The Online Library of Liberty

A project of Liberty Fund, Inc.

• Preface
• Foreword
• Part One: Setting the Stage
• 1: Overview
• 2: The Evolution of a Free Banking System
• Part Two: Free Banking and Monetary Equilibrium
• 3: Credit Expansion With Constant Money Demand
• 4: Monetary Equilibrium
• 5: Changes In the Demand For Inside Money
• 6: Economic Reserve Requirements
• Part Three: Free Banking Versus Central Banking
• 7: The Dilemma of Central Banking
• 8: The Supply of Currency
• 9: Stability and Efficiency
• 10: Miscellaneous Criticisms of Free Banking
• 11: Free Banking and Monetary Reform
• Conclusion
• Notes

6

Economic Reserve Requirements

The finding that free banks will maintain monetary equilibrium even as the demand for money changes rests upon the claim that the reserve multiplier alters in sympathy with changes in the demand for inside money. Many conventional discussions contradict this claim. Some treat the reserve multiplier as an institutionally given constant, rather than as a variable that adjusts in response to changes in the public’s behavior and in response to bankers’ reactions to changes in the public’s behavior. Others go to the opposite extreme and hold the reserve multiplier to be, in some situations at least, indeterminate. The purpose of this chapter is to show that both of these alternative views are, for a free banking system, incorrect.

The Conservation Theory

The view that the reserve multiplier is a constant may be dubbed the “conservation theory” of bank money.1 It concurs that an individual bank may expand or contract credit as a result of persons holding greater or lesser amounts of its liabilities. But it denies that system-wide expansions or contractions of the money supply can happen in response to changes in aggregate demand: individual banks may gain or lose business relative to one another, but gains by some banks are always compensated by losses of other banks.2 As long as the reserve base is unchanged, the system as a whole will support only a certain amount of inside money—no more, no less.3

The conservation theory looks upon the volume of liabilities in a banking system as if it were like the volume of water in a waterbed. A little pressure on one part of the waterbed reduces the amount of water there but causes an equal increase in its amount somewhere else. Likewise, a fall in the demand for one bank’s liabilities is supposed to cause that bank to contract, but only with the accompanying effect of an offsetting shift of reserves and lending power to other banks. In contrast, an increase in supply of one bank’s liabilities is held to be possible only if its rivals contract.

In money and banking literature the conservation theory is generally expressed in terms of bank deposits only, since competitive note issue is rarely discussed. John Philip Wernette’s argument (1933, 32) that “an effective thrift campaign cannot increase the total deposits of an entire banking system” is typical:

Another example is George Clayton. Although he concedes that banks may respond positively to growing demands for inside money in the early stages of their development, Clayton denies that this is possible in the “developed stage” of banking. He states that the “immobilization” of part of a bank’s liabilities as the result of deposits “left inactive at the bank . . . does not put the bank in a position to lend or invest any more money than before.”4 Thus deflation, according to Clayton (1955, 98), “can only be overcome by a deliberate policy of credit expansion under the direction of the central bank, which would have to provide the extra cash reserves necessary to maintain the [reserve] ratio.” Other theorists have made similar statements denying the possibility of a general contraction of inside money given a fixed amount of bank reserves.

The problem with the conservation theory is that it miscomprehends the forces that determine banks’ need for reserves. It assumes that this need depends only on the amount of banks’ outstanding liabilities and not on the demand for these liabilities relative to income as it affects their turnover.5 This error may stem from conservation theorists’ identification of economic reserve requirements with statutory reserve requirements. These are legally prescribed, minimum ratios of reserves to total liabilities. Obviously statutory reserve requirements are institutionally “given,” and they set an upward limit to the reserve multiplier. But statutory reserve requirements do not exist in all central banking systems, and are absent from a free banking system. Under free banking, reserve requirements are determined by the optimizing decisions of bankers. They are economic, rather than statutory, requirements. Granting this, the critical questions become, what factors determine a free bank’s economic reserve demand?6 and will this reserve demand necessarily be a constant fraction of a bank’s total outstanding liabilities?

