Solution to The Financial Crisis

Below is a copy of a research paper I did for an English class recently that brought me to the conclusion I should post something about it here. I am not arguing that an entirely free banking system is a complete answer to all of our financial problems nor am I saying that an entirely free banking system is the right answer, I am simply putting forth this argument as something for us to discuss and think about. I welcome compliments and criticism for discussions, I am also very interested to see how people will react to this. Incase anyone is wondering I belong to the libertarian party in the U.S. which believes in reduced government and that government should return towards its more basic functions and advocate for freedoms in society with lower taxes.

Free Banking

At the present time every single nation on the face of this planet has a centralized banking system or a system very similar to that of the United States Federal Reserve. People generally view banking regulations by government to be essential to maintaining a stable economy. The need for, and cost of strict banking regulations should be explored more fully by all in society who are affected by the status of the economy. Free banking is a legitimate, self-regulated alternative to a centralized banking system that offers more financial stability, non-contagious bank failures, a stable monetary supply, more transparency, and eliminates the moral hazard problem of a lender of last resort.

Free banking is a theory of banking in which commercial banks and market forces control the provision of banking services. Under free banking, government central banks and currency boards do not exist, and banking specific government regulations are either non-existent or not as strict. Banking services may include bank note issue, checking accounts, deposit acceptance, and/or money lending.” (”Free Banking”). The current centralized banking system in place in every country involves setting interest rates on a variety of short term financial products and services, and central banks are also considered a lender of last resort during times of financial crisis. The government intervention on the free markets by manipulating interest rates on monetary supply is largely accused of creating the boom bust economic cycle we have today (Duncombe 18). The lack of government interference that creates booms and busts would create a more stable monetary supply which would force assets to only be allocated to enterprises worthy of credit supply (Cato).

Free banking advocates point out moral problems associated with a government chartered centralized bank. Central banks are a source of revenues because of seigniorage, which is money earned by the issuance of currency, and other money making activities such as bond issuance. Many people view this as an immoral tax on the economy (”Central Bank”). “If taxation without representation is a just cause of complaint, why are chartered banking companies indulged in collecting such immense revenues from the people?” (Duncombe 133). Another moral issue involves interest rates and risk taking. Under a free banking system there would be no enforced fractional reserve ratio and banks would be free to set their own reserve ratios, even sell products with differing reserve ratios thus varying the interest rates and risk levels available to investors on their accounts (”Free Banking”). In a centralized banking system there is no self correcting mechanism and all responsibility is put into the hands of a group of select people, but in a free banking system each transaction could be at a different interest rate which means market forces will be a self correcting force under such a system (Cato). The fact that the market forces are not entirely in control of the market at the present are also viewed as a moral and possible source of today’s financial problems. “Some economists, though not necessarily advocates of free banking, argue that banking regulations (such as interest-rate ceilings, restrictions on loans and investments, and requiring reserves) can be a source of instability.” (Cato). Moral Hazard issues also arise because there is a lender of last resort in the event of a financial crisis. Banks will be more likely to take on more risk than they otherwise would if they know that a monetary authority will likely bail them out during times of need. In a free banking system inter-bank short term credit markets would likely be necessary (”Free Banking”).