Free Banking in 25 Questions and Answers

(Translation of Dutch original: Vrij Bankieren)

The logical conclusion to be drawn from these facts would have been to do away with privileged banks altogether and to subject all banks to the rule of common law and the commercial codes that oblige everybody to perform contracts in full faithfulness to the pledged word. Free banking would have spared the world many crises and catastrophes.
- Ludwig von Mises, The Theory of Money and Credit (pdf), p. 440.

1. What is free banking?
Free banking is the completely free market in money and banking. It would have at least the following characteristics:
* Freedom to choose, accept or refuse money; no legal tender or monetary standards would exist.
* Freedom to establish banks, mints and other financial service providers, without entry barriers, charters, licenses or privileges.
* Freedom to offer financial services such as means of payment, clearing, digital accounts, letters of credit, bonds and savings funds.
* Freedom to have coins minted and to issue own-brand payment instruments.

2. How does free banking differ from the current banking system?
Free banking would be centered around customers' needs, as any free market. Of the greatest importance would be the quality of their money. People would make individual arrangements with banks or other financial service providers, to protect their deposited money according to property rights and to sue the banker if he violates them. There would be no central bank and money would not be a government task. Money would return as an original market product. Banks would be subject to ordinary anti-fraud legislation and not have barriers nor privileges. They would then exist on the basis of quality, profitability and customer confidence.

3. What kind of money would there be with free banking?
People in the free market would mostly choose gold and silver as money, depending on individual preferences and the size of their transactions. Precious metals have enjoyed the people's confidence throughout the world for thousands of years. People could also use metals like copper, platinum and palladium for tiny or extraordinary large purchases, in addition to gold and silver. People would have gold and silver freely minted or melted; coins would be standardized, based on users' convenience. There would be no competing fiat currencies. Banks, mints and other businesses could mint gold and silver coins. Gold, silver and all other metals would fluctuate freely against another (free metallism), as there would be no legal, hence disruptive exchange rates (bimetallism).

4. What are the advantages of free banking in comparison to the current system?
The most important benefit is freedom for everyone. All the others ensue from this:
* People in a society with free banking would be politically and economically emancipated. Money and banking issues would be easy to grasp for everyone, as people would organize them self-interestedly among property rights.
* Money and state would be strictly separated with free banking. At best, a government task would be the legal protection against counterfeiting, including fractional reserve banking.
* Economic boom-bust cycles and their accompanying runaway inflation or deflation would not exist under gold and silver money.
* Political, disruptive institutions like the Bank for International Settlements (BIS), the International Monetary Fund (IMF) and the World Bank would not exist, nor any national banking supervisors.
* Wars and other large-scale, political pet projects financed by money printing, resulting in misery and inflation, would be non-existent under free banking.

5. How would free banks operate?
Under free banking, banks would be normal businesses, without privileges and regulations, but with the explicit contractual obligation to respect their customers' property rights. Banks would have both a safe keeping and an investment function, but keep both strictly separated. The present, exceptionally large bonuses and other excesses would be non-existent, as free bankers could never achieve unjustified large profits or a dominant market position due to fractional-reserve banking and its use of businesses as collateral for newly created debt. Only by investing very successfully, using existing savings or newly mined precious metal, could they achieve large profits, but these would also benefit the bank's customers and lenders.

