Legal Tender, from Gordon Haave

September 26, 2007 |

Stonington BankPrior to the Federal Reserve, there were private bank notes. They traded freely, such that if a bank was deemed to have too few reserves, the notes traded at a discount. In the late 1800s there was a big information problem, not only on the quality of the banks, but also authenticity of notes, because of distance. Does someone in St. Louis recognize a bank in New York?

All those problems would be gone today. Citibank and B of A would issue currencies. They would be backed with real assets (like a money market fund, sort of). Everyone would have a real interest in bank solvency, and if banks did silly things, their notes would trade at discounts and their customers would be miffed.

Vitaliy N. Katsenelson replies:

By definition banks cannot have all of their debt backed by liquid assets, as banks have little equity (around 8-10%) and a good chunk of their loans are illiquid long-term loans that may or may not be salable on a secondary market at a fair price in a prompt way. To some degree this is the role the Federal Reserve is supposed to play, being a lender of last resort. If all customers came to their banks at once and demanded their money back, banks would simply go bankrupt overnight as they would not be able to pay off all the debt at once. This is a run on the bank. We just saw a mini version of it play out in the UK, where the UK's central bank bought loans from Northern Rock, thus granting instant liquidity and thus preventing a run on the bank, and actually a run on the whole banking system.

Gordon Haave explains:

Banks wouldn't need to have all of their debt backed by liquid assets. They could simply have the currency that they issue backed by liquid assets. And the currency needn't necessarily be backed 100%. The required reserves for people to accept the currency at face value would be set by the market.

Stefan Jovanovich writes:

Head TellerLong before common stocks became important enough in the public mind for American publishers to print their daily quotations, there were regular circulars assessing the discounted value of state-chartered bank notes. Merchants would subscribe to the circulars to determine how much of a discount to the value of specie was appropriate for accepting in payment the notes of the wildcat bank of Up In the Mountains, Name Your State. Theoretically, all bank notes were redeemable in specie when presented to the issuer; but the Sheriff in Up In the Mountains might be less than enthusiastic about having someone actually removing from the jurisdiction the four gold pieces held by his brother-in-law, the Head Teller.





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