Implementing Free Banking Today

Is a manipulated market better than none at all?

One of the most dramatic changes in the world intellectual landscape of the past 10 years has been a gradual realization that most markets in today’s industrialized countries are anything but free. To put the matter succinctly, the existence of a market in no way constitutes proof that that particular market is in any way “free”.

Arguably unfree markets tend to produce more attractive results than no markets at all. And yet, at least the economic misallocations caused by the prohibition of markets is apparent to all – and can be considered in the context of the long term economic planning of all would-be market participants. By contrast, the misallocations and disruptions caused by market manipulations are often neither foreseeable nor calculable for the majority of market participants. Moreover, the damage can remain hidden for years, only to surface suddenly – and then with a vengence.

Manipulation in the bank market

The misallocation caused by government-mandated one-size-fits-all bank insurance schemes is surely a fine example of this. In today’s standard fiat currency scenario, as long as prices and credit volumes continue on a steady upward course, it remains relatively easy to conceal poor management and pending losses. At some point however, when the inevitable crunch comes, increasing numbers of bad bets become impossible (or uneconomical) to conceal. The government or its “insurance” entity is then called in to pick up the tab.

As many observers have pointed out, this type of model rewards the bad investors (the banks who placed the risky losing bets) at the expense of the risk-adverse and winning bettors.  This is because both high-risk and low-risk investors all pay the same “deposit insurance” rates. In a crisis scenario, however, most of the cost is likely to be covered by the insuring government. Typically this leads to cranking up the printing press.

Designing a free market in banking

Over the past several years much thought around the world has been given to imagining how free markets might work if allowed to. This includes the market for banking. Is fractional reserve banking compatible with free markets? How about a government insurance scheme? Many, including such penetrating thinkers as Murray Rothbard, have characterized fractional reserve banking as institutionalized fraud. While this is understandable given the prodigious amount of resources historically “appropriated” in connection with fractional reserve banking, I would question if this is not a case of guilt by association. Were those resources stolen by means of fractional reserve banking, or by means of the government protection afforded to the thieves? I would propose that the latter is the case – as long as the bank does not profess to be doing anything else. On the contrary, it seems obvious to me that nothing openly admitted to by a contract party can be characterized as inherently fraudulent.

So how might such a system work in practice? Every one with a bank account will have to admit that – from an individual perspective – having a government guarantee for bank deposits is a fine thing. The price to be paid for this is after all a subtle one. Even the theoretical (hard-to-check) assurance that a bank has a “100% reserve ratio” seems less attractive than a firm deposit guarantee. Given this reality, it seems unlikely that the banking public would prefer an uninsured bank to an insured one, regardless of their position on fractional reserve banking. 

Could privately owned insurance companies equally fulfill the same role – like the insurance companies which provide title insurance for real estate transactions? Could they compete with government-sponsored insurance?

Though it may not be immediately apparent why this is, I think the historical evidence supports a guess in the affirmative. True, the government is likely to attempt to continue to subsidize its friends in the “government-insured” banking sector. But there are limits to this. For one thing, as soon as private deposit insurance becomes available, there will finally be a market. Thanks to this market, at least over the medium term the cost of these subsidies will become more apparent. In other words, it will finally become possible to compare state insurance rates with a market rate. At the same time, calls for government bailouts of the state-sponsored banking sector will ring increasingly false.

But there is a more pertinent question: Why would I as a consumer prefer a privately insured bank over a public insured one? There may well be a simple answer to this: The privately insured banks are likely to be able to give me something I cannot get from the government-insured ones: better rates and better products. History shows that regardless of the subsidies paid, the public sector is almost never able to outcompete the private sector. Hence, private sector insurance rates are going to be lower. Unlike government entities, they have a strong incentive to know their customers and charge them accordingly. The well-capitalized low-risk banks are going to pay less, and have more flexibility.

Perhaps more crucially in a highly inflationary scenario, government-sponsored insurance companies are unlikely to be willing to guarantee large amounts of deposits in paper gold or paper silver, because the government’s central bank cannot print such deposits at will in case of a major crisis. (To cite one piece of anecdotal evidence for this: It can hardly be a co-incidence that today major banking centers allowing accounts to be denominated in gold are restricted to a few mini-states such as Hong Kong.) For privately insurers, by contrast, this is no different than insuring deposits in fiat currency. Their risk assessments remain the same.


It is an error to believe that market reform requires an “all or nothing” / big bang solution. What IS required is that market participants be allowed to make their own assessments about what to buy and what to sell. There is no reason why private “free” banking cannot exist side-by-side with the old clumsy state-sponsored type – and beat it fair and square. All that’s needed is a market.

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2 Responses to Implementing Free Banking Today

  1. two_worlder says:

    Private bank insurance exists in at least two cases now that I can think of:
    NCUA private insurance for deposits at credit unions
    SIPC private insurance for deposits at brokerage accounts
    i have no idea what their rates or rules are, but these both work like banks and i would consider them safer, they are not allowed to do fractional reserve banking, however i believe they transfer the digits daily to normal banks.

    • Ponderer says:

      Are you sure that the NCUA and SIPC insurance schemes are “private”? After all, both are US Government “entities”. The NCUA is an “independent federal agency”, whereas the SIPC is nominally independent, akin to the Federal Reserve Board. “The SIPC is led by 7 directors, some appointed by the President of the United States, and others by the member firms.” I suspect that even if there is no explicit government guarantee for the latter, it is certainly assumed and expected by much of the financial community.

      Be that as it may, the more critical question is: Is participation in their insurance schemes voluntary or mandatory? Can credit unions or brokers look elsewhere for insurance? And to what extent are the non-participating financial institutions freed of the myriad regulatory constraints which currently limit innovation?

      In a free market scenario, each insurance company will almost certainly set up its own “regulatory regime” according to its assessment of how certain types of behavior impact risk. This allows not only a competition between insurance companies, but also a competition between regulatory regimes.

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