michaeld. bordo and anna j. - cato institute. bordo and anna j. schwartz ... be denied the right...

THE PERFORMANCE AND STABILITY OFBANKING SYSTEMS UNDER “SELF-

REGULATION”: THEORY AND EVIDENCE

Michael D. Bordo and Anna J. Schwartz

Recent literature thatmakes thecase for the elinunationof govern-ment regulation of a banking system rests on a variety of theoreticalpropositions. Each of these propositions, addressing the questionwhether self-regulation by. banks will set an external limit on theirissues, reaches an affirmative conclusion. We propose to test thecogency of three of these propositions and to examine the validity ofthe empirical evidence that has been adduced as confirmation of thetheory. The three propositions are:

1. The operation ofan interbankclearing mechanism checksoveris-sue by individual banks and, in some versions of the theory, bythe system as a whole.

2. Private issuers in a competitive system have incentives to estab-lish confidence in the value of the moneys they produce andtherefore limit the quantities they can safely emit.

3. Restrictionofdiscounting by banks to real bills limitsthe quantityof money they issue,

Those propositions do not define whether government retains arole as an issuer of outside money. They relate only to whethergovernment should intervene in the provision of inside money byprivate sector banking institutions. The empirical evidence that bearson the propositions wehere consideris drawn from monetary systemsin which banks were regulated in a variety of ways and in whichoutside money of specie was supplemented by government-controlledflat-money elements. The performance of thebanks in those systems

CatoJoumal,VoL 14, No.3 (Winter1995).Copyright ©Cato Institute. All rightsreserved.Michael D. Bordo Is Psofessor of Economics at Rutgers University and a Research

Associate of the National Bureau of Economic Research. Anna J. Schwartz is a ResearchAssociate of the National Bureau of Economic Research.

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cannot be evaluated asreflecüngsolely theparticular theoreticalprop-osition the evidence is supposed to support. The performance isobviously also related to the existing regulations and inside money-convertibility requirement. it is therefore not easy to sort out thecontribution of the theoretical proposition.

In any event, proposing a rationale for eliminating governmentintervention in the provision of inside money does not adequatelydefine a monetary system. It is essential in addition to discuss theconditions for the provision of outside money. In our view, a morefundamental question than whether government intervention in theprovision of inside money is desirable is whether the institutionalarrangements for theprovision of outside money produce a relativelystable monetary environment. Aprerequisite ofgood performance byabanking system is such an environment thatonly the outside moneyarrangements can assure.

The paperproceeds as follows. Webeginby discussing inside moneyin the first three sections, whichin turn presenteach ofthe theoreticalpropositions and the supporting evidence. We find the theories to beflawed and the evidence unconvincing. In the fourth section, wesuggest an alternative approach to “self-regulation” that would freebanks to establish offices where they chose, to pay whatever interestwasrequiredto obtainfunds, and to acquire assets yielding thehighestreturn as they judged it. The alternative approach is based on twoprinciples: first, the system is so designed that risk is borne by ownersandmanagers, not by moneyholders and taxpayers; second, theprovi-sion of outside money produces a stable monetary environment. Ina stable monetary environment, price level stability prevails. As aresult, if banks make mistakes in acquiring assets, the mistakes areattributable to faulty credit analysis, not to price level or inflationsurprises. Available historical evidence can be cited in support of theapproach only in the negative sense that the evidence violates one orthe other principle. In the fifth section,we discuss the current world-wide flat-outside-money regimes, and ask whether they can be cons-trainedto limit theoutsidemoneythey supply.Wetake for grantedthatoutside-money arrangements willremain in thehandsofgovernments.Provisionofoutside money by government raisesthe questionwhetherit should exercise the role oflender oflast resort. We do not, however,deal with that question. The final section summarizes ourconclusions.

The Clearing MechanismTheory

Adam Smith was among the first to propound the doctrine that aclearinghouse provides an automatic mechanism of adverse clearings

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thatservesto regulatethe issues of its members. Originally thedoctrineapplied to note issues,butlater it applied to theclearing ofbothnotesand deposits. The doctrine is a prominent feature of recent advocacyof a self-regulated banking system.

The essentials of the process bywhich a deposit in one bank leadsto an expansion of the aggregate money supply as a multiple of thereserves that banks maintain were also understood early on and havebeenrestatedin therecent literature. Under theclearingmechanism,a bank that increased its issues disproportionately to those of otherbanks wouldexperience a drain of its reserves. Itwould findbalancesrunning against it at the clearinghouse and be forced to contract.The mechanism thus provides a check to individual bank overissue.Advocates stress the importance of frequent clearing of notes andchecks as means to prevent overissue. In the main, however, neitherthe early writers on the subject nor more recent ones have under-stood that a clearinghouse provides no check if all banks expandsimultaneously.

The theory ofthe banking firm underlying the clearinghouse para-digm is based on a set of fixed coefficients, of which the reserve ratiois the one most ofteti cited. For a dollar of additional deposits in aparticularbank, the fixed reservemultiplier defines the extent towhichthe aggregate money supply increases. A set of fixed coefficients,however, does not illuminate the role ofmarket conditionslike interestrates anduncertainty that affects the holding of reserves. The theoryof clearinghouses as regulators of bank issues is thus derived from arudimentary level of analysis.

The chief ermr of the clearinghouse paradigm is to infer that thelimits to expansion to which an individual bank is subject apply also tothe banking system as a whole acting in unison. Lawrence H. White(1984: 1.7) does not make this error, noting that adverse clearings willnot arise amongagroup ofbanks sharing a common expansion. GeorgeSelgin (1988: 80) attempts to respond to this criticism of the effective-ness of a dearing arrangement as a method of controlling the supplyof money by arguing that “spontaneous in-concert expansions will beself-correcting” because the growth in total clearings will increase thevariance of clearing debits and credits.’ Banks in his view will protectthemselves againstthe risk ofdefault at theclearinghouse atanyclearingsession, leading to a unique equilibrium supply of inside money.

‘Yet In discussing Australian experience, SelgIn (1988: 50) notes that “prices were fairlystable, and the principleof adverse clearings insured that no single bank could step out of.line with Its competitors. Ifbychance the entire system went out ofline, adjustment wouldcome as a consequence of gold losses abroad.” He here ignores his own dictum of self-correcting in-concert expansions.

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Clearinghouses were formedto minimize the costs ofnote exchangeand checkclearing but in timeacquired amonitoring and supervisoryrole in the banking industry.The clearinghouse in that aspect providedself-regulation for the industry. Membership in a clearinghouseattested to theadequacyofabank’s capital. Audits bythe clearinghousewhich also required the banks to publish statements of conditionsupplemented the regulatory demands of government supervisors.Most of the recent discussion of the role of clearinghouses does not

emphasize their direct supervisory activities in enforcing limits onoverissue by member banks and thus creating monetary confidencebut rather concentrates on the restraint imposed by adverse clearings.One commentary, however, links clearinghouse monitoring of theproduct quality of demand deposits that served also to control thebehavior of bank managers to the information-related disadvantagesof checks (Gorton and Mullineaux 1987: 458—60).

