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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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The creation of fiduciary media also entails an increase in the money supply and a consequent decrease in the purchasing power of money. In this way banks collectively and almost imperceptibly “expropriate” the value of citizens’ monetary units. It certainly smacks of a bad joke to declare that the economic agents who suffer such expropriation are actually (voluntarily?) “saving.” It is not surprising that these doctrines have been defended by authors like Keynes, Tobin, Pointdexter and, in general, all who have justified inflationism, credit expansion and the “euthanasia of the rentier” for the sake of aggressive economic policies geared to insure an “adequate” level of “aggregate demand.” What is surprising, however, is that authors like Selgin and Horwitz, who belong (or at least belonged) to the Austrian School and thus should be more aware of the dangers involved, have had no alternative but to resort to this sort of argument in order to justify their “fractional-reserve free-banking” system.144 144As an additional advantage of the system he proposes, Selgin mentions that economic agents who maintain cash balances in the form of fiduciary media created in a free-banking system can obtain a financial yield on their money and use a series of banking facilities (payment, bookkeeping, cashier, etc.) “free of charge.” However Selgin fails to mention certain costs of fractional-reserve free banking, such as artificial booms, malinvestment of resources, and economic crises. He also fails to touch on what we definitely consider the highest cost: the harmful effects of the violation of legal principles in a free-banking system gives rise to a Central and Free Banking Theory

THE PROBLEM WITH HISTORICAL ILLUSTRATIONS OFFREE-BANKING SYSTEMS

Neo-banking authors devote strong efforts to historical studies which they intend to support the thesis that a freebanking system would protect economies from cycles of boom and depression, owing to the “monetary equilibrium” mechanism. Nevertheless the empirical studies produced thus far have not focused on whether free-banking systems have prevented credit expansion, artificial booms and economic recessions. Instead they have centered on whether bank crises and runs have been more or less frequent and severe in this type of system than in a central-banking system (which is obviously quite a different issue).145 tendency toward the establishment of a central bank as a lender of last resort designed to support bankers and create the liquidity necessary to insure citizens the recovery of their deposits at any time. As for the supposed “advantage” of receiving interest on deposits and “free” cashier and bookkeeping services, there is no telling whether, in net terms, the interest economic agents would earn on funds truly saved and lent in a system with a 100-percent reserve requirement, less the cost of the corresponding deposit, cashier and bookkeeping services, would be equal to, higher than or lower than the real interest they currently receive on their demand checking accounts (minus the decline which chronically affects the purchasing power of money in the current banking system).

145To date, theorists have carefully examined around sixty free-banking

systems from the past. The conclusion they have generally drawn follows:

Bank failure rates were lower in systems free of restrictions on capital, branching and diversification (e.g., Scotland and Canada) than in systems restricted in these respects (England and the United States).

However this matter is irrelevant from the standpoint of our thesis, since the above studies do not specify whether cycles of expansion and economic recession were set in motion. See The Experience of Free Banking, Kevin Dowd, ed., pp. 39–46. See also Kurt Schuler and Lawrence H.

White, “Free Banking History,” The New Palgrave Dictionary of Money and Finance, Peter Newman, Murray Milgate and John Eatwell, eds. (London: Macmillan, 1992), vol. 2, pp. 198–200. The above excerpt appears on p. 108 of this last article.

