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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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Money, Bank Credit, and Economic Cycles This table reflects the existence of two banks, Bank A and Bank B, both of which have two options: either to refrain from expanding credit or to adopt a policy of credit expansion. If both banks simultaneously initiate credit expansion (assuming there are no other banks in the industry), the ability to issue new monetary units and fiduciary media will yield the same large profits to both. If either expands credit alone, its viability and solvency will be endangered by interbank clearing mechanisms, which will rapidly shift its reserves to the other bank if the first fails to suspend its credit expansion policy in time. Finally it is also possible that neither of the banks may expand and both may maintain a prudent policy of loan concession. In this case the survival of both is guaranteed, though their profits will be quite modest. It is clear that given the choices above, the two banks will face a strong temptation to arrive at an agreement and, to avoid the adverse consequences of acting independently, initiate a joint policy of credit expansion which will protect both from insolvency and guarantee handsome profits.97 In lumping money and money substitutes together under the joint title of “money” as if they were somehow the same thing, Selgin and White fail to grasp that the issue of fiduciary media—an increase of property titles—is not the same thing as a larger supply of property and that relative price changes effected through the issue of fiduciary media are an entirely different “externality” matter than price changes effected through an increase in the supply of property. With this the fundamental distinction between property and a property title in mind, Huerta de Soto’s analogy between fractional reserve banking and the tragedy of the commons makes perfect sense. (Hans-Hermann Hoppe, Jörg Guido Hülsmann and Walter Block, “Against Fiduciary Media,” The Quarterly Journal of Austrian Economics 1, no. 1 (1998): 23, footnote 6) Furthermore Mises emphasizes that the chief economic effect of negative external costs is to complicate economic calculation and discoordinate society, phenomena which clearly take place in the case of credit expansion in fractional-reserve banking. See Mises, Human Action, pp.


97Table VIII-2 is typically used to illustrate the classic “prisoner’s dilemma,” which A.W. Tucker first formulated and of which the Central and Free Banking Theory The above analysis extends to a large group of banks which operate in a free-banking system and maintain a fractional reserve. The analysis shows that under such circumstances, even if interbank clearing mechanisms limit isolated expansionary schemes, these spontaneous mechanisms actually encourage implicit or explicit agreements between the majority of banks to jointly initiate the process of expansion.

Thus in a fractional-reserve free-banking system, banks tend to merge, bankers tend to arrive at implicit and explicit agreements among themselves, and ultimately, a central bank tends to emerge. Central banks generally appear as a result of requests from private bankers themselves, who wish to institutionalize joint credit expansion via a government agency “tragedy of the commons” is merely a generalized version involving more than two participants. See A. Rappaport’s article, “Prisoners’ Dilemma,” published in The New Palgrave: A Dictionary of Economics,

John Eatwell, Murray Milgate and Peter Newman, eds. (London:

Macmillan, 1987), vol. 3, pp. 973–76. The reasoning behind our application of the “tragedy of the commons” to the fractional-reserve freebanking system parallels the argument originally offered by Longfield, though he attempts, without much justification, to apply his case even to isolated instances of expansion by a few banks, while in our analysis such instances are limited by the interbank clearing mechanism, a factor Longfield fails to consider. The tragedy of the commons also accounts for the forces which motivate banks in a fractional-reserve free-banking system to merge and to request the creation of a central bank, with the aim of establishing general, common policies of credit expansion. The first time we explained this typical “tragedy of the commons” process in this context was at the regional meeting of the Mont Pèlerin Society which took place in Rio de Janeiro September 5–8, 1993. At this meeting, Anna J. Schwartz also pointed out that modern fractional-reserve freebanking theorists cannot seem to grasp that the interbank clearing mechanism they refer to does not curb credit expansion if all banks decide to simultaneously expand their credit to one degree or another.

See her article, “The Theory of Free Banking,” presented at the above meeting, esp. p. 5. At any rate, the process of expansion obviously stems from a privilege which conflicts with property rights, and each bank clearly reserves for itself all the benefits of its credit expansion and allows the costs to be shared by the entire system. Moreover if most bankers implicitly or explicitly agree to “optimistically” join in the creation and granting of loans, the interbank clearing mechanism does not effectively curtail abuses.

Money, Bank Credit, and Economic Cycles designed to orchestrate and organize it. In this way, the “uncooperative” behavior of a significant number of relatively more prudent bankers is prevented from endangering the solvency of the rest (those who are more “cheerful” in granting loans).

Therefore our analysis enables us to conclude the following: (1) that the interbank clearing mechanism does not serve to limit credit expansion in a fractional-reserve free-banking system if most banks decide to simultaneously expand their loans in the absence of a prior rise in voluntary saving; (2) that the fractional-reserve banking system itself prompts bankers to initiate their expansionary policies in a combined, coordinated manner; and (3) that bankers in the system have a powerful incentive to demand and obtain the establishment of a central bank to institutionalize and orchestrate credit expansion for all banks, and to guarantee the creation of the necessary liquidity in the “troublesome” periods which, as bankers know from experience, inevitably reappear.98 The privilege which allows banks to use a significant portion of the money placed with them on demand deposit, i.e., to operate with a fractional-reserve, cyclically can result in a dramatic discoordination of the economy. A similar effect appears when privileges are granted to other social groups in other areas (unions in the labor market, for example).

