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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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Banking legislation has always developed in response to crises. When crises have hit, existing legislation has always been found inadequate and devoid of the necessary answers and solutions. Thus it has always been necessary to come up with hasty emergency solutions which, despite the context of their “invention,” at the end of each crisis have been incorporated into a new general legal framework, which has lasted only until the following shock, when a similar cycle has begun. (Tomás-Ramón Fernández, Comentarios a la ley de disciplina de intervención de las entidades de crédito [Madrid: Serie de Estudios de la Fundación Fondo para la Investigación Económica y Social, 1989], p. 9) Elena Sousmatzian expresses the problem in this way: if bank crises are preventable, government intervention has proven unequal to the task of preventing them; and if crises are inevitable, government intervention in this area is superfluous. Both positions have truth to them, since fractional-reserve banking makes crises inescapable, regardless of the banking legislation which governments insist on drafting and which often does more to further aggravate cyclical problems than it does to lessen them.

Money, Bank Credit, and Economic Cycles keeping with Mises’s view, the above proposal entails the substitution of several clear, simple articles, to appear in the commercial and penal codes, for the current web of administrative banking legislation, which has not achieved the objectives set for it.101 It is interesting to note that modern defenders of fractional-reserve free banking wrongly believe, due in part to their lack of legal preparation, that a 100-percent reserve requirement would amount to an unfair administrative restriction of individual freedom. Nevertheless, as the analysis of the first three chapters shows, nothing could be further from the truth. For these theorists do not realize that such a rule, far from being an example of systematic, administrative government coercion, merely constitutes the recognition of traditional property rights in the banking sector. In other words, theorists who endorse a fractional-reserve free-banking system, which would infringe traditional legal principles, fail to see that “free trade in banking is synonymous with free trade in swindling,” a famous phrase attributed to an anonymous American and reiterated by Tooke.102 Moreover if a free-banking system must ultimately be defended as a “lesser evil” in comparison with central banking, the motive should

101Mises, Human Action, p. 443.102To be specific, Tooke remarked:

As to the free trade in banking in the sense which it is sometimes contended for, I agree with a writer in one of the American papers, who observes that free trade in banking is synonymous with free trade in swindling. Such claims do not rest in any manner on grounds analogous to the claims of freedom of competition in production. It is a matter of regulation by the State and comes within the province of police.

(Thomas Tooke, A History of Prices, 3 vols. [London: Longman, 1840], vol. 3, p. 206) We agree with Tooke in that if free banking implies freedom to operate with a fractional reserve, then essential legal principles are violated and the state, if it is to have any function at all, should diligently attempt to prevent such violations and punish them when they occur. This appears to be precisely what Ludwig von Mises had in mind when, in Human Action (p. 666), he quoted this excerpt of Tooke’s.

Central and Free Banking Theory not be to permit the exploitation of the lucrative possibilities which always arise from credit expansion. Instead free banking should be seen as an indirect route to the ideal free-banking system, one subject to legal principles, i.e., a 100-percent reserve requirement. All legal means available in a constitutional state should be applied at all times in the direct pursuit of this goal.



The last twenty years have seen a certain resurgence of the old economic Banking School doctrines. Defenders of these views claim that a fractional-reserve free-banking system would not only give rise to fewer distortions and economic crises than central banking, but would actually tend to eliminate such problems. Given that these theorists base their reasoning on different variations of the Old Banking School arguments, some more sophisticated than others, we will group the theorists under the heading, “Neo-Banking School,” or “modern pro-Fractional-Reserve Free-Banking School.” This school is composed of a curious alliance of scholars,103 among 103As David Laidler accurately points out, recent interest in free banking and the development of the Neo-Banking School originated with Friedrich A. Hayek’s book on the denationalization of money (F.A.

Hayek, Denationalization of Money: The Argument Refined, 2nd ed. [London: Institute of Economic Affairs, 1978]). Prior to Hayek, Benjamin Klein offered a similar proposal in his article, “The Competitive Supply of Money,” published in the Journal of Money, Credit and Banking 6 (November 1974): 423–53. Laidler’s reference to the above two authors appears in his brief but stimulating article on banking theory, “Free Banking Theory,” found in The New Palgrave: A Dictionary of Money and Finance (London and New York: Macmillan Press, 1992), vol. 2, pp.

