Front Page Titles (by Subject) PART THREE: Free Banking versus Central Banking - The Theory of Free Banking: Money Supply under Competitive Note Issue
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PART THREE: Free Banking versus Central Banking - George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 
The Theory of Free Banking: Money Supply under Competitive Note Issue (Lanham, MD.: Rowman & Littlefield, 1988).
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Free Banking versus Central Banking
The Dilemma of Central Banking
If free banking did not promote a well-behaved money supply, there would be little to gain from harping on the defects of central banking. Few deny that central banks do a less than satisfactory job in controlling the money supply. But this fact, and the fact that some of the shortcomings of central banking are inherent in the institution itself, is only worth investigating if some potentially superior alternative to central banking exists.
The possibility of free banking justifies a critical appraisal of central banking. This chapter presents such an appraisal. It begins with a brief, general comparison of markets and centralized planning as means for directing the use of scarce resources. Emphasis is placed on the importance to proper resource administration of knowledge of conditions of supply and demand that is limited, dispersed, and unarticulated. The results of this discussion of the “knowledge problem” are then related to the issue of the choice between free and central banking. The chapter ends by criticizing particular central banking policies, which are attempts to overcome the knowledge problem as it confronts central bankers.
The Knowledge Problem
The goal of economic action is to employ scarce consumption goods and means of production in a way that minimizes foregone opportunities. Consumers have wants, some of which are more pressing than others, and not all of which can be satisfied by means of the limited resources available. Consumers’ wants also change frequently, as do the conditions of factor supply and the technological possibilities for combining factors of production to make consumer and capital goods. The economical administration of resources depends on agents being aware of changing priorities, endowments, and techniques of production.
The problem of resource administration is complicated by the fact that the knowledge relevant to its solution is divided among numerous individuals. No single person or bureau can hope to accumulate any significant part of it. This is especially true of consumers’ knowledge of their own preferences, which is mainly confidential and unarticulated. But knowledge of the state of technology and natural resources is also atomistic; it remains, in the words of F. A. Hayek (1948b, 80), “knowledge of the particular circumstances of time and place,” existing only as “dispersed bits” (ibid., 77). Thus, harnessing knowledge for the economic administration of resources, the “knowledge problem,” is challenging, not only because of the extent of relevant knowledge, but also because of the form in which it is held. As Thomas Sowell notes (1980, 217-18),
It is not merely the enormous amount of data that exceeds the capacity of the human mind. Conceivably, this data might be stored in a computer with sufficient capacity. The real problem is that the knowledge needed is a knowledge of subjective patterns of trade-off that are nowhere articulated, not even to the individual himself. I might think that, if faced with the stark prospect of bankruptcy, I would rather sell my automobile than my furniture, or sacrifice the refrigerator rather than the stove, but unless and until such a moment comes, I will never know even my own trade-offs, much less anybody else’s. There is no way for such information to be fed into a computer, when no one has such information in the first place.
That conditions of supply and demand continually change is an essential aspect of the problem of resource administration, since it means that, even if the relevant knowledge were accessible, it would have to be acquired rapidly before it ceased to be relevant.
In noncentralized economies the economic administration of resources is achieved by and large through the interaction of persons in competitive markets. Entrepreneurs, referring to price and profit signals established through rivalrous buying and selling of goods and services, are led to administer supplies as if they had direct knowledge of the state of consumer preferences. Yet even the totality of entrepreneurs engaged in production and exchange in any particular market do not possess the knowledge that would be needed by a central planning agency put in place of them and in place of that market:
Prices convey the experience and subjective feelings of some as effective knowledge to others; it is implicit knowledge in the form of an explicit inducement. Price fluctuations convey knowledge of changing trade-offs among changing options as people weigh costs and benefits differently over time, with changes in tastes or technology. The totality of knowledge conveyed by the innumerable prices and their widely varying rates of change vastly exceeds what any individual can know or needs to know for his own purposes [ibid., 167].
The price system assists entrepreneurship in two ways. First, it provides information directly. This is the ex ante function of market prices: their contribution towards entrepreneurs’ recognition of the existing state of market conditions. This ex ante function of market prices is emphasized by F. A. Hayek in his essay on “The Use of Knowledge in Society.” Hayek considers the tin market as a case in point:
Assume that somewhere in the world a new opportunity for the use of [tin] has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose—and it is significant that it does not matter—which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply [1948b, 85-86].
Available tin will, at a higher price, continue to be used only where the need for it is considered most urgent by its users. Less urgent uses will employ tin substitutes, which in turn will cause an increase in production of these substitutes. The existence of a market price for tin “brings about the solution which . . . might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process” (ibid.). What Hayek stresses here is the ability of prices, or rather price movements, to convey knowledge of changes in existing conditions so that entrepreneurs will direct their actions accordingly.
The problem of economic resource administration is not, however, merely one of disseminating knowledge of existing conditions. Nor is the solution of this part of the problem the sole contribution of market prices. Economic administration of resources ultimately depends upon correct anticipation of conditions (for example, consumer preferences) of the future. Information describing present conditions is only partially adequate for this task. When conditions are continually changing, and when the future is unpredictable, decision makers must speculate, and their speculations may be incorrect even though they are based on the most complete information conceivable. In other words, decisions may be inadequately informed. This need not be due to any incorrect (as opposed to insufficient) information, from price signals or from other sources; it is a necessary consequence of the inherent uncertainty of future conditions combined with the fact that action takes time. For this reason no administrative or entrepreneurial decision can be regarded as perfectly informed ex ante. It follows that decision makers must also be informed ex post of the appropriateness of their actions, and that they should be informed as quickly as possible.
Fortunately, the same price signals that inform decision makers in competitive markets of changing conditions of supply and demand also help them evaluate their actions ex post. Market prices, including prices reflecting entrepreneurs’ incorrect speculations, ultimately determine the profitability of entrepreneurial ventures. (In contrast, in their ex ante role, prices are used to inform profitability estimates for projects not yet undertaken.) Suppose the problem is to supply the market for neckties. Will consumers buy wide or narrow ties? Where are their preferences headed? No available information can give a certain answer. The only knowledge to be communicated, by prices or otherwise, is knowledge of the preferences of the present or, more accurately, of the immediate past. The entrepreneur has to speculate about the future state of the necktie market. Market prices afterwards will assist him in determining whether his speculations were correct. If he misjudges the wants of consumers, that is, if he employs factors of production in a manner inconsistent with the priorities of consumers, his error will lead to an accounting loss. If, on the other hand, he correctly anticipates consumer wants, he will be awarded by profits. The incidence of profit and loss will, in the words of Israel Kirzner (1984, 200), “systematically bring about improved sets of market conditions.” In helping to “stimulate the revision of initially uncoordinated decisions in the direction of greater mutual coordinatedness” (ibid., 201), profit and loss calculations based on market prices function as ex post guides to speculative decision making.
To summarize, prices communicate changing knowledge of market conditions and thus inform speculation; but when they enter into entrepreneurs’ calculations of profit and loss, they also reveal whether or not earlier speculations were correct, and so they guide action even where knowledge relevant to its success, knowledge of future market conditions, is in principle unavailable to anyone before the fact.
The price system can be likened to a tapestry in which holes are always appearing but which continually patches itself. The tapestry represents the (dispersed and inarticulate) knowledge concerning conditions of supply and demand translated into price signals through processes of exchange. The holes represent the uncertainty inherent in decision making. The tapestry is self-patching because a current set of prices, while indicating actual changes in economic conditions, also generates profits and losses that signify a need to modify entrepreneurial plans informed by a previous set of prices.1 Price and profit signals are not just “communicators” of knowledge, but knowledge “surrogates.” The significance of knowledge surrogates lies not just in the use they make of data that exist somewhere, but also in their ability to compensate for data that (when first needed) do not exist at all.
Advocates of centralized resource administration commonly fail to appreciate the dynamic, speculative nature of economic action and the corresponding need for ex post guidance of allocative decisions. The central planner is also a speculator: he cannot escape the uncertainty of the future no matter how much data he collects concerning existing conditions, which are constantly changing. What he needs is not merely present data but also some basis for assessing rapidly the correctness of his imperfectly informed decisions.
The principal ex post device available to central planners anxious to identify and correct their mistakes is not profit and loss accounting, which depends on market prices, but the observation of various disequilibrium consequences of misguided decisons. Typically, shortages or surpluses of commodities are taken as signals justifying a revision of plans, but the concepts of shortage and surplus, divorced from any reference to cost and profit calculations based on freely adjusting market prices, are arbitrary. Supermarket queues and overflowing inventories give some account of how production and consumer preferences are mismatched, but not as reliable, timely, or systematic an account as is conveyed to entrepreneurs by price and profit signals.2 The central planner is not driven to produce goods at minimum cost, that is, with a minimum of foregone opportunities, which is what systematic avoidance of shortages and surpluses implies, because the knowledge available to him does not adequately indicate the subjective desires of consumers that give the concept of cost its meaning. The planner is not, generally speaking, bound to discover the presence of error in carrying out his plans except in the most obvious and egregious cases.3
Even when shortages and surpluses are correctly identified in a centralized economy, their usefulness in a trial and error approach, directly or via changes in a set of centrally administered prices, is limited by the fact that conditions of supply and demand are likely to change significantly even during the course of a single “trial,” before any obvious shortage or surplus becomes apparent.4 The holes or gaps in a system of centrally administered prices, rather than being frequently patched through entrepreneurial reactions to profit and loss signals, tend instead to widen and multiply. In contrast, profit and loss signals in a market system tend systematically to reveal to agents the appropriateness or inappropriateness of their decisions well before more visible signs of discoordination become evident and therefore before conditions of supply and demand can change significantly.
The Problem of Money Supply
How is the problem of money supply the same as other problems of economic resource administration? How does it differ?
In essence, the problem of administering the supply of money is like other problems of resource administration. Consumers and businessmen have definite wants for money balances—for deposits and currency—and a banking system should satisfy these wants without diverting resources from more highly valued uses. Like other consumer demands, the demand for money balances cannot be known in advance by any individual or agency; it requires speculation. If real factor costs and banking technology are unchanging, the problem of administering the money supply boils down to one of maintaining monetary equilibrium in the short run.5
What makes the problem of administering the money supply unique is, first, that it is only a short-run problem. In the long run, assuming the demand for money does not change continually and by great leaps, general price adjustments will alter the value of money, causing supply (whether considered in real or nominal terms) to conform with demand. This will be the case regardless of what the nominal supply of money is. The challenge of administering the money supply is therefore one of avoiding short-term disequilibrium by having short run nominal supply adjustments take the place of more disruptive and costly long run price-structure adjustments that would otherwise be needed to restore equilibrium.6
Second, a correct supply of inside money cannot necessarily be guided by cost accounting in the usual sense—where costs are taken to mean expenditures on physical inputs involved in the “production” of bank notes and checking accounts. These “physical” costs of production—the cost of machinery, paper, ink, and labor expended in the production and issue of notes and deposit credits—are mainly fixed costs. They are not marginally increasing. Were note and deposit creation to proceed until the marginal revenue from their issue (which is approximately equal to their purchasing power) equaled the marginal cost of production, it would necessitate a significant fall in the former magnitude. That could only occur (in a stationary or progressing economy) if the nominal supply of money surpassed the demand for it.7 Although this would still be profitable to the banks of issue, some part of the resulting output of inside money would be unnecessary and, indeed, destructive from consumers’ point of view. It follows that something other than the cost of machinery, paper, ink, and administration that go into the issue of inside money must act as a guide to desired issues and as a restraint against overissue.
This brings to bear a third important difference between the economic administration of money and that of other resources. In general, centralized administration of any single market does not confront planners with any great calculational challenge, since they can rely on the existence of competitive market prices for other resources that serve as inputs for the production of the good for which they are responsible. For example, suppose shoe production is assigned to a central planning bureau, but that leather, tacks, tanning materials, and labor, are all supplied and priced in competitive markets. The shoe bureau cannot be certain it is producing at minimum cost, because it does not have to compete with other firms rivalrously experimenting with other techniques. Nevertheless it is, like any single-industry monopolist, still able to calculate costs and to produce shoes in amounts reasonably consistent with the scarcity of inputs. If markets did not exist for the means of shoe production, as they would not in a completely socialist system, then there would be no basis for making profit and loss calculations.
In contrast, the existence of competitive markets for all relevant factors used to produce inside money does not significantly lessen the knowledge problem faced by a central bank. Therefore, the risk of incorrect management of the money supply is not limited by its being the only resource in the economy subject to centralized administration. Furthermore, an improperly managed money supply leads to much greater economic discoordination than an incorrect supply of any other good or service. Excess demand or excess supply of money affects spending in numerous other markets, and hence affects the entire system of market price and profit signals. One can think of the market as being like a wheel, with money as the hub, prices as the spokes, and other goods as the rim. A change in the relation of one good to the rest is like a tightening or loosening of a single spoke: it has a great effect on one small part of the wheel, but much less effect on the rest of the wheel. A change in the relation of money to other goods is like moving the hub: it has a great effect on all parts of the wheel, because it moves all the spokes at once. Adjust a spoke—a particular price—improperly, and you make one small part of the wheel wobble; adjust the hub—money—improperly, and you bend the whole wheel out of shape.
The far-reaching consequences of monetary disequilibrium are a matter of grave concern precisely because market prices have a coordinating role to perform. Incorrect adjustments in the money supply promote general calculational chaos. They undermine the normal, beneficial operation of the price system in guiding entrepreneurial action. If the money industry does not function well, then the rest of the economic system cannot function well.
If reference to input costs cannot assist the managers of a centralized supply of inside money, how are the decentralized producers of inside money better off? How can profit and loss signals guide the issue of inside money if, of necessity, the costs of inputs associated with its manufacture have to be, even at the margin of production, less than its exchange value? Is the money industry the Achilles heel of market economies? Is the price system, which is supposed to be superior to central planning as a means for administering resources, itself dependent upon the centralized administration of money?
The theory of free banking suggests that it is not. In the money industry as elsewhere, the free interplay of market forces leads to effective resource administration. The key to the market solution in this case is the guidance provided by the clearing mechanism. That mechanism is the source of debit and credit signals that rapidly (and timing is critical) follow free banks’ over- and underissue of inside money. By responding to these signals free bank managers are led to adjust their liabilities to conform with the public’s demand for inside money balances as if they had direct knowledge of, and were concerned with satisfying, consumer wants. It is not just the costs connected with the issue of inside money which regulate its supply under free banking; rather, it is these costs plus the costs associated with the return of notes and checks to their issuers for redemption in base money, that is, liquidity costs.
