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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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Nonetheless we must remember that banks do not directly transfer the new fiduciary media they create to their final users (the economic agents whose demand for fiduciary media has increased by the volume represented by surface “A” in Chart VIII-1). Instead, the deposits are lent to entrepreneurs, who spend it on investment goods and thereby initially create a more capital-intensive structure, which we represent in Chart VIII-3.

Nevertheless this more capital-intensive productive structure cannot be maintained in the long term. For once the new fiduciary media reach their final recipients (who in the very beginning accumulated the bank money they needed, as surface “A” in Chart VIII-1 indicates), they will spend them, according to our postulate of unchanging time preference, on consumer and investment goods in a proportion equal to that shown in Charts VIII-1 and VIII-2. If we superimpose Chart VIII-3 on Chart VIII-2 (see Chart VIII-4), the distortion of the productive structure becomes clear.

Shaded area “B” represents the investment projects entrepreneurs have launched in error, since all of the fiduciary media banks have issued to adjust to the increase in the demand for them have been channeled into investment loans.135 Shaded area “C” (with a surface identical 135Selgin and White implicitly acknowledge this point when they assert:

Benefits accrue... to bank borrowers who enjoy a more ample supply of intermediated credit, and to everyone who works Money, Bank Credit, and Economic Cycles to “B”) reflects the portion of the new fiduciary media which the final holders spend on the goods closest to consumption.

The productive structure regains the proportions shown in Chart VIII-1, but only following the inevitable, painful readjustments which the Austrian theory of economic cycles

–  –  –

explains and which a free-banking system, as we have just seen, would be incapable of preventing. Therefore we must conclude, in contrast to what Selgin and White suggest,136 that even if the expansion of fiduciary media fully matches a prior increase in the demand for them, it will provoke the typical cyclical effects predicted by the theory of circulation credit.

136 We deny that an increase in fiduciary media matched by an increased demand to hold fiduciary media is disequilibrating or sets in motion the Austrian business cycle. (Ibid., pp. 102–03) Money, Bank Credit, and Economic Cycles



The attempt to recover at least the essence of the old “needs of trade” doctrine and to show that a fractional-reserve free-banking system would not trigger economic cycles has led George A. Selgin to defend a thesis similar to the one John Maynard Keynes presents in connection with bank deposits.

Indeed let us remember that, according to Keynes, anyone

who holds additional money from a loan is “saving”:

Moreover, the savings which result from this decision are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth.137 George Selgin’s position resembles Keynes’s. Selgin believes public demand for cash balances in the form of banknotes and deposit accounts reflects the desire to offer shortterm loans for the same amount through the banking system.

Indeed, Selgin states:

To hold inside money is to engage in voluntary saving....

Whenever a bank expands its liabilities in the process of making new loans and investments, it is the holders of the liabilities who are the ultimate lenders of credit, and what they lend are the real resources they could acquire if, instead of holding money, they spent it. When the expansion or contraction of bank liabilities proceeds in such a way as to be at all times in agreement with changing demands for inside money, the quantity of real capital funds supplied to borrowers by the banks is equal to the quantity voluntarily offered to the banks by the public.

137Keynes, The General Theory of Employment, Interest and Money, p. 83.

This thesis, which we covered in chapter 7, stems from the tautology of equating saving with investment, an error which underlies all of Keynes’s work and which, according to Benjamin Anderson, is tantamount to equating inflation with saving.

Central and Free Banking Theory

Under these conditions, banks are simply intermediaries of loanable funds.138

Nonetheless it is entirely possible that the public may simultaneously increase their balances of fiduciary media and their demand for consumer goods and services, if they decide to cut back on their investments. For economic agents can employ their money balances in any of the following three ways: they can spend them on consumer goods and services;

they can spend them on investments; or they can hold them as cash balances or fiduciary media. There are no other options.

The decision on the proportion to spend on consumption or investment is distinct and independent from the decision on the amount of fiduciary media and cash to hold. Thus we cannot conclude, as Selgin does, that any money balance is equal to “savings,” since a rise in the balance of fiduciary media may very well depend on a drop in investment spending (via the sale of securities on the stock market, for instance) which makes it possible to increase final monetary expenditure on consumer goods and services. Under these circumstances an individual’s savings would drop, while his balance of fiduciary media would rise. Therefore it is incorrect to qualify as savings all increases in fiduciary media.

To maintain, as Selgin does, that “every holder of demand liabilities issued by a free bank grants that bank a loan for the value of his holdings”139 is the same as asserting that any creation of money, in the form of deposits or notes, by a bank in a fractional-reserve free-banking system ultimately amounts to an a posteriori concession of a loan to the bank for the amount created. However the bank generates loans from nothing and offers additional purchasing power to entrepreneurs, who receive the loans without a thought to the true desires of all other economic agents regarding consumption and investment, when these other individuals will ultimately become the final holders of the fiduciary media the bank creates.

Hence it is entirely possible, if the social time preference on 138Selgin, The Theory of Free Banking, pp. 54–55.

139Selgin, “The Stability and Efficiency of Money Supply under Free Banking,” p. 440.

Money, Bank Credit, and Economic Cycles consumption and investment remains unchanged, that the new fiduciary media the bank creates may be used to step up spending on consumer goods, thus pushing up the relative prices of this type of good.

