Vince and George: both singing from the statist hymn-book

According to the BBC, today both Tories and Lib Dems will formally outline their current plans for dealing with the regulation of the banking sector in a post election world. Neither, it seems, are prepared to think "outside the box" as that early century cliche went: the Tories looking at returning banking oversight to the Bank of England, whence it came a few years ago, the Lib Dems more firm on plans to break up the biggest banks, starting at least with the ones in de facto public ownership. However, one thing we can be pretty sure of: neither will be proposing the single most important possible change to banking that would do the most to stabilize the money system and longer term the economy...Free Banking.

As a concept it's pretty simple: Free Banking is where banks, and potentially other organizations such as communities, trading companies and so on, issue their own currencies instead of trading in the "national" currency of the territory in which they are operating. These currencies compete against each other for users. The value of each rests solely on the soundness of the business practices of the organization issuing them. If one bank/issuer over-extends itself all the others who would normally accept their currency at par with their own (say when a business customer of theirs tries to deposit them at the end of each day) will want to pay less for them and the message will soon get round that the over-extended bank needs to change its business practices, its risk profile say, or risk complete devaluation of its issued currency. There are also lots of other mechanisms that, in a free market, but not a fiat system, would come into play to ensure the currency issuers play responsibly.

The system we have today, fiat currency "guaranteed" by the nation is whose name it is issued, is the result of a long term grab for power by the state. Why would they do that, in a market that functioned quite well? Well, there are profits to be had in issuing currency - so called "seignorage". However in the current system where fiat money tends to be introduced via lending by the commercial banks regulated to do so this seignorage profit has reduced, and has also been passed to those issuing banks rather than to the state. The big reason is inflation. We take it as axiomatic that inflation can be a good thing, if you are in debt. With your future repayments more or less fixed in numerical terms if you can inflate the money supply your payments will tend to fall in real terms with time.

Who are the biggest single borrowers in our economy? Well usually the government. So the government can inflate away the running costs of their debt. Well, okay, says you, but it also eats into the costs of everyone else's debt too, doesn't it - so we all benefit from inflation, right? Wrong. Lots of us may well be in debt, but after many decades of inflation and only a few of burgeoning private debt, the lenders have become savvy to this. How many of you are now on variable rate mortgages? Government induced inflation really assists really long term borrowers on fixed rates (ie gilt issuers predominantly).

And on that subject, on the other side of the coin, if you pardon the pun, inflation erodes savings. All of us need some of those, even if we are in debt - for example for our retirement. Inflation keeps eating into our pension funds - firms and returns have to grow faster in monetary terms just to maintain the value of our savings. But equally, if inflation undermines our savings, so it also undermines the money we have in our pockets now. If we think the prices are going to go up, we want to buy more now. Inflation actually drives us into more debt, transferring more in interest from less well off to the better off lenders, so we can buy now before the prices rise.

But inflation also distorts in all sorts of other ways - if it is more difficult for us to work out as individuals whether we should borrow to buy that new Hi-fi today and pay the interest, or wait until we don't need to borrow because it will still be there at the same, or perhaps a lower price, how much more difficult is it for people who have to make borrowing decisions about investing in capital goods? Inflation corrupts the signals that prices are sending to manufacturers for example - they don't know necessarily whether they are getting a better price because of inflation or because their product is in greater demand.

Since the US finally adopted central bank run currency, followed by a fully fiat monetary system a few years later, the state has overseen a devaluation in the currency of over 98% - roughly a period of a hundred years; the Federal Reserve system was established in 1913. But this most recent decade shows the problem at work perfectly and the government's part in it. At least until 1997 the government, through the regular collaboration between the Treasury and the Bank of England, was instrumental in setting the base rate as we call it here. That is used to create a signal to all the banks who are regulated to lend in sterling that they should lend more, if the base rate goes down, or lend less, perhaps call in loans, if the base rate goes up.

After the political turmoil caused by the events of "Black Wednesday" when speculation against the pound led the government to raise interest rates three times and to 15% at one point, we were left with hundreds of thousands of households who could no longer afford their mortgages. A housing slump ensued and led to a policy for the next few years of keeping interest rates as low as possible - lower probably than the economy deserved. Just as the housing market was getting back to relative values from before that crash, another asset was bubbling - the "dot com" stocks and shares.

When that bubble burst, there was a great concern in Treasuries on both sides of the Atlantic that the burst would turn to recession (and indeed it did in the US). Gordon Brown in the UK was so concerned that Labour's first term in twenty years would end with a recession that again base rates were kept artificially low, signaling to the commercial banks that were part of this cosy central-commercial bank cartel that they should lend even more, even more irresponsibly, and we had the housing price bubble that has resulted in the current economic carnage. All the way up that price bubble the least well off are encouraged to transfer more of their wealth to the lenders and now, all the way down, that cosy relationship means that the banks, the lenders, are the ones being baled out while everyone else will suffer vast capital losses with no compensation.

And finally, central banking and its bastard daughter inflation kills. Literally. You'll notice that the history of central banking has been closely related to when government wanted to borrow to fight wars. In the past century, more of this has been done via inflation than by direct government borrowing. If there's an inflationary surplus already in the economy, go to war, destroy some capital goods, and with it some human capital and all of a sudden there are things to spend that surplus inflationary money on. If you are already n a war, perhaps an unpopular one, and you cannot finance it via extra taxes or selling debt, inflate, inflate, inflate and you'll be able to buy up your war-goods before everyone else sees the inflation in the form of a reduction in the value of their money.

So, which of Vince, or George, will take such a brave step? Of course, we know the answer - what they really want of course is for themselves to be in charge of this vast power inflation gives. But wouldn't it be great if just for once, politicians made the right policy decision for us not them.