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would you be willing to trade all the days from this day to that for one chance just one chance come back [Music] free banky hello students professor watts here and today I want to give you a very brief crash course in free banking and the reason it's important to understand free banking and we'll look at kind of a theoretical version of free banking as it might have existed and then we'll look at free banking as it was actually implemented in US history it's important to understand this because it helps us understand what actually went wrong in US banking history and financial history and what led to some some major problems with credit and currency and banking panics financial crises recessions which led to the institutional features we have in the US economy to this day to understand why free banking was implemented let's take a brief look at what existed before free banking free banking laws came into the fore in the United States and starting in the late 1830s up until about the 1850s so here we're talking about the earliest days of the US so to form a bank you had to get a charter from a government state or national much more commonly state governments chartered bank so it's a couple instances in which the United States government chartered what was known as the National Bank the first think in the United States and then the second bank of the United States okay now imagine to start a business you have to go get basically an act of legislation passed by your state legislature well that's going to make this a very political enterprise and if the politicians are in charge of chartering the certain kind of business you can imagine they're going to ask for some favors and some quid pro quo from that business so what was pretty common in the what's called the Charter era for banks politicians would use the legislative pressure basically say you know we'll charter your bank only if you do the following one was to what I call force feed government debt into banks and this was done through bond capital requirements so the Charter would say you know Joe Schmoe here can form a bank but a certain portion of that banks paid in capital has to be in the form of bonds of the state of Michigan or the state of Kentucky or something like that so what that did was help to create and sustain markets for that state's debt that state's bonds even if there wasn't really a natural market of investors that wanted to buy that state's bonds and similarly bond collateral requirements where banks had to post collateral or security for the banknotes they issued in the form of bonds of that state or in some cases bonds of certain corporations that were maybe kind of special interests or pet constituencies of certain members of that government and then you had pressure for banks to lend to politically well-connected constituencies so state senator Jones might say hey Joe Schmoe remember I chartered your bank I could revoke your charter so you better lend to my buddies in the railroad industry or the the milling industry or whatever so the result of this kind of politicization of banks is going to be politicians making decisions rather than a market process of profit and loss and price signals guiding investment decisions so you're probably going to have a much less efficient system of capital allocation and investment done by the banking industry now enter free banking while at least in theory let's think about what free banking would allow well there's a lot of questions we need answered how many banks should there be in the economy where should banks be located what business model should banks use very important question remaining to this day all right should banks be very conservative should they only lend on security or should they be more liberal with their credit should they make unsecured loans should think specialize in one kind of loan or another I should make specialized in doing mortgage and real estate loans or should thanks have a diversified loan portfolio so there's a lot of different ways to run a bank out how should it be done here's a burning question should banks be able to issue money substitutes bank notes or basically their own paper currency that can circulate on its own as money in addition to issuing deposit liability and then on the question of regulation should the government or some kind of authority issue specific regulations for banks for instance you know banks have to hold a certain percentage of their positive liabilities as cash reserves you could also talk about lending regulations capital adequacy regulations etc well here's the basic answer from free banking at least in theory these are all important questions we don't necessarily know but we can let the market decide and discover the optimal structure number location business model currency issuance etc for every individual bank and there is going to be a robust regulatory process that occurs in a competitive market for banking services now in practice we're not going to get a pure free banking system we're only going to get a partial free banking system nonetheless there are some notable improvements over the Charter system in practice in US history one is you can streamline the bank formation process bankers no longer have to go and your hat in hand beg for two to pass a law and give them a charter they can just sign some simple documents file incorporation and bam they have a bank so that's a plus a lot more growth and development of banking services in the economy where they might be needed because it's more streamlined more efficient and people who think they might be able to make money opening a bank can now do so much easier so that's a plus one drawback though is that politicians are going to basically play the same kind of games in terms of utilizing banks for their own ends and the way free banking will be actually structured will generally serve to corral banks into supporting state government debt that represents a political capture of the banking industry and forcing them into the role of what I call a fiscal helper for state governments and that is politicized so it can be very inefficient and wasteful so thumbs down of that okay now let's look at what actually played out and we'll compare free banking theory versus free banking practice as it existed in the United States okay so in free banking theory says you have free entry and banking anyone who wants to start a bank can start a bank as long as they can collect the capital draw some deposits and you know set up the operation well they're free to go into the banking business for banking and practice generally had free entry but the government's usually didn't post some minimal capital requirements so you had to you know come up with $50,000 with a capital first and it had to be certified by the state Banking Authority then they would your banking license for banking theory says there's no legal restrictions on the bank's ability to issue banknotes this is gonna be one of the real hot-button issues in the free banking era and later on in US history now I note here there are market-based limits and that's in part two of the lecture I'm going to work through how that market-based regulatory mechanism operates free banking practice unfortunately has bond collateral required for note issue in every case the problem with this is going to be that oftentimes those bonds are very dubious value to end dubious quality so instead of creating what would be a good security for any banks note issuance it's actually very counterproductive in many cases creates very dubious very crummy security for these banks note issuance and so that's a regulatory practice that actually undermines the efficacy