Exclusive Interviews
Lawrence White on Austrian Economics, Free Banking and Real Bills
By The Daily Bell - October 24, 2010

Introduction: Lawrence H. White is a professor of economics at George Mason University. Prior to position at George Mason, he was the F. A. Hayek Professor of Economic History in the Department of Economics, University of Missouri-St. Louis. He has been a visiting professor at the Queen's School of Management and Economics, Queen's University of Belfast, and a visiting scholar at the Federal Reserve Bank of Atlanta. Professor White is the author of The Theory of Monetary Institutions (Blackwell, 1999), Free Banking in Britain (2nd ed., IEA, 1995), and Competition and Currency (NYU Press, 1989). He is the editor of several works, including The History of Gold and Silver (3 vols., Pickering and Chatto, 2000), The Crisis in American Banking (NYU Press, 1993), African Finance: Research and Reform (ICS Press, 1993), and Free Banking (3 vols., Edward Elgar, 1993). His articles on monetary theory and banking history have appeared in the American Economic Review, the Journal of Economic Literature, the Journal of Money, Credit, and Banking, and other leading professional journals.

Daily Bell: Give us some background on yourself.

Lawrence White: I became interested in Austrian economics by reading Murray Rothbard's, Man, Economy and State in the summer before college. I went to Harvard where they were teaching Keynesian economics but I was already anti-Keynesian and baffled that they were still teaching it. My first job was at New York University and from there to the University of Georgia. In 2000, I went to the University of Missouri-St. Louis and was offered the Hayek Chair of Economic History. Who wouldn't want that? I came to George Mason last year to work with good graduate students and it's keeping me very busy.

Daily Bell: How did you become interested in free banking?

Lawrence White: When I was in college I wrote a paper about an American newspaper editor named William Legget who was one of the more sophisticated thinkers on economic issues in the US at the time. I discovered a piece praising the free-banking system of Scotland as the model the United States ought to adopt; he was writing in the 1830s. I had never heard of free banking in Scotland and he made wonderful claims. I didn't have a chance to investigate it then but when I got to graduate school, I took a course in monetary economics at UCLA from Axel Leijonhufvud and for my term paper I wrote a paper about the free-banking system in Scotland. That's what turned into my doctoral dissertation when Axel encouraged me to expand it.

Daily Bell: What is free banking and why has it been controversial with Austrians?

Lawrence White: A free-banking system means a monetary system where private, competitive, unregulated banks are responsible for providing all kinds of payment instruments and intermediation. So generically it means the absence of restrictions on banking – in other words laissez-faire banking. An implication is banks and not the government will provide currency as well as transferrable deposits. It implies the absence of the central bank and central banks are everywhere in the world today. That's the big difference from the status quo. F.A. Hayek was somewhat ambivalent – and I wrote a paper about that – about free banking, out of the concern that banks might be inherently unstable, pro-cyclically.

Some people questions deny that free banking would or should be allowed to function with fractional reserve accounts. Murray Rothbard was the leader of the point of view that fractional reserve banking ought to be outlawed. He thought the fractional-reserve bank was inherently defrauding the customer. Some of his followers have switched to other kinds of objections. I don't hear the fraud argument as often these days, but I do hear the argument that there is something absurd about a fractional reserve generally because it implies that two people are exclusive owners of the same coin, which is I think a misunderstanding of the arrangement between the bank and its customer. Another objection is that it reduces the value of gold held by third parties, but there are all kinds of changes in the value of your property that come about through market forces, and we can't outlaw those consistent with properties property rights.

Daily Bell: Do you consider yourself an Austrian Economist?

Lawrence White: Yes. If Austrian means heavily influenced by Ludwig von Mises and FA Hayek, then certainly yes. And on my CV, you will see that I was part of the Austrian Economics program at NY University and I am now part of the Austrian economics program at George Mason. I was on the committee that wrote and evaluated the Austrian economics field exams. So I don't think I can deny being an Austrian.

Daily Bell: Is free banking the freest kind of money association available?