196–97. According to Oskari Juurikkala, the current debate among freebanking theorists (pro-100-percent reserve requirement versus pro-fractional reserve) is strictly parallel to the nineteenth century French debate between Victor Modeste (and Henry Cernuschi) and J. Gustave Courcelle-Seneuil. See his article, “The 1866 False-Money Debate in the Journal des Economistes: Déjà Vu for Austrians?” Money, Bank Credit, and Economic Cycles whom we could mention certain members of the Austrian School who, in our opinion, have missed some of Mises’s and Hayek’s teachings on monetary matters and the theory of capital and economic cycles, members like White,104 Selgin105 and, more recently, Horwitz;106 members of the English Subjectivist School, like Dowd;107 and finally, theorists with a monetarist background, like Glasner,108 Yeager109 and Timberlake.110 Even 104Lawrence H. White, Free Banking in Britain: Theory, Experience and Debate, 1800–1845 (London and New York: Cambridge University Press, 1984); Competition and Currency: Essays on Free Banking and Money (New York: New York University Press, 1989); and also the articles written jointly with George A. Selgin: “How Would the Invisible Hand Handle

Money?” Journal of Economic Literature 32, no. 4 (December 1994):

1718–49, and more recently, “In Defense of Fiduciary Media—or, We are Not Devo(lutionists), We are Misesians!” Review of Austrian Economics 9, no. 2 (1996): 83–107. Finally, Lawrence H. White has compiled the most important writings from a Neo-Banking School standpoint in the following work: Free Banking, vol. 1: 19th Century Thought; vol. 2: History;

vol. 3: Modern Theory and Policy (Aldershot, U.K.: Edward Elgar, 1993).

105George A. Selgin, “The Stability and Efficiency of Money Supply

under Free Banking,” printed in the Journal of Institutional and Theoretical Economics 143 (1987): 435–56, and republished in Free Banking, vol. 3:

Modern Theory and Policy, Lawrence H. White, ed., pp. 45–66; The Theory

of Free Banking: Money Supply under Competitive Note Issue (Totowa, N.J.:

Rowman and Littlefield, 1988); the articles written jointly with Lawrence H. White and cited in the preceding footnote; and “Free Banking and Monetary Control,” pp. 1449–59. I am not very sure if Selgin does still consider himself a member of the Austrian School.

106Stephen Horwitz, “Keynes’ Special Theory,” pp. 411–34; “Misreading the ’Myth’: Rothbard on the Theory and History of Free Banking,” published as chapter 16 of The Market Process: Essays in Contemporary Austrian Economics, Peter J. Boettke and David L. Prychitko, eds. (Aldershot, U.K.: Edward Elgar, 1994), pp. 166–76; and also his books, Monetary Evolution, Free Banking and Economic Order and Microfoundations and Macroeconomics (London: Routledge, 2000).

107Kevin Dowd, The State and the Monetary System (New York: Saint Martin’s Press, 1989); The Experience of Free Banking (London: Routledge, 1992);

and Laissez-Faire Banking (London and New York, Routledge, 1993).

108David Glasner, Free Banking and Monetary Reform (Cambridge: Cambridge University Press, 1989); “The Real-Bills Doctrine in the Light of

the Law of Reflux,” History of Political Economy 24, no. 4 (Winter, 1992):


Central and Free Banking Theory Milton Friedman,111 though he cannot be considered a member of this new school, has been gradually leaning toward it, especially following his failure to convince central bankers that they should put his famous monetary rule into practice.

Modern fractional-reserve free-banking theorists have developed an economic theory of “monetary equilibrium.” They base their theory on certain typical elements of the monetarist and Keynesian analysis112 and intend it to demonstrate that a fractional-reserve free-banking system would simply adjust the volume of fiduciary media created (banknotes and deposits) to public demand for them. In this way they argue that fractional-reserve free banking would not only preserve “monetary equilibrium” better than other, alternative systems but would also most effectively adjust the supply of money to the demand for it.

