Here we go Again…

I really do think free banking Austrians seriously need to stop attacking the Rothbardians and their thoughts on full reserve banking. Not because I am sympathetic to the Rothbardians (far from it) but it just that whenever free bankers do criticize the Rothbardians, we see the crowds of Rothbardians and their looney views on fractional reserve banking. Or if it is not this, they tend to grossly distort the free bankers. But what I find funny in that recent post by Salerno is this comment (linked in the previous sentence):

One more point: Both Rothbard and Krugman would have had a good belly laugh together over George’s peculiar notion that, in the absence of a central bank and government deposit insurance, a fractional-reserve banking system would be stable and flourish on a free market.

First off, Krugman would probably laugh more at Rothbardian theory than on George Selgin’s theory. Nevertheless, as much as Rothbard wanted to consider fractional reserve banking fraud or immoral, he did not leave out the possibility of a free banking system to be efficient in a free market environment. So contra to what Salerno states about Rothbard, Rothbard would probably not have laughed with Krugman at Selgin. For example, here is Rothbard (2002) on the Suffolk Bank*:

Despite the flaws and problems, the decentralized nature of the pre–Civil War banking system meant banks were free to experiment on their own with improving the banking system. The most successful such device was the creation of the Suffolk system… It is a fact, almost never recalled, that there once existed an American private bank that brought order and convenience to a myriad of privately issued bank notes. Further, this Suffolk Bank restrained the overissuance of these notes. In short, it was a private central bank that kept the other banks honest. As such, it made New England an island of monetary stability in an America contending with currency chaos (Rothbard 2002: 114-5).

The Suffolk ground rules from beginning (1825) to end (1858) were as follows: Each country bank had to maintain a permanent deposit of specie of at least $2,000 for the smallest bank, plus enough to redeem all its notes that Suffolk received. These gold and silver deposits did not have to be at Suffolk, as long as they were at some place convenient to Suffolk, so that the notes would not have to be sent home for redemption. But in practice, nearly all reserves were at Suffolk. (City banks had only to deposit a fixed amount, which decreased to $5,000 by 1835.) No interest was paid on any of these deposits. But, in exchange, the Suffolk began performing an invaluable service: It agreed to accept at par all the notes it received as deposits from other New England banks in the system, and credit the depositor banks’ accounts on the following day.

With the Suffolk acting as a “clearing bank,” accepting, sorting, and crediting bank notes, it was now possible for any New England bank to accept the notes of any other bank, however far away, and at face value. This drastically cut down on the time and inconvenience of applying to each bank separately for specie redemption. Moreover, the certainty spread that the notes of the Suffolk member banks would be valued at par: It spread at first among other bankers and then to the general public… How did the inflationist country banks react to this? Not very well, for as one could see the Suffolk system put limits on the amount of notes they could issue. They resented par redemption and detested systematic specie redemption because that forced them to stay honest. But country banks knew that any bank that did not play by the rules would be shunned by the banks that did (or at least see its notes accepted only at discount, and not in a very wide area, at that). All legal means to stop Suffolk failed: The Massachusetts Supreme Court upheld in 1827 Suffolk’s right to demand gold or silver for country bank notes, and the state legislature refused to charter a clearing bank run by country banks, probably rightly assuming that these banks would run much less strict operations… The biggest, most powerful weapon Suffolk had to keep stability was the power to grant membership into the system. It accepted only banks whose notes were sound. While Suffolk could not prevent a bad bank from inflating, denying it membership ensured that the notes would not enjoy wide circulation. And the member banks that were mismanaged could be stricken from the list of Suffolk-approved New England banks in good standing. This caused an offending bank’s notes to trade at a discount at once, even though the bank itself might be still redeeming its notes in specie. In another way, Suffolk exercised a stabilizing influence on the New England economy. It controlled the use of overdrafts in the system. When a member bank needed money, it could apply for an overdraft, that is, a portion of the excess reserves in the banking system. If Suffolk decided that a member bank’s loan policy was not conservative enough, it could refuse to sanction that bank’s application to borrow reserves at Suffolk. The denial of overdrafts to profligate banks thus forced those banks to keep their assets more liquid. (Few government central banks today have succeeded in that.) This is all the more remarkable when one considers that Suffolk—or any central bank—could have earned extra interest income by issuing overdrafts irresponsibly (Rothbard 2002: 117-8).

While it lasted, though, the Suffolk banking system showed that it is possible in a free-market system to have private banks competing to establish themselves as efficient, safe, and inexpensive clearinghouses limiting overissue of paper money (Rothbard 2002: 122).

* I already posted a comment some months ago here

References

Rothbard, Murray. 2002. History of Money and Banking in the United States. Auburn, AL: Ludwig von Mises Institute

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