«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 ...»
We must warn that an item cannot be considered purchased on credit if the price is withdrawn from a bank account, even if an immediate cash payment is not made; for the banker will pay the amount owed in cash when the market is over, if not sooner.9 Juan de Lugo, for his part, strictly adheres to Molina’s doctrine and views the monetary bank deposit as a “precarious” loan or mutuum which the banker may use in his private business dealings as long as the depositor does not claim it.10 Molina and Lugo are so confused as to the legal basis of the bank deposit contract that they actually claim it can have a distinct legal nature for each of the parties involved (i.e., that it can simultaneously be a deposit to the depositor and a loan to the banker). These two theorists apparently see no contradiction in this position, and with respect to bankers’ activities, content themselves with cautioning bankers to act “prudently,” so that, in keeping with the law of large numbers, their liquidity will always be sufficient to allow them to satisfy “customary” requests for deposit returns. They fail to realize 8Ibid., p. 147; italics added.
9Ibid., p. 149.
10 Quare magis videntur pecuniam precario mutuo accipere, reddituri quotiscumque exigetur a deponente. Communiter tamen, pecunia illa interim negotiantur, et lucrantur, sine ad cambium dando, sine aliud negotiationis genus exercendo.
This is a direct quotation taken from p. 406, section 5, no. 60, “De Cambiis,” by Lugo Hispalensis, Disputationum de iustitia et iure.
Money, Bank Credit, and Economic Cycles that their standard of prudence is not an objective criterion adequate to direct the actions of bankers. It certainly does not coincide with bankers’ ability to return all deposits in their keeping at any time, and Molina and Lugo themselves are careful to point out that bankers commit “mortal sin” when they use their depositors’ funds speculatively and imprudently, even if such actions end well and they are able to return their depositors’ money in time.11 Moreover the standard of prudence is not a sufficient condition: a banker may be very prudent yet not very perceptive, or he may even have bad luck in business, so that when the time comes to pay he lacks ample liquidity and cannot return deposits.12 What, then, is an acceptable standard of prudence? This question clearly has no objective answer capable of serving as a guide in banking. Furthermore as we saw in earlier chapters, the law of large numbers is inapplicable to fractional-reserve banking, since the credit expansion involved in such banking practices leads to recurrent cycles of boom and recession which invariably cause difficulties for bankers. Indeed the banking business itself creates the liquidity crises and thus, the widespread insolvency of banks. At any rate, when the crisis hits it is highly likely that the bank will be unable to pay, i.e., that it will suspend payments, and even if in the end all its creditors are lucky enough to receive their money, in the best of circumstances this only happens after a long liquidation process in which the depositors’ role is altered. They lose immediate availability of their money and become forced lenders with no choice but to postpone withdrawal of their deposits until the liquidation is over.
Tomás de Mercado was undoubtedly motivated by the above considerations when he emphasized that Molina and 11Perhaps it is Juan de Lugo who most clearly and concisely expresses this principle, as we saw in footnote 102 of chapter 2.
12In other words a banker may commit pure or genuine entrepreneurial errors (ones not insurable by the law of large numbers) which result in serious entrepreneurial losses, regardless of the degree of prudence he has shown. On the concept of “genuine error,” see Israel Kirzner, “Economics and Error,” in Perception, Opportunity and Profit (Chicago: University of Chicago Press, 1979), chap. 8, pp. 120–36.
Central and Free Banking Theory Lugo’s principles of prudence were an objective no bank fulfilled in practice. It seems as if Tomás de Mercado was aware that such principles do not constitute a practical guide to guaranteeing the solvency of banks. Moreover if these principles are ineffectual in consistently achieving the goal of solvency and liquidity, the fractional-reserve banking system will not be capable of honoring its commitments in all situations.
