….a logical (but also conjectural) story of the evolution of a “typical” free banking system, as it might occur in an imaginary, unregulated society called Ruritania.~George Selgin: The Theory of Free Banking

This article provides a synopsis for George Selgin’s Ruritania, a conceptual example of what would arise in a financial system in which there is no existing monopoly over the control or supply of money. Quotes are from his dissertation on The Theory of Free Banking.

Selgin breaks the metaphor into four parts and explains how they would natural evolve to logically follow each other without any outside intervention or altruistic action:

Our story involves four stages: First, the warehousing or bailment of idle commodity money; second, the transition of money custodians from bailees to investors of deposited funds (and the corresponding change in the function of banks from bailment to intermediation); third, the development of assignable and negotiable instruments of credit (inside money); and fourth, the development of arrangements for the routine exchange (clearing) of inside monies of rival banks.

A notable quote that will satisfy Smithians and Hayekians alike, Selgin’s invisible hand (not discussed) is based on the selfish pursuit and not from a grand altruistic vision or plan by any subset of the participants of the society:

…though every step is a result of individuals finding new ways to promote their self-interest, the final outcome is a set of institutions far more complex and important than any individual could have contemplated, and one which was not consciously aimed at by anyone.

From Barter to Commodity Money

Ruritania starts out from simple barter of commodities and eventually settles on certain commodities that are optimal for trading purposes. This practice eventually settle on metals as coinage-commodity money:

Ruritania’s earliest media of exchange are therefore simply its most barterable goods. Eventually, traders throughout Ruritania converge on some single good as their most generally accepted medium of exchange, i.e., money. Historically cattle were often the most frequently exchanged commodity. Yet, owing to their lack of transportability and their nonuniformity, cows left much to be desired as a general medium of exchange (Burns 1927a, 286–88). Their chief contribution to the evolution of money seems to have been as a unit of account (Menger 1981, 263–66; Ridgeway 1892, 6–11). It was the discovery of methods for working metals which finally allowed money to displace barter on a widespread basis. 3 So we assume that Ruritania’s first money is some metallic medium.

The emergence of such money is quite inline with a natural process of evolution:

Like that of money itself the idea of coinage does not “flash out upon” Ruritania or in the mind of one of its rulers (Burns 1927a, 285). Rather, it is the unplanned result of Ruritanian merchants’ attempts to minimize the necessity for weighing and assessing amounts of crude commodity money (e.g., gold or silver) received in exchange.

Without legal tender laws in place Gresham’s law does not apply. “Good money” is favored over any less quality counterfeit:

In Ruritania, however, since state interference is absent, coinage is entirely private. It includes various competing brands, with less reliable, more “diluted” coins first circulating at discount and eventually forced out of circulation entirely. This appears to contradict Gresham’s Law, which states that “bad money drives good money out of circulation.” Yet, properly understood, Gresham’s Law applies only where legal tender laws force the par acceptance of inferior coins. 6 In contrast, Ruritania’s free market promotes the emergence of coins of standard weights and fineness, valued according to their bullion content plus a premium equal to the marginal cost of mintage.

Foreign exchange, Warehouses, and Banks

Money can still be used over long distances, in trade with other economies, but there are costs associated with such exchange. Eventually arbitrage becomes profitable and exchanges and proto-banks start to bring these costs down:

Under Ruritania’s pure commodity-money regime traders who frequently undertake large or distant exchanges find it convenient to keep some of their coin (and bullion) with foreign-exchange brokers who can then settle debts by means of less costly ledger-account transfers. Money-transfer services also develop in connection with deposits initially made, not for the purpose of trade, but for safekeeping. Wealthy Ruritanians who are not active in commerce begin placing temporarily idle sums of commodity money in the strongboxes of bill brokers, moneychangers, scriveners, goldsmiths, mintmasters, and other tradespeople accustomed to having and protecting valuable property and with a reputation for trustworthiness. Coin and bullion thus lodged for safekeeping must at first be physically withdrawn by its owners for making payments. These payments may sometimes result in the redeposit of coin in the same vault from which it was withdrawn. This is especially likely in exchanges involving money changers and bill brokers. Such being the case, it is possible for more payments to be arranged, without any actual withdrawal of money, at the sight of the vault, or better still by simply notifying the vault’s custodian to make a transfer in his books.

