Friday, March 22, 2013

Free Banking

Proposals to tax deposits in Cyprus to fund bank bailouts have provoked a rash of articles pointing out that inflation (or more exactly, systematic currency debasement by government-controlled central banks) is essentially the same thing as a deposit tax.  That's indisputably true.

But there's much else that is rotten in Cyprus, and in the EU, and in the USA, and perhaps wherever central banks operate under government control.  We should not stop short of clearly identifying the main problem: deposit insurance and other coercive, anti-competitive meddling in the financial markets by governments.  Without abolishing such progressive/fascist constructs, the perverse and destructive phenomenon of forcing the general public to subsidize and insure the risky investments of wealthy elites through deposit taxes, tax-funded bailouts and massive currency debasement will continue.  The gulf between wealthy elites and the poor will continue to widen, the middle class will continue to shrink, and malinvestment will continue to destroy capital, until sustainable growth is no longer possible and systemic decline sets in. 

There is a better system: free banking.  In a voluntary market banking system, the principle of "depositor beware" would apply: those that chased higher interest rate on their deposits would suffer a greater risk of total loss, instead of forcing those who just want to keep their principle safe to subsidize the risky lending practices of others.  Meanwhile, risk-averse savers might keep their savings "in their mattresses" or pay a non-fractional reserve bank for storage, ATM, checking and/or debit card services.

Crowd-lending sites like "" provide a glimpse of how lending can work for micro-lenders in a voluntary market.  Anyone wishing to generate interest on their savings can conveniently diversify their lending by contributing small amounts of capital to fund a portfolio of small loans made to members of the club.   Earned interest rates are currently in the range of about 5-11%, depending on the investment grade of micro-loans invested in.  Those chasing interest the old-fashioned way in a free system could just buy a CD at their non-fractional reserve bank, which the bank could lend for a term not exceeding that of the CD.  The traditional bond market would remain available, and financial services would compete to make it more accessible and useful to small savers and investors.

In a free banking system, central banks would have no reason to exist, and if existing, would be prohibited from buying government, mortgage or other politically favored bonds with newly created money.  Nor would governments be permitted or capable of bailing out industries while favoring their cronies over bondholders, as in the auto industry bailouts.  Government deposit insurance would not exist.  In a free system, fractional reserve banks would not be prohibited, but would have to compete with non-fractional reserve banks, loan aggregators, insurance companies and other financial service companies for deposits.  Fractional reserve banking would likely be uncompetitive, in the long run, without the government protection it currently enjoys.  It adds little or no value to a lender or micro-lender seeking interest on funds available to lend, merely playing the role of a middle man.  It's more efficient for lenders to control their risks by purchasing a selected portfolio of bonds directly.  In a free system, such lending would be quite easy and efficient to do even for very small lenders, as crowd funding technology has already demonstrated.

It's hard to see how society transitions to a totally free banking system without first experiencing a total economic collapse followed by severe depressions and massive human suffering.  Perhaps such outcomes are inevitable.  There may be just too many powerful interests invested in the status quo to permit gradual reforms leading to a freer, more stable banking system.  More hopeful visionaries such as Ron Paul have suggested a constructive alternative: enable competitive currencies and more competition in diverse forms of banking -- more freedom to innovate in the financial system.  Absent government prohibition, it's likely that alternatives such as Bitcoin, micro lending clubs, mutual aid societies, and many other forms of peaceful and voluntary cooperation in financial transactions would grow from the rich soil of freedom.  Many of these free institutions would survive to carry humanity forward when the progressive/fascist social paradigm finally collapses or gradually falls out of favor.  Or so one can hope. 

If the idea of free banking system seems unworkable to you, you might pick up "The Case Against The Fed" by Murray Rothbard.  It's an easy read and arguably still the best introduction to modern central banking out there.  It can be read in a weekend, and might transform your thinking on central banking almost that quickly.   "A History of Money and Banking in the United States," also by Rothbard, is an excellent follow on. Read them both!