Fed monetary system.

6:09 Branch banking and currency issuance. Under free banking, would banks be the only suppliers of currency or merely the holders of deposits of government money? Today banks issue a lot of people's money holdings in the form of various kinds of deposits. Until recent times, banks were the only suppliers of any kinds of money. Pre-Fed times, pretty much banks and mints supplying money. Banks could issue their own circulating notes. The brands issued by different banks weren't truly distinct underlying monies. Different banks issued $1 notes, $5 notes, etc., but they were all claims to some underlying amount of gold. Uniform monetary standard, but no monopoly on the issuance of the paper. Stopped in two stages. During the Civil War, the state-chartered banks, which were the only kinds of banks that had existed at the time of the outbreak were deprived of the right by subjecting them to a stiff tax. Before that took effect another kind of bank was established--National Banks under Federal charter--and those continued to issue their own notes, but had to back them more than fully with government securities, to help finance the Civil War. Didn't have anything to do with improving the performance of the monetary system. As the government retired its debt, it became exceedingly costly for them to supply currency, so currency supply shrank; set stage for financial crises into the early 20th century. Argument for establishing the Fed: Let's set up 12 banks that can issue currency when the laws prevent the national banks and state banks from doing it. New set of banks not subject to the same rules. Problem was these banks could issue too much currency, and did so. If private sector created the roads, we'd have roads going everywhere--like we have now? If all currency were issued privately, would currency issuers have an incentive to inflate the currency? Just like the government does. If all currency were privately issued, what would be the protection for holders from inflationary pressure? Today if the bank makes too many loans (holding available stock of Fed-supplied reserved constant), no bank can go too far in making loans because checks are drawn on those loans, get redeposited and cleared, so a bank that is being too generous is running out of reserves. Puts strict limit on money creation in the form of deposits. Same discipline historically. Rival banks sent notes back for redemption. Doesn't work if you give one bank a monopoly because its notes are treated as reserves. Restraint in the private system. Suppose a bank makes too many loans, putting out too many bank notes. They circulate and get turned in naturally to my rivals. Rivals come to me looking for gold. If I've issued too many, I run out of gold. What protects the holders of my notes? They will continue to accept your notes as long as they believe you are behaving responsibly. What will usually happen if a bank gets a reputation for lending too aggressively, the clearing house will probably catch on before anyone else and throw that bank out; and then other banks won't accept its notes. Historical incident: Ayre Bank, Scottish bank pursued an easy money policy and was issuing too many notes; quickly discredited and Ayre Bank collapsed in fairly short order. Depositors suffered, but most of the losses were suffered by the bank owners, of which Adam Smith was one. Clearing system disciplines banks and keeps them from going overboard because they know what they can expect.

15:40 Banks vs. other businesses. Car manufacturer cheats on quality of the car --some get stuck with mediocre car, but most of the losses are borne by the stockholders who lose future benefits. With banking, you are going to wipe out people's savings. In such a world, would not people be uneasy putting any significant sum of money in any one bank, instead spreading them across many banks? Or would there be insurance of some kind? That's what bank capital is for. Front line of defense of the banks is their capital. Put your money in a bank that's got a lot of capital. Any losses it suffers as a result of bad loans come out of that capital. If it overissues, it will suffer reserve losses and a liquidity problem that should constrain it very quickly. If it makes bad loans, lack of solvency, comes out of capital; only after capital exhausted do depositors and note holders suffer. In whole Scottish free banking history until 1845, total losses of those who held Scottish bank notes were minuscule compared to losses borne by taxpayers as a result of bank failures in modern times. Capital suppliers like Adam Smith bore the losses. Feedback loops: if car doesn't run well or falls apart quickly, word of mouth spreads information. Hard to see how that would work with free banking. Would get signals much faster than with car maker. Notes are assets, traded in secondary market; the minute there is any doubt about the value of a bank's balance sheet, solvency, its notes are going to trade at a discount. Generally notes stay at par. Which of all these banks do I consider worthy of having my money? Individuals have an incentive to do some research, into its capital; will want to put as much effort into choosing a bank as into buying a car--which today nobody does for banks because of deposit insurance. Next, will want to ask: What notes and checks of other banks is my bank willing to take? If your bank accepts them, you can safely accept them. Usually same as group within clearinghouse. Banks not in good standing get weeded out or couldn't get started in the first place.

