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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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First, we must point out that the monetary equilibrium analysis of modern free-banking theorists contains many of the same limitations as the traditional neoclassical analysis, which, both in a micro- and macroeconomic context, merely deals with the final state of social processes (monetary equilibrium), a state to which the rational, maximizing behavior of economic agents (private bankers) supposedly leads. In contrast, the economic analysis of the Austrian School centers on dynamic entrepreneurial processes, rather than on equilibrium. Each entrepreneurial act coordinates and establishes a tendency toward equilibrium, which, nevertheless, is never reached, because during the process itself circumstances change and entrepreneurs create new information. Thus, from this dynamic point of view, we cannot accept a static model which, like that of monetary equilibrium, presupposes that immediate, perfect adjustments between the demand for and the supply of fiduciary media take place.

In real life, each banker, according to his insight and entrepreneurial creativity, subjectively interprets the information he receives from the outside world, both in terms of his level of optimism in evaluating the course of economic events, and in terms of the volume of reserves he considers “prudent” with a view to maintaining his solvency. Hence each banker, in an environment of uncertainty, decides each day what volume of fiduciary media he will issue. In the above entrepreneurial process, bankers will clearly commit many errors which will manifest themselves in the unilateral issuance of fiduciary media and will distort the productive structure.

rise in the demand for money are exceptional, like wars and natural disasters. Seasonal variations are comparatively less important and a freebanking system with a 100-percent reserve requirement could counteract them with a seasonal transfer of gold and slight price modifications.

Money, Bank Credit, and Economic Cycles Granted, the process itself will tend to reveal and eliminate the errors committed, but only following a period of varying length, and damage to the real productive structure will not be avoided. If we add that, as we saw in the last section, the supply of fiduciary media tends to create its own demand, we see it is highly unlikely that a fractional-reserve free-banking system (or any other market) could reach the “monetary equilibrium,” that its theorists so desire. For in the best of cases, private bankers will attempt through a process of trial and error to adjust their supply of fiduciary media to the demand for them, which is unknown to bankers and tends to vary as a consequence of the very issuance of fiduciary media. Hence scholars may debate whether or not the entrepreneurial coordination process will bring the coveted state of “monetary equilibrium” within bankers’ reach, but scholars cannot deny that throughout this process entrepreneurs will commit innumerable errors in the form of the unjustified issuance of fiduciary media, and that these errors will inevitably tend to affect the productive structure by provoking economic crises and recessions, just as the Austrian theory of economic cycles explains.124 Second, a large or small group of bankers could also collectively orchestrate the expansion of fiduciary media or decide to merge in order to share and better “manage” their reserves, thus increasing their capacity to expand credit and improve profits.125 Unless fractional-reserve free-banking theorists wish to prohibit this type of entrepreneurial strategy (which we doubt), it will obviously result in credit expansion and consequent economic recessions. It can be argued that inconcert expansion will tend to correct itself, since, as Selgin maintains, the total increase in interbank clearings will raise the variance in the clearing of debits and credits.126 However, aside from Selgin’s assumption that the total volume of metallic reserves in the banking system remains constant, and 124See Jörg Guido Hülsmann, “Free Banking and Free Bankers,” Review of Austrian Economics 9, no. 1 (1996): 3–53, esp. pp. 40–41.

125Remember our analysis contained in pages 664–71. See Laidler, “Free Banking Theory,” p. 197.

126Selgin, The Theory of Free Banking, p. 82.

Central and Free Banking Theory

despite the doubts of many authors regarding the effectiveness of Selgin’s mechanism,127 even if we allow for the sake of argument that Selgin is correct, it can still be argued that the adjustment will never be perfect nor immediate, and therefore in-concert expansion and mergers may provoke significant increases in the supply of fiduciary media, thus triggering the processes which set economic cycles in motion.

Third and last, with every increase in the overall stock of specie (gold) banks keep as a “prudent” reserve, a fractionalreserve free-banking system would stimulate growth in the issuance of fiduciary media which does not correspond to prior rises in demand. If we remember that the world stock of gold has been mounting at an annual rate of 1 to 5 percent128 due to the increased world production of gold, it is clear that this factor alone will permit private bankers to issue fiduciary media at a rate of 1 to 5 percent per year, regardless of the demand for them. (Such creation of money will produce an expansion followed by a recession.)129 In conclusion, significant (fiduciary) inflationary processes130 and severe economic recessions131 may occur in any fractional-reserve free-banking system.

127See, for example, Schwartz, “The Theory of Free Banking,” p. 3.

128Skousen, The Structure of Production, chap. 8, pp. 269 and 359.

129We cannot rule out even greater credit expansion in the event of shocks in the supply of gold, though Selgin tends to play down the importance of this possibility. Selgin, The Theory of Free Banking, pp. 129–33.

