Free vs Regulated Banking: Canada's Free Banking Era - Modern Day Criticism and the Post-Keynesian School (Part 2)

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

10 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff apologizes for the length of this latest entry, but an intelligent Post-Keynesian blogger has made formidable criticisms of Canada’s successful, lightly regulated banking history which requires a thorough response and (as CO says) everything is better when presented as a numbered list.

Blogger "Lord Keynes"

In Part 1 we addressed a single criticism of the Canadian free banking story by University of Ottawa professor Mark Lavoie, a Post-Keynesian economist.

We also discussed Post-Keynesianism’s similarity to Modern Monetary Theory (MMT) and their shared enthusiasm for heavier government regulation of the financial sector and economy as a whole, and shared dislike of any idea of bank deregulation let alone stories of its success.

“LORD KEYNES”

In Part 2 we examine a much more comprehensive list of objections from a more formidable critic: a self-described “Left socialist… … Post Keynesian in economics” blogger named “Lord Keynes” whose website is titled “Social Democracy for the 21st Century: A Realist Alternative to the Modern Left.”

Lord Keynes’ writing is proficient enough that the Correspondent believes he could very well be an economist by training. He has also done a prodigious amount of work on his blog and provides plenty of academic sources.

In his post: “Canada’s Banking Stability in the Early 20th Century and the 1930s,” Lord Keynes criticizes what he calls “Austrian, libertarian and free banking myths.” 

We’ll analyze it here, but you can read the entire column yourself at:

https://socialdemocracy21stcentury.blogspot.com/2013/12/canadas-banking-stability-in-early-20th.html

Lord Keynes’ chief complaint is that Canada’s banking system was not regulation-free during the early 20th century and proceeds to list several examples of regulations that he argues saved the system from what would otherwise have been systemic crisis or even collapse during the 1920’s and 1930’s.

There are a lot of objections in his article, and we’ll try to address them one-by-one.

LORD KEYNES’ LIST

Lord Keynes’ criticisms, in nine parts, include:

(1) - Free bankers claim Canada did not have a lender of last resort (such as Selgin, 2018), but in fact it did.

Lord Keynes points out that during the 1930’s some smaller Canadian banks that were short on liquidity received short-term cash loans from the Bank of Montreal, the largest bank in Canada at the time.

But Selgin’s “lender of last resort” commentary was, within the very same sentence, referring to the United States Federal Reserve, a government-privileged central bank which failed in its role miserably during the 1930’s leading to nearly 10,000 American bank failures.

While it’s true that the Bank of Montreal did act as a private-sector lender of last resort on several occasions, if anything its experience demonstrates the private banking system of Canada performed that function far better than the U.S. Federal Reserve did. And the Canadian system was also effective without the downside of a government-privileged central bank inflating multiple crisis-inducing asset bubbles as the U.S. Federal Reserve and Bank of England have done so many times throughout history. 

Score one for free banking.

(2) - Lord Keynes immediately follows up his lender of last resort critique with “Nor was it true that Canada’s banking system was unregulated.”

This is tearing down a straw man. The Economics Correspondent knows of no pro-free banking academic, Selgin included, who has written that Canada’s or any other free banking system was 100% laissez-faire.

Rather free bankers have argued that Canada’s lightly regulated regime was neither harmful enough to precipitate financial crises (one possible exception below) nor did it rescue Canadian banks from some impending panic of their own alleged creation.

(3) - Lord Keynes concedes that the nationwide branch banking system, which was legally prohibited in the USA, did make Canadian banks more resilient to crisis. 

But he counters that “The number of branches dropped from 4049 to 3640 between 1929 and 1933, loans and deposits fell, and bank-stock prices dropped. The interwar period showed a trend towards fewer and larger banks.”

To which the Economics Correspondent replies: “So what if some branches closed?”

There was, after all, a Great Depression taking place in Canada.

If the worst thing that happened in a Great Depression was 10% of branches closed, loans fell, and the prices of bank shares fell – but not a single bank failed and there was no financial crisis while in the USA nearly 10,000 banks failed – the Economics Correspondent calls that a very positive outcome and an endorsement, not indictment, of the Canadian system.