When the currency supply is monopolized, as it is under central banking, the clearing mechanism ceases to be an effective guide to changing the money supply in accordance with consumer preferences. Creation of excessive currency and deposit credits by a central bank will not cause a short-run increase in its liquidity costs. This means that other knowledge surrogates (including both means for informing money-supply decisions and means for their timely ex post evaluation) must be found to replace surrogate knowledge naturally present under free banking. That is why there is need for “monetary policy” and money-supply “guidelines” under centralized issue. The question is, are such guidelines superior to free banking?
Defects of Monetary Guidelines
In reviewing various guidelines for central banking we shall adopt as a starting point the assumption that the monetary authorities desire to maintain monetary equilibrium, that is, that their only goal is to avoid as far as possible any difference between the nominal supply of money—of commercial bank deposits plus central bank currency in circulation—and the nominal demand for it at a given level of nominal income.8 Furthermore, we are only concerned with whether the monetary authority can know when there is need for monetary expansion or contraction. Chapter 8 will consider, in the context of a particular sort of change in consumer preferences, whether a central bank can actually achieve some desired adjustment.
Some of the more popular alternatives for central bank monetary policy are:
Each of these alternatives involves a knowledge surrogate or policy guideline which substitutes for knowledge surrogates present under free banking.
To simplify discussion, let us assume that the central bank is not restricted by factors such as convertibility of its issues in some commodity money. This does not mean that the conclusions reached are inapplicable to, say, a central bank tied to a gold standard. Rather, given the assumption of a “world” central bank, with no demand for gold in circulation and with a sufficiently inelastic industrial demand for gold, gold-standard convertibility requirements would still allow a central issuer substantial leeway to pursue any policy it wanted.
Price-level stabilization had many proponents during the 1920s and 1930s and continues to have advocates today.9 Its appeal is based on the reasoning that, since an excessive or deficient supply of money results in a rising or falling general structure of prices (other things being equal), stabilization of the price structure or of some index representing it will preserve monetary equilibrium.10 There is a serious theoretical flaw in this argument, but before examining it we should consider briefly some practical difficulties that frustrate construction of a reliable price index.
Before a price index can be constructed, three problems must be solved. The first and most obvious is that of choosing goods and services to include in the index. The second concerns choosing a measure of central tendency to collapse the chosen set of prices into a single value. The last is assigning to each price a weight or measure of relative importance.11 For example, should a change in the price of a bale of cotton influence the index to the same or to a greater or lesser extent than a proportional change in the price of an ounce of gold? Furthermore, assuming that a value can be chosen for each “coefficient of importance,” will it have to be modified regularly according to changes in the relative prominence of particular goods? Would the coefficient of importance of slide rules be the same today as it might have been twenty years ago?
Such practical issues might be of minor importance were it not for the fact that each of the countless ways of resolving them (there is no obvious, right solution) leads to a different index which would, in turn, suggest a different schedule of money supply adjustments. Presumably, if any one schedule is correct for maintaining monetary equilibrium, the others cannot be. Chances are that the correct schedule would not be the one actually adopted.12
Yet the problem is even more complicated than this because, contrary to the reasoning of advocates of price-level stabilization, the value of a consumer-goods price index, no matter how carefully constructed, may actually have to rise or fall for monetary equilibrium to be preserved. This will be the case whenever there is a significant change in the efficiency of production of one or more goods included in the price index. When there are changes in the volume of real output, a rise or fall in prices of the affected goods reflecting the change in their average cost of production is the only means for avoiding unwarranted profit and loss signals13 while also allowing the goods market to clear. A price index does not itself reveal whether its movements reflect changes in the conditions of real output or are symptoms of monetary disequilibrium.
The effect that a change in productivity should have on prices and on the nominal supply of inside money depends on the influence that increased real output has on the demand for real money balances. There are two possibilities: One is that the real demand for money balances is constant; the other is that the real demand for money balances relative to real income (“k” in the Cambridge equation of exchange) is constant. In the second case an increase in real per-capita output brings about a proportional increase in real money demand.
When k is constant, a fall in prices following an increased volume of output ensures market clearing (at a constant level of nominal income) while simultaneously increasing the value of money in agreement with the increased demand for it. Any effort to offset such price reductions by increasing the nominal money supply would only interfere with monetary and goods-market equilibrium. For example, suppose that technical innovations lead to an increase in per-capita output of several consumer goods, with a proportional increase in the real demand for inside money balances. In this case the prices of the more abundant goods should be allowed to fall in sympathy with the fall in their per-unit cost of production, allowing for differences in price-elasticities of demand. The fall in prices itself provides the desired increase in the real supply of money balances. Also, with the total nominal outlay of producers unchanged, and an unchanged nominal demand for money balances, the aggregate nominal demand for goods remains the same as before the expansion in per-capita output, and this demand will be just adequate to purchase the increased total output only if the per-unit selling price of goods now supplied in greater quantities is lower than it was before the increase in output. Therefore, when the per-unit real cost of a good falls, its selling price should fall as well to preserve monetary equilibrium.14
To see that a fall in prices in response to reduced per-unit costs is, not only consistent with, but essential to the maintenance of equilibrium, consider what would happen if the money supply were increased so that a greater output of goods could be purchased without any fall in the general price structure. Then producers would, following the injection of new money, have nominal revenues exceeding their nominal outlays: illusory profit signals would be generated, spurring additional investment. As Haberler notes, “the entrepreneurs would be led on by the double inducement of (1) reduced costs [without reduced revenues] and (2) interest rates falsified by the increase in the volume of money to undertake capital improvements on too large a scale” (1931, 21):
Suppose, in a particular branch of industry, production is increased as the result of a technical improvement, aggregate costs remaining stationary, by 10 per cent (equivalent to a reduction of average costs of 10 per cent). If the demand increases by exactly the same figure [i.e., is unit elastic with respect to nominal price, holding other prices constant] the price of the product will fall by 10 per cent, and the economic position will otherwise be unchanged. If, however, the effect of this reduction of price on the price-level is compensated by increasing the volume of money . . . new purchasing power will be created which will clearly produce exactly the same results as . . . inflation.
The illusion ends once the excessive money supply has its effects on wage rates and on the prices of other factors of production: an injection of money has the same discoordinating consequences whether it results in absolute inflation (rising prices) or only in relative inflation which, instead of causing prices to rise, merely prevents them from falling in accordance with increased productivity. Relative inflation does not reveal itself in a rising consumer price index, although it does result in an upward movement in the prices of factors of production.15
E. F. M. Durbin, in comparing the consequences of expanding the money supply to offset increased productive efficiency with those from expanding it to meet an increased demand for money balances relative to income, says (1933, 186-87) that the latter “will exert no effect on relative price levels. . . . It will merely maintain the level of money incomes and allow prices to decline in proportion to costs.” The former, on the other hand, will add to the aggregate stream of money payments, thereby interfering with those adjustments that would otherwise guide relative prices to their proper levels.
What if there is a decline in productive efficiency, that is, what if the per-unit cost of production of a number of consumer goods increases? Stabilization of a consumer-goods price index would then cause a reduction of consumers’ aggregate nominal income and expenditure. This would in turn lead to a deficiency of producer revenues relative to outlays, to the disappointment of entrepreneurs’ “expectations of normal profit,”16 and to further curtailment of production. The lull in productive activity continues until factor prices, including wages, fall to a level consistent with the restoration of producer profits.
R. G. Hawtrey provides a quantitative illustration (1951, 143-44):
Suppose . . . that a consumer’s outlay of £100,000,000 has been applied to 100,000,000 units of goods, and that producers who have hitherto received £20,000,000 for 20,000,000 units find their output reduced to 10,000,000 units, but the price of their product doubled. They still receive £20,000,000 and the other producers can continue to receive £80,000,000 for 80,000,000 units.
But as £100,000,000 is now spent on 90,000,000 units the price level has risen by one-ninth. In order to counteract that rise, the consumers’ outlay must be reduced from £100,000,000 to £90,000,000. Every group of producers will find the total proceeds of its sales reduced by 10 percent. Wages, profits and prices will be thrown out of proportion, and every industry will have to face the adverse effects of flagging demand. . . . The producers whose prices have been raised by scarcity will be no exception. Their total receipts are reduced in the same proportion, and they must reduce wages like their neighbors.
Nor, Hawtrey continues (ibid., 147) does this depend on the assumption that goods have a unitary price-elasticity of demand:
If the shortage is in a product of which the elasticity is greater than unity, the adverse effect on the producers of that product is greater and on other producers less. If elasticity is less than unity the adverse effect on the former is less and may be more than counteracted, but what they gain their neighbors loose. Whatever the circumstances, the stabilization of the community price level in the face of [increased] scarcity will always tend to cause depressions.
It is somewhat less obvious that maintenance of monetary equilibrium may require a price-index change even when the absolute level of demand for real balances is constant. Suppose there is a general increase in productive efficiency which leads to a general reduction in goods prices. The fall initially seems necessary (given a constant nominal money supply) to clear the goods markets while also keeping selling prices in line with average per unit costs of production. But a general fall in prices will also increase the real value of existing nominal money balances. If the demand for real balances is unchanged, the nominal supply of money will become excessive. It is tempting to think in light of this that the increase in productive efficiency independent of any increase in the real demand for money should leave the price level unchanged after all, because the spending of excess balances would, other things being equal, cause prices to return more or less to their original levels.17 Therefore, it might be argued, changes in productivity are not after all an independent cause of the price-level changes that should be of concern to a monetary authority.
Nevertheless the argument is mistaken. The return of prices due to the real-balance effect occurs only after some delay, during which a monetary authority following a price-level stabilization policy might be tempted to increase the nominal supply of money. Yet what is really needed to maintain monetary equilibrium in the face of a real-balance effect following an increase in productivity is, not an expansion of the nominal money supply, but a contraction. Otherwise the spending-off of surplus nominal balances will increase nominal income, generating false profit signals. The sequence of adjustment should be: increased output, reduced prices, real-balance effect, and contraction of the nominal money supply. The procedure that best maintains monetary equilibrium—one that accounts for the fact that the real-balance effect does not take place instantaneously—is therefore one that allows lasting changes in an index of prices even when the real demand for money has not changed.
Thus a “neutral” monetary policy, one that maintains monetary equilibrium, is not likely to keep any price index stable. What is needed is a policy that prevents price changes due to changes in the demand for money relative to income without preventing price changes due to changes in productive efficiency.
As our earlier discussion made clear, a free banking system tends to accommodate changes in the demand for inside money with equal changes in its supply. An increase in the demand for inside money balances results in banks’ discovering that their formerly optimal reserve holdings have become superoptimal—the banks are encouraged to expand their issues of inside money. Conversely, a fall in the demand for inside money exposes banks to a greater risk of default at the clearinghouse, prompting balance-sheet contraction. In both cases the system avoids unjustified fluctuations in aggregate nominal income and prices.
On the other hand, insofar as prices tend to fluctuate under free banking on account of changes in the conditions of real output (e.g., technological improvements leading to increased per-capita output, or a negative supply shock due to bad weather),18 no countervailing adjustments in the supply of inside money will occur; instead, the nominal supply of inside money will adjust only in response to any change in spending associated with some real-balance effect. This sustains rather than prevents the movement of prices.19 Such price movements are automatic and “painless” in the sense that they come in response to changes in per-unit costs and therefore maintain constant (elasticity of demand considerations aside) the nominal revenues of producers. In short, free banks prevent only those potentially disruptive changes in prices and in the value of money that would otherwise result from uncompensated changes in the public’s demand for money balances relative to income.
This result of free banking accords perfectly with the ideal of monetary equilibrium discussed in chapter 4. Free banks maintain constant the supply of inside money multiplied by its income velocity of circulation. They are credit intermediaries only, and cause no true inflation, deflation, or forced savings.
But if this is true of the results of free banking it cannot be true of any monetary policy that prevents price changes having their source in changes in the conditions of production. The fundamental theoretical shortcoming of price-level stabilization is that it calls for changes in the money supply where none are needed to preserve equilibrium.
Yet even this does not exhaust the defects of price-level stabilization, for even if a price index could be constructed that would change only in response to monetary disequilibrium, the index would still be a defective policy guide: any corrections made by the monetary authority would come too late. They would come too late, not just because there is a lag between the actions of the central bank and adjustment of commercial bank deposits and currency in circulation, but, more fundamentally, because price changes recorded in an “ideal” price index are themselves equilibrating adjustments to previous money-supply errors. To the extent that general price adjustments occur in response to monetary disequilibrium, the gap between the nominal demand for money and its nominal supply is reduced. Once such price adjustments are revealed in an altered price index, the excess demand or excess supply of money has already been at least partly eliminated by changes in the purchasing power of money. Changing the quantity of money at this point would simply cause a new disequilibrium change opposite the original disturbance. In other words, changing the money supply to return an “ideal” price index to some target level may actually make matters worse—like backing over someone to compensate for running him over in the first place.
Such compounding of error is especially likely in the face of what Milton Friedman (1959, 87-88) calls the “long and variable lag” separating changes in the money supply from their observed effects on general prices.20 Even before the authorities realize that there has been a discrepancy between the nominal demand for money and its nominal supply at the target price level, the nominal demand for money may already have altered significantly, not only because general price-level changes have altered the real value of money balances, but also because of entirely independent changes in the demand for real balances. The result might be, to use Keynes’s analogy in his Treatise on Money (1930, 2: 223-24), that the money doctors prescribe castor oil for diarrhea and bismuth for constipation!
Price-level stabilization therefore suffers from the same flaw as in the trial and error approach to overall central planning. It recognizes the need for some ex post guidance of money-supply decisions, but it relies upon a “knowledge surrogate”—the general level of prices—which does not signal disequilibrium fast enough. In contrast, the knowledge surrogates provided by clearing operations in a free banking system work relatively quickly: they sponsor modifications in the money supply well before money supply errors can have observable, macroeconomic consequences.
The preceding arguments also apply, with appropriate modifications, to a policy of foreign-exchange rate stabilization, discussion of which requires us to relax the assumption of a closed economy or “world” central bank. Exchange-rate movements are inappropriate as indicators of monetary disequilibrium because rates vary in the short run for reasons other than changes in the purchasing power of domestic and foreign monies, such as a change in preferences for foreign produced goods, or fear of political instability. But even if this were not true—even if the pure purchasing-power parity theory of exchange rates were valid for the very short run—exchange rates would still possess all the defects (and then some) of price indeces as guides to monetary policy: they would merely reflect perceived changes in the domestic price level relative to the foreign price level. Assuming the latter to be constant, a “pure purchasing power” exchange rate would be nothing other than another price index, made up of prices of goods involved in foreign trade. As such it would be no better than any other price index as a guide to credit expansion.
Another popular central banking policy is interest rate pegging or targeting (pegging within a specified range).21 This policy draws attention to what may sometimes be an early symptom of monetary disequilibrium—namely, interest rate changes. It might sometimes allow money supply errors to be corrected before they could substantially influence economic activity. Indeed, this approach invokes a knowledge surrogate that would in some instances be theoretically superior to the surrogates involved in free banking, since credit creation or destruction involves an immediate dislocation of interest rates from their equilibrium levels.
