Old Banking Myths
MAY 01, 1989 by HANS SENNHOLZ
Dr. Sennholz heads the Department of Economics at Grove City College in Pennsylvania. He is a noted writer and lecturer on monetary affairs,
Many banks and thrifts are tottering on the brink of bankruptcy. The deficit ,in the fund that insures deposits in savings institutions more than doubled last year, and continues to rise. Government action may well be needed again to sustain the structure. Even the future of mighty city banks is in doubt: billion-dollar loans have been made to third-world countries that have neither the ability nor the intention to repay.
To explain such ominous happenings in American finance is to search for the ideas that are guiding Americans in their financial matters. Ideas and images in men’s minds are the invisible powers that govern them. The financial structure, in disrepair and disrepute, is the logical outcome of financial thought that places legislators and regulators in the center of things. It rests on their wisdom and discretion, and relies primarily on political force rather than individual freedom. It is a precarious system that builds on government insurance and government guarantees and, in final analysis, depends on monopoly money and legal tender force. It is a discredited system that is inflicting immeasurable harm on many people.
To rebuild the financial structure is to identify and discard the features that discredit it, and to lay a new foundation. It is to explode the erroneous thought that permeates it, and to dispel old myths that guide it. It is to refute the fictions and fallacies that have created the banking myths, especially the following:
Myth 1: Banking is inherently unstable when left free and unhampered.
Although economists disagree on many things, most see eye to eye on their acceptance of political control over money and banking. Being accustomed to banking legislation and regulation, and addicted to a money monopoly and legal tender force, they rarely spare a thought for individual freedom in such matters. Most economists pin their hope on legislators and put their trust in regulators who are to safeguard the system.
The deep-seated aversion to individual freedom does not spring from any explicit theory that pinpoints the shortcomings of freedom, nor does it rest on any consistent school of banking thought that elaborates specific faults. It springs from intellectual lethargy and a long tradition of political control over money and banking. “We’ve had it so long. It’s the American way.” This is the most convenient, although rarely enunciated, justification for government control. These economists invariably point at American money and banking before the Civil War which, in their judgment, confirms their belief. In particular, they cite the “Free Banking Era” of 1838-1860 as a frightening example of turbulent banking and, therefore, applaud the legislation that strengthened the role of government.
In reality, the instability experienced during the Free Banking Era was not caused by anything inherent in banking, but resulted from extensive political intervention. At no time in American history has banking been free of onerous legislation and regulation. The “free banking” law, which New York State adopted in 1838 and many other states emulated thereafter, did not establish free banking; it merely ended the creation of banks by special charter. “Free banking” acts were little more than “incorporation acts” that invited applicants to seek charters from the administration rather than the legislature. They did not repeal burdensome statutory provisions and regulatory directives. In fact, they added a few, especially for note issues by these “free” banks.
“Free” bank notes were printed by the of-rices of the state comptrollers. To obtain these notes, a New York bank had to deposit with the comptroller an equivalent value of (1) U.S. Treasury obligations, state bonds, or bonds of other states approved by the comptroller, or (2) mortgages on improved real estate with a 50 percent or better equity. Severe restrictions curtailed the issue of mortgage notes, which limited their volume rather significantly. State bonds became the primary collateral for note issue. Most states and, eventually, the federal government (in the National Banking Act of 1863) emulated the system.
Many banks that failed during the “Free Banking Era” went to ruin when the states defaulted on their debts. Florida, Mississippi, Arkansas, and Indiana defaulted in 1841, followed by Illinois, Maryland, Michigan, Pennsylvania, and Louisiana in 1842. Mississippi, Arkansas, and Florida even repudiated their debt. The state governments continued their operations in debt default; the banks that were built on the obligations of those states lacked such a privilege.
State bonds were the major component of free bank portfolios, which exposed the banks to the ever-present risk of rising interest rates and declining state bond prices. When state governments suffered budgetary deficits, interest rates on state obligations tended to rise, which immediately cast doubt on the banks that carded the debt. State politics obviously played a major role in the life and death of a bank.
In several states with free-banking laws, the stated value of eligible government bonds exceeded their market value, which not only invited multiple credit expansion but also bred fraud and corruption. With government bonds selling at a discount, bankers could use them at face value, issue notes, then buy more discountbonds, and issue even more notes. For example, with government bonds selling at 80 percent of par, an unscrupulous operator could purchase a $I,000 bond for just $800, issue $1,000 worth of notes, purchase $1,250 in face-value bonds, issue another $1,250 worth of notes, buy more bonds and issue more notes, and finally acquire valuable assets, and abscond with them, in “wildcat banking” fashion. Obviously, law and regulation bred the scheme and led to instability.
When compared with many other countries, the total number of local banks in the U.S. became rather large, which points to yet another important source of bank disorder: the restriction of banks to unit size. Many states prohibited intrastate branch banking as well as banking across state lines, which prevented much diversification, and limited lending and borrowing to one location. Unit banking tied the solvency of a bank to the fortunes of the town in which it happened to be located, and to the commerce and industry that sustained the town. As a town prospered or decayed, so did the bank that served it.