6. Is fractional-reserve banking possible under free banking?
No, even legally permitted (i.e. not forbidden) fractional-reserve banking would not be viable in the free market, as human action would automatically prevent or stop it and limit the damage in case of. Moral hazard would be prevented. A large number of factors would have a role in this:
* A bank would first have to build a reliable reputation over a long period of time, by strictly enforcing the property rights of its customers and business partners.
* Nobody would be obliged to do business with a fractional-reserve bank and/or accept its money, with dubious property rights and of which the purchasing power and public acceptance would diminish.
* Fractional-reserve banking destroys the bank: customers would start a bank run as well as lawsuits, hence let the bank go bankrupt, because of violating the contractual prohibition of fractional-reserve banking.
* Fractional-reserve banking would also strengthen competitors, which would redeem the fractional money at face value, build up more (gold and silver) reserves and hence become richer, at the expense of the fractional-reserve bank.
* People could use other forms of payment than banknotes or bank credit, such as gold and silver coins, shares and corporate bonds. Easy-to-create banknotes and especially digital money are not the only forms of payment. Hence people could circumvent fractional-reserve banking and render it all the more useless. Banks are not always necessary for transactions.
* There would be no private or government (deposit) insurance against the risks and consequences of fractional-reserve banking, for banks nor customers, contrary to the present central banks and deposit guarantee schemes. Instead, fractional-reserve banking in the free market would lead to damage claims against such a bank.
* Banks and clearing institutions would sharply check the operations of all banks and immediately expose and publicly announce a fraudulent bank. This would initiate a bank run and expulsion from clearing and other business services, as contractually arranged. A public call to a bank run would not only be permitted, but even encouraged.
* A bank on the free market has a limited clientele, due to free competition. Fractional money, in whatever form, would soon end up with customers of other banks and create a surplus at a clearing institute. To redeem this money back into gold or silver would ruin the bank soon. To create unbacked money actually means the bank giving away its customers' gold and silver deposits against worthless created money, with bankruptcy as a result.
* Free banks will not form a cartel to engage in fractional-reserve banking, as customers will demand enduring quality and reliability of money and services, as well as openness on their banks' operations. On the contrary, there would be an incentive to prevent cartels by underpricing and/or providing better products and services.
* When depositing gold or silver at a bank, nobody would accept a banknote in return without being fully redeemable. Otherwise customers would simply give away their own gold or silver to the bank.

7. Would free banks commit fractional-reserve banking to maintain economic- and price stability?
No, fractional-reserve free banking as a macro stability tool is not viable as well, for many reasons.
* People in the free market would choose precious metals as money, because of the qualities they provide for them as an individual, including relative stability in supply. Economic stability in prices, demand and supply would be automatically achieved as a byproduct, hence fractional-reserve free banking, even as an "adjustment tool", would be unnecessary and simply harmful.
* Fractional-reserve (free) banking reverses cause and effect: instability, like boom-bust cycles, bubbles and unnaturally strong price fluctuations, arises through fractional-reserve banking in the first place.
* Free banks would have no tools to correctly discover price developments, identify their cause and adjust the money supply up or down: price indexes, price levels, price information, econometric formulas and price targeting rules would be as incomplete and flawed as under the present central banking.
* Banks would have to engage together in fractional-reserve free banking in order to make it "work", but such cartel-like behavior, against their customers' needs and wishes, is unthinkable in the free market.
* Any bank would never know how much to inflate or deflate the money supply, individually or collectively, in order to battle the supposed price instability. Nor would they agree on how much price instability and with which cause, they would have to battle or accept.
* Customers would be keen on money quality as well as property rights and not accept meddling with them or else the bank will loose customers to competing or new, sound money banks. Hence, fractional-reserve free banking will not even take off.
* The mining and minting of precious metals would not be an exclusive task of banks, but as well of mints and any other businesses the customers would choose. Banks would be much less important in supplying money.
* Free market money and banking would prevent instability and people would not see any natural (seasonal) instability as problematic, let alone justify fractional-reserve free banking.
* Macroeconomics would not play a role in the free market, where only individual actions would have relevance.

8. Doesn't the lack of government insurance lead to unacceptable risks?
No, quite the opposite. Bank charters, bailouts, supervision and the deposit guarantee schemes that ought to protect deposits, only exist because banks now have permission to commit fractional-reserve banking. Government supervision would be non-existent under free banking. Only decentralized, individual contracts between banks and customers offer the guarantee of respecting property rights and thus the quality of money by excluding fractional-reserve banking. The risk of bank runs and bankruptcies would be minimal. Fractional-reserve banking would also be uninsurable. The absence of state guarantees and the discipline of the free market, prevent fractional-reserve banking and all its associated risks. With free banking, customers, competitors and trading partners automatically form strict supervision.

