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«8 CENTRAL AND FREE BANKING THEORY T his chapter contains a theoretical analysis of the arguments raised for and against both central and free banking ...»

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his chapter contains a theoretical analysis of the arguments raised for and against both central and free

banking throughout the history of economic thought.

To begin we will review the theoretical debate between those

in favor of a privileged banking system, i.e., one not subject to

traditional legal principles and therefore capable of expanding credit (the Banking School), and those theorists who have always contended that banks should follow universal rules and principles (the Currency School).1 The analysis and evaluation of the theoretical contributions of both schools will 1The definitions of “Banking School” and “Currency School” offered in the text basically coincide with those Anna J. Schwartz proposes.

According to Schwartz, theorists of the Currency School believe monetary policy should be disciplined and subject to general legal rules and principles, while members of the Banking School generally advocate granting bankers (and eventually the central bank) complete discretionary freedom to act and even to disregard traditional legal principles.

In fact Anna J. Schwartz notes that the whole controversy centers on whether policy should be governed by rules (espoused by adherents of the Currency School), or whether the authorities should allow discretion (espoused by adherents of the Banking School). (Anna J. Schwartz’s article, “Banking School, Currency School, Free Banking School,” which appeared in volume 1 of The New Palgrave: Dictionary of Money and Finance [London: Macmillan, 1992], pp. 148–51) Money, Bank Credit, and Economic Cycles also provide us with a chance to study the controversy between supporters of the central bank and defenders of a free banking system. We will see that at first members of the Currency School by and large defended the central bank, and Banking School theorists favored a free banking system, yet in the end the inflationist doctrines of the Banking School prevailed, ironically under the auspices of the central bank.

Indeed one of the most important conclusions of our analysis is that the central bank, far from being a result of the spontaneous process of social cooperation, emerged as the inevitable consequence of a fractional-reserve private banking system. In a fractional-reserve context it is private bankers themselves who eventually demand a lender of last resort to help them weather the cyclical economic crises and recessions such a system provokes. We will wrap up the chapter with a look at the theorem of the impossibility of socialist economic calculation. When applied to central bank operations, this theorem explains the problems of administrative banking laws as we know them. Finally we will argue that current free-banking advocates usually make the mistake of accepting and justifying fractional-reserve practices and fail to see that such a concession would not only inevitably lead to the resurgence of central banks, but would also trigger cyclical crises harmful to the economy and society.


In this section we will examine the theoretical arguments advocates of fractional-reserve banking have constructed to justify such a system. Although these arguments have traditionally been considered a product of the Banking and Currency School controversy which arose in England during the first half of the nineteenth century, the earliest arguments on fractional-reserve banking and the two opposing sides (the banking view versus the currency view) can actually be traced back to contributions made by the theorists of the School of Salamanca in the sixteenth and seventeenth centuries.

Central and Free Banking Theory


The theorists of the School of Salamanca made important contributions in the monetary field which have been studied in detail.2 The first Spanish scholastic to produce a treatise on money was Diego de Covarrubias y Leyva, who published Veterum collatio numismatum (“Compilation on old moneys”) in 1550.

In this work the famous Segovian bishop examines the history of the devaluation of the Castilian maravedi and compiles a large quantity of statistics on the evolution of prices. Although the essential elements of the quantity theory of money are already implicit in Covarrubias’s treatise, he still lacks an explicit monetary theory.3 It was not until 1556, several years later, that Martín de Azpilcueta unequivocally declared the increase in prices, or decrease in the purchasing power of money, to be the result of a rise in the money supply, an increase triggered in Castile by the massive influx of precious metals from America.

Indeed Martín de Azpilcueta’s description of the relationship between the quantity of money and prices is faultless:

2See especially the research Marjorie Grice-Hutchinson published under the direction of F.A. Hayek, The School of Salamanca: Readings in Spanish Monetary Theory, 1544–1605; Rothbard, “New Light on the Prehistory of the Austrian School,” pp. 52–74; Alejandro A. Chafuen, Christians for Freedom: Late-Scholastic Economics (San Francisco: Ignatius Press, 1986), pp. 74–86. On Marjorie Grice-Hutchinson see the laudatory comments Fabián Estapé makes in his introduction to the third Spanish edition of Schumpeter’s book, The History of Economic Analysis [Historia del análisis económico (Barcelona: Editorial Ariel, 1994), pp. xvi–xvii].

3We have used the Omnia opera edition, published in Venice in 1604. Volume 1 includes Diego de Covarrubias’s treatise on money under the complete title, Veterum collatio numismatum, cum his, quae modo expenduntur, publica, et regia authoritate perpensa, pp. 669–710. Davanzati often quotes this piece of writing, and Ferdinando Galiani does so at least once in chapter 2 of his famous work, Della moneta, p. 26. Carl Menger also refers to the treatise of Covarrubias in his book, Principles of Economics (New York and London: New York University Press, 1981), p.

317; p. 257 in the original version, Grundsätze der Volkswirthschaftslehre.

