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)?

ACADEMIC PRAISE AND AGREEMENT

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.

SPLIT ON HAMILTON

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.

MOSTLY WRONG?

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.

San Francisco Walgreens Bubble Gum, Toothpaste, Candy Bars... and More Now Locked Up

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Yes Cautious Rockers, the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff can now report that San Francisco Walgreens stores are even locking up the chewing gum for safekeeping. 

Want a pack of Doublemint? Who wouldn't love the convenience of finding a "customer service button" to press and waiting for an employee with a security key to walk over and unlock it for you? (see photo)

The Economics Correspondent, a resident of San Francisco, normally goes to a Walgreens in his fancy, stuck up limousine liberal neighborhood and previously only saw security barriers for higher dollar items.

This time he visited a Walgreens in the Central Richmond District on Geary Boulevard, by no means a bad part of town but in a higher traffic area, and saw the difference immediately.

He would estimate more than 50% of the store's merchandise is locked up -- toothpaste, deodorant, vitamins, candy bars, cosmetics, you name it. It's a strange and claustrophobic sight to walk down a store aisle where both sides are covered with protective barriers from head to toe. (see photo)

All those security barriers and extra employees constantly running from one floor call to another must also do wonders for operating costs that are always passed on to consumers... a majority of whom voted for this "social justice" outcome.

England's NHS Waitlist Now 7.1 Million, Like 42 Million Americans Waiting for Hospital Admission

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A two-month dated story, but the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff calculates 7.1 million people equals 12.7% of England's population.

That's like 42 million Americans on waiting lists for hospital admission and 2.4 million waiting for more than a year.

Read details in the Guardian: "Record 7.1m people in England waiting for NHS hospital treatment."

https://www.theguardian.com/society/2022/nov/10/record-71m-people-england-waiting-nhs-hospital-treatment

Even Yellen Has Limits, Opposes Trillion Dollar Coin Idea Again

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2 MIN READ - From the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff

Treasury Secretary Janet Yellen on rekindled proposals for the U.S. Treasury to mint trillion dollar platinum coins to continue spending without raising the debt limit:

"It truly is not by any means to be taken as a given that the Fed would do it, and I think especially with something that's a gimmick. The Fed is not required to accept it, there's no requirement on the part of the Fed. It's up to them what to do."

And Yellen in 2021:

"I'm opposed to it, and I don't believe we should consider it seriously. It's really a gimmick, and what's necessary is for Congress to show the world can count on America paying its debts."

Read details here:

https://www.businessinsider.com/will-the-us-mint-platinum-coin-yellen-dismisses-debt-ceiling-2023-1

Given that she also testified before Congress in 2022 that she does not believe corporate greed causes inflation, and testified as Fed Chair that raising the nationwide minimum wage would result in a significant number of low-skilled workers losing their jobs we know Yellen is not always wrong.

However her occasional flashes of correctness have to be kept in context with her repeated 2021 and 2022 predictions that inflation was "transitory" and would go away on its own, her recent television interview blaming the American public for causing price inflation, her opposition to adopting any rules-based discipline at the Fed, her efforts to coordinate a "minimum global corporate tax" with other countries to stop companies from relocating to tax havens, and (verdict is still out on this one) her prediction that the Biden administration can avoid a recession.

Altogether America can do better than Yellen.

ps. In a bizarre choice the attached article interviews Rohan Grey, a law professor at Willamette University, for an opinion on the debt ceiling debate and trillion dollar coin proposal where he argues Congress has to do whatever it takes to keep the federal government spending, spending, spending.

But Grey is one of the most visible/vocal advocates of Monetary Monetary Theory, an eccentric economic movement that states Congress can fund a Green New Deal, universal healthcare, free college tuition, a guaranteed jobs program, Universal Basic Income, and minority reparations all with the printing press and little to no inflationary repercussions.

After a brief burst of popularity among far left disciples, MMT has been wholly discredited by the last year's bout of inflation. The federal government never got started spending on any of the MMT wish-list of uber-programs and just what little money creation the central bank embarked on to counter Covid lockdowns produced elevated inflation rates that it's now scrambling to contain.