109Leland B. Yeager and Robert Greenfield, “A Laissez-Faire Approach to Monetary Stability,” Journal of Money, Credit and Banking 15, no. 3 (August 1983): 302–15, reprinted as chapter 11 of volume 3 of Free Banking, Lawrence H. White, ed., pp. 180–95; Leland B. Yeager and Robert Greenfield, “Competitive Payment Systems: Comment,” American Economic Review 76, no. 4 (September 1986): 848–49. And finally Yeager’s book, The Fluttering Veil: Essays on Monetary Disequilibrium.

110Richard Timberlake, “The Central Banking Role of Clearinghouse

Associations,” Journal of Money, Credit and Banking 16 (February 1984):

1–15; “Private Production of Scrip-Money in the Isolated Community,” Journal of Money, Credit and Banking 19, no. 4 (October 1987): 437–47;

“The Government’s Licence to Create Money,” The Cato Journal: An

Interdisciplinary Journal of Public Policy Analysis 9, no. 2 (Fall, 1989):


111Milton Friedman and Anna J. Schwartz, “Has Government Any Role in Money?” Journal of Monetary Economics 17 (1986): 37–72, reprinted as chapter 26 of the book, The Essence of Friedman, Kurt R. Leube, ed. (Stanford University, Calif.: Hoover Institution Press, 1986), pp. 499–525.

112Thus Selgin himself states:

Despite... important differences between Keynesian analysis and the views of other monetary-equilibrium theorists, many Keynesians might accept the prescription for monetary equilibrium. ( Selgin, The Theory of Free Banking, p. 56; see also p. 59) Money, Bank Credit, and Economic Cycles In a nutshell, this argument centers around the hypothetical results of an increase in economic agents’ demand for fiduciary media, assuming reserves of specie in the banking system remain constant. In that event, theorists reason, the pace at which fiduciary media are exchanged for bank reserves would slacken. Reserves would increase and bankers, aware of this rise and eager to obtain larger profits, would expand credit and issue more bills and deposits, and the growth in fiduciary media would tend to match the prior increase in demand. The opposite would occur should the demand for fiduciary media decrease: Economic agents would withdraw greater quantities of reserves in order to rid themselves of fiduciary media. Banks would then see their solvency endangered and be obliged to tighten credit and issue fewer banknotes and deposits. In this way a decrease in the supply of fiduciary media would follow the prior decrease in the demand for them.113 The theory of “monetary equilibrium” obviously echoes Fullarton’s law of reflux and, especially, the Old Banking School arguments concerning the “needs of trade.” According to these arguments, private banks’ creation of fiduciary media is not detrimental if it corresponds to an increase in the “needs” of businessmen. These arguments are repeated and crystallized in the “new” theory of “monetary equilibrium,” which states that private banks’ creation of fiduciary media in the form of notes and deposits does not generate economic cycles if it follows a rise in public demand for such instruments.

Although Lawrence H. White does develop an embryonic version of this reformed “needs of trade” doctrine in his book on free banking in Scotland,114 credit for theoretically formulating 113The detailed analysis appears, among other places, in Selgin’s book, The Theory of Free Banking, chaps. 4, 5 and 6, esp. p. 34 and pp. 64–69.

114Stephen Horwitz maintains that Lawrence White explicitly rejects the real-bills doctrine and endorses a different version of the “needs of trade” idea. For him the “needs of trade” means the demand to hold bank notes. On this interpretation, the doctrine states that the supply of bank notes should vary in accordance with the demand to hold notes. As Central and Free Banking Theory the idea goes to one of White’s most noted students, George A.

Selgin. Let us now critically examine Selgin’s theory of “monetary equilibrium,” or in other words, his revised version of some of the Old Banking School doctrines.



Selgin’s analysis rests on the notion that the demand for money in the form of fiduciary media is a variable exogenous to the system, that this variable changes with the desires of economic agents, and that the main purpose of the free-banking system is to reconcile the issuance of deposits and banknotes with shifts in the demand for them.115 Nevertheless such demand is not exogenous to the system, but endogenously determined by it.

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