A Georgist Case For Free Banking

By Raja Vaze

Georgist campaign button from the 1890s (image link)

Georgism has always been an ideology of freedom. As a Georgist myself, I believe this support for freedom should include the concept of free banking. In the following article, I will explain what free banking is, why it is the most Georgist banking policy, and address Georgist criticisms of free banking. In doing so, I hope to show why freedom in banking should be an integral part of our movement. 

What is “Free Banking”?

Free banking in the simplest sense is just free-market banking. In pure free banking¹, there is no central bank, there are no legal tender laws, and the government would in general not privilege any particular currency. With free banking, the money supply and interest² rates are left to be determined by the free market. There would be no arbitrary governmental restrictions on honest banking services. The only regulations are those which are required in a free market: those which prevent fraudulent, harmful, and dishonest activities. Firms would be allowed to provide whatever sort of banking services they want, such as fully reserved or fractionally reserved, and consumers would be able to choose whichever ones they want to use. No banks would receive any special privileges under the law. In practice, banks would competitively issue money substitutes in the form of “bank notes” (their own paper currency). These could be redeemed for a shared “basic” or “real” money such as gold or a frozen quantity of fiat currency like dollars or yen. 

Banking would be competitive since new banks can be created when there are profits in the industry. Reflux (the convertibility of money substitutes into real money) would prevent inflation, as the quantity of money substitutes would be limited by the demand of the public to hold them. Competition among banks would limit their profit to normal returns, as the rest of the debt service paid by borrowers goes to interest payments to depositors. Instead of a singular central bank deciding what inflation rate to target, when to raise the money supply and when to influence interest rates, free banking would not have any inflation and no centralized monetary policy. Actually, the likely outcome of free banking, rather than no inflation or 2% inflation, would be slight deflation as a result of normal economic growth³.

One might be skeptical that such a system could work in real life. However, the results of previous experiences historically have been highly successful. While few examples are 100% pure, various lightly-regulated banking systems with all the essential attributes of free banking have existed in the past. The Experience of Free Banking covers a wide array of them across the world. Two of the best examples are probably the free banking practiced in Scotland until 1844⁴ and the free banking that existed in Canada in the 1900’s. Scottish free banking was seen by advocates in multiple countries as a highly successful model to be emulated. Canadian free banking was “famously sound and famously stable” (the influential Georgist Thomas G. Shearman praised it himself). The result of true free banking in practice has been to produce a stable yet flexible supply of money, adjusting to changes in the public’s desire to hold money, while at the same time allowing the natural rate of interest based on time-preference to perform its economic function⁵.

Free Banking as Georgist Banking Policy

Free Banking is in fact the most Georgist banking policy. This is for a variety of reasons.

Firstly, Georgism has always been an anti-monopoly movement. This includes both the modern definition of “single-sellers” and the Adam Smith definition as meaning barriers to entry that restrict supply. With free banking, you eliminate one of the largest monopolies of them all: the central bank. If one is against monopoly, then one should also oppose the monopoly issue of currency. Also, today there is very wide government regulation of banking, making it difficult and cumbersome to enter the banking business, requiring banks to get federal and legal charters, requiring banks to get special licenses, provide insurance and so on. With free banking, there are no restrictions on entering the banking industry other than regulations preventing fraud. There would likely be a much wider variety of banking services than there are today. Additionally, privileged bankers would no longer be able to extract large sums from consumers through these various restrictions on competition. 

Tied to this anti-monopolism is the strong support among Georgists for free trade. Henry George wrote:

“The free-trade principle is, as we have seen, the principle of free production—it requires not merely the abolition of protective tariffs, but the removal of all restrictions upon production.” (Protection or Free Trade, p. 218)

Money and banking are goods and services like any other. When the demand for money rises, it should be possible to accommodate this with a greater supply of money and vice versa. There is no good economic reason to hamper the production of peaceful and honest banking services. To restrict production with unfree banking policy is a violation of George’s desire for true free trade. 

Secondly, central banking falls prey to the knowledge and incentive problems that Henry George criticized in state socialism:

“any attempt to carry conscious regulation and direction beyond the narrow sphere of social life in which it is necessary, inevitably works injury, hindering even what it is intended to help.

It is only in independent action that the full powers of man may be utilized. The subordination of one human will to another human will, while it may in certain ways secure unity of action, must always where intelligence is needed, involve loss of productive power. This we see exemplified in slavery and where governments have undertaken (as is the tendency of all government) unduly to limit the freedom of the individual. But where unity of effort, or rather combination of effort, can be secured while leaving full freedom to the individual, the whole of productive power may still be utilized and the result be immeasurably greater.

…

Taking no note of the difficulties which universal experience shows always to attend the choice of the depositaries of power, and ignoring the inevitable tendency to tyranny and oppression — even if the very wisest and best of men were selected for such purposes — simply consider the task that would be put upon them in the ordering and supervision of the almost infinitely complex and constantly changing relations involved in a civilized community. The task transcends the power of human intelligence at its very highest. It is evidently as much beyond the ability of conscious direction as is the correlation of the processes that maintain the human body in health and vigor.”