Yet of all the monetary economists available out there to choose from Business Insider picked an MMT apostle to interview? Who just coincidentally urging spend, spend, spend?

Gavin Newsom Fact Check: "95% of Texans pay higher taxes than Californians"

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“Our tax rates, again, are lower than the state of Texas. I just want to remind everybody out there, 95% of Texans pay higher taxes than Californians.”

-Gavin Newsom last week during his news conference announcing a projected $22.5 billion state deficit

4 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff, who has lived in both states, runs an easy fact check on the California governor.

Gavin Newsom says California’s tax system is more progressive so middle class and working citizens pay less tax in California than Texas.

Well let’s do some simple math on the four largest tax items: Income, sales, property, and gasoline.

(1) Income tax. California’s marginal tax rates on low-and middle-class earners are (example for singles):

1% - $0 to $10,099
2% - $10,100 to $23,942
4% - $23,943 to $37,788
6% - $37,789 to $52,455 ***
8% - $52,456 to $66,295 ***
9.3% - $66,296 to $338,639 ***

The Economics Correspondent would venture to say that all middle-class workers are captured in the three (***) brackets, paying 6%, 8%, and 9.3% of their marginal income taxes.

Texas’ income tax rate for all earners: 0%

Sort of hard for 95% of Californians to pay less income tax than Texans when Texans pay zero.

But what about other taxes? Some Californians claim Texans make up for the zero-income tax by paying higher sales, gasoline, and property taxes.

(2) Sales tax. California’s base sales tax is 7.25%. Texas’ base sales tax is 6.25%.

Both states give counties and cities the option to add additional taxes. 

In Texas counties can add up to 1% and cities another 1% for an absolute top sales tax rate of 8.25%. Most major cities in Texas opt for the full 8.25% as do many rural counties.

In California counties and cities can go higher than 8.25% if they want. But do they?

Every city in Los Angeles County has a sales tax anywhere from 9.5% to 10.25%. San Francisco’s sales tax is 8.625%. Bay Area counties with major cities like Oakland, San Jose, and San Mateo (San Mateo, Alameda, Santa Clara, and Contra Costa counties) all charge sales taxes anywhere from 9.375% to 10.75%.

The exceptions are Orange, Sacramento, and San Diego counties which charge 7.75% as do many rural counties.

Both states exempt certain necessities like groceries.

So the final verdict is mostly 8.25% in Texas, 9.375% to 10.75% in California’s most populous cities, and 7.75% in mid-level cities and rural areas.

Also, given that virtually everything in California is more expensive than in Texas, most Californians are paying higher sales tax rates but all of them are paying sales taxes on more expensive goods and services.

Verdict: Californians on the whole pay more in sales taxes than Texans.

ps. Incidentally California law requires residents to report purchases *outside* California and pay sales tax on them too, but hardly anyone complies. The law was designed mostly to target California businesses.

(3) But what about property taxes? Californians love to complain about Texas’ property tax rates.

During the 1970’s California tax revolt voters approved Proposition 13 which capped residential property tax rates at about 1.2% the value of the home.

In Texas property rates are usually around 2.5%-2.8%. 

So yes, property tax *rates* are higher in Texas.

But it’s not only the rate that determines your tax bill, but the home value too. And in Texas homes are a lot less expensive, and you get more house for the money.

Granted, the recent Federal Reserve zero interest rate Covid policy pushed Texas home prices up and slightly narrowed that gap, but given that California home prices also inflated the gap is still huge.

Comparing major cities, a house that might cost $300,000 in Houston or Dallas will cost more like $1 million in Los Angeles or Oakland. And closer to $1.5 million or $2+ million in San Francisco and San Jose.

So Texas property tax rates are about 2 to 2.3 times higher, but California homes are 3 to 7 times more expensive.

Verdict: Californians also pay more in property taxes.

Comment: One advantage old homeowners have in California is that their property tax rate is based on the purchase price of their home, not the assessed price, whereas in Texas every time the home is assessed by the tax collector the tax bill rises. 

