Discussions of alternative monetary systems usually focus on what kind of money we are to have: gold coins, pieces of green paper redeemable for gold coins, or pieces of green paper redeemable for other pieces of green paper. This is, I think, a mistake. The most important issue is not how the money is produced but by whom.
The fundamental problem with government money is not that government cannot provide stable money but that it is not always in its interest to do so. Inflation via the printing press is a way in which the government can spend money without collecting taxes. It may also be politically profitable as a device to benefit debtors at the expense of creditors, especially when the government is itself a major debtor. Other forms of monetary instability are often a result of attempts to manipulate economic variables such as the unemployment rate for short-run political objectives.
This suggests that instead of arguing about whether our government should return to the gold standard we should instead be thinking about whether the government should produce money at all. The idea of private monetary systems may seem odd to us, but such systems have existed before; one example is described by Lawrence White in a book cited in Appendix II.
The simplest private monetary system is a commodity money produced by a number of private firms. Each firm mints coins of standard weight and sells them. Customers can shift away from a firm that starts producing underweight coins, so the opportunities for such fraud would be rare, or at least rarer than if the government does the coining. Such a system is very much like the competing international monies of the Middle Ages. While those monies were produced by governments, they were sold, for the most part, to customers over whom the producing governments had no control. The governments producing them competed like private firms to induce merchants to use their money. The obvious way of doing so was by maintaining its quality.
In a modern society, another sort of commodity money is also possible: warehouse receipts. Instead of carrying around pieces of gold, one carries around receipts for pieces of gold in storage somewhere. In such a system, unlike a fractional reserve system, every piece of paper is backed by a specific piece of gold. It is a hundred percent reserve system.
The advantages of a system of warehouse receipts over an ordinary commodity system are that it eliminates the wear and tear on the coins and permits the use as monies of commodities poorly suited for coinage. Enough iron to buy an automobile would be a bit heavy to carry, but carrying around receipts for enough iron would be no more inconvenient than carrying receipts for enough gold. Since the characteristics of the commodity used for money affect how well a commodity system works, expanding the range of possible commodities may lead to a considerable improvement in the system.
Once a private commodity money is established, there are good reasons why a fractional reserve system is likely to develop. By holding only enough reserves to meet its day-to-day needs a bank frees the rest of its assets for other uses; it can lend them out directly or use them to buy interest-bearing assets such as stocks and bonds. The first bank to establish such a system is getting, in effect, an interest-free loan from those who choose to hold its money. Once other banks follow its lead, competition forces them all to pay interest, in money or services, on their deposits. Hundred percent reserve banks, which must charge their customers for the service of holding their money, become an unattractive alternative.
The result is a system in which money consists partly of physical commodities (privately minted gold coins) or claims on physical commodities (warehouse receipts) circulating as currency, partly of circulating claims against private fractional reserve banks (bank notes) and partly of non-circulating claims against such banks (checking accounts).
This assumes that the fractional reserve banks can offer depositors a reasonable certainty of being able to get their money back if they want it. Most criticisms of private fractional reserve systems depend on their being either unable or unwilling to do so. It is often argued that such a system is inherently unstable; a run due to rumors of weakness in one bank persuades many depositors to withdraw their money. Since the banking system as a whole has obligations much larger than its reserves the banks are unable to pay and the system collapses.
But even if a bank, or a whole banking system, has obligations much greater than its reserves, it may still be able to fulfill its obligations in full. A bank’s reserves are not all of its assets, merely the assets held in the reserve commodity. A bank facing a run can sell non-reserve assets for currency, getting back the currency it has paid out to one set of frightened depositors and using it to pay off a second set. One dollar in currency can pay off an unlimited number of dollars worth of deposits, provided that the bank has enough liquid assets to buy the dollar back enough times.
The real problems for such a bank arise either from having assets that are insufficiently liquid, from having total assets that are less than total liabilities, or from having assets whose market value measured in money falls in a panic. This last is likely unless the value of the assets is somehow linked to the value of money, since in a panic the money supply falls, the value of money rises, and the money prices of commodities other than the monetary commodity consequently fall.
There are a number of ways in which banks can protect themselves. One is to hold assets, such as loans and bonds, whose market value is fixed in money rather than in real terms. Another is to start with total assets larger than total liabilities, so as to guarantee to their depositors that even if the bank loses money it can still fulfill its obligations. A historical example is the Scottish banking system described by Adam Smith and, more recently and in more detail, by Lawrence White; the banks were partnerships and the partners were generally wealthy men. Since they were not protected by limited liability, the partners were individually liable for the debts of the bank. The depositors could lose their money only if the bank’s net liabilities exceeded the combined fortunes of the partners. Several of the banks did fail, but in most cases the depositors were paid off in full.
Another alternative for a private fractional reserve bank, and one used by the Scottish banks, is an option clause. The banks issued notes guaranteeing the bearer “one pound sterling on demand, or in the option of the directors one pound and six pence sterling at the end of six months after day of demand.” The customer, by accepting such a note, accepts the bank’s right to temporarily suspend payment, provided it pays interest during the interval.
Even if private fractional reserve banks can be stable, will they choose to be? Once a bank has built up a reputation for reliability it might pay it to convert that reputation into cash by vastly expanding its deposits without any adequate backing and then convert that cash from an asset of the corporation to a private asset of its owners and officers, leaving the depositors with a worthless shell.
While such frauds are possible in private banking and elsewhere in the economy, there is no obvious reason to expect them to be common, especially in a modern economy with well-developed institutions for generating and transmitting information on the financial condition of firms. If such a problem did develop in a private system, one consequence might be a preference by depositors for banks that were not protected by limited liability.
Two further arguments are sometimes made for why money creation cannot be private; both, I think, are mistaken. The first is that competition is impossible since without a uniform money every transaction requires the intervention of a money changer. But this argument confuses standardization with monopoly. It is convenient for the monies of different firms to exchange at a ratio of one to one, just as it is convenient for nuts made by one firm to fit bolts made by another, but this does not require that all money, or all nuts and bolts, be made by the same firm. The obvious way to arrange for standardization is for the different banks offering fractional reserve monies to use the same commodity in the same units.
If all banks make their money, whether notes or deposits, redeemable in grams of gold, for example, then all monies should exchange at one for one (or five or ten to one in the case of different denominations). The only exception would be the money of a bank believed to be financially shaky. Such money would sell at a discount; the resulting inconvenience would greatly reduce the demand for it, providing an incentive for banks to be careful of their reputations.
A second argument against private banking is that, since it costs almost nothing to produce money, it always pays a private bank to produce more of it. There are two errors here. The first is not recognizing that in order to produce money that people will accept, a bank must demonstrate its ability to redeem it; that is not costless, and the cost increases with the amount of money outstanding. The second is the assumption that when a bank gets the use of assets by getting people to hold its money, it need not pay for them. In a competitive market the interest paid for deposits would be bid up until it absorbed any excess, with the result that banks, like other competitive firms, would receive only enough to cover their costs of operation.