When folks save more money, a good banking system would issue a greater amount of bank-money. Conversely, when folks want to spend more money, a good banking system would reduce the supply of bank-money. To adequately achieve this, you need a free market in money and banking. There is no scientific way for a central bank to know in advance the correct supply of money. It lacks the knowledge necessary to make such decisions. However, when there is a free market in banking, banks across the economy can make good use of their dispersed and specialized knowledge.

Lastly, there are also benefits that arise in the land market. The intersection of land monopoly and banking monopoly is a rich subject. For example, in the paper Causes of Downturns: an Austro-Georgist Synthesis, the Georgist economist Mason Gaffney explains how one of the main subsidies to land value is cheap credit, allowing speculators to use the cheaper funds and artificially balloon the price of land even further. Without the subsidies to land value, we would have a much healthier market in land.

Georgist criticisms of Free Banking

The most prominent Georgist critique of free banking was made by Henry George himself (though there have been others⁶). It is important to understand George’s stance to dispel mistaken ideas that are sometimes propagated about it. His position revolved around his belief that:

“competition plays just such a part in the social organism as those vital impulses which are beneath consciousness do in the bodily organism. With it, as with them, it is only necessary that it should be free. The line at which the state should come in is that where free competition becomes impossible” (Protection or Free Trade, p. 329)

In other words, the state should administer on behalf of the public only when monopoly is necessary. George believed that issuing currency needed to be a monopoly because it couldn’t be done properly by individual enterprise⁷. He based this belief on the experience of “wildcat banking” in the United States and its problems. His position is summed up in this quote from Social Problems:

“it is the business of government to issue money. This is perceived as soon as the great labour-saving invention of money supplants barter. To leave it to every one who chose to do so to issue money, would be to entail general inconvenience and loss, to offer many temptations to roguery, and to put the poorer classes of society at a great disadvantage. These obvious considerations have everywhere, as society became well organized, led to the recognition of the coinage of money as an exclusive function of government. When, in the progress of society, a further labour saving improvement becomes possible by the substitution of paper for the precious metals as the material for money, the reasons why the issuance of this money should be made a government function become still stronger. The evils entailed by wildcat banking in the United States are too well remembered to need reference. The loss and inconvenience, the swindling and corruption, that flowed from the assumption by each State of the Union of the power to license banks of issue ended with the war, and no one would now go back to them. Yet, instead of doing what every public consideration impels us to, and assuming wholly and fully as the exclusive function of the General Government the power to issue paper money, the private interests of bankers have , up to this, compelled us to the use of a hybrid currency, of which a large part, though guaranteed by the General Government, is issued and made profitable to companies. The legitimate business of banking-the safe keeping and loaning of money, and the making and exchange of credits, is properly left to individuals and associations; but by leaving to them, even in part and under restrictions and guarantees, the issuance of money, the people of the United States suffer an annual loss of millions of dollars, and sensibly increase the influences which exert a corrupting effect upon their government.” (The Functions of Government, pp. 178-179)

If the wildcat banking of the United States was a true representation of free banking, George would be correct in opposing it. On the other hand, his own logic would support free banking if issuing money could be shown to work fine in it. The latter is in fact exactly the case. While the United States’ bad experiences with “free banking” are a typical criticism in general, many of these problems were caused by harmful government regulations rather than free banking itself. One such regulation was that banks were not allowed to branch and have banks in other states. Banks were intentionally made fragile as they could not expand and have more offices in other states. Regulations against branch banking also weakened the primary check against over-issuing money: note exchange and clearing. Another highly problematic restriction was that the government imposed collateral restrictions on issuing bank notes. Unfortunately, state governments weren’t willing to give up the special assistance they normally received. Regulation made it so that banks had to buy and hold state government bonds or other approved assets to provide a redemption fund for their notes. The critics claim that it was meant to provide security to note holders. But this was generally not the case. The argument for greater security only works if the bonds are liquid and secure in value more than what could be gotten elsewhere. In fact, the opposite was generally the case: much of the state-bonds were junk. The “wildcat banks” that are referenced were a product of this regulation, emerging solely to speculate on the fluctuations of these junk bonds. In states and in times where these regulations were not imposed such as Scotland and Canada, this problem did not occur and the system worked well.

True free banking would not entail inconvenience, tempt roguery, or disadvantage the poor as George believed. A free market in money and banking liberates the whole economy by allowing savings to be properly intermediated to those who want to use it for investment. As more funds are saved, banks will automatically expand the money supply since a greater amount of savings will allow banks to lower the interest rate and make more loans. Conversely, when folks spend more money; banks will see a larger number of redemptions forcing them to contract the money supply. Issues in the money market permeate across the entire economy so keeping that market healthy is necessary for maintaining general economic health.