9. How could customers and investors assess the quality and reliability of free banks?
As fractional-reserve banking would be non-existent, banks and other financial institutions would automatically enjoy more public confidence. Capital would be much more scarce, hence bankers would invest in quality projects, based on genuine human needs. Nevertheless, banks can always go bankrupt due to poor investments. People might consult financial reports, auditors or consumer organizations that are truly independent in the free market, due to the absence of political interests. Transparency of information from the banks and knowledge among investors and the public, make a responsible choice for banks possible. Building and maintaining a reputation is crucial for banks in the free market; by advertising their financial results they can add to this and by distinguishing it in sound services.

10. Could banks in the free market adequately respond to demand and supply in money?
Yes, but banks and other financial institutions would act differently then under central banking, with its virtually unending growth of the fiat money supply.
* Under free market banking, people would let the money supply fluctuate with their preferences for the application of gold and silver as money. There would be a "flexible limit" in terms of the available amount of gold and silver. Increasing purchasing power of money, achieved by innovations and productivity growth, stimulates people to mine and mint gold and silver. Banks could invest in this, deploying their customers' savings. When the money supply increases slightly, its purchasing power may fall somewhat; gold and silver mining and minting could decline: people could take some precious metals out of the money supply by melting and applying it elsewhere, as they yield relatively little as money. This in turn increases its purchasing power. This price mechanism continuously controls supply and demand of gold and silver money, without causing economic disruption. Individual needs would again be leading here, not bankers adjusting the money supply to a price index.
* For the demand for money (loans), banks and other institutions would continuously raise savings against interest rates, out of which they create loans, without increasing the money supply. And repayment of these loans would therefore not reduce the money supply either.

Mind that growth or shrinkage itself of the money supply is not decisively economically good or bad, as abstractions do not count. It is only peaceful, individual actions that can justify it.

11. How does the free market provide small change?
In addition to gold and silver, people could use metals like copper, platinum and palladium for small or large transactions, possibly in an alloy, even with a tiny weight. Metals would always have the free rate against each other, as there would be no legal tender and hence Gresham Law wouldn't come into force. Coins would be good marketing tool for banks and mints in terms of design and convenience.

12. Would loans still lead to double claims to money, hence to fractional-reserve banking?
No. Under free banking there would be a strict separation between:
* Demand deposits, mostly for payments and earning no interest, as the bank does not invest them, but with a fee charged for safekeeping and services.
* Time deposits, with interest and for a fixed period of time to be unavailable for customers. The bank can lend such deposits to earn the interest. Banks can also raise investment capital with shares and bonds.

Any supposed "third way" of mixing both types of deposits, such as being available on demand but with interest, would not be viable: people would not freely choose contradictory hence unnatural options, but legally exclude them.

13. Are free banks independent of politics?
In the free market there is by definition no political pressure, including on monetary issues. Banks and other institutions then only have one purpose, namely to serve their customers' needs. This automatically ensures optimum employment and real economic growth; it does not require the creation of money from a central bank or "economic policy" for which to lobby.

14. Shouldn't there be a central bank to control the money supply and stabilize prices?
No, for various reasons.
* Stable prices are not a feasible or even meaningful goal in itself. Supply and demand of goods constantly change due to factors such as people's subjective preferences, the availability of commodities and technological developments. This is all completely legitimate and cannot be stabilized.
* Gold and silver as money ensure that at least the money side is relatively stable, as their supply is limited and can only be expanded by large investments. That is why people will voluntarily choose precious metals as their money. The infinitely growing fiat currency of today is by definition unstable and not viable in the free market.
* Central and private bankers who manage the fiat money supply fail for several reasons. They have no clear definition of what the money supply is. Central bankers also lack the necessary comprehensive market information for their policies. Central bankers and economists use a manipulated consumer price index, that never exactly applies to anyone in society, as individual spending patterns differ infinitely.
* Price stabilization is also just fighting symptoms as central bankers circumvent the cause of most price increases: the rapidly growing supply of money through credit creation. Without this fractional-reserve banking, the goal of "price stabilization" is simply unnecessary, as it would be achieved mostly automatically. The apparent price stability, with at most a few percent price inflation per year, means a huge fall in the purchasing power of the currency in the long term. Gold as money automatically means the highest attainable form of stability; fiat currency is made free of charge and is therefore not even an economic good. The former, relative price stability can be achieved again on the free banking market with gold and silver.