21:17 Would there be fractional reserve banking in a free banking system? Yes. Going back to the Scottish case, about 1820, not a lot of modern devices; typical Scottish bank held gold reserves of 1-2%, in an arrangement where everybody had the right in principle to convert a Scottish bank note into Scottish gold. Such was the faith in the banks that nobody every did it, which is why the reserves were so low. Quote: The first thing anyone in Scotland would do if someone paid him a gold guinea would be to get rid of it quick by depositing it in a Scottish bank and receive paper. So, only 1-2% could show up at a time, though they didn't. Bank run: if depositors did lose confidence, there wouldn't be enough. How do banks in a free reserve system do in that kind of system? Do they have to shut down? Remember that the 1-2% figure evolved through trial and error. If there had been a run and banks had no other recourse, they'd have to shut down as soon as they ran out of gold reserves. However, that doesn't mean that remaining depositors would get nothing. Bank would be liquidated and assets and capital used; often would be a complete payout to depositors. Recourse the banks themselves had until a law was passed preventing them from using it was called the Option or Optional Clause, that banks put on their notes. Clause said they reserved the right to suspend payment on notes and gold, but if they exercised it, then during the period of suspension they had pay the maximum allowed rate of interest of 5% to the note-holder. Note gets converted to a little bond. Note raids used by rival banks against each other were the only occasion of using this Clause, not runs from their own customers. Would have been a useful device had a run happened, but one never really happened. Problem as an insurance system--many such private contractual arrangements in today's economy--if a bank was profligate and made bad loans, the likelihood that the assets would cover the costs is even smaller because of the delay. Beauty of the Optional Clause: if designed right with proper rate of interest, incentive-compatible. The only time it would pay for a bank to use the Option Clause instead of winding up, going bankrupt, would be if in fact it was solvent, and people were panicking even though nothing was wrong--pure panic, imperfect information. If a bank has instead been profligate, it doesn't pay to invoke the Clause--simply shut down. But the shut-down would be disastrous for the depositors. If you do business with a profligate bank, you do badly. Could be a takeover. Bottom line is, a bank customer faces a positive probability of losing your money. Every government scheme for trying to do away with that aspect of free banking has ultimately given rise to a less safe system of banking in which though the depositors don't face losses, the taxpayers do. Losses become systemic.

29:55 In a free banking system, mid-18th century to 1845, in that world, what is restraining the bank from opportunistic behavior? Loss of reputation and ability to run their bank? Loss of capital. Many had unlimited liability, so owners' personal property was exposed. Common before the Fed to have capital that was 30% of liabilities. Central Banks are substitutes for capital in the eyes of depositors--if you have a lender of last resort you don't need that kind of capital. That's why bank capital has to be regulated today--we've gotten rid of all the natural incentives for depositors to insist that they do. Why do we think that the Scottish "experiment" was killed? What happened was the careless extension of legislation adopted for England being extended to Scotland. Peale's Act; England had a central bank, subjected currency component of the money stock to strict limits. Implemented by trying to impose strict limits on the note issue of the Bank of England; and also capped the note issues of other banks and made them subject to 100% reserve requirements. Gave Bank of England complete monopoly and didn't solve the problems. Extended to Scottish banks. That's why today there are only two Scottish banks of issue whose notes outstanding at least until the recent crisis have still been at the upper limits set by Peale's Act.

34:17 Is ideal a decentralized both banking system and money supply? In such a world, what would business cycles or inflation look like? Two things at stake. One, what sort of banks do we want to have? Need a system where banks can fail and customers take losses, because if you don't do that there will be a strong tendency to have only lousy banks. Macroeconomic question: how will money supply behave and will there be fewer or more business cycles? Reason for talking about free banking isn't just because of "freedom" or being libertarian. Want theory of free banking. No country with perfect free trade, but we have an understanding of what tariffs do comes from theorizing about free trade. Most monetary economists don't have a conception of what a free banking system looks like. You can only say what a Central Bank is doing if you have an underlying notion of what the system looks like before the Central Bank gets created. No alternative in most people's minds to the Central Bank regulating the money supply. Milton Friedman, fixed growth rate in high powered money. Until about 6 months ago, most people would have said we've got the hang of this Central Bank thing, 25 years of more or less steady growth, two small recessions. Current mess, not clear it indicts that viewpoint. Counterpoint to Central Banks being necessary. Statement presumes some knowledge of what Central Banks would do. Performance of Central Banks at best was not great. Inflation rates were generally above 2%; there were cycles. To pick on a 10-year interval and ignore the many decades in which Central Banks have screwed things up is biased. But we had to figure things out! Current crisis proves that wrong. Central Bank played an important role in pumping up the housing bubble. What looked like a period of stability really wasn't, just setting the stage for a cycle.