So initially Californians do pay a lot more in property taxes, but after the California and Texas homes rise about 50% to 200% in value, depending on location, the two homeowners start paying about the same tax bill, and once the home values rise even higher the Texan pays more for a few years to compensate for his far lower tax bill in the early years.

Finally, after all those years have passed the Texan starts paying more property taxes overall going forward. It's difficult to calculate exactly how long it takes for this process to play out but a good ballpark guess would start at living for two decades in the same home.

(California homeowners feel free to chime in with any comments or corrections)

(4) Gasoline taxes. This one is easy.

California adds 53.9 cents per gallon in taxes. And by law it increases by about 5% every year. 

Texas adds 20 cents per gallon in taxes.

So your average Texan has to burn through 2.7 times more gasoline annually to pay the same taxes Californians do.

Both states’ residents have long commutes, particularly in the big cities. 

Having lived in both states it’s an easy call.

Residents of Los Angeles and Orange County metro area (13.2 million people) have longer drives and get stuck in more traffic than those of Dallas/Fort Worth and Houston areas (14.6 million people). 

The same is mostly true for residents of the San Francisco Bay Area (6.6 million people) compared to the San Antonio and Austin areas (4.8 million people).

OK, San Antonio is easier. Anyone who has lived in Austin will tell you the traffic congestion is probably worse although the commutes are still shorter than those for Bay Area residents.

(5) One more. If Newsom is right that 95% of Californians pay fewer taxes than Texans, wouldn’t Texans be fleeing to California instead of the other way round?

Final summation? Californians pay more in income taxes, sales taxes, and gasoline taxes. Most Californians pay far more in property taxes although once you’ve lived in your house for perhaps two decades it evens out and after that Texans might start paying more.

And the final verdict? Newsom’s lips were moving. Therefore his claim was false.

America's Highest Taxes and California Projects a $22.5 Billion Deficit... and We're Not Even in a Recession Yet

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4 MIN READ - As a near two-decade resident of San Francisco the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff has the inside scoop on California’s budget burlesque.

So Gavin Newsom, who was just crowing over a $100 billion budget surplus last year, is now facing a projected $22.5 billion deficit for FY2023-24. This is on top of the Golden State’s current $144 billion in outstanding debt.

So why, with the highest taxes in the nation, is California’s government heading back into the red again? 

If you read the attached San Francisco Chronicle article...

https://www.sfchronicle.com/politics/article/California-is-going-from-a-100-billion-surplus-17708694.php

...you’d think it’s all a tax receipts problem with a handful of rich Californians (that the state is overly reliant upon for revenue) due to the unpredictable variations in capital gains taxes and a down stock market year.

But the Economics Correspondent remembers better.

Here's a little background on how California got to this point.

THE 2008 FINANCIAL CRISIS

When the Economics Correspondent first moved to California the highest marginal state income tax rate was “only” 9.3%. For singles, any income above an AGI of $40,346 (which is nothing in California) was taxed at a marginal 9.3% rate, even for multimillionaires.

Even with what was then the fourth highest income tax rate in the nation, California was still running large deficits. But as the national and California economies improved into 2005 and 2006 those deficits narrowed.

Then came the 2008 financial crisis and Great Recession.

With stock, real estate, and other asset prices plunging and the economy falling into a major slump California’s tax revenues nosedived. 

Of course government spending didn’t.

Governor Arnold Schwarzenegger had run in 2003 as a moderate conservative. But in 2005, four out of four of his fiscally conservative state ballot proposals were rejected by voters and Schwarzenegger converted overnight to a fiscal liberal, announcing the very next day a package of new government spending programs.

But in late 2008 and 2009, faced with a huge deficit, Schwarzenegger backtracked and halfheartedly tried to convince the Democratic legislature to make budget cuts.

They didn’t budge. Historical budget tables (data below) show California state spending increased by 4.8% in 2009, another 4.8% in 2010, and a jawdropping 14.5% in 2011.

Schwarzenegger quickly abandoned spending cuts and compromised, announcing he would agree to tax increases during a major recession.

