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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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23See Sir William Petty’s Quantulumcumque Concerning Money, 1682, included in The Economic Writings of Sir William Petty (New York: Augustus M. Kelley, 1964), vol. 1, pp. 437–48.

24Locke’s writings on monetary theory include “Some Considerations of the Consequences of the Lowering of Interest, and Raising the Value of Money” (London: Awnsham and John Churchill, 1692) and his “Further

Considerations Concerning Raising the Value of Money” (London:

Awnsham and John Churchill, 1695). Both of these pieces were reprinted in The Works of John Locke, 12th ed. (London: C. and J. Rivington, 1824), Money, Bank Credit, and Economic Cycles others, it was not until John Law, Richard Cantillon, and David Hume had made their contributions that we find express reference to the problems posed by fractional-reserve banking with respect to both monetary issues and the real economic framework.

We have already referred to John Law (1671–1729) elsewhere in this book: in chapter 2 we pointed out his unusual personality, as well as his utopian, inflationist monetary proposals. Although he made some valuable original contributions, such as his opposition to Locke’s nominalist, conventional theory on the origin of money,25 John Law also made the first attempt to give a veneer of theoretical respectability to the fallacious and popular idea that growth in the quantity of money in circulation always stimulates economic activity. In fact, from the correct initial premise that money as a widelyaccepted medium of exchange boosts commerce and encourages the division of labor, Law arrives at the erroneous conclusion that the greater the amount of money in circulation, the larger the number of transactions and the higher the level of economic activity. What follows would constitute another fatal error in his doctrine, namely the belief that the money supply must at all times match the “demand” for it, specifically the number of inhabitants and the level of economic activity. This implies that unless the amount of money in circulation keeps pace with economic activity, the latter will decline and unemployment will rise.26 This theory of Law’s, vol. 4. Locke was the first in England to introduce the idea that the value of the monetary unit is ultimately determined by the amount of money in circulation.

25We must remember that, according to Carl Menger, Law was the first to correctly formulate the evolutionist theory on the origin of money.

26See John Law, Money and Trade Considered: With a Proposal for Supplying the Nation with Money (Edinburgh: A. Anderson, 1705; New York:

Augustus M. Kelley, 1966). In Law’s own words:

The quantity of money in a State must be adjusted to the number of its inhabitants.... One million can create employment for only a limited number of persons... a larger amount of money can create employment for more people than a Central and Free Banking Theory later discredited by Hume and Austrian School monetary theorists, has in one form or another survived up to the present, not only through the work of nineteenth-century BankingSchool theorists, but also through many modern-day monetarists and Keynesians. In short, Law attributes Scotland’s poor level of economic activity in his time to the “reduced” money supply and thus carries the ideas of the Mercantilist School to their logical conclusion. For this reason, Law claims the primary objective of any economic policy must be to increase the amount of money in circulation, an aim he attempted to accomplish in 1705 by introducing paper money

backed by what then was the most important real asset:

land.27 Law later changed his mind and centered all his economic-policy efforts on the establishment of a fractionalreserve banking system which, through the issuance of paper money redeemable in specie, was expected to increase the money supply as needed in any given situation to sustain and foster economic activity. We will not dwell here on the details of the inflationary boom Law’s proposals generated in eighteenth-century France, nor on the collapse of his entire system, which brought great social and economic harm to that nation.

A contemporary of John Law was fellow banker Richard Cantillon (c. 1680–1734), whose life and adventures we have already covered. Cantillon, also a speculator and banker, was endowed with great insight for theoretical analysis. He produced a highly significant study of the influence an increase in the quantity of money in circulation exerts on prices, an influence which first becomes evident in the prices of certain goods and services and gradually spreads throughout the entire economic system. Therefore Cantillon argued, as Hume later would, that variations in the quantity of money mainly affect the relative price structure, rather than the general price smaller amount, and each reduction in the money supply lowers the employment level to the same extent. (Quoted by Hayek in “First Paper Money in Eighteenth-Century France,” chapter 10 of The Trend of Economic Thinking, p. 158) 27See John Law’s Essay on a Land Bank, Antoin E. Murphy, ed.


Aeon Publishing, 1994).

Money, Bank Credit, and Economic Cycles level. Cantillon, a banker first and foremost, justified fractional-reserve banking and his self-interested use of any money or securities his customers entrusted to him as an irregular deposit of fungible goods indistinguishable from one another. In fact chapter 6 (“Des Banques, et de leur credit”) of part 3 of his notable work, Essai sur la nature du commerce en général, contains the first theoretical analysis of fractional-reserve banking, in which Cantillon not only justifies the institution but also draws the conclusion that banks, under

normal conditions, can smoothly conduct business with a 10percent cash reserve. Cantillon states:

If an individual has to pay a thousand ounces to another, he will pay him with a banker’s note for that sum. Possibly this other person will not claim the money from the banker, but will keep the note and, when the occasion requires it, hand it over to a third person as payment. Thus the note in question may be exchanged many times to make large payments, without anyone’s thinking of demanding the money from the banker for a long time. There will hardly be anyone who, due to a lack of complete trust or to a need to make small payments, will demand the sum. In this first case, a banker’s cash does not represent as much as 10 percent of his business.” (Italics added)28 28 Si un particulier a mille onces à païer à un autre, il lui donnera en paiement le billet du Banquier pour cette somme: cet autre n’ira pas peut-être demander l’argent au Banquier; il gardera le billet et le donnera dans l’occasion à un troisième en paiement, et ce billet pourra passer dans plusieurs mains dans les gros paiements, sans qu’on en aille de long-temps demander l’argent au banquier: il n’y aura que quelqu’un qui n’y a pas une parfaite confiance, ou quelqu’un qui a plusieurs petites sommes à païer qui en demandera le montant. Dans ce premier exemple la caisse d’un Banquier ne fait que la dixième partie de son commerce. (Cantillon, Essai sur la nature du commerce en général, pp. 399–400) Cantillon obviously makes the same observation the theorists of the School of Salamanca had almost two centuries earlier with respect to bankers in Seville and other cities. Because these bankers enjoyed the public’s trust, they could consistently conduct their business while maintaining only a small fraction in cash to cover current payments.

Central and Free Banking Theory After Cantillon, and aside from some interesting monetary analysis by Turgot, Montesquieu, and Galiani,29 no important references to banking appear until Hume makes his essential contributions.

David Hume’s (1711–1776) treatment of monetary matters is contained in three brief but comprehensive and illuminating essays entitled “Of Money,” “Of Interest” and “Of the Balance of Trade.”30 Hume deserves special recognition for having successfully refuted John Law’s mercantilist fallacies by proving that the quantity of money in circulation is irrelevant to economic activity. Indeed Hume argues that the volume of money in circulation is unimportant and ultimately influences only the trend in nominal prices, as stated by the quantity theory of money. To quote Hume: “The greater or less plenty of money is of no consequence; since the prices of commodities are always proportioned to the plenty of money.”31 Nevertheless Hume’s 29Ferdinando Galiani follows in Davanzati and Montanari’s footsteps, and his writings, included in Della moneta, rival even the works of Cantillon and Hume.

30These essays have been reprinted in splendid editions by Liberty Classics. See Hume, Essays: Moral, Political and Literary, pp. 281–327.

31See “Of Money,” ibid., p. 281. Even today this essential observation of Hume’s escapes some highly distinguished economists, as is clear from

the following assertion Luis Ángel Rojo makes:

From a social standpoint, the real money balances held by the public should be at a level where the social marginal productivity of the money is equal to the social marginal cost of producing it—a cost which is very low in a modern economy.

From a private perspective, the overall possession of real money balances will reach a level where their private marginal productivity—which, for the sake of simplicity, we may assume to be equal to their social marginal productivity—is equal to the private opportunity cost of holding riches in money form. As the public will decide, based on personal standards, the volume of real money balances they wish to maintain, the amount actually held will tend to be lower than that which would be ideal from a social viewpoint. (Luis Ángel Rojo, Renta, precios y balanza de pagos [Madrid: Alianza Universidad, 1976], pp. 421–22) Money, Bank Credit, and Economic Cycles unqualified acknowledgment that the volume of money is inconsequential does not prevent him from correctly recognizing that rises and falls in the amount of money in circulation do have a profound effect on real economic activity, since these changes always influence primarily the structure of relative prices, rather than the “general” price level. Indeed certain businessmen are always the first to receive the new money (or to experience a slump in their sales as a result of a decrease in the money supply), and thus begins an artificial process of

boom (or recession) with far-reaching consequences for economic activity. Hume maintains:

In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry.32 Although Hume lacks a theory of capital to show him how artificial rises in the quantity of money damage the productive structure and trigger a recession, the inevitable reversal of the initial expansionary effects of such rises, he correctly intuits the process and doubts that increases in credit expansion and in the issuance of paper money offer any long-term economic advantage: “This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous to every nation.”33 For this reason Hume condemns credit expansion in general and fractionalreserve banking in particular and advocates a strict 100-percent reserve requirement in banking, as we saw in chapter 2.

Hume concludes:

[T]o endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them In this excerpt Luis Ángel Rojo not only views money as if it were a sort of factor of production, but he also fails to take into account that money fulfills both its individual and social functions perfectly, regardless of its volume. As Hume established, any amount of money is optimal.

32Hume, Essays, p. 286.

33Ibid., p. 284; italics added.

Central and Free Banking Theory

under disadvantages, by encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant and manufacturer.

And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received [this is the case with the Bank of AMSTERDAM], and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.34 Equally valuable is Hume’s essay, “Of Interest,” devoted entirely to criticizing the mercantilist (now Keynesian) notion that a connection exists between the quantity of money and

the interest rate. Hume’s reasoning follows:

For suppose, that, by miracle, every man in GREAT BRITAIN should have five pounds slipt into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, not for some time, be any more lenders, nor any variation in the interest.35 According to Hume, the influence of money on the interest rate is only temporary (i.e., short-term) when money is increased through credit expansion and a process is initiated

which, once completed, causes interest to revert to the previous rate:

The encrease of lenders above the borrowers sinks the interest; and so much the faster, if those, who have acquired those large sums, find no industry or commerce in the state, and no method of employing their money but by lending it at interest. But after this new mass of gold and silver has been digested, and has circulated through the whole state, affairs will soon return to their former situation; while the landlords and new money-holders, living idly, squander above their income; and the former daily contract debt, and the latter encroach on their stock till its final extinction. The whole money may still be in the state, and make itself felt 34Ibid., pp. 284–85.

35Hume, “Of Interest,” Essays, p. 299.

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