EvidericeThe principle of clearing means of payment was known and

employed even in ancient times but the modern clearinghouse datesfrom 1760 in Edinburgh, followed by London in 1773, and decadeslater in other European cities. In the United States, the first clearing-house was established in New York in 1853 and in five other citiesbefore the outbreak of the Civil War.

The evidence most often cited in support of the significance ofclearing and redemption systems in controlling the aggregate moneysupply includes theperformance ofthe Scottish banking system before1845, the First and Second Banks of the United States, the SuffolkBank in Massachusetts, and Canadian clearing arrangements (Dowd1989). We comment on each of these exemplars in turn.

Scottish Banks. Except for three chartered institutions, Scottishbanks from 1749 operatedaspartnerships, under individual ownershipor as unregistered joint stock companies, enjoying freedom of noteissue (except for the prohibition of small notes after 1829) with theowners subject to unlimited liability for the institutions’ debts. TheBank Act of 1844 in England ended freedom of issue in Scotland forall but the nine banks in existence at that date. A new bank wouldbe denied the right of note issue, but an existing note-issuing bankcould exceed its authorized circulationif collateralized by 100percentmarginal specie reserves.

The operation of the Scottish system has been adjudged a successrelative to that of the English banldng system, where the Bank ofEngland possessedcertain monopoly privileges, andlimits on thesizeof other banks were legislated.

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In accounting for the “outstanding success of the Scottish free-banking system,” Roland Vaubel (1984:61),a sympathetic commenta-tor, mentions freedom of entry, absence of limited liability, and nolimits on the size of banks. He does not refer to the operation of theclearing system, a significant omission that implies it had no impor-tance, White, another sympathetic commentator, treats the clearingarrangements as “self-policing” in that dearing losses restrain anindividual bank from expandingfaster than the average. In discussingthe restraint on the banking system as a whole, however, he stressesnot the clearinghouse but the role of internal and external reservedrains that guaranteed convertibility of notes into specie effected(White 1984: 1—22). The Scottish experience therefore is inconclusiveon the role of the clearing arrangements in limiting expansion by thesystem as a whole,

First and Second Banks of the United States. Both the First Bank(1791—1811) and the Second Bank (1816—36) promptly presentedstate banknotes for redemption and served to that extent as clearing-houses that regulated the currency, although in their own operationstheir performancewas not invariably above reproach. Statistics on theoperation of the First Bank do not exist, but it apparently extendedpermanent loans to individuals and banks (Holdsworth 1910: 124).

The Second Bank was mismanaged before 1819 when WesternandSouthern branches overissued their notes, which were redeemable inthe East, until redeemability of all notes at all branches was discon-tinued (Schweikart 1991: 607—18). After that date, under NicholasBiddle’s tutelage, the Second Bank created a uniform currency byforcing the redemption of state bank notes (Fraas 1974). It thenexpanded rapidly in 1828—31 and subsequently, with Jackson’s vetoof its charter and the removal of Treasury deposits, it was forcedto contract.

The Suffolk Bank. Founded in Boston in 1818 as an ordinary bankof issue and deposit, its management decided a year later to redeemcountry bank notes itpurchased at a discount from merchants, indi-viduals, and other banks. It allowed the issuing banks to purchasetheir notes from the Suffolk at the same discount, provided theymade permanent deposits in the Suffolk of $5,000 plus additionaldeposits to covernotes redeemed. Discounted notesof anon-partici-pating bank were immediately returned for redemption at par. Thearrangement proved to be unprofitable for the Suffolk since appar-ently investment ofthepermanent deposits provided the only sourceof net income.

In 1825 the bank modified the arrangement by establishing aninterest-free fund of $300,000 assessed on the Associated Banks in

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proportion to their capital, paid in the notes of the participants, withthe Suffolk as their agent. The aim was to reduce the size of thediscount on notes. Within ayear, notes of the banks in good standingwere accepted at par at the Suffolk. Individual bank behavior wassubject to control by the Suffolk, which could suspend or expel abank if its permanent deposit were eroded by excessive note issues(Mullineaux 1987: 888—921),

We observe thatalthough theSuffolkbankunquestionablyprovideda check on overissue by an individual bank, the evidence of its totalannual redemptions from 1834 to 1857 contradicts the theory of “self-correcting in-concert expansions.” Not only is there a clear upwardtrend in the figures, rising from $76 million in 1834 to $376 millionin 1857, in linewithagrowing banking industry, but in addition everycyclical upturn and downturn in the period is registered in the timeseries (Dewey 1910: 89). The Suffolk system was no bulwark againstinstability in the monetary system.

CanadianClearing Arrangement. Afterconfederation in 1867, Can-adapermitted branchbanking andauthorized charteredbanks to issuenotes equal to their paid-in capital, but required them by law toestablish redemption agencies at the main city in each of the thenseven provinces and elsewhere as determined by the Department ofFinance. The chartered banks exchanged notes daily at dearinghousesIn each ofthe larger cities andtheirbranchesat other centers. Balanceswere paid in Dominion notes, a government-issued currency, or indrafts on commercialcenters. Chartered bank notes circulated at par.Legal tender was either Dominion notes or gold. Some bank failuresoccurred, but in 1907, unlike the panic in the United States, norestrictionof payments tookplace in Canada, despite a currency drain,For that reason, in 1908, the limit on note issue was raised to 115percent of paid-in capital during the crop moving season (Schuler1992: 88).

It is not obvious, however, that the clearing arrangement ratherthan branchbanking, competitive note issue, or convertibility contrib-uted most to the good record of Canadian banks before 1914. Afterthat year the Department of Finance acted as a quasi-central bank,and in 1935, the Bank of Canadawas established (Bordo and Redish1987: 402—06).

Private Competitive Note Issue

TheoryThis is an argument against the classical view that unregulated

competition in the supply offiduciary money would lead to overissue,

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the destruction ofits value, and an infinite price level. True, as arguedin the classical view, if different private money producers offeredindistinguishable homogeneous monies, convertible into one anotherat fixed exchange rates, overissue would be possible. For competitiveproduction of flduciaiymoney, however, according to the recent view,output differentiated by brand names is essential. By relying on thebrand name attached to each producer’s money, consumers canacquire information about the quality of the monetary service flowfrom each one, The brand name is not only information for theconsumer but capital for the producer (Klein 1974: 431—35).

