George Selgin on Free Banking

Episode Summary

Executive Summary: Russ Roberts and George Selgin examine free banking as a system with minimal special regulation, arguing that competitive private banks can safely issue deposits and notes under a commodity standard. Selgin uses Scottish banking and British private coinage to show how market discipline, capital, and clearinghouse rules restrained abuse, while government monopolies and central banking often amplified instability.

Main Topics: What free banking means (Priority: 5/5): Selgin defines free banking as banking without special regulations, with government limited mainly to ordinary contract enforcement, and with banks operating like other competitive firms. Historical evidence from Scotland (Priority: 5/5): Scottish banking is presented as the closest real-world example of free banking: low note losses, strong capital, clearinghouse discipline, and occasional failures absorbed by owners rather than taxpayers. Why pre-Fed U.S. banking was unstable (Priority: 5/5): Selgin argues that unit banking restrictions and limits on note issue, not the absence of a central bank, largely caused 19th-century American currency shortages and crises. Market discipline on private money (Priority: 4/5): Private notes and deposits are constrained by redemption, clearing, reputational effects, and bank capital; excessive issuance leads to discounts, loss of counterparties, and failure. Free banking and macro stability (Priority: 5/5): Selgin contends that a free banking system would stabilize total spending by allowing money supply to adjust endogenously to changes in velocity, dampening business cycles better than discretionary central banking. Private coinage and Good Money (Priority: 4/5): The discussion of Selgin's book 'Good Money' shows how private mints in Britain solved coin shortages during industrialization and outperformed the Royal Mint until legalized monopoly ended them. Gresham's Law and legal tender (Priority: 4/5): Selgin argues Gresham's Law applies mainly when governments impose bad money by fiat; in competitive markets, good money tends to drive out bad money, not the reverse.

Key Arguments: Free banking is not lawlessness; it is banking subject to ordinary market discipline, contract enforcement, and competition rather than special privileges or protections. Historical U.S. instability before the Fed stemmed significantly from single-office unit banking and restrictions on note issuance, which prevented banks from supplying needed currency. Private note issuance is constrained by redemption into reserves and by clearinghouse discipline; banks that overexpand lose reserves and can be cut off by rivals. Bank capital is the first buffer against losses in free banking, so losses fall mainly on owners, not depositors or taxpayers. Scottish banks operated with very low gold reserves, often around 1% to 2%, yet remained stable because their liabilities were trusted and disciplined by market mechanisms. The optional clause in Scotland was designed mainly to deter 'note raids' by rival banks, not to shield insolvent banks from customer runs. Central banking and deposit insurance reduce the incentive for banks and depositors to demand capital, encouraging weaker banking structures over time. A free banking system would tend to keep aggregate spending stable because banks can expand when money demand rises and contract when it falls. Monetary rules like the Taylor Rule can fail because stabilizing the price level is not the same as stabilizing total spending; productivity growth should be allowed to lower prices. Private coinage in Britain solved severe coin shortages during industrialization by meeting demand better than the Royal Mint, until the government reasserted monopoly control. Gresham's Law applies mainly under legal-tender coercion; in free markets, merchants can demand good money and bad money does not automatically drive out good.

Data Points: Scottish bank reserves: 1% to 2% - Selgin says typical Scottish banks of issue held very low gold reserves in the early 19th century while still functioning safely. Bank capital before the Fed: 30% of liabilities - He notes that before central banking it was common for banks to have capital around this share of liabilities. Option clause interest rate: 5% - Scottish banks that invoked the optional clause had to pay note holders the maximum legal interest rate during suspension. Private coinage scale: 20 mints producing coins for about 200 issuers - British private coinage expanded substantially to meet circulating coin demand during the Industrial Revolution. Initial private coinage period: late 18th century, especially after 1797 - Private coinage emerged as the Royal Mint failed to supply enough copper coin; a second wave followed after 1810. Federal Reserve system structure: 12 banks - Selgin describes the Fed as effectively creating 12 banks able to issue currency under different rules from existing banks. Key U.S. banking milestone: 1913 - The discussion contrasts the pre-Fed era with the creation of the Federal Reserve in 1913. Scottish banking ending point: 1845 - Peel's Act extended English restrictions to Scotland and capped Scottish note issues, ending the freer system.

Pivotal Quotes: "banking without any special regulations." — George Selgin: Selgin defines free banking at the start of the interview. "The banks can do everything that the government does now except contribute to crises, which is something that government agencies are particularly good at doing." — George Selgin: He contrasts private banking discipline with government-created instability. "the only good banking system is a system where bank customers, the holders of bank liabilities, never have to worry about taking losses, that idea is just a fundamentally rotten idea." — George Selgin: He argues that eliminating all depositor risk creates worse systemic outcomes.

Implications: Listeners should question the assumption that government control is the safest monetary arrangement. Selgin argues competition, capital, and clear rules can reduce crises and improve money’s responsiveness to demand.