Determinants of Reserve Demand

A free bank’s economic reserve demand for any planning period can be thought of as having two components. These are, first, a component equal to what the bank, because of the structure of its assets and liabilities, anticipates will be the difference between its total clearing debits and its total clearing credits for the period—its “average net reserve demand”—and, second, a component to cover the bank against any adverse clearings it may face during the planning period that (singly or cumulatively) exceed its average net reserve demand. The latter component is the bank’s “precautionary reserve demand.”7 It protects the bank, not from such adverse clearings as might be predicted given a determinate structure of the demand for the bank’s liabilities, but from temporary, random fluctuations in these adverse clearings above their expected value. A bank that fails to hold precautionary reserves might, on average, have credit clearings equal to its debit clearings, so that its average net reserve demand would be zero. Yet the bank would stand a great risk (one chance in two in fact) of being unable to redeem all its debits at the clearinghouse during any particular clearing session if it held zero reserves. It follows that banks have to hold positive precautionary reserves so long as the exact incidence of clearing debits is unknowable or uncertain,8 and even though they may have no reason to doubt that their clearing debits and credits will be equal in the long run.9

Both of these components of a free bank’s reserve demand are related to the total clearing debits it faces, and not necessarily to the total of its outstanding liabilities. Moreover, the quantity of a bank’s liabilities returned to it through the clearing mechanism depends just as much on their average turnover as on the quantity of them outstanding. Thus, to take the limiting case, additional liabilities with zero turnover would not add to an expanding bank’s reserve demand, and contraction of zero turnover liabilities by a bank would not add to its excess reserves. On the other hand, a bank’s reserve demand may increase even though it has not expanded its liabilities, because turnover of its liabilities has increased. Finally, a bank’s reserve needs may fall although its liabilities are unchanged because the average period the public holds its liabilities has increased.

In long-run equilibrium the average net reserve demand for every bank in a system with a fixed supply of reserve media has to be zero. A bank cannot continue to suffer a positive average net reserve demand without eventually disappearing, and it cannot have a continuously negative average net reserve demand unless it fails to exploit fully the demand to hold its liabilities and hence its lending power. Profit-maximizing banks will strive to adjust their outstanding liabilities to compensate for demand-induced changes in their net clearing debits so as to keep their average net reserve demand equal to zero: a bank that expects to acquire more reserves than it expects to lose during a planning period (because the demand to hold its liabilities has increased) will expand its loans and investments to make up the difference; one that expects to lose more than it gains (because the demand to hold its liabilities has fallen) will contract. A bank that does not adjust its issues when faced with changes in the demand for them is in no less unprofitable a position in relation to its rivals than one that overexpands or underexpands relative to its rivals when faced with an unchanged demand for inside money.

Does extending this conclusion to the banking system and hence to adjustments in aggregate liabilities involve a fallacy of composition? It does not, because expansion by any one bank in response to reduced clearing debits against it does not, in the case of an increased demand for (reduced turnover of) its liabilities, involve any reduction of the reserves or lending power of rival banks. Indeed, such expansion actually prevents the redistribution of reserves that would occur if the supply of inside money were not adjusted in response to demand. The same holds for credit contractions by individual banks when these contractions serve to maintain an equilibrium of supply and demand for their liabilities.

Uniform Changes in Money Demand

What has just been said refers only to actions brought about by banks’ desire to maintain zero long-run net average reserve demand, that is, by their need to remain in equilibrium in relation to one another. It leaves a very crucial issue unaddressed—an issue that is sometimes raised in connection with the conservation theory. Granted that particular banks may contract or expand the aggregate sum of bank liabilities to stay in line with other banks in the face of changing demands for their liabilities only, what incentive can there be for system-wide expansion or contraction when all banks are confronted by equal and simultaneous changes in the demand for their issues? For example, if there is a general fall in the demand for inside money that uniformly raises the gross clearings of all banks no single bank will suffer a deficiency of average net reserves. Each will have its debit and credit clearings increase in equal amounts, with no change in adverse clearings. Similarly, if all banks witness equal increases in the demand for their issues, none will feel a need to expand in so far as the only motivation to do so is to prevent excess reserves (due to positive clearings) from accumulating.

Obviously banks have no incentive to contract or to expand under such circumstances if their only motivation for doing so is to keep in step with one another; they are already in step, and a uniform increase in inside-money demand will not put any of them out of it. Does it follow, therefore, that under such conditions the banks do nothing, so that the conservation theory is correct?