Fractional-reserve free-banking theorists generally consider any note or deposit a bank issues to be a “financial asset” which corresponds to a loan. From a legal standpoint, this notion involves serious problems, which we examined in the first three chapters. Economically speaking, the error of these theorists lies in their belief that money is a “financial asset” which represents the voluntary saving of an economic agent who “loans” present goods in exchange for future goods.140 Nevertheless money is itself a present good,141 and the possession of cash balances (or deposits) says nothing about the proportions in which the economic agent wishes to consume and invest. Thus increases and decreases in his 140How is it conceivable that banknotes and deposits, which are money in themselves, are also “financial assets” that signify that the bearer has turned over money to a third party today in exchange for a certain amount of money in the future? The idea that notes and deposits are “financial assets” exposes the fact that banks in a fractional-reserve banking system duplicate means of payment ex nihilo: there is the money lent to and enjoyed by a third party, and there is the financial asset which represents the operation and is also considered money. To put it another way, financial assets are titles or certificates which signify that someone has given up present money on handing it over to another in exchange for a larger quantity of future money. If, at the same time, financial assets are considered money (by the bearer), then an obvious, inflationary duplication of means of payment takes place in the market which originates in the granting of a new loan without anyone’s having to save the same amount first.

141Money is a perfectly liquid present good. With respect to the banking system as a whole, fiduciary media are not “financial assets,” since they are never withdrawn from the system, but circulate indefinitely and, hence, are money (or to be more precise, perfect money substitutes). In contrast, a financial asset represents the handing over of present goods (generally money) in exchange for future goods (also generally monetary units) on a specified date, and its creation corresponds to a rise in

an economic agent’s real saving. See Gerald P. O’Driscoll, “Money:

Menger’s Evolutionary Theory,” History of Political Economy 4, no. 18 (1986): 601–16.

Central and Free Banking Theory money balances are perfectly compatible with different combinations of simultaneous increases and decreases in the proportions in which he consumes or invests. In fact his balances of fiduciary media may rise simultaneously with his spending on consumer goods and services, if he only disinvests some of the resources saved and invested in the past. As Hans-Hermann Hoppe points out, the supply of and demand for money determine its price or purchasing power, while the supply of and demand for “present goods” in exchange for “future goods” determine the interest rate or social rate of time preference and the overall volume of saving and investment.142 Saving always requires that an economic agent reduce his consumption (i.e., sacrifice), thus freeing real goods. Saving does not arise from a simple increase in monetary units. That is, the mere fact that the new money is not immediately spent on consumer goods does not mean it is saved. Selgin defends 142 First off, it is plainly false to say that the holding of money, i.e., the act of not spending it, is equivalent to saving.... In fact, saving is not-consuming, and the demand for money has nothing to do with saving or not-saving. The demand for money is the unwillingness to buy or rent non-money goods—and these include consumer goods (present goods) and capital goods (future goods). Not-spending money is to purchase neither consumer goods nor investment goods.

Contrary to Selgin, then, matters are as follows: Individuals may employ their monetary assets in one of three ways. They can spend them on consumer goods; they can spend them on investment; or they can keep them in the form of cash. There are no other alternatives.... [U]nless time preference is assumed to have changed at the same time, real consumption and real investment will remain the same as before: the additional money demand is satisfied by reducing nominal consumption and investment spending in accordance with the same pre-existing consumption/investment proportion, driving the money prices of both consumer as well as producer goods down and leaving real consumption and investment at precisely their old levels. (Hans-Hermann Hoppe, “How is Fiat Money Possible?—or The Devolution of Money

and Credit,” in Review of Austrian Economics 7, no. 2 (1994):

72–73) Money, Bank Credit, and Economic Cycles this position when he criticizes Machlup’s view143 that the expansionary granting of loans creates purchasing power which no one has first withdrawn from consumption (i.e., 143Selgin’s unjustified criticism of Machlup appears in footnote 20 on p. 184 of his book, The Theory of Free Banking. Selgin would consider the entire volume of credit shown by surface “A” in our Chart VIII-2 “transfer credit,” because it is “credit granted by banks in recognition of people’s desire to abstain from spending by holding balances of inside Central and Free Banking Theory saved). For credit to leave the productive structure undistorted, it logically must originate from prior saving, which provides present goods an investor has truly saved. If such a money” (ibid. p. 60). In contrast, for Machlup (and for us), at least surface “B” of Chart VIII-4 would represent “created credit” or credit expansion, since economic agents do not restrict their consumption by the volume shown by surface “C”.

Money, Bank Credit, and Economic Cycles sacrifice in consumption has not taken place, and investment is financed by created credit, then the productive structure is invariably distorted, even if the newly-created fiduciary media correspond to a previous rise in the demand for them.

Hence Selgin is obliged to redefine the concepts of saving and credit creation. He claims saving occurs ipso facto the moment new fiduciary media are created, provided their initial holder could spend them on consumer goods and does not. Selgin also maintains that credit expansion does not generate cycles if it tends to match a prior increase in the demand for fiduciary media. In short these arguments resemble those Keynes expresses in his General Theory, arguments refuted long ago, as we saw in chapter 7.

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