15. Wouldn't free banking automatically lead to a cartel or a central bank?
No, only if customers see some advantage in such a cartel, which is unlikely, as it could only harm them by facilitating fractional-reserve banking. And even then, banks could only make voluntary agreements without any legal confirmation. This is again not viable in the free market and with a crucial good such as money. Producers would benefit from breaking cartel agreements, because they can then increase their profit by taking on customers. Free entry by new providers is also a factor in this.

16. If free banking is that good, why don't we have it right now?
There are people who benefit from the current system. Ideology and economic beliefs among politicians and economists also play a role here. For example, some think that money is a natural government monopoly. They think the market cannot supply money as it would then lead to chaos. Or they simply don't know this option. But the enormous devaluation of fiat money, wars and wasteful projects financed by money creation, the enormous artificial wealth of the financial sector and the returning boom-bust cycles prove the contrary: money under the central banking cartel is a fallacy. And it's free banking that is the contrary of all this. However, since free banking is not a political issue, maybe until the present system collapses, monetary power remains in the hands of politicians and central bankers.

17. How do banks in the free market deal with each other's money?
As people would freely choose precious metals as money, there would not be competing fiat currencies or "brands of money". Banks and other trusted institutions could issue free tradeable notes, as well as digital forms of payment, all fully redeemable for gold and silver, deposited by customers. Hence, payments could take place with various means. As long as banks trust each other, they will exchange their coins, banknotes and digital balances at face value. This could also take place in a (fully automated) clearing institute. When their confidence in a competitor declines, or on a regular basis, they would demand gold or silver for the resulting balance; irredeemable money would be discovered immediately during this settlement. The fractional-reserve free bank would lose its gold and silver stock and go bankrupt. A bank run if that fact would become known, would speed up that process. Banks and clearing institutes thus have a monitoring and information function, to expose fraud and directly benefit customers. To accept each other's notes at a discount would not be a viable way. Another feature of the free market is that without legal tender laws, Gresham's Law ("Bad money drives out good if their exchange rate is set by law") would be turned around: bad money would simply disappear from circulation, be it redeemed or refused. This stimulates the issuance and maintenance of qualitative superb money. Again the working of the free market provides the best guarantee.

18. And what if banks would refuse another bank's money?
Banks will only do so if they see reason for it, or else they would dupe at least their own clients who deal with that bank. They may be suspicious about unbacked or counterfeit money or the financial situation of a competitor may be dire. By communicating this in the financial community, a refusing (or even a suspicious itself) bank also reinforces its own name and carries out its control function. A bank that refuses someone else's money for no reason, is likely to be acutely isolated. Confidence in cooperation would vanish and its customers would immediately experience huge difficulties. After all, money is a generally accepted means of exchange, hence cooperation between banks is crucial for everyone as well.

19. Do financial institutions operate differently under free banking?
Yes. Under free banking, banks and other financial players would not be as artificially large and rich as they are now. Fractional-reserve banking not only increases the money supply, but also financial businesses, using up scarce resources and at the expense of productive companies. Financial institutions lure staff out of other sectors into the financial world, which drives up labor costs. The growing organization needs larger buildings, which raises property prices. Banks and project developers also benefit from public facilities paid for with tax money, which increases their attractiveness and further increases profits for them. Productivity and entrepreneurship decline due to phoney wealth. Such disruptions cannot happen in the free banking market.