When monies are differentiatedby issuer, andeach is valued relativeto competing monies at flexible exchange rates, overissue by a singleproducer might gain him a short-termprofit, butat a cost of clisinvest-ment in the producer’s brand-name capital. A decision by a producerof money to overissue would be at the expense of his long-run profitin making hisproduct acceptable to the market. Acompetitive moneyproducer creates confidence in his product by limiting its issue.

Flexible exchange rates among private competing monies may bea condition of a system with flat outside money, not of a systemwith commodity-based outside money. If one assumes the latter, ina contemporary setting, would competitive bank notes trade at dis-counts in cities distant from the place of issue, given low moderncommunications andtransportation costs? The conclusion reached byLawrence H. White (1989: 372) is that nowadays, in a competitivesystem with unrestricted branch banking, all banks would be drivento accept one another’s liabilities at par. They would do so either toprofit from replacing. rivals’ notes with their own or to enhance thedemand for liabilities of all banks thanks to par acceptance.The checkon overissue would be the adverse clearing mechanism.

Richard Cooper (1989: 393—94), however, finds this scenarioimplausible. Heaskswhethe~’governmentwould not inevitably intrudein ahypothetical private competitive banldng system ifonly to decidewhich bank notes it would accept in payment for taxes, and which itwould use in making its own payments. If the government set highstandards for bankswhose notes it wouldaccept or use, ease of entryand free banking would become limited.

Evidence

Althoughselected episodesof historicalexperience havebeenInter-preted by some observers as representing flexible exchange ratesbetween competing monies, the author of the theory (Klein 1974)finds that conclusion dubious when he discusses historical examples.The reason is that in these examples competing monies were all

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convertible on demand into a single outside money that served as theunit of account and in factwere closer to internal fixed exchange ratemonetary arrangements than to internal flexible rates. The historicalevidence suggests that such arrangements arose to minimize moneychanging and valuation costs (that is, transaction and informationcosts) of competitive independent monies.

In a recent study Kurt Schuler (1992) identifies about60 historicalcases of what he defines as competing free banks, which lasted froma few years to over a century. Free-banking systems included manythatwere regulated and a dozen or so thatwere not. The absence ofacentral bankwas the criticalfactor in determining whetherabankingsystem qualified as one with competing free banks. Many such caseswere colonial possessions of European imperial powers, The studydoesnot examine whether flexible exchange rates between thecompet-ing monies were a feature of the historical cases.

The literature on competing banks focuses on their performanceas note issuers, in part reflecting the historical period when bankliabilities were predominantly notes. The main reason for this focus,however, is theemphasis in the literature on the malignconsequencesof the monopoly of note issue by central banks. The examples areintended to convince readers that the record of competing banks asnote issuers was beneficent and that competitive banking systemswithout central banks in today’s economies would be superior toexisting monetary arrangements.

Wereportexamplesofcompetitive monies thatare commonly cited,beginning with evidence for colonial Americaand the United States,then for the United Kingdom and Europe, and for East Asia andOceania. The questions that need tobe answered include the follow-ing: Were the banks self-regulated? Were they competitive? Wasoverissue avoided? Did macroeconomic stability prevail?

The United StatesNewEnglandColonial Issues.Bills ofcredit issuedby theMassachu-

setts, Connecticut, Rhode Island, and New Hampshire colonies inthe first half of the 18th century were accepted at par under anarrangement with the other New England colonies in payment oftaxes and in general exchange, stimulating overissue. As a result, thepaper monies of the New England colonies experienced a greaterdepreciation than those ofthe middle colonies, where issues of differ-ent colonies (inthe absence ofthe type of arrangementthatprevailedin New England) circulated domestically at flexible exchange rates.New England government issues with fixed exchange rates amongthem is consistent with the theory of theconditions for their overissue.

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Merchants petitioned Parliamentagainst thecolonial government billsofcredit. Their issue in the four New England colonieswas prohibitedin 1751.

Various land bank schemes were also projected in the colonies,some under private, and others under government sponsorship. Theland bank private experiments survived at most for a year, suppressedeither by the colonial or British legislature. Public land banks wereorganized in 12 of the 13 colonies, issuing notes on the security ofland. When the size of the loans made was limited, and their termfixed, overissue was not a problem—the famous example of RhodeIsland to the contrary notwithstanding.

State Chartered BankIng, 1790—1816. Competitive charteredbanksexisted in the states, issuing their ownnotes. Their unimpressive recordhas been analyzed as a failure,not ofprivate currency competition, butofstate interference with thebanks’ production andpricing decisions,“since they [the states] hada financial interest in their expansion evenat the price of inflation and irredeemability” (Vaubel 1984: 67). Thestates are also heldresponsible for their failure “to provide an adequatelegal framework for the competitive part of the process: to ensureinformation, to enforce contracts, and to prevent or prosecute fraud.”These criticisms seem to imply a need for regulation of banks, rein-forced by the critic’s statements of approval for annual examinationsof banks by state-appointed regulators.

Free-Banking Era. So-called free-banking laws in New York (1838)and Michigan (1837) permitted free entry—a requirement for a com-petitive system—but enforced capital requirements, specie-reserverequirements, and state bonds as security for note issues—forms ofregulation. Sixteen other states followed suit, but in only eight werefree banks established. Distinguishable bank notes circulated at vary-ingdiscounts from par determined by their distance from citieswheretheywere presentedfor redemption. Merchants andbrokers acceptedthe notes at these discounts.

The literature on free banks beforeWorld War II portrayed themas wildcatters. Recent studies find the earlier reports of wildcattingexaggerated, the losses noteholders experienced minimal, and conta-gious runs on banks limited in extent (Rockoff 1975; Rolnick andWeber1983: 1080—91; 1984:267—91; Schweikart 1991:621—23).Somestate free banks were successful; many were not, and failure rateswere considerably higher in free bank than in non-free bank states(Kahn 1985: 883). Free banks failed either because of capital losseson the bonds in their portfolios that depreciated with unstable statefinances, possibly because the banks’ performance was imprudent(Rockoff 1991: 73—109).

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Yet the demise of state free banking had nothing to do with adecline in market demand for those banks. The end came becauseof the enactment of a national banking system authorized to issuenotes backedby federal bonds, and ofa prohibitive tax, effective July1866, on state bank notes.

Because most state bank notes did not fluctuate widely in terms ofone another and in terms of specie, andbecause inconvertible notes,no matter how large the discount, were unacceptable in transactions,one commentator (Klein 1974: 440) reached a skeptical conclusionon the significance of this episode: “Monetary arrangements duringthe 19th century free-bankingerawere muchcloser to multiple moniescirculatingat fixed exchange rates than to multiple monies circulatingat flexible rates.”

