Wednesday, January 4, 2023

Free vs Regulated Banking: Canada's Free Banking Era - Modern Day Criticism and the Post-Keynesian School (Part 1)

Click here to read the original Cautious Optimism Facebook post with comments

6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff pivots to addressing a few criticisms of Canada’s free banking story from very left-leaning economists.

Canadian Post-Keynesian economist Marc Lavoie

Up to now we’ve examined Canada’s vastly superior track record of banking stability vis-à-vis the United States, established that Canada had none of the highly destructive laws that America imposed on its banks, and discussed the handful of mostly inconsequential regulations that existed during Canadian banking’s 19th and early 20th centuries.

Canadian banking’s successful history is largely unknown—or deliberately buried—by mainstream economists and the American media, and its lack of major financial regulations is even more unknown. The idea that a largely deregulated system could be so successful is such an anathema to government policymakers and mainstream academics that the subject has been largely stricken from the history books.

However there are a handful of intellectuals who have kept the history alive. The subject is still well known among Canada's economists and financial historians, and outside of Canada the story is still preserved by the “free banking” economics school and economic historians dedicated largely to banking – the largest cluster at Rutgers University starting with Milton Friedman understudy Michael Bordo, then Hugh Rockoff, and more recently Eugene White.

Example: "Why Didn't Canada Have a Banking Crisis in 2008 (or in 1930, or 1907, or ...)?" 

-Michael Bordo, Angela Redish, Hugh Rockoff: NBER, 2011

Of those few economists who are even aware of Canada’s free banking story, most praise its record of stability and success.

However over the years the Economics Correspondent has actually discovered two critics.


The first comes from Mark Lavoie at the University of Ottawa, a leading Post-Keynesian economist.

Before we get into Lavoie’s critique, a word for those who haven’t heard of Post-Keynesian economics.

The heterodox Post-Keynesians view the larger, more mainstream New Keynesian school –which largely controls the liberal-wing of governments around the world – as betrayers of the original ideas and spirit of British economist John Maynard Keynes’ book “The General Theory of Employment, Interest, and Money.”

In the Post-Keynesian worldview, New Keynesians like Paul Krugman, Larry Summers, Janet Yellen, and Ben Bernanke have “sold out” Keynes’ ideas to the free market crowd and  don’t go nearly far enough pressing for greater government control of the economy. 

Post-Keynesians call for far more central bank money printing, far larger government deficits, and much tighter regulation to manage effective demand and properly steer the economy away from its inherent (in their view) instability towards technically managed full employment.

If any of this sounds familiar, it’s worth noting that Post-Keynesians consider themselves natural allies with Modern Monetary Theory economics. Nearly any interview you read with a Post-Keynesian and you’ll hear at minimum qualified, although usually very enthusiastic, support for MMT.

Since Post-Keynesians and MMT’ers think banking systems are inherently crisis-prone and must be tightly controlled by authorities, it follows that any evidence of free banking systems being historically resilient and stable doesn’t sit very well with them.

Another example: “Against Free Banking: The Liability Side Isn't The Place For Market Discipline” 

-Warren Mosler (MMT)


Which brings us back to Lavoie.

His criticism of Canadian free banking? That its reputation for stability is a myth—at least in the 1930’s.

In a podcast interview with George Mason economist David Beckworth, Lavoie disagreed with Beckworth’s characterization that no Canadian banks failed during the Great Depression.

Lavoie: “During the Great Depression in Canada, the belief is that many, perhaps all of our banks, were insolvent, but because nobody ever said anything, then they just keep on going until things got better, and they became solvent again.”

So free banking, in Lavoie's view, was not a success but a failure, but Canadian banks hid their failure from the public.

Unfortunately that was the end of discussion on the Canadian banking subject and the two moved on to talking about central bank floor operating systems. No evidence was offered nor were any sources provided.

However the Economics Correspondent considers the claim that “many, perhaps all of our [Canadian] banks were insolvent” (but all successfully hid their bankruptcy by saying nothing) quite incredible.

A few problems with Lavoie’s theory:

1) Keep in mind ever since the Bank Act of 1871 Canadian banks were required to open their financial books to both federal government officials and shareholders several times a year. 

Lavoie must therefore believe that most or all Canadian banks successfully committed blatant fraud and doctored their books – accounting deceptions that still have not been uncovered to this very day – or that banks, government officials, and shareholders were all aware of mass insolvencies but engaged in a perfect conspiracy to conceal their problems from depositors.

2) Another problem. The biggest culprit behind the nearly 10,000 bank failures in the United States during the 1930’s was illiquidity, not insolvency.

American banks were unable to diversify their portfolios due to unit banking laws, yet most, while distressed, were not insolvent. And at minimum a full 60%+ of U.S. banks survived outright with solvent balance sheets.

Thus it’s even more unbelievable that “most or all” Canadian banks (ie. more than 60%), which unlike American banks were allowed to diversify their loans and depositors nationally, were more bankrupt than even their legally handtied American counterparts.

3) All of Canada’s major banks paid shareholder dividends uninterrupted throughout the 1930’s. A simple online check of the histories of Canada’s “Big Five” banks confirms that RBC, Bank of Montreal, Scotiabank, and the original components of Toronto-Dominion and the Canadian Imperial Bank of Commerce have all paid uninterrupted dividends going back to the late 19th century at least.

That’s a neat trick for allegedly bankrupt banks: to not only go about financing their day-to-day operations, making loans, paying out for withdrawals, and hiding their insolvency, but also paying consistent dividends to their shareholders.

4) History has consistently demonstrated that it’s incredibly difficult for even a single bank to hide financial distress, let alone insolvency, from the public and its depositors who nearly always run for the exits. Word of financial difficulty has always found a way of getting out and depositors have always sniffed out problems and lined up to withdraw their money. The United States was no exception.

Yet somehow we’re to believe the customers of Canadian banks, which were huge and branched nationally during the 1930’s, were somehow more stupid than depositors in virtually every country on earth. 

Evidently Canadians never had the slightest clue that most or even all their banks were bankrupt and putting up a façade of solvency every day, year after year, even as Canadian newspapers were reporting that American banks were failing by the thousands.

Lavoie’s claim is a tall order to believe, but it would be interesting to see if he’s written a paper with more evidence backing his claim.

Finally, keep in mind that during Canada’s free banking era (1817-1935) there were thirteen systemic banking panics in the United States – in 1819, 1837, 1839, 1857, 1873, 1884, 1890, 1893, 1896, 1907, 1930, 1931, 1933. 

Lavoie claims Canadian banks were insolvent in the 1930’s but doesn’t produce any claims of financial crises being concealed at any other time in the 118-year free banking era.

It's a strange argument that Canadian banks, which had done such a pristine job of managing their loan portfolios and avoided the bad credit pitfalls that had plagued American banks for over a century, suddenly became insolvent in the 1930’s at a far greater rate than even U.S. banks.

But even in the unlikely event Lavoie’s incredible claim about the Great Depression is true, Canada’s very lightly regulated system would still have only produced a single panic during a period when the USA’s much more heavily regulated system, with a central bank for 48 of those 118 years, endured thirteen.

We’ll address a more formidable set of challenges to Canadian free banking in the next installment.

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.