In the beginning money is only “warehoused” or stored, but eventually opportunity for profit through lending and investing arises:

In transfer banking of this kind money on deposit is meant to be “warehoused” only. The custodian is not supposed to lend deposited money at interest, and receipts given by the “banker” for it are regular warehouse dockets.Thus, primitive Ruritanian bankers are bailees rather than debtors to their depositors, and their compensation comes in the form of depositors’ service payments. The lending of depositors’ balances is a significant innovation: it taps a vast new source of loanable funds and fundamentally alters the relationship between Ruritanian bankers and their depositors. “The . . . bailee develops into the debtor of the depositor; and the depositor becomes an investor who loans his money . . . for a consideration” (Richards 1965, 223). Money “warehouse receipts” or bailee notes become IOUs or promissory notes, representing sums still called deposits but placed at the disposal of the banker to be reclaimed upon demand (ibid., 225).

IOU and promissory notes evolve based on two important factors (that come about naturally!):

The ability of bankers, in Ruritania and elsewhere, to lend out depositors’ balances rests upon two important facts. The first is the fungibility of money, which makes it possible for depositors to be repaid in coin or bullion other than the coin or bullion that they originally handed to the banker. The second is the law of large numbers, which ensures a continuing (though perhaps volatile) supply of loanable funds even though single accounts may be withdrawn without advance notice.

Alas, the system isn’t optimal yet:

Since purchases must still be made with actual coin, substantial savings remain locked up in circulation.

The Birth of Inside Money

Inside money is born, used by the individuals while the banks begin to prepare to settle with the commodity money:

Nonnegotiable checks open the way to negotiable ones, while assignable promissory notes open the way to negotiable bank notes. What distinguishes the latter is that they are not assigned to any one in particular, but are instead made payable to the bearer on demand. Thus Ruritania would evolve the presently known forms of inside money — redeemable bank notes and checkable deposits.

This new technology increases the economic benefits for everyone involved:

…giving inside money, not only to depositors of coin or bullion, but also to those who come to borrow it. The use of inside money is not just convenient to bank customers. It also makes for greater banking profits…

We can already note that as commodity money (favorably) falls out of circulation some of it can now be exported and/or used for non-monetary purposes (without sacrifice to the entire money system!). This change allows industrial efforts to shift much of its focus from commodity money production to other endeavors. The society benefits as its financial system is now able to service a larger economy (without dramatic effects on the pricing system):

Aside from its immediate benefits to Ruritania’s bankers and their customers, the use of inside money has wider, social consequences. Obviously it reduces the demand for coin in circulation, while generating a much smaller increase in the demand for coin in bank reserves. The net fall in demand creates a surplus of coin and bullion, which Ruritania may export or employ in some nonmonetary use. The result is an increased fulfillment of Ruritania’s nonmonetary desires with no sacrifice of its monetary needs. This causes a fall in the value of money, which in turn “acts as a brake” on the production of commodity money and directs factors of production to more urgent purposes (Wicksell 1935, 124). Of even greater significance than Ruritania’s one time savings from fiduciary substitution (the replacement of commodity money with unbacked inside money) is its continuing gain from using additional issues of fiduciary media to meet increased demands for money balances. By this means every increase in real money demand becomes a source of loanable funds to be invested by banks, whereas under a pure commodity-money regime an increase in money demand either leads to further investments in the production of commodity money, or, if the supply of commodity money is inelastic, to a permanent, general reduction in prices. The latter result involves the granting of a pure consumption loan by money holders to their contemporaries. Thus, fiduciary issues made in response to demands for increased money balances allow Ruritania to enjoy greater capitalistic production than it could under a pure commodity-money regime.