A different question concerns the assumption that free bankslowered barriers to entry in the U.S. banking industry. The numberof banks after their introduction in states with free-banking lawswas either unchanged or declined (Ng 1988: 877—89). Hence thecompetitive banking paradigmlacks confirmation on this score aswellas with respect to the observation of flexible exchange rates amongcompeting monies.

In any event, the free-bankingera did not coincide with economicstability in the United States. It coincided with the disturbance to themonetary system produced bythe great gold discoveries in Californiain 1848 andsubsequently in Eastern Australia and elsewhere(Rockoff1991:77). Even so, thebimetallic standard thenprevailing mighthaveproduced a stabler and slower rate of monetary growth than wouldhave been the caseunder a flat-money system. Whether the historicalrecord of state free banks lends support to the case for the adoptionof free banking now is not easy to sort out,

The United Kingdom and Europe

Free Banking In Scotland before 1845. The Scottish competitivenote issue has been discussed above to assess the contribution thatclearing arrangements made to what has been described as a centuryof stable free banldng that ended with the Bank Charter Act of 1844and the Act of 1845, which, as noted, restricted Scottish note issue.Here we examine the episode to determine if it conforms to anessentially unregulated free-market monetary system. The episodeclearly does not conform to the theory of flexible exchange ratesamong distinctive monies, since Scottish bank notes circulated atpar, with no variations in their market value reflecting differences inperceived qualities.

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Other features of the Scottish system have also been interpretedas deviations from a free-market system. Limited liability charterswere restricted to three banks, and all other banks operated withunlimited liability. The impact of unlimited liability on free bankingas acompetitive system is an unresolved issue, Unlimitedliability maybe a barrier to entry and a limit on the size of firms, since access toorganized capital markets is a benefit of limited liability (Carr andMathewson 1988: 766—84). However, the chartered banks had nocompetitive edge in note issue or intermediation, andnote exchangeamong the provincial banks emerged before the chartered banksdecided to jointhe system (L.H. White 1991: 19).

Even the role of thenote exchange systemhas aroused controversy,since free-bank advocates imply that all note issuers benefit from itand should therefore have voluntarily joined. But some did not, andthe larger banks exercised market power to compel their membership(Munn 1985: 341—43).

Another subject of debate has been the interpretation of the com-parative failure rate of Scottish and English banks. Seventeen bankswent out of business during the 100 years ofthe Scottish free-bankingperiod endingin 1844, afailure rateone-quarter that ofEnglishbanks,and losses to note holders and depositors were less than halfthat ofbanks in the London areaalone. For subsets ofthe century, however,the Scottish failure rate was not invariably lower than the Englishfailure rate (Sechrest1988:251—52). Low failure rates themselveshavebeen challenged as unacceptable indicators of superior performance(Rothbard 1988: 230). The prohibition of adequately capitalized anddiversified joint stock banks presumably was responsible for theEnglish system’s instability. Was the failure rateof Scottish free bankswith no limits onthe number of partners proofof greater stability offree banks than regulated banks, or merely a reflection of the impor-tance of adequate capitalization?

Also in dispute is the possible dependence of the Scottish bankson the London money market. Each of the banks is said to have heldits own specie reserves, but, as has been suggested, in periods ofstringency did the chartered banks act as lenders oflast resort to theprovincial banks and did the chartered banks in turn look to theLondon moneymarket and the Bank of England for support? (Good-hart 1987: 129—31). Cases of borrowing from the Bank of Englandby Scottish provincial and chartered banks do not, however, appearin bank archives (Munn 1991: 64)’

Finally, doubtsare raised aboutclaimsfor the superior performanceof Scottish banks by instances of absence of full convertibilityof theirnote issues, even after the Act of 1765 denied the legality of option

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clauses and affirmed redeemabiity on demand. One commentatorregards imperfect convertibility as limiting the banks’ costs and dan-gers and thus promoting the success of Scottish banking (Checidand1975: 186). Alternatively, deferring redemption until a future datemay be indicative of the system’s weakness.

The upshot of the debate on the Scottish banks is that the extentto which they were a model of a private, competitive, unregulated,and independent system remains unsettled. Convertibility of notesinto specie, the unlimited liability of theowners ofbanks, whobecamepersonally liable for their issues, and the familiarity of note holderswith the private means and standing in the community of the ownersseem to have been factors accounting for the relative stability of theScottish competitive banks before 1845.

Free Banking in France, 1790—92, and 1797—1806. Two experi-ments in free banking occurred In France. The first was a satellite ofgovernment-issued assignats, printed only in large denominations andthat drove coin from circulation. So-called caisses patriotiques wereestablished by towns, merchants, manufacturers as well as bankersto exchange assignats for small-denomination notes. Originally 100percent reservebanks thatchargedasmall transaction fee, in time theybecame fractional reserve banks that operated without governmentregulation, engaging in discounting commercialbills. Charges ofcoun-terfeiting andexcessive issues of the notes—known as billets de confi-ance—have not beensubstantiated, but attacks in the press, the refusalof some government tax collectors to accept the notes, and a NationalAssembly proposal that the caisses deposit their reserves with localauthorities undermined the confidence ofthenoteholders, whostageda run on the banks. On November 8, 1792, the Assembly voted toclose the caisses by the end of the year. Few needed governmenthelp to redeem their notes. Although inflation was generated not byoverissue of billets de conflance but of assignats, the revolutionariesadoptedpricecontrols to contain it, closed thebourse, andprohibitedtrade in specie. By mid-1793, the Reign of Terror ended most privatebanking (E. White 1991: 131—39).

The revolution’s original espousalof free enterprise was revived bythe Directory,which repealed anti-banldng laws in 1796. New banksof issue were soon established, the structure of the system much likethatof thecaisses patriotiques—two or three dominant banks in Paris,accounting for a large fraction of all notes issued, and other relativelysmallbanksboth in Paris and the provinces. The largebanksredeemedtheir high denomination notes in silver or gold coin, while the smallbanks redeemed their small note issues in copper coin. As in theU.S. free-banking era, issues of the small banks circulated at small

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discounts. Competition prevailed,withno widespread failures orcoun-terfeiting. A defalcation at a large bank in October 1798 threatenedits solvency, but the Treasury offered .a loan, shareholders depositedcoin to guarantee the bank’s liabilities, and a run was avoided.

