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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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It is no coincidence that theorists of the Fractional-Reserve Free-Banking School begin their analysis by focusing on certain more or less mysterious variations in the demand for fiduciary media, and that they neglect to explain the origin or etiology of these variations.116 It is as if these theorists realized I shall argue, this is just as acceptable as the view that the supply of shoes should vary to meet the demand for them. (Horwitz, “Misreading the ‘Myth’, p. 169) To be specific, White appears to defend the new version of the Old Banking School’s “needs of trade” doctrine on pp. 123–24 of his book, Free Banking in Britain. In contrast to the thesis of Horwitz, Amasa

Walker indicates, in connection with fiduciary media:

The supply does not satisfy the demand: it excites it. Like an unnatural stimulus taken into the human system, it creates an increasing desire for more; and the more it is gratified, the more insatiable are its cravings. (Amasa Walker, The Science of Wealth: A Manual of Political Economy, 5th ed. [Boston: Little Brown and Company, 1869], p. 156) 115“Free banking thus works against short-run monetary disequilibrium and its business cycle consequences.” Selgin and White, “In Defense of Fiduciary Media—or, We are Not Devo(lutionists), We are Misesians!” pp. 101–02.

116Joseph T. Salerno points out that for Mises, increases in the demand for money do not pose any coordination problem whatsoever, as long as the banking system does not attempt to adjust to them by creating new Money, Bank Credit, and Economic Cycles that, on the side of the money supply, the Austrians have demonstrated that credit expansion seriously distorts the economy, a fact which in any case seems to warrant a rigid monetary system117 capable of preventing the monetary expansions and contractions typical of any fractional-reserve banking system. Therefore on the side of supply, theoretical arguments appear to support the establishment of a relatively inelastic monetary system, such as a pure gold standard with a 100-percent reserve requirement for banknotes and deposits.118 Hence if defenders of the Neo-Banking School loans. Even a rise in saving (that is, a fall in consumption) expressed solely in increased cash balances (hoarding), and not in loans linked to spending on investment goods, would lead to the effective saving of consumer goods and services in the community and to a process by which the productive structure would become longer and more capitalintensive. In this case the rise in cash balances would simply boost the purchasing power of money by pushing down the nominal prices of the consumer goods and services of the different factors of production.

Nonetheless, in relative terms, the price disparities characteristic of a period of rising saving and increasing capital intensity in the productive structure would arise among the different stages of factors of production. See Joseph T. Salerno, “Mises and Hayek Dehomogenized,” printed in Review of Austrian Economics 6, no. 2 (1993): 113–46, esp. pp.

144ff. See also Mises, Human Action, pp. 520–21. In the same article, Salerno strongly criticizes White for maintaining that Mises was the forerunner of the modern free-banking theorists and for not realizing that Mises always challenged the essential premises of the Banking School and only defended free banking as a way to reach the final goal of a banking system with a 100-percent reserve requirement. See pp.

137ff in the above article. See also upcoming footnote 119.

117Let us remember that Hayek’s objective in Prices and Production was precisely to demonstrate that the cry for an “elastic” currency which expands or contracts with every fluctuation of “demand” is based on a serious error of reasoning. (See p. xiii of Hayek’s preface to the first edition of Prices and Production) 118Mark Skousen states that a system based on a pure gold standard with a 100-percent reserve requirement in banking would be more elastic than the system Hayek proposes and would not have the defect of conforming to the “needs of trade”: decreases in prices would stimulate the production of gold, thereby generating a moderate expansion of the

money supply without producing cyclical effects. Skousen concludes:

Central and Free Banking Theory wish to justify a fractional-reserve free-banking system in which there may be substantial increases and decreases in the money supply in the form of fiduciary media, they must independently look to the side of demand in the hope of being able to demonstrate that such modifications in the supply of fiduciary media (which are inevitable in a fractional-reserve system) correspond to prior variations in demand which are satisfied by the reestablishment of a hypothetical, preexistent state of “monetary equilibrium.” Growth in the money supply in the form of credit expansion distorts the productive structure and gives rise to an economic boom and subsequent recession, stages during which significant variations in the demand for money and fiduciary media take place. Hence the process is not triggered, as theorists of the modern Free-Banking School suppose, by independent, catalytic changes in the demand for fiduciary media, but by the manipulation of the supply of them. All fractionalreserve banking systems carry out such manipulation to one degree or another by expanding credit.

It is true that in a system composed of a multiplicity of free banks unsupported by a central bank, credit expansion would stop much sooner than in a system in which the central bank orchestrates widespread expansion and uses its liquidity to aid those banks in jeopardy. This is the pro-free-banking argument Parnell originally developed and Mises later identified as second-best.119 However it is one thing to assert that in a Based on historical evidence, the money supply (the stock of gold) under a pure gold standard would expand [annually] between 1 to 5 percent. And, most importantly, there would be virtually no chance of a monetary deflation under 100 percent gold backing of the currency. (Skousen, The Structure of Production, p. 359) 119Selgin himself recognizes that Mises’s support for free banking is based in part on his agreement with Cernuschi, who (along with Modeste) believed that freedom of note issue would automatically lead to 100 percent reserve banking;

and also that Mises “believed that free banking will somehow lead to the suppression of fractionally-based inside monies.” See Selgin, The Money, Bank Credit, and Economic Cycles completely free banking system credit expansion would be curbed sooner than in the current system, and it is quite another to claim that credit expansion brought about in a fractionalreserve free-banking system would never distort the productive structure, since a state of supposed “monetary equilibrium” would always tend to return. In fact Mises himself very clearly indicates that all credit expansion distorts the productive system. Hence Mises rejects the essence of the modern theory of

monetary equilibrium. Indeed Mises affirms:

The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle.120 The chief failing of Selgin’s theory of “monetary equilibrium” is that it ignores the fact that the supply of fiduciary media Theory of Free Banking, pp. 62 and 164. Lawrence H. White attempts to place a different interpretation on Mises’s position and presents Mises as the forerunner of modern fractional-reserve free banking defenders.

See Lawrence H. White, “Mises on Free Banking and Fractional Reserves,” in A Man of Principle: Essays in Honor of Hans F. Sennholz, John W. Robbins and Mark Spangler, eds. (Grove City, Penn.: Grove City College Press, 1992), pp. 517–33. Salerno, in agreement with Selgin, makes

the following response to White:

To the extent that Mises advocated the freedom of banks to issue fiduciary media, he did so only because his analysis led him to the conclusion that this policy would result in a money supply strictly regulated according to the Currency principle.

Mises’s desideratum was... to completely eliminate the destortive influences of fiduciary media on monetary calculation and the dynamic market process. (Salerno, “Mises and Hayek Dehomogenized,” pp. 137ff and p. 145) 120Mises, Human Action, p. 442, footnote 17; italics added.

Mises adds:

“Free banking... would not hinder a slow credit expansion” (Human Action, p. 443). Here Mises conveys an excessively optimistic impression of fractional-reserve free banking, particularly in light of this earlier passage from Theory of Money and Credit (1924): “[I]t is clear that banking freedom per se cannot be said to make a return to gross inflationary policy impossible.” Mises, Theory of Money and Credit, p. 436 (p. 408 in the German edition).

Central and Free Banking Theory largely creates its own demand. In other words, modern freebanking theory contains the Old Banking School’s fundamental error, which, as Mises adeptly revealed, lies in a failure to reflect that public demand for credit depends precisely on banks’ inclination to lend. Thus those bankers who, in the beginning, are not overly concerned about their future solvency are in a position to expand credit and place new fiduciary media in the market simply by reducing the interest rate they ask for the new money they create and easing their normal credit terms.121 Therefore, in contrast with the assumptions of Selgin and the other theorists of his school, bankers can initiate credit expansion in a free-banking system if for some reason they disregard their own solvency, whether or not a prior variation in the demand for fiduciary media has occurred. Another factor explains why, during a prolonged period, the increase in the quantity of depoisits (from credit expansion) actually tends to stimulate demand for fiduciary media.

In fact all economic agents who are unaware that an inflationary process of expansion has begun, and that this process will ultimately cause a relative decrease in the purchasing power of money and a subsequent recession, will notice that certain goods and services begin to rise in price faster than others and will wait in vain for such prices to return to their “normal” level. Meanwhile they will most likely decide to increase their demand for fiduciary media. To again cite


121 The Banking School failed entirely in dealing with these problems. It was confused by a spurious idea according to which the requirements of business rigidly limit the maximum amount of convertible banknotes that a bank can issue. They did not see that the demand of the public for credit is a magnitude dependent on the banks’ readiness to lend, and that banks which do not bother about their own solvency are in a position to expand circulation credit by lowering the rate of interest below the market rate. (Mises, Human Action, pp.

439–40) Moreover let us remember that the process spreads and feeds upon itself as debtors borrow more newly-created deposits to repay earlier loans.

Money, Bank Credit, and Economic Cycles This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings.122 Not only are banks in a fractional-reserve free-banking system able to unilaterally instigate credit expansion, but during a prolonged period the resulting increase in the supply of fiduciary media (which can always be placed in the market through an opportune reduction in the interest rate) tends to create further demand. This increase in demand will last until the public loses some of its unrealistic optimism, begins to distrust the economic “bonanza,” and foresees a widespread rise in prices, followed by a crisis and profound economic recession.

We have argued that the origin of monetary changes lies on the side of supply, that banks in a free-banking system are able to manipulate the money supply, and that the corresponding issuance of fiduciary media creates its own demand in the short and medium term. If the above assertions are true, then Selgin is utterly mistaken in claiming that the supply of fiduciary media merely adjusts to the demand for them.

Indeed the demand for fiduciary media, at least during a considerable period of time, adjusts to the increased supply which banks create in the form of loans.123 122Mises, Human Action, pp. 427–28; italics added.

123Curiously, like Keynesians and monetarists, modern free-banking theorists are obsessed with supposed, sudden, unilateral changes in the demand for money. They fail to see that such changes tend to be endogenous and to occur throughout an economic cycle which is first triggered by shifts in the supply of new money the banking system creates in the form of loans. The only other situations capable of producing a sudden Central and Free Banking Theory



Various circumstances make it possible for a fractionalreserve free-banking system to initiate credit expansion in the absence of a corresponding, prior increase in the demand for fiduciary media.

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