Lawrence White: Well, that's how I think of it. It's a system based on a free contract without third-party legal interference between banks and customers. Various kinds of contracts are available. The ones we observe historically are the ones that we presume would prevail if free banking were re-established today. So it's usually described as being based a gold or silver standard, which we saw historically before governments began to interfere.

Daily Bell: The idea is to let the market decide on the amount of reserves?

Lawrence White: Yes, in the sense that there would be competition among banks. Banks have a trade-off to consider between earning more interest and holding more reserves. Holding more reserves makes the bank safer. Being safer may be important for attracting customers. Not all banks may follow the same policy but people will sort themselves among banks according to how safe they think the banks are versus how big a return the bank pays. Most people want a very safe bank, so there is a market force that compels banks to act prudently. Remember deposits would not be guaranteed in a free-banking system, so banks have to convince potential customers that they are trustworthy.

Daily Bell: Murray Rothbard believed the Central Bank of England had a role to play in the Scottish experiment. Can you expand?

Lawrence White: Rothbard wrote a review of my first book, Free Banking in Britain. Rothbard argued that the Bank of England, which was the central bank in England, played the central banking role toward the banks in Scotland and that we shouldn't regard Scotland as a good example of a free-banking system.

There were cases in which Scottish banks maintained a credit line at the Bank of England, but the Bank of England actually cut off the credit line when it was needed, so it acted the opposite from the way a lender of last resort is supposed to operate. In that sense the Bank of England was not providing any protection or privileges to the Scottish bank. In general the Bank of England did not take any notice of what was going on in Scotland and did not supervise or restrict the Scottish system. I think Scotland is a good example of free banking.

Daily Bell: Can you give us a brief history of free banking?

Lawrence White: Numerous books have been written on this topic and I recommend a book edited by Kevin Dowd, entitled, The Experience of Free Banking. There are a dozen chapters and each chapter deals with free banking in a different country. Basically, free banking is what arises naturally through market forces until government steps in to try to restrict banking. In countries with restricted banks we by and large see weak banking systems. In England for example, with the Bank of England, we see monopoly privileges, which weakens the other banks in the system. In the United States, government restricted the chartering banks and the branching of banks and the note issuance of banks in ways that weakened the banks. By contrast, if you look at countries where banking is the freest – those countries like, say, Scotland before 1844, you have a system where you have large, well capitalized banks, well branched, well diversified, very competitive, providing all the payment services and currency.

Daily Bell: Is the American experiment one of free banking?

Lawrence White: The United States had decentralization, but it did not have free banking. That is, state governments rather than the federal government performed the licensing and regulation of the banks. There was a ban on interstate branch banking. So you have to look at each state to get the whole picture. The area of the country that was closest to free banking was New England, where bank charters were given out fairly liberally; in other parts of the US, you had very strict restrictions on banks that created monopoly privileges or weakened banks in other ways. In some states, big government created a state-owned monopoly bank and didn't allow any other banks. That is certainly not free banking. In the state of Illinois they banned all bank notes; that's certainly not free banking.

Daily Bell: Could you have a private central bank within a free-banking system?

Lawrence White: That is an interesting question. A former colleague of mine at the University of Georgia, named Richard Timberlake, created wrote a paper on the central banking role of clearing house associations. So, we have to define what a central bank means before we can answer whether a central bank would arise within a free-banking system. The best I can do is to list the major functions associated with central banking. There isn't any one defining role of central banking. Some of the major roles are serving as the banker's bank, regulating commercial banks, serving as the lender of last resort and all of those are things that private commercial bank clearing houses did. So you can think of those clearing house associations in the major cities as private central banks, in the sense that they served as banker's banks; that is, banks pay each other by transferring money on the books of the clearing house association.

The association had membership standards, so in that sense it regulated the capital within a bank; banks had to have a certain amount of capital to be a member of the association and that's because the members want assurance the other banks in the system wouldn't default on their obligation. Occasionally in the United States, the association acted as lender of last resort. It issued more currency when more currency was needed; it expanded the quantity of bank reserves temporarily when there was a temporary shortage of bank reserves during a financial panic. They did all those things. Now they weren't central banks in two other senses. That is they did not have a monopoly of note issue, which is characteristic of central banks, and they did not conduct the monetary policy. They did not try to control the quantity of money in pursuit of economic growth or low inflation or low unemployment; they did not have a macro economic policy. But in respect to serving the interests of member banks, doing what banks want done on a joint basis, they served as central banks.