The answer is an emphatic “no.” Forces operate in a free banking system to make the supply of inside money adjust to changes in demand even when such changes fall upon the banks simultaneously and uniformly. The reason for this has to do with the precautionary demand for reserves. Unlike the average net demand for reserves, the precautionary demand is affected by unaccommodated, uniform changes in the demand for inside money. The reasons for this are discussed in detail in the literature on precautionary reserve demand, beginning with Edgeworth’s pioneering article.10 The essential conclusion of this literature, based on the law of large numbers, is that the precautionary demand for reserves rises or falls along with changes in the total volume of gross bank clearings, though not necessarily in strict proportion to the change in gross clearings. Specifically, a uniform increase in the total volume of clearing debits due to an increase in the frequency of payments (such as would occur if there were an across-the-board fall in the demand for inside money with income constant) requires that precautionary reserves increase by a factor at least equal to the square root of the factor by which clearings have increased. A fall in the total volume of clearings will likewise lead to a fall in the demand for precautionary reserves.11

This result can be represented by a set of simple diagrams (Fig. 6.1) showing the frequency distribution of clearing debits at a representative bank before and after a doubling of the total volume of clearings. The smoothness of the diagrams implies a fairly long planning period with many clearing sessions; one might also interpret them as showing the statistical likelihood of particular net clearings based on a large number of trials. The doubling of gross clearings doubles the scale of the horizontal axis of the frequency-distribution diagram. Because of the law of large numbers, however, the distribution becomes more concentrated at its center and the variance increases, but by less than the increase in the scale of clearings.

The intuition behind the square-root result is fairly simple. As the volume of gross clearings increases, so do random fluctuations in their distribution among the banks—the source of variance of net clearings faced by individual banks—only less than in proportion. This comes directly from the laws of probability. Since precautionary reserves are held against deviations of average net demand from its mean or expected value, it follows that precautionary reserve demand rises by the same factor as the variance of net clearings. Since gross bank clearings increase whenever there is an uncompensated, general decline in the demand for inside money (income constant), and gross clearings fall when there is an uncompensated, general increase in the demand for inside money, it follows that bank reserve needs are affected by changes in the demand for inside money even when these changes affect all banks simultaneously and uniformly.

If a banking system has a fixed supply of reserves, the square-root law of precautionary reserve demand implies (a) that banks contract their issues in response to a uniform fall in the demand for inside money to prevent their need for precautionary reserves from exceeding the available supply of such reserves (so that they do not come up short more frequently at the clearinghouse); and (b) that banks expand their issues in response to a uniform increase in the demand for inside money so that the aggregate demand for precautionary reserves does not fall short of the available supply.12

Algebraically, with f′ and h′ > 0, where R^d is the optimum (minimum) precautionary reserve demand for the banking system, and is a measure of the variance of net clearings for a representative bank around their mean of zero for some level of gross bank clearings, G. In a state of monetary equilibrium, for some given price level, income and gross bank clearings are still positive. Let this monetary-equilibrium value of gross clearings be equal to N. Then, more generally,

G = N + λ (IM^s - IM^d)

where λ >1,13 IM^s is the nominal supply of inside money, IM^d is the nominal demand for inside money, and IM^s - IM^d is the excess supply of (or negative excess demand for) inside money. Thus G increases when there is excess supply of inside money, and falls when there is excess demand for inside money. Since

R^d = f {h [N + λ (IM^s - IM^d)]}

it follows that R^d also increases whenever there is excess supply of inside money, and that R^d falls whenever there is excess demand for inside money. If available reserves, R^s, are fixed, then any change in R^d causing it to differ for R^s must be offset by an appropriate adjustment of IM^s (assuming IM^d is exogenous).

The square-root law of precautionary reserve demand assumes that bank clearings rise or fall due to changes in the frequency of payments. The total volume of clearings may also rise or fall because of an increase or decrease in the average size of individual payments where the frequency of payments is constant. This results in an increase in precautionary reserve demand proportional to the increase in bank clearings.14 Though this possibility gives further strength to most of the conclusions just arrived at, it also points to a potential cause of monetary disequilibrium under free banking. Consider a situation where the volume of gross bank clearings per week is $1 million, consisting of 100,000 checks with an average value of ten dollars. Now suppose that bank customers alter their spending habits by writing only 50,000 checks per week with an average value of twenty dollars. The weekly volume of gross bank clearings is still $1 million, but the smaller number of larger, “lumpier” payments leads to an increased precautionary demand for bank reserves. The tendency (given a fixed volume of reserves) is, therefore, for the supply of inside money to fall. Yet the change in the public’s spending habits reflects, not a smaller, but a greater demand for money balances. So the money supply, rather than adjusting in the same direction as the demand for money (as it does when average payment size is unchanging and the volume of clearings moves inversely with the demand for money) adjusts in the opposite direction.

