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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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At the same time, the establishment of a central bank to meet crises tends to worsen economic recessions. The existence of a lender of last resort aggravates expansionary processes and makes them much more rapid and lengthy than they would be in a fractional-reserve free-banking system (i.e., with no central bank). Therefore it is paradoxical to claim that the correct treatment of economic and bank crises depends on the existence of a central bank, when the central bank is ultimately the main culprit in dragging out and exacerbating crises. Nevertheless let us remember that even if the introduction of a fractional-reserve free-banking system were to tame crises somewhat, it could not completely eliminate them, and the different economic agents involved (mainly the bankers and citizens potentially harmed in each crisis) would inevitably urge the establishment of a central bank.

The only way to end this vicious circle is to recognize that the origin of the entire problem lies in fractional-reserve banking. In fact the reestablishment of a 100-percent reserve requirement would not only avoid bank crises and recurrent economic recessions, but it would also invalidate this third argument, one of the stalest invoked to justify the existence of the central bank.

Finally, two additional, subsidiary arguments in favor of the central bank have been expressed. The first refers to the Central and Free Banking Theory supposed “need” for a “rational” monetary policy imposed from above through the central bank. The second argument is related to the first and centers around the need to establish an adequate policy of monetary cooperation among different countries. Supposedly this goal also requires the existence of different, coordinated central banks. We will examine the theoretical impossibility of implementing a monetary and banking policy in a centralized, coercive manner through a central bank in a forthcoming section, where we will apply the theory of the impossibility of socialism to the banking and financial sector. Therefore we will refrain from analyzing these last two arguments in depth here.


Unfortunately, due to their inability to equate the economic effects of deposits with those of banknotes, and to their naiveté in proposing the creation of a central bank to check the abuses of fractional-reserve banking, Currency School theorists were unable to foresee that the remedy they prescribed would necessarily prove much worse than the sickness they had correctly diagnosed. Only a handful of Currency School theorists understood that their goals of monetary stability and solvency would be at much greater risk if a central bank were created, and as a lesser evil and in order to prevent abuses as far as possible, these theorists recommended the maintenance or establishment of a free-banking system with no central bank. Nonetheless most Currency School writers who defended free banking were not deceived as to the expansionary possibilities of such a system, and they always maintained that the final solution to the problems posed would only be achieved with the prohibition of the issuance of new fiduciary media (i.e., with the prohibition of credit expansion unbacked by an increase in real voluntary saving). In proposing a system in which banks could freely issue bills and deposits, they basically hoped that interbank clearing mechanisms, customer supervision and control through the market, and the immediate failure of banks which lost public confidence would serve to more effectively limit the issuance of unbacked Money, Bank Credit, and Economic Cycles banknotes and deposits.61 By this indirect route, they planned an effective move toward the objective of a 100-percent reserve requirement (for both bills and deposits), an aim to be pursued by all legal means available in each historical context.

This idea was first defended in France by Victor Modeste.62 With the same goal in mind, Henri Cernuschi, on October 24, 1865, before a commission appointed to investigate

banking activities, stated:

I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.63 61The future development of payment and clearing systems through the Internet and other forms of computer-based communications will make the “emptying” of those banks which operate with a fractional reserve almost immediate upon the emergence of the slightest doubt concerning their solvency. In this respect the technological revolution in the field of computer communications will tend to promote private banking with a reserve requirement close to 100 percent (assuming the current system were to be completely privatized and the central bank were to disappear). See the paper by our pupil, Jesper N. Katz, “An Austrian Perspective on the History and Future of Money and Banking,” Erasmus Programme in Law and Economics, Summer 1997. See also The Future of Money in the Information Age, James A. Dorn, ed. (Washington, D.C.: Cato Institute, 1997). As for credit cards, or “plastic” or “electronic” money, as they are commonly known, we should note that they are not money, but mere instruments which, like paper checks, provide the ability to pay by charging to real money (or perfect money substitutes, such as bank deposits).

62Victor Modeste, “Le billet des banques d’émission et la fausse monnaie,” Le Journal des Économistes n.s. 3 (August 15, 1866).

63 Je crois que ce qu’on appelle liberté bancaire aurait pour résultat la disparition complète des billets de banque en France. Je souhaite donner à tout le monde le droit d’émettre des billets, de sorte que plus personne désormais n’en

accepterait. (Henri Cernuschi, Contre le billet de banque [Paris:

Guillaumin, 1866], p. 55) See also Cernuschi’s interesting work, Mécanique de l’échange (Paris: A.

Lacroix, 1865). Ludwig von Mises fully accepts Modeste’s and Cernuschi’s views as expressed above and includes the excerpt in Human Central and Free Banking Theory Cernuschi’s doctrine had only two flaws: it referred merely to banknotes and ignored bank deposits. And furthermore, it was not so radical as Modeste’s who considered fractional-reserve free banking a fraudulent business that should not be allowed at all.

While the French Currency School was establishing this position in favor of free banking and a 100-percent reserve ratio, a number of German economists, among them Hübner and Michaelis, were carrying out a more in-depth theoretical analysis which led to the same conclusions. In the United States, the panic of 1819 had sparked the formulation of a doctrine against both fractional-reserve banking and the establishment of a central bank, and this doctrine strongly influenced the above school of German-speakers. As we already know, in the U.S., Condy Raguet and others (William M.