Money, Bank Credit, and Economic Cycles In fact, in a recent study, George A. Selgin looks at the occurrence of bank runs in different historical free-banking systems versus certain systems controlled by a central bank and reaches the conclusion that bank crises were more numerous and acute in the second case.146 Moreover the main thesis of the main neo-banking book on free banking in Scotland consists entirely of the argument that the Scottish banking system, which was “freer” than the English one, was more “stable” and subject to fewer financial disturbances.147 However, as Murray N. Rothbard has indicated, the fact that, in relative terms, fewer banks failed in the Scottish freebanking system than in the English system does not necessarily mean the former was superior.148 Indeed bank failures have been practically eliminated from current central-banking systems, and this does not make such systems better than a free-banking system subject to legal principles. It actually makes them worse. For bank failures in no way indicate that a system functions poorly, but rather that a healthy, spontaneous reversion process has begun to operate in response to fractional-reserve banking, which is a legal privilege and an attack on the market. Therefore whenever a fractional-reserve free-banking system is not regularly accompanied by bank failures and suspensions of payments, we must suspect the existence of institutional factors which shield banks from the normal consequences of fractional-reserve banking and fulfill a role similar to the one the central bank currently fulfills as lender of last resort. In the case of Scotland, banks had so encouraged the use of their notes in economic transactions that practically no one demanded payment of them in gold, and those who occasionally requested specie at the window of their banks met with general disapproval and enormous pressure from 146George A. Selgin, “Are Banking Crises a Free-Market Phenomena?” a manuscript presented at the regional meeting of the Mont Pèlerin Society, Rio de Janeiro, September 5–8, 1993, pp. 26–27.





147White, Free Banking in Britain.

148Rothbard, “The Myth of Free Banking in Scotland,” Review of Austrian Economics 2 (1988): pp. 229–45, esp. p. 232.

Central and Free Banking Theory their bankers, who accused them of “disloyalty” and threatened to make it difficult for them to obtain loans in the future.

Furthermore, as Professor Sidney G. Checkland has shown,149 the Scottish fractional-reserve free-banking system still went through frequent, successive stages of credit expansion and contraction, which gave rise to economic cycles of boom and recession in 1770, 1772, 1778, 1793, 1797, 1802–1803, 1809–1810, 1810–1811, 1818–1819, 1825–1826, 1836–1837, 1839, and 1845–1847. In other words, even though in relative terms fewer bank runs occurred in Scotland than in England, the successive stages of boom and depression were equally severe, and despite its highly praised free-banking system, Scotland was not free from credit expansion, artificial booms and the subsequent stages of serious economic recession.150 The nineteenth-century Chilean financial system provides another historical illustration of the inadequacy of fractionalreserve free-banking systems to prevent artificial expansion and economic recessions. In fact during the first half of the nineteenth century, Chile had no central bank and implemented a 100-percent reserve requirement in banking. For several decades its citizens firmly resisted attempts to introduce a fractional-reserve banking system, and during those years they enjoyed great economic and financial stability. The situation began to change in 1853, when the Chilean government hired Jean-Gustav Courcelle-Seneuil (1813–1892), one of the most prominent French fractional-reserve free-banking theorists, as professor of economics at the University of Santiago de Chile.

149Sidney G. Checkland, Scottish Banking: A History, 1695–1973 (Glasgow: Collins, 1975). White himself recognizes in his book that Checkland’s is the definitive work on the history of the Scottish banking system.

150Though much work remains to be done, historical studies on fractional-reserve free-banking systems with very few (if any) legal restrictions and no central bank appear to confirm that these systems were capable of triggering significant credit expansion and provoking economic recessions. This is what took place, for instance, in Italian and Spanish financial markets in the fourteenth and sixteenth centuries (see chapter 2, section 3), as Carlo M. Cipolla and others have revealed, as well as in Scotland and Chile, as we indicate in the text.

