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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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decrees.75 The above is true for the following four reasons:

first, it is impossible for the agency to constantly assimilate the enormous volume of practical information stored in the minds of different human beings; second, the subjective, practical, tacit, and nonverbal nature of most of the necessary information precludes its transmission to the central organ; third, information which actors have not yet discovered or created and which simply arises from the free market process, itself a product of entrepreneurship subject to the law, cannot be transmitted; and fourth, coercion keeps entrepreneurs from discovering or creating the information necessary to coordinate society.

This is precisely the essence of the argument Mises originally raised in 1920 on the impossibility of socialism and, in general, of state intervention in the economy. The argument theoretically explains the failure of economies of the former Eastern bloc, as well as the growing tensions, maladjustments 74Huerta de Soto, Socialismo, cálculo económico y función empresarial, p. 87.

See also Jesús Huerta de Soto, “The Economic Analysis of Socialism,” in Gerrit Meijer, ed., New Perspectives on Austrian Economics (London and New York: Routledge, 1995), chap. 14.

75Huerta de Soto, “The Economic Analysis of Socialism,” p. 95.

Central and Free Banking Theory

and inefficiency which stem from the interventionist welfare state characteristic of western economies.

Likewise, the granting of privileges which conflict with traditional legal principles prevents coordinated cooperation among the different agents in society. Indeed traditional legal principles are essential to the coordinated, peaceful exercise of entrepreneurship. Their systematic violation hinders the free creativity of entrepreneurs, as well as the creation and transmission of the information necessary to coordinate society.

When these principles are disregarded, social maladjustments remain hidden and tend to worsen systematically.76 The inevitable outcome of states’ systematic coercion of society and of the concession of privileges against traditional legal principles is widespread social disorder and lack of adjustment in all areas and at all levels of society which are affected by such coercion and privileges. In fact both coercion and privileges encourage inaccurate information and irresponsible acts, and both lead to the corruption of individual behavioral habits subject to the rule of law, favor the development of the underground economy and, in short, cause and sustain all sorts of social maladjustments and conflicts.




One of the central theses of this book is that the theorem of the impossibility of socialism, and the Austrian analysis of the social discoordination which inevitably follows institutional coercion and the granting of privileges at variance with the law, are directly applicable to the financial and banking system which has evolved in our economies. This system is based on private fractional-reserve banking and is controlled by an official institution (the central bank) which has become the architect of monetary policy.

76A detailed analysis of all the theoretical conclusions outlined above appears in the first three chapters of Huerta de Soto, Socialismo, cálculo económico y función empresarial, pp. 21–155.

Money, Bank Credit, and Economic Cycles Indeed the modern financial and banking system of market economies is entirely based on systematic coercion against the free exercise of entrepreneurship in the financial sector and on the concession to private banks of privileges which conflict with traditional legal principles and allow banks to operate with a fractional reserve.

We need not dwell on the juridical nature of the “odious” privilege involved in fractional-reserve banking, since we studied this aspect in detail in the first three chapters. As to the systematic exercise of coercion in the field of banking and finance, it is easy to understand that such manipulation is carried out via the legal tender regulations which compel the acceptance, as a liberatory medium of exchange, of the monetary unit issued by the monopolistic central bank.77 The institutional coercion the central bank applies also manifests itself in an entire network of administrative banking legislation designed to rigorously control the operations of banks and, on a macroeconomic level, to define and implement the monetary policy of each country.78 In short we can hardly avoid concluding that “the organization of the banking system is much closer to a socialist economy than to a market economy.”79 Therefore in banking 77For example, see article 15 of autonomy statute 13/1994 of the Bank of

Spain, July 1. The statute reads:

The Bank of Spain shall have exclusive authority to issue bills in pesetas, which, notwithstanding the status applied to coinage, shall be the only legal tender with full, unlimited liberatory power in Spanish territory. (Spain’s Official Gazette, July 2, 1994, p. 15404; italics added) Logically, with Spain’s entrance into the European Monetary Union as of January 1, 2002, the euro and the European Central Bank have replaced the peseta and the Bank of Spain, respectively.

78See, for example, the general list of central-bank duties included in article 7 of the above autonomy statute of the Bank of Spain.

79See the paper written by our student Elena Sousmatzian Ventura, “¿Puede la intervención gubernamental evitar las crisis bancarias?” Revista de la Superintendencia de bancos y otras instituciones financieras 1 (April–June 1994): 66–87. In this paper Elena Sousmatzian adds that Central and Free Banking Theory and credit matters, our situation matches that which prevailed in the socialist countries of the former Eastern bloc, which attempted to coordinate their economic decisions and processes through a system of central planning. In other words “central planning” has become commonplace in the banking and credit sector of market economies, so it is natural that in this area we should see the same discoordination and inefficiency which plagues socialism. Let us now examine three separate instances of interventionism and/or privileges in the organization of banking. The theorem of the impossibility of socialism applies in each, namely: (a) the most widespread case of a central bank which oversees a fractionalreserve banking system; (b) the case of a central bank which manages a banking system that operates with a 100-percent reserve ratio; and finally, (c) the case of a free-banking system (with no regulation and no central bank) which nevertheless exercises the privilege of maintaining only a fractional reserve.