Daily Bell: Is it important to back money with gold and silver?

Lawrence White: The answer is yes, if you want to have a non-political, self-regulating monetary system. Fiat money inherently is in the hands of the government and not self-regulating. A system based on gold or silver provides self-regulation of the quantity of money, because ultimately the quality of money isn't going to grow any faster than the stock of gold or silver and that depends on the economics of gold mining.

So it's market forces that determine the quantity of the most basic money and then it's the banks themselves based on what the consumers are demanding that determine the quantity of bank- issued money. So it's market forces that are prevailing both in the basic money and the bank- issued money rather than political influences. If you want a system that is self-regulating rather than politically restricting, yes, it's important to back it with gold and or silver.

Daily Bell: Doesn't a private gold and silver standard work hand-in-hand with a private, free banking model?

Lawrence White: Yes. One of the talks I gave as a very young man has recently re-surfaced on the Internet – on free banking and the gold standard. I believe it was 1983 when I gave this lecture. But that was my argument, yes, that the two of them work hand in hand. A private free banking model works when the quantity of reserves is determined by market forces rather than being subject to the whim of a central bank and vice versa. So they do work hand in hand.

Daily Bell: How do modern (mercantilist) central bankers know when they have printed enough money?

Lawrence White: Well it's a problem for them; they don't know. In a free-banking system, a bank that printed too much money would start losing its commodity reserves. That's immediate feedback. Modern central banks don't have to redeem bank notes with gold and or silver. Thus, they have no decentralized immediate feedback as to whether they have issued too much or too little. The best a central bank can do is look at macroeconomics indicators: the price level, the interest rate, the exchange rates, but those things often give conflicting indications. Central banks also have political pressures to try to pursue multiple inconsistent objectives, so there isn't any unambiguous feedback as to when they have printed enough money or too much money. It's an application of the Mises/Hayek argument against central planning that if you don't have feedback from genuine market prices you are just fumbling in the dark.

Daily Bell: They always print too much?

Lawrence White: (Laughing). There is a chronic tendency to expand the quantity of money under fiat standards. It's a source of revenue for the government to have the central banking printing money to either give it to them to spend or for purposes of indirectly buying federal government debt and thereby making it cheaper for the federal government to borrow money. So I think there's a fiscal motive as why you see chronic inflation under fiat standards.

Daily Bell: Why hasn't free banking caught on in the 21st century? Will it catch on yet?

Lawrence White: Well there are two meanings your questions could have. One is to catch on intellectually and the other is that governments themselves dismantle restrictions on banking and move toward a free banking. There's a certain amount of intellectual interest amongst some people. But in America, the Federal Reserve's influence is very great. Many academic economists who are not Fed employees are nonetheless part-time employees or are consultants or present papers at Federal Reserve conferences.

This is a problem that Milton Friedman identified. If the major employer in the field has a certain point of view, you are not doing your career any good by antagonizing that potential employer. So there's a tendency to not rock the boat, and the Fed is an enterprise that tries to engage them. The Fed has influence on the terms of the debate. The people who are editing the major journals in academic monetary economics have Fed linkages. They want to remain on good terms with their friends who are in the upper echelon of the Fed. The Federal Reserve Board itself is appointing more and more academic economists as governors, and of course Ben Bernanke was an academic economist before he was Chairman. So there is a kind of "go along to get along" tendency, which means you are not going to see a lot of eagerness to challenge the status quo.

Daily Bell: Is the Internet important in this resurgence of interest in private money?

Lawrence White: That's a good question. I think one of the things that constrain bank regulations at the margins is the availability of offshore banking. And the Internet makes transferring money to and from an offshore bank account a little easier. So in that sense it helps to put a limit on the restriction of banks. Of course offshore banking is considered a loophole so there's the battle on their part to try to shut it down.

