flavianopolis

I have read that some economists argue in favour of a supposedly free banking system based either on a foreign currency, some kind of price index or a constant number of notes with legal tender status.

In my opinion all those ideas are mistaken. A free banking system based on anything but precious metal is in my opinion no free banking system, some kind of unrealistic theoretical speculation and/or dysfunctional.

If you like to study a supposedly free banking system based on a somewhat secure foreign currency, I think that Ecuador is a pretty good example of that. But does Ecuador really have a free banking system? My answer is no. Ecuador is in uniltaral monetary union with the United States and though the institution called the Central Bank of Ecuador in reality is no central bank, Ecuador does have a central bank called the Federal Reserve Bank.

One could of course imagine a situation where the private banks of Ecuador would try to substitute dollar notes with promissory demand notes, but I do not think that that will happen since dollar notes hardly possess any intrinsic value. To substitute legal tender with promissory demand notes only makes sense in case the intrinsic value of the monetary base is identical to it's value in exchange. However: That does not mean that it is meaningless to arrange currency boards on the basis of foreign paper currencies, but in case of a currency board the notes and coins issued by the currency board do possess full legal tender status in the jurisdiction in question which of course is hard to imagine in case the issuer is a private institution.

But what about a free banking system based on a price index? My answer is that any system of payments is based on a basic medium of cash payment which may not be rejected by creditors. It would perhaps be theoretically possible to issue a law according to which a specific number of units of national currency is defined as being at par with that quantity of a specific foreign currency which buys you a specific basket of commodities in a speficic place. Sweden could issue a law according to which that quantity of cash Euros which buys you one Big Mac in Germany - at the moment €3,10 - is legal tender for 33,- Swedish Kronor and that all notes and coins issued by the Swedish Riksbank will be replaced by euros at a fixed rate during a limited period of time. If the price of one Big Mac in Germany were raised, than the exchange rate of the Swedish Krona in terms of Euros would be revalued although it would not be possible to hold a One Swedish Krona coin in your hand.

However: I strongly doubt that anybody would be willing to borrow or lend as much as one Swedish Krona if such a reform were realized. The outcome would most likely be that the Krona would be replaced by the Euro. Most importantly such a system seems highly artificial and would most likely not be the outcome of a spontaneous market process.

But what about a constant quantity of legal tender notes and coins as monetary base? In my opinion that is the perhaps most realistic attempt to create a non-metallic system similar to a free banking system, but one weakness of such a system is that it would remain possible for the government to issue additional legal tender and another weakness is that the value of the monetary base would depend on legislation, whereas gold and silver do possess intrinsic value. Another weakness I see is that in case of deflationary tendencies, there would be no natural forces working in the opposite direction. Under a gold standard, a decline in prices and wages will make gold mining more profitable and perhaps more importantly also make already extracted non-monetary gold flow back into the banking system. Therefore deflation under a gold standard will bring about a tendency towards inflation and in my opinion the gold standard can be described as a symmetrical inflation target. It is true that prices and wages fell during the Great Depression 1929-1932, but it is also true that prices and wages never fell back to their level prior to World War I and that for this reason it never became profitable to extract less fertile mines, which would have been profitable to extract given the nominal wage rates prevailing just before the outbreak of World War I. In Sweden nominal wages in 1931 were almost three times higher than they were in 1914, but the gold parity was unchanged.

I believe that a constant monetary base system would bring about deflation without any natural forces counteracting that tendency. I also believe that a system with a deflationary tendency, but without any natural forces working in the opposite direction would be dysfunctional.