though the notion that the current banking system shares the characteristics of a socialist or controlled economy may initially surprise many, it is easy to understand when we remember that: (a) the entire system rests on the government monopoly on currency; (b) the system is based on the privilege which permits banks to create loans ex nihilo by holding only a fractional reserve on deposits; (c) the management of the whole system is performed by the central bank, as an independent monetary authority which acts as a true planning agency with respect to the financial system; (d) from a legal standpoint, the principle which applies to the government, i.e., that it may act only within its jurisdiction, also applies to banks, in contrast to the rule for other private entities, who may always do anything that is not prohibited; (e) banks are commonly excluded from the general bankruptcy proceedings stipulated in mercantile law and are instead subject to administrative law procedures such as intervention and the replacement of management; (f) bank failures are prevented by externalizing the effects of banks’ liquidity crises, the costs of which are met by the citizenry through loans from the central bank at prime rates or non-recoverable contributions from a deposit guarantee fund; (g) a vast, inordinately complicated set of regulations applies to banking and closely resembles that which controls government; and (h) there is little or no supervision of government intervention in bank crises. In many cases such intervention is determined ad hoc, and principles of rationality, efficiency, and effectiveness are disregarded.

Money, Bank Credit, and Economic Cycles (a) A system based on a central bank which controls and oversees a network of private banks that operate with a fractional reserve The system made up of a central bank and private banking with a fractional reserve is the most disruptive example of “central planning” in the financial sphere.80 Indeed this system is founded upon a privilege which private bankers enjoy (the use of a fractional-reserve ratio) and which naturally causes distortions in the form of credit expansion, malinvestment and recurrent cycles of boom and recession. Moreover the entire system is orchestrated, managed, and supported by a central bank which acts as lender of last resort and exercises systematic, institutional coercion in the field of banking, finance and money.

In providing banks with the necessary liquidity in times of crisis, the central bank tends to counteract the mechanisms which work in a free market to spontaneously reverse the expansionary effects of banking. (Such mechanisms consist precisely of the rapid failure of the most expansionary and least solvent banks.) Consequently the process of deposit creation and credit expansion (i.e., without the backing of real, voluntary savings) may be prolonged indefinitely, thus aggravating its distortion of the productive structure and exacerbating the inevitable economic crises and recessions it creates.

The system of financial planning which rests on the central bank cannot possibly eliminate recurring economic cycles.

The most it can do is to delay their appearance by creating new liquidity and providing support to endangered banks in times of crisis, at the cost of aggravating the inevitable economic recessions. Sooner or later, the market always tends to spontaneously react and to reverse the effects of monetary aggression unleashed on it, and therefore deliberate attempts to prevent such effects via coercion (or the granting of privileges) are condemned to failure. The most these attempts can achieve is the postponement, and consequent worsening, of the necessary reversion and recovery, or economic crisis. They

–  –  –

cannot prevent it. In a fractional-reserve free-banking system (with no central bank), the reversion tends to occur much earlier, due to spontaneous interbank clearing processes (though the productive structure is still somewhat distorted). The creation of a central bank to act as lender of last resort and supply the liquidity necessary in times of crisis tends to neutralize the market’s spontaneous reversion and recovery processes, and as a result expansionary policies can become much more lasting and damaging.81 The central bank, as the “financial central-planning board,” embodies an intrinsic contradiction. Indeed, as F.A.

Hayek has revealed, all central banks face a fundamental dilemma, since they invariably wield great discretionary power in the administration of their policies, yet they do not have all the information they need to reach their objectives. The central bank exercises its power over private banks mainly by threatening to not provide them with the liquidity they need. And at the same time it is believed that the chief duty and purpose of the central bank consists precisely of not refusing to supply the liquidity necessary when bank crises hit.82 81Furthermore the central bank cannot guarantee all customers of private banks the recovery of their deposits in monetary units of unaltered purchasing power. The belief that central banks “guarantee” all citizens the return of their deposits, regardless of the actions of the private banks involved, is pure fiction, since the most central banks can do is to create new liquidity ex nihilo to meet all deposit demands private banks are confronted with. Nevertheless, by doing so they trigger an inflationary process which often significantly lowers the purchasing power of the monetary units withdrawn from the corresponding deposits.

82 There is one basic dilemma, which all central banks face, which makes it inevitable that their policy must involve much discretion. A central bank can exercise only an indirect and therefore limited control over all the circulating media. Its power is based chiefly on the threat of not supplying cash when it is needed. Yet at the same time it is considered to be its duty never to refuse to supply this cash at a price when needed. It is this problem, rather than the general effects of policy on prices or the value of money, that necessarily preoccupies the central banker in his day-to-day actions. It is a task which makes it necessary for the central bank constantly Money, Bank Credit, and Economic Cycles The above accounts for the great difficulty central bankers face in eliminating economic crises, despite their effort and dedication. It also explains the tight control the central bank maintains over private banking, through administrative legislation and direct coercion.83 Moreoever, like Gosplan, the most important economicplanning agency of the now extinct Soviet Union, the central bank is obliged to make an unceasing effort to collect an extremely vast quantity of statistical information on the banking business, the different components of the money supply, and the demand for money. This statistical information does not include the qualitative data the central bank would need to harmlessly intervene in banking affairs. For such information is not only extraordinarily profuse; but what is more important, it is also subjective, dynamic, constantly changing, to forestall or counteract developments in the realm of credit, for which no simple rules can provide sufficient guidance.

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