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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 doctrine (i.e., that bank deposits are part of the monetary supply) had already been espoused by the Salamancan group most favorable to banking (Luis de Molina, Juan de Lugo, etc.), in nineteenth-century England it had been practically forgotten when Banking School theorists rediscovered it. Perhaps the first to refer to this point was Henry Thornton himself, who, on November 17, 1797, before the Committee on the Restriction of Payments in Cash by the Bank, testified: “The balances in the bank are to be considered in very much the same light with the paper circulation.”48 Nonetheless, in 1826 James

Pennington made the clearest assertion on this matter:

The book credits of a London banker, and the promissory notes of a country banker are essentially the same thing, that they are different forms of the same kind of credit; and that they are employed to perform the same function... both the one and the other are substitutes for a metallic currency and are susceptible of a considerable increase or diminution, without the corresponding enlargement or contraction of the basis on which they rest. (Italics added)49 In the United States, in 1831, Albert Gallatin revealed the economic equivalence of bank bills and deposits and did so more explicitly than even Condy Raguet. Specifically, Gallatin


48Reprinted in the Records from Committees of the House of Commons, Miscellaneous Subjects, 1782, 1799, 1805, pp. 119–31.

49James Pennington’s contribution is dated February 13, 1826 and entitled “On Private Banking Establishments of the Metropolis.” It appeared as an appendix to Thomas Tooke’s book, A Letter to Lord Grenville; On the Effects Ascribed to the Resumption of Cash Payments on the Value of the Currency (London: John Murray, 1826); it was also included in Tooke’s work, History of Prices and of the State of the Circulation from 1793–1837, vol. 2, pp.

369 and 374. Murray N. Rothbard points out that before Pennington, Pennsylvania Senator Condy Raguet, an American theorist of the Currency School and defender of a 100-percent reserve requirement, had already shown (in 1820) that paper money is equivalent to deposits created by banks which operate with a fractional reserve. On this topic see Rothbard, The Panic of 1819, p. 149 and footnote 52 on pp. 231–32, as well as p. 3 of Rothbard’s book, The Mystery of Banking.

Central and Free Banking Theory The credits in current accounts or deposits of our banks are also in their origin and effect perfectly assimilated to banknotes, and we cannot therefore but consider the aggregate amount of credits payable on demand standing on the books of the several banks as being part of the currency of the United States.50 Nevertheless despite this valuable contribution from the Banking School, i.e., the rediscovery that bank deposits and paper money perform exactly the same economic function as specie and cause the same problems, the rest of the Banking School doctrines were, as Mises asserted, seriously faulty.

Banking School theorists were unable to coherently defend their contradictory ideas; they tried in vain to refute the quantity theory of money; and they failed in their attempt to develop an articulate interest rate theory.51 These Banking School doctrines met with fierce opposition from defenders of the Currency School, who carried on a timehonored tradition which dates back not only to the Salamancan scholastics who were most uncompromising in their views on banking (Saravia de la Calle, Martín Azpilcueta and, to a lesser extent, Tomás de Mercado), but also, as we have seen, to Hume and Ricardo. The leading theorists of the nineteenthcentury Currency School were Robert Torrens, S.J. Lloyd (later Lord Overstone), J.R. McCulloch, and George W. Norman.52 50Albert Gallatin, Considerations on the Currency and Banking System of the United States (Philadelphia: Carey and Lea, 1831), p. 31.

51 It was the only merit of the Banking School that it recognized that what is called deposit currency is a money-substitute no less than banknotes. But except for this point, all the doctrines of the Banking School were spurious. It was guided by contradictory ideas concerning money’s neutrality; it tried to refute the quantity theory of money by referring to a deus ex machina, the much talked about hoards, and it misconstrued entirely the problems of the rate of interest. (Mises, Human Action, p. 440) 52The most valuable contributions from these authors are covered in Hayek’s recently-published summary of the controversy between the Banking and Currency Schools. See chapter 12 of The Trend of Economic Money, Bank Credit, and Economic Cycles Currency School theorists provided a valid explanation of the recurring phases of boom and recession which plagued the British economy in the 1830s and 1840s: the booms had their roots in credit expansion which the Bank of England initiated and the other British banks continued. Gold systematically flowed out of the United Kingdom whenever her trading partners either did not engage in credit expansion or did so at a slower pace than Britain, where the fractional-reserve banking system was comparatively more developed. Each of the arguments Banking School theorists devised in their attempt to refute the Currency School’s central idea (i.e., that the outflow of gold and cash from Great Britain was the inevitable consequence of domestic credit expansion) failed miserably. However defenders of the Currency School position made three serious mistakes which in the long run proved fatal. First, they failed to realize that bank deposits play exactly the same role as banknotes unbacked by specie. Second, they were unable to combine their sound monetary theory with a complete explanation of the trade cycle. They merely scratched the surface of the problem, and, lacking an adequate theory of capital, were unable to perceive that bank credit expansion exerts a negative influence on the different capital-goods stages in a nation’s productive structure. They did not analyze in detail the existing relationship between variations in the money supply and the market rate of interest, and thus they implicitly relied on the naive, mistaken assumption that money could be Thinking. In particular we must cite the following: Samuel Jones Lloyd (Lord Overstone), Reflections Suggested by a Perusal of Mr. J. Horseley Palmer’s Pamphlet on the Causes and Consequences of the Pressure on the Money Market (London: P. Richardson 1837); later reprinted by J.R.

McCulloch in his Tracts and Other Publications on Metallic and Paper Currency, by the Right Hon. Lord Overstone (London: Harrison and Sons 1857). Also George Warde Norman, Remarks upon some Prevalent Errors with respect to Currency and Banking, and Suggestions to the Legislature and the Public as to the Improvement in the Monetary System (London: P.

Richardson 1838); and especially Robert Torrens (perhaps the finest Currency School theorist), A Letter to the Right Hon. Lord Viscount Melbourne, on the Causes of the Recent Derangement in the Money Market, and on Bank Reform (London: Longman, Rees, Orme, Brown and Green, 1837).

Central and Free Banking Theory neutral, an idea today’s monetarists have supported. Therefore it was not until 1912, when Ludwig von Mises reformulated Currency School teachings, that monetary theory was finally fully integrated with capital theory, within a general theory of the economic cycle. The third fatal error of the Currency School lay in the notion that, in keeping with Ricardo’s suggestions, the best way to curtail the Banking School’s inflationary excesses was to grant an official central bank a monopoly on the issuance of bills.53 Currency School theorists failed to realize that in the long run such an institution was bound to be used by Banking School members themselves to speed up credit expansion in the form of bills and deposits in circulation.

These three mistakes of the Currency School proved fatal:

they were the reason Sir Robert Peel’s famous Bank Charter Act (passed on July 19, 1844), despite the highly honorable intentions of its drafters, failed to ban the creation of fiduciary media (deposits unbacked by metallic money) though it did ban the issuance of unbacked bills. As a result, even though Peel’s Act marked the beginning of a central bank monopoly on the issuance of paper currency, and although the central bank theoretically issued only banknotes fully backed by specie (100 percent reserve), private banks were free to expand money by granting new loans and creating the corresponding deposits ex nihilo. Hence expansionary booms and the subsequent stages of crisis and depression continued, and during these periods the Bank of England was obliged time and again to suspend the provisions of the Peel Act and to issue the paper currency necessary to satisfy private banks’ demand for liquidity, thus, when possible, saving them from bankruptcy.

Therefore it is ironic that the Currency School supported the creation of a central bank which, gradually and due mainly to political pressures and the negative influence of predominant Banking School theorists, was eventually used to justify and 53Nevertheless Ricardo foresaw the importance of making the central bank independent of the government. See José Antonio de Aguirre, El poder de emitir dinero: de J. Law a J.M. Keynes (Madrid: Unión Editorial, 1985), pp. 52–62 and footnote 16.

Money, Bank Credit, and Economic Cycles encourage policies of monetary recklessness and financial excesses much worse than those it was originally designed to prevent.54 Consequently, even though in terms of theory the Banking School was utterly defeated, in practice it ultimately triumphed.

Indeed Peel’s Bank Charter Act failed because it did not prohibit the issuance of new loans and deposits in the absence of a 100 percent reserve. As a result, recurrent cycles of boom and recession continued, and the proposals and theories of the Currency School understandably lost a tremendous amount of prestige. Therefore popular demands for inflationary policies which facilitate credit expansion, demands backed by the ever handy mercantilist theories of the Banking School, found a breeding ground in the central-bank-based system, which ultimately became an essential instrument of an interventionist, planned credit and monetary policy invariably aimed at virtually unchecked monetary and credit expansion.

Only Modeste, Cernuschi, Hübner, and Michaelis, followed by Ludwig von Mises and his much more profound analysis, saw that the Currency School’s recommendation of central banking was mistaken and that the best, indeed the only, way to uphold the school’s principles of sound money was to adopt a free banking system subject to private law (i.e., to a 100-percent reserve requirement) and unbenefited by privileges. However we will study this point in greater detail in the next section, in which we will examine the debate between supporters of free banking and those of central banking.

54We agree entirely with Pedro Schwartz when he classifies Keynes (and to a lesser extent, Marshall) as “Banking School” theorists who nonetheless defended the central bank system (precisely to gain the maximum “flexibility” to expand the money supply). See Schwartz’s article, “El

monopolio del banco central en la historia del pensamiento económico:

un siglo de miopía en Inglaterra,” pp. 685–729, esp. p. 729.

Central and Free Banking Theory



An analysis of the nineteenth-century debate between defenders of the central bank and advocates of free banking must begin with an acknowledgment of the indisputable, close connection which initially existed between the Banking School and the Free-Banking School, on the one hand, and between the Currency School and the Central-Banking School, on the other.55 Indeed it is easy to understand why supporters of fractional-reserve banking, on the whole, initially championed a banking system free from any kind of interference: they wished to continue to do business based on a fractional reserve.

Likewise it was only natural for Currency School theorists, ever distrustful of bankers, to naively embrace government 55See Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative. Leland B. Yeager has written the preface to this magnificent edition. This work is a doctoral thesis written by the future Vera Lutz under the direction of F.A. Hayek. In fact Hayek had already devoted some time to a projected book on money and banking when, following his famous lecture series at the London School of Economics which yielded his book Prices and Production, he was appointed Tooke Professor of Economic Science and Statistics at that prestigious institution and was forced to interrupt his research. Hayek had completed four chapters: the history of monetary theory in England, money in eighteenthcentury France, the evolution of paper currency in England, and the controversy between the Banking and Currency Schools. It was at this point he decided to hand over the work he had completed thus far, as well as the notes for a fifth and final chapter, to one of his most brilliant students, Vera C. Smith (later Vera Lutz), who, as a doctoral thesis, expanded on them and produced the above-mentioned book. Fortunately Hayek’s original manuscript was recently recovered by Alfred Bosch and Reinhold Weit, and an English translation by Grete Heinz has been published as chapters 9, 10, 11, and 12 of volume 3 of The Collected Works of F.A. Hayek. See F.A. Hayek, The Trend of Economic Thinking. On pp. 112–13 (2nd English ed.) of her book, Vera C. Smith mentions the initial general agreement between the Banking and Free-Banking Schools, and between the Currency and Central-Banking Schools. On this matter see also Rothbard, Classical Economics, vol. 2, chap 7.

Money, Bank Credit, and Economic Cycles regulation in the form of a central bank intended to avoid the abuses the Banking School attempted to justify.



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