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Sunday, May 19, 2013

Free Market Banking

Have you ever had too much money? I have. I once had so much money, that I had no idea what to do with all of it, so I went to my local bank to see if they would hold onto some of it for me. You know, keep it safe until I needed it for a large purchase. This should be a familiar sounding story for most people, yet the process by which banking truly takes place is extremely large and complex. The story of too much money, however, is exactly where banking starts. Banking is a result of the law of association. Its existence is based on specialization. When people build up a large store of wealth, they can either employ their own resources to protect that wealth, or they can seek out those who already have the necessary “set-up” to protect large amounts of money.

Originally, banking took place when people paid banking institutions a fee or some kind for protecting their stores of value. For our purposes, we will use gold as an example of a store of value. In any scenario, an individual would bring his or her gold to the bank and deposited it into a vault of some sort. The bank would then charge a fee large enough to cover all costs and still make a profit while remaining competitive. In exchange for the gold, the bank would issue units of promissory notes that reflected the amount of the gold he had stored. This note would state that at any time, the individual may come back and exchange the promissory notes for the gold he had stored in the bank. By this process, promissory notes make way for currencies. It is much easier to measure values in exchanges by using units of promissory notes instead of deciding the value of gold. They’re also much easier to carry around. As long as the bank kept their word, then the notes could be exchanged for other goods and services, and the party that ended up with the notes could return to the bank where the gold was stored and redeem the store of value.

Banks, then, have a very strong incentive to keep their word, and also to keep a 100% reserve storage of all of their customers’ valuables. This strict policy of honest banking, like any honest exchange, is kept alive by market competition. Banking institutions that don’t keep promises would go out of business, or at least lose business, overtime because customers would be willing to pay someone else for better service. Many banks, however, may be incentivized to cheat on their promissory notes by lending out a greater number of promissory notes than the given store of value that they held. In doing this, they have both stolen from the person whose store of wealth they promised to keep on hand, and they have committed fraud against the person who was lent promissory notes that may not be redeemable for the promised amount in the future.

Through the market process, however, competing banks with competing promissory notes would diminish the incentives to commit such crimes and inflate the supply of money. This is because not only can customers bring their gold to other banks, but competing banks could put rivals out of business by exposing their bad behavior and buying up a large amount of the promissory notes that the competitor has issued. In doing so, the competing bank could attempt to redeem said notes for the given amount of gold. If the rival bank was, indeed, issuing more notes than he had gold, he would be unable to give back enough gold to all of the people that he promised, and that bank would go out of business, and potentially be subject to the law.

Sadly, this is not the banking system that is utilized in America today. There is not market process to provide checks and balances to the operations of competing banks. Banks are not subject to the will of consumers, but rather to the will of the government and the Federal Reserve. When money is deposited into a bank today, there is no fee that is paid for the storage. In fact, in most cases the bank pays the customer a very small amount of interest. The money that is stored is not kept safe in a vault with the customer’s name on it; it is loaned out to others or used in various investment ventures. Granted, there is FDIC insurance, which allows for a portion of an individual’s deposits to be paid back were anything to happen to the bank, but this type of “insurance” comes with a heavy price: Inflation. Because banks do not see the same incentives to keep an honest store of value in the same way that they would in a free market banking, they may engage in riskier loans and investments. When these loans are unable to be paid at the same time as people come to redeem their deposits, banks (theoretically) would not be able to come through on all of their promises. Because of the Federal Reserve, banks can simply ask for an influx of cash from the central bank in order to fulfill their short-term obligations. This activity, coupled with the issuance of a multiplicity of promissory notes, leads to a severe increase in the supply of money over time. This drastic increase in money ultimately leads to inflation, and a decrease in the purchasing power of each unit of money.

 The only cure to such a disease is to allow people to bank freely, without force or coercion from the government or the Fed. Through the market process, competing currencies would once again emerge with a sound store of value, providing incentives to keep customers happy and keep dollars strong. Free the money... free the people.

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