Two Jesuit economists recently examined the doctrine of the scholastics on banking; one did so from the perspective of the Banking School, and the other from that of the Currency School. The first is the Spanish Jesuit Francisco Belda, the author of an interesting paper entitled, “Ética de la creación de créditos según la doctrina de Molina, Lesio y Lugo” [“The ethics of the creation of loans, according to the doctrine of Molina, Lesio and Lugo”].13 Indeed Father Belda considers it
It can be gathered from Molina’s description that in the case of bankers there is a true creation of loans. The intervention of banks has lead to the creation of new purchasing power previously nonexistent. The same money is simultaneously used twice; the bank uses it in its business dealings, and the depositor uses it as well. The overall result is that the media of exchange in circulation are several times greater in quantity than the real amount of cash at their origin, and the bank benefits from all these operations.
Furthermore according to Belda, Molina believes banks can reasonably do business with the deposits of their clients, as long as they do so prudently and do not risk being unable to honor their own obligations on time.14 In addition, Belda states that Juan de Lugo offers 13Published in Pensamiento, a quarterly journal of philosophical research and information, published by the Facultades de Filosofía de la Compañía de Jesús en España 73, no. 19 (January–March 1963): 53–89.
14Belda, pp. 63 and 69.
Money, Bank Credit, and Economic Cycles a thorough description of the practices of money changers and bankers. Here we do find explicit approval of credit creation, though not with the formal appearance of created credit. Banks do business with the deposits of their clients, who at the same time do not give up the use of their own money. Banks expand the means of payment through loans, trade-bill discounting and other economic activities they carry out with the money of third parties. The final result is that the purchasing power in the market is pushed far beyond that represented by the cash deposits at its origin.15 Belda obviously concludes correctly that of all the scholastics’ doctrines, those of Molina and Lugo are the most favorable to banking. Nevertheless we must criticize Father Belda for not explaining the positions of the other members of the School of Salamanca, for example Tomás de Mercado, and especially Martín de Azpilcueta and Saravia de la Calle, who as we know, are much harsher and more critical judges of the institution of banking. Furthermore Belda bases his analysis of the contributions of Molina and Lugo on a Keynesian view of economics, a perspective which not only ignores all the damaging effects credit expansion exerts on the productive structure, but also presents such practices as highly beneficial because they increase “effective demand” and national income. Therefore Belda adopts the Keynesian and Banking-School view and only analyzes the contributions of those members of the School of Salamanca who are the least strict concerning the legal justification for the monetary bank deposit and, thus, the most inclined to defend fractional-reserve banking.
Nonetheless another prominent Jesuit, Father Bernard W.
Dempsey, is the author of an economic treatise, entitled Interest and Usury,16 in which he also examines the position of the members of the School of Salamanca on the banking business.
15Ibid., p. 87. Belda refers to Juan de Lugo, Disputationum de iustitia et iure, vol. 2, provision 28, section 5, nos. 60–62.
16Dempsey, Interest and Usury. We must note that Father Belda actually intended his article to be a Keynesian criticism of the ideas Father Dempsey presents in this book. Our thanks to Professor James Sadowsky, of Fordham University, for supplying a copy of Dempsey’s book, which we were unable to find in Spain.
Central and Free Banking Theory Father Dempsey’s theoretical knowledge of money, capital and cycles serves as the foundation of his study and represents a much sounder basis than the one Father Belda builds upon.17 Strangely, Dempsey does not develop his thesis with an analysis of the views of those members most against banking (Saravia de la Calle, Martín de Azpilcueta, and Tomás de Mercado), but instead focuses on the writings of those most favorable to the banking business (Luis de Molina, Juan de Lugo and Lesio). Dempsey carries out an exegesis on the works of these authors and concludes that fractional-reserve banking would not be legitimate even from the standpoint of their own doctrines. These Salamancan authors defend certain traditional principles concerning usury, and Dempsey supports his conclusion by applying such principles to banking and its economic consequences, which, though unknown in the age of these scholastics, had been revealed in the theories of Mises and Hayek before Dempsey produced his treatise. Indeed though we must acknowledge Molina and Lugo’s more favorable treatment of banking, Dempsey expressly states that the loans banks generate ex nihilo in the course of their operation with a fractional-reserve entail the creation of buying power backed by no prior voluntary saving or sacrifice. As a result, considerable harm is done to a vast number of third parties, who see the purchasing power of their monetary units fall owing to the inflationary expansion of banks.18 According to 17In his introduction to Father Dempsey’s book, Schumpeter strongly emphasizes Dempsey’s deep theoretical knowledge of and complete familiarity with the economic doctrines of Ludwig von Mises, Friedrich A. Hayek, Wicksell, Keynes and others. Moreover, in his monumental work, The History of Economic Analysis, Schumpeter makes laudatory mention of Dempsey.
