On Legitimate Free Banking

The financial meltdown has affected the typical Indian saver and investor. He is taking his money out of multinational banks and the stock market and depositing them in state-owned banks, believing them to be sounder. And there is going to ensue a “battle for Asian bank deposits,” according to this extremely interesting report in Mint.

Of course, smart Indians are doing better than that: they are buying gold. Here is the story of how the Post Office is selling gold coins in rural Karnataka.

Here is the report on how gold is expected to hit US$865 an ounce soon, up from US$832 now. In times like this, gold is the only safe haven. Even real estate is crashing here.

Since the smart people are moving into gold, what can be said of those who are moving their money into banks owned by our The State? After all, gold is a better asset to hold than the paper money issued monopolistically by our The State simply because the value of that paper money is in constant decline. While the value of gold is rising.

The most serious questions in the Rule of Law concern banking. Since bankers hold the wealth of others in trust, they must be governed by good law. It is this Law, not State-ownership of banks, which can keep all depositors secure.

Legitimate free banking is based on the legal notion that there are basically two kinds of contracts between bankers and their depositors. One is a deposit that can be withdrawn on demand: the demand deposit. Under the Rule of Law it should be illegal for a banker to lend out any money that is handed over to him for “safekeeping.” Indeed, he may charge a fee to keep such deposits. This means no “fractional reserve.” This means 100 percent reserve banking – as far as demand deposits are concerned.

The second kind of contract between a banker and his depositor is a loan contract. The depositor in this case keeps his money in the bank, for earning interest, on the condition that it be returned at some future date. It is only such deposits that the banker can lend.

And there might be hybrid contracts. The report in Mint talks of modern advances:

“Basic products that have worked in other markets— low-balance transaction accounts, hybrid interest-bearing checking accounts, flexible savings accounts that combine cheque-writing privileges with higher-yield term-deposit features, and no-frills high-rate savings instruments—are largely unknown in India and Asia.”

These are hybrids between the two basic contracts outlined above.

How do we move from here to there?

Simple: Just set up one legitimate bank outside the RBI cartel. It will attract all the deposits. Recall the historical case of the Municipal Bank of Amsterdam, which maintained a 100 per cent reserve from 1609 to 1780. This legitimate bank attracted all the money in Europe, reeling under money and banking scandals.

In reality, the simple but smart Indian people are already moving there – buying gold. This is an act of preference in markets. All that is required is legitimate banking that allows them to use this gold as money. Private money backed 100 per cent by gold.

The transition from here to there is very easy.

This post is written in the interest of all private people who save and who need legitimate banking. They should not be cheated. State-owned banking creates a huge “moral hazard” anyway. Under legitimate free banking there is no moral hazard; rather, the banker is forced to be extremely prudent. And, as Hayek said, all these “prudent private bankers are the overseers of the market economy.”

Tally ho central planner.

Tinkerty-tonk central banker.

Pip-Pip.

Hooray!