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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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Fleischmann’s Buchhandlung, 1867). See also Geyer’s book, Banken und Krisen (Leipzig: T.O. Weigel, 1865). Vera C. Smith criticizes Geyer and Tellkampf’s proposal to abolish the issuance of fiduciary media and Money, Bank Credit, and Economic Cycles free-banking system as a means to curb abuses and move toward the ideal of a 100-percent reserve requirement.69 The tradition of Modeste, Cernuschi, Hübner, and Michaelis was continued by Ludwig von Mises, who in 1912 conclusively upheld the tenets of the Currency School. He not only asserted that both banknotes and deposits were fiduciary media, but he also grounded monetary theory on that of marginal utility and Böhm-Bawerk’s theory of capital. The result was, for the first time, a complete, coherent and integrated theory of economic cycles. Thus Mises realized that English Currency School theorists were mistaken in recommending a central bank and that the best, in fact the only, way to achieve the school’s goals of monetary solvency was through the establishment of a free-banking system subject, without privileges, to private law (i.e., to a 100-percent reserve requirement). Furthermore Mises recognized that in the end most advocates of Banking School principles cheerfully accepted the establishment of a central bank which, as lender of last resort, would guarantee and perpetuate the expansionary privileges of private bankers. These individuals made an increasing effort to shirk their commitments and devote themselves to the lucrative “business” of creating fiduciary money via credit expansion, and central-bank support allowed them to do so without having to worry too much about liquidity problems. Not surprisingly, Mises is especially critical of the fact that Peel’s Bank Charter Act of 1844, despite the excellent establish a 100-percent reserve requirement. Smith claims such an action would involve a deflationary process, but she fails to take into account that, as we will see in the next chapter when we consider the process of transition toward a 100 percent-based system, it is not necessary to reestablish the relationship which existed between banknotes and specie prior to the issuance of fiduciary media. On the contrary, any healthy transition process demands the avoidance of deflation and the redefinition of the relationship between fiduciary media and specie in light of the total quantity of bills and deposits already issued by the banking system. Therefore the point is not to trigger a monetary contraction, but to prevent any subsequent credit expansion.

69Otto Michaelis, Volkswirthschaftliche Schriften (Berlin: Herbig, 1873), vols. 1 and 2.

Central and Free Banking Theory intentions with which it was drafted, failed to ban the expansionary creation of fiduciary deposits as it did with banknotes.

Mises also condemns the use of the law to constitute and reinforce a central-bank system which, as we know, was eventually used to justify and promote policies of monetary chaos and financial excess much more damaging than the ones it was designed to prevent.

Mises’s essential contribution to the study of money and economic cycles appears in his work, The Theory of Money and Credit, first published in 1912.70 It was not until eight years 70Mises, Theorie des Geldes und der Umlaufsmittel. H.E. Batson translated the work into English, and Jonathan Cape published the first English edition (in London) in 1934. Thus it may have influenced Vera Smith’s doctoral thesis, which was published two years later. It is interesting to note that Smith includes Mises, along with Hübner, Michaelis, and Cernuschi, in the double-entry table on pp. 144–45 of her book. She lists them in the section corresponding to the strictest Currency School theorists, who nevertheless defend a free-banking system as the best route to a 100-percent reserve ratio, given the circumstances. Perhaps one of the most valuable aspects of Smith’s book is that it reveals that the Banking School and Free-Banking School do not exactly and automatically coincide, nor do the Currency School and Central-Banking School. Instead theorists fall into four distinct groups which can be outlined in a double-entry table. Because Vera Smith’s table is relevant and illuminating, we include a revised version here.

Money, Bank Credit, and Economic Cycles

later, in 1920, that he expounded his famous theorem of the impossibility of socialist economic calculation, initiating the important debate that would surround this topic in the following decades. No explicit evidence suggests Mises was aware that the fundamental arguments he raised in 1920 on the impossibility of socialism were also directly applicable to fractional-reserve banking, and especially to the establishment and operation of a central bank. However in the next section we will defend the thesis that our analysis on fractional-reserve banking and the central bank is simply a specific case which arises when the general theorem of the theoretical impossibility of socialism is applied to the financial sphere.71 The classification of theorists into four schools (Fractional-Reserve Free Banking, Fractional-Reserve Central Banking, Free Banking with a 100 percent reserve, and Central Banking with a 100 percent reserve) is much clearer and more accurate than the method chosen by (among others) Anna J. Schwartz and Lawrence H. White, who identify only three schools, the Currency School, the Banking School, and the FreeBanking School. (See Anna J. Schwartz, “Banking School, Currency School, Free Banking School,” pp. 148–52.) 71On the development in Spain of the doctrine in favor of the central bank and on this doctrine’s influence on the establishment of the Spanish bank of issue, see Luis Coronel de Palma, La evolución de un banco central (Madrid: Real Academia de Jurisprudencia y Legislación, 1976), and the references cited therein. See also the writings of Rafael Anes, “El Banco de España, 1874–1914: un banco nacional,” and Pedro Tedde de Lorca, “La banca privada española durante la Restauración, 1874–1914.” Both appear in volume 1 of La banca española en la Restauración (Madrid: Servicio de Estudios del Banco de España, 1974). Despite the valuable references included in these works, a history of Spanish economic thought on the debate between central- and free-banking supporters has yet to be written. The most important (fractional-reserve) free banking theorist in Spain was Luis María Pastor (1804–1872). See his book Libertad de Bancos y Colas del de España (Madrid: B. Carranza, 1865).