20. What kind of economy would we have under free banking?
With free banking, there would be prosperity growth based on the efficient, productive deployment of capital, rather than today's redistribution of wealth under fractional-reserve banking. People would be very keen on the importance of sound money. With gold and silver as the reward for employees and entrepreneurs, people would appreciate productive labor and not be inclined to spend their money as easily as today. As interest rates would be higher because of the real scarcity of capital and no artificial suppressing of rates by central banks, people would by far not have as much debt as today. The wasteful consumer society of today would not be viable. Instead there would be a productive economy in which primary needs would be fulfilled much more cheaper than today. As a result, there will be a structural price deflation in particular of the most important goods. Much less or even no debt would be needed purchases and hence there would be an increasing real prosperity.

21. How would interest rates be set under free banking?
Banks would set their interest rates individually, taking into account various dimensions of saving (like short- or long term and the amount of savings needed and offered), their competitors' rates and expected profitability or risk of any project or enterprise to invest in. No projects would be started or funded just to generate debt and income for the bankers, as in the present system; only existing savings would be deployed. This leads to natural, various and competing interest rates which reflect the estimations of bankers and the needs of customers. It ensures an optimum, although never definite or perfect, distribution of money between consumption and production.

22. Would there still be economic crises under free banking?
No, boom-bust cycles including recessions or depressions result from fractional-reserve banking, with artificially low interest rates and newly created credit instead of deploying existing savings. As people in the free market would contractually prevent fractional-reserve banking, there would only be natural fluctuations in preferences among people. Disruptive actions with which (central) bankers cause cyclical cycles, would then be absent.

23. Would free market banks lend and invest in a responsible way?
Yes; investments would be made out of real savings and would hence be limited by them. There would then be a more constant, real economic growth, through innovations and product improvements. Prices for producers and consumers would be falling steadily, resulting in increasing prosperity. Interest rates would reflect factors like risk and time preference (short or long saving) and there would be a much greater economic harmony. Financing investments can also be done through the issuance of shares or bonds, which in turn are real investments and not the objects of speculators that are currently driven by cheap money. Credit-providing banks would actively keep up the "golden rule": credit transactions = debit transactions, in other words: the obligations (money in the bank) must not be shorter than the assets (money lent by the bank), otherwise illiquidity arises. That is completely different from fractional banking, where long-term investments do take place without the backing of time deposits. In the free market, this is no more viable than fractional banking:
* Short-term borrowing - long-term borrowing is risky because continuing it depends on renewing short-term loans.
* The exchange of money for gold at the free bank prevents fractional banking and thus also the credit expansion.
* Competitors could undermine a weak bank by lending money in the short term and, after investing in long-term projects, claiming it through a bank run.
* Something similar is possible by suddenly selling the shares of such a bank. That also makes such a bank ready for cheap takeover.

24. Has free banking ever existed?
In recent centuries, there have been relatively free markets for money and banking in various countries, which some economists call "free banking." However, none of these were completely free as governments were still deeply involved in money, banking and regulations. As a result, the benefits of free banking were hardly realized. Some examples:
* In the United States between 1837 and 1863 there was the so-called Free Banking Era without a central bank, but conditions differed state to state, including government intervention. For example, banks often had to purchase state debts as collateral for money issue; a debt crisis led to the demise of many "free" banks.
* Sweden had a relatively free money market from 1830 to 1903, but retained a central bank and the free banks were not allowed to issue small denominations.
* Scotland in the period of 1716-1845 is seen as the example of free banking, but that is a myth: banks piled credit on top of funds kept at the Bank of England and often suspended specie payments. Bankers were hostile to customers and the reserve ratios were very low, around two percent.
* Hong Kong had no central bank between 1935 and 1964, no reserve requirements, no deposit guarantees. Three private banks did have the privilege of issuing banknotes; coins and low values ​​were a government task.

These historical examples do not prove that free banking can not work; one can learn from them how to do it different and better in the future.

25. How can we implement free banking?
In theory, money and banking can be privatized from the current system, although it is a costly and risky way out because people have built up many interests in savings, pensions and insurance. In any case, it is necessary that the legislator abolishes all laws regarding money and banking, allows free competition in this and cancels the central bank. As an alternative, the current system would first crash and burn because banks and countries would collapse under debt, accompanied by hyperinflation or hyperdeflation. Afterwards, citizens will be more inclined to set up a money market themselves.

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