That this is a potential defect of free banking cannot be denied. But it is unlikely to be of great practical importance. This becomes apparent if one considers that changes in the average size of payments are usually accompanied by changes in frequency in the same direction, in which case their effect is to reinforce demand-accommodating changes in money supply. The exceptional case, where the frequency and average size of payments move in opposite directions, is only likely to occur in response to a change in the general level of prices which is not itself a consequence of monetary disequilibrium. In this case a real balance effect might lead to a change in frequency of payments opposite the change in average payment size. The scope for this kind of price-level change under free banking is rather limited. Suppose though, for the sake of argument, that such a price-level change did occur, causing a disequilibrating change in the supply of inside money. The disequilibrium would be short lived, because its effect would be to reverse the movement in prices that set it in motion to begin with.

Thus the potential damage from disequilibrium money-supply changes under free banking is likely to be very slight. To the extent that such changes could occur, their effect would be to counter somewhat the already limited potential for changes in the general price structure under free banking (such as when there is a general change in productive efficiency per capita). This should be kept in mind in later chapters where the special possibility considered here is ignored and it is assumed that the structure of prices adjusts fully under free banking to reflect changes in productive efficiency.

Variability of the Reserve Multiplier

The variability of reserve demand implies that, under free banking, the reserve ratio (the ratio of reserves to demand liabilities) would vary considerably from bank to bank and also within individual banks viewed at different points of time. Other things being equal, a bank would operate with a lower reserve ratio when the demand for its liabilities is greater and vice versa. For the banking system, in turn, the reserve multiplier (the number of units of inside money supported, in the aggregate, by a unit of outside money) would increase with increases in aggregate demand for inside money balances, and would decrease when aggregate demand for inside money balances decreases (holding the number of banks and their market shares constant).

These results show the conservation theory to be invalid for a free banking system. Moreover, they suggest that it is invalid even for a system with monopolized currency supply (which is less able to accommodate changes in demand) and even where statutory reserve requirements exist. Empirical research supports this. In the United States figures for excess reserves held by banks constantly change, and some economists have even recommended that statutory requirements be modified to reflect the diverse and continually changing turnover rates of liabilities of various banks—with higher requirements for banks with greater deposit turnover. Thus Neil Jacoby (1963, 218-19) recommends that “the legal reserve requirement of an individual bank should be proportional to the contribution of its depositors to the aggregate demand for the total national product.” In this way “banks whose deposits turned over rapidly would be required to carry a higher reserve per dollar of deposit balances than banks with a low deposit turnover.”15 The effect of such proposals, not acknowledged by their authors, would be to have statutory reserve requirements mimic their economic or voluntary counterparts in an unregulated system. Examples of this already exist in the United States. Lower statutory reserve requirements are imposed on certain classes of time deposits than on demand deposits, presumably because time liabilities turn over less rapidly. This arrangement approximates the actual liquidity needs for different kinds of deposits, which implies that, in a deregulated system, it would be at best superfluous.

In a comparative survey of 12 nations Joachim Ahrensdorf and S. Kanesthasan also observed money multipliers that varied substantially over time and from country to country.16 They claim that variations in money multipliers were responses to changes in the behavior of the public, and not simply to changes in the demand for currency relative to total money demand which (under systems with monopolized currency supply) would alter the supply of bank reserves.17

Despite all this there is some justification for accepting the conservation theory as an approximate, though flawed, description of conditions under monopolized currency issue, even in systems without statutory reserve requirements. The reason is that, with a limited supply of high-powered money available to them, the deposit banks are limited in their ability to accommodate increases in the demand for money that involve increases in the demand for currency. The reserve multiplier in a monopolized system, given a constant supply of base money, has an imposed upper limit. Accommodative credit expansion depends on additions to the supply of base money to meet increased needs for currency in circulation. It cannot be accomplished by deposit banks acting alone except when increases in the demand for deposit balances are unassociated with any increase in currency demand.18

For these and other reasons traditional banking studies devote very little attention to the possibility of demand-induced changes in the supply of inside money. Most ignore this possibility entirely.19 Their focus is on supply-side driven changes in the quantity of inside money: changes caused by the injection or withdrawal of sums of high-powered money to and from deposit bank reserves. The chain of causation they consider runs from (a) expansion or contraction of the issues of the monopoly bank to (b) multiple expansion or contraction of deposit bank liabilities (via an institutionally fixed reserve multiplier) to (c) increased or decreased nominal income and prices to (d) increased or decreased nominal demand for inside money and, finally, to (e) monetary equilibrium with nominal variables scaled up or down in the same proportion as the quantity of high-powered money.