Regrettably, this theoretical advantage has no practical counterpart. Wicksell’s theory—that monetary disequilibrium arises whenever there is a difference between the market rate of interest and the natural or equilibrium rate—is consistent with pegging the market rate only if the natural rate is unchanging, and only if the market rate happens to be equal to the natural rate when the policy takes effect. Then and only then would further changes in market rates be evidence of inadequately accommodated changes in the demand for money.
In practice, as Robert Greenfield and Leland Yeager point out (1986), to regard all market interest rate movements as evidence of shifting money demand, necessitating accommodative changes in money supply, confuses the demand for money balances with the demand for credit or loanable funds. While changes in the interest rate may represent a departure of the market rate from an unchanging natural or equilibrium rate due to a disequilibrium money supply, they may also represent changes in the natural or equilibrium rate of interest itself. Whether observed changes in the interest rate are equilibrium changes or not depends on what is happening to the public’s relative preference for present commodities, bonds, and money. The natural or equilibrium rate of interest may rise, even though the demand for money hasn’t changed, because of a shift in demand away from bonds and into commodities. If the monetary authority tried to prevent this kind of increase in the interest rate through monetary expansion (as if a rise in the interest rate always meant an increase in the market rate above the equilibrium rate, due to insufficient growth of the money supply), the result would be an excess supply of money. Likewise, if the interest rate fell due to a shift in preferences from present commodities to bonds (again with no change in the demand for money), any effort to keep the rate from falling by contracting the money supply would be deflationary. Furthermore there may be times when, although the demand for money is changing, an accommodative change in the supply of money will not be the same as a change aimed at pegging the rate of interest. For example, if the demand for money increases primarily at the expense of the demand for present commodities, the equilibrium rate of interest falls. Finally, if the demand for money increases primarily at the expense of the demand for bonds, there may be no change in the equilibrium rate of interest. The latter case is the only one consistent with a policy of pegging the rate of interest in the face of a changed demand for money.
In short, so long as market rates move in a manner consistent with changes in the (voluntary) supply of and demand for loanable funds, their movement is no indication of excessive or deficient money supply. The achievement of monetary equilibrium by interest rate pegging (or targeting) could only be an incredible, and short lived, stroke of luck.22
A third major guideline of monetary policy in recent years has been full employment. Like the other guidelines considered so far, its reliability as a sign of monetary equilibrium is quite limited. Obviously changes in the rate of employment may be due to the failure of the monetary authorities to preserve monetary equilibrium. An excess demand for money may lead to a rise in unemployment, especially if monopolistic elements in the labor market or other causes interfere with downward adjustments in wage rates. Likewise an excess supply of money may sometimes manifest itself in a fall in unemployment, due to delayed upward adjustment of labor-supply schedules (caused perhaps by a temporary bout of “money illusion”). But to assign to monetary policy the goal of guaranteeing “full” employment, when this means fixing a target rate of unemployment (such as in the Employment Act of 1946 and the Humphrey-Hawkins Act of 1978), is to assume that all fluctuations of unemployment around the targeted rate are due to maladjustments of the money supply which could be avoided by proper adjustment of the money supply. This is not so. Rather than being caused by deficient monetary expansion in the past, much of the unemployment observed today must be attributed to imperfect competition in the labor market. Unemployment caused by minimum wage laws is only the most flagrant example of this. The existence of stagflation—the simultaneous occurrence of high unemployment and rising prices—is, in a growing economy, almost certain proof that the unemployment is not due to any deficiency of aggregate demand. Attempts to combat such unemployment by further monetary expansion can only serve to augment an already satisfactory or excessive money supply, furthering the tendency of prices to rise. This in turn will provoke a new round of monopolistic wage developments, so that any temporary improvement in employment must be short lived.
A final set of monetary guidelines consists of rules prescribing a fixed rate of growth for the monetary base or for some monetary aggregate.23 At first glance it might seem that the very crudeness of such rules makes them inferior to the other procedures just discussed: a fixed growth rate rule obviously ignores the fact that the demand for money fluctuates on a day-to-day (or at least month-to-month) basis. It would produce the stability in nominal income that its advocates desire only if the demand for money grew steadily at the prescribed money growth rate.24
But the rationale of monetary rules lies precisely in the fact that information is lacking for implementing more sophisticated techniques. Thus Milton Friedman, undoubtedly the best known advocate of a fixed growth-rate rule, says (1959, 98) that, although “there are persuasive theoretical grounds for desiring to vary the rate of growth [of money] to offset other factors . . . in practice, we do not know when to do so and how much.” A central bank is not capable of making accurate provision for short-term fluctuations in the demand for money, and its attempts to do so using the imprecise guidelines available to it are likely to introduce more instability and disequilibrium than they eliminate. It follows that a simple growth-rate rule, although crude, may be the best attainable.
That a central monetary authority lacks the knowledge needed to execute sophisticated policies properly is not the only reason for wanting to restrict it to a fixed growth-rate rule. There are also political considerations, which weigh increasingly in the arguments of monetarists. Their claim is that a constitutionally mandated rule will prevent the monetary authorities from engaging in capricious or politically motivated manipulations of the money supply. In the words of Henry Simons, it “would be folly” to allow “temporary,” discretionary departures from a rule designed for this purpose.
These arguments for having a central bank adhere to a growth-rate rule are valid and compelling. But they do not see the issue as involving a choice between central banking and free banking. They offer what is perhaps the best solution to the problem of money supply given that currency issue is to remain a government-controlled monopoly. Nevertheless, central banking, even when it is based on a monetary rule, is decidedly inferior to free banking as a means for preserving monetary equilibrium.
So far we have simplified the problem of money supply by assuming that the demand for currency is a constant or fully predictable fraction of total money demand. Suppose that we take this assumption a step further and postulate a demand for currency that is absolutely constant and equal to the stock of central bank currency in circulation. How does the new assumption affect the problem facing the central bank? The answer is that it makes it disappear entirely! Once the supply of currency is assumed to be taken care of, the central bank can simply withdraw from the scene, and a policy of “free deposit banking” (without competitive note issue) is all that is needed to ensure the maintenance of monetary equilibrium. Thus the essential policy goal for a central bank—assuming that it will retain a monopoly of currency supply—is to adjust its issues to accommodate changes in the public’s demand for currency without influencing the availability of excess reserves to the banking system. The reason for this is that, under the assumption of a fixed and satisfied demand for currency, the only fluctuations in money demand that could occur would be fluctuations in the demand for checkable deposits. Such fluctuations could be accommodated by unregulated commercial banks without any central bank assistance. In contrast, if the demand for currency is not stationary, commercial banks lacking the power of note issue could not independently maintain monetary equilibrium.
These conclusions should not be surprising: the issue of currency is, after all, the principal money-supply function that commercial banks are presently prohibited from undertaking themselves. To argue, in view of this, that central banks serve to “regulate” deposit creation by commercial banks by controlling the supply of currency is like arguing that a monopoly supplier of shoes for left feet would be useful for regulating the production of shoes for right feet: it overlooks that in the absence of any monopoly the supply of both kinds of shoes would be self regulating, and in a manner vastly superior to what could be accomplished by a centralized left-shoe supply. In the same way, the total supply of inside money would regulate itself in a desirable manner if part of that supply which is now monopolized—the issue of currency, were thrown open to competition.
We have already seen that central banks are not well equipped to know whether an adjustment in the supply of currency is needed. We now turn to consider a relatively simple circumstance where the total demand for money is constant. Our aim is to examine whether a central bank can respond properly to known changes in the proportion of money demand represented by demand for currency assuming that the total demand for inside money does not change.
The Supply of Currency
Money may be held in either of two forms: deposits, from which payments can be made by check, or currency—hand-to-hand money. This chapter examines the capacity of free banks and central banks to accommodate changes in currency demand. To simplify the problem it assumes that the total demand for money is unchanging, so that the central bank can treat it as known. Then the only changes in currency demand that need to be accommodated are those arising from decisions to alter the composition of money holdings—their division between currency and deposits.1
Suppose, for example, that a shift from deposit demand to currency demand occurs in a central-banking system in which deposit banks have no excess reserves. Although the total demand for money has not changed, people want to exchange their deposit balances for currency balances. How can a central banking system provide the needed adjustment? Can it change the relative mixture of deposits and currency in circulation without disrupting monetary equilibrium? How, in this regard, will its performance compare to that of a free-banking system?
Before answering these questions we must carefully distinguish currency demand, which is simply a demand for circulating means of payment, from outside-money demand, which is demand to hold a form of money that does not involve granting credit to banks. A rise in currency demand is a routine occurrence which does not involve any loss of confidence in banks; it can in theory be satisfied by a circulating form of inside money. In contrast, a rise in outside-money demand means a demand to exchange inside money for outside money, the ultimate money of redemption. In a closed system this implies either a loss of confidence in banks issuing inside money (which contradicts the assumptions of the present part of this study) or a failure of the banking system to provide enough inside money for use as currency.2
The Relative Demand for Currency
The public’s division of its demand for money between deposit demand and currency demand is not arbitrary. Particular sorts of plans call for holding currency rather than checkable deposits. Currency is more useful for making change; but more importantly the demand to hold currency reflects the degree to which sellers more readily accept currency than checks. One reason for the greater acceptability of currency is that sellers of goods and services may wish to avoid the inconvenience of depositing or cashing checks. More significantly, acceptance of a check requires a level of trust beyond what is required in the acceptance of currency of equal face value: the acceptor of a check has to have confidence not just in the bank upon which the check is drawn, which may or may not be good for the transferred sum, but also in the drawer of the check himself, who may or may not possess an adequate deposit balance.
Nor is the relative demand for currency constant. As Agger notes (1918, 85), it changes along with “basic changes in the economic life of the community” and with “changes in the disposition that is to be made of . . . borrowed funds.” In the United States until the 1930s the historical trend was toward less reliance upon currency and greater use of checks and other means for direct transfer of deposit balances. This was due mainly to improvements in deposit banking, which were spurred-on in part by the suppression of competitive note issue. In the last fifty years or so the trend has changed, and the demand for currency relative to total money demand has grown substantially.3
Other factors have historically caused the currency-deposit mixture to alter in a less regular way. An increase in retail trade relative to wholesale trade favors greater use of currency, because the former involves smaller, anonymous exchanges where less trust is possible, whereas the latter involves larger exchanges among previously acquainted parties. In the past, when wage payments were more often made in currency, payroll requirements caused weekly and quarterly cycles in currency demand. The demand for currency also increased during the autumnal expansion of agricultural activity, and there are still seasonal peaks in demand due to holidays (such as Christmas) which involve a burst of retail trade. Besides these influences Phillip Cagan, in his study of “The Demand for Currency Relative to Total Money Supply” (1958) lists the following: (a) expected real income per capita; (b) interest rates available on demand deposits (a measure of the opportunity cost of holding currency); (c) the volume of travel; (d) the degree of urbanization; (e) the advent of war; (f) the level of taxes and incentives for tax evasion; and (g) the extent of criminal and black-market activities. Changes in the currency ratio due to these and other factors since the turn of the century are shown in figure 8.1.
A final factor already alluded to which affects the relative demand for currency is the extent of business confidence. According to Agger (1918, 86), a decline in confidence “lessons the acceptability of the check as an instrument of exchange and usually involves an increase in the demand for media of more general acceptability.” Except during panics a loss of confidence extends only to individuals and not to banks so that, although it causes an increase in currency demand, it does not necessarily involve any increase in outside-money demand; that is, it does not involve a desire to remove outside money from the banking system. “Ordinarily,” Agger notes, “the shifting of demand is rarely so complete [and] it is only isolated banks that suffer a complete loss of confidence.”4 Pressure is more likely to be exerted by depositors desiring currency, including bank notes, than by holders of notes seeking to redeem them in outside money.5
This variety of influencing factors makes the relative demand for currency highly variable and sometimes unpredictable.6 In consequence, a central bank may have difficulty accommodating changes in the relative demand for currency even when the demand for inside money as a whole does not change. Yet it is essential that the public be able to acquire media of exchange in a mixture that suits its needs. Holders of inside money want to be able to switch from deposits to currency or vice versa depending upon which means of payment or combination of means suits its circumstances. If the public’s wants are not satisfied significant inconvenience and reduced opportunities for making desired purchases result.
Bank borrowers also may need to receive credit in one rather than the other form (checkable deposits or currency), so that a relative deficiency of either form will cause credit-market stringency just as if the the total availability of loanable funds were reduced. As Agger puts it:
Inability to meet an expanding demand or impediments in the way of issue of either form of bank credit may entail serious consequences. For those desiring credit in either form and unable to obtain it [for want of the desired media] the situation is alarming. The normal conduct of their business may depend upon obtaining bank accommodations of an acceptable form. Stringency in the market for such accommodation is . . . bound to be costly and a source of anxiety.7
The amount of credit granted in a well-working banking system should not depend on the form of payment medium wanted, so long as there is no special demand for the ultimate money of redemption. A well-working system should also permit the unrestricted interconversion of deposits and currency once either is already outstanding.
Currency Supply under Free Banking
When banks are unrestricted in their ability to issue bank notes each can meet increases in its clients’ demands for currency without difficulty and without affecting its liquidity or solvency. Under such free-banking conditions the “transformation of deposits into notes will respond to demand,” and banks will be able to supply credit in the form that borrowers require (Agger 1918, 154). The supply of currency is flexible under unrestricted note issue because bank note liabilities are, for a bank capable of issuing them, not significantly different from deposit liabilities.8 “In the absence of any restriction,” Agger writes, “it is a matter of indifference to the [note-issuing] bank which form its credit takes” (1918, 154). When the customers of a note-issuing bank—borrowers or depositors—desire currency, the bank offers them its own notes instead of a deposit balance. The issue of notes in exchange for deposit credits involves offsetting adjustments on the liability side of the bank’s balance sheet, with no change on the asset side. Suppose, for example, that a deposit-holder having a balance of $500 wants to withdraw $100 in currency.9 The bank simply hands him $100 of its notes. Then, on its balance sheet, it reduces the entry for “liabilities-deposits” $100 and increases the entry for “liabilities-circulation” $100. The composition of the bank’s liabilities changes but their total amount stays the same; and this is all that ought to happen, since by hypothesis the total demand for inside money has not changed.