Legislators and regulators further circumscribed banking with onerous charter requirements. To obtain a bank charter, an individual had to petition the state banking authority and, among other requirements, bring proof of a minimum capital of $10,000 or $20,000, or even $50,000, as was later required for national banks in communities with populations under 6,000, or $100,000 for national banks in larger cities. Most Americans with low incomes and little material wealth were barred from entering the banking business. The restrictions obviously kept the industry smaller than it otherwise would have been, and bred countless local banking monopolies, especially in rural communities. In most of their money and credit transactions the American people became dependent upon a local bank. In many a town in territories just opened up they depended on a single bank if there was one at all.
During the “Free Banking Era” the banks obviously were not free; they were curious combinations of public enterprise and special interest. No matter how free other industries may have been throughout this period, the principles of the market order never took hold in the fields of money and banking. Motivated by the popular hostility against money lenders and the age-old belief in the desirability of ever more money, politicians and officials carefully regulated all important aspects of money and banking and protected their charges from the full severity of commercial and civil law. In periods of financial crisis many states permitted banks to flout their contractual obligations, to suspend payment of specie, or resort to makeshift devices in order to avoid payment on demand. Such practices did not make for a sound and reliable banking system.
Myth 2: Banks tend to charge usurious rates of interest, contrary to the commands of charity, justice, and natural law.
The myth of banking instability receives strong support from the ancient usury doctrine, which led authorities to outlaw interest-taking altogether or at least to set maximum rates. In their zeal for preventing usurious interest-taking, many regulators set their maxima at levels far below free market rates, thereby curtailing lending or preventing it altogether. Banks, which seek to bring lenders and borrowers together, cannot serve them properly with government stipulating the rates. Usury laws are price-control laws; they disrupt markets, mislead production, cause shortages, and waste economic resources. Yet, they have been popular throughout the ages because moneylending was believed to have evil effects on the community. Even Adam Smith endorsed legislation that put a ceiling on interest rates. His contemporary, Jeremy Bentham, promptly took him to task in a famous essay, Defense of Usury, that made a strong plea for individual freedom in determining the terms of a loan.
Throughout U.S. history the states set usury ceilings to interest-taking. In many cases, especially at the frontier, they set maxima far below the rates that would have prevailed if there had been freedom. Consequently, capital markets were crippled and sound banking was hampered. The institutions that emerged kept their interest charges at or below the legal limit and, to remain profitable under given conditions, issued money substitutes in the form of unbacked notes. Circumscribed by usury legislation, they printed bank notes against which they maintained fractional reserves in legal money-silver or gold. Unfortunately, fractional reserves always are an invitation for disaster as soon as the note holders lose confidence in the solvency of the issuer.
Especially in the West, where the need for capital was enormous and the credit risk very great, the maximum rates of 6 to 10 percent as set by state laws constituted a severe impediment to the banking business. At the frontier the debtor’s risk component alone often amounted to a multiple of the ceiling rates, which made most lending clearly illogical. When market conditions call for rates of 10 to 20 percent while the usury rates are set at 6, 7, or 8 percent, most lending comes to a halt. As the courts endeavored to enforce the laws with fervor and severity, the banks were forced to choose between closing their doors or issuing unbacked notes at permissible rates of interest. Many chose to issue notes and face the risk inherent in unbacked issue and fractional reserves.
The precarious situation of American banking today springs from similar causes. The 1970s were years of accelerating inflation and soaring interest rates. Commercial banks welcomed the abundance of credit, which meant more bank loans and higher profits. Yet, in some states, lending ground to a halt as the market rates of interest reached usury levels and were barred from going higher. Under such conditions financial institutions readily placed their funds in other states and other countries without usury restrictions. A bank in Pennsylvania could freely place its funds in Mexico at market rates, but could not legally do so in Pennsylvania.
Many savings and loan associations are sharing the fate of the big city banks. Some can be charged with making poor loans; yet, most lived faithfully by the strictures of legislation and regulation, financing the construction and purchase of homes through mortgage loans. They, nevertheless, are in dire straits because inflation together with regulation is inflicting painful losses. Until 1981, legislation narrowly circumscribed the rates of interest they were permitted to pay their passbook depositors while inflation raised the market rates far above the permissible rates, which lifted them right out of the competition for funds. They lost many billions of dollars of deposits, which sought higher interest rates in money-market funds and other instruments. To survive the painful drain of savings and safeguard their liquidity, the thrifts then had to “purchase” funds through the sale of certificates at interest rates far above those earned on old mortgage loans. Compounding the difficulties, the market value of old loans fell precipitously as interest rates rose to new highs.