However appropriate this approach may be for describing monopolized or central banking, it is unsuitable for describing credit expansion under free banking. Here demand-responsive changes in the supply of inside money are the rule rather than the exception. The relevant chain of causation generally runs from (a) changes in demand for inside money to (b) expansion or contraction to (c) a de facto change in the reserve multiplier and to (d) monetary equilibrium with no change in nominal prices or income. For example, consider a hypothetical free banking system with commodity-money reserves of $1000. The supply of inside money is $50,000 and this is, initially, the amount desired by the public. The reserve multiplier has a value of 50. Now imagine that the demand for inside money falls $10,000 to $40,000. As a result, bank demand liabilities contract $10,000, and the reserve multiplier falls to 40; that is, the final, aggregate ratio of reserves to demand liabilities rises from 2 to 2.5 percent.20

Of course there may also be supply-side driven changes in the quantity of inside money under free banking stemming, for example, from increases in the quantity of outside (commodity) money. The historical significance of such outside-money supply changes will be discussed later in chapter 9. For now it will suffice to note that commodity-money supply shocks have been of only minor historical significance as compared with shocks due to fluctuations in supplies of base monies caused by central banks.

Credit Expansion “in Concert”

The arguments used here to criticize the theory that the reserve multiplier is rigidly fixed also refute the view that the reserve multiplier is, under certain circumstances, indeterminate. That view is implicit in the argument that, with a fixed reserve supply, if banks expand in concert none suffer negative effects even if the expansion is not warranted by any increase in the demand for money.

Eugene A. Agger provides a very clear statement of the indeterminate-multiplier idea:

Thus the system as a whole is supposedly able to expand, on the basis of a fixed supply of reserves, not merely in response to a general increase in the demand for inside money (as was argued in the previous section) but also if demand does not increase.

Keynes takes a similar position in his Treatise on Money:

Two more examples of this view are especially interesting since they refer specifically to free-banking arrangements. The first concerns the note-clearing system supervised by the Suffolk Bank. The author writes that arrangements of this sort “keep the various banks more or less in step with one another in their emission of notes, but would not [prevent] them from preceding too fast (or too slowly) as a whole”:

The second example is taken from Lawrence H. White’s analysis of the Scottish free banking system: “Supposing [a] group of banks expand by a common factor, no consequent adverse clearings will arise among members of the group. Adverse clearings will not arise among a group of banks in consequence of whatever degree of expansion is common to all.”23 If the group comprises a closed system, White continues (1984d, 18), then only an internal drain of reserves to meet the public’s desired commodity-money holdings acts as a check on expansion. Later in his book White notes that “no important theorist of the Free Banking School” explicitly denied the theoretical possibility of in-concert overexpansion by banks in an unregulated system.24 Nevertheless most of them “found the scenario of coordinated expansion implausible as a description of actual events.”25

Even if one grants, following members of the Free Banking School, that in-concert overexpansion is improbable, one might still question whether the supply of inside money under free banking adjusts properly to changes in demand for it. The previous section showed why banks as a group tend to respond positively to a uniform change in demand—refuting the fixed-multiplier view. But we must also confront the possibility that in such a situation the banks can not only respond but can respond to any extent they desire, so long as they act in common. What is to prevent them, furthermore, from “responding” when there is no change in demand at all?

Once again the difficulty is resolved by considering the determinants of precautionary reserve demand. Under in-concert expansion no member of a system of banks expanding in unison (and in the face of an unchanged demand for money) will experience any increase in its average net reserve demand; the change in expected value of its clearing credits will be exactly equal to the change in expected value of its clearing debits. But the growth in total clearings will bring about a growth (though perhaps less than proportionate) in the variance of clearing debits and credits, which increases the precautionary reserve needs of every bank. Thus, given the quantity of reserve media, the demand for and turnover of inside money, and the desire of banks to protect themselves against all but a very small risk of default at the clearinghouse at any clearing session, there will be a unique equilibrium supply of inside money at any moment. It follows that spontaneous in-concert expansions will be self-correcting even without any “internal drain” of commodity money from bank reserves.

Banks as Pure Intermediaries

This and the preceding chapter have attempted to show that, even in the face of changes in the demand for inside money, free banks help to maintain monetary equilibrium. They passively adjust the supply of inside money to changes in the demand for it. They are credit transferers or intermediaries, and not credit creators.