It is even possible, as far as currency demand is concerned, for a note-issuing bank to hold enough notes on hand (in its vault and tills) to meet currency demands of its creditors and borrowers to the full amount of its outstanding demand liabilities. The only cost involved would be the cost of the notes themselves—an investment in paper and engraving. The notes are not obligations of the bank and pose no threat to its solvency until they start circulating. On the other hand, as long as notes are in a bank’s vault or tills they cannot be treated by it as a reserve asset capable of supporting its outstanding credits: unlike outside money, they are useless for settling clearing balances with other banks. A competitive bank’s own notes serve one purpose only, which is to satisfy that part of its clients’ demands for inside money which consists of a demand for currency. When no longer needed in circulation the notes return to the issuing bank, which may use them again the next time the demand for currency increases.10
In practice free banks would generally not keep on hand notes equal to 100 percent of their deposits, because the likelihood of demand for inside money shifting entirely into currency is minuscule. Even though only minor costs are involved, excessive note stockpiles would be wasteful. Banks would, instead, keep on hand as many notes as they would be likely to need to cover unusual, but not extremely freakish, demands. In the truly exceptional event of demands exceeding available note supplies relief would be no further away than the printing press.11
Freedom of note issue thus ensures the preservation of an equilibrium money supply as demand shifts from deposits to currency and vice versa. It assures that credit offers of persons willing to hold inside money are exploited even when the offerers want to hold bank promises in a form useful in circulation. It also assures that a growing demand for inside money that involves an absolute increase in currency demand is readily accommodated, instead of going unsatisfied because of a shortage of currency.12 The ability of free banks to function smoothly as intermediaries even in the face of changing currency demand stems from their note-issuing powers.
Monopolized Currency Supply
Under monopolized currency supply the ability of non-note-issuing (deposit or commercial) banks to convert deposits into currency is restricted. Deposit banks are not able independently to fulfill currency demands. They have to draw instead on their holdings of notes or fiat currency (or deposits convertible into notes or fiat currency) of the monopoly bank of issue.13 In doing so they reduce their reserves of high-powered money. It follows that, unless the monopoly bank of issue adjusts the amount of its credits to the deposit banks to offset their reserve losses due to currency demand,14 their lending power decreases. The banks will have to contract their liabilities. A change in the form in which the public wishes to hold money balances causes a disequilibrating change in the total supply of money.15
The same conclusion holds for uncompensated reductions in the relative demand for currency, which in a system with monopolized currency issue results in a return of currency to the deposit banks, who add it to their reserve holdings and use it as a basis for credit expansion. A fall in the relative demand for currency results in monetary overexpansion even though the demand for money has not fallen and even though there is no expansion of credit by the monopoly bank of issue. If changes in the relative demand for currency are not to result in monetary disequilibrium under central banking, the central bank must engage in continual “reserve compensation.” It has to adjust the supply of base or high-powered money in response to changes in the amount of base money needed in circulation.
This result, that changes in the relative demand for currency will affect total money supply under central banking unless offset by reserve compensation, is well recognized in the literature on central banking.16 But past writers have tended to view the problem as one inherent in all fractional-reserve banking, whereas the truth is that it is inherent only to systems where the issue of currency is monopolized.17
The amount of reserve compensation needed under central banking to maintain a constant money supply as the demand for currency changes can be calculated using a simple formula. Let
Then, under central banking
whereas, under free banking
Under central banking the relation between the supply of base money and total money supply is a function of the relative demand for currency, whereas under free banking this is no longer the case. The reason for the difference is that under central banking the public’s use of central bank notes as currency competes with the banks’ use of them as reserves. Under free banking high-powered (outside) money is not usually used as currency.
The amount by which the supply of base money needs to be adjusted under central banking to offset a change in currency demand can be derived by assuming that Mf is equal to the demand for money. We wish, in this case, to have Mc = Mf. If r is the same in both systems, this requires that
Bc - Cp (1 - r) = Bf
Bc = Bf + Cp (1 - r).
Thus, for example, if Cp rises $1000, and r = .10, then the monetary base under central banking would, other things being equal, have to increase
($1000) - ($1000) × (.10) = $900.
Put generally, the base needs to be adjusted by the amount of the increase in the relative demand for currency (the shift from deposit demand to currency demand) minus this value multipled by the reserve ratio.
Notice that this procedure is not equivalent to one of maintaining constant the level of deposit-bank reserves. This is because deposit banks only need to hold reserves against that part of the money supply that consists of deposit balances; they do not need to hold reserves against currency in circulation because it is not part of their outstanding liabilities. If, in the above example, the initial level of reserves of the deposit banks was $10,000 then, after the growth in Cp and corresponding reserve compensation, the new, equilibrium level of reserves is $10,000 - $1000 + $900 = $9,900. It follows that a central banking policy of maintaining constant the level of bank reserves, which might be desirable if the relative demand for currency were unchanging, will not preserve monetary equilibrium when the relative demand for currency flutuates.
Instruments for Reserve Compensation
Having seen the precise adjustments in the monetary base needed to compensate changes in deposit bank reserves due to changes in the relative demand for currency, we can ask how such reserve compensation might actually be undertaken by a central bank. Let us assume still that the total demand for money (currency plus deposits) is unchanging, and that only its division between currency demand and deposit demand alters. To simplify the problem even further, let us assume as well that the relative demand for currency is known to the monetary authority. We thus put aside for the moment the greater part of the knowledge problem discussed in the last chapter, which has to do with how the monetary authority could know how much currency it ought to supply, to consider whether the authority can actually make desired adjustments. Our concern is to examine the efficacy of various instruments for reserve compensation—statutory reserve requirements, open-market operations, and rediscount policy—in accommodating a known currency demand.19
The first instrument we have to consider, statutory reserve requirements, highlights the significant distributional impact of certain approaches to reserve compensation: although a correct adjustment of statutory requirements preserves monetary equilibrium on the whole, the uneven distribution of changes in liquidity brings welfare losses or gains to particular banks.20 Since changes in the relative demand for currency do not affect all banks simultaneously or uniformly, an ideal policy would have to make continual adjustments in statutory reserve requirements, bank by bank. This poses an impossible administrative problem. It requires, moreover, that the central authority know, not just the total extent of the public’s shift into (or out of) currency, but also which banks are affected by the shift.
Second, for adjustments in statutory reserve requirements to be adequate to accommodate substantial shifts into currency, the supply of base money held up in “free” statutory reserves would have to be large: a reduction in statutory reserve needs frees up more base money for use in circulation, but this is of no avail if the total supply that can be released is less than the increase in demand. Finally, phasing out statutory reserve requirements is obviously impossible if they are needed for reserve compensation.
The last point is important since statutory reserve requirements are themselves a barrier to automatic adjustments in the supply of deposit money. The significance of this becomes apparent when the assumption that the total demand for money is unchanging is (momentarily) relaxed. Of course the monetary authorities, if they knew the extent of changes in total money demand, could make the necessary modifications in their reserve-requirement adjustments, but this would just add another layer of complexity to an already tremendous administrative and calculational burden.21
A second vehicle for reserve compensation is open-market operations. The fundamental problem with this instrument is also distributive. Although it allows direct control of the total amount of base money created or withdrawn, it does not provide any means of ensuring that base money issued goes to banks that are experiencing currency withdrawals or, alternatively, that base money withdrawn is withdrawn from banks experiencing redeposits of currency. Lauchlin Currie draws attention to this in his Supply and Control of Money in the United States (1934, 117):
If the reserve banks should buy bonds to the amount of the increase in cash in circulation, less the amount of the reserve formerly held against withdrawn deposits, it would appear that the composition of money has changed but not its volume. This would be true if the reserve bank funds, arising from the purchase of bonds, go to those banks . . . experiencing withdrawals.
But, Currie observes (ibid., 114), the banks receiving the new base money from open-market sales will probably be different from those stricken by currency withdrawals. Those banks receiving new base money that do not need it to offset reserve drains will employ it like any other increment of excess reserves, by increasing their loans and investments.22
Opposite consequences follow attempts to offset by open-market sales an inflow of currency due to a shift in demand from currency to deposits. “Here again,” Currie writes, “the difficulty is that the bank gaining reserves from the deposit of cash [currency] may not be the same bank losing reserves from the selling operations of the reserve banks” (ibid.). As with adjustments in statutory reserve requirements monetary equilibrium in the gross sense will be preserved, but with substantial welfare effects.
To some extent inter-bank lending might reduce these welfare effects from reserve compensation. But this possibility is limited by the fact that banks receiving excess base money will not necessarily lend it to other banks in need of reserve compensation: this may or may not be the most profitable avenue of employment for the surplus funds. Banks suffering reserve losses from currency drains might not offer to pay a high enough interest rate to attract emergency loans, for fear that the currency withdrawals may be permanent ones, which would make it difficult to repay the loans. Or, if banks losing reserves do offer to pay higher rates, other banks may still be reluctant to lend to them because they fear that the rates represent increased risk that the borrowing banks are suffering, not just temporary currency withdrawals, but a permanent loss of business.
A final instrument for reserve compensation is rediscount policy. This seems to offer the advantage of automatically channeling emergency supplies of base money only to banks in need of them, without requiring the monetary authorities to make decisions on a bank-by-bank basis. Murray Polakoff, who is generally critical of rediscount policy, writes (1963, 203) that it “is particularly well suited to supply a portion of reserves for seasonal needs and reserve losses and supplying them directly and immediately to the points where they are most needed.” He adds that “this is not true of open-market operations” (ibid.).23 A defect of rediscounting, however, is that it relies on deposit banks’ knowing whether currency is being withdrawn from them because of (a) an increase in their clients’ demand for currency or (b) dissaving (a fall in the demand for inside money).24 In general it is not possible for banks to know which of these causes is behind some withdrawal of currency by their depositors. Banks may mistakenly borrow base money from the central issuer (by rediscounting) to offset drains of the second type, forestalling the credit contraction needed in such cases to preserve monetary equilibrium. Distributing emergency base money by the rediscount mechanism does not guarantee that it goes to banks suffering from currency drains due solely to changes in the relative demand for currency.
All this assumes that banks, if they knew how, would borrow from the central issuer only the precise amount needed to compensate their losses caused by changes in the relative demand for currency. But the extent of borrowing depends on the rate of rediscount that the central bank charges. A rate below the market rate encourages borrowing, not merely for reserve compensation, but for acquiring excess reserves to relend at a profit. Furthermore, even if banks borrow from the central bank only to offset reserve losses due to currency withdrawals, the return of currency from circulation when the relative demand for it declines may not lead to offsetting repayment of borrowed reserves. If the rediscount rate is too low, the surplus base money will be re-lent instead. Winfield Riefler (1930, 161) cites an example of this in the United States just after World War I. Commercial banks had borrowed heavily from the Federal Reserve during the war to offset reserve losses due to an increased relative demand for currency. At the close of the war, when demand shifted back to deposit balances, returning Federal Reserve notes “were not used to repay member bank borrowings in any corresponding amounts.” Instead, redeposited currency “went in considerable part to build up member bank reserve balances”:
Member banks as a group . . . were content to maintain their indebtedness [to the Federal Reserve banks] at about the level it had previously attained, using funds released from circulation . . . to expand their loans, for which there was an active demand at attractive rates.
The resulting expansion of the money supply undoubtedly contributed to the boom-bust cycle of 1920-1921.
An above-market rediscount rate, a “penalty” rate, also does not ensure proper borrowing for reserve compensation. A penalty charge for funds borrowed to be kept in reserve leads to a less than optimal amount of reserve compensation, since a bank that pays penalty rates for its reserves is not, at the margin, better off than one that contracts its liabilities to make do with reserves it already has. Therefore a penalty rediscount rate is likely to lead to insufficient reserve compensation at times of expanded relative demand for currency. This conclusion applies with greatest force when increases in the relative demand for currency are expected to be long lasting or permanent.25
All of this assumes that a penalty rate or below-market rate of interest can at least be identified. In truth the variety of interest-earning assets available to banks, all with somewhat different nominal rates of interest, makes it difficult to choose a measure for “the market rate” against which the rediscount rate may be compared. As Polakoff notes (1963, 192), the existence of a distinct market rate is a peculiarity of English banking not present in other systems:
In Great Britain, it is the bill dealers and not the commercial banks that borrow directly from the Bank of England. Since the former specialize in a particular kind of asset—formerly commercial bills and now Treasury bills—and since the Bank rate is higher than the rate on bills, the discount rate in that country truly can be considered to be a penalty rate when dealers are forced to seek accommodation at the central bank.
Finally, even where some reasonable rule for setting it does exist, the rediscount rate has to be continually adjusted to reflect changes in the market rate.26
History offers many episodes of banks failing to respond to changes in the relative demand for currency. Most have been due to the failure of monopoly banks of issue to supply deposit banks with supplementary reserve media so that the deposit banks could withstand their depositors’ temporary withdrawals of currency. A few examples will help to illustrate points made in the previous section.
We have already noted an episode, which occurred in the United States in 1919, where an uncompensated shift of money demand from currency to deposits resulted in an excess supply of inside money taken as a whole. More notable and frequent, however, have been cases in which the supply of inside money has been allowed to contract excessively due to insufficient issues of currency to accommodate depositor withdrawals. In London, for instance, the Bank of England has been the sole supplier of currency since it was established in 1694. Other London banks rely upon their reserves of Bank of England notes to supply depositors’ currency needs. Through most of the first one and a half centuries of its existence the Bank of England felt no obligation to assist other bankers when they found themselves stripped of cash by a shift of demand from deposits to currency. Partly in consequence of this a series of financial crises occurred in 1763, 1772, 1783, 1793, 1797, 1826, 1836, and 1839. Every one was marked by a significant increase in the demand for currency for making payments in and around London: confidence in Bank of England notes was not lacking, and there were few demands to redeem these in specie. Nor was there any evidence of a rush to redeem country bank notes or to exchange them en masse for Bank of England notes. The problem was that country bank notes were not suitable for use in London where their issue and redemption was prohibited. A drop in the acceptability of checks and other noncurrency means of payment therefore translated entirely into greater requests for the notes of London’s sole issuing bank.
Henry Thornton (1802, 113), referring to the crisis of 1797, observed that “the distress arising in London . . . was a distress for notes of the Bank of England”:
So great was the demand for notes, that interest of money, for a few days before the suspension of payments of the bank, may be estimated . . . to have been about sixteen or seventeen per cent. per ann.
If other London banks had been allowed to issue notes the pressure might have been significantly reduced, since customers might simply have converted their deposits into notes which were also liabilities for the banks making the conversion. Then Bank of England notes would not have occupied a privileged position in bank portfolios; they would have been routinely returned to their issuer for redemption like other competitively issued liabilities. The public, in turn, would have had no special reason to demand Bank of England notes, since notes of other banks would probably have been just as useful for making payments around the city of London. As matters stood, however, the extraordinary demand for currency in London could only result in an extraordinary demand for Bank of England notes. The directors of the Bank of England were, however, concerned only with keeping it solvent; they did not manage its issues to protect other London banks or to prevent a general contraction of credit. Instead, observing the prevailing state of panic and confusion, and fearing that bank closings would generate a general loss of confidence which would threaten the Bank’s (specie) reserves, they actually contracted its issues, making matters even worse. This action was perhaps not calculated even to serve the interests of the Bank of England, but then the extent of that Bank’s involvement in the monetary affairs of the rest of the country was not fully appreciated. Indeed, although changes in the relative demand for currency were a frequent cause of what later became known as “internal drains” upon the resources of the London banks, Hayek observes in his introduction (p. 39) to Thornton’s Paper Credit of Great Britain that “it took some years . . . for the Bank of England to learn that the way to meet such an internal drain was to grant credits liberally.”