Paypal, which of course is an Internet phenomenon, was started by a bunch of libertarians who thought they were wanted to come up with a payment mechanism that would compete with the Federal Reserve System. It turns out it was in their interest to make it more of an adjunct; a standard dollar transfer system instead of creating their own currency. It's very difficult to create your own currency in a world where people want to be paid with the stuff that they can turn around and spend; it's a chicken- and or-egg problem. It's hard to introduce a new currency until you get a critical mass but how do you get a critical mass? There is also E-Gold that provides gold-denominated accounts, transferable from account- holder to account-holder denominated in gold, but they are very small at this point and hassled by the authorities.

Daily Bell: It is true that private banks were the main issuers of paper currency in the United States and Canada a century ago, and were the sole issuers in virtually every country two centuries ago.

Lawrence White: Yes and this sounds like a paraphrase of something I wrote. It's true that the idea of the government issuing paper money only came along after government thought it deserved to get in on the act, or even monopolize the act, which they have done now. But before this happened, private institutions introduced this innovation. We are actually not sure when the first bank note was but sometime in the 1400s in Italy; then it takes off in the 1700s in England in a big way.

Daily Bell: Are private commercial banks more reliable than the current system?

Lawrence White: A system of laissez-faire private commercial banking would be more reliable than the current system. The current system is nominally private and based on commercial banks but the commercial banks are restricted by the government in many ways. I think a fully private system would be more reliable than the current system. The moral hazard problem, government guarantees on nominally private banks, the chickens come back to roost. Eliminating those kinds of guarantees, where everybody lives at the expense of everybody else, would be important in creating a more reliable system.

Daily Bell: Isn't it true that a central bank enjoys "sovereign immunity" from claimholder lawsuits?

Lawrence White: Well, that's right. In a free-banking system if you think your bank is acting in a way that makes it more likely to fail, you move your money across the street to a bank you perceive as safer. In a central banking system if you think your government is about to devalue, you can try to move some of your money into other currencies but it's hard to move your checking account into another currency if you still want to write checks to people in your domestic economy.

There's a limit to how much people can discipline the central bank by voting with their feet, and you can't sue a bank that devalues currency. If they devalue the currency tomorrow, tough luck to you; whereas, under free banking if this note says it is redeemable for a silver dollar then they have to give you a silver dollar. But central banks don't have contracts with their customers; their customers are captive in that way.

Daily Bell: You have written, "If domestic citizens want high-quality redeemable currency, they are better served by privatization of note-issue than by a central bank dollar peg." Explain this, please.

Lawrence White: I was writing about developing countries in particular where the local central bank often takes pegs the local currency to the US dollar. In some places, it's the euro. So the question is can the holders of those currencies rely on 'the peg'? Can they be sure they are going to get as many dollars tomorrow as they are getting today for each unit of local currency? The answer is they can't rely on it; they can't sue the central bank if it devalues. By contrast if those countries would allow private commercial banks to issue dollar denominated currency, and the courts would enforce those contractual obligations; then they could rely on the forces of reputation among the competing banks to keep the currencies at par.

Daily Bell: You have written, "State bank notes weren't nearly as bad as the older accounts make out, and their suppression by the Federal government wasn't really motivated by quality concerns." Can you explain this, please?

Lawrence White: That was in reference to the legislation test passed during the US Civil War to provide federally chartered system of banks that would issue what was called a uniform currency. One of the arguments for imposing federal charters and later for suppressing the issue of notes by state chartered banks was that the state chartered bank notes were unreliable and this legislation would provide a more uniformed system of currency.

I think it was a very disingenuous argument at the time. The real motive was the federal government wanted to finance the Civil War. It wanted to force-feed their federal debt to the banks and the way they did that was by saying to the banks you have to have federal debt in order to back your bank notes. They were particularly worried that the new federally chartered banks notes were going to add to the stock of money, together with the state bank notes and cause too much inflation, so they put a prohibitive tax on state bank notes and basically taxed them out of existence.

If the federal government had really wanted to raise the quality of the currency, it would have emulated the Canadian banking system where the banks were allowed to branch nation wide and thereby there was par acceptance nation wide. I think the talk about providing a uniform currency was just talk and it was really a revenue measure.

Daily Bell: Is it true that by the outbreak of the Civil War, sound state bank currencies were the norm?