In light of this, and granting appropriate assumptions (namely, a fixed stock of commodity money, with no demand for its use in balances of the public), what can be said about banks in a system with monopolized note issue? A monopoly bank of issue is clearly not a pure intermediary, since the principle of adverse clearings does not apply to it. The position of deposit banks in a system where the supply of currency is monopolized is more complicated. They can respond by a multiplicative expansion to any issues by the monopoly bank that exceed the public’s pre-existing demand for currency. Since such expansion is a response to the exogenous actions of the monopoly bank and not to any change in the money-holding behavior of the public, it involves “created” credit and is disequilibrating. Similarly, if the monopoly bank of issue contracts its issue in excess of any fall in the public’s demand for currency, a multiplicative, disequilibrating reduction in the supply of deposit money will result.

But what role do deposit banks play in the absence of any expansion or contraction by the monopoly bank of issue? In this context deposit banks are more like free banks and other “pure intermediaries”: they cannot, generally speaking, engage in disequilibrating expansion or contraction of the money supply. There are two exceptions to this: First, insofar as the public wish to save in part by holding greater balances of currency, deposit banks are, beyond a certain point, powerless to accommodate their wants without assistance from the monopoly bank. They can issue currency from the monopoly bank held in their reserves only by sacrificing liquidity. Second, changes in the public’s relative demand for currency (i.e., shifts from deposit holding to currency holding and vice-versa) are disequilibrating: they alter the supply of high-powered money available in deposit-bank reserves, and so affect lending power and the total supply of deposit money even though the overall demand for inside money (though not its division between notes and deposits) is unchanged.

Chapter 8 will discuss problems caused by changes in the demand for currency under monopolized issue in some detail. But first, given the conclusions just reached, let us compare our view—that deposit banks are intermediaries of credit—with views of other writers on this subject. J. Carl Poindexter (1946) and James Tobin (1963) have held similar beliefs, as did Edwin Cannan in his much-derided “cloakroom” theory (1921). Cannan denied that bankers are any more capable of lending more than is offered to them than cloakroom clerks are capable of “creating” hats and umbrellas. “The banker,” he wrote, “is able to lend X, Y, and Z more than his own capital because A, B, and C are allowing him the temporary use of some of theirs on condition that he will let them have what they want when they ask for it” (ibid., 32).

Cannan seemed unaware, however, that monopoly banks of issue can create credit by creating new reserves, which throw deposit banks out of equilibrium in their holdings of monopoly-bank liabilities. Tobin, in contrast, recognizes a difference between possibilities for overexpansion of “bank-created” money and those for overexpansion of “government” money. “The community,” he writes (1963, 415), “cannot get rid of” an excess supply of the latter. Therefore “the ‘hot-potato’ analogy truly applies.” On the other hand, “for bank-created money . . . there is an economic mechanism of extinction as well as creation, contraction as well as expansion. . . . The burden of adaptation is not placed entirely on the rest of the community.” Furthermore, for deposit banks acting alone the possibility of credit expansion “depends on whether somewhere in the chain of transactions initiated by the borrowers’ outlays are found depositors who wish to hold new deposits equal in amount to the new loan” (ibid., 413). This is very close to our own view, allowing for the two provisos with regard to currency supply, except that Tobin’s category of “government” money should really include all money issued by any bank with a monopoly in currency supply, whether the bank is officially a government bank or nominally a private one.

Poindexter’s analysis of the role of deposit banks, although less well known than those of Cannan and Tobin, is in some ways superior. Unlike Cannan, Poindexter is fully aware of the credit-creating powers of central banks of issue. But regarding deposit banks he writes (1946, 142): “It is merely the fact that they are at the institutional center of the credit-creating and credit-destroying process of the community that gives their role the apparently unique character which is commonly imputed to them.” In fact, Poindexter argues, deposit banks, like other private competitive financial institutions, cannot lend beyond what their depositors desire unless the central bank that operates alongside them alters the “data” of the system, to which they respond (ibid., 143-44). Otherwise deposit banks are merely “the institutional media through which the public determines the volume of bank deposit currency which will be created at any given moment” (ibid., 142).

Controversy has surrounded the views of J.G. Gurley and E. S. Shaw, who first argued, in a series of articles,26 that banks always function as pure intermediaries—responding through profit signals to the wants of the public—and who later modified their position and claimed that banks and non-bank financial firms alike are equally capable of active credit creation.27

The error of these authors’ earlier writings lay in their use of an ex post definition of savings. This approach failed to distinguish properly individuals’ voluntary abstinence from purchasing from their involuntary abstinence due to forced saving. “Pure intermediation” should refer to credit operations based on voluntary savings only.28

The early Gurley and Shaw view does not really differ from Cannan’s “cloakroom” approach, which also failed to recognize that certain kinds of banks, namely those having a monopoly or quasi-monopoly in the issue of currency, can indeed create credit, and that deposit banks also could contribute to this credit creation by responding to changes in their holdings of high-powered money having its source in unwarranted issues by a privileged bank.