Shortly after Napoleon seized power in 1799,he establishedabankto serve his purposes, the Banque de France. The large banks in Pariswere forced to convert their shares to shares of the Banque and thesmall bankswere dissolved; in 1803 the Banque obtainedthe exclusiveprivilege of note issue for 15 years in Paris. The circulation of theprovincial banks was relatively slight. At Napoleon’s insistence thebimetallic standard was reestablished in 1803, which constrained therevenue the government could raise from money creation. In 1806he appointed his choices for governor and deputies, increased thebank’s capital, andextended to 25 years its monopolyof issue in Paris.It lost its monopoly from 1815 to 1848 and had to compete withprivate banks of issue in the provinces. These were regulated bankswhose notes were restricted to the provinces in which they operated.In 1848, however, the Banque de France became the exclusive issuerof notes in France (E. White 1991: 139—44),

Competitive Banking In SwItzerland, 1825—91. Until the NationalBank of Switzerland was establishedin 1905, after 25 years of debate,and given a monopoly of note issue, as many as 36 provincial state-incorporated banks and private bankers had engaged in the note-issuing business—the first one in 1826, according to one source, in1834, according to another, who does not refer to an earlier cantonalbank (Weber 1988: 461—62; Landmann 1910: 9). The notes initiallycirculated only locally at varying discounts. Few currency issuersdefaulted before 1850. Freedom of entry existed even after uniformreserve requirements were imposed in 1881. Notes thereafter werelimited to doubletheamount of share capital, andbankswere requiredto accept in payment at full value their own as well as other banks’notes (Landmann 1910: 9—63, 204—38). The Swiss banks, it has beenargued, depended on Paris in times ofstringency, much as theScottishbanks before 1845 are said to have depended on the London moneymarket and the Bank of England (Goodhart 1987: 131).

Competitive Banking In Sweden before 1897. The Riksbank, inexistence since 1656, remained as the only bank in Sweden in the1820s, following the bankruptcies of private banks in the precedingdecade. In 1824 privately owned and operated partnerships withunlimited liability were authorized by royal proclamation andin 1830the first such note-issuing bank was chartered, Many others followedeven though usury laws limited their access to funds. In the 1860s,usury laws were repealed, and joint stock banks were authorized but

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denied the right of note issue. Private bank notes competed with theRiksbank issues until 1897 when the bank obtained a monopoly ofnote issues. Private note issueswere prohibited andceased to circulatein 1903. The Swedish banking systemwas stable, both types of privatebanks and the Riksbank itself never having been subject to runs orfailures. The gold standard and unlimited liability of the private bankissuers promoted, according to Lars Jonung (1984: 363—65), stablenote issue policies.

Competitive versus Monopoly Issue in Italy. Proponents ofcompeti-tion in note issue were ascendant when Italy was unified in 1861, atwhich date nine bankswere in existenceandvarious firms and individu-als also printed notes. This practice ended in 1874. In 1893 one ofthe nine banks failed and two others merged, leaving three banks,according to a law of 1894, with the right of issue. Until 1926 thiswas the extent of competition. It ended with the victory of the Bankof Italy as the sole bankwith the right of issue (Fratianni and Spinelli1984: 408—09).

East Asia and Oceania

Paper Money in Chinafrom the 9th to the 20th CenturIes. Papermoney circulated in China from the 9th century onward, but appar-ently the issues were made not ‘by private firms but by the rulers ofChina, who initially maintained reserves of copper cash, and wereobligated by law to redeem the emissions triennially. Wars led tooverissue, depreciation, and eventually repudiation. By 1567 papermoney had ceased to circulate.

During the first years of the reign of the Manchus beginning in1644, some treasury bills were issued. Otherwise the Manchus issuedno papermoney until 1852. During the Taiping Rebellion that beganthat year note issue expanded until it depreciated andbecame value-less. The government then left note issue to private and provincialbanks. These were notablysuccessful in Foochow, thecapital ofFukienprovince, and in other cities, where unregulated local banks issuednotes redeemable in copper cash. Notes of larger banks circulated atpar, and only 1 large bank of 45 in existence at the conclusion ofthe episode failed. Failures of smaller banks, however, were morenumerous (Selgin 1988: 7—8).

After the Republican revolution of 1911, the new central govern-ment favored “modern style” banks, which had given it financialsupport. These banks issued silver-based notes. When the National-ists gained power in 1927, they prohibited the issue of coppernotes (Selgin 1988: 7—8). Kann (1937: 366—68) reports that overissue

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occurred in the provinces during the first three decades of the20th century.

A recent study presents evidence that inside money in Chinaexpanded during the years after 1930 while the price level declinedand industrial output rose. Despite numerous bank failures, banksby and large maintained convertibility of their liabilities into silver.Although the government had full or partial ownership of three ofthe largest banks, there was nocentral bank with amonopolyof bankissues. Other banks possessed the right of issue on the same termsas the largest government-owned bank. Bank notes were backed by100 percent reserves of silver, gold, foreignexchange, andgovernmentsecurities. There were no reserve requirements for deposits. Adher-ence to a silver standard in China before November 1935 when acentral bank was establishedis interpreted as a decision ofthe privatebanks that operated according to real bills rules. The private bankson this view exemplified free banking under a commodity standard(Brandt and Sargent 1989: 34—38).

In November 1935 the notes of the three largest modern bankswere given legal tender status. The Nationalist governmentmonetizedits deficits, and the currencybecame flat.

Competitive Note Issue In Japan. From the middle of the 16thcentury onward, feudal lords, merchants, and private cooperativesissued notes. In 1882, when the Bank ofJapan became themonopolyissuer, private issues ceased. The record of the success of privateissuers inmaintaining thevalue oftheir noteshas not been established(Vaubel 1984: 69).

Competitive NoteIssue In Hong Kong. Most Hong Kongnotes wereissues of four charteredprivate banks, with government issues limitedto one-dollar and subsidiary denominations amounting to less than10 percent of total issues. The private banks are regulated, and thetotal authorized issue requires 100 percent reserves of foreignexchange. Excess issues must be covered by certificates of indebted-ness of the Hong Kong Government Exchange Fund.

Australia before World War I. Until 1910 several note-issuingbankssettled clearing balances with each other in specie. Alaw thenauthorized the issue of Australian government legal-tender notes,and in 1911 theCommonwealth Bank was establishedto act as agentin issuing these notes. A prohibitive 10-percent tax on all privatebank note issues was imposed and restrictions on the issue of legal-tendernotes were relaxed. In September 1914, when the governmentdeclaredagoldembargo, the private banks stoppedsettling balancesat the clearinghouse in specie. Thereafter they settled balances inthe notes of the monopoly bank of issue (Copland 1920: 490—91).

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ConclusionA summaryof the evidence on private competitivebanking covering

many geographical areas and past monetary systems is difficult. Thebanks were regulatedin a variety of ways. Outside money wasusuallyspecie supplemented bygovernment fiat-money elements. Aconvert-ibility requirement existed. We cannot be sure thatwhatever successprivate competitive banks achieved at different times and places con-firms the theory that self-regulation limits overissue.