Besides, who on earth expects a banking industry to expand and its share prices to rise in the middle of a Great Depression?

(4) - Lord Keynes revisits regulations and argues “Chartered banks in Canada even in the 1920s and 1930s were ‘heavily regulated’ by the Bank Act of 1871 and subsequent revisions of that act, which ‘specified (among other things) audits, capital requirements, directors’ qualifications, and loan restrictions…’”

We’ve covered this territory before. The Economics Correspondent already wrote previously about these specific restrictions in the articles where he stated:

“Even in the earliest days of Canadian banking there were still a few regulations common to the various provinces. However, they virtually all involved policing fraud and insider conflicts of interest… ...limits were placed on the size of loans banks could make to their own directors, and banks were prohibited from using shares of their own stock as borrowing collateral.”

But such restrictions hardly equal “heavily regulated.” As the Correspondent has also pointed out:

“None of them [Canadian laws] mirrored the foolhardy U.S. regulations that prohibited branching, forced banks to buy lousy government bonds for permission to issue currency, or established central banks that blew multiple asset bubbles which ultimately crashed into financial panics.”

Previous commentary on light regulations at:

http://www.cautiouseconomics.com/2022/12/free-regulated-banking-29.html

(5) - Lord Keynes argues that the government actually did save the Canadian banking system from crises because: 

“The ‘Canadian Bankers Association’ [formed in 1891] – which in 1900 became a public corporation – also provided stability by organising bank mergers to deal with insolvent banks.”

But the CBA was always a private entity throughout, making it yet another example of the private sector, not regulations, more successfully addressing industry difficulties.

By calling the CBA a “public corporation,” Lord Keynes is referring to (from the CBA’s own website): “[CBA was] incorporated by a special act of Parliament in 1900.”

Receiving a charter for incorporation as a publicly owned company does not make one a government agency nor is it an example of stabilizing regulation. General Electric and Apple are also incorporated by filings with the government of Delaware.

(6) - Lord Keynes suggests Canadian depositors didn’t inflict runs on their banks because some implied form of government deposit insurance existed – even though Canada didn't adopt federal deposit insurance until 1967.

LK: “There is some evidence that successive Canadian governments from the 1920s made public statements and implicit promises to protect depositors in failed private banks, at least to some extent…”

Well that's a bit thin. “Some evidence” of…

“public statements” [not legislation, regulation, or policy] and…

“implicit promises” during the 1920’s…

“at least to some extent”

…is a pretty weak case that depositors held firm in the turmoil of the Great Depression because they had unshakeable confidence in deposit insurance that didn’t really exist.

(7) - His attempt at a slightly more forceful argument for “implied deposit insurance,” which ultimately undermines his case, is:

(Lord Keynes) “Governments did pay to reimburse or protect depositors: when in August 1923 the Home Bank of Canada failed, the Canadian government in June 1925 passed legislation which eventually resulted in the government paying 22.3% of average depositors’ claims.”

Lord Keynes omits a lot from the story here, the details of which are in the very paper he cited as his source (Carr, Mathewson, Quigley 1995). 

The missing facts are:

When the Home Bank failed depositors, who were not insured, argued the government should make up their losses due to what they claimed was the state’s failure to adequately investigate allegations of bank fraud from years prior.

A suit was filed, a Royal Commission was established to hear the arguments, and the claims languished in hearings for two years before the House of Commons finally agreed to reimburse depositors.

However, the Senate held up the ruling and eventually lowered the compensation to just 22% of depositor’s claims.

And two years later the Bank Act of 1927 settled the matter for good when it “…made clear that the government was not responsible for losses to depositors, shareholders, or creditors to the banks.” (Calomiris: 2014).

This evidence effectively demolishes all the “implied deposit insurance” arguments as well.

Whatever “public statements” or “implied protections” may have been floated in the 1920’s, weak as they may have been, the 1927 law declared there will be no depositor reimbursements coming from the government, squashing any implied expectations.

