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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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Money, Bank Credit, and Economic Cycles by the encrease of prices: But not being now collected into any large masses or stocks, the disproportion between the borrowers and lenders is the same as formerly, and consequently the high interest returns.36 Hume’s two brief essays constitute as concise and correct an economic analysis as can be found. We may wonder how different economic theory and social reality would have been if Keynes and other such writers had read and understood from the start these important contributions of Hume’s, and had thus become immune to the outdated mercantilist ideas which, time and again, reappear and gain new acceptance.37 Compared to Hume’s, Adam Smith’s contributions must largely be considered an obvious step backward. Not only does Smith express a much more positive opinion of paper

money and bank credit, but he also openly supports fractional-reserve banking. In fact Smith claims:

What a bank can with propriety advance to a merchant or undertaker of any kind, is not, either the whole capital with which he trades, or even any considerable part of that capital;

but that part of it only, which he would otherwise be obliged to keep by him unemployed, and in ready money for answering occasional demands.38 The only restriction Smith places on the granting of loans against demand deposits is that banks must use 36Ibid., pp. 305–06; italics added.

37Hayek has pointed out the surprising gaps in Keynes’s knowledge of the history of economic thought concerning monetary matters in eighteenth- and nineteenth-century England and has indicated that, had Keynes’s knowledge been deeper, we would have been spared much of the clear regression Keynesian doctrines have represented. See F.A.

Hayek, “The Campaign against Keynesian Inflation,” in New Studies in Philosophy, Politics, Economics and the History of Ideas, p. 231.

38Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, vol. 1, p. 304; italics added. On the evolution of Adam Smith’s ideas on banking, see James A. Gherity, “The Evolution of Adam Smith’s Theory of Banking,” History of Political Economy 26, no. 3 (Autumn, 1994): 423–41.

Central and Free Banking Theory deposits “prudently,” for if they abandon caution, they lose the confidence of their customers and fail. As was the case with those Salamancan scholastics (Molina and Lugo) whose views were closest to those of the Banking School, nowhere does Smith define his criterion of “prudence,” nor does he ever comprehend the devastating effects temporary credit expansion (beyond the level of voluntary saving) exerts on the productive structure.39 After Adam Smith, the most important thinkers on banking activities are Henry Thornton and David Ricardo. In 1802 Thornton, a banker, published a noteworthy book on monetary theory entitled An Inquiry into the Nature and Effects of the Paper Credit of Great Britain.40 Thornton produced a highly precise analysis of the effects credit expansion exerts on prices in the different stages of the productive structure. He even guesses that whenever banks’ interest rate is lower than the average rate of profit companies derive, an undue increase in the issuance of bills results, triggering inflation and, in the long run, recession. Thornton’s intuitions foreshadowed not 39Edwin G. West has noted that Perlman believes Smith was aware of the problems of expanding credit beyond voluntary saving, even though Smith was unable to resolve the contradiction between his favorable treatment of fractional-reserve banking and his sound thesis that only investment financed by voluntary saving is beneficial for the economy. See Edwin G. West, Adam Smith and Modern Economics: From Market Behaviour to Public Choice (Aldershot, U.K.: Edward Elgar, 1990), pp. 67–69. Pedro Schwartz mentions that “Adam Smith did not express his thoughts on credit and monetary matters as clearly as Hume did” and that, in fact, “he misled several of his followers... by not always identifying his institutional assumptions.” Pedro Schwartz also indicates that Adam Smith knew much less about banking and paper money than James Steuart and even states: “Some of the criteria in Smith’s presentation may have come from reading Steuart’s book, Political Economy.” See the article by Pedro Schwartz, “El monopolio del banco central en la historia del pensamiento económico: un siglo de miopía en Inglaterra,” printed in Homenaje a Lucas Beltrán (Madrid: Editorial Moneda y Crédito, 1982), p. 696.

40See F.A. Hayek’s edition of this book and the introduction (New York:

Augustus M. Kelley, 1978).

Money, Bank Credit, and Economic Cycles only Wicksell’s theory on the natural rate of interest, but also much of the Austrian theory of the economic cycle.41 After Thornton’s, the most notable work was produced by David Ricardo, whose distrust of banks parallels Hume’s.

Ricardo may be regarded as the official father of the English Currency School. In fact Ricardo strongly disapproved of the abuses committed by bankers in his day and particularly resented the harm done to the lower and middle classes when banks were unable to honor their commitments. He deemed such phenomena the result of banking offenses, and while he did not anticipate the precise development of the Austrian, or circulation credit theory of the business cycle, he at least understood that artificial processes of expansion and depression stem from certain banking practices, namely the unchecked issuance of paper money unbacked by cash and the injection of this money into the economy via credit expansion.42 In the following section we will examine in detail the key principles of the Currency School, started by Ricardo, as well as the main postulates of the Banking School.43



AND THE The popular arguments raised by defenders of fractionalreserve banking from the days of the School of Salamanca 41Hayek, The Trend of Economic Thinking, pp. 194–95.

42Schwartz, “El monopolio del banco central en la historia del pensamiento económico: un siglo de miopía en Inglaterra,” p. 712.

43Ricardo’s chief banking contributions appear in his well-known book, Proposals for an Economical and Secure Currency (1816), which has been reprinted in The Works and Correspondence of David Ricardo, Piero Sraffa, ed. (Cambridge: Cambridge University Press, 1951–1973) vol. 4, pp.

34–106. Ricardo’s criticism of banks is present in, among other documents, a letter he wrote to Malthus on September 10, 1815. This letter is included in volume 4 of The Works, edited by Sraffa, p. 177. Again, we must remember that Ricardo would never have advised a government to restore the parity of its devalued currency to predepreciation levels, as he

clearly implies in his letter to John Wheatley of September 18, 1821 (contained in volume 9 of The Works, pp. 71–74). Hayek himself wrote in 1975:

Central and Free Banking Theory became more widespread and systematic in England during the first half of the nineteenth century, owing to the efforts of the so-called Banking School.44 During that period a sizeable group of theorists (Parnell, Wilson, MacLeod, Tooke, Fullarton, etc.) formed, bringing together and systematizing the three main tenets of the Banking School, namely: (a) that fractional-reserve banking is juridically and doctrinally justified and highly beneficial to the economy; (b) that the ideal monetary system is one which permits the expansion of the money supply as required by the “needs of trade,” and particularly to adjust to population and economic growth (this is the idea John Law initially developed); and (c) that the fractionalreserve banking system, through credit expansion and the I ask myself often how different the economic history of the world might have been if in the discussion of the years preceding 1925 one English economist had remembered and pointed out this long-before published passage in one of Ricardo’s letters. (Hayek, New Studies in Philosophy, Politics, Economics and the History of Ideas, p. 199) In fact the fatal mistake manifest in the British post-war attempt to return to the gold standard abandoned during the First World War and to restore the pound to its previous value, lowered by wartime inflation, had already been revealed in a remarkably similar situation (following the Napoleonic wars) by David Ricardo a hundred years earlier. Ricardo stated at that time that he never should advise a government to restore a currency which had been depreciated 30 percent to par; I should recommend, as you propose, but not in the same manner, that the currency should be fixed at the depreciated value by lowering the standard, and that no farther deviations should take place. (David Ricardo, in the above-mentioned letter to John Wheatley dated September 18, 1821, included in The Works and Correspondence of David Ricardo, Sraffa, ed., vol. 9, p. 73;

see also chap. 6, footnote 46 44Actually, the main doctrines of the Banking School had already been put forward, at least in embryonic form, by theorists of the Anti-Bullionist School in eighteenth-century England. See chapter 5 (“The Early Bullionist Controversy”) from Rothbard’s book, Classical Economics (Aldershot, U.K.: Edward Elgar 1995), pp. 159–274; and Hayek, The Trend of Economic Thinking, vol. 3, chaps. 9–14.