The Real-Bills Doctrine

TheoryThe doctrine maintains that a banking system that confines its

lendingto discounting short-term self-liquidating commercial bills ofexchange arising from real transactions in goods and services—theproductive use as opposed to the speculative use of credit—cannotoverissue.

Adam Smith was among the first to uphold the real-bills doctrine,although he also insistedon subjecting banks to the legal requirementto convert their notes on demandinto specie. Lateradherents includedthe antibullionists who absolved the Bank of England of the chargeof overissue during the Napoleonic period when convertibility ofits notes into specie was suspended. They argued that, even wheninconvertible, overissue of notes was impossible if theywere emittedon loans collateralized only by sound, short-term commercial paper.The Banking School, whose chief proponents were Thomas Tooke,John Fullerton, andJohn Stuart Mill, denied that a convertible cur-rency could be overissued because the needs of trade automaticallylimited the quantity of money. Moreover, ifbanks lent on long termor for speculative purposes instead of on real bills only, the law ofreflux would cause excess issues to return immediately to banks torepay loans. In the United States the real-bills doctrine was popularwith many supporters of the act that created the Federal ReserveSystem. According to the Act, the amount of Federal Reserve notesto be issued would depend on “notes, drafts, and bills of exchangearising out of actual commercial transactions” (section 13), offeredfor discount rates to be established “with a view of accommodatingcommerce and business” (section 14d).

Criticism ofthe real-bills doctrine hasan equally long history. HenryThornton denied that the quality of the loans securing note issuesprovided a proper limit on the size of the issues. Ricardo was also aprominent critic. One problem with the doctrine is that even if eachloanwere made on short-term commercial paper, the volume of bills

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depends on the turnover of goods in process. The same goods solda number of times couldgenerate an equal number ofbills. The sameapplies to the term of the bills, which might exceed the period ofturnover ofthegoods. Moreover, it is notclear howbanks are supposedto be able to distinguish real from fictitious bills.

Hence the money supply could greatly exceed the needs of trade.The fact that an increase in money supply contributes to a rise incommodity prices would justil~iastill further increase in money supplyto meet the needs of trade. The money value of real transactionstherefore cannot serve as an effective regulator of the quantity ofmoney. A further fallacy of the doctrine is its implicit assumption thatno one wouldpay interest on unneeded funds but instead would returnsuch loans to thebank. The doctrine ignores the fact that the loan rateofinterest maybe below theexpectedrate ofreturn on funds borrowed.Such a differential encourages borrowing, causing money and pricesto rise as long as the interest rate differential exists on discounted realbills (Humphrey1982:3—13). In addition, the choiceofassetsgoverningthewayin which banks introduce their liabilities provides no check ontheamount of liabilitiesbanks circulate. In short, the real-bills criterionprovides no effective limit on money or prices.

Recently “something of a rehabilitation of the real-bills doctrine”hasbeen claimed(Sargent andWallace 1982: 1214). The version ofthedoctrine supposedly rehabilitated,however,bears little resemblancetotheactual doctrine. That version is basedona modelofan overlapping-generations consumption economy in which agents have perfect fore-sight, population is exogenous, and there is no production. For thismodel Sargent and Wallace show that a laissez-faire banldng regimeleads to price-level instability or indeterminacy. Since real-bills advo-cates believed that the doctrine guaranteed price-level stability, andits critics argued that it did not, Sargent andWallace clearly have notrehabilitated the doctrine—even iftheir version ofit were accurate—but have instead confirmed its critics’ views. Their version of thedoctrine as one characterized by the absence of government restric-tions on bank intermediation, however, is a caricature. The actualdoctrine was not a defense of laissez faire in banking, but one thatmandated specie convertibility of notes on demand and prescribedthe class of bills eligible for discount. Moreover, in the Sargent andWallace model, banks make unlimited consumption loans, whereasaccording to the actual doctrine banks were to lend only to financecurrent production and distribution and eschew all other types oflending (Laidler 1984: 149—55).

Another restatement (Smith 1994: 28—29) of the real-bills doctrine“in modern form” asserts that there is a crucial distinction between

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the consequences of monetary change dependingon how the changewas accomplished. (It is debatable whether the restatement is “mod-ern,” since it was already expressed in 1844 by John Stuart Mill, ifnot earlier.) On this viewwhat matters is whether the claimspurchasedin creating money are backed by real goods or a sinking fund. Thusan open-market operation thatswaps an asset in private portfolios forgovernment currency is held tohave no effect on theprice level. Onlyprinting press issues that are not swapped, on this view, have priceeffects. Monetary changes that raise seigniorage revenue would beexpected to be inflationary, andthose that are pure portfolio rearrange-ments would not be. Theoretically, this approach elevates what hap-pens as aresult of the first roundof spending to encompass the effectsof subsequent rounds.

Evidence

We first look at evidence that relates to the traditional version ofthe real-bills doctrine, then at its “modern form.”

Two bits of evidence in the literature give a negative verdict onthe traditional real-bills doctrine: Britain during the Napoleonic war-period of suspension of specie payments, and Germany during the1922—23 hyperinflation. Evidence in favor of the modern form hasbeen offered for the American colonial period, for the Second Bankof the United States, for China, 1930—35, for the ends of four biginflations, and for Taiwan. How valid is the latter evidence?

Britain during Suspension ofSpeciePayments. From February 1806to February 1811 the circulation of Bank of England notes rose from£17.7 to 23.4 million, and its accommodation to private borrowersfrom £11.8 to 19.0 million, while its coin and bullion declined from£6.0 to 3.4 million. The premium on bullion rose from 110.0 in1806 to 121.1 in 1811. Commodity prices rose 15 percent over thecorresponding period. The Report ofthe Bullion CommIttee to Parlia-ment in 1810 arrayedthebullionists,who criticized monetarydevelop-ments, against anti-bullionists, who defended the Bank of Englandand the government. The anti-bullionists claimed that so long asbanksissued notes only to discount sound short-term commercIal paperoverissue was impossible. No one would borrow at interest amountsthat he did not need. They attributed inflation to cost-push factors,such as wartime shortages. The bullionists pointed out that the rateof interest banks chargedwas no regulator of issue when usury lawsprevented the Bank of England from charging more than 5 percent.Thornton also showed that with risingprices, the real rate of interestwas below the nominal rate and hence made borrowing even moreprofitable. The anti-bullionists offered no counterargument.

