Everyone fantasizes about something now and then. But even I was surprised (and not at all displeased) to discover that at least one person besides me–Warren Gibson–fantasizes about…free banking! Better yet, he’s invited anyone who wishes to stroll down fantasy lane with him to witness his vision of what a Wells Fargo branch might look like, if only governments would leave it and other banks alone.

I hope my readers will accept Warren’s kind invitation. And the last thing I want to do is to spoil his personal pipe-dream. Still I can’t help wanting to take advantage of the tantalizing picture Warren paints to dispel some common misconceptions about free banking, and especially about what a future free banking system is likely to look like.

“The first thing we notice,” say Warren as we enter his fantasy bank, “is a display case showing a number of gold coins and a placard that says, “available here for 1,000 Wells Fargo Dollars each, now and forever.”

Hold it right there. In the past competitively-supplied banknotes, including those of free banking systems in Scotland and elsewhere, were convertible into either gold or silver, because back then “real” money consisted of gold or silver coins. But if you think that a return to free banking in the future would mean returning to a gold (or silver) standard, you’d better keep dreaming. Banks themselves, first of all, aren’t in the business of establishing new monetary standards. A banker’s job is to get people to trade whatever basic money they already employ, which is to say whichever basic money is in common use, for his or her bank’s IOUs. Those IOUs will, in turn, be made redeemable in the same sort of money they were substituted for in the first place. That “Gold has physical properties that have endeared it to people over the ages—durability, divisibility, scarcity to name a few,” though true, is irrelevant once some other stuff, whatever its physical properties, has come to be generally accepted in its place. The long and short of it is that, were I able to wave a magic wand right now, eliminating all obnoxious banking laws, disbanding the FOMC, and privatizing the Fed’s remaining bits, including its clearing and settlement facilities, chances are we’d still find ourselves be on a paper dollar standard. Sheer momentum alone would tend to keep the dollar going, while the fact that the supply of basic dollars could no longer be expanded would, if anything, make the dollar appreciate. That’s not saying that the new dollar standard would be perfect–far from it. But neither will it go “poof” and have gold appear, like magic, in its place.

So our future Wells Fargo may be allowed to issue all the IOUs it wants to, including circulating paper ones. But odds are that, unless other steps were taken to re-establish a gold standard, its IOUs will be promises to pay, not gold, but old-fashioned Federal Reserve dollars.

Warren manages, thank goodness, to avoid another popular misconception about free banking: the neo-Rothbardian claim that it would lead in practice to 100-percent reserves. “Wells Fargo,” Warren says, “practices fractional reserve banking.” But what, Warren imagines his companion asking, keeps Wells from issuing way more banknotes and other IOUs than it should? “The market will stop them, that’s who,” says Warren. He’s right, but “the market” can’t work as he imagines it will. “In my scenario,” Warren says,

Consumer Reports and a number of lesser known organizations track Wells Fargo and other banks. These organizations post daily figures online showing the number of Wells Fargo dollars (WF$) outstanding and the amount of gold holdings that the bank keeps in reserve to back these dollars. Premium subscribers, I imagine, can get an email alert any time a bank’s reserves fall below some specified levels. Large depositors will notify Wells Fargo of their intention to begin withdrawing deposits and/​or demanding physical gold. Small depositors piggyback on the vigilance efforts of big depositors. They know it is not necessary for them to pester the bank when the big guys are doing it for everybody.

Terrific: Wells Fargo is free to go wild until Consumer Reports gets ’round to publishing its annual Fractional Reserve Bank special, in which Wells, assuming it is still around, earns it “unsatisfactory” rating, whereupon a run wipes it out at last. Runs, you see, are a little like pregnancy, in that there’s no having part of one only. And if you think it makes sense for a worried depositor, large or small, to “notify” his bank before running, I strongly urge you to keep your money under a mattress. Finally, even if Consumer Reports or some other (presumably private) watchdog could somehow manage to supply real-time reports on Wells Fargo’s reserve ratio, just how are consumers supposed to distinguish a reserve ratio that’s just dandy from one that portends disaster? As we’ll see, they can’t do it by just guessing–and especially so if their guesses are as wildly off as Warren’s are. (More on that below.)