Lawrence White: Well they were the norm in New England, which I said earlier was most like a free-banking system. By and large most of the banking systems had been reformed and many of them had adopted what they called free banking laws, which weren't laissez-faire but rather freer entry into banking. The notes available in other parts of the country weren't close to 100 cents in New York or in Chicago.

Daily Bell: Is it true that the counterfeiting of state bank notes was generally less profitable than the counterfeiting of today's central bank currencies, because private bank notes don't stay in circulation long?

Lawrence White: I am not sure about the counterfeiting of state bank notes but I do know about the counterfeiting of notes in private free-banking systems like Scotland. Namely that it wasn't a big problem. By the way, this is the subject on which I was called to testify before a congressional committee, the only time in my life. This was at the invitation of Ron Paul back when they were redesigning the Federal Reserve notes and he wanted to insert somewhere into the discussion something about the character of the currency and not just the technical problems of counterfeiting.

Someone on his staff noticed that I my book Free Banking in Britain had this discussion of how counterfeiting was not a problem under free banking and so I came in and explained that to several congressman. (I think there were three in the room.) I said counterfeiting is not just a technical problem. One of the things that eases counterfeiting is how long it is between the time the note is printed and somebody spots it, because if it's been traded through dozens and dozens of hands, the trail is going to be very cold at that point and it's going to be a lot harder to trace it back to the originator.

But in free-banking systems notes behave more like checks, that is they go into circulation and came out of circulation fairly frequently. Scottish bankers estimated it was about a week on average between the issuing of a note and its return to the clearinghouse. A note would be put into circulation; it would be spent at a shop, and the shopkeeper would take the notes at the end of the day and put them in his own bank. His own bank would sort them out and run them through the clearing system and back to the banks that issued them.

The notes would be under the scrutiny of the banks that issued them and they would be able to spot counterfeiting pretty quickly. The Scottish banks had a policy that if someone came to the counter with a counterfeit note or a fake note, they would accept it at face value, providing the customer could tell them where he or she got it. Then they would go back and trace it to the counterfeiter. the origin.

Daily Bell: Is it true that today's central bank currency monopolies from government's appetite for revenue?

Lawrence White: I think that is basically true. If you look at arguments for why the government should issue currency, there are people who've tried to argue there is some kind of market failure. Either private issuers are unreliable, and so there endemic fraud and the government can provide a more reliable currency, or there's some kind of natural monopoly and so the government can more efficiently be the sole currency issuer.

I think there really isn't any historical merit or empirical content to either of those arguments; I think they are both wrong. So what is left is the revenue motive for monopolizing the issue of currency; it's a way of generating revenue for the central government and especially it's a way of raising revenue in a hurry when there's an emergency need. If you have a government monopoly central bank and are on a gold standard, you suspend the gold standard, if you are not, then issue as much money as you need to finance the emergency expenditures. You can't do that as directly if the money is in private hands.

Daily Bell: Please comment on Real Bills and how they work.

Lawrence White: "Real bills" are simply the short-term IOUs of firms who are financing real goods in the process of production. For example Joe the Baker might buy flour from a grain mill and pay the miller with a bill that says: "Joe the Baker will pay $1000 in 90 days." He figures to repay after he's baked the flour into bread and sold the bread. The miller can either wait for the bill to mature, or he can sell it immediately to a banker, who will discount the bill; that is, pay him something less than $1000, the present discounted value of $1000 due in 90 days. Bills of this sort were an important source of business credit in the nineteenth century, and a major category of assets in a typical bank's asset portfolio. They had low default risk, low interest-rate risk, and were very easy to re-sell in case the bank needed to replenish its reserves.

The "Real Bills Doctrine" has been important in the history of monetary theory. It is the mistaken idea that if the banking system lends only by discounting real bills, it can't over-expand. It's a dangerous idea when applied to a central bank, because limiting a central bank to real bills discounting doesn't actually prevent it from over-issuing, and following the Real Bill Doctrine will lead a central bank to over-expand money – rather than letting interest rates rise to reach their new equilibrium level – whenever the business demand for credit rises.