Central and Free Banking Theory



In chapter 2 we saw that throughout history central banks have emerged not as a result of the spontaneous, evolutionary free-market process, but as a consequence of deliberate government intervention in the banking sector. In fact the institution of the central bank is rooted in the failure of public authorities to adequately define and defend depositors’ property rights; in other words, to put an end to bankers’ misuse of the money their customers entrust to them on deposit. This failure gave rise to the development of fractional-reserve banking, a practice which, as we know, permits bankers to create new monetary instruments ex nihilo, and thus to generate large profits. We are already familiar with the harmful effects such banking activity exerts on the economic structure in the form of malinvestment, severe crises, and recessions which should, in principle, justify particularly diligent care on the part of governments to guarantee the fulfillment of traditional legal principles (a 100-percent reserve requirement on demand deposits). Nevertheless throughout history, far from increasing their zeal to ensure compliance with the law in banking, governments have been the first to take advantage of the banking business, granting bankers many privileges. In order to cope with the perpetual fiscal difficulties created by their financial carelessness, governments have not only legalized fractional-reserve banking via the corresponding privilege, but they have throughout history continually attempted to take advantage of this set-up, either by requiring that a large number of the loans created ex nihilo by the fractionalreserve banking system be given to the government itself, or by reserving all or part of the highly lucrative fractionalreserve banking business for themselves.

For their part, private bankers themselves did not fail to notice that their industry underwent recurrent panics and liquidity crises which regularly endangered the continuity of bankers’ lucrative business. Hence private bankers have been the first to request the establishment of a central bank which, Money, Bank Credit, and Economic Cycles as lender of last resort, would guarantee their survival in times of trouble. In this way the interests of private bankers came to coincide with those of the state and its central bank, and a symbiosis formed between the two. The state obtains easy financing in the form of loans and inflation, the cost of which goes unnoticed by the citizens, who do not initially experience a heavier tax burden. Private bankers gladly accept the central bank’s existence and the rules it imposes, since bankers realize the entire framework of their business would ultimately collapse without the support of an official institution to provide the necessary liquidity once the “inevitable” bank crises and economic recessions hit.

Therefore we can conclude with Vera Smith that the central bank is not a spontaneous result of the market process.

Instead the state has coercively imposed it in order to achieve certain objectives (particularly easy financing and the orchestration of inflationary policies, which are always very popular), all with the acquiescence or support of private banks, which in this area have almost always acted as the government’s accomplices in the past.72 72 A central bank is not a natural product of banking development. It is imposed from outside or comes into being as the result of Government favours. This factor is responsible for marked effects on the whole currency and credit structure which brings it into sharp contrast with what would happen under a system of free banking from which Government protection was absent. (Smith, The Rationale of Central Banking and the Free Banking Alternative, p. 169) Thus we accept the hypothesis of Professor Charles Goodhart (see footnote 73), who believes the emergence of the central bank to be a necessary consequence of the shift from a system of commodity money to a system of fiduciary money. We accept this hypothesis as long as acknowledgment is made to the effect that such a shift is not a spontaneous result of the market, but on the contrary, an inevitable outcome of the violation of traditional legal principles (100-percent reserve ratio on demand deposits), which are essential to the correct functioning of any free market. The only serious flaw we see in Vera Smith’s book lies in the author’s failure to fully recognize that the central-bank system is simply the logical and unavoidable consequence of private bankers’ gradual Central and Free Banking Theory The above explains the historical appearance of the central bank, which is founded on the complicity and community of interests which have traditionally united governments and bankers and which fully account for the intimate “understanding” and “cooperation” between these two types of institutions. Nowadays this relationship, with only slight variations, is evident in all western countries and in almost all situations. The survival of private banks is guaranteed by the central bank, and thus this institution, and ultimately the government itself, exercises close supervision and political and economic control over banks. Moreover the central bank is intended to direct the monetary and credit policy of every country, with the aim of achieving certain economic policy goals. In the next section we will see why it is theoretically impossible for a central bank to sustain a monetary and credit system which produces no severe economic maladjustments and disturbances.73 and surreptitious introduction (in historical complicity with governments) of the fractional-reserve banking system. It is unfortunate that Smith neglects to devote some attention to the proposals for a 100-percent reserve requirement which were already circulating at the time she wrote the book. If she had examined these proposals, she would have realized that a true system of free-banking requires the re-establishment of a 100-percent reserve ratio on demand deposits. As we will see, many present-day theorists who defend the free-banking system commit the same error.

73The classic work on the evolution of central banks is Charles Goodhart’s The Evolution of Central Banks, 2nd ed. (Cambridge, Mass.: MIT Press, 1990), esp. pp. 85–103. A brief, helpful outline of the emergence and development of central banks appears on pp. 9ff of Tedde de Lorca’s book, El Banco de San Carlos, 1782–1822. Ramón Santillana provides a good illustration of the formation of the central bank in nineteenth-century Spain to cope with the financial difficulties of the state, which was continually forced to take advantage of the privileges of money creation (bills and deposits) enjoyed by the fractional-reserve banking industry. See Santillana’s book, Memoria histórica sobre los bancos Nacional de San Carlos, Español de San Fernando, Isabel II, Nuevo de San Fernando, y de España (reprinted by the Banco de España [Madrid, 1982]), esp. pp. 1, 3, 132, 236 and 237.

Money, Bank Credit, and Economic Cycles




Elsewhere we have defended the thesis that socialism should be redefined as any system of institutional aggression on the free exercise of entrepreneurship.74 This aggression may take the form of direct physical violence (or the threat of it) perpetrated by government authorities or of privileges granted to certain social groups (unions, bankers, etc.) so that they may violate traditional legal principles with state support. To attempt to coordinate society via institutional coercion is an intellectual error, because it is theoretically impossible for an agency in charge of committing this type of aggression (a central planning board) to obtain the information it would need to establish social coordination with its

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