Wednesday, February 1, 2023

Free vs Regulated Banking: Canada's Free Banking Era - Modern Day Praise and Debate

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8 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues analyzing the historically successful and stable Canadian banking system with the academic question of Alexander Hamilton’s influence on its original blueprint.

Canadian banking: A Hamiltonian framework (or not)?

Although the story of Canadian banking’s success under very light regulation has been largely stricken from history books, there are a few intellectuals who have kept the history alive.

As one might expect the story is more widely known in Canada where many monetary economists and historians still study the subject. Some the Economics Correspondent has read or followed include Angela Redish (University of British Columbia), James Darroch (York University) and Joe Martin (University of Toronto).

In the United States the Free Banking School of economics writes extensively on Canada’s experience, notably George Selgin (Professor Emeritus, University of Georgia), Lawrence White (George Mason University), and Kurt Schuler (Johns Hopkins, George Mason, and most recently the U.S. Treasury Department).

Several scholars at Rutgers University’s unique economics department have written on the Canadian experience such as Michael Bordo and Hugh Rockoff.

And Charles Calomiris of Columbia University–now at the United States Office of the Comptroller of the Currency—has written much on Canada’s banking success.

What all these academics agree on is that Canada’s nationwide branch banking networks made its industry far more resistant to crisis than the United States where state laws prohibited interstate branching and often banned branching of any kind whatsoever from 1787 to as late as the 1990's.

U.S. economists, also having naturally studied problems in the American system, have cited problems with the U.S. National Banking System (1863-1914) that forced U.S. banks to buy and hold U.S. government bonds to back their private banknote issuances – even when Treasury bonds were disappearing as the Civil War national debt was paid down. 

And the mainstream economics community is acutely aware of massive failures by the U.S. Federal Reserve during the Great Depression.


Where opinions differ concerns the original blueprint for the Canadian system.

Many Canadian economists, along with Calomiris, argue the original authors of Canada’s 1871 Bank Act borrowed Alexander Hamilton’s vision of banking which in turn planted the seeds of success for over 150 years.

The Free Banking school economists disagree with this characterization and the Economics Correspondent hasn’t yet found a position from the Rutgers economists.

But first let’s clarify what is meant by a “Hamiltonian” framework.

American founding father Alexander Hamilton advocated for a much stronger central government than his political nemesis Thomas Jefferson. Among their many disagreements, Hamilton wanted the federal government to charter private banks and pressed for the establishment of a privileged, national central bank in the mold of the Bank of England.

Jefferson, who distrusted centralized government power, argued consistently that the federal government had no constitutional authority to either charter banks or establish a central bank.

Hamilton won out on the issue of a central bank. Congress and George Washington approved the First (1791-1811) and Second Bank of the United States (1816-1836), both of which were 20% owned by the federal government itself.

But Hamilton lost on the question of chartering which was left to the individual states. From the nation’s founding to the Civil War, private banks other than the First and Second Bank of the United States were chartered exclusively by state legislatures.

The Economics Correspondent has already discussed the aftereffects: state governments largely traded bank favors for charters and became shareholders in the banks themselves. To maximize bank profits and state government revenue streams, legislatures granted monopoly privileges to thousands of banks by making them “unit banks” that were forbidden from branching, but by extension enjoyed exclusive banking rights in their own townships.

The vulnerability in this arrangement was unit banking made it impossible for banks to diversify their loans outside of their local towns, and the result was waves of bank failures and frequent banking panics when the prices of certain crops fell in farming regions or when imports or exports declined in trading cities.

One more criticism leveled at the Jeffersonian model is that, lacking a centralized government banking authority, individual states regulated their own banks. 

Later at the outset of the Civil War the federal National Banking Acts established the Office of the Comptroller of the Currency to regulate new nationally chartered banks.

After 1914 the Federal Reserve was tasked with regulating its member banks, and once the FDIC was created in the 1930’s it too took on regulatory responsibilities since it was liable for depositor claims in the event of bank failures.

But in Canada, which granted chartering and oversight powers to the central government shortly after Confederation, a single national agency has regulated banks: OSFI or the Office of the Superintendent of Financial Institutions, although its origins go back to embryonic predecessors in 1925.

Hence another argument for the success of adopting a Hamiltonian model arises: the splintered American system led to four agencies capriciously regulating different and often overlapping groups of banks while the Canadian system has been straightforward with a single national entity applying a single, consistent set of rules.


In the Economics Correspondent’s opinion, the “stable Hamiltonian vision” argument is mostly, albeit not entirely, mistaken. The Free Banking School shares skepticism towards the Hamiltonian hypothesis.

But first let’s start with what’s right about the Hamiltonian theory.

Yes, it’s true that had Hamilton gotten his way and American banks were all required to obtain national charters then it’s very unlikely the American states would have been able to engineer the fractured unit banking system that dominated finance for over 150 years.