130Let us remember that for Mises (see footnote 120 above): “Banking freedom per se cannot be said to make a return to gross inflationary policy impossible,” especially if an inflationary ideology prevails among

economic agents:

Many authors believe that the instigation of the banks’ behavior comes from outside, that certain events induce them to pump more fiduciary media into circulation and that they would behave differently if these circumstances failed to appear. I was also inclined to this view in the first edition of my book on monetary theory. I could not understand why the banks didn’t learn from experience. I thought they would certainly persist in a policy of caution and restraint, if they were not led by outside circumstances to abandon it. Only later did Money, Bank Credit, and Economic Cycles



We must point out that the analysis of modern free-banking theorists ignores the microeconomic effects which arise from increases and decreases in the supply of and demand for fiduciary media instigated by the banking industry. In other words, even if we admit for the sake of argument that the origin of all evil lies, as these theorists suppose, in unexpected changes in economic agents’ demand for fiduciary media, it is clear that the supply of fiduciary media which the banking system supposedly generates to adjust to changes in the demand for them does not instantaneously reach precisely those economic agents whose valuation of the possession of new fiduciary media has altered. Instead this supply flows into the market at certain specific points and in a particular manner: in the form of loans granted via a reduction in the interest rate and initially received by individual businessmen and investors who tend to use them to initiate new, more capital-intensive investment projects which distort the productive structure.

Therefore it is unsurprising that modern free-banking theorists overlook the Austrian theory of business cycles, since I become convinced that it was useless to look to an outside stimulus for the change in the conduct of the banks.... We can readily understand that the banks issuing fiduciary media, in order to improve their chances for profit, may be ready to expand the volume of credit granted and the number of notes issued. What calls for special explanation is why attempts are made again and again to improve general economic conditions by the expansion of circulation credit in spite of the spectacular failure of such efforts in the past. The answer must run as follows: According to the prevailing ideology of businessman and economist-politician, the reduction of the interest rate is considered an essential goal of economic policy. Moreover, the expansion of circulation credit is assumed to be the appropriate means to achieve this goal.

(Mises, On the Manipulation of Money and Credit, pp. 135–36) 131“Crises have reappeared every few years since banks... began to play an important role in the economic life of people.” Ibid., p. 134.

Central and Free Banking Theory this theory does not fit in with their analysis of the issuance of fiduciary media in a fractional-reserve free-banking system.

These theorists thus take refuge in an exclusively macroeconomic analysis (monetarist or Keynesian, depending on the case) and, at most, use instruments which, like the equation of exchange or the “general price level,” actually tend to conceal the truly relevant microeconomic phenomena (variations in relative prices and intertemporal discoordination in the behavior of economic agents) which occur in an economy upon the expansion of credit and growth in the quantity of fiduciary media.

In normal market processes, the supply of consumer goods and services tends to vary along with the demand for them, and new goods generally reach precisely those consumers whose subjective valuation of them has improved.

However where newly-created fiduciary media are concerned, the situation is radically different: an increased supply of fiduciary media never immediately and directly reaches the pockets of those economic agents whose demand for them may have risen. Instead, the money goes through a lengthy, cumbersome temporal process, or transition phase, during which it first passes through the hands of many other economic agents and distorts the entire productive structure.

When bankers create new fiduciary media, they do not deliver them directly to those economic agents who may desire more. On the contrary, bankers grant loans to entrepreneurs who receive the new money and invest the entire amount without a thought to the proportion in which the final holders of fiduciary media will wish to consume and save or invest. Hence it is certainly possible that a portion of the new fiduciary media (supposedly issued in response to increased demand) may ultimately be spent on consumer goods, and thereby push up their relative price. We know (chap. 7, p. 567)

that according to Hayek:

[S]o long as any part of the additional income thus created is spent on consumer’s goods (i.e., unless all of it is saved), the prices of consumer’s goods must rise permanently in relation to those of various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the Money, Bank Credit, and Economic Cycles relative prices of the various kinds of input and on the methods of production that will appear profitable.132

Hayek clarifies his position even further:

All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumer’s goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumer’s goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income [created by credit expansion], and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved.133 As a graphic illustration of our argument, let us suppose that the demand for fiduciary media increases, while the proportion in which economic agents wish to consume and invest remains unchanged.134 Under these conditions, economic agents must reduce their monetary demand for consumer goods, sell bonds and other financial assets and, especially, reinvest less money in the different stages of the productive process until they can accumulate the greater volume of bank deposits they wish to hold. Therefore if we suppose that the social rate of time preference has not altered, and we use a simplified version of the triangular diagrams from chapter 5 to represent society’s real productive structure, we see that in 132Hayek, The Pure Theory of Capital, p. 378.

133Ibid., p. 394. This appears to be the extreme case of an increase in saving which manifests itself entirely as a rise in balances of fiduciary media, the case Selgin and White use to illustrate their theory. See Selgin and White, “In Defense of Fiduciary Media—or, We are Not Devo(lutionists), We are Misesians!” pp. 104–05.

134Such a situation is definitely possible, as Selgin and White themselves recognize when they affirm: “An increase in savings is neither necessary nor sufficient to warrant an increase in fiduciary media.” Selgin and White, “In Defense of Fiduciary Media—or, We are Not Devo(lutionists), We are Misesians!” p. 104.

Central and Free Banking Theory Chart VIII-1 the increase in the demand for fiduciary media shifts the hypotenuse of the triangle toward the left. This movement reflects a drop in the monetary demand for consumer and investment goods, since the proportion of one to the other (or time preference) has not varied. In this chart, surface “A” represents economic agents’ new demand for (or “hoarding” of) fiduciary media (see Chart VIII-1).

The fundamental conclusion of the theory of monetary equilibrium in a fractional-reserve free-banking system is that banks would respond to this rise in the demand for fiduciary media by expanding their issuance by a volume equal to that of the new demand (represented by surface “A”), and the productive structure, as shown in Chart VIII-2, would remain intact (see Chart VIII-2).

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