Laissez-faire Banking.

A generation or so ago most "mainstream" economists would have dismissed laissez-faire (or free) banking as a radical idea at best and more likely labeled it obvious nonsense. Even today many find the major ideas of free banking to be rather mysterious. However, more recently the main ideas of free banking are enjoying a rather remarkable renaissance; to a large extent the current book by Dowd will continue to fuel this revival. As Dowd points out in the excellent introduction to the book, free banking is a novel idea that challenges too much of what most people still take for granted; that is, (1) that banking is inherently unstable, (2) that the banking system needs a lender of last resort or deposit insurance to prevent system collapse, and (3) that the government has to (or is able to) protect the value of the currency to insure stable long-run growth. Dowd demonstrates that each of these assumptions contains major flaws.

The argument for free banking is very simple. If markets are generally better at allocating resources than governments, then what is so different about money or (the industry that produces it) banking.? Dowd's book does a convincing job of casting suspicion on most traditional answers to the above question.

Dowd's book is actually a collection of recent essays on free banking. These essays are presented as separate chapters that can be classified into one of three categories. The first category (Part I) deals with the theoretical issues raised by the free banking debate. This includes chapters 2 through 6. The second category (Part II) features the historical evidence on free banking. Several revealing historical episodes of successful free banking are presented in chapters 7-11, with chapter 12 reserved as a demonstration of how the major issues in the free banking debate have sometimes been side stepped by Dowd's critics. An eclectic selection of monetary and banking reform issues is addressed in chapters 13 through 16 (Part III).

Overall, this collection of high quality essays by Dowd is essential reading for students of banking and monetary policy alike. It is worthwhile to briefly discuss or summarize each chapter here.

Chapter 2 uses the Mengerian "invisible hand" process to describe how a free banking system "might" develop from a primitive economy. It is quite illustrative and suggests that a free banking system would have three distinct features. First, it would feature multiple note issuers who issued convertible currency (e.g., convertible into gold or more likely the notes of another bank). Second, a regular note exchange (or clearing-house) between the issuers would develop. And, third, the insertion of an "option clause" into banknote contracts would likely develop; the option clause would give issuers the right to postpone demands for redemption provided they later paid compensation to those whose redemption demands had been deferred. The chapter presents arguments that each of these features would help to stabilize the hypothetical banking system.

Chapter 3 follows up on the option clause idea. It explains why the option clause might be in the mutual interest of both banks and banknote customers. It also examines further why the option clause would be a stabilizing feature. The chapter ends with an examination of the Scottish experience with option clauses over the period 1730-65. The chapter suggests that the option clause idea might be a useful area for future research on free banking. I agree with Dowd on this point as I am skeptical about the ability of the bank to credibly "bond" its customers against default within an option clause based framework. Additionally, and more importantly, it can be forcefully argued that the option clause mechanism actually converts banknote customers into bank stockholders. If the bank suspends convertibility the banknote becomes a different class of liability--closer to equity than a "regular" banknote. The banknote (or deposit) now more resembles shares in a mutual fund.(1) This shift in the form of the liability has very significant welfare and wealth transfer implications.

Chapter 4 demonstrates the possibility of a stable free banking monetary system and discusses the vicious circle of one mess leading to another when government (the political process) is introduced into the system.

Is banking (i.e., the issuing of money) a natural monopoly? This question is analyzed in chapter 5 of Dowd's book and answered with a very decisive no.

Chapter 6 may well be the most important chapter in Dowd's book. This chapter wrestles with one of the gigantic theoretical issues in banking; the need for government provided deposit insurance to prevent bank runs. Dowd confronts the well established case for deposit insurance based on the work of Diamond and Dybvig |1~ and explains very clearly the deficiencies in these types of theoretical models. Dowd concludes that the basic problem with the Diamond-Dybvig (D-D) model is that the intermediary takes in deposits which it invests in projects in the "real" economy, and issues to depositors liabilities which they can redeem in either of two periods, but the intermediary's resources are limited to whatever the public deposits with it, and there is no outside capital. That is, there is no bank capital in the model. Dowd argues that a bank run of the sort analyzed in the D-D model may well apply to intermediaries that have no equity capital, but it does not apply to real-world banks which can use capital to guarantee the value of their deposits. This chapter offers a very important critique of the Diamond-Dybvig model; especially considering that the vast majority of the theoretical literature in this area follows the D-D model of an intermediary issuing only one class of liability (a debt-equity hybrid type of liability that is debt if redeemed in the first period and equity if redeemed in the second). The chapter further develops the point (a crucial one) that the type of liabilities an intermediary issues has a critical bearing on its exposure to runs. Dowd thus develops a very useful theoretical rationale for why capital adequacy matters. The chapter ends with a brash (but probably true) assessment of the theoretical banking literature on instability as having nothing to say on the real-world problems we face today.