Money, Bank Credit, and Economic Cycles issuance of paper bills unbacked by commodity-money, permits increases in the money supply to meet the “needs of trade” without producing inflationary effects or distortions in the productive structure.

John Fullarton (c. 1780–1849) was undoubtedly the most prominent of Banking School representatives. He was among the school’s most persuasive authors and in 1844 published a widely-read book entitled On the Regulation of Currencies.45 Here Fullarton puts forward what would become a famous doctrine, Fullarton’s law of reflux of banknotes and credit.

According to Fullarton, credit expansion in the form of bills issued by a fractional-reserve banking system poses no danger of inflation because the bills banks issue are injected into the economic system as loans, rather than direct payment for goods and services. Thus, Fullarton reasons, when the economy “needs” more means of payment it demands more loans, and when it needs less, loans are repaid and flow back to banks, and therefore credit expansion has no negative effects whatsoever on the economy. This doctrine became quite popular, yet it was a clear step backward with respect to advances Hume and other authors had already made in monetary theory. Nevertheless it surprisingly gained the unexpected support of even John Stuart Mill, who eventually, by and large, endorsed Fullarton’s theories on the issue.

We have already explained at length why the essential principles of the Banking School are fundamentally unsound.

Only ignorance of the simplest basics of monetary and capital 45John Fullarton, On the Regulation of Currencies, being an examination of the principles on which it is proposed to restrict, within certain fixed limits, the future issues on credit of the Bank of England and of the other banking establishments throughout the country (London: John Murray, 1844; 2nd rev.

ed., 1845). Fullarton’s law of reflux appears on p. 64 of the book. In continental Europe, Adolph Wagner (1835–1917) popularized Fullarton’s version of the Banking School inflationist creed. John Fullarton was a surgeon, publisher, tireless traveler, and also a banker. On the influence Fullarton exerted on such diverse authors as Marx, Keynes, and Rudolph Hilferding, see Roy Green’s interesting essay published in The New Palgrave: A Dictionary of Economics, vol. 2, pp. 433–34.

Central and Free Banking Theory theory might make the inflationist fallacies of this school appear somewhat credible. The main error in Fullarton’s law of reflux lies in its failure to account for the nature of fiduciary loans. We know that when a bank discounts a bill or grants a loan, it exchanges a present good for a future good. Since banks which expand loans create present goods ex nihilo, a natural limit to the volume of fiduciary media the banking system could create would only be conceivable under one condition: if the quantity of future goods offered in the market in exchange for bank loans were somehow limited. However, as Mises has eloquently pointed out, this is never the case.46 In fact banks may expand credit without limit simply by reducing the interest rate they apply to the corresponding loans. Moreover, given that loan recipients pledge to return a greater amount of monetary units at the end of a certain time period, there is no limit to credit expansion. Indeed borrowers can repay their loans with new monetary units the banking system itself creates ex nihilo in the future. As Mises puts it, “Fullarton overlooks the possibility that the debtor may procure the necessary quantity of fiduciary media for the repayment by taking up a new loan.”47 Although the monetary theories of the Banking School were invalid, in one particular respect they were accurate.

Banking School theorists were the first to recover a monetary doctrine of the “banking” sector of the School of Salamanca, namely that bank deposit balances fulfil exactly the same economic function as banknotes. As we will later see, throughout the debate between the Banking and Currency Schools, in which the latter focused solely on the damaging effects of unbacked paper bills, Banking School defenders correctly argued that if the recommendations of the Currency School were sensible (and they were), they should also be applied to all bank deposits, since, as bank money, deposits play a role identical to that of unbacked banknotes. Even though this 46Mises, The Theory of Money and Credit, pp. 340–41.

47Ibid., p. 342. For more on Mises’s criticism of the Banking School, see On the Manipulation of Money and Credit, pp. 118–19 and Human Action, pp. 429–40.

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