Banks begin to arbitrage competing money thus setting the stage for clearinghouses:

…profit opportunities exist to promote a more general use of particular inside monies. The discounting of notes outside the neighborhood of the issuing bank’s office provides an opportunity for arbitrage when the par value of notes exceeds the price at which they can be purchased for commodity money or local issues in a distant town, plus transaction and transportation costs. Competition eventually reduces note discounts to the value of transaction and transportation costs, plus an amount reflecting redemption risk. In accepting the notes of unfamiliar banks at minimal commission rates, brokers unintentionally increase the general acceptability of all notes, promoting their use in place of commodity money. Moreover, because they can issue their own notes (or deposit balances) to purchase “foreign” notes and therefore need not hold costly till money, banks can out-compete other brokers. Still another incentive exists for banks to accept rival notes: larger interest earnings. If a bank redeems notes it acquires sooner than other banks redeem the first bank’s notes issued in place of theirs, it can, in the interim, purchase and hold interest-earning assets. The resulting profit from “float” can be continually renewed. In other words, a bank’s earnings from replacing other notes with its own may be due, not just to profits from arbitrage, but also to enhanced loans and investments. If transaction and transportation costs and risk are low enough, competition for circulation reduces brokerage fees to zero, reflecting the elimination of profits from arbitrage. This leads Ruritanian banks to accept each other’s notes at par.

From Banks to Clearinghouses

The cost of transportation is a major factor in the usefulness and formation of clearinghouses:

Because notes from one town come to be accepted in a distant town at par, there is little reason to lug around commodity money any more. This, too, can be seen in history. As par note acceptance developed during the 19th century in Scotland, Canada, and New England — places where note issue was least restricted — gold virtually disappeared from circulation. 21 In England and in the rest of the United States where banking (and note issue in particular) were less free, considerable amounts of gold remained in circulation.

Commodity money places a perfect role for settlement among banks. Since it is now mostly used only for settlement more of the commodity is freed for non-monetary uses:

Commodity money, formerly used in circulation to settle exchanges outside Ruritania’s banks, might now be used to settle clearings among them. To really economize on commodity money rival banks have to exchange notes frequently enough to allow their mutual obligations to be offset. Then only net clearings, rather than gross clearings, need to be settled in commodity money. Thus banks can take further advantage of the law of large numbers, and more commodity money becomes available for nonmonetary uses.

The selfish pursuit keeps banks and money honest. Some reserves are kept as a safety buffer from competition:

During that period, banks’ sought to bankrupt their rivals by “note dueling” — aggressively buying large amounts of their rival’s notes and presenting them for redemption all at once. For a bank to stay solvent during such raids it has to keep substantial reserves, so that its contribution to the process of fiduciary substitution is small. More typically, reserves during Scotland’s note-dueling era were in the neighborhood of 10 percent of total liabilities (Munn 1981, 23–24). Yet even this smaller figure contrasts greatly with reserve ratios of around 2 percent which were typical under the Scottish free banking system after note clearings became routine (ibid., 141).

Settlement among banks is mutually beneficial:

Suppose Ruritania has three banks, A, B, and C. A has $20,000 of B’s notes, B has $20,000 of C’s notes, and C has $10,000 of A’s notes. 24 If they settle their obligations bilaterally, they need to have $20,000 to $40,000 of commodity-money reserves on hand among them, depending on the chronological sequence of their exchange. On the other hand, if they settle their balances multilaterally, they need only $10,000 of reserves among them: A’s net balance to B and C combined is +$10,000; B’s net balance to A and C combined is $0; and C’s net balance to A and B combined is -$10,000. Hence all three balances can be settled by a transfer of $10,000 from C to A. Apart from reducing reserve needs, multilateral clearing also allows savings in operating costs by allowing all debts to be settled in one place rather than in numerous, scattered places.

By joining up with a single clearinghouse a bank is privy to the benefits of a network of clearinghouses. A “member” system arises and allows reputations to be monitored which keeps the system honest:

Also, where there are several clearinghouses within a region that clear with each other, a bank would only need to join one of them to partake of the full advantages of multilateral clearing. The principal purpose of Ruritania’s clearinghouses is the economical exchange and settlement of banks’ obligations to each other. …the most important of the unintended effects of Ruritania’s clearinghouses has not been mentioned. This is their ability to regulate strictly the issues of their members through the automatic mechanism of adverse clearings. Together with free note issue, the existence of an efficient clearing arrangement gives Ruritania’s banking system special money-supply properties, to be examined in detail in later chapters.