This is not an inconsequential argument. Unit banking was a major originator of banking crises in the United States from the late 18th century through the Great Depression although it wasn’t alone – part of a trio comprised of central banks and bondholding mandates, both state and federal, that share the blame.

Also, to the extent one wants governments regulating banks, it is indeed simpler for one national agency to consistently apply rules than assigning oversight responsibilities to separate state regulatory agencies, the OCC, the Federal Reserve, and the FDIC all at once.

However the Hamiltonian argument falters on several fronts.

1) Hamilton championed a government-connected central bank.

Not only did Canada not have a central bank for the first 118 years of its banking history –a very un-Hamiltonian framework – but it was also precisely the absence of a central bank that contributed heavily to financial stability.

By contrast Alexander Hamilton’s central banks produced horrendous results. The First Bank of the United States (1791-1811) and its successor, the Second Bank of the United States (1816-1836), inflated three different asset bubbles, all of which burst and set off banking panics in 1792, 1797, and 1819 with the last two hatching major depressions.

America’s modern central bank, the Federal Reserve System is largely blamed for transforming the Recession of 1929 into the Great Depression, and the Economics Correspondent has written in detail on the Fed’s inflation of the stock market and real estate bubbles of the 1920’s that started the whole catastrophe.

There’s more anguish associated with central banks. Since the United States went off the international gold standard in 1971 central banks have dominated the global monetary system, spawning an unprecedented 107 financial crises in 83 countries including the S&L Crisis and 2008 Great Financial Crisis in the United States.

Thus in at least one major respect Canada absolutely did not model its banking system on Hamilton’s vision and subsequently avoided a lot of pain and suffering.

2) Per Hamilton’s design America’s antebellum central banks were 20% owned by the federal government, his objective being to align the interests of the State with those of the bank.

To further align their interests Hamilton deliberately packed the Bank of the United States’ coffers with U.S. Treasury bonds, and he required subscribers to the Bank’s shares to pay with Treasuries in a scheme to inflate demand for sovereign debt thereby lowering the government’s borrowing costs.

The outcome was a bubble in Treasury securities that burst in 1792, instigating the young United States’ first banking panic.

But the Canadian Bank Acts contained no such crony provisions. Hence the new Dominion of Canada averted the government securities bubble and collapse that rocked the United States.

3) One might argue that it’s more efficient to have a single, all-powerful federal bank regulator than multiple state bureaucracies, an OCC, a central bank, and a deposit insurance agency all regulating at once.

However, as we’ve noted at length, it was precisely bad regulations that triggered the United States’ seventeen banking panics from 1792 to 2008 (one possible exception: 1837-1839).

We’ve discussed several of America’s old regulations before, but new bad regulations both forced and rewarded banks to lower lending standards on home mortgages during the 1990’s and 2000’s which led to massive real estate loan losses and the 2008 financial crisis.

Canada avoided any crisis in 2008, all its banks remained profitable, and none of its banks took a penny of government bailout money.

In fairness to Canada, bad regulations *were* floated in the House of Commons in 1869: a bill to convert the Bank of Montreal into a central bank and condemn all remaining private banks to no branches (effectively recreating unit banking in Canada), but Parliament soundly rejected it. 

Which reveals the hazards of crediting the “single regulator” concept for Canada’s stability. For the key is not the number of regulators but rather good versus bad regulations, and Canada has had mostly the former and very little of the latter.

In the Economics Correspondent’s opinion Canada’s success was rooted more in its decisions to avoid adopting bad bank regulations, not in assigning fewer agencies to administer them.

4) Even though the “Hamiltonian vision” crowd agrees with everyone else that the U.S. unit banking system was horrible all-around, unit banking laws were regulations too. 

Once again the real issue is whether bad regulations were imposed on the banking sector or not, not whether a powerful central government or states/provinces enforced the rules. Canada could have imposed bad regulations in 1869 but declined.

Professor Joe Martin of the University of Toronto goes out of his way to reject the alternate “free banking” narrative of Canada's success – that Scottish immigrants emulated their native country’s lightly regulated system when they arrived – and insists Canada followed the Hamiltonian model, not the Scottish one.

The Economics Correspondent is impressed with Martin’s breadth of knowledge and has enjoyed several of his articles and interviews, but based on the evidence and historical record maintains the Canadian banking system's first 118 years were molded more in the spirit of Adam Smith than Alexander Hamilton.

In summary the Economics Correspondent believes Canada’s free banking era was so successful because it was, well… so free, not because the federal government molded it from Alexander Hamilton’s template.

The one and only Hamiltonian aspect of Canadian banking that can claim credit for stability is the national charter which prevented provincial-level unit banking from ever taking hold.

That’s about it. Because there are many more traits of Hamiltonian banking that would have spawned crisis and panic, but which Canada avoided precisely by not adopting them.

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