And a last word on the Home Bank story: 

Even if the 1927 law had never been passed, it’s unbelievable that depositors of the 1930’s, unnerved by the Great Depression and ready to run on Canadian banks, chose to leave their money on deposit because they were thinking…

Depositor: “I’m not worried. If my bank fails, first I can hope it was due to fraud and that someone had previously complained to the government years ago.”

“Then I just need to organize a petition with other depositors, file a suit, hope that a Royal Commission is set up to listen to arguments for two years, and then let the Senate water down my compensation to just 22% of my money which I might get a few years later if I’m lucky.”

“With iron-clad guarantees like that, why would I ever consider pulling my cash out now?"

(8) - Lord Keynes’ most compelling arguments involve Dominion notes. He points out that:

“In 1907 the Canadian government lent $5 million in Dominion notes to the private sector banks during a banking panic, which averted a serious financial crisis.”

There are several problems here, starting with the fact that no economic historian considers 1907 “a banking panic” in Canada.

However, it is true that Canada’s banks were short of paper currency in 1907, and that that shortage did create duress in the industry that led to the failure of three small banks (only one of which was unable to pay its depositors back in full).

However, as the Economics Correspondent has already pointed out in an earlier column, the shortage of cash itself was the result of government regulations—the worst, most damaging regulations Canadian Parliament had attempted to that date.

Canadian banks were legally forbidden from issuing private banknotes beyond 100% of their paid-in capital. When customer demand exceeded that limit, depositors withdrew gold coin as a hand currency substitute leading to a national credit contraction.

Therefore it’s no surprise that, in the middle of a problem of its own creation, Parliament loaned liquid Dominion notes to make up for a shortfall that its own regulations, not free banking, had induced.

(9) - In his last Dominion notes objection, Lord Keynes points out that banks repeatedly borrowed Dominion notes from the federal government throughout the 1920’s, so it can be assumed these borrowing facilities saved the banking industry in the 1930’s.

LK: “More important was the Finance Act of 1914. This allowed Dominion banks to borrow notes directly from the Canadian Department of Finance: such notes were issued at the request of the banks with no gold-reserve requirement…”

“The Finance Act (1914) allowed the Canadian government the power to expand the money supply by creating dominion notes… … Moreover, the use of this system continued long after the war… …this mechanism had extensive use during the 1920’s.”

Once again Lord Keynes leaves out important details that undermine his thesis.

First, the 1914 Act wasn’t so much a bank-assistance "regulation" as it was a simple wartime inflation measure. At the outbreak of World War I the Dominion government, like every member of the empire coming to Great Britain’s aid, suspended the gold standard, declared its own notes a legal gold reserve substitute, and aggressively inflated the money supply to finance its own war expenditures.

Also, as the Economics Correspondent has already written about, in 1880 the federal government granted itself a monopoly on the issuance of banknotes under $5 and restricted the issuance of private banknotes to multiples of $5 only.

Hence from 1880 onwards, federal law forced Canadian private banks to become completely dependent on the Canadian government for low denomination notes since they were forbidden from supplying any of their own under $5.

Although Lord Keynes doesn’t offer evidence that Canadian banks made healthy use of the discount window in the 1930’s (only “one can posit that the heaviest use… was in the crisis years from 1929–1933”), to do so would prove nothing: least of all that a deregulated Canadian system got itself into crisis and was only saved by government assistance.

If banks experienced higher than normal cash withdrawals during the 1930’s, they would logically notice that demand for low denomination notes was also higher than usual. Since the 1880 regulation made it illegal for them to provide the public low denomination notes, it follows that of course they would approach the only source legally available –the federal government—for more.

In fact, the history of central banking is the story of all governments eventually granting banknote monopolies to their central banks which in turn set up facilities through which private banks can access those banknotes, going back to the first central bank currency monopoly granted to the Bank of England by the Peel Act of 1844.

The federal government’s Dominion notes facility and monopoly is another example of Canada flirting with bank regulations that made the industry less flexible and forced Canadian banks to come begging-on-knee to the government to fix a problem that Parliament itself had created.

The Economics Correspondent has written more details on Parliament’s private banknote restrictions and the problems they caused at:

http://www.cautiouseconomics.com/2022/12/free-regulated-banking-30.html