98Precisely for the reasons given I cannot agree with my friend Pascal Salin, who concludes that “the problem is [central bank] monetary monopoly, not fractional reserve.” See Pascal Salin, “In Defense of Fractional Monetary Reserves.” Even the most prominent defenders of fractional-reserve free banking have recognized that the interbank clearing system which would emerge in a free-banking environment would be incapable of checking a widespread expansion of loans. For example, see George Selgin’s article, “Free Banking and Monetary Control,” printed in Economic Journal 104, no. 427 (November 1994): 1449–59, esp.

p. 1455. Selgin overlooks the fact that the fractional-reserve banking system he supports would create an irresistible trend not only toward mergers, associations and agreements, but also (and even more importantly) toward the establishment of a central bank designed to orchestrate joint credit expansion without compromising the solvency of individual banks, and to guarantee necessary liquidity as a lender of last resort with the power to assist any bank in times of financial difficulties.

Central and Free Banking Theory Fractional-reserve banking distorts the productive structure and provokes widespread, intertemporal discoordination in the economy, a situation bound to spontaneously reverse in the form of an economic crisis and recession. Although in a fractional-reserve free-banking system independent reversion processes tend to curb abuses sooner than in a system controlled and directed by a central bank, the most harmful effect of fractional-reserve free banking is that it provides banks with an immensely powerful incentive to expand loans jointly and, particularly, to urge authorities to create a central bank aimed at offering support in times of economic trouble and organizing and orchestrating widespread, collective credit expansion.


Society’s market process is made possible by a set of customary rules of which it is also the source. These rules constitute the behavioral patterns embodied in criminal law and private contract law. No one has deliberately formulated them.

Instead such rules are evolutionary institutions which emerge from practical information contributed by a huge number of actors over a very prolonged period of time. Substantive or material law, in this sense, comprises a series of general,


rules or laws. They are general because they apply equally to all people, and they are abstract because they establish only a broad scope of action for individuals and do not point to any concrete result of the social process. In contrast to this substantive conception of law, we find legislation, understood as a set of coercive, statutory, and ad hoc orders or commands which are the materialization of the illegitimate privileges and the systematic, institutional aggression with which the government attempts to dominate the processes of human interaction.99 This concept of legislation implies the abandonment of the traditional notion of the law (explained above), and the replacement of it with “spurious law” composed of a conglomeration of administrative orders, regulations and 99Hayek, The Constitution of Liberty and Law, Legislation and Liberty. See also Huerta de Soto, Socialismo, cálculo económico y función empresarial, chap.


Money, Bank Credit, and Economic Cycles commands which dictate exactly how the supervised economic agent should behave. Thus to the extent that privileges and institutional coercion spread and develop, traditional laws cease to act as standards of behavior for individuals, and the role of these laws is taken over by the coercive orders and commands of the regulatory agency, in our case, the central bank. In this way the law gradually loses its scope of implementation, and as economic agents are robbed of the criteria of substantive law, they begin to unconsciously alter their personalities and even lose the custom of adapting to general, abstract rules. Under these conditions, to “elude” commands is in many cases simply a matter of survival, and in others it reflects the success of corrupt or perverse entrepreneurship.

Hence, from a general standpoint, people come to see deviation from the rules as an admirable expression of human ingenuity, rather than a violation of a regulatory system which seriously jeopardizes life in society.

The above considerations are fully applicable to banking legislation. Indeed the fractional-reserve banking system, which has spread to all countries with a market economy, primarily entails (as we saw in the first three chapters) the violation of an essential legal principle in relation to the monetary bank-deposit contract and the granting of an ius privilegium to certain economic agents: private banks. This privilege allows banks to disregard legal principles and make self-interested use of most of the money citizens have entrusted to them via demand deposits. Banking legislation mainly constitutes the abandonment of traditional legal principles in connection with the monetary demand-deposit contract, the heart of modern banking.

Furthermore banking legislation takes the form of a tangled web of administrative orders and commands which emanate from the central bank and are intended to strictly control the specific activities of private bankers. This welter of injunctions has not only been incapable of preventing the cyclical appearance of bank crises, but (and this is much more significant) it has also fostered and aggravated recurrent stages of great artificial boom and profound economic recession. Such stages have regularly seized western economies

and entailed a great economic and human cost. Thus:

Central and Free Banking Theory Each time a new crisis hits, a complete set of new laws or amendments to prior ones is swiftly enacted under the naive assumption that the former laws were insufficient and that the new, more detailed and all-encompassing ones will better avoid future crises. This is how the government and the central bank excuse their unfortunate inability to avert crises, which nevertheless arise again and again, and the new regulations last only until the next bank crisis and economic recession.100 Therefore we can conclude that banking legislation is condemned to failure and will continue to be so unless the present form is thoroughly abolished and replaced by a few simple articles to be included in the commercial and penal codes.

These articles would establish the regulation of the monetary bank-deposit contract according to traditional legal principles (a 100-percent reserve requirement) and would prohibit all contracts which mask fractional-reserve banking. In short, in 100See p. 2 of our student Elena Sousmatzian Ventura’s article, “¿Puede

la intervención gubernamental evitar las crisis bancarias?” Ms. Sousmatzian quotes the following description (offered by Tomás-Ramón Fernández) of the crisis-legislation cycle:

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