We Need Free Enterprise in Banking

Former House Speaker Dennis Hastert has pleaded guilty in what has been called a “hush-money” case. Hastert could receive up to five years in prison, though prosecutors have recommended six months as part of his plea deal. The amazing thing about this case is that such a harsh sentence comes not from any misconduct in the distant past. As the NPR story explains: “The former Republican speaker was charged with one count of evading bank rules about currency transactions and one count of lying to federal investigators. Under the plea agreement Hastert pleaded guilty only to the charge involving currency violations.” When an individual can get six months in prison–to avoid five years–for the crime of withdrawing his own money out of the bank, you know we have left the realm of economic freedom.

The public understandably has little sympathy for Hastert because he was apparently withdrawing large sums in order to pay off a blackmailer. Hastert reportedly withdrew some $3.5 million to pay to “Individual A,” who was a former student back when Hastert was a high school teacher and wrestling coach. But to repeat, Hastert’s law-breaking has nothing to do with whatever harm he may have caused decades ago. Instead, Hastert is now facing prison time because he (apparently) intentionally kept his withdrawal amounts small enough to avoid automatic bank reports, and then lied to federal agents about the nature of these withdrawals once his bank had tipped the government off that something looked fishy.

The Hastert case underscores two important lessons from Ludwig von Mises, both of which I highlight in my new book Choice. First, it illustrates Mises’s point that one intervention paves the way for another. Federal scrutiny of large cash holdings has historically been justified as a tool with which to combat drug trafficking (and more general money laundering) and, more recently, terrorist financing. Yet nobody was accusing Hastert of any of those things. Indeed, it is illegal to blackmail people–so Hastert was withdrawing his own money as he himself was being victimized (in the eyes of U.S. law, though not in the eyes of some libertarian theorists). The current suite of financial regulations and snooping won’t “work” either, and eventually politicians will call for even further inroads into Americans’ monetary freedom and privacy.

Second, the Hastert case underscores just how much our freedom has eroded in the financial sector. As Mises says in Human Action, there was never a reason to abandon the principle of free enterprise when it comes to banking.

In Choice, one of my contributions is to flesh out how “free banking” would work. Mises makes some succinct remarks about the system, but in Choice I give a numerical illustration to make sure the reader understands the elegance of the mechanism.

Specifically, in a market with free entry into banking and where the banks are allowed to set whatever policies they wish regarding note issue, competition would quickly establish sharp limits on how much any individual bank could inflate. If one commercial bank engaged in relative inflation and unilaterally lowered its “reserve ratio”–meaning how much hard cash it kept in the vaults, in order to “back up” its customers checking deposits–then its clients would be able to outspend others in the community. On average, people who banked with other banks would receive a net influx of spending from people who banked with the inflating bank. As the banks in the community periodically “settled up” with each other, there would be a net drain on the vaults of the single inflating bank. It would have more claims on its customers accounts, than it would hold claims against customers of other banks. To stay in business in the community, the inflating bank would have to ship actual cash from its vaults to the other banks. If the expanding bank had been too aggressive in its program of inflation, it would run out of reserves and go belly up.

Thus we see that the market contains built-in checks on inflation by any single bank. In this context, we understand Mises’s argument that central banks–far from protecting the public–actually serve to cartelize the banks. A central bank throws the commercial banks into one pool that can inflate together, and by acting as a “lender of last resort” the central bank can rescue any individual bank that suffers the normal consequences of creating too much money and seeing its reserves dwindle. A central bank thus makes it easier for the banking system as a whole to engage in waves of credit creation and contraction, giving rise to the familiar boom-bust cycle that many people erroneously blame on “free-market capitalism.”

The Dennis Hastert case underscores just how much freedom we have lost in the areas of money and banking. If Americans don’t want federal agents monitoring their checking account habits, they need to understand how the market economy works when it comes to banking. My new book Choice is a great place to start.