of the free banking system free banking theory says banks have to redeem the bank notes the issue just like banks have to pay out deposits if you go and fill out a withdrawal slip or write yourself a check the bank is obliged to give you the money in your account in the forms of what we would call underlying money during the free banking area in the United States that would be gold or silver coin and reality this was generally fulfilled in the United States with a brief exception in the panic of 1857 so I a brief suspension of the payment of bank notes in certain parts of the country in free banking Theory you have the unrestricted ability of thanks to open up branch offices one bank then can meet the credit needs of a large part of the country we could potentially have banks operating throughout a city or even throughout a state unfortunately another big drawback of free banking in practice was that unit banking was strictly enforced meaning each bank only had one office and branches were not allowed and this proved to be very very detrimental to the United States economy in the free banking era and beyond because it caused each Bank to be much much riskier in terms of its loan portfolio then it could have been had banks been able to achieve what we called geographic diversification of their credit risk by having branches across you know throughout a city or even across the state or even you know across multiple states finally in free banking Theory there is no role for government to ensure bank deposits or or banknotes for that matter and the reason here is because government based insurance or rescue schemes lead to moral hazard and that kind of moral hazard causes banks to engage in excessive lending and excessive risk-taking with regard to their lending in practice it was something of a mixed bag a few states formed their own deposit insurance schemes most famously the New York safety fund and those tended to blow up and cause a lot more losses than they they saved and kind of deal agenda mize the idea of government backstops of government Deposit Insurance in the United States for quite a while now I highlight two of these here bond collateral and unit banking were really not in line with free banking and so it's probably improper to even call the free banking era free banking that's why I've listed labeled it as so-called free banking because free banking one it force-feed to government debt into the banking industry through bond collateral abroad capital requirements and of course banks would be allowed to adopt whatever business model they wanted whether they wanted to be a unit bank with just one location or a branch throughout their territory those two features of free banking then practice are going to prove very troublesome and plagued the United States banking system and economy really throughout the rest of the nineteenth century and well into the 20th century okay now let's talk about features of free banking both in theory and to some extent these were realized in practice despite the shortcomings and and free banking not being really free banking in US history nonetheless it did accomplish some of these beneficial features which we want to highlight one is that free banking allows for the creation of an elastic currency and currency that meets the needs of the economy through competitive unrestricted note issuance the banks can issue their own payment media again what we call bank notes where that issuance can grow and shrink is dictated by the needs of commerce so if people want to convert their deposits and occur see and free banking banks are allowed to do that and there's no enough set cap or limit or security requirement that hinders banks from being able to give people currency as it's needed again the only regulation is that banks must honor their bank now let's pay out the underlying money of gold or silver at the time right we could have free banking today the underlying money would maybe be you know a paper monetary unit as defined by the government they could still work functionally the same when those notes are presented the bank has to pay out the underlying money what prevents banks from issuing too much currency too many banknotes let's a common fear but it's a needless fear because there are two very strong market-based regulatory mechanisms that will prevent a single bank or the banking system in general for that matter from issuing too much currency and again this is I'm going to show you the mechanics of this in part two of the lecture when we look at some kind of model Bank operations but that they're known as the law of reflux for a single bank and then adverse clearings in the banking system market processes prevent banks from over issuing notes basically boils down to if a bank issues too many notes those notes will come back and people holding them will demand payment of the underlying money and that could drain the reserves of the issuing bank to the point where it drives it out of business so banks have very strong incentives and rationales to be careful about not issuing too much currency bank notes not issuing more than the public is willing to hold and then finally the free banking ERA features a development of a very beneficial institution known as The Clearing House clearing houses our bankers banks that help facilitate interbank payments and also help banks economize on the storage and transference and security of the outside money or the underlying money for and again at the time that would have been gold and silver and clearing houses are initially established by banks who are trying to increase their profits by engaging in Clearing House operations and they evolved naturally in the it's in the self-interest of banks to establish them because they reduce costs they're a vehicle by which banks can gain efficiency and increase prophets as they evolve and become widely used and accepted throughout a banking system clearing houses take on some additional roles one is they kind of adopt some informal regulatory functions in terms of monitoring member banks credit risk and lending and they are also able to act as lender of last resort in times of crisis because clearinghouse banks are to some extent entities that centralized reserves and that are able to channelize banking reserves from liquid banks to potentially illiquid banks and clearing houses are also very adept at allocating reserves among banks because clearing houses will keep close tabs on the credit worthiness and liquidity and riskiness of all their member banks so it's a it's a very close in connected institution that can serve these regulatory and lender of last resort functions that we of course in our day and age would take it for granted that would be supplied by the central bank well if that can be supplied through a market process by clearing houses if only we let this develop and this did develop pretty well in the United States and the 1800s and even beyond the free banking era Clearing House has played a very important role due to really inefficient legal restrictions and in really unwise government regulations that were imposed pretty much on the entire banking system throughout the entire country in the national banking acts of the Civil War era unfortunately clearing houses were very limited in the role they were able to play and financial crises still plagued the economy okay so it's a very brief introduction to what free banking could look like what actually did look like and what it can do now we'll turn to part two and we'll dive into some bank operations will will analyze banking activity through the lens of banks balance sheets and we'll think about how a few important aspects of free banking operations would work out in practice