The Bank Act of 1844, although it restricted the ability of the Bank of England to generate excessive quantities of base money (as the Bank had, according to the Bullion committee, in the years following the suspension of 1797), also prevented it from making needed adjustments to the supply of currency in response to greater demand. Furthermore, by limiting the note issues of the country banks the Act caused them to employ Bank of England notes to meet depositors’ demands where before they might have been able to rely exclusively upon their own issues.
Thus after 1844 episodes of credit stringency were as frequent as before, with interest rates fluctuating in response to the periodic ebb and flow of the relative demand for currency. Rates rose every autumn—when currency was used instead of checkbook money for agricultural transactions—and also at the close of every quarter when stock dividends were paid (often in cash). Jevons was so impressed by this pattern that he devoted a lengthy article to an analysis of it (1884, 160-93). He observed the growing tendency of the London and country banks “to use the Bank of England as a bank of support, and of last resort” (ibid., 170-71).27 He remarked, in addition, that freedom of note issue along the lines of the Scottish banks was an inviting alternative means for English banks to accommodate their clients’ demands for currency, especially since additional currency issued this way would “return spontaneously as the seasons go round” (ibid., 179).28 In spite of his observations, however, Jevons did not recommend that England adopt free banking; on the contrary, he ended his article by defending the Bank of England’s quasi-monopoly of note issue, suggesting incoherently that proponents of free banking were guilty of “confusing” free banking with freedom of trade (ibid., 181).
In many ways Jevons’s opinions, except for his opposition to free banking, anticipated29 those of Walter Bagehot who, in Lombard Street (1874, 235-53) drew so much attention to the “lender of last resort” function that it came to be regarded as an official responsibility of the Bank of England and as a rationale for centralizig reserves and note—issue. Because of his influence Bagehot is sometimes viewed as the first champion of scientific central banking. Yet the truth is that Bagehot preferred in principle the “natural system” of competitive note issue—the kind of system that “would have sprung up if Government had let banking alone.” His formula for central banking was not a recommendation of monopolized note issue but an attempt to make an “anomalous,” monopolized system work tolerably well. Bagehot did not want to “propose a revolution” (1874, 67ff). Nor would he have seen any need for one—or for a lender of last resort—save for the fact that monopolization of note issue prevented banks other than the Bank of England from using their own notes to fulfill depositors’ demands for currency.30
Bagehot was aware of the true connection between monopolization of note issue and the need for a centrally directed monetary policy. Unfortunately, many of those who followed him, including later advocates of central banking, forgot it. Ralph Hawtrey wrote (1932, 285): “When a paper currency is an essential part of the monetary circulation and one bank possesses a monopoly of note issue, that bank can secure to itself the position of central bank. It can cut short the supply of currency and drive other banks to borrow directly or indirectly from it.” Precisely. Yet Hawtrey, who more than anyone saw the lender of last resort function as the principal rationale for central banking, did not see how central banks’ ability to cut short the supply of currency once they possess a monopoly of note issue creates the need for them to serve as lenders of last resort in the first place. If there is competitive note issue, the traditional argument for a lender of last resort carries much less weight.
The case of England is only the most notorious example of problems arising from a lack of currency under monopolized note issue. In Germany a law similar to the Bank Act was passed in 1875. It placed a ceiling on the note issues of the Imperial Bank, Germany’s monopoly bank of issue. According to Charles Conant (1905, 128) “high discount rates became the rule . . . as soon as the business of the country grew up to the limit of the note issue.” If banks other than the Imperial Bank had been free to issue notes this might have been avoided, because there would not have been any shortage of media to supply the growing demand for currency. There would not have been any great danger of inflation, either (as there was when the Imperial Bank took advantage of its monopoly privilege) because competitively-issued notes would not have served as base money. If issued in excess by any bank, notes would have been returned to their issuer for redemption. As it happened, interest rates in Germany did not return to normal until 1901, when “the limit of the ‘uncovered circulation’ [of Imperial Bank notes] was raised to conform to the increased needs for currency growing out of the expansion of business.”31
Another significant financial stringency caused by an uncompensated drain of currency from bank reserves was the “great contraction” in the United States from 1930 to 1932. This involved a large-scale movement from deposits to currency, which was only partly offset by Federal Reserve note issues. The result was a drastic decline in the total money stock followed by a terrible banking collapse.32
According to James Boughton and Elmus Wicker (1979, 406), this particular shift from deposits to currency was triggered by the “massive decline in income and interest rates” that began in the fall of 1929.33 That meant an increase in the relative frequency of small payments combined with a reduced opportunity cost of holding currency. Also encouraging the shift from deposits to currency were a 2 percent federal tax on checks (enacted in June 1932) and an increase from two to three cents in the postal rate for local letters (from July 1932 to June 1933), which increased the cost of paying local bills by check (ibid., 409). Finally, when state authorities began declaring bank holidays in response to insolvencies caused by currency withdrawals and loan losses, they unwittingly provoked even greater withdrawals of currency by depositors. When banks go on holiday, deposits are immobilized, and checks become practically useless in making payments. Currency can, however, still circulate while banks are temporarily closed. Therefore, any suspicion by the public that their banks will go on holiday will lead to a wholesale flight to currency as consumers rush to protect themselves against the risk of being stuck without any means for making purchases.34 The failure of the Federal authorities to provide adequate reserve compensation during this flight to currency contributed significantly to the severity of this phase of the Great Depression. It caused interest rates, which for a decade before were probably below their “natural” level, to suddenly rise substantially above it.
The American crises under the pre-Federal Reserve National Banking System were also aggravated—and in some cases perhaps caused—by restrictions on note issue by deposit banks. Here, however, the problem was not monopolization of the currency supply, since note issue was still decentralized. Instead, the currency supply was restricted by special bond-collateral requirements on National bank note issues.35 When eligible bond collateral was in short supply and commanded a premium, note issue became excessively costly. In consequence, banks sometimes met their depositors’ requests for currency by allowing them to withdraw greenbacks, a form of currency issued by the Treasury that also functioned as a reserve medium. The consequence was a contraction of total bank liabilities equal to a multiple of the lost reserves.36 That greenbacks were sometimes not available in desired, small denominations also added to the inconvenience suffered by the public.37
The problems of the pre-Federal Reserve National Banking System would have been much less severe had note issue been unrestricted, that is, had banks been able to issue notes on the same terms as they created demand deposits. Free note issue would have satisfied most customers’ currency requirements while leaving banks’ reserves in place. It also might have made it unnecessary to resort to an agency for reserve compensation such as finally emerged in the shape of the Federal Reserve System.38 As Friedman and Schwartz note in their Monetary History of the United States (1963, 295fn), the troubles of the National Banking System “resulted much less from the absence of elasticity of the total stock of money than from the absence of interconvertibility of deposits and currency.” To achieve the latter, free note issue would have been, not only adequate, but more reliable than centralized note issue.39
In all of these historical episodes undesirable changes in the total supply of money occurred as a result of changes—sometimes merely seasonal changes—in the relative demand for currency. Had it not been prohibited freedom of note issue would have gone far in eliminating this problem, and where note issue was relatively free, as it was in Scotland and Canada, the problem did not arise.40 Reliance upon a lender of last resort, on the other hand, does not get to the root of the problem, since it generally involves a monopolized currency supply which is also “inelastic” and which can be managed properly only with great difficulty, if at all.
The findings of this and the previous chapter contradict the claim that central banking is superior to free banking as a means for guaranteeing monetary equilibrium and general economic stability. But before any broad conclusion can be reached concerning the relative merits of free and central banking we must consider some other, potential shortcomings of unregulated banking. In particular we must consider the possibility that free banking may be unstable due to causes not dealt with in preceeding pages, along with the possibility that it may be inefficient. These issues are taken up in chapter 9.
Appendix: Reserve-Compensation Formulae
A. CENTRAL BANKING
The reserve ratio is defined as:
By definition, since Sp = O, (currency held by the public). Also, (since Sp and Sb = 0)
B. FREE BANKING
The reserve ratio is:
Since Bf (high-powered money) = Sp + Sb = S and Sp is assumed = 0, it follows that
By substitution, .
Stability and Efficiency
We have seen that under free banking the supply of inside money tends to be demand elastic. Changes in the price structure due to changes in the demand for money balances are avoided. To this extent the value of the monetary unit is stabilized, and events in the money market do not disturb the normal course of production and exchange. On the other hand, banking systems with centralized currency supply are not as likely to escape monetary disequilibrium and its consequences.
There are, however, three problems related to the stability of free banking that still have to be addressed. These are: unanticipated revaluation of long-term debts due to those movements in general prices that free banking would not prevent, monetary disequilibrium caused by commodity-money supply shocks, and disturbances caused by bank runs and panics. This chapter examines briefly each of these problems. After reaching a verdict as to whether free banking is stable, it turns to consider its efficiency.
Chapters 5 and 6 showed how a free banking system tends to prevent changes in the general level of prices that might arise from changes in the aggregate demand for balances of inside money. Free banks, however, do not prevent general price movements having as their source either (a) a general advance in per-capita output or productive efficiency or (b) a general decline in per-capita output or productive efficiency. This result is desirable as far as the maintenance of monetary equilibrium is concerned. But it might also involve a revaluation of long-term debts that would be contrary to the expectations and interests of debtors or creditors. If free banking is likely to frustrate the intentions of buyers and sellers of long-term debt—if it leads to frequent debtor-creditor “injustice”—then a search for some less defective alternative would be warranted.
To address the problem of debtor-creditor injustice, one must first understand how different kinds of price changes actually affect the well-being of parties on either side of a debt contract. One also has to have a definition of injustice. For the latter we may adopt the following: parties to a long-term debt contract may be said to be victims of injustice caused by price-level changes if, when the debt matures, either (a) the debtors on average find their real burden of repayment greater than what they anticipated at the time of the original contract and creditors find the real value of the sums repaid to them greater on average than what they anticipated; or (b) the creditors find the real value of the sums repaid to them smaller on average than what they anticipated and debtors find their real burden of repayment smaller than what they anticipated at the time of the original contract. When injustice occurs the parties to the debt contract, if they had had perfect foresight, would have contracted at a nominal rate of interest different from the one actually chosen.
It is not always appreciated that not all movements in the general level of prices involve injustice to debtors or creditors. Unanticipated general price movements associated with changes in per-capita output, such as could occur under free banking, do not affect the fortunes of debtors and creditors in the same, unambiguous way as do unanticipated price movements associated with monetary disequilibrium. Where price movements are due to changes in per-capita output, it is not possible to conclude that unanticipated price reductions favor creditors at the expense of debtors. Nor can it be demonstrated that unanticipated price increases favor debtors at the expense of creditors. The standard argument that unanticipated price changes are a cause of injustice is only applicable to price changes caused by unwarranted changes in money supply or by unaccommodated changes in money demand.
This is so because in one of the cases being considered aggregate per-capita output is changing, whereas in the other it is stationary. In both cases a fall in prices increases the value of the monetary unit and increases the overall burden of indebtedness, whereas a rise in prices reduces the overall burden, other things being equal. In the case where per-capita output is stationary (the monetary disequilibrium case), the analysis need go no further, and it is possible to conclude that falling prices injure debtors and help creditors and vice versa. Were parties to long-term debt contracts able to perfectly anticipate price-movements, they would, in anticipation of higher prices, contract at higher nominal rates of interest; in anticipation of lower prices they would contract at lower nominal rates of interest. In the first case the ordinary real rate of interest is increased by an inflation premium; in the latter, it is reduced by a deflation discount. These adjustments of interest rates to anticipated depreciation or appreciation of the monetary unit are named the “Fisher” effect, after Irving Fisher who discussed them in an article written just before the turn of the century.1
When per-capita output is changing, one must take into account, in addition to the Fisher effect, any intertemporal-substitution effect associated with changes in anticipated availability of future real income.2 Here (assuming no monetary disequilibrium) reduced prices are a consequence of increased real income, and increased prices are a consequence of reduced real income. Taking the former case, although the real value of long-term debts increases, debtors do not necessarily face a greater real burden of repayment since (on average) their real income has also risen. In nominal terms they are also not affected because, as distinct from the case of falling prices due to a shortage of money, their nominal income is unchanged. Thus debtors need not suffer any overall hardship: the damage done by the unanticipated fall in prices may be compensated by the advantage provided by the unanticipated growth of real income. If the parties to the debt contract had in this situation actually negotiated with the help of perfect foresight, their anticipation of reduced prices would have caused the nominal rate of interest to be reduced by a deflation discount—the Fisher effect. But their anticipation of increased real income would also reduce their valuations of future income relative to present income, raising the real component of the nominal rate of interest—the intertemporal-substitution effect. Since the Fisher effect and the intertemporal substitution effect work in opposite directions it is not clear that the perfect-foresight loan agreement would have differed from the one reached in the absence of perfect foresight—at least, the direction in which it would have differed is not obvious. So there is no reason to conclude that a monetary policy that permits prices to fall in response to increased production would prejudice the interests of debtors.
Similarly, to allow prices to rise in response to reduced per-capita output would not result in any necessary injustice to creditors, even if the price increases were not anticipated. Here the Fisher effect in a perfect-foresight agreement would be positive, and the intertemporal substitution effect would be negative, so it cannot be said a priori that the perfect-foresight nominal rate of interest would differ from the rate agreed upon in the absence of perfect foresight.
In short, as far as the avoidance of debtor-creditor injustice is concerned, free banking is not defective despite its failure to prevent all general price changes. Though it would tend to prevent price changes that might lead to debtor-creditor injustice, it would also allow price changes to occur that would not result in obvious injustice. A policy of price-level stabilization, substituted for free banking, would, on the other hand, merely be a more likely source of monetary disequilibrium, without serving to reduce instances of debtor-creditor injustice.