Immediately minority Republicans abandoned Schwarzenegger and told him “you’re on your own,” and he quickly moved with majority Democrats to enact a new “temporary” 11.3% tax rate on any income over $1 million.

JERRY BROWN

As Ronald Reagan famously said, a temporary tax is the closest thing to eternal life on earth.

But in Schwarzenegger’s case he actually told the truth. The 11.3% tax rate really was temporary. Well, sort of.

Because in 2011 Jerry Brown moved into the governor’s mansion and, with the help of the Sacramento legislature, raised the top rate again, this time to 13.3%.

There were also elevated 12.3% rates above $500,000, 11.3% above $300,000, and 10.3% above $250,000.

California continued to run large deficits each year until 2014, when a combination of a slowly improving economy and the higher taxes nearly closed the gap.

In 2015, seven years after the financial crisis, California finally ran a small surplus.

At which point California liberals in government, the media, and on Internet boards all lectured that “See, Republicans just don't get it. You need taxes to run a government” as if it’s impossible for a state government to function on less than 13.3% tax rates (never mind Texas and Florida can do it with no income tax at all).

Meanwhile wealthier and more productive Californians were steadily moving out, setting the stage for another budget crisis whenever the next recession came along.

The Economics Correspondent remembers several conversations with friends during that period where he repeatedly said “Yes, they bailed their budget out with a big tax increase and it will work in the short term. But as more high income taxpayers move out I guarantee you next recession they’ll discover even a 13.3% tax rate isn’t enough and run deficits again. At which point they’ll probably press for yet another tax increase.”

Well here we are, not even in a serious recession yet (that’s probably coming later this year) and the state is already forecast to run a $22.5 billion deficit. If the USA falls into a significant recession later that deficit will only increase.

SPENDING

So back to the San Francisco Chronicle article. 90% of the column blames erratic revenue streams for the forecasted shortfall but makes very little mention of spending.

Fortunately the Economics Correspondent has the data.

Going back to 2008 through 2021, California’s population rose by 7.2% and prices increased nationwide by 31.8% due to inflation (excludes 2022). 

Has California state government spending kept pace?

In 2008 California’s state budget was $151.8 billion.

Therefore if the budget simply kept pace with inflation and population growth (+41.3%) California should have been spending $214 billion in FY2021 (July 2021 through June 2022).

Instead in 2021 California’s state budget was $344.7 billion, up an outlandish 127% from 2008.

While California blows egregious amounts of money on just about everything, the two biggest culprits are insane unionized government worker salaries and pensions and generous services for ballooning numbers of illegal immigrants.

In 2021 the Economics Correspondent posted truly preposterous specifics on California profligacy at:

http://www.cautiouseconomics.com/2021/03/government-budget01.html

This is no surprise to anyone familiar with how Sacramento… or Albany, or Springfield, or even Washington, DC for that matter, operates.

When recession arrives and governments run deficits, a “temporary” tax increase goes into effect, politicians declare victory, and then for every $1 in new revenue they find $2 in new spending.

The recovering national economy then masks the impact of the excessive spending increases and fleeing taxpayers… at least until the next recession hits several years later and the government falls back into deficit and crisis again despite the permanently elevated tax rates.

The Economics Correspondent will hardly guarantee this prediction, but if a serious recession strikes the economy in 2023 or early 2024 California’s deficit will expand to much more than $22.5 billion. And the odds are on Gavin Newsom and the Sacramento legislature then pursuing yet another tax hike—either raising the top rate yet again or, if they’re desperate enough, going after the middle class this time.

Source data:

California population 2008: 36.6 million
California population 2021: 39.2 million (down 260,000 from 2020)

California state spending

FY2008: $151.8 billion
FY2009: $159.0 billion
FY2010: $166.7 billion
FY2011: $191.0 billion
FY2012: $183.6 billion
FY2013: $188.5 billion
FY2014: $194.8 billion
FY2015: $222.3 billion
FY2016: $239.1 billion
FY2017: $242.0 billion
FY2018: $257.8 billion
FY2019: $281.1 billion
FY2020: $306.7 billion
FY2021: $334.7 billion (elevated Covid spending)
FY2022: $330.5 billion

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

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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