In their later work, on Banking in a Theory of Finance, Gurley and Shaw commit the even more serious error of claiming that all financial institutions are equally capable of actively creating credit. Because of its failure to recognize the role of monopoly banks of issue as the ultimate source of created credit this view has served as a rationale for maintaining legal restrictions on credit expansion by deposit banks and for imposing similar restrictions on savings institutions and other non-bank financial intermediaries.29 Such restrictions not only interfere with efficient intermediation, but reinforce the erroneous notion that competitive financial firms are independent sources of inflation, which the central bank has to “control.”

Students of banking theory often get the impression that central banks are uniquely capable of preventing monetary disequilibrium: they are not inclined to think of them as throwing a wrench in the works. Yet, in contrast to deposit banks and to banks in a free banking system, central banks (or any bank with a monopoly or quasi-monopoly in currency supply) have a unique capacity for generating monetary disturbances. The question that has to be asked, therefore, is whether the disturbances central banks perhaps prevent outweigh the disturbances they cause that would otherwise not occur.

PART THREE

Free Banking versus Central Banking

[1.] By analogy with the “law of conservation of energy” (the first law of thermodynamics), which states that energy can be moved from one place to another but cannot be created or destroyed.

[2.] “That any single person can make his own balance at [a] bank rise by paying in money . . . (whether in cash or in checks) and make it fall by withdrawing cash or paying away checks, everyone who has ever had a balance to his credit knows. No one denies this, but some theorists have denied that what is true of each lender taken separately is true of the whole body of lenders taken together.” Edwin Cannan, “Growth and Fluctuations of Bankers’ Liabilities to Customers” (1935, 8).

[3.] It is generally recognized that, in systems with monopolized currency supply, changes in the demand for currency relative to deposits will alter the base-money multiplier by causing base money to shift between bank reserves and circulation. This perverse adjustment is different from the accommodative adjustments considered here, which are adjustments in the supply of inside money in response to changes in demand when the supply of bank reserves is constant.

[4.] George Clayton (1955, 97-98). The only exception Clayton allows for is the case of a transfer of funds from demand accounts to time-deposit accounts. This reflects a presumption that different statutory reserve ratios apply to these types of accounts. On the reliance of the conservation theory on the assumption that there are binding statutory reserve requirements see below.

[5.] The turnover of liabilities will change temporarily if the demand for them changes (with constant supply) as consumers attempt to spend off excess balances or to add to their deficient balances.

[6.] Following J.H.G. Olivera (1971, 1096), “reserve demand” is used here to indicate needs arising in connection with bank clearing transactions that “make it necessary for the reserve holder to transfer some amount of the reserve asset.”

[7.] Ernst Baltensperger (1974, 205) defines precautionary reserve demand as the “excess of total holdings of the reserve asset . . . over the expected or average net demand for (‘loss’ of) reserves.” Olivera (1971) defines it as “the part of the total reserve which is held against possible deviations of net demand above its expected value.”

[8.] That is, so long as “reserve changes are known in probabalistic form only” (Baltensperger 1974, 205).

[9.] It is assumed throughout this analysis that the demand for reserves is uninfluenced by changes in interest rates on loans and investments. In defense of this assumption it may be noted that interest rates on overnight, “emergency” loans to cover reserve deficiencies will tend to rise along with other rates of interest, so that the penalty costs for insufficient reserve holding increase with the opportunity costs of keeping adequate reserves on hand. This suggests that high interest rates do not necessarily make it desirable for banks to skimp on reserves. For arguments and evidence in support of this view see Leijonhufvud (1968, 358), and Hancock (1983). Of course, if high rates are passed on to deposit holders, this might increase the quantity of money demanded and so reduce indirectly the demand for reserves.

[10.] F.Y. Edgeworth (1888). The best recent articles on this subject are the ones previously cited by Baltensperger and Olivera. In addition to these articles the discussion in Don Patinkin (1965, 82-88) is recommended.

