Free Banking - Promises to Pay

Look at the above note. It is fairly ornate but it is simply a promise. It reads as follows:

The President, Directors and Company of Hagerstown Bank will pay 5 dollars on demand to bearer.

It is a fascinating document incomprehensible to average spender of money today. Today, when one has a five dollar bill in one's pocket, one would say that they already have $5 dollars. And in fact today, that is true. If you have a five dollar bill, you have $5. But that wasn't true in the days this note was issued. This note was issued in what is now known as the Free Banking era in the United States.

I first came across the notion of Free Banking in the book Greenback, The Almighty Dollar and the Invention of America bu Jason Goodwin which tells the history of the dollar in the United States. I was fascinated to read about the Free Banking era of the United States which was in its heyday in the first half of the 1800s. I have read about it in other books since then but only recently that I came across an article advocating for the return to Free Banking as a monetary system.

Free Banking is a banking concept that is quite different from how banks are run today. If the subject of banking theory seems dry, it has a tremendous impact on the nature of the money we spend and on how our economy operates, how it promotes the creation of wealth and jobs, or not. I dare say the banking crisis and the financial crisis of the past few years would look very different if our financial world was allowed to function according to free banking principals.

In its essence, a free bank is a bank that is subject to no more, no less than the same rules that apply to corporations in general. We don’t often realize to what extent banks are regulated by rules formulated just for banks.

Probably the most noticeable thing a free bank can do is issue its own notes. Now, when you go to a bank to get cash what you get are Federal Reserves Notes (in the United States), notes on the Bank of Canada (in Canada), notes on the Bank of England (in England and in Wales), notes on the European Central Bank (in Eurozone countries) and so on and so forth.

But there was a time in the history of the United States when paper money was not just Federal Reserve Notes. In fact, before 1913, there was no such thing as a Federal Reserve Note. Yet there was lots of paper money. It is a fallacy that before the creation of the Federal Reserve in 1913, that all people spent was gold and silver coins.

By contrast, if you are in Scotland, and you go to say an ATM for the Royal Bank of Scotland take out say a 20 pound note, what you get is a note by the Royal Bank of Scotland that promises to pay the bearer on demand the amount of 20 pounds. What does that mean? It means that you can go to the counter with that note and demand 20 pounds, and if you do that you will receive a 20 pound note on the Bank of England. If you were to then go to the counter of the Bank of England with that 20 pound note on the Bank of England, what you’ll get a nice clean fresh one. Back when Britain was on the gold standard, you would have ultimately received gold sovereigns, gold coin weighing each a little less than a quarter ounce reflecting the legal definition of the British pound.

In actuality, Scotland is one of the few places in the world where a non-central bank has the right to issue notes. In the free banking era in the United States, before the existence of the Federal Reserve, a bank note generally promised redemption of so many dollars in gold rather than in Federal Reserve Notes.

Money Printing without the Guilt - If only the Fed had listened to me!

A few weeks ago, I wrote in this blog that the Federal Reserve should return to the gold standard at the current market price and from that moment forward maintain the value of the dollar in terms of gold from then on. At the time I wrote that blog entry, gold was trading at about $1850 per ounce.

Now, with recession fears gripping the market, the dollar price of gold has dropped to around $1700 per ounce. And had the Fed followed my advice, they would now be working to bring the price of gold back up to the target price of $1850 per ounce. There are at least two mechanisms for doing this: 1) purchase U.S. Treasuries much like theyn have been doing over the past couple three years; 2) purchase gold on the gold markets. In both cases, the purchaces would be made with dollars printed as it were out of thin air.

What is ironic is that the Fed would dearly love to print more dollars to try and stimulate the economy. But after two rounds of Quantitative Easing and the severe criticism that resulted, the Fed has been reticent to print more dollars. Bernanke has also expressed scepticism if not scorn about returning to the gold standard. Yet, were we on the gold standard, printing money is what they'd doing now, it would be happening automatically to counter-act deflationary pressures as exhibited by the falling dollar price of gold.

Money, the Fed, Free Banking and the Gold Standard

Looking at the title, I am wondering if I have not bitten off more than I can chew. The emphasis here will be on free banking.

I have been fascinated by the subject of money for much of my adult life. I'd pretty much read up whatever the local library had on the subject whenever I'd move to a new place. The internet has been a godsend to me in this regard since allows me to move beyond what the local library happens to be offering.

In the course of my readings, I have become more and more an advocate of returning to a gold standard. I find it shocking the degree to which educated people (in the area of economics) are ignorant of how a gold standard works. A recent example of this was when Bernanke stated that there was not enough gold to return to a gold standard. Obviously a very smart man who knows a lot about money in particular and yet for him to make such a statement shows a depth of ignorance relating to the gold standard which I find disturbing. (By contrast, former Fed chairman Alan Greenspan is an advocate of returning to a gold standard and I am sure he would never have made such a statement.)

In simple cookies on the lowest shelf terms, all the Fed has to do is start managing the currency to keep it stable in terms of gold. Today that would mean that it would start selling debt with an eye on arresting the steady rise of the dollar price of gold. If it were to overshoot the mark somewhat, and the dollar price were to begin falling, it would do the opposite, it would buy debt, putting dollars into circulation, driving the dollar price back towards its target.

As a target, I would suggest whatever the current market price of gold is the day the policy is implemented. Today, that would be about $1880 per ounce. That would mean from this day forward, the Fed's policy would be maintain the dollar price of gold within a narrow range around $1800 per ounce.

And there you would have a de-facto gold standard and the amount of gold doesn't even enter into it.

Now I can just imagine the great collective screaming that would come from those who smoke Keneysian weed. You can't reduce the money supply at a time like this. The economy needs more stimulous not less.

First of all, it doesn't seem that all the additional liquidity that was added through QE and QE2 did much good so I don't see how taking liquidity out of the market would do much harm. Secondly, given that commodity price have been increasing even as the economy falters, I argue that there is too much liquidity in the market.

But beyond that, I am not so that there would be reduction of liquidity. The world is a dynamic place. And looking three moves out instead of just one, I see the money supply actually increasing but in a precisely controlled manner so as not to generate inflation.

If you were to stop the incase in dollar price of gold, you would cause many who own gold to trade their gold for dollars do that they could those dollars into investments that pay interest or a dividend. Which would you rather own? Gold whose dollar price will no longer increase or dollars which can be invested to pay interest or dividends? Which would you rather own? Foreign floating currencies which will continue to decline in value or dollars which would then be holding their value?

All things being equal, that would cause more capital to come into this country. (I say all things being equal, because our crappy dollar is but one of a number of factors that keep job creating capital from coming into this country).

One thing the recent stimulus has shown it that all that government spending here seems to do is create jobs in China. And the reason for that is that the U.S. is undercapitalized right now.

If you are trying to make money with your capital right now, you choose China over the U.S. It's that simple. And it's not going to change until the U.S. makes some changes and one of those changes would be to turn to a gold standard in the manner described.

Wow, I didn't even get to free banking. Maybe I should change the picture.

I'll keep the picture as a teaser for a future installment. Look at that note carefully. It was issued by a private bank in the 1800s. There was a period in our history when most notes in circulation were actually issued by private banks. There are some that advocate a return to where private banks would again be allowed to issue notes which would circulate along side of and compete against Federal Reserves Notes.