Gouge, John Taylor, John Randolph, Thomas Hart Benton, Martin Van Buren, etc.) developed a body of monetary doctrine highly critical of banking.64 These men correctly identified fractional-reserve banking as the ultimate cause of crises and concluded that a return to a 100-percent reserve ratio was Action, with the following comment: “[F]reedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it.” Mises, Human Action, p. 446. Banking School theorists in favor of free banking opposed Cernuschi. In France this school was led by J.G. Courcelle-Seneuil. See especially his book, La banque libre: exposé des fonctions du commerce de banque et de son application à l’agriculture suivi de divers écrits de controverse sur la liberté des banques (Paris: Guillaumin, 1867). The best account of Modeste’s and Cernuschi’s dctrines (including an analysis of their differences) is that of Oskari Juurikkala’s “The 1866 False Money Debate, in the Journal des Économistes: Déjà Vu for Austrians?” Quarterly Journal of Austrian Economics 5, no. 4 (Winter, 2002): 43–55.

64Another voice in support of a banking system subject to a 100-percent reserve requirement was that of the famous Davy Crockett, the frontier hero-turned-senator, for whom fractional-reserve banking systems were “species of swindling on a large scale” (Skousen, The Economics of a Pure Gold Standard, p. 32). Similar views were held by Andrew Jackson, the above-cited Martin Van Buren, Henry Harrison, and James K. Polk, all of whom would later become U.S. presidents.

Money, Bank Credit, and Economic Cycles the only way to eradicate them.65 Tellkampf, who had visited the U.S. as a young man, witnessed the abuses and highly damaging effects of fractional-reserve banking there and was imbued with the rigorous monetary doctrine being developed in America at the time. When he returned to Germany and was appointed professor of economics at Breslau, he wrote several papers in which he called for a ban on banks’ issuance of fiduciary media.66 Otto Hübner also shared some of the 65An outline of the evolution of this school in the United States during the first half of the nineteenth century appears in James E. Philbin’s article, “An Austrian Perspective on Some Leading Jacksonian Monetary Theorists,” The Journal of Libertarian Studies: An Interdisciplinary Review 10, no. 1 (Autumn 1991): 83–95. Another book which covers the different Banking and Monetary Schools which emerged in the first half of the nineteenth century in the United States is Harry E. Miller’s Banking Theory in the United States Before 1860 (1927; New York: Augustus M. Kelley, 1972).

66Johann Ludwig Tellkampf, Essays on Law Reform, Commercial Policies, Banks, Penitentiaries, etc., in Great Britain and the United States of America (London: Williams and Norgate, 1859). See also his Die Prinzipien des Geld- und Bankwesens (Berlin: Puttkammer and Mühlbrecht, 1867). As

early as 1912 Mises made reference to Tellkampf’s (and Geyer’s) proposals in the following rather puzzling passage:

The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduce the cost of the monetary apparatus. (Mises, The Theory of Money and Credit, p. 359) This does not seem to square with other comments made by Mises, who at the end of the book proposes a return to a 100-percent reserve ratio and a ban on the creation of new fiduciary media, just as Tellkampf and Geyer (among the defenders of a central bank), and Hübner and Michaelis (among the defenders of free banking) do. As we observed in chapter 7, a parallel contradiction exists between the Hayek of Monetary Theory and The Trade Cycle (1929) and that of Prices and Production (1931).

The only explanation lies in the process of intellectual development followed by the two authors, who were at first reluctant to vigorously defend the implications of their own analysis. Moreover we must keep in mind that, as we will see in the next chapter, Mises defends the establishment of a 100-percent reserve requirement, but only on newly-created banknotes and deposits, in the same vein as Peel’s Bank Charter Act.

Therefore it is somewhat comprehensible that he should mention the advantages of the past issuance of fiduciary media, though it is surprising that he neglects to explain why the system he considers most suitable Central and Free Banking Theory views of Tellkampf and the American school. Hübner observed that the less regulated banks were, the less frequent their solvency problems tended to be. He felt the choice was between a system of privileged banks protected by a central bank and apt to encourage irresponsible practices, and a freebanking system with no central bank to confer any privileges or protection. In this second system, each bank would necessarily be responsible for its own policies, and consequently bankers would act in a more prudent way. According to Hübner, the final objective should be an end to the issuance of banknotes not backed 100 percent by specie. Nevertheless, in light of the current situation, he believed the fastest and most effective way to move toward the ideal system was through free banking, in which each bank would be required to fulfill its obligations entirely.67 As early as 1867, the notable theorist Philip Joseph Geyer formulated a theory to explain economic cycles (a precursor to the theory proposed in this book) which Mises and Hayek would later carry to its logical conclusion. In fact Geyer impeccably summarises the defects of the fractional-reserve banking system and describes how it provokes economic crises. According to Geyer, the banking system produces “artificial capital” (künstliches Kapital), which refers precisely to fiduciary media generated by banks and unbacked by real wealth from voluntary saving. Geyer explains why a boom follows and must inevitably reverse in the form of a bank crisis and an economic recession.68 Finally, like Hübner, Otto Michaelis defended a for the future would not also have been best in the past. We believe the advantages of the issuance of fiduciary media in the past were few compared with the severe damage it caused in the form of economic crises and recessions, and especially with the gross inadequacies of our current financial system, which is a result of those past errors.

67See Otto Hübner, Die Banken, published by the author in Leipzig in 1853 and 1854.

68Philip Geyer, Theorie und Praxis des Zettelbankwesens nebst einer Charakteristik der Englischen, Französischen und Preussischen Bank (Munich:

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