Commodity money is still relevant but not in the hands or eyes of the daily user. It disappears from everyday use but inside money is still ultimately backed by the commodity money. More of the commodity money is freed for non-commodity use:

Since no statutory reserve requirements exist, reserves are held only to meet banks’ profit-maximizing liquidity needs, which vary according to the average size and variability of clearing balances to be settled after routine (e.g. daily) note and check exchanges. The holding of reserve accounts at one or more clearinghouses results in significant savings in the use of commodity money. In the limit, if inter-clearinghouse settlements are made entirely with other assets (perhaps claims on a super-clearinghouse which itself holds negligible amounts of commodity money), and if the public is weaned completely from holding commodity money, the only active demand for the old-fashioned money commodity is nonmonetary: the flow supply formerly sent to the mints is devoted to industrial and other uses. Markets for these uses then determine the relative price of the money commodity. Nonetheless, the purchasing power of monetary instruments continues to be fixed by the holders’ contractual right (even if never exercised) to redeem them for physically specified quantities of commodity money. The special difficulty of meeting any significant redemption request or run on a bank in such a system can be contractually handled, as it was historically during note-dueling episodes, by invoking an “option clause” allowing the bank a specified amount of time to gather the needed commodity money while compensating the redeeming party for the delay. The clause need not (and, historically, did not) impair the par circulation of bank liabilities. In the evolution of Ruritania’s free banking system, bank reserves do not entirely disappear, since the existence of bank liabilities that are promises to pay continues to presuppose some more fundamental money that is the thing promised. Ruritanians forego actual redemption of promises, preferring to hold them instead of commodity money, so long as they believe that they will receive money if they ask for it. Banks, on the other hand, have a competitive incentive to redeem each other’s liabilities regularly. As long as net clearing balances are sometimes greater than zero, some kind of reserve, either commodity money itself or secondary reserves priced in terms of the commodity money unit of account, has to be held.

The pricing system is remains unperturbed:

The scarcity of the money commodity, and the costliness of holding reserves, also serves to pin down Ruritania’s price level and to limit its stock of inside money.

From Clearinghouses to an Ideal Money Equilibrium

This previous unfolding of the evolution of Ruritania as a free banking system lays the grounds for the great equilibrium Selgin describes. This equilibrium, or some version of it, is notably present in historical economic literature:

Even if actual commodity money disappears entirely from reserves and circulation, media of exchange are not divorced from the commodity unit of account. Rather, they continue to be linked to it by redeemability contracts. Nor is renunciation of commodity-redemption obligations compelled by economization of reserves, as Warren Woolsey predicts (1985). There is, therefore, no reason to expect deregulation to lead to the spontaneous emergence of a multi-commodity monetary standard or of any pure fiat monetary standard, as is suggested in works by Robert Hall, Warren Woolsey, Benjamin Klein, and F. A. Hayek. In few words, unregulated banking is likely to be far less radically unconventional, and much more like existing financial arrangements, than recent writings on the subject suggest. One important contemporary financial institution is nonetheless absent from the Ruritanian system: to wit, the central bank. This is because market forces at work in Ruritania do not lead to the natural emergence of a monopoly bank of issue capable of willfully manipulating the money supply. As was shown in chapter 1, the historical emergence of central banks was typically a consequence of monopoly privileges respecting note issue being conferred on some state-owned or state-chartered bank. Legal restrictions imposed on commercial banks directly or indirectly promoting unit (instead of branch) banking have also played an important part in the historical emergence of central banks. Where legislation did not inhibit the growth of plural note issue and branch banking, as in Scotland, Sweden and Canada in the 19th century, there was not any movement toward monopolized note issue or toward spontaneous emergence of a central bank.