18 The credit expansion results in the depreciation of whatever circulating medium the bank deals in. Prices rise; the asset appreciates. The bank absolves its debt by paying out on the deposit a currency of lesser value.... No single person would be convicted by a Scholastic author of the sin of usury. But the process has operated usuriously; again we meet systematic or Money, Bank Credit, and Economic Cycles Dempsey, this ex nihilo generation of buying power, which implies no previous loss of purchasing power to other people, violates the essential legal principles Molina and Lugo themselves lay down and in this sense is reprehensible. Specifically,
We may conclude from this that a Scholastic of the seventeenth century viewing the modern monetary problems would readily favor a 100-percent reserve plan, or a time limit on the validity of money. A fixed money supply, or a supply altered only in accord with objective and calculated criteria, is a necessary condition to a meaningful just price of money.19 Dempsey insists that bank credit expansion drives down the purchasing power of money, and that therefore banks tend to return deposits in monetary units of increasingly reduced purchasing power. This leads him to conclude that if members of the School of Salamanca had possessed a detailed, theoretical understanding of the functioning and implications of the economic process which fractional-reserve banking triggers, then even Molina, Lesio, and Lugo would have condemned it as a vast, harmful, and illegitimate process of institutional usury.
Now that we have analyzed the main postures members of the School of Salamanca adopted on banking, we will see how their ideas were collected and developed in later centuries by both continental European and Anglo-Saxon thinkers.
institutional usury.... The modern situation to which theorists have applied the concepts of diversion of natural and money interest, diversion of saving and investment, diversion of income disposition from tenable patterns by involuntary displacements, all these have a sufficient common ground with late medieval analysis to warrant the expression, “institutional usury,” for the movements heretofore described in the above expressions. (Dempsey, Interest and Usury, pp.
225 and 227–28; italics added) In short, Dempsey simply applies to banking the thesis Juan de Mariana presents in his work, Tratado y discurso sobre la moneda de vellón.
19Dempsey, Interest and Usury, p. 210.
THE RESPONSE OF THE ENGLISH-SPEAKING WORLD
TO THESE IDEAS ON BANK MONEYAlthough a comprehensive analysis of the evolution of monetary thought from the scholastics to the English Classical School would exceed the scope of this book,20 it is fitting that we should comment briefly on the evolution of ideas concerning fractional-reserve banking up to the time the controversy between the Banking and Currency Schools officially arose, in nineteenth-century Britain.
The seminal monetary ideas conceived by members of the School of Salamanca later won the support of Italians Bernardo Davanzati21 and Geminiano Montanari, whose book, La moneta, was published in 1683.22 In their treatises these theorists take the contributions of the School of Salamanca as a starting point and go on to develop the quantity theory of money as presented by Azpilcueta and other scholastics. Although the influence of this monetary trend soon spread to England, basically through the works of Sir William Petty (1623–1687),23 John Locke (1632–1704),24 and 20A brilliant, concise summary of this monetary history appears with the title, “English Monetary Policy and the Bullion Debate,” in chapters 9–14 (part 3) of volume 3 of F.A. Hayek’s The Collected Works. See also D.P. O’Brien, The Classical Economists (Oxford: Oxford University Press, 1975), chap. 6; and Rothbard, Classical Economics, chaps. 5 and 6.
21An English translation of Davanzati’s book, entitled A Discourse upon Coins, was published in 1696 (London: J. D. and J. Churchill, 1696).
22Montanari’s book was originally entitled La zecca in consulta di stato and was reprinted as La moneta in Scrittori classici italiani di economía política (Milan: G. Destefanis, 1804), vol. 3.