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Note Issue by Banks: A Step Toward Free Banking in the United States?
By Kurt Schuler
Introduction
After having all but forgotten free banking for decades, in the last 25 years economists have rediscovered its history, updated its theory, and explored its relevance to the spread of electronic money (for a summary, see Selgin and White 1994). Free banking has influenced recent debate about currency boards, dollarization, and other monetary systems that are rivals to central banking. Yet despite interest in free banking as a historical fact and a future possibility, free banking nowhere exists today as a living system. The heyday of free banking was before the First World War. During and after the war, a combination of governmental desire to manipulate money and economic theory favoring central banking led governments to replace competitive issue of notes (paper money) by commercial banks with monopoly issue by central banks or other monetary authorities. The last system of competitive note issue among the nearly 60 countries that once had it ended in 1962 (Schuler 1992: 40-45). Hong Kong, Scotland, and Northern Ireland still have multiple banks issuing notes, but the issuing banks operate under rules that make them no more than agents of the Hong Kong Monetary Authority or the Bank of England, respectively.
Notes are only a small share of broad measures of the supply of money and credit such as M2 or M3. However, monopoly note issue has an importance much greater than its share of such measures indicates because it gives the issuer an indirect instrument of control over the rest of the money supply. When a commercial bank or other financial institution can issue its own notes without special restrictions, its notes form part of its liabilities just as its deposits do. If its customers wish to switch out of deposits and into notes, say because they wish to have extra cash on hand to buy Christmas presents, the overall liabilities of the bank do not change. In contrast, when a government establishes a monopoly of note issue, the notes issued by the central bank or other monetary authority count as reserve assets for banks. If the customers of a commercial bank wish to switch out of deposits and into notes, the bank loses reserves. Because deposits and notes have a fixed rate of exchange—banks must be prepared to give depositors $1 of notes for $1 of deposits—the supply of monopoly- issued notes affects the supply of bank deposits.
Most everywhere, the laws that ended competitive issue of notes are still on the books. The United States, however, is an exception. Nobody seems to have noticed that state-chartered banks have been effectively free to issue notes since 1976, and national (federally chartered) banks have been free to issue notes since 1994. An important element of free banking has the potential to begin immediately; it need not wait until the time, if any, that electronic money makes the government monopoly of note issue obsolete. Banks can issue notes, a comparatively low-technology form of money that also has the lowest costs in some uses.
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