Once the natural occurence of a self regulating system evolves a long term equilibrium of ideal money supply is achieved:

Assuming that free-bank liability issues run up against increasing marginal costs (an assumption to be defended in the next chapter), the conditions for long-run equilibrium of a free banking industry can be stated. As the public holds only inside money, with commodity money used only in bank reserves to settle clearing balances, these conditions are as follows: First, the demand for reserves and the available stock of commodity money must be equal. Second, the real supply of inside money must be equal to the real demand for it. Once the first (reserve-equilibrium) condition is met, the tendency is for any disequilibrium in the money supply to be corrected by adjustments in the nominal supply of inside money. An excess supply increases, and an excess demand reduces, the liquidity requirements (reserve demand) of the system. This is shown in chapters 5 and 6 below. On the other hand, if the reserve-equilibrium condition is not satisfied, the system is still immature. An excess supply of reserves then causes an expansion of the supply of inside money. If this leads to an excess supply of inside money, it will promote an increase in both reserve demand and prices, causing both the nominal demand for money and the demand for reserves to rise. There must be one price level at which both equilibrium conditions are met. When this price level is achieved, the system is in a long-run equilibrium. For the sake of simplicity, the analysis that follows starts with a free banking system (similar to Ruritania’s) in long-run equilibrium and assumes an unchanging supply of bank reserves.

This equilibrium continues to keep the banking system and the money it produces honest:

This result has other important implications. It means that a solitary bank in a free banking system cannot pursue an independent loan-pricing policy. A “cheap-money” policy in particular would only cause it to lose reserves to rival banks. Also, no bank would be able, by overissuing, to influence the level of prices or nominal income to any significant degree, since the clearing mechanism rapidly absorbs issues in excess of aggregate demand, punishing the responsible bank. Consequently, the structure of nominal prices would not be indeterminate. Assuming stationary conditions of production, free banks face a determinate schedule of nominal money demand which strictly limits the extent of their issues.

We arrive at what might be the thesis for the analogue:

In a mature free banking system, commodity money does not circulate, its place being taken entirely by inside money.

It is in this equilibrium in which Say’s Law becomes valid:

According to Koopmans (1933, 257), who has developed this approach most thoroughly, monetary policy should have the goal of “compensating for any deflation, due to hoarding, by creating a corresponding amount of new money, or of compensating for any inflation, due to dishoarding, by destroying money in like measure.” When this goal is achieved “the money outlay stream should remain constant.” In other words, money is neutral as long as Say’s Law remains valid (that is, as long as excess demand for money is zero). Conversely, monetary disequilibrium occurs and money is non-neutral whenever Say’s Law is violated: Hoarding and money destruction cause a leakage in the circular flow of income; dishoarding and money creation make, so to speak, new purchasing power spring from nowhere. In the first case, that of pure supply [of non-money goods], the situation is deflationary, in the second, where pure demand occurs, it is inflationary; in neither case does Say’s Law apply. If net pure demand is nil, monetary equilibrium prevails . . . the monetary equilibrium situation corresponds to Say’s Law [De Jong 1973, 24].

(With a small caveat to Hayek) Selgin presents different historical economists with similar supporting arguments:

Hayek is more equivocal in his suggestions concerning an ideal monetary policy. Hayek’s equivocation is due, on one hand, to his view that desirable adjustments in the money supply cannot be formulated into a “language of practice” (1935, 108) which, of course, does not argue for rejecting them as a theoretical ideal.. Allowing for the ambivalent views of Hayek, all of the continental writers cited have notions of monetary equilibrium similar to the one adopted in the present work. Typically these writers express the notion in question in the form of the rule that the supply of money multiplied by its income velocity of circulation should remain constant. According to Durbin (1933, 187) such a policy would “avoid income deflation on the one hand and a profit inflation on the other.” J. E. Meade (1933, 8) argues along the same lines that the total increase in the supply of money in a given period of time should equal the net increase in the demand for money during the same period, with bank investments adjusted correspondingly. Besides preventing changes in final (nominal) income this policy would assure an equilibrium interest rate.

The story of Ruritania speaks: