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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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We will not embark here on a comprehensive account of the controversy between the Free-Banking and Central-Banking Schools: Vera C. Smith and others have already come up with excellent studies on this topic. Nonetheless a few additional points merit discussion. One thought we must keep in mind is that most advocates of free banking based their doctrine on the spurious, inflationist Banking School arguments covered in the last section. Therefore, regardless of the effects a free-banking system might actually exert on the economy, the theoretical foundation on which most free-banking advocates built their arguments was either entirely fallacious or, at best, highly questionable. Consequently, during this period the Free-Banking School made few contributions of any doctrinal value. One such contribution was the correct acknowledgment that, economically speaking, deposits and unbacked bills play the same role. Another, one of particular analytical interest, was made by Sir Henry Parnell as early as 1827. According to Parnell, a free-banking system would place natural limits on the issuance of banknotes, due to the influence of the corresponding interbank clearing house, which, on the model of the Scottish banking system, Parnell believed would develop wherever banks freely competed in the issuance of banknotes.

Parnell argued that banks in a totally free banking system would be unable to endlessly expand their paper-money base without prompting their competitors to demand payment of the bills, in specie, through a clearing house. Thus banks, for fear of being unable to weather the corresponding outflow of gold, would, in their own interest, adopt strict limitations on the issuance of fiduciary media.56 Parnell’s 56Henry Parnell, Observations on Paper Money, Banking and Other Trading, including those parts of the evidence taken before the Committee of the House of Commons which explained the Scotch system of banking (London: James Ridgway, 1827), esp. pp. 86–88.

Central and Free Banking Theory analysis has considerable merit and lies at the heart of the arguments invoked to date in favor of free banking. His analysis was used and developed even by certain authors of the Currency School (like Ludwig von Mises) who were nonetheless highly skeptical of the central-bank system.57


Two distinguished theorists of the Currency School, J.R.

McCulloch and S.M. Longfield, challenged Parnell’s claim.

McCulloch argued that the mechanism Parnell described would not curb inflation if all banks in a free-banking system should collectively yield to a wave of expansion in the issuance of banknotes.58 Samuel Mountifort Longfield carried McCulloch’s objection even further and contended that even if a single bank expanded its paper-money base, in a free-banking system the rest would inevitably be forced to follow suit lest their financial-market share or their profits drop.59 Longfield’s argument contains an important kernel of truth, since the liquidation of excess banknotes through a clearing house 57See, for example, Mises, “The Limitation of the Issuance of Fiduciary Media,” section 12 of chapter 17 of Human Action, pp. 434–48; see esp.

“Observations on the Discussions Concerning Free Banking,” p. 444.

58J.R. McCulloch, Historical Sketch of the Bank of England with an Examination of the Question as to the Prolongation of the Exclusive Privileges of that Establishment (London: Longman, Rees, Orme, Brown and Green, 1831).

See also his A Treatise on Metallic and Paper Money and Banks (Edinburgh:

A. and C. Black, 1858).

59Longfield’s contributions appeared in a series of four articles on “Banking and Currency” published by the Dublin University Magazine in

1840. Vera C. Smith concludes:

The point raised by the Longfield argument is by far the most important controversial point in the theory of free banking.

No attempt was made in subsequent literature to reply to it.

(Smith, The Rationale of Central Banking and the Free Banking Alternative, p. 88) See also our analysis supporting the initial Longfield insight on pp.


Money, Bank Credit, and Economic Cycles takes time, and there is always a (perhaps irresistible) temptation to overissue on the assumption that all other banks will sooner or later do the same. In this way the first bank to launch an expansionary policy derives the most profit and eventually establishes a position of advantage over its competitors.

Regardless of the theoretical basis for the arguments of Parnell, or for those of McCulloch and Longfield, one thing seems certain: their debate sparked off a false controversy between central-bank and free-banking supporters. We use the term “false” because the theoretical discussion between these two sides misses the heart of the whole problem. Indeed Parnell is correct when he states that in a free-banking context, the clearinghouse system tends to act as a buffer against isolated cases of expansion in the issuance of banknotes. At the same time, McCulloch, and Longfield as well, are right in pointing out that Parnell’s argument fails if all banks simultaneously embark on a policy of expansion. Nevertheless Currency School theorists felt their arguments against Parnell’s views lent prima facie support to the establishment of a central bank, which they believed would offer the most effective protection against the abuses of fractional-reserve banking. Parnell, for his part, contented himself with defending free banking, though with the limits the interbank clearinghouse system would set as a safeguard against banks’ reckless expansion of their paper-money base. Nonetheless he failed to realize that, regardless of the arguments of McCulloch and Longfield, a return to traditional legal principles and a 100percent reserve requirement would be much simpler and more effective than any clearinghouse system. Having overlooked this option, at least with regard to bank deposits, is the most crucial error committed by McCulloch and Longfield’s branch of the Currency School as well. By endorsing the creation of a central bank, this faction inadvertently paved the way for the future strengthening of the very inflationary policies its adversaries favored.60

–  –  –


Thus began a prolonged controversy between free-banking champions and central-bank promoters. The latter offered the following arguments to support their case against the

position of the Banking and Free-Banking School:

First, a free-banking system, by its very nature, even under optimal conditions, would be prone to occasional, isolated bank crises which would harm customers and holders of bills and deposits. Therefore, under such circumstances, there is a need for an official central bank with the power to step in to protect noteholders and depositors in the event of a crisis.