In turmoil and change the Depository Institutions Deregulation and Monetary Control Act of 1980 sought to give relief to the ailing industry. It relaxed some controls over banking and tightened others. It repealed old interest-rate legislation, which was playing havoc with banks and thrifts, it made monetary control more comprehensive and effective, and sought to solve the problem of declining membership in the Federal Reserve System. In particular, the law authorized banks and thrift institutions to offer interest on checking accounts starting at the beginning of 1981. It introduced so-called NOW accounts (negotiable order of withdrawal accounts), which were to make banks and thrifts more competitive with money market funds. Moreover, the law phased out Regulation Q, the ceiling on interest rates payable on time deposits, and set aside the usury ceilings that many states had imposed on mortgage loans as well as business and agricultural loans. The new freedom to pay market rates of interest was to give relief to a suffering industry. Unfortunately, it came too late for many institutions that had suffered so long in the vice of inflation and usury legislation.
Myth 3: Effective economic policy requires government control over banks.
In recent years the old doctrines of banking instability and usurious interest rates have found a new ally in the doctrine of government responsibility for full employment and economic growth. The old and the new have joined forces to deny freedom to banking and confirm government as a money monopolist and banking regulator. Government is held responsible for economic prosperity and full employment, and, therefore, is expected to direct, control, and manage the national economy through the Treasury, the central bank, and numerous other agencies. Yet, it is prevented from doing so effectively, we are told, if it lacks control over all issuers of money, in particular all banking institutions. Money balances must be concentrated in narrowly defined banks so that the total stock of money can be properly guarded and managed.
Most economists readily accept this dogma; they are convinced that legislators and officials must manage the people’s money. In the footsteps of John Maynard Keynes, mainstream economists hold government solely responsible for prosperity and full employment and, therefore, expect it to manipulate and fine-tune money and banking. Monetarists contend that government must increase the stock of money at a steady rate, in order to achieve economic stability and steady growth. And supply-siders call on monetary authorities to manage the people’s money, keeping an eye on gold. Only economists in the Austrian tradition reject all such notions as myths or fictions that contribute so much to the sorry state of banking today. They reject not only the popular acclaim of government control over the stock of money, but also the very foundation of the Keynesian structure, the “full-employment policy.”
More Regulation Ahead?
It is unlikely that the Austrian explanations and recommendations will prevail in the coming years of savings and loan disasters and banking crises. The doctrines of political power and wisdom in all matters of money and finance are deeply imbedded in the American frame of reference and discourse. This is why we must brace for more efforts at regulation. Surely, some controls may be relaxed as others are tightened, reacting continuously to an unsatisfactory state of affairs.
Politicians and regulators can be expected to lay the blame on the remaining margin of indi-vidual freedom however small it may be. They will seek to tighten the controls as the losses mount and the U.S. Government is called upon to honor its guarantees. Surely, he who pays the bill will want to have a say on how it may be incurred. This is why the federal government can be expected to tighten its grip on American banking and finance. And, once again, it may confirm the old observation that one government intervention tends to breed another and ultimately leads to all-round regimentation.
Yet, no matter how dark our financial future may look, individual freedom is alive and well in many other parts of the world. It bestows its largess to any country with the wisdom and courage to pursue it. Its light is shining brightly all over the world, visible to all who can see. Having suffered staggering losses and economic stagnation, and having tried every conceivable highway and byway of the political command system, we do not doubt that, in the end, we, too, will see the light again and make it our guiding beacon.
1. Paul Studenski and Herman E. Kroos, Financial History of the United States (New York: McGraw-Hill Book Co., 1952), p. 114; Bray Hammond, Banks and Politics in America (Princeton, N.J.: Princeton University Press, 1957), pp. 572-604; Major B. Foster, Raymond Rodgers, Jules I. Bogen, Marcus Nadler, Money and Banking, Fourth Edition (New York: Prentice-Hall, 1955), pp. 9798; Gerald C. Fisher, American Banking Structure (New York: Columbia University Press, 1968), p. 181; Charles L. Prather, Money and Banking, Sixth Edition (Homewoed, Ill.: Richard D. Irwin, 1957), p. 163 et seq.
2. Hugh Rockoff, The Free Banking Era: A Re-examination (New York: Arno Press, 1975), pp. 125-130; also Robert G. King, “On the Economics of Private Money,” Journal of Monetary Eeo-nomics, July 1983, pp. 127- 158.
3. Arthur J. Rolnick and Wanda E. Weber, “The Causes of Free Bank Failures_’ A Detailed Examination,” Journal of Monetary Economics, October 1984, pp. 267-291; also “New Evidence on the Free Banking Era,” American Economic Review, December 1983, pp. 1080-91.
5. Lawrence White points at the Scottish free banking system (1727-1844) as an example of a sounder system. Individual freedom and unlimited banker liability gave rise to a banking system that did not suffer from panic-induced runs. Cf. Free Banking in Britain: Theory. Experience, and Debate. 1800-1845 (Cambridge: Cambridge University Press, 1984).
8. It was also more profitable and convenient to place a few big loam with a few borrowers than to make many small loans to numerous borrowers. The big city banks in the money centers showered their favors on foreign governments all over the world. Eager to make friends and win allies, the U.S. Government encouraged and guided them every step of the way.