The supposed need for unfree banking policy to fix the evils actually caused by banking restrictions in the 19th century US is actually a perfect example of the following Henry George quote:

“Restrictions, prohibitions, interferences with the liberty of action in itself harmless, are evil in their nature, and, though they may sometimes be necessary, may for the most part be likened to medicines which suppress or modify some symptom without lessening the disease and, generally, where restrictive or prohibitive laws are called for, the evils they are designed to meet may be traced to previous restriction — to some curtailment of natural rights.” (ibid, p. 174)

Conclusion

As the economist, geolibertarian, and free banker Fred Foldvary often remarked, the primary purpose of studying economics is to understand the implicit reality that exists beneath superficial appearances. Land and banking monopoly are such pervasive and dominant parts of the status quo that it can seem like there’s no viable alternative to them. Georgism shines a light on how weak their justifications actually are. We can eliminate them and we must eliminate them if we want to fulfill our ideals. Just like freedom in land, freedom in banking is not just compatible with Georgist principles: it embodies them. Despite the criticisms hurled its way, free banking is a policy which champions individual liberty, fosters economic justice, and hinders concentrations of power and wealth. By stripping away the privileges of monopoly banking, everyone can compete on a fair field.

1. For a detailed and sophisticated introduction to the theory of free banking, see the economist George Selgins The Theory of Free Banking: Money Supply under Competitive Note Issue.

2. The term “interest” in this article does not refer to Henry George’s definition (the return to capital as a factor of production). Instead it is used in the modern financial sense as the premium paid for borrowing money.

3. While many mainstream economists warn of the dangers of deflation, these dangers are often very overstated and lack nuance. As the economist George Selgin has explained, deflation isn’t always bad

4. A good overview of Scottish free banking is described in the book Free Banking in Britain by the economist Lawrence White.

5. Given that free banking was fairly successful, you might wonder why it was discarded in favor of central banking. The answer is political imperatives. This might be political pressure on the government (as in Canada) or political interests within the government:

“Where free banking was given a reasonable trial, for example in Scotland and Canada, it functioned well for the typical user of money and banking services. Why then did national governments adopt central banking? Free banking often ended because the imposition of heavy legal restrictions or creation of a privileged central bank offered revenue advantages to politically influential interests. The legislature or the Treasury can tap a central bank for cheap credit, or (under a fiat standard) simply have the central bank pay the government’s bills by issuing new money. Economic historian Charles Kindleberger has referred to a “strong revealed preference in history for a sole issuer.” As George Selgin and I have noted (Selgin and White 1999), the preference that history reveals is that of the fiscal authorities, not of money users. In some places (e.g., London) free banking never received a trial for the same reason. Central banks primarily arose, directly or indirectly, from legislation that created privileges to promote the fiscal interests of the state or the rent‐​seeking interests of privileged bankers, not from market forces.” (What You Should Know about Free Banking History)

6. Besides Henry George, Georgist opponents of free banking can be diverse. For example, some oppose free banking because they believe in a state theory of money, that only state issued fiat money can be called "money". Stephen Zarlenga for instance writes that money is “as an abstract social power embodied in law” and that historical bank notes were only accepted since they were required for taxes. They say that taxation is needed, arguing that forcing people to pay taxes with fiat money is what “gives it its value.”. However, these arguments make little sense. The common definition of money is that it is the generally or commonly accepted medium of exchange. Claiming that money is an “abstract social power” is so vague it might as well have no meaning at all. Historically there have been a variety of commonly accepted media such as seashells, tobacco, metals, gold and more that were not a product or motivated by government action. Hence, the proposition that only state issued fiat money can be called "money" is obviously false. It is true that forcing folks to pay taxes in a certain currency can reinforce that currency as a medium of exchange, however fiat money today gets its weight by imposing on top of what existed prior to government imposition. Even in the situations where the government imposed its currency on the people and forced payment of taxes using that currency, the currencies were only in use so long as the government did not over-inflate its currency. Therefore, taxation is clearly not the fundamental reason that money is valued by society.

Other Georgist critics point out a special aspect of money, that those who issue money will benefit from “seigniorage”, the gain that arises from the difference between the face value of the new money and the cost of creating it. They argue that it is a kind of economic rent and therefore that the government ought to be the sole issuer of money and share this seigniorage with everybody. However, this again involves the problems of knowledge and incentive. The government would have a strong incentive to over-issue money. Free banking works through the mechanisms it implies: profit motive motivating banks to lower rates and issue more when folks save more and the tendency of excess money to reflux back to the issuer. More importantly, with free market banking, private banks don’t gain from seigniorage in the long run, as any temporary economic profits would attract more lenders and drive the gain back down to normal returns. It’s true that money issuers can receive seigniorage, but it is no economic rent. It is a return on a produced economic good, hence it is a profit like any other and not an economic rent.

7. This led George to support what we refer to today as the “greenback movement”, a primarily agrarian movement that favored currency expansion in order to maintain higher prices and combat deflation after the Civil War. While he didn’t align himself on every issue of interest to the historical greenbackers, George nonetheless supported the movement in general.