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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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In this example the most critical discoordination would be intratemporal, rather than intertemporal,89 because new money created by the central bank and placed in the economic system would tend to affect the relative-price structure “horizontally.” In other words it would tend to engender a productive structure which, horizontally speaking, would not necessarily coincide with the one consumers wish to sustain. A poor allocation of resources would ensue, along with a need to reverse the effects new injections of money would exert on the economic system.90 89Nonetheless we cannot completely rule out the possibility of intertemporal distortions in this case. Even if banks are required to maintain a 100 percent reserve, intertemporal distortions will inevitably occur if the central bank injects new money into the economic system via massive open-market purchases which directly affect securities markets, rates of return, and hence, indirectly, the interest rate in the credit market.

90F.A. Hayek has explained that unemployment often stems from the existence of intratemporal discrepancies between the distribution of the demand for different consumer goods and services and the allocation of labor and the other productive resources necessary to produce these goods. The creation and injection of new money by the central bank at different points in the economic system tends to produce and aggravate such qualitative discoordination. This argument, which is illustrated and reinforced by fractional-reserve banking to the extent that it combines intratemporal distortion with far more acute intertemporal discoordination, would still carry weight even if the central bank were to direct a banking system which operated with a 100-percent reserve ratio. In this case any increase in the money supply brought about by the central bank to achieve its monetary-policy goals would always horizontally or intratemporally distort the productive structure, unless (and this is inconceivable in real life) the new money were equally distributed among all economic agents. In this case the rise in the quantity of Central and Free Banking Theory Furthermore, although we cannot refer to any true instance in which a central bank has overseen a system of private banks which have operated with a 100 percent reserve, such a system would also be subject to the political influences and lobby pressures studied by the Public Choice School. It would be naive to believe that central bankers with the power to issue money would desire and be able to develop a stable, undistorted monetary policy, even if they supervised a private banking system which functioned with a 100-percent reserve requirement. The authority to issue money poses such an overwhelming temptation that governments and special interest groups would be unable to resist taking advantage of it.

Therefore, even if the central bank did not compound its errors through a fractional-reserve banking system, it would still face the constant risk of succumbing to pressure from politicians and lobbyists eager to take advantage of the central bank’s power in order to accomplish the political goals deemed most appropriate at any particular moment.

In short we must acknowledge that because the privilege of fractional-reserve banking is absent in the model covered in this section, most of the intertemporal discoordination behind economic cycles is absent there as well. Nevertheless multiple possibilities of intratemporal discoordination remain, owing to the injection into the economic system of new monetary units created by the central bank, and regardless of the specific method used to inject this new money into society (financing public spending, etc.). In addition, the effects examined by the Public Choice School would play a key role in these intratemporal maladjustments. Indeed it is almost inevitable that the central bank’s power to issue money should be politically exploited by different social, economic, and political groups, with the resulting distortion of the productive structure.

Though monetary policy would certainly be more predictable and less distorting if private banks maintained a 100 percent money in circulation would exert no effect, except to proportionally boost the prices of all goods, services and factors of production. All real conditions which could initially be cited as justification for an increase in the money supply would remain unaltered.

Money, Bank Credit, and Economic Cycles reserve, theorists who defend the conservation of the central bank under these circumstances are naive in that they consider that the government and different social groups would desire and be able to develop a stable, and (as far as possible) “neutral,” monetary policy. Even if banks kept a 100 percent reserve, the very existence of the central bank, with its tremendous power to issue money, would attract all sorts of perverse political influences like a powerful magnet.91 (c) A fractional-reserve free-banking system The third and last system we will analyze in light of the theory of the impossibility of socialism is a privileged freebanking system, i.e., one with no central bank, but with permission to operate with a fractional reserve. The theory of the impossibility of socialism also explains that the concession of privileges which allow certain social groups to violate traditional legal principles produces the same widespread discoordination as socialism, understood as any system of regular, institutional aggression toward the free exercise of entrepreneurship. We have devoted a significant portion of this book (chapters 4–7) to examining how the infringement of traditional legal principles in connection with the monetary bankdeposit contract offers banks the possibility of expanding their credit base even when society’s voluntary saving has not increased. We have also seen that as a consequence, discoordination arises between savers and investors and must reverse in the form of a bank crisis and economic recession.





The main clarification to be made concerning a fractionalreserve free-banking system is that the spontaneous market processes which reverse the distorting effects of credit expansion tend to begin sooner in this system than in the presence 91The principal defenders of a private banking system based on a 100percent reserve requirement and managed by a central bank include the members of the Chicago School in the 1930s and, currently, Maurice Allais, a recipient of the Nobel Prize in Economics. In the next chapter we will analyze their proposals in detail.

Central and Free Banking Theory of a central bank, and therefore abuses and distortions cannot become as severe as they often do when a lender of last resort exists and orchestrates the entire expansionary process.