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German Hyperlnflatlon, 1922—23. The Reichsbank pegged its dis-count rate at 5 percent until the middle of 1922, and then raised itas high as 90 percent by October 1923, when the market rate ofinterest wasa huge multiple of thediscount rate. In effect, thebank’srediscounts were cost free to the commercialbanks and their debtors.Private Reichsbank credits to industry andcommerce increased from.03 billion marks in June 1922 to 1,215 thousand trillion in October1923, and the sum of Reichsbank and private bank notes was doublethe creditsat the laterdate. The Reichsbank’s president believed thatthe bank was simply meeting the legitimate needs of business andtherefore was not responsible for the hyperinflation (Angell 1929:368~—71).

The evidence that has been adduced in support of the so-calledmodern form of the real-bills doctrine associates failure of prices torise following injections of money as symptomatic of asset backingfor the new money either through the levy of future taxes or privatesector bills. One example of the evidence is the experience of Chinaduring the U.S. silver purchase program.

China, 1930—35. The experience of Chinaduring thi5 period hasbeen interpreted as a successful demonstration of the working of thereal-bills doctrine. In those five years the money supply increasedfrom 6.1 billion to 7.8 billion yuan, but the price index, except for arise in 1931, fell in every other year. Bank portfolios consisted ofgovernment securitiesand loans to finance inventories. Both are heldto be real bills, the government securities because the levyof futuretaxes provided backing for them, the inventory loans because theywere secured bycommodities deposited in warehouses of the lendingbanks or in other warehouses (Brandt and Sargent 1989: 33_47)•2

The characterization of the Chinese banking regime as one thatfollowed real-bills rules flouts the historical content of the doctrine.No believer in real bills, as the doctrine was formulated, would haveaccepted thepresence of government securities in a bank’s portfolio,whatever their backing, as validating the doctrine. It is further ques-tionable that loans on warehoused inventories would have qualified

2The context In which Brandt and Sargent introduce real bills is their reinterpretation ofthe Influenceon China of the U.S. silver purchase program of 1933. They deny that thatprogram caused internal deflation in China as its currency appreciated, andthat the deficitIn its balance of payment led to silverexports that contracted the Internal money supply.They contend Instead that China experienced no economic difficulties and that It wasthe deliberate choice of the Chinese government to abandon the silver standard In orderto acquire the capitalgain from silver appreciation and to be freeof restrictions on govern-ment finance that a commodity standard Imposed. For a contrastingview, see Friedman(1992: 157—88).

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as real bills. Inventories more likely would have been regarded asfrozen assets, especially when commodity prices were falling.

ConclusionThe real-bills doctrine, in its traditional or restated form, seeks to

restrict the definition ofoverissue. Examples ofchanges in thequantityof money that are asserted not to have had price effects are cited asvalidating the theory. The historical examples, however, involve dataof uncertain reliability. The emphasis on the source of the initialinjection of money is myopic. The sources of the initial injection arenot distinguishable in the money stock.

An Alternative Proposal: “Self-Regulation” byBanks, with Owners and Managers at Risk

TheoryThe propositions that we have examined in the preceding sections

in our judgment are an unsatisfactory basis for the case made byproponents of self-regulation by banks. We offer an alternativeapproach thatwe believe makes abetter case for deregulation. Banksare not inherently unstable, provided the institutional setting in whichbanksoperate andthe incentives they are exposed todo not predisposethemto excessively riskyundertakings. It is possible to designabankingsystem in which banks are free to choose any assets yielding thehighest return as they judge it and to pay whatever price for fundstheydeemreasonable,withminimum risk for depositors andcreditors.One condition is that the institutional setting fosters price stability.The importance of this condition is related to the procedures banksrely on in making loan and investment decisions. The value of thecollateral for secured loans andprojections of the ratios ofborrowers’current assets to current liabilities for unsecured loans serve as thebasis for credit analysis. Unanticipated price-level change can invali-date the assumptions underlying bank portfolios. Price-level stabilitypromotes a stable banking system. We defer to a later section issuesrelated to the achievement of a stable price level.

Asine quanon ofabanldng systemin which theactivities institutionsengage in are no longermonitoredis thata setofrestraints be imposedon theconduct of owners andmanagers. Any mistakes theymake thatwipe out capital and reserves would prompt the immediate closingor reorganization of the institution. Stockholders might be liable foran assessment equal to their equity, and managers would lose theirjobs. Depositors and creditors under these arrangements would be

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fully protected, as networth wouldnot have turned negative, shouldthe marginal costs of products and services the institution offers themarket turn out to exceed market prices. Whatever risks institutionswere prepared to undertake, whether the activities were on or offbalance sheets, the mistakes would be borne by the owners andmanagers, not by depositors and taxpayers. A set of restraints thatwould safeguard against excessive risk taking might include capitalrequirements, marking assets to market, provision of information toauthorities, and double liability for shareholders.

In this setup, a reg!il~toryagency is needed to certi1~’the integrityof individual institutions. In principle, it could be a private agency,although to have the right to close down an institution wouldrequirelegislative authorization. Whether quasi-private or governmental, theagency would function under a changed set of conditions, concernedwith market-value accounting, capital adequacy, and the informationrequired from the institutions it supervises, not with bank location orbranching, or the products and services that banks provided.

The existing regulatory framework encourages regulators to paperover bank failures by relaxing regulatory standards and by givingsubsidies to failing institutions. They are responsive to concerns forloss ofjobs as a result of bank failures, and the burden imposed onborrowers of establishing credit with a new bank. In the proposedregulatory climate, it would be in the self-interest of regulators notto delay recapitalizing, merging, or liquidating an institution thecapital ofwhich had declined to zero. Failedbanks that other banksacquire entail no loss of jobs. If shut down, they will be replaced byother banks if there is a market for their services. Timely action byregulators that would safeguard depositors’ interests, minimize therisk of disruption of the payments mechanism, and eliminate third-party effects would burnish their image as promoters of the publicwelfare.

With depositors’ funds secure, bank failures wouldnot precipitateruns. The lenderof last resort would not need to anticipate panics. Ifdeposit insurance were maintained, it could be privately administered,with the aim of providing depositors and creditors in reorganized orclosed institutions immediate access to the full value of their depositsor their claims.

In such abanking system, self-regulation wouldprevail, in thesensethateach institutionwouldhave an incentive to be prudentin acquiringassets and funding their acquisition, on penalty that foolhardyownersand managers would lose their equity and stake in the institution.Safeandsound banking would be achieved, contingent on the mainte-nance by monetary authorities of a stable price level.

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Evidence

To identify banking systems that conform to the theory, one mustestablish in which periods approximate price stability prevailed andwhether during those intervals banks essentially were free of restric-tions on their choice of activities and provision of inside money. Weare not aware that such evidence exists.

