07/01/2013 05:00 EDT | Updated 08/31/2013 05:12 EDT

Canada's Banks Used to Be Strong and Free

Canada's banks stayed afloat during the Great Recession without a real need for the taxpayer's life jacket, whereas American banks either sank or needed the taxpayer's life boat. But what is less known about our financial system is that its merits go beyond its resolve over the last decade.


Canada's banks stayed afloat during the Great Recession without a real need for the taxpayer's life jacket, whereas American banks either sank or needed the taxpayer's life boat. Most accordingly, bodies such as the World Economic Forum and International Monetary Fund lauded Canada's financial system as one of the safest and strongest around the globe. But what is less known about our financial system is that its merits go beyond its resolve over the last decade.

Pundits and politicos appear to think Canada's tighter regulatory regime helped it weather the recent economic storm, and that America's supposed lack thereof caused it. But history puts forth a different narrative. Throughout the 1800s and early 1900s, Canada had the freer financial system and yet produced fewer banking calamities than did its more stringent, American counterpart. Indeed, as the lead of a Wall Street Journal article told it not so long ago, "Since 1790, the United States has suffered from 16 banking crises," while "Canada has experienced zero."

Historically, Canadian banks freely and competitively issued private currencies and carried out their dealings as they saw fit, with very little help from the government and not a smidgeon of help from the Bank of Canada, which politicians didn't incorporate into the picture until 1934.

The first private bank to open and issue currency was the Bank of Montreal on June 23, 1817, which at the time was arguably the most important monetary institution in North America. As more banks emerged in Lower Canada, they not only accepted each other's money, but also redeemed it by cashing it as a claim against the issuing bank's gold or silver.

Shortly after seeing the benefits of such banking in Lower Canada, the businesses of Upper Canada wished for a comparable financial system to accommodate their monetary demands and keep pace with their Canadian neighbours. Lawmakers consequently chartered the Bank of Upper Canada on April 21, 1821.

Politicians who boasted quite the appetite for money and power and acclaim incrementally centralized and took control of the financial system from hereon. After Upper and Lower Canada united, lawmakers imposed upon the banks capital requirements, shareholder restrictions, and limitations as to how much currency the banks could issue. The last measure, however, remained ineffective, since banks never actually had to issue more currency than the limitation dictated.

Poor governance seemed to fuel the push more so than anything else, for the government of the Province of Canada squandered a lot of money on unprofitable railways and canals and had to handle its debts. More boldly, the first Governor General of the Province of Canada wanted to open a governmental bank that issued its own currency upon which it could yield a profit and finance public works.

All of the banks -- save for BMO, which, as it ironically happens, served as the government's banker -- didn't see merit in the Governor General's proposal and opposed it, and so the government foisted a tax upon the circulation of money to raise revenue instead. The government also felt it necessary to create a market for its bonds, which served as another way to deal with its debt.

By promising incorporation, the government convinced five banks to buy its bonds, which financiers in London had rather tellingly refused to purchase. Not surprisingly, the government did eventually issue its own currency despite many a banker's opposition in hope of turning a profit so as to restore its fiscal mess, as it had admittedly done in the past to raise revenue.

Though the bankers opposed a lot of what the politicos did and proposed, there existed a political demand for intervention and governmental solutions because economic crises had spread to Canada from Britain and the United States. But the system remained relatively free, and Canada still showed greater strength during these turbulent episodes than did its neighbor to the south, which heavy-handedly managed the dealings of its banks.

Even before the American government instituted the Federal Reserve System, banking troubles plagued the United States. American banks not only couldn't do business across state borders, which led to the formation of small and undiversified banks prone to bankruptcy, but also had to buy government bonds to issue more currency, which made it more costly to accommodate the demand for money as it rose.

Conversely, Canadian banks didn't have any meaningful geographical restrictions and were virtually free to issue currency on their terms. The supply of money and how it fluctuated depending on the commercial demands of the day exemplifies how elegantly the freer Canadian banks really worked.

Every harvest season, merchants needed more money to pay the farmers for their products, which the banks accordingly loaned out. After the merchants exported the crop and the harvest season finally ended, the supply of money returned to its prior level. What's more, Canadian currency even found its way around parts of the United States to meet their monetary needs, which American banks couldn't always fulfill as easily. Indeed, as one American observer had noted at the time, "The Canadians never know what it is to go through an American money-squeeze in the autumn."

Nonetheless, what our federal government did at the outset of the First World War marked the beginning of the end of free banking within Canada. The government disallowed Canadians from redeeming their banknotes for gold to finance the wartime effort through an inflationary tax. Canadians hoarded the governmentally issued currency with the hope cashing it as a claim against the gold after the war had passed, and so such currency inevitably dominated the market. The suspension was uplifted in 1926, but at this point the governmental banknotes had already become the regularly used means of exchange.

The Great Depression served as the end of free banking, but for all the wrong reasons. Academics and politicos erroneously believed that unfettered capitalism and banking caused the economic downturn, although their belief was unfounded. While thousands of American banks failed during the Great Depression under the Federal Reserve System, not a single Canadian bank did under the freer regime. Regardless of the resilience the Canadian banks showed, the political class supported central banking as a way to combat such crises -- as evidenced in the party platforms of the day -- and thereby established the Bank of Canada in 1934, which brought to an end a working monetary arrangement that was once free and competitive.

Truth be told, government actors have centralized and regulated Canada's monetary system over the decades with both noble and cynical intentions. The ideological climate during those days tended toward more regulatory oversight and direction, and it was believed the movement away from unfettered economic activity was for the best. Sometimes politicians introduced and enacted legislation with ulterior motives in response to whatever incentives they faced. Still, Canadian banks have performed relatively well despite all of that, and Canadians should hope the trend persists.

A version of this article was originally published in the Prince Arthur Herald.

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