Liquidity creation, efficiency, and free banking

I explore the functioning of inside money competition in an overlapping generations model to address the question of whether the base of currency supply should be a monopoly. In such an economy, banks enhance allocative efficiency by offering short-term contracts (banknotes) in order to finance long-term investments since wealth has to be transferred between the generations prior to the fruition of the high-yielding long-term investments. Liquidity is created by offering agents favor able short-term contracts for funds that are earmarked for long-term investments. I study how issuance of banknotes, liquidity creation, and payment processes interact in competitive and monopolistic banking industries. I show that neither free banking (banking with free entry) nor monopoly banking achieves a first-best (Pareto-efficient) allocation. However, free banking is Pareto-inefficient compared to monopoly banking. This inefficiency arises from the overissuance incentives of competing banks. Additional liquidity needs are distributed among all banks through the payment system provided that households are indifferent to which banknotes they use to satisfy their liquidity needs. Hence, the issuer of banknotes creates a negative externality since other banks must invest more in short-term investments in order to balance liquidity needs. Under free banking, the first holders of banknotes receive an implicit return, so they can profit from funds earmarked for long-term investments. The monopoly does not provide implicit returns, but the first holders get returns from their banks' shares. Monopoly banking Pareto-dominates free banking since it has to devote a smaller portion of resources to less profitable shortterm investments. (C) 1998 Academic Press.