The Bear’s Lair: Banknotes should be issued only by banks

The world’s central banks are working on issuing digital currencies, where through the “blockchain” they will have knowledge of all transactions. This idea is clearly a gross affront to civil liberties, but it raises the question: why do governments and central banks have the sole right to issue bank notes? Over the last 30 years, they have proved that they will abuse this right whenever they get the chance. Since bank notes, in their origins, were issued by commercial banks, why do we not go back to that system and prohibit any institution other than a licensed privately-owned commercial bank from issuing bank notes? Such a provision would have major economic advantages, as I will explain.

Issuing bank notes is a highly profitable business; the issuer gains “seigniorage” on all the notes it has issued. That seigniorage does not amount to 100% of the value of the banknotes, but at the very least it amounts to the prevailing rate of interest on those notes (since bank notes do not bear interest) plus an extra factor for those notes that are held in perpetual storage, destroyed by fire or get lost in some other way. That is why modern governments, seeking to profit from their subjects’ subjection in all possible ways, generally enforce a prohibition on private banks issuing banknotes – the seigniorage is too attractive to relinquish. Even with today’s ultra-low interest rates, the Federal Reserve sent $88.5 billion in profit to the Treasury in 2020, and you can bet that was after its taking all the expenses it could think of, as well as a handsome reserve for future potential losses.

Now consider the economic effect of the Fed’s ability to issue banknotes. Unlike with a private sector bank, which would have to maintain some kind of reserves (unless it was confident of a bailout) there is no economic force preventing the Fed from issuing unlimited quantities of bank notes. At the same time, the seigniorage it receives increases with every bank note it issues. If interest rates are very low, as now, the seigniorage from interest income on the notes is small, but the seigniorage from losses of the notes is just as large as when interest rates are higher. Indeed, the seigniorage from losses or disappearance of the notes may be higher when interest rates are so low, because the opportunity cost (in terms of foregone interest) to criminals and foreign billionaires from holding the notes is small, so they will tend to hold more of them.

Thus, to the extent that the Fed and the Treasury act in concert (which in practice, they almost always do – the Fed needs favors from the Treasury, and vice versa) the Fed has an incentive to maximize its issuance of bank notes, to maximize the seigniorage revenue to the Treasury. As a result, situations like the present are always likely to occur, where the Fed issues too much money and keeps interest rates too low – it has little incentive to do anything else, while inflation remains subdued.

We are now beginning to see the ghastly consequence of the Fed’s misdirected incentives. U.S. inflation has come in well above the consensus forecasts for several months in a row and is currently running at around 10% annually. We can anticipate similar unexpected surges in prices in Britain and the EU, where central banks have similarly grossly over-inflated the money supply. While the immediate surge in inflation from COVID supply chain disruptions may die down, inflation will not return to its historic low levels for two reasons. First, money supply has been expanded excessively during the pandemic, and prices must catch up once a normal economy is restored. Second, real interest rates during this surge in inflation are now sharply negative, exacerbating still further the damaging mis-incentives of “funny money.”

Britain’s economically savvy prime minister Lord Liverpool explained the difference between government and private issues of paper money, in a debate on July 9, 1813, during a period when wartime exigencies had taken Britain off the Gold Standard:

“The great mistake continually made on the continent is, that such a paper currency having produced those ruinous consequences in every country in which it has been tried, it is therefore expected that a paper currency must produce the same consequences here. The great security of our paper currency, and that which constitutes the important difference between it and the paper currency of other countries is, that it is issued by an individual banking company, or by individuals for the sake of their own interest. The Bank of England [then privately owned] would no doubt be willing to accommodate the public service, but they could refuse to issue their notes, and whenever they acted on any ground other than their own interest, it would be the first step to their ruin.”

Overall, Liverpool supported a Gold Standard, but with paper money issued by private banks, in accordance with their own interests. Such a system had the absolute solidity of a Gold Standard, but with the flexibility to accommodate the growing needs of commerce and industry, even though the supply of gold in bullion or coin form was very limited.

Whether we return to the Gold Standard is a separate discussion (we should do so as soon as possible) but even without it, we can improve monetary policy by following Liverpool’s prescription of 1813, at a time when Britain’s budget was severely in deficit to prosecute the war and Britain’s balance of payments and gold reserves correspondingly strained.

Liverpool spotted that if private banks issued notes, and there were no guaranteed bailouts, they would do so only to the extent that they prudently could. There would always be a possibility of notes being exchanged for cash and withdrawn from the bank, so a substantial percentage of the notes issued would need to be kept as cash reserves. In that way, the money supply would be self-regulating. If demand for money increased, interest rates would naturally rise, as banks sought increased funding to back their issues of notes. Without the central bank automatically supplying extra money, increased bank demand for funding would raise its cost.

There is unfortunately quite a large gap between the idealized small-unit banking system that Liverpool envisaged and dealt with, and the state-backed behemoth banking system we have today. Citigroup, for example, has been bailed out by the Feds every couple of decades in the 209 years of its existence; it cannot be relied upon to issue notes prudently without relying on being bailed out yet again.

There is also a problem on the consumer side. In Liverpool’s idealized banking system, consumers only accepted the notes of banks that were thought to be solid. Unscrupulous employers would occasionally attempt to push notes of near-insolvent banks into employee pay packets, but word quickly got around, and those employers would quickly find themselves unable to get competent employees. However, with deposit insurance there is no control over bank note issuance; a fly-by night operation can flood the market with notes and rest assured that when it inevitably goes bust, those notes would be honoured by the FDIC or similar institution.

A free-market system whereby individual banks would issue notes and the Fed would not do so would thus require three unbreakable regulations. First, obviously, the Fed must be prevented from creating money; money creation must be left entirely to the private sector. In practice, that might best be achieved by abolishing the Fed; if it exists, it will be tempted to meddle. Second, deposit insurance must be abolished, or limited to a very small “petty cash” ceiling of say $500. Third, bank regulations similar to those that existed before the 1980s must be brought back, prohibiting interstate banking and possibly limiting banks’ size, so that there would be no question of “too big to fail” institutions imposing their money creation on the public.

It is probably a dream – the changes needed in regulation would be too great to get through the system, although one could wish the U.S. banking system had remained as it was before 1913, and the British banking system had avoided the agglomerations of the 19th Century. But the current system, whereby notes are issued and money created by institutions driven solely by political goals, is highly detrimental to the health of the economy as a whole. As in all matters, political resource allocation destroys any kind of market system.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)