Lawrence H. White has argued forcefully that Scottish experienceteaches us that government has no role to play in regulating privatefirms that produce money (1984: 137—50). For the period that hecelebrates as validating laissez-faire principles, we lack informationon the detailed assets and liabilities of Scottish banks. The record ofpricemovements in Scotland was presumablyparallel to that in Britain,since both shared similar experience in adhering to or suspendingconvertibility. The record was one of price instability.

But even ifWhite couldprovide detailed evidence supporting supe-rior economic stability in Scotland than in Britain, the question ofthe applicabilityof that finding to present-day economic andfinancialcircumstances would remain. He relies on “a very short period [that]typically elapsedbetween the issue of abank note and the fulfillmentof a promise to pay, the note returning to its issuer through theclearinghouse after deposit in another bank” (1984: 140) to checkboth fraud and “indeliberate” overissue. Perhaps that was adequatein Scotland before the mid-l9th century. We are skeptical that thatwould be adequate protection currently for note holders and deposi-tors, in an era of global banks engaged in novel activities, giventhe incomplete information about today’s complex world available toeconomic agents. That is why we can endorse White’s plea for freebanking in the provision of inside money at the same time that werecognize aneed for safeguards. We propose giving the utmost scopefor lending andinvesting by depository intermediaries, without inter-ference by government,while reservinga specializedrole for a regula-tory agency thatmay be governmental as judge of institutions’perfor-mance. That role is to close or reorganize depository institutions ifthey have been mismanaged before losses have been sustained bytheir liability holders.

Whatever risks institutions were prepared to undertake, whetherthe activities were on or off balance sheets, the mistakes would beborne by owners and managers, not by note holders, depositors, andtaxpayers. Bank failures invite government intervention either to bailout management or to make bank depositors and creditors whole,using taxpayer funds. Closing institutions before their net worth hasturned negative is a way of precluding government intervention.

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Possible Constraints on Outside MoneyEconomists can offer no well-understood prescription to achieve

price-level stability other than limited growth of outside money, thatis, the monetary base. Gold and bimetallic standards—commodity-money systems—have the effect of limiting excessive growth of thebase. White and Selgin, who favor gold convertibility as the comple-ment to the complete deregulation of inside money and disestablish-ment of central banks, do not discuss the defects ofthe gold standardand theabsence of professional andpolitical support for it (U.S. GoldCommission 1982).

In our judgment, restoration of either a gold- or bimetallic-basedmonetary standard is highly unlikely, andwe doubt that centralbankswill cease to functionas monetary authorities in the foreseeable future.Withfew exceptions (Canada, NewZealand), each ofthemnow essen-tially operates a fiat monetary standard at its discretion, with nocommitment to maintain anyparticular price level or rate of inflation.Underexisting monetary arrangements, to theextent thatbanks makecontracts thatstipulate fixed rates offuture money payments to othersand from others, the consequences are arbitrary. This is so becausebanks have no wayofknowing whether the price level or the inflationrate they expect will be realized. What is needed is a formula forcentral banks to follow in creating outside money that will limit itsgrowth, with the objective of approximating a long-run stable pricelevel.

A quarter of a century ago Milton Friedman advocated a constantrate of money growth at 4 percent a year (assuming real incomegrowth of3 percent a year and a 1 percent annual decline in velocity)to achieve a zero inflation rate. Although convinced that the conse-quences of this rule wouldhave been preferableto the discretion thatcreated first inflation and then disinflation, for two reasons Friedmanhas since abandoned this strategy. The variable the monetary authori-ties control directly is outside money. Their control ofinside money isindirect and from quarter-to-quarter is loose. The particular numbersFriedman reliedon alsohave not been constant over time. He believesthat his suggestion has encouraged the Federal Reserve to pleadinability to live by the rule and that it has thus escaped accountability.He then suggested a constitutional amendment that would establisha range of 3 to 5 percent a year in the growth of outside money, butdiscarded it as a half-measure of reform. As a full-measure, he pro-posed instead that, after a transitionperiod, outside money be frozenat a fixed amount. Private depository institutions would thenbe freedto issue bank notes. The money-creating powers of the central bankwould cease (Friedman 1984: 40—52).

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In choosingthemoney stock for hisinitial rule, Friedman’s objectivewas to link thatmagnitude to subsequent changes in national income.In the spirit of Friedman’s suggestion, Bennett McCallum (1989:329—43) has proposed a rule linking the quarterly change in outsidemoney to the quarterly change in nominal GNP. His rule, he con-cludes, would lead to roughly 3 percent annual growth in nominalGNP and approximately zero inflation.

Whether monetary authorities will set aside conflicting objectivesthathave made their policieserratic andunpredictable andbe resolutein pursuingprice stability as their overriding concern, noone can say.If they fail to achieve price stability, the performance and stability ofbanking systems under “self-regulation” will be in jeopardy.

ConclusionWe have surveyed three theories and the evidence that is said to

confirm that under private market arrangements self-regulated bank-ing systems will limit their inside money issues. These theories arguethat intermediation by note- and deposit-issuing banks can safely bederegulated because:

1. An interbank clearing mechanism checks overissue;2. Competitive produëers of money establish confidence in their

issues by limiting their magnitude;3. Banks thatrestrict their discounting to real bills cannotoverissue.

Eachof the theories is problematic.The supporting evidence is drawnfrom many countries and periods in the past. In no episode is itpossible to isolate the particular theoretical proposition it is supposedto confirm; Bank performance mayhave been influenced by existingregulations and the requirement that inside money be convertibleinto some form of outside money. The significance of the theoreticalproposition is accordingly ambiguous. Moreover, the relevance ofhistorical banking experience to current economicand financialcondi-tions is overdrawn.

Our support for deregulation of bank intermediation features twoimportant provisos: First, the risks that are undertaken are borne byowners and managers, not bymoney holders and taxpayers, and sec-ond, monetary authorities can be relied on to achieve price-levelstability.

The first proviso leads us to advocate restraintsondepository institu-tions such as capital requirements, provision of information to a super-visory agency, marking assets to market, and possiblydouble liabilityfor equity holders. The key responsibility of the regulatory agency

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would be to close or reorganize promptly an institution before its networth turned negative, thus safeguarding the funds of depositors andcreditors. The agency couldbe administered as a private undertaldngif the legislature empowered it to close troubled institutions.

The second proviso leads us to inquire about possible ways toconstrain the issue of outside money. Areturn to a commodity-basedstandard by the world seems improbable. Wereview some suggestionsto limit the issue of fiat outside money, the only prescription econo-mists can offer to achieve price-level stabthty. Price-level stability inour view is a prerequisite for safe and sound banking. If the pricelevel is stable, any mistakes that banks make in acquiring assets willbe attributable to faultycredit analysis, not to price-level or inflationsurprises. Ifthe outlook for future price-level stabilityis doubtful, thesuccess of a self-regulated banking system is also doubtful.

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