All this implies that monetary reform proposals aimed at achieving money of constant purchasing power are superfluous. One such proposal recommends the use of inside money that is a claim to an assortment or “basket” of commodities.3 Besides being more complicated and costly to administer, a multiple-commodity standard actually has no advantage over free banking with a single-commodity standard as a means for eliminating debtor-creditor injustice, so there is no reason for considering it.4
Commodity-Money Supply Shocks
This brings us to another criticism frequently leveled at single-commodity standards: that they are subject to “shocks” in the supply of the money commodity. In previous chapters it has been assumed that the supply of commodity money is constant. This would be a correct description of conditions under free banking if the only inducement to increase production of commodity money were an increase in its relative price, given that the complete substitution of inside money for outside money in persons’ balances makes such an increase in the relative price of commodity money unlikely.5 But increased production of commodity money may also occur because of a fall in its cost of production, due perhaps to some technological innovation or to a discovery of new sources (if the commodity is a natural resource) with lower marginal extraction costs than those already in use.
In the long run, automatic forces tend to limit cost-related changes in the output of commodity money. Michael Bordo (1984, 201) explains this in reference to gold:
A rapid increase in the output of gold due to gold discoveries or technological improvements in gold mining would raise the prices of all other goods in terms of gold, making them more profitable to produce than gold and thus ultimately leading to a reduction in gold output. Moreover, the initial reduction in the purchasing power of gold would lead to a shift in the demand for gold for nonmonetary use, thus reinforcing the output effects.
The question is, how serious are short-run shocks likely to be? There are as many potential answers to this question as there are potential money commodities. Particularly intriguing is the historical performance of the gold standard, since gold would probably have continued to serve as base money if governments in previous centuries had permitted free banking. Was the gold standard as inherently unstable as critics suggest? How does its record compare, for instance, to that of the fiat dollar?
One cannot adequately answer such questions by simply noting that gold output has fluctuated widely during the so-called gold standard era, or that changes in the relative price of gold have occurred.6 Changes in gold output may have been exogenous supply shocks or they may have come in response to shifts in the demand for gold. Only exogenous changes in output, which imply a shift in the supply schedule of gold (rather than mere movement along the supply schedule) support the conclusion that gold output has been unstable. As for changes in the relative price of gold—which are the proximate cause of endogenous changes in its supply—it is necessary to ask whether these are due to shifts in the demand schedule for gold such as might occur under free banking, or whether they are linked to the existence of centralization or other kinds of government interference. With these points in mind, let us look at the historical evidence.
Charts of world gold production since the 19th century, the first period for which fairly reliable statistics exist, show an obvious pattern of peaks and valleys, like a series of U’s strung together, usually in ascending fashion (figure 9.1). The question is, does this pattern indicate a series of supply shocks (the upward strokes of the U’s), or does it indicate a response to changes in demand?
Both theory and history show the pattern to be a response to existing demand. The economics of mining are such that at a fixed price for the mineral produced, the pattern of output that yields the greatest time-discounted income stream looks something like the interval between the troughs of two adjacent U’s. That pattern is the product of two counteracting forces. One is the rate of interest: were mining to require no capital investment, at any rate of interest greater than zero it would pay to extract ore as quickly as technologically possible so as to receive the greatest possible present income. The other force is capital investment: were the rate of interest zero, given some initial capital investment it would pay to extend the mine’s life as long as necessary to extract all the ore (assuming all of the ore to be of a uniform grade). Typically, mining does require a capital investment and the rate of interest is greater than zero, so production follows a curve that maximizes time-discounted income per unit of capital invested. It neither extracts all the ore at once nor extends the mine’s life to the maximum technologically feasible.7
Once this is understood, the claim that gold has a “backward-rising” supply curve, which supposedly detracts from its desirability as outside money, can be shown to be incorrect.8 It is true that when the price of gold goes up, gold production at first often decreases. This happens because certain factors of ore production, most notably the crushing and refining equipment, are fixed in the short run. When gold production becomes cheaper a lower grade of ore becomes newly profitable to mine; hence if the equipment is always working at full capacity, it will produce less gold than before. Were the lower-grade ore not mined then, it might never be, since a rise in production costs would make its extraction unprofitable. Any other mining strategy would also be uneconomical, for it would extract a lower time-discounted value of gold than is profitable. If the cost of production remained low, though, it would pay to bring new deposits into production, build new refineries, etc., thus increasing gold supply.
History supports the view that gold discoveries and improvements in extraction techniques are best understood as responses to increased demand for gold rather than as supply shocks. A recent, careful study of the great 19th-century gold discoveries concludes that only the California discovery of 1849 was accidental. The rest, those of Siberia (1814, 1829), eastern Australia (1851), western Australia (1889), and South Africa (1886), were results of more or less methodical searches encouraged by high real prices for gold. Even in the case of the California discovery most accounts suggest that gold would sooner or later have been found by methodical search, as prospecting was taking place elsewhere in the state.9
The major technological advance in gold mining during the 19th century was the MacArthur-Forrest process for using cyanide to leach gold from crushed ore. In some areas it increased yields as much as 50 percent. The process, first used commercially in 1889, replaced a chlorination process discovered in 1848. Both methods were developed during periods of high real prices for gold, and evidence suggests that the high real gold prices were the motivating force behind them.10
The record of gold production in this century is as free of supply shocks as that of the 19th century. The only major accidental discovery of gold was the Amazon River discovery of early 1980. Like the California discovery of 1848, this was a find of alluvial (riverbed) gold. Alluvial gold is much easier to mine than underground gold. The former takes the form of nuggets or particles that can be dredged and sifted with nothing more elaborate than a pan, whereas the latter occurs mixed in the rock with other minerals, and requires more complicated equipment to mine and separate. The cheapness of mining alluvial gold, and its quality of being less predictable in deposit size than underground gold, make it a likelier source of supply shocks. However, as the number of unexplored rivers diminishes, so does the chance of large new discoveries of alluvial gold. Most of the easily accessible gold seems to have been mined already. For this reason gold mining today is more institutional than it was in the past,11 making its supply even less prone to supply shocks.12 Recent advances in mining technology, like those of the 19th century, also seem to have been brought on by increases in the real price of gold. The carbon-in-pulp extraction process, though known in rudimentary form since the last century, was not used commercially until 1973, the year the price of gold surpassed $100 an ounce (Weston 1983, 134).
A final point to bear in mind when looking at the historical record of gold production is that during the period of the so-called classical gold standard few nations allowed completely free banking. Nor did they permit their central banks to take advantage of the true economies of fiduciary substitution. Statutory reserve requirements and prohibitions against small notes spurred much gold production that, under free banking, would never have taken place.
By far the most important source of disturbances to gold supply has been, not accidental discoveries, but political interference. The “golden avalanche” of the 1930s (as a contemporary book termed it) and the recent great increase in gold production both resulted from inflation by central banks leading to currency devaluations. In addition, the chief gold-producing nations of the 19th and 20th centuries have all taxed, regulated or subsidized the gold mining industry in ways that have systematically distorted output. Wars and revolutions, such as the Boer War of 1899-1902 in South Africa and World War II, have also affected production (ibid., 633-39).13 Still, there is no evidence that political interference has had any worse effects on gold production than it has had on the production of other commodities, on international trade, or on labor migrations; hence a gold standard is at least no worse in this respect than any other conceivable commodity standard.
Still another kind of shock to which a commodity standard may be vulnerable is a change in the nonmonetary demand for the money commodity. As fiduciary substitution becomes more complete, the consequences of such demand shocks become more serious. The extreme case is that of a pure credit banking system of the sort mentioned in chapter 2, in which there are no reserves of commodity money. As Knut Wicksell noted (1935, 125), in such a system an increase in the nonmonetary demand for the money commodity might make it necessary for banks to contract drastically their issues, forcing prices to fall so that redemption demands are checked and further production of the money commodity is encouraged. Thus, under a commodity standard the goal of preserving monetary equilibrium may come into conflict with that of achieving maximum efficiency by minimizing resource costs. (This must be kept in mind when we appraise the efficiency of free banking in section 4 below.)
Bank Runs and Panics
The above arguments concerning the long-run stability of free banking ignore the possibility of contractions and crises due to bank runs. In its broadest sense a bank run is an incident where customers of a bank turn to it en masse to convert its liabilities. There are two kinds of bank runs. One is a run to convert deposits into currency, where currency includes competitively issued bank notes. This can be called a “currency run.” The second is a run to convert deposits or competitively issued notes into high-powered money, meaning commodity money, redeemable notes of a monopoly bank of issue, or centrally issued fiat money. This can be called an “redemption run.” Because we are still assuming the existence of a commodity standard, the case of runs for fiat money will not be considered here.
The above-noted difference between a currency run and a redemption run is subtle but crucial. Arrangements satisfactory for handling increases in currency demand may be worthless when it comes to handling increases in the demand for high-powered money. On the other hand, arrangements for the emergency supply of high-powered money, while perhaps necessary to combat redemption runs, can also bring about inflation, and are therefore not desirable if all that is needed is some way to provide depositors with media for making hand-to-hand payments.
As was shown in chapter 8, there is no reason for a currency run to be a cause of stringency in a free banking system, since banks in such a system are unrestricted in their ability to issue notes in exchange for outstanding deposits. Such note issues do not affect the liquidity or solvency of banks undertaking them.
This state of affairs differs greatly from what transpires under centralized banking or wherever note issue is artificially restricted. A currency run under these conditions can easily exhaust the resources of unprivileged banks, draining them of their reserves of high-powered money. Yet the same banks might meet demands up to the full value of their deposits if they could resort to unrestricted note issue. As was shown in chapter 8, there is considerable evidence showing that many past banking crises were consequences of currency runs in the face of restrictions upon note issue.14
In addition to their other differences, there is also a big difference between the causes of a currency run and those of a redemption run. A currency run may be triggered by any event that reduces the acceptability of checks relative to currency. An example mentioned in chapter 8 was a decline in business confidence leading to greater fear of persons writing bad checks, i.e., tendering spurious claims against their bank. This risk does not exist when bank notes are tendered (provided the notes are not forgeries). Tradespeople might be perfectly willing to accept bank notes from persons whose checks they would refuse.
Redemption runs involve a loss of confidence of a much higher order. Here, it is not would-be check writers, but the banks themselves, which are suspect. When loss of confidence goes this far, freedom to issue bank notes is no solution, since a suspect bank’s notes, as well as its deposits, are equally distrusted. Until something happens to restore their confidence those who hold such liabilities will opt for nothing less than their redemption in high-powered money. If the bank in question is a monopoly bank of issue, then the run will be a run for commodity money exclusively.
A currency shortage, besides provoking a currency run, may cause a redemption run as well. If by virtue of some restriction a deposit holder seeking currency cannot be accommodated by a further issue of notes, his bank will have no alternative but to satisfy him by drawing on its reserves of high-powered money. Thus a currency run in the face of restrictions on note issue causes banks to suffer a loss of liquidity just as if the run had been for high-powered money in the first place. The loss of liquidity increases the risk that the bank will be unable to redeem its issues. If the precariousness of the bank’s position is discovered, this can in turn cause its liability holders to lose confidence in it and to convert even its notes into high-powered money. In general, however, a redemption run can occur in response to any event that liability-holders view as a threat to their bank’s net worth. Historically, war, recession, or the failure of one or more large businesses have been taken as warning signs.15
There is nothing unreasonable about this sort of behavior on the part of holders of bank liabilities. People want to avoid losses from having their savings improperly managed. Nor is it undesirable in principle that individual banks be allowed to fail: if a bank is poorly managed then it is in the best interest of consumers to have it yield its share of the market to more reliable firms. Relieved of the prospect of failure, firms in any industry are apt to become stagnant and inefficient. This is no less true of banks. Banks will be more adept at managing the supply of inside money if the worst of them are allowed to perish.
Such failures need not involve losses to those holding liabilities of failed banks. Responsibility for these liabilities could be assumed by other banks, as when an insolvent bank is liquidated by a merger with one of its rivals. This was how many Scottish and Canadian free banks, aided by the absence of restrictions on branch banking, wound up their affairs. Some holders of liabilities of Scottish banks were also protected by their banks’ shareholders being subject to unlimited liability, making them personally responsible for all of their banks’ debts. Although as many as 19 banks went out of business during the Scottish free banking era,16 their closings cost liability holders only £32,000.17
Private insurance could also protect note and deposit holders against losses due to bank failures.18 Such insurance, provided on a competitive basis, would have a distinct advantage over present government-administered insurance. Government insurance assesses individual banks using a flat-rate schedule, charging them only according to their total deposits. This procedure subsidizes high-risk banks at the expense of low-risk ones, creating a serious moral-hazard problem—itself a cause of more frequent bank failures. In contrast, profit maximizing, competing private insurers would attempt to charge every bank a premium reflecting the riskiness of its particular assets.19 While available information would be inadequate to guarantee perfect risk-pricing ex ante, premiums could be continually readjusted ex post, with the help of frequent audits. Another possibility would be combination insurance-safety fund arrangements, perhaps administered by clearinghouse associations, in which participant banks establish escrow-type accounts by depositing assets with the insurer as a condition for being insured.20 The safety-fund accounts could be continually “marked to market” to reflect loan losses, and they could be attached by the insurer whenever a failure resulted in losses exceeding amounts predicted in the original insurance estimate. Such an arrangement would be very close to the full-information ideal, which entirely eliminates subsidization of risk. Though some mismeasurement would still occur, it would not pose any more serious a problem than risk-measurement problems routinely dealt with in other private casualty insurance.
Still another private means for giving protection to bank-liability holders would involve banks protecting one another’s liabilities through a system of cross-guarantees.21 A failed bank with its liabilities guaranteed by a group of other banks could draw on the capital of those banks to the extent of its insolvency loss. Guarantees could be arranged so that no bank would be both a guarantor of and guaranteed by another bank. Such an arrangement would disperse losses widely, making the liabilities of each bank a contingent claim on the equity capital of numerous other banks. This would be similar in its effects on bank-customer confidence to the unlimited-liability provisions in Scottish free banking.
As was said in chapter 2, a free banking system also presents greater opportunities for the establishment of equity or mutual-fund type accounts with full checkability privileges. Such accounts might be offered by banks as well as by non-bank firms. To the extent that equity accounts take the place of conventional bank debt liabilities, the burden placed on private means for depositor-protection is correspondingly reduced. As regulatory restrictions (such as the Glass-Steagall Act) are phased-out, equity accounts would take up a growing share of the public’s financial holdings, and private deposit-guarantees would become more and more feasible. Many criticisms of private deposit-guarantee arrangements, based as they are on comparisons of the current value of bank or insurance-industry capital with the current value of bank debt, are therefore not relevant for assessing the merits of private guarantees in a fully deregulated banking system.
If a bank that suffers a redemption run is solvent, so that its assets, liquidated in an orderly fashion, could pay its debts, then it might be unfortunate from the point of view of consumers for the bank to fail simply because it lacked sufficient base money to pay its anxious customers on the spot. Still, a bank that is run on for any reason is likely to be unable to liquidate its assets in an orderly fashion to redeem its liabilities. It may have to sell assets in a rush, and therefore realize much less than their potential value, or else close its doors. Either way, its customers will be disappointed.