This argument is clearly paternalistic and aimed at justifying the existence of a central bank. It ignores the fact that when support is provided to those hit by a crisis, in the long run such support merely tends to further hamper the smooth running of the banking system, which requires constant and active supervision and confidence on the part of the public.

Supervision is relaxed and confidence bolstered when the general public takes for granted the intervention of the central bank to avoid any damage in the case of a bank failure. Moreover bankers actually tend to exercise less responsibility when they too are sure of the central bank’s support should they need it. Hence it is quite credible that the existence of a central bank tends to aggravate bank crises, as has been revealed even recently in many cases. The “deposit insurance” system in many countries has played a major role in fostering perverse behavior among bankers and in facilitating and aggravating bank crises. Nevertheless, from a political standpoint the above paternalistic argument can become extremely influential, even nearly irresistible, in a democratic environment. At any rate, this first argument marks the beginning of the false Coquelin, Chevalier, and others) and Currency School theorists in favor of a central bank (such as Lavergne, D’Eichtal, and Wolowsky). In Germany the quarreling factions were led by Adolph Wagner and Lasker, on the side of free banking, and Tellkampf, Geyer, Knies, and Neisser, on the side of the pro-central-bank Currency School. On this matter, see chapters 8 and 9 of Smith, The Rationale of Central Banking, pp. 92–132.

Money, Bank Credit, and Economic Cycles start in the free-banking/central-banking debate, in the sense that the argument would be meaningless if traditional legal principles were respected and a 100-percent reserve requirement were reestablished for banking. Under these conditions, no harm would be done to holders of banknotes and deposits, who would always be able to withdraw their money, regardless of the fate of their bank. Therefore the paternalistic argument that a central bank is necessary to protect the interests of injured parties makes no sense. If we follow the logic of a fractional-reserve banking system, this first argument in favor of a central bank is at least very doubtful, while in the context of a free-banking system based on traditional legal principles and a 100-percent reserve requirement, it is completely irrelevant.

The second argument expressed in favor of central banks rests on the notion that a banking system controlled by a central bank provokes fewer economic crises than a free-banking system. This argument, like the first one, represents an inappropriate approach to the debate. We already know that the fractional-reserve free-banking system may stimulate growth in the money supply in the form of loans, and that this growth invariably distorts the productive structure of capital goods and endogenously and repetitively triggers a reversion process that manifests itself as an economic recession that hits banks particularly hard. In fact it was the very desire to protect banks from the effects of the repetitive crises created by fractional-reserve banking which prompted bankers themselves to demand the establishment of a central bank to loan them money as a last resort. Experience has shown that far from defusing economic crises, the advent of the central bank has exacerbated them. In a fractional-reserve free-banking system (with no central bank), even though the expansionary processes which provoke crises cannot be avoided, the reversion mechanisms which lead to the necessary readjustment and correction of economic errors operate much sooner and more quickly than in the central-bank-based system. Indeed the loss of public confidence is not the only factor to endanger the most expansionist banks, the reserves of which rapidly diminish as the holders of their bills withdraw their countervalue in specie. Interbank clearing mechanisms related to deposits also Central and Free Banking Theory jeopardize those banks which expand their credit base faster than the rest. Even if most banks expand their deposits and bills simultaneously, the spontaneous processes identified by the theory of economic cycles soon gather momentum and tend to reverse the initial expansionary effects and bankrupt marginally less solvent banks. In contrast, the existence of a central bank, a lender of last resort, may prolong the process of credit and monetary expansion much further in relation to the independent process which would be set in motion in a free-banking system. It is impossible to ignore the contradiction inherent in the institution of the central bank, which was theoretically created to curb monetary expansion, maintain economic stability and prevent crises, but which in practice is devoted to providing new liquidity on a massive scale when banks face crises and panics. If we also consider political influences and the inflationary desires of the public, we will understand why inflationary processes and their distortion of the productive structure have been aggravated and the historical result has been much more severe and profound economic crises and recessions than those which would have arisen in a free-banking system. Therefore we can conclude that this second argument in favor of the central bank is groundless, since the very existence of the central bank tends to exacerbate economic crises and recessions. Nevertheless we must also acknowledge that crises would erupt even in a fractionalreserve free-banking system, though they would not cause as many repercussions as in a monetary system directed by a central bank. We have made this point in previous chapters and will demonstrate it further on. In any case, we do not have to resign ourselves to living with recurrent economic crises and recessions, since the mere re-establishment of general legal principles (100-percent reserve requirement) would prevent a free-banking system from exerting any negative effects on economic processes, and in this way the most common pretext for creating a central bank would disappear.

The third argument in favor of a central bank is that in supplying the liquidity necessary, it provides the best way to deal with crises once they have hit. Again it is evident that the failure to clearly identify the essential root of the economic problems of banking leads theorists to err substantially in Money, Bank Credit, and Economic Cycles their approach to the debate between central-banking and free-banking supporters. Although interbank clearing mechanisms and continuous public supervision would tend to limit credit expansion in a fractional-reserve free-banking system, they would be unable to prevent it completely, and bank crises and economic recessions would inevitably arise. There is no doubt that crises and recessions provide politicians and technocrats with an ideal opportunity to orchestrate central-bank intervention. Therefore it is obvious that the very existence of a fractional-reserve banking system invariably leads to the emergence of a central bank as a lender of last resort. Until traditional legal principles are reestablished, along with a 100-percent reserve requirement in banking, it will be practically inconceivable for the central bank to disappear (in other words, it will inevitably arise and endure).

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