Daily Bell: Have you done all you intend to do regarding free banking?

Lawrence White: Oh, I doubt it. There are still so many interesting questions out there. I have students working on research on free banking and I'm working on a paper with George Selgin and a third economist named Bill Lastrapes, which is not directly on free banking but is critical of the record of the Federal Reserve System. It's connected to the idea that government control of the monetary system has not given us better results. There are lots of historical and theoretical issues that remain interesting to try to examine in more detail.

Daily Bell: What books do you recommend on the topic?

Lawrence White: On the topic of free banking, the von Mises book, Theory of Money and Credit and his book, Human Action. Also Adam Smith's Wealth of Nations, Barris Vera Smith's book, The Rationale of Central Banking. My books, too, and the books of George Selgin, who was a student of mine, not that I taught him anything. He knew everything before I met him.

Daily Bell: Professor White, thank you for being so generous with your time today.

Lawrence White: You are welcome.

After Thoughts

There is a wealth of knowledge in this interview, and we are pleased to be able to pro-offer it to those who stop by the Daily Bell. Lawrence White is indeed a gracious and generous man to share his time and knowledge so freely. Once can see that simply by reading his words. He certainly doesn't duck controversial issues, either. In fact, the issues he addresses lie at the center of an ongoing controversy in the ranks of Austrian economics. They have to do with whether fractional-reserve (gold and silver) banking is inherently fraudulent. We come down on side of free-markets and have urged that the debate center on letting the market decide – once free banking is legal again. This seems to us a rational conclusion.

In business, as we have often pointed out, there are many instances where customers are promised fulfillment in one form or another while the business itself does not have requisite supply. Airlines do this all the time with seats, promising too many of them because they know from past experience that not all passengers will show up. Additionally, just-in-time manufacturing relies on ordering certain goods as the contract is signed. Some companies will not make a suit, a car, even a house, until the goods are paid for partially or in full. We can see in many instances that business receives money and yet does not have the promised product in house.

Professor White also does us a service by simplifying the Real Bills debate. The Real Bills debate has raged for some time and his perspective clarified matters in our view. Ultimately, what we come away with is that the market itself can easily sort out these issues. Real Bills, fractional reserve (private banking) even private central banks (clearing houses, really) all can likely work (and probably did) within a private environment that uses the invisible hand of competition to discipline the system and separate what works from what doesn't.

Even though Professor White was doing his best to simplify free-banking issues, they remain complex for most people because they are theoretical constructs and not part of daily life, as they once were. However, (leaving aside Professor White's fine work) we want to point out that Austrian finance is not an arcane, desolate or indecipherable backwater, or not anymore. The Ludwig von Mises Institute – especially – has helped make Austrian economics available to anyone who wanted to learn about the way the world really works. (And we can acknowledge this even though on some issues, like free-banking, we and others have perceived different solutions.)

Though some of the texts are complex, and some of the issues seem formidable, Austrian economics does NOT rely on econometrics or other fanciful projective analyses to prove its points (or not yet anyway). Additionally, from what we can tell, Austrian economics has not, at least in the 20th century, focused zealously on the microeconomics – an economic discipline that tends in our view to isolate various concepts and thus make the whole more difficult to discern.

What Murray Rothbard (and Lew Rockwell, and even Lawrence White in his own way) have shown us over and over again is that Austrian economics is NOT the property of an academically literate few but the heritage of every thinking man and woman who wants to build a better life and create a better future. We would urge people who want to fully understand how free-markets work to push through the complexities of Austrian economic texts by reading the many simple annotations now available on the 'Net generally or at the Ludwig von Mises Institute.

Austrian economics is about the heart and soul of human beings. You can apply it to any part of human activity and come away with a better idea of how the world REALLY works. One reason why Austrian economics has succeeded in the 21st century is because it is truly comprehensible to most people, once they start reading the literature (when it was finally available on the 'Net). Not only is it comprehensible, but it is truthful and shows us how we can live better lives in a communal (free-market) aggregate. Venezuela's dictator Hugo Chavez, in one of his more memorable quotes, said, "Socialism is love." He had it wrong. "Austrian economics is love." And free markets. And freedom.

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