Thus it is conceivable that in a free-banking system, isolated attempts to expand bank credit would be curbed relatively quickly and spontaneously by customers’ vigilance toward banks’ operations and solvency, the constant reassessment of the trust placed in banks, and, more than anything, the effect of interbank clearing houses. In fact any isolated bank expanding its credit faster than the sector average or issuing notes more rapidly than most would see the volume of its reserves drop quickly, due to interbank clearing mechanisms, and the banker would be forced to halt expansion to avoid a suspension of payments, and eventually, failure.92 Nonetheless, even though this definite market reaction tends to check the abuses and isolated expansionary schemes of certain banks, there is no doubt that the process only works a posteriori and cannot prevent the issuance of new fiduciary media. As we saw in chapter 2, the emergence of fractionalreserve banking (which in its early days was unaccompanied by a central bank) marked the beginning of substantial, sustained growth in fiduciary media, first in deposits and loans unbacked by saving, and later, in banknotes unbacked by reserves of specie. This process has continually distorted the productive structure and generated cycles of boom and recession which have been historically recorded and studied in many situations in which private banks have functioned with a fractional reserve and without the existence and supervision of a central bank. Some of the earliest of such studies can be traced back to the economic and bank crises which hit fourteenthcentury Florence. Just as the theory of free banking indicates, the great majority of these expansionary banks did eventually fold, but only after issuing fiduciary media for a varying length of time, an activity which never failed to exert crippling 92It is precisely this process that Parnell originally described in 1826 and Ludwig von Mises later developed further in chapter 12 of Human Action: “The Limitation on the Issuance of Fiduciary Media,” pp.

434–48.

Money, Bank Credit, and Economic Cycles effects on the real economy by provoking bank crises and economic recessions.93 Not only is fractional-reserve free-banking incapable of avoiding credit expansion and the appearance of cycles, but it actually tempts bankers in general to expand their loans, and the result is a policy in which all bankers, to one extent or another, are carried away by optimism in the granting of loans and in the creation of deposits.94 It is a well-known fact that whenever property rights are not adequately defined—and this is the case with fractional-reserve banking, which by definition involves the violation of depositors’ traditional property rights—the “tragedy of the commons” effect tends to appear.95 Thus a banker who expands his loans brings in a handsome, and larger, profit (if his bank does not fail), while 93Charles A.E. Goodhart states: “There were plenty of banking crises and panics prior to the formation of central banks” and cites O.B.W.

Sprague’s book, History of Crises and the National Banking System, first published in 1910 and reprinted in New Jersey by Augustus M. Kelley in 1977. See Charles A.E. Goodhart, “What Should Central Banks Do?

What Should be their Macroeconomic Objectives and Operations?” p.

1435. See also the article by the same author, “The Free Banking Challenge to Central Banks,” published in Critical Review 8, no. 3 (Summer 1994): 411–25. A collection of the most important writings of Charles A.E. Goodhart has been published as The Central Bank and the Financial System (Cambridge, Mass.: MIT Press, 1995).

94On banks’ optimism and the “passive inflationism” which arises from bankers’ fear of not aborting artificial expansion in time, see Mises, Human Action, pp. 572–73. Moreover Mises argues that benefits derived from privileges tend to run out (in the realm of banking this is due to an increase in branches, expenses, etc.), thus sparking demands for further doses of inflation (ibid., p. 749).

95The expression “tragedy of the commons” came into use following Garret Hardin’s article, “The Tragedy of the Commons,” Science (1968);

reprinted on pp. 16–30 of Managing the Commons, Garret Hardin and John Baden, eds. (San Francisco: Freeman, 1970). However the process had already been fully described twenty-eight years earlier by Ludwig von Mises in his “Die Grenzen des Sondereigentums und das Problem der external costs und external economies,” section 6 of chapter 10 of part 4 of Nationalökonomie: Theorie des Handelns und Wirtschaftens (Geneva: Editions Union, 1940; Munich: Philosophia Verlag, 1980), pp.

599–605.

Central and Free Banking Theory the cost of his irresponsible act is shared by all other economic agents. It is for this reason that bankers face the almost irresistible temptation to be the first to initiate a policy of expansion, particularly if they expect all other banks to follow suit to one degree or another, which often occurs.96 The above example differs only slightly from Hardin’s classic illustration of the “tragedy of the commons,” in which he points to the effects an inadequate recognition of property rights may exert on the environment. Unlike in Hardin’s example, in fractional-reserve free banking a spontaneous mechanism (interbank clearing houses) tends to limit the possibility that isolated expansionary schemes will reach a successful conclusion. Table VIII-2 outlines the dilemma banks encounter in such a system.

96Selgin and White have criticized our application of the “tragedy of the commons” theory to fractional-reserve free banking. They claim that what occurs in this sector is a pecuniary externality (i.e., one derived from the price system), which has nothing to do with the technological externality on which the “tragedy of the commons” rests. See George A.

Selgin and Lawrence H. White “In Defense of Fiduciary Media, or We are Not (Devo)lutionists, We are Misesians!” Review of Austrian Economics 9, no. 2 (1966): 92–93, footnote 12. Nevertheless Selgin and White do not seem to fully grasp that the issuance of fiduciary media stems from the violation of traditional property rights in connection with the monetary bank-deposit contract, and that hence fiduciary media are not a spontaneous phenomenon of a legally based free-market process.

Hoppe, Hülsmann, and Block, for their part, have come to our defense

with the following assertion:



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