Money, Bank Credit, and Economic Cycles In the lands where there is a serious shortage of money, all other saleable items and even the labor of men are given for less money than where money is abundant; for example, experience shows that in France, where there is less money than in Spain, bread, wine, cloth and labor cost much less;

and even when there was less money in Spain, saleable items and the labor of men were given for much less than after the Indies were discovered and covered Spain with gold and silver. The reason is that money is worth more when and where it is scarce, than when and where it is abundant.4 In comparison with the profound and detailed studies which have been conducted on the monetary theory of the School of Salamanca, up to this point very little effort has been made to analyze and evaluate the position of the scholastics on banking.5 Nevertheless the theorists of the School of Salamanca carried out a penetrating analysis of banking practices, and by and large, they were forerunners of the different theoretical positions which more than two centuries later reappeared in the debate between members of the “Banking School” and those of the “Currency School.” As a matter of fact, in chapter 2 we mentioned the severe criticism of fractional-reserve banking voiced by Doctor Saravia de la Calle in the final chapters of his book, Instrucción de mercaderes. In a similar vein, though not as strongly critical as Saravia de la Calle, Martín de Azpilcueta, and Tomás de Mercado undertake a rigorous analysis of banking which includes 4Azpilcueta, Comentario resolutorio de cambios, pp. 74–75; italics added.

However Nicholas Copernicus preceded Martín de Azpilcueta by almost thirty years, since he formulated a (more embryonic) version of the quantity theory of money in his book, De monetae cudendae ratio (1526). See Rothbard, Economic Thought Before Adam Smith, p. 165.

5See, for instance, the comments Francisco Gómez Camacho makes in his introduction to Luis de Molina’s work, La teoría del justo precio (Madrid: Editora Nacional, 1981), pp. 33–34; the remarks Sierra Bravo makes in El pensamiento social y económico de la escolástica desde sus orígenes al comienzo del catolicismo social, vol. 1, pp. 214–37; the article by Francisco Belda which we cover in detail on the following pages; and the more recent article by Huerta de Soto, “New Light on the Prehistory of the Theory of Banking and the School of Salamanca.” Central and Free Banking Theory a catalog of the requirements for a fair and lawful monetary bank deposit. These early authors could be viewed as members of an incipient “Currency School,” which had long been developing at the very heart of the School of Salamanca. These scholars typically adopt a consistent, firm stance on the legal requirements for bank-deposit contracts, as well as a generally critical, wary attitude toward banking.

A distinct second group of theorists is led by Luis de Molina and includes Juan de Lugo and, to a lesser extent, Leonardo de Lesio and Domingo de Soto. As stated in chapter 2, these authors follow Molina’s example and, like him, they demand only a weak legal basis for the monetary bankdeposit contract and accept fractional-reserve practices, arguing that such a contract is more a “precarious” loan or mutuum than a deposit. We will not repeat here all arguments against Molina’s position on the bank-deposit contract. Suffice it to say that underlying his position is a widespread misconception which dates back to the medieval glossators and their comments on the institution of the depositum confessatum.

What concerns us now is the fact that this second group of scholastics was much more lenient in their criticism of bankers and went as far as to justify fractional-reserve banking. It is not, then, altogether far-fetched to consider this group an early “Banking School” within the School of Salamanca. As their English and Continental heirs would do several centuries later, members of this school of thought not only justified fractional-reserve banking, in clear violation of traditional legal principles, but also believed it exerted a highly beneficial effect on the economy.

Though Luis de Molina’s arguments concerning the bank contract rest on a very shaky theoretical foundation and in a sense constitute a regression with respect to other attitudes held by members of the School of Salamanca, it should be noted that Molina was the first in the “Banking School” tradition to realize that checks and other documents which authorize the payment, on demand, of certain quantities against deposits fulfill exactly the same function as cash. Therefore it is not true, though it is widely believed, that the nineteenthcentury theorists of the English Banking School were the first Money, Bank Credit, and Economic Cycles to discover that demand deposits in banks form part of the money supply in their entirety, and thus affect the economy in the same way as bank bills. Luis de Molina had already clearly illustrated this fact over two centuries earlier in Disputation 409 of his work, Tratado sobre los cambios [“Treatise on

exchanges”]. In fact, Molina states:

People pay bankers in two ways: both in cash, by giving them the coins; and with bills of exchange or any other type of draft, by virtue of which the one who must pay the draft becomes the bank’s debtor for the amount which the draft indicates will be paid into the account of the person who deposits the draft in the bank.6 Specifically, Molina is referring to certain documents which he calls chirographis pecuniarum (“written money”), and which

were used as payment in many market transactions. Thus:

Though many transactions are conducted in cash, most are carried out using documents which attest either that the bank owes money to someone or that someone agrees to pay, and the money stays in the bank.

Moreover Molina indicates that these checks are considered “on demand”: “The term ‘demand’ is generally used to describe these payments, because the money must be paid the moment the draft is presented and read.”7 Most importantly, long before Thornton in 1797 and Pennington in 1826, Molina expressed the essential idea that the total volume of monetary transactions conducted at a market could not be carried out with the amount of cash which changes hands at the market, were it not for the money banks create with their deposit entries, and depositors’ issuance of checks against these deposits. Hence banks’ financial activities result in the ex nihilo creation of a new sum of money (in the form of deposits) which is used in transactions. Indeed Molina

expressly tells us:

6Molina, Tratado sobre los cambios, p. 145.

7Ibid., p. 146.

–  –  –

Most of the transactions made in advance [are concluded] using signed documents, since there is not enough money to permit the huge number of goods for sale at the market to be paid for in cash, if they must be paid for in cash, or to make so many business deals possible.8 Finally, Molina distinguishes sharply between those operations which do involve the granting of a loan, since the payment of a debt is temporarily postponed, from those carried

out in cash via check or bank deposit. He concludes:

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