This chapter alone makes Dowd's book a valuable addition to any serious banking scholars library. However, I think Dowd does not go far enough in the critique of the D-D model. The D-D paper is obviously a seminal article. The vast literature that follows the D-D approach is evidence of this fact. However, it is based on an aggregate bank approach that tends to ignore individual bank differences and contagion effects. And, as Kaufman |2~ and Selgin |4~(2) have argued, the social cost of a run on an individual bank may be much less than a run on many banks, or all out banking panic in which depositors are unable to distinguish between "ex ante" good and bad (insolvent) banks. Therefore, the role of contagion becomes particularly important for evaluating and modeling the economic losses and costs of bank runs. The point is that banks are different and depositors may be well informed about these differences such that an informational role may exist in bank runs. If this is true then greater bank-specific solvency information might well deter panic type bank runs from developing and thus reduce or eliminate the need for deposit insurance. Thus, the existence of well informed depositors (an empirical question) is central to the debate on the need for deposit insurance. In a recent paper by Saunders and Wilson |3~ evidence of well informed depositors during the bank panic of 1930-1932 is documented. It is interesting that Dowd also documents similar evidence from the Australian banking crises of 1893 in the first chapter of Part II of the book.

Part II of Dowd's book presents some historical evidence on the stability and nature of free banking in several countries. Chapter 7 details the Australian experience. The U.S. (so-called) free banking experiments are discussed in chapters 8 and 9. Chapter 10 is a review essay that refutes the argument that central banking is a natural phenomenon which evolved as a response to market failure. It also presents evidence of free banking systems that worked well in Scotland and Canada (and other countries).

The evolution of central banking in England is the topic of chapter 11. Although Dowd introduces chapter 12 as a reply to his discussant at a conference on the evolution of central banking in England; it is actually a prime example of the autarky equilibrium that often occurs in the intellectual marketplace of traditional and free-banking scholars. That is, it is an example of how the main issues in the free-banking debate are often repudiated using no more than cognitive dissonance. Hopefully, this autarky equilibrium will not become a steady state.

The final category of essays in Dowd's book (Part III) attempt to apply many of the insights from free banking theory to current monetary and banking reform issues. The first of these chapters presents a proposal to reconvert Australian currency and tie it to a basket of goods and services. It also reviews some potential objections to the proposal and evaluates related historical evidence on monetary reform. The next two chapters are insightful discussions of different aspects of the European monetary unification debate. And, the last chapter focusses on the banking crisis in the U.S. This chapter outlines a plan to resolve the crisis in the U.S. given, what Dowd rightfully calls, the heroic assumption that some group in power eventually decides to take it seriously. Dowd correctly points out that the cause of the crisis is a perverse incentive structure based on outdated regulations. Thus, the key to resolving the crisis is to restore reasonable incentives. Dowd advocates sweeping away restrictions on banking--branch laws, Glass-Steagall, and most importantly, deposit insurance. Dowd next sets forth a plan to carry out this rather radical surgery to the U.S. banking system. Although the plan contains nothing really new or novel, it is presented and discussed quite well.

Overall, the collection of essays that comprise Dowd's book will make a significant contribution to the library of almost all serious banking scholars. Although free banking in the U.S. is about as likely to occur as the return of the dinosaur, there are many useful ideas embedded in this theory and in Dowd's book.

1. I thank Robert A. Eisenbeis for sharing this important insight with me in a recent conversation about free banking.

2. Selgin |4~ also provides a very useful critique and extension of the Diamond-Dybvig model.

References

1. Diamond, D. W. and P. H. Dybvig, "Bank Runs, Deposit Insurance, and Liquidity." Journal of Political Economy 91 (1983): 401-419.

2. Kaufman, G. G. "Bank Contagion: Theory and Evidence." Working Paper 93-1, Loyola University of Chicago, 1993.

3. Saunders, A. and B. Wilson. "Contagious Bank Runs: Evidence from the 1929-1933 Period." Salomon Center/GBA Working Paper, 1993.

4. Selgin, George. "In Defense of Bank Suspension." Journal of Financial Services Research 7 (1993): 347-64.