41:05 Inevitably the rule of human beings rather than rule of law. Greenspan worried about 9/11 and about the tech crisis went too far; Bernanke, when deciding to bail out Bear Sterns did that in an effort to avoid recession but may have hastened it. What's alternative theory of what business cycles and inflation would look like under free banking? Have to specify the standard--gold standard, silver standard, even fiat dollar created by a Central Bank. Wouldn't need to have an activist Fed. The Fed monopolizes only currency. The Fed's control of that one component gives it leverage over the whole stock. Can't shut down its operations without there being a mismatch of supply and demand. If you allowed banks complete freedom you could simply freeze the monetary base--just keep that stock constant. Need adjustments for currency flowing in from abroad, redeposits in banks. What you really want to freeze is supply of bank reserves. Imagine that the system has evolved so that no more green pieces of paper in circulation, just liabilities in the form of reserve credits. Two forms: Federal reserve notes, dollar bills, about half of which is abroad; rest of monetary base is monetary reserve credits, claims against the Federal Reserve on the Fed's books. Fed is the banker's bank. Bank puts money at the bank; deposit entry at the Fed. Freeze the total of that. Banks can supply the paper currency that people need. The frozen base won't be a problem. Changing needs of the public can be accommodated by the system. Falling price level if productivity positive. Less-than-zero argument. If public wants to accumulate more money and stops spending, don't draw as many checks or pass on their bank notes, decline in the velocity of money, would be a tendency for banks to issue more money, make more loans; their demand for reserves is a function of the flow of payments through the clearing system. When flow goes down, banks can bring it back up again by lending more. Changes in velocity get offset by money stock. Theory of Free Banking, first book. Why is there a Fed at all? Are we going to keep the Fed? Only if we want to keep the dollar rather than transition to a gold standard. Fed's role could be nothing more than a maintenance institution, no discretionary power. Strip it of open market operations and discount window; all done by private sector. Get rid of FDIC; could privatize the Fed clearing system. Get rid of the reserve requirements so reserve ratio can be flexible. Banks can also go bankrupt. How will whole system behave? In principle, total money supply adjusts: if people spend less of a bank's liabilities, the bank can afford to offer more. Stream of reserves. Precautionary balances: bank can inject more into the stream because the money isn't going to translate into more reserve losses. If people write checks every week and suddenly stop, bank can expand forever, because no one is going to draw on it.

52:01 Would we have a business cycle? One of the things everyone agrees contributes to business cycles today is swings in demand for goods, aggregate demand. If you have too much spending, it can contribute to a bubble. If you have a collapse of spending, you can get a recession. Maintaining a fairly stable level of spending is important to dampening the business cycle. You want to have a money stock grows when velocity of money goes down and vice versa. That's just what happens in a free banking system. Taylor Rule was thought to do the same thing. What has that failed? A lot of these rules look at the price level as a proximate signal of whether there is too much money or too little--can be misleading. Look instead at total spending. More or less equivalent if you hold productivity constant. Think of the equation of exchange: MV=PY. (M=money; P=average price level; Y=output; V=rate it turns over, called the "velocity of money".) What you really want is to stabilize PY, or equivalently MV. If you stabilize MV, you are stabilizing PY, but you are only stabilizing P itself if Y is unchanging. If you have a change in output due to productivity improvements, which you hope for, and want to stabilize spending, then you want the price level to fall; and to rise if productivity suffered a setback. Want to stabilize the aggregate demand schedule, but if the aggregate supply schedule changes you let it bounce around. The price level measures prices of finished goods. If more output for any given input, you've got a big relative price that has to change. If you stabilize the output price level, you've got to inflate input prices.

57:12 Political economy: government likes having control over the money supply. One argument is that we need the government's hand on the tiller to stabilize things. Doesn't look so good in practice, but could justify it by things that are outside the monetary authority's control. Some monetary institutions are looking less attractive than they once did. Governments want to move in the direction of insurance guarantee and no risk, which can't be done. Or is there something more sinister going on? private benefits from controlling the money supply? Lack of faith or public choice issues? Most people believe you have to have control of the monetary system or all hell would break loose. Many interests at stake which would suffer from a move toward free banking. Central banking creates interest groups that lobby for or against inflation or deflation or stabilizing policies. Pressure to inflate from certain groups including debtors the value of whose debts would decline. Latest book, Good Money--historical episode. No longer talking about banks. Bank of England existed in late 18th century. Money in those days consisted of coins, silver or copper, for all but the well-to-do. Also have the Industrial Revolution happening, rapidly increasing the need for these coins for retail and wage payments. Supply: Royal Mint, agency charged with creating those coins, was producing no silver coins and practically no copper coins. Result was change shortage, money shortage, which became extremely severe, threatening to undo a big part of the process of the Industrial Revolution. Merchants had trouble to pay their workers or make change to accomplish sales. Necessity is the mother of invention: a couple of entrepreneurs who had interests in copper mining tried to persuade the government to do something about the coinage by commissioning more which they offered to do by minting coins. Proposals fell on deaf ears. Thomas Williams, one of the entrepreneurs, set up a mint and minted coins bearing his mark. Later, John Wilkinson put his own bust on the coins. The coins' makers didn't run into the problems the Royal Mint had run into, such as counterfeiting and distribution problems. Coins initially were actually heavier than Royal Mint; beautifully engraved, redeemable on demand. In all respects superior money than Royal Mint. Solved the shortage. Why did it come to an end? First ended after 1797 when in a reaction to the suspension of the Bank of England the government finally supplied more coins. New coins didn't solve the problem though because the lack of competition caused these coins to not satisfy demand. New shortages, another outbreak of private coinage after 1810. That episode included silver coins, because Bank of England had been doing that; and then finally someone issued private gold coins. That was viewed as a threat to the Bank of England's sovereignty.