June 2, 2011 Reading Time: 4 minutes

A relevant figure in a free banking scenario is that of the private clearing house association (CHA). The CHA facilitates clearing services among its members, supplies some regulation to the market and eventually it may become a lender of last resort. Isn’t the case, then, that the invisible hand that operates under free banking will result in a spontaneous central bank, the exact same institution that by definition cannot be present in free banking? Isn’t after all, the case that central banks are in place to give stability to the financial markets, one of the roles of CHAs? There are, however, two problems with this approach. First, there are reasons that make a CHA and a central bank different entities. Secondly, this is not the evolution that is commonly observed in historical cases.

There are different reasons why private banks may be interested in voluntarily form and become members of a CHA. To lower transaction costs through the clearing services is clearly one of them. But to become a quality check and a self-policing arrangement is another one just as important. Before any bank lends to another it will be interested in knowing its financial situation. Why is he in need of borrowing resources? Is it expanding its activities or is it having a liquidity problem? How does its future cash flow look like? What would be the credit rating of this bank? If the CHA only accepts investment grade banks, then any bank knows that that’s how it’ll be considered by other banks if he gets to be accepted by the CHA. This bank will be already in advantage when approaching other bank for a loan. Importantly, the self-policing works in both ways. Banks that belong to the CHA are recognized as efficient institutions in the market, but if the CHA evaluations are not good, then the banks will leave the CHA and apply to another one with a more rigorous evaluation process. The CHA has no monopoly benefits, it may be replaced and face competition in the market as any other association or club does.

But to be accepted in a CHA a bank should not only conform with certain performance level, but also comply with the regulations required to all members as well. Similarly as a football player needs to have a minimum of ability, be healthy and accept the rules of the team members to be accepted by one of them, the candidate bank needs to be in shape and accept the conditions to belong as well. These regulations, however, are voluntarily accepted by the members of the CHA for the benefits they produce. Should the CHA try to regulate against the will of the banks, they will transfer their subscription to another CHA. Similarly as any individual may do if his football coach regulates against the interest of the players as a team. It would be a misnomer to refer to this kind of regulation as if it were similar in kind to state regulation. The kind of regulation a CHA can do is very different, and much more limited, than the regulation a central bank can put forward.

If the CHA, besides reducing transaction costs associated to clearing transfers, achieves to separate efficient banks from inefficient banks, then there should be no reason to fear a financial crisis due to a run against insolvent banks. There are no incentives for the banks to lend money to insolvent banks, and as such the financial distress of these institutions is stopped before it spreads to solid banks. What, then, has a central bank to add to this picture? If it is argued that both perform a similar role, shouldn’t we prefer competitions among CHAs than a state-monopoly central bank?

This leads us to the second point. Something else has to be taking place to go from private CHA to central banks. Historical evidence does not support the case that CHA became, naturally and spontaneously, central banks. It was, on the contrary, the government needs of funds to finance wars and/or fiscal deficits what lead to the appearance of central banks. The banks were in good shape, the government wasn’t. The former had to finance the later. Of course, the specifics of each case vary from country to country. But with a some exceptions, what is commonly observed is that central banks appear to cope with fiscal problems. In some cases more directly and explicitly, in other more slowly and indirectly. On of the most quoted cases, for example, is that of the Bank of England, which became a central bank after receiving several privileges from the government in exchange of the loans received. If there are no good incentives to lend to a government with fiscal deficits and no prospect of improving the situation, then an institutional privilege may be needed to get the borrowing. Vera C. Smith’s (1936) The Rational of Central Banking offers a study on the origins of central banks in different countries.

CHA and central banks, although similar on some aspects, are very different creatures. If the argument is solely that the role of the central bank is to monitor and police the financial markets then it is not clear what it is the benefit with respect to competitive CHAs. If, however, the reason to have a central bank involves to financially help the government, then the story becomes very different.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image: scottchan / FreeDigitalPhotos.net

Nicolás Cachanosky

Dr. Cachanosky is Associate Professor of Economics and Director of the Center for Free Enterprise at The University of Texas at El Paso Woody L. Hunt College of Business. He is also Fellow of the UCEMA Friedman-Hayek Center for the Study of a Free Society. He served as President of the Association of Private Enterprise Education (APEE, 2021-2022) and in the Board of Directors at the Mont Pelerin Society (MPS, 2018-2022).

He earned a Licentiate in Economics from the Pontificia Universidad Católica Argentina, a M.A. in Economics and Political Sciences from the Escuela Superior de Economía y Administración de Empresas (ESEADE), and his Ph.D. in Economics from Suffolk University, Boston, MA.

Dr. Cachanosky is author of Reflexiones Sobre la Economía Argentina (Instituto Acton Argentina, 2017), Monetary Equilibrium and Nominal Income Targeting (Routledge, 2019), and co-author of Austrian Capital Theory: A Modern Survey of the Essentials (Cambridge University Press, 2019), Capital and Finance: Theory and History (Routledge, 2020), and Dolarización: Una Solución para la Argentina (Editorial Claridad, 2022).

Dr. Cachanosky’s research has been published in outlets such as Journal of Economic Behavior & Organization, Public Choice, Journal of Institutional Economics, Quarterly Review of Economics and Finance, and Journal of the History of Economic Thought among other outlets.

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