[11.] As Baltensperger notes (1974, 205), the “square-root” law gives a conservative estimate of the relation between changes in gross clearings and precautionary reserve demand, in part because it assumes an increase in frequency, rather than in average size, of transactions. Edgeworth’s demonstration of the square-root law also relies on the assumption that individual clearing debits are stochastically independent and identically distributed. Olivera shows, however, that the law holds even if individual clearing debits (“the components of net average demand”) are serially correlated.

[12.] Whether adjustments in nominal supply of bank liabilities will entirely offset changes in nominal demand depends on the extent of note-brand discrimination. An increase in demand among nondiscriminating persons results in a smaller reduction in precautionary reserve needs than an equal increase in demand (affecting all banks uniformly) of discriminating persons. When there is 100 percent (marginal) note-brand discrimination, nominal supply adjustments will be complete.

For the sake of simplicity the argument assumes that banks are in equilibrium with respect to one another, that is, it assumes that the average net demand for reserves is zero. Then precautionary demand for reserves = total demand. Olivera (1971, 1100) notes that the square-root law is relevant to “decision units taken individually” and that “its possible use as a macroeconomic relationship involves a nonlinear aggregation problem.” He adds, however, that “the obvious ‘aggregation condition’ is that the number of reserve-holders, as well as their shares of the expected market demand, remain stationary when the latter grows.” But this simply means that it is necessary to abstract from changes in average net reserve demand, which is precisely the procedure I have adopted.

[13.] For the banking system, every dollar’s worth of excess money supply generates several dollars’ worth of additional bank clearings during any extended (but finite) planning period.

[14.] See Patinkin (1965, 87-88 and 576-77).

[15.] Jacoby (1963, 220). Similar proposals were made in the 1930s, following the lead of Winfield Riefler. See George Garvey and Martin R. Blyn (1969, 56-57).

[16.] Joachim Ahrensdorf and S. Kanesthasan (1960). For evidence on cross-sectional and temporal variation in Scottish free banks’ reserve rations, see Munn (1981).

[17.] See note 3 above, and also chapter 8.

[18.] Once again I am abstracting from problems arising due to changes in the demand for currency relative to total money demand. These problems are discussed at length in chapter 8.

[19.] See for example Albert E. Burger (1971), which is one of the more detailed, modern discussions of factors influencing the money supply. McLeod, whose analysis is also very detailed, merely hints at the possibility of a demand-elastic money supply when he notes (1984, 100) that the “credit multiplier” may rise to infinity, while the “total income multiplier” associated with a given increase in credit (bank loans and investments) may at the same time approach zero if increased lending is offset by increased holdings of inside-money balances. McLeod cites borrowings used to increase borrower’s liquidity—a case similar to the one of compensating balances discussed above—as a limiting case. Our claim is a much stronger one, viz, that under free banking changes in money supply generally do not influence total income and spending.

[20.] The example assumes 100 percent marginal note discrimination.

[21.] Eugene E. Agger (1918, 101). Were he writing about an unregulated system Agger might also have referred to an increase in the volume of notes.

[22.] Keynes (1930, 1: 27). Keynes’s two premises are incorrect: an individual bank may “move forward” on its own without weakening itself if the demand for its liabilities has increased, and overexpansion by one bank or set of banks generally will not inspire sympathetic overexpansion by remaining ones.

[23.] L. White (1984d, 17). White presumably meant to say “by the same amount” rather than “by a common factor.”

[24.] The more important members of the Free Banking School were Sir Henry Parnell, Samuel Bailey, and James William Gilbart. (For other names see ibid., 52.)

[25.] L. White (1984d, 98). Not surprisingly, opponents of free banking also accepted the in-concert overexpansion argument, and were in addition more willing to view it as a description of the likely course of events under unregulated banking. They included J. R. McCulloch and Samuel Jones Loyd (cited in ibid., 98-99), and G. W. Norman, a Director of the Bank of England (cited in V. Smith, 68).

[26.] See especially Gurley and Shaw (1955, 1956).

[27.] Gurley and Shaw (1960, 202, 218).

[28.] Joseph Aschheim, in response to Gurley and Shaw, argues (1959, 66) that commercial banks “can make ex post savings exceed ex ante savings,” i.e., can engage in credit creation that leads to forced savings. In contrast, Aschheim says, other financial institutions “can lend no more than they have received from depositors and, therefore, cannot create loanable funds.” What I have tried to show, in contrast, is that deposit commercial banks are mainly passive “credit creators.” The only active credit creators are those institutions having a monopoly or quasi-monopoly in the supply of currency.

[29.] See, for example, James M. Henderson (1960).