Money, Bank Credit, and Economic Cycles Courcelle-Seneuil’s influence in Chile during the ten years he taught there was so great that in 1860 a law permitting the establishment of fractional-reserve free banking (with no central bank) was enacted. At this point the traditional financial stability of the Chilean system gave way to stages of artificial expansion (based on the concession of new loans), followed by bank failures and economic crises. The convertibility of the paper currency was suspended on several occasions (1865, 1867, and 1879), and a period of inflation and serious economic, financial and social maladjustment began. This period resides in the collective memory of Chileans and explains why they continue to mistakenly associate financial disturbances with the doctrinal economic liberalism of CourcelleSeneuil.151 151Albert O. Hirschman, in his article, “Courcelle-Seneuil, Jean-Gustav,” The New Palgrave: A Dictionary of Economics, John Eatwell, Murray Milgate, and Peter Newman (London: Macmillan, 1992), vol. 1, pp. 706–07), states that Chileans have even come to demonize Courcelle-Seneuil and to blame him for all the economic and financial evils which befell Chile in the nineteenth century. Murray N. Rothbard believes this demonization is unjust and stems from the fact that the poor functioning of the free-banking system Courcelle-Seneuil introduced in Chile also discredited the deregulating initiatives he launched in other areas (such as mining), when these efforts had a positive effect. See Murray N. Rothbard, “The Other Side of the Coin: Free Banking in Chile,” Austrian Economics Newsletter (Winter 1989): 1–4. George Selgin responds to Rothbard’s article on free banking in Chile in his paper, “Short-Changed in Chile: The Truth about the Free-Banking Episode,” Austrian Economics Newsletter (Spring–Winter, 1990): 5ff. Selgin himself acknowledges that the period of free banking in Chile from 1866 to 1874 was an “era of remarkable growth and progress,” during which “Chile’s railroad and telegraph systems were developed, the port of Valparaiso was enlarged and improved, and fiscal reserves increased by one-quarter.” According to the Austrian theory, all of these phenomena are actually symptoms of the substantial credit expansion which took place during those years and was ultimately bound to reverse in the form of a recession (as, in fact, occurred). However Selgin attributes the subsequent bank crises (but not the recessions) to the Chilean government’s maintenance of an artificial parity between gold and silver. When gold rose in value, this parity resulted in the massive outflow of gold reserves from the country (see Selgin, “Short-Changed in Chile,” pp. 5, 6 and footnote 3 on p. 7).

Central and Free Banking Theory Moreover the fact that various historical studies appear to indicate that fewer bank runs and crises arose in free-banking systems than in central-banking systems does not mean the former were completely free of such episodes. Selgin himself mentions at least three instances in which acute bank crises devastated free-banking systems: Scotland in 1797, Canada in 1837, and Australia in 1893.152 If Rothbard is correct, and in the rest of the cases institutional restrictions played the role of central bank to at least some extent, then the number of bank crises might have been much larger in the absence of these restrictions.153 At any rate we must not consider the elimination of bank crises to be the definitive criterion for determining which banking system is the best. If this were the case, even the most radical fractional-reserve free-banking theorists would be obliged to admit that the best banking system is that which requires the maintenance of a 100 percent reserve, since by definition this is the only system which in all circumstances prevents bank crises and runs.154 In short, historical experience does not appear to support the thesis of modern fractional-reserve free-banking theorists.

Bank credit expansion gave rise to cycles of boom and depression in even the least controlled free-banking systems, which were not free from bank runs and failures. The recognition of this fact has led certain neo-banking authors, such as Stephen Horwitz, to insist that though historical evidence against their views is of some significance, it does not serve to refute the theory that fractional-reserve free banking produces only 152Selgin, “Are Banking Crises a Free-Market Phenomena?” Table 1(b), p. 27.

153Raymond Bogaert appears to confirm Rothbard’s thesis. According to Bogaert, we have documented proof that of 163 banks created in Venice starting at the end of the Middle Ages, at least 93 failed. Raymond Bogaert, Banques et banquiers dans les cités grecques, p. 392 footnote 513.

154Thus Selgin himself recognizes: “A 100-percent reserve banking crisis is an impossibility.” See George A. Selgin, “Are Banking Crises a Free-Market Phenomena?” p. 2.

Money, Bank Credit, and Economic Cycles benign effects, since strictly theoretical procedures must be used to refute this theory.155

IGNORANCE OF LEGAL ARGUMENTS

Theorists of fractional-reserve banking tend to exclude legal considerations from their analysis. They fail to see that the study of banking issues must be chiefly multidisciplinary, and they overlook the close theoretical and practical connection between the legal and economic aspects of all social processes.



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