Tuesday, September 11, 2007

Free Market Banking

In the previous article we looked at money and how it arises in the market. We determined that money is a commodity that is selected by the market as the medium of exchange. Only a commodity with prior value can gain this status, as exemplified by Mises' regression theorem. The commodity that gained wide acceptance was precisely gold, and to a lesser extent silver. Although money is the lifeblood of the market economy, as physical gold it has not realized its full potential -- for that, we need banking.

Recall that money should be portable, divisible, and durable. Gold is all of these, however, for large transactions, it can still prove cumbersome. There is also the added complication of storage. Even though physical gold eliminates many costs of barter exchange, such as time and effort, it cannot eliminate all costs, particularly transaction and storage costs. However, the market has a solution: money warehouses. I use the term warehouses and not banks because free market banking is different from the current fractional reserve system. In order to understand this difference it is important to first look at how warehouses would function in a free market and then consider the differences with the current banking system.

Banking as a convenience

In a free market, money warehouses function as depositories, much like how any storage facility works today. The owner deposits his gold, pays a storage fee, purchases insurance if desired, and receives a receipt certifying the deposit. This receipt entitles him to immediate withdrawal of his gold at a moments notice. Precisely how the receipt at any storage facility today allows one to retrieve their property whenever they desire.

Storage fees and insurance costs are unavoidable no matter how gold is stored. Storing gold anywhere, whether at home, in the backyard, or buried under a tree incurs costs. Sometimes these are indirect (time, effort, lost opportunity) and not recognized as costs, but they still exist. In addition, there is always the risk of theft and insurance is necessary to protect against this. Clearly the price paid for insurance is commensurate with the safety of the storage facility. Due to the benefits of specialization, money warehouses can offer the lowest storage and insurance costs. In fact, there is a huge economic incentive for money warehouses to forward integrate their business to provide storage as well as insurance. This ensures rock-bottom fees, and aligns the incentives of the customer and warehouse: now neither wants the gold stolen; the customer for obvious reasons, and the warehouse because they are on the hook as sellers of the insurance policy.

Warehouses greatly reduce the cost of storing gold, but what about transaction costs? They serve to lower these as well. Suppose Smith and Jones enter a trade where Smith agrees to pay Jones 100 ounces of gold. To fulfill his commitment, Smith must withdraw gold from his warehouse and deliver it to Jones. Jones then deposits it in his own warehouse for safekeeping. This requires time and effort. Alternately, Smith can write Jones a check, which, when cashed, instructs Smiths warehouse to pay Jones 100 ounces of gold, drawn on Smiths account. Most likely Jones will deposit the check at his own warehouse. If they belong to the same warehouse this is a simple bookkeeping entry. If they are customers of different warehouses this can still be cost effective since the two warehouses can aggregate all such trades between their customers and physically settle in the manner most convenient. Economies of scale ensure that the costs borne are lower than individual transactions. Presumably, Smith and Jones prefer low costs and high convenience so they opt to pay the service fee for using their warehouses rather than making a direct exchange.

We see that money warehouses play an important role in making gold more cost effective as the medium of exchange. Ultimately, however, they are nothing more than a convenience. They merely serve to lower the costs and increase the convenience of trading physical gold. This is not to say that lending institutions paying interest on gold deposits will not exist in a free market. They absolutely will. However, they should be recognized as distinct from money warehouses. This will be discussed more clearly in the next article on fractional reserve banking.

Paper money

While the system above is already a vast improvement over direct exchange, there is still one further improvement we can envision. If the receipts issued by a gold warehouse are redeemable by the bearer of the receipt, then individuals can simply trade receipts as if trading actual gold. These paper receipts, or bank notes, eliminate transaction costs, but introduces a new risk: counterfeiting -- the notes may be fake. However, again due to economies of scale, well known and trusted warehouses can issues hard to counterfeit notes, similar to federal reserve notes (dollars) today. This situation presents the same risk as using dollars today, so it is highly conceivable that it can evolve and be sustained in a free market. In fact, this phenomenon has been observed repeatedly throughout history, but unlike the system today, there will be no monopoly on the issuance of bank notes.

(An interesting corollary is the origin of the word "dollar", which can be traced to thalers, silver money coined by the Count von Schlick. These private coins gained wide reputations for their integrity. Most people recognizing the seal were willing to trust the integrity of the coin, much as anyone recognizing the seal on federal reserve notes today is willing to trust the integrity of the note. Why should it be any different with private bank notes?)


Banking in a free market takes the shape of money warehouses which serve as a secure place to store gold and an efficient way to trade it. Since warehouses issue receipts that are redeemable at a moments notice, they must keep all the gold on the premises at all times. They are not the owners, they are merely the caretakers. To do otherwise is fraud or theft. This will be discussed more clearly in the article on fractional reserve banking. The best known example of free market banking has been the Banca della Piazza del Rialto, which grew to become the center of Venetian commerce. Another example is the Bank of Hamburg, which was eventually compromised when Napolean took control of it.

In the article on fractional reserve banking we will also look at the structure of free market lending institutions. It should be clear, however, that gold warehouses, as described above, are not lending institutions. They are merely storage facilities to lower the costs of transacting in gold.

As for whether bank notes will be widespread, it is very likely so, but it will depend on the relative costs. Only the market can decide. As individuals evaluate alternatives and make choices, they will decide if they prefer checking accounts or bank notes. Each individual, weighing his preferences against the costs and risks and deciding on the former, the latter, or a hybrid of the two, will have the effect of the market selecting the most appropriate solution. When Austrians talk about to the market "selecting" a good or services, it is precisely this phenomenon that they are referring to. It derives from profit-loss accounting, an extremely important concept in understanding how markets function.


Rothbard's must read introduction to money and banking.

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