If having people spy on its reserves won’t suffice to keep a liberated Wells Fargo of the future in check, what will? The answer is still “the market,” as Warren likes to say. But it’s more precise than that: it’s the competitive market for bank money, including paper banknotes, that matters. In that market a bank’s notes, like checks drawn on it, make their way to (mostly rival) banks within a matter of days after being put into circulation. The rivals then return them to their source for payment. After offsetting payments are “netted out,” banks’ remaining dues to one another are settled in basic money. Consequently, any bank that’s overgenerous in its lending doesn’t have to wait for some watchdog agency to complain about its reserve ratio: it gets the message, and quickly, by seeing its reserves chipped away by its rivals.* In missing this, by the way, Warren paradoxically misses the key advantage of having multiple suppliers of convertible currency instead of just one. Free banking without a role for competition is like Hamlet…(blah blah blah).

As I mentioned, Warren avoids the misconception that a free Wells Fargo would resemble a Rothbardian money warehouse. Still, in imagining that Wells’ fractional-reserve status would be “clearly outlined in the contract that depositors sign and…printed on their banknotes,” he risks giving credence to the related misconception that the language on current bank depositor agreements and current and past redeemable banknotes is somehow misleading. In fact, no one who actually bothers to read a modern bank depositor’s agreement can have any doubt that he or she isn’t doing business with a mere warehouse. And though the phrase “fractional reserves” never appeared on past commercial banknotes, such notes, I’ve noted here previously, far from pretending to be warehouse receipts, were clear proof of debts contracted between their issuers and their holders.

Warren’s free-banking fantasy is also fantastically off in its suggestion that a future free bank might hold reserves equal to a very substantial fraction–he uses 40% in his illustration–of its banknotes and deposits. Such high numbers reflect the view, traceable to Henri Cernuschi and repeated by von Mises, that open competition would force banks to hold much higher reserves than they’ve gotten away with historically. But consider: even the goldsmith bankers of the mid-17th century, when there was no question of banks being propped-up by government guarantees, implicit or otherwise (there was as yet no Bank of England to serve them as a last-resort lender), typically kept reserves equal to less than 30% of their liabilities–and this despite having relatively few, larger clients and very few ways to diversify.

The goldsmiths were also, one must admit, not the safest bankers ever. But consider the Scottish free banking system. Once the dust settled from the Ayr Bank’s fantastic collapse, that system remained almost perfectly safe for the better part of a century, and yet managed to do so on specie reserves that frequently fell below two percent of their liabilities. Here again, the banks had no lender of last resort to turn to, Rothbard’s suggestion to the contrary notwithstanding: although Scottish banks naturally placed funds in, and occasionally borrowed from, the London money market, they could never expect help from that quarter when they most needed it, which was during emergencies that tended to be felt most acutely there.

When one considers all the technological progress in interbank settlement technology, together with a still-more impressive increase in both opportunities for banks to engage in liability management and to employ highly-liquid securities as secondary reserves, its hard to imagine why the reserve ratios of any future free bank would be higher than that of Scottish banks two centuries ago. It’s therefore unnecessary as well to worry that, were a future free banking system somehow to revert to a gold standard after all, its doing so would involve substantial real resource costs.

Warren’s vision of his imaginary Wells Fargo’s way of dealing with runs is, I think, generally spot-on, though I’m not sure that clearinghouses would get involved in extending emergency credit as he imagines might happen. (They did so in the U.S.; but that was a peculiar response to artificial restrictions placed upon their members’ ability to issue their own banknotes.) He’s also correct in arguing that having competing banks of issue doesn’t mean having multiple monetary standards, though he makes free banks’ inclination to adhere to a single standard appear to be merely a matter of doing what’s most convenient for their customers, rather than what they cannot avoid doing in a business dedicated in the first place to receiving, and making promises to repay, some preexisting standard money. To repeat: banks aren’t in the business of choosing monetary standards. Unlike a light bulb, a bank IOU isn’t something its issuer can toy around with. That’s why you will never see such a note with “New and Improved!” written across it, except perhaps in reference to changes in its physical design. (And even that would be tacky.)

Finally, to end on another positive note, Warren is to be commended for arguing that, were a future free banking system to witness occasional bank runs and failures, and even were it to inflict occasional losses on bank depositors and note holders, this would be no proof of its inadequacy. “Under my free banking scenario,” he says, “depositors must take some responsibility for their actions.” Show me a banking system where they don’t have to do so, and I’ll show you one that ends up being, not a dream, but a nightmare.
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*Note, please, that this “adverse clearings” mechanism for constraining rival banks of issue has nothing to do with the fallacious “real bills doctrine” or with John Fullarton’s related notion that bankers would be constrained to do no more than accommodate the “needs of trade” by means of the “reflux” of excess notes via loan repayments. Call it the “bad penny” theory of credit control.