Fortunately such a bank, if it alone is distressed or if it is one of a small number of threatened banks, can seek assistance from unaffected branches of its own parent banking firm or from other banking firms, directly or through a clearinghouse. Other banks can make a profit by lending emergency funds to their troubled rivals, so long as the latter offer adequate collateral. An alternative method for dealing with isolated runs, adopted for a time by the Scottish free banks, is to have an “option clause” on circulating notes.22 Such a clause would allow notes to be paid either on demand or within six months following their original presentation for redemption, with interest paid for the length of the delay. This arrangement would permit illiquid banks to suspend payment to their customers for a period up to six months, time enough to liquidate their loans and investments, avoiding the more costly alternative of borrowing emergency funds from rivals. The option clause would resemble, and be really no more sinister than, the notice of withdrawal clauses now appended to many passbook-savings agreements. The latter are also meant to protect bankers against short-term liquidity crises.23
Of greater concern are runs that, instead of being restricted to one or a few particular banks, spread like a contagion to a large number of banks in a system. Such a rash of bank runs is called a panic. When a panic occurs, unthreatened banks may be too few in number to supply adequate emergency funds. When the entire system is in danger of collapsing, it would seem that only universal suspension or resort to an outside source of high-powered money, such as a central bank operating outside the limits of lost confidence, could offer any hope for rescue.
But why should panics ever occur? Why should liability holders suddenly lose confidence in all or many banks just because something has happened to cause a run on or the failure of one or several of them? According to one theory, panics happen because liability holders lack bank-specific information about changes in the banking systems’ total net worth. For example, they may be aware that some event has resulted in losses to certain banking firms. Yet they may lack information regarding precisely which banks are affected, because an “information externality” prevents the price system from performing its normal function of disseminating information about the riskiness of particular liabilities. In other words, panics occur when liability holders feel a need to test the safety of their balances.24
If deposits are guaranteed using some of the means discussed a moment ago, depositors would have little reason to run on their banks, and panic would likewise be curtailed. But there is reason to suspect that, under free banking, panics would be unlikely even without deposit guarantees. As Gary Gorton has shown in several articles (Gorton 1985a, 1985c; Gorton and Mullineaux 1985), in a market where bank liabilities are competitively bought and sold there would not be any risk-information externality. Note and deposit exchange rates would reflect potentials for capital losses depending on the soundness of underlying bank loans and investments. Chapter 2 showed how note brokerage systematically eliminates note-discounting except when it is based on risk-default generally acknowledged by professional note dealers, including banks themselves. In short, note brokerage produces information on bank-specific risk. With such information available to depositors, no information externality could cause bank runs to spread indiscriminantly through a banking system. After confirming through the newspaper that there is no discount on the notes he holds, a bank customer would feel no urge to redeem them in a hurry. Gorton also points out that, even though no distinct secondary (arbitrage) market exists for the risk-pricing of deposit liabilities,25 so long as notes and deposits of any one bank are backed by the same asset portfolio (as would be the case under free banking) the existence of a secondary note market provides depositors with all the information required to prevent them from staging a redemption run.
Thus under free banking no risk-information externality problem would arise. This may explain why failure of individual banks never precipitated general runs either in the Scottish free banking system or in Canada during the period when its banks engaged in relatively unregulated note issue.
In the United States, on the other hand, there have been banking panics, not only since 1914 (when plural note issue was eliminated), but also throughout the 19th century when many banks issued notes. Obviously the secondary market for notes in this case failed to be a useful indicator of bank-specific risk. There were at least three reasons for this, all of them connected to legislative restrictions: (a) the requirement of special asset backing for note issues, (b) the consequent non-price rationed deficiency of the note supply relative to the demand for currency, and (c) the requirement, after 1866, of mandatory par note acceptance by all nationally chartered banks, which were at the time the only banks able to issue notes. Under the bond collateral laws, beginning with the misleadingly named “free banking” laws passed in many states after 1837, deposits of special bond-collateral were required to secure bank-note issues. Since the special collateral applied to notes only (and not to deposits), risk premiums attached to notes did not always reflect the riskiness of deposits. Therefore, in the case of deposit liabilities, an information externality still existed. Holders of these liabilities could not rely on price signals from the note market as guides to the safety of portfolios backing their balances. The Panic of 1857 occurred under these circumstances, and, as might be expected, the evidence suggests that it began as a panic of deposit holders which note holders subsequently joined.26
The currency shortages that plagued the National Banking System caused varying premiums to be placed on notes of all kinds, interfering with the ability of note prices to indicate changes in the riskiness of underlying bank portfolios. This must also have contributed to risk-information externalities. Finally, the forced par acceptance of post-Civil War currency mandated by the government to prevent discounting of greenbacks (which were unredeemable at the time of their issue) short-circuited the secondary market for bank notes, ending any remaining possibility for efficient pricing of bank-specific risk. Market prices failed to reflect, even in rough fashion, the expected value of risky redemption promises.
These are some compelling reasons for viewing banking panics, not as phenomena likely to occur under unregulated banking, but rather as events caused by interference with the natural development of note issue and note exchange.
The Efficiency of Free Banking
Opponents of commodity standards, and of the gold standard in particular, often criticize them as being inefficient. They deplore the wastefulness of expending resources in producing commodity money, such as in gold mining, pointing out that, were there some other monetary standard (usually a fiat standard), these resources could be used to satisfy other wants. Three quotations from influential sources, one by a banker financier of the 18th century and the others by economists of this century, illustrate the persistence and respectability of this line of reasoning:
all this part [that is, all the gold and silver in monetary use] has been withdrawn from ordinary commerce by a law for which there were reasons under the old government, but which is a disadvantage in itself. It is as if a part of the wool or silk in the kingdom were set aside to make exchange tokens: would it not be more commodious if these were given over to their natural use, and the exchange tokens made of materials which in themselves serve no useful purpose?27
gold mines are of the greatest value and importance to civilization. Just as wars have been the only form of large-scale loan expenditure which statesmen have thought justifiable, so gold-mining has been the only pretext for digging holes in the ground which has recommended itself to bankers as sound finance; and each of these activities has played its part in progress—failing something better.28
The fundamental defect of a commodity standard, from the point of view of society as a whole, is that it requires the use of real resources to add to the stock of money. People must work hard to dig something out of the ground in one place—to dig gold out of the ground in south Africa—in order to rebury it in Fort Knox, or some similar place.29
Since the hypothetical free banking system we have so far been concerned with is based on a commodity standard, do these criticisms apply to it? In answer it must be noted that, although free banking may require the existence of some base money,30 it also promotes maximum fiduciary substitution—the replacement of base money with unbacked inside money—given the constraint that inside money must continue to be redeemable in base money. By allowing any increased demand for money balances to be met through an increased supply of inside money, free banking minimizes the devotion of resources to production of the base-money commodity.
Given this arrangement, would-be investments in commodity money—such as might take place if bank money had to be backed by 100 percent reserves—are translated into increased loanable funds. This, as was shown in chapter 2, is the principal economic advantage of fractional-reserve banking. The extent to which commodity money is economized also tends to increase as the banking system develops over time. This happens because of the economies of scale in reserve holding (especially marked in systems with branch banking) and because of improvements in clearing arrangements and practices. The latter improvements are made so long as their marginal contribution to bank revenues, through their incremental effects on the size of the loan fund, exceed their marginal costs, including costs associated with any increased risk of non-payment of clearing balances.
When these considerations are taken into account, the costs of maintaining a commodity standard under free banking are seen to be much lower than those of maintaining the same standard in a more restrictive system. This can be illustrated for the case of the gold standard. Perhaps the most widely-accepted estimate of the cost of a gold standard is Milton Friedman’s estimate (1960, 104fn), which claims that the cost of a pure gold standard would be approximately 2.5 percent of net national product, based on figures from 1960. But this result assumes that banks hold gold reserves equal to 100 percent of their liabilities. Past experience suggests that the reserve ratio under free banking would be closer to 2 percent.31 Lawrence H. White (1984d, 148-49fn), using 1982 figures together with facts relating to the Scottish free banking episode, derives an alternative estimate of the proportion of GNP which, under free banking, would be devoted to production of monetary gold. He arrives at a figure of 0.014 percent. Even this is too high, however, since it assumes that the public would keep gold coin in circulation costing about 0.010 percent of GNP to produce. If free banks are not hampered (as they were in Scotland) by prohibitions against small notes, the tendency would be for less gold to circulate. Finally, White also assumes that monetary gold production would increase along with the demand for inside money; but since complete reliance by the public on inside money makes this unnecessary, even 0.004 percent of GNP is probably too high an estimate of the resource costs of a free banking gold standard.
A well-developed free-banking system, rather than divert resources into production of commodity money, can function on whatever stock of commodity money happens to be available in bank reserves; it does not promote production of commodity money, since it is not a source of upward pressure on the relative price of the money commodity. Ideally, then, the annual resource cost of a free-banking commodity standard would be close to zero, if only the costs of acquiring additional sums of commodity money are considered. Remaining costs would be sunk costs, and these could even diminish as further fiduciary substitution permits more of the reserve base to be released for industrial uses and for export.
There is no reason to believe that a central-bank commodity standard would be more efficient than one based on free banking. Insofar as central banks are likely to be a source of monetary disequilibrium they would tend to raise resource costs unnecessarily. When a central bank underissues, it directly stimulates production of commodity money by causing the relative price of commodity money to rise. When a central bank overissues, it at first diverts industrial and other nonmonetary demands from regular sources of commodity money to its own redemption counter. But this must eventually force it to contract. Therefore any temporary savings from reduced production of commodity money are illusory, whereas the costs of monetary disequilibrium due to the ensuing disruption of economic activity are very real.
Even if opponents of a free-banking commodity standard concede that the costs from using commodity money may all be sunk costs, they can still point to the ongoing costs of storing gold in bank vaults rather than selling it for nonmonetary use. Based on this they may argue that an inconvertible fiat standard could be less costly than any commodity-money standard, including a free-banking commodity-money standard. But there are other opportunity costs besides the cost of commodity money that make the switch from a commodity standard to fiat money so unattractive that it has rarely, if ever, been made without coercion. If experience teaches anything, it teaches that there are tremendous costs to a fiat-money regime, mainly in the form of inappropriate responses to changes in the demand for inside money and the disruptions and business cycles they cause. Trying to save resources by forcing a switch from a commodity standard to a fiat standard is like trying to save resources by forcing people to take off the locks on their doors and give them to scrap-metal dealers. It is obvious that the cost of making locks is far less than the cost of losing one’s property. The same is true of the cost of holding claims redeemable in commodity money. If consumers were willing to accept a fiat standard voluntarily, banks could induce them to do so by offering higher interest rates than competitors who still held commodity-money reserves, reflecting the lower operating costs of not having to hold non-interest earning assets. If this does not happen, one must conclude that consumers perceive a commodity standard as a higher-quality good than a fiat standard.32
A further disadvantage of a forced fiat standard is that, like a central-bank-based commodity standard, it is actually likely to increase the resources devoted to production of commodity money. It may do so by creating a new motive for holding commodity money that would not exist under a commodity standard—the speculative demand to hold commodity money against the possibility of a fall in the fiat currency’s value.33 That fiat money may be issued costlessly, because it is not a liability but rather a form of wealth to its issuers, does not merely present possibilities for greater economy: it also acts as a temptation to the issuers. Informed by the great inflations of history, the public is not blind to this, and it takes appropriate precautions. The experience with gold in the 1930s and in the years since 1968 amply illustrate this truth. In both periods steps were taken to limit the convertibility of inside money, and gold jumped up in price—from $20.67 to $35 an ounce in the 1930s, and from $35 to $42.50 and as high as $850 since 1968. Gold production also shot up.34 In the most recent episode of currency devaluation, huge futures markets in gold have sprung up where none existed before, resulting in an estimated additional demand of several million ounces of gold just for clearing contracts that are rarely held for delivery. In short, recent history suggests that substantially more resources are being devoted to “digging for gold in order to bury it again” than in the days when persons could place their confidence in claims supposed to be redeemable in gold. In the face of such palpable evidence of the increase in resources devoted to gold production (and to the building of organized futures markets and other inflation-inspired institutions) it is ludicrous to maintain that a forced fiat standard is less costly than a gold standard.35
Although its arguments have been in defense of gold, this chapter is not aimed at advocating a return to the gold standard. Nor should it be interpreted as saying that any sort of commodity standard is desirable. Its purpose has been to show that the traditional view that commodity standards are inherently unstable and inefficient is not necessarily valid, especially as regards a free-banking commodity standard. Nevertheless, free banking does not have to be based on a reproducible commodity money. It can also be based on any generally accepted, noncommodity medium of exchange, such as fiat currency. Such an arrangement is considered in chapter 11, where a possible free banking reform is outlined. In the proposed reform there is no possibility of a base-money supply shock. Furthermore, the opportunity costs of maintaining a stock of fiat base money are zero, so it is inconceivable even in theory that replacement of inside money convertible in it with inconvertible paper could produce any savings whatsoever.
Miscellaneous Criticisms of Free Banking
The preceding chapters addressed the major, traditional criticisms of free banking. They showed that free banking is not inflationary, that it does not promote monetary disequilibrium, that it does not allow undesirable fluctuations in the value of money, that it is not otherwise unstable or especially subject to runs and panics, and that it does not use resources inefficiently.
But some criticisms of free banking still need to be discussed. Many lack substance, being products of conventional wisdom. Other, more sophisticated criticisms are that free banking encourages fraud, that it inhibits economic growth, that it is inconsistent with full employment, that note issue is a natural monopoly, that the production of money is a public good, that there are externalities in the production or consumption of money that cause its competitive supply to be deficient or excessive, and that a banking system needs a lender of last resort. Finally, some criticisms of free banking are based on considerations of expediency; they refer, not to any theoretical shortcoming of free banking, but to the claim that free banking is unpopular, politically unacceptable, or difficult to implement and hence impractical as a means of reform.
Criticisms from Conventional Wisdom
The first criticism we must consider, based on conventional wisdom, holds that free banking cannot be desirable because, were it desirable, it would have been adopted long ago; at least there would be no such widespread support for central banking as currently exists among theorists and policy makers.1 This poses a form of argument by authority, and would not merit attention were it not the major reason why free banking is not considered a serious alternative for monetary reform.
In response it must be said that the vast majority of economists, including monetary economists, have never given serious thought to the possibility of free banking: they take centralization for granted, not because they have compared it with free banking and found it superior, but because they are unfamiliar with free banking and because they prefer to study money and banking as they find them in economies today. Also, economists are prone to make the unwarranted assumption that legislation and institutions are generally sponsored by considerations of social welfare. The truth, as we have seen, is that many central banks are an outgrowth of monopoly banks of issue established by governments anxious to monetize their debt but not particularly interested in promoting monetary stability. Furthermore, in many places centralized banking prevailed only after a struggle, with respectable theorists participating on both sides.2
A related criticism holds that central banking has triumphed because free banking has historically failed to work. This claim, as chapter 1 showed, is simply false. Though episodes of free banking have been rare in history, where they occurred (as in Scotland, Sweden, China and, to a less complete extent, Canada) the evidence does not indicate that they were replaced because they were not functioning well. On the contrary, the record of these systems was quite favorable. The test they failed was political, not economic.
Banking in the United States in the first half of the 19th century is often cited as an instance of the failure of laissez faire. This, too, is incorrect: the free banks that are supposed to have performed so poorly throughout this era were not truly free at all.3 They are more accurately called “bond deposit” banks because of the special security needed for their note issues. State laws also prohibited them from forming branch networks that would have added to their stability and efficiency. Comparing the theoretical implications of these restrictions to the actual performance of America’s “free” banks shows the U.S. episode to be evidence, not of the shortcomings of free banking, but of the shortcomings of regulations.
Another common argument against free banking is that note issue is a government prerogative. Drawing a parallel with coinage, the argument claims that, because coinage has everywhere for centuries been a prerogative of government, the issue of currency should also be subject to government control. But the analogy to coinage is not persuasive. Even if governments must monopolize the production of coins it does not follow that they must monopolize currency. Otherwise one might with equal reason argue that the government should monopolize the production of checkable deposits and other financial assets, since these have as much in common with paper currency as it has with coin. Of course, very few theorists argue for nationalization of deposit banking. They see a crucial difference between deposits and bank notes. Still, it must be shown that the difference is crucial enough to warrant nationalization of one but not the other, and a mere analogy with coinage does not do this.
Even if the analogy of bank notes with coin were airtight, it would justify nationalization of currency production only if the government’s coinage prerogative were itself justified. Yet no convincing argument exists to show that private coinage is inefficient. Jevons’s argument for government coinage—one of the only attempts to give theoretical justification to this institution—which criticized Herbert Spencer’s defense of private coinage,4 is based on a misunderstanding of Gresham’s Law. Jevons (1882, 64-65) wrote that “if coining were left free, those who sold light coins at reduced prices would drive the best trade.” He failed to see that there is no more reason for sellers “of light coins at reduced prices” to be preferred to sellers of heavier coins at higher prices than there is for sellers of milk at 75¢ a quart to be preferred to those selling it at $1.50 a half-gallon. If consumers show a preference in such cases, it must be for size rather than quality. Such preferences have nothing to do with Gresham’s Law that “bad money will drive out good money,” to which Jevons tried to appeal. Indeed, it is only when light coins do not sell at reduced prices relative to heavy coins—that is, if their exchange rates are not allowed to reflect their lower metallic content—that Gresham’s Law takes effect. This would not happen in a free market where exchange rates reflect consumer preferences.
Empirical evidence also disputes the argument that governments must monopolize production of coin. As we observed in chapter 2, the first coins were produced by private mints rather than governments, and there is no evidence that government issues when they appeared were superior to private ones.5 Instead, the government prerogative in coinage required the use of force to outlaw private competitors whose issues the public preferred.
The coinage monopoly of the United States government has been challenged on several occasions. The gold coins of Templeton Reid of Georgia—which actually had a bullion value slightly above their face value—and the gold Bechtler coins of North Carolina—minted in the 1830s and still in circulation half a century later—competed successfully with coins produced by nearby Federal rivals, and the Bechtler coinage (over three million dollars worth) was for some time the favored money of the mid-Atlantic states.6 During the California gold rush at least fifteen private mints struck coins to satisfy a demand that would otherwise have gone unfulfilled due to the absence of any government mint. Some of them produced inferior coin, but those that did so fell rapidly into disrepute and were outcompeted by other firms such as Moffat & Co., Kellogg & Co., and Wass, Molitor & Co. The latter firms enjoyed excellent reputations (in addition to tacit government approval) even though private coinage had become a misdemeanor in California law after April 1850 (Adams 1913, xii).
One of the last American private mints, Clark, Gruber & Co., operated between 1860 and 1862 and produced high-quality gold coins often superior to United States coins of like denomination. In its two years of existence, it produced approximately $3,000,000 of coin and threatened to rob the Federal mints of a substantial part of their market. To guard against this the government bought the mint out in 1863 for $25,000 (Watner 1976, 27-28). Two years later the Federal government passed a law prohibiting all private coinage.
Fraud and Counterfeiting
A more substantive argument against free banking is that it is prone to fraud. Thomas Tooke, in his History of Prices, endorsed the opinion of an anonymous American writer that “free trade in banking is synonymous with free trade in swindling” (Tooke 1840, 205).7 Milton Friedman, who has since modified his views on this subject, was only slightly more charitable in A Program for Monetary Stability. He claimed that bank note contracts “are peculiarly difficult to enforce”:
The very performance of its central function requires money to be generally acceptable and to pass from hand to hand. As a result, individuals may be led to enter into contracts with persons far removed in space and acquaintance, and a long period may elapse between the issue of a promise and the demand for its fulfilment. In fraud as in other activities, opportunities for profit are not likely to go unexploited. A fiduciary currency is therefore likely . . . to be overissued.8
To support his argument, Friedman referred to the occurance of fraud during the so-called “free banking” era in the U. S. We have already seen why many inferences concerning free banking drawn from this episode are inappropriate: American “free banks” were regulated bond-deposit banks, and bond-deposit requirements, rather than anything inherent in free banking, were responsible for the worst episodes of fraud.9
The substance of Friedman’s argument is also defective. It seems to say that because money (i.e., commodity money) must be generally acceptable, so must bank notes. It is true that banks, in order to stay in the business of note issue, must establish a fairly wide market for their notes, but no bank when it first begins business is presented with such a market as a given. Every bank must slowly construct a market for its notes by consistently honoring its promises. Some banks might establish their reliability in the businesses of lending and deposit administration, using this as a way of securing entry into the market for notes. In any event a bank is likely to have to make a considerable investment in brand-name capital before its notes can travel to persons “far removed in space and acquaintance” who will unhesitatingly accept them. The circumstances are not especially favorable to fraud. This is not to say that fraud will not take place, but only that there is no reason to believe that it will happen more regularly than in a system of deposit banks. Indeed, the danger of fraud is likely to be greatest under monopolized banking: a monopoly bank of issue can defraud its customers with impunity, especially if it is aided by a suspension of payment sanctioned by the government. History bears evidence to this time after time.
Connected to the idea that free banks will be prone to fraud is the belief that their notes, once issued, will circulate for long periods before being returned as clearings which will test the reliability of their issuer.10 This delay between issue and reflux is supposed to invite swindlers, who can use it as an opportunity to escape to some far-off hideaway.
This argument compounds the error of assuming that bank notes of uncertain reputation are readily put into circulation by suggesting that their acceptance will be so general that few persons will discriminate against them by exchanging them for liabilities of other banks. But passive acceptance is not likely to take place where note issue is competitive, even for the notes of well-established banks: diverse consumer preferences as regards notes from various issuers will cause the average circulation period for notes of any single issuer to be fairly short. In 1873 (when, due to the influence of the Bank Act, the Scottish system was undergoing substantial consolidation) the average period of circulation for a Scottish bank note was still only 10 or 11 days (Somers 1873, 161). It may have been even shorter at the height of the free-banking era, when Scotland had twice as many note-issuing institutions. If one considers the same degree of competition combined with modern means of communication and transport it is easy to see how the delay would be still shorter. In fact, for note issues in excess of demand there is no reason to assume a delay or float period exceeding the average float period for checks written in an unregulated system. The error of authors who assume that notes would behave differently may stem from improper generalization from the behavior of currency in a centralized system. The currency of a monopoly bank of issue will be returned to its source less frequently than currencies that are not high-powered money.
That competitively issued notes would have brief circulation periods also undermines the charge that free banking would promote counterfeiting, a particular form of fraudulant note issue. The likelihood of detection of counterfeit notes is inversely related to their average period of circulation. It rises with the frequency with which the notes pass under the specially trained eyes of tellers at the legitimate bank of issue. Counterfeiting should therefore be less lucrative and less tempting under free banking than under monopolized note issue. Experience confirms this. According to Emmanuel Coppieters, during the free-banking era Scottish bank notes, which had a short period of circulation, were rarely forged or counterfeited, whereas Bank of England notes—which circulated for long average periods or even indefinitely—were forged continually.11
A final argument concerning fraud claims that sellers of goods or services cannot possibly scrutinize all the notes offered to them in exchange, even though they are bound to accept notes that are not really familiar to them. This is supposed to invite overissue.12 This argument misconstrues the nature of the checks against overissue under free banking. Individuals do not need to keep informed of the reliability and solvency of all the diverse banks of issue whose notes might be offered to them. They only need to be convinced of the reliability and solvency of the bank with which they do most of their business, and to accept at par in addition to that bank’s notes only those notes that it will accept (for deposit or redemption) at par.13 Thus proximate responsibility for the testing or monitoring of note issues falls, not upon the public, but upon the rival issuers themselves. That no non-bank individual wishes to take on this task does not, therefore, mean that it is a public good which the private market would not supply.14
Restriction of Economic Growth and Full Employment
Another argument sometimes made against free banking is that it may restrict economic growth.15 F. Crouzet (1972, 46fn), in disputing the claims of Rondo Cameron, has claimed that this was the case in the Scottish system.16 But his claim has been convincingly answered by Munn in the latter’s study of the provincial banking companies (1981, 229-33). Even the halfhearted American experiment in “free banking”—with all its restrictions against branch banking and note issue—does not seem to have frustrated economic growth in any discernible way.17 New England, which for most of the first half of the 19th century had the least regulated banking system in the U.S., witnessed the greatest industrial progress. Sweden and Canada also prospered during the era when their banks were relatively unregulated and free to issue notes. Freedom of note issue seems, if anything, to promote economic growth.
Still, examples from history do not completely settle the issue. The real question is whether the amount of lending and investment financed by a free banking system would be greater or less than it ought to be to promote maximum sustainable economic growth. Most theorists agree that a banking system should utilize all voluntary savings made available to it, without creating credit in excess of voluntary savings which causes monetary disequilibrium.18 The limits of a banking system’s contribution to economic growth then become a function of its efficiency in attracting and investing private savings. We have already seen in the last part of chapter 4 that free note issue does not interfere with the efficiency of intermediation. We may conclude from this that free banks do not inhibit economic growth, either.19
Related to the issue of economic growth is that of full employment. Earlier it was shown that free banking maintains equilibrium in the market for inside money. For this to be regarded as inconsistent with full employment the latter must be supposed to require either deflation, meaning changes in the supply of inside money such as will result in sustained excess demand for it, or inflation, meaning changes in supply such as will result in sustained excess supply. No economists believe that full employment requires deflation. Some Keynesians do believe that it requires inflation. Their views have, however, been the object of mounting criticisms by economists of the Monetarist, New Classical (Rational Expectations), and Austrian schools.20 These theorists have pointed out that the alleged inflation-unemployment tradeoff to which many Keynesians refer assumes that firms or their employees suffer from long-run money illusion. Such a dubious assumption does not constitute a strong basis for rejecting free banking.21
Money Supply as Natural Monopoly
Another argument against free banking holds that the issue of currency is a natural monopoly.22 This implies that a single banking firm is more efficient in supplying the demand for currency than any combination of smaller firms. But once a firm achieves a monopoly of currency supply, its issues are not limited by adverse clearings, and it can exploit its monopoly of currency supply by overissuing. Therefore the monopoly bank has to be regulated, or a government-controlled bank has to be erected in its place.
Although a monopoly in currency supply allows the monopoly bank to escape adverse clearings in the short run, for such a monopoly to be “natural,” that is, for it to represent a stable market equilibrium, it must be able to maintain its notes in circulation more efficiently than rival firms in an environment of free entry where adverse clearings result in demands for its reserves. In other words, the average costs of maintaining notes in circulation, i.e., of building a market for currency holding by the public so that adverse clearings are avoided, must be declining with scale or at least subadditive.23 For a single bank to gain a monopoly of note issue it is not sufficient that banking involve substantial fixed costs, with relatively small marginal costs, from issuing additional notes. The bank must also take steps to improve the popularity of its notes relative to commodity money or relative to notes of other banks, or it must suffer the expense of redeeming them soon after their issue. If the costs to the bank of extending the market or of redemption rise rapidly enough at the margin,24 its average costs per unit of outstanding currency will rise above the minimum level long before the point at which it would saturate the market for currency. In this case the industry cannot be considered a natural monopoly, and no single firm will be able to avoid the consequences of rivals establishing their own circulations and returning its excess notes to it for redemption.
An error sometimes committed in considering the natural monopoly question is to assume that the only marginal costs of currency issue are the cost of paper and ink, which do not rise significantly at the margin and may even fall due to economies of large-scale purchasing. This implies that banks face an inexhaustible demand for their notes, or that they will not be asked to redeem them in base money. But, where notes are convertible, this can happen only if the issuer has a monopoly of currency supply to begin with—one based, for example, on special legislation prohibiting the entry of other note-issuing banks that might redeem their rival’s issues.25 To assume the existence of a monopoly in currency supply in order to explain its “natural” occurrence obviously begs the question.
Allowing that there are costs of maintaining a note circulation (including, but not limited to, marketing and liquidity costs) which individual firms must reckon with, the possibility of natural monopoly still exists, but its plausibility is much diminished. There is no strong a priori case for the view that competition in currency supply will lead to the emergence of a single bank of issue.
What, then, does the empirical evidence suggest? Simply this: that throughout the experience of both Europe and America the tendency under unrestricted entry has always been toward a plurality of note-issuing banks.26 The appearance of monopoly banks of issue in these areas has in every instance been due to legislation restraining rival issuers by limiting their issues, imposing special capitalization or geographical constraints upon them, setting up barriers to new entry, or overtly and directly forcing them out of the issue business altogether. Where such measures were not taken no obvious tendencies toward monopolization were seen.27
Even if the natural monopoly argument were valid it would not justify erecting barriers to entry in the note-issue business. If the issue of currency is indeed a natural monopoly the monopoly bank should be be able to employ its advantage in production (an advantage which it must maintain even as competitors threaten to return its issues for redemption) to discourage or outcompete any rival that might enter into competition with it.28 In the meantime, the potential entrants encourage the monopoly issuer to operate as efficiently as possible while standing ready to supplement its output in case it should fail to fulfill entirely the needs of the public.
To support their claim that currency production is a natural monopoly, which to them constitutes a rationale for limiting entry into the business of note issue, Michael Melvin (1984, 13-14) and Benjamin Klein (1978) argue that confidence building is more costly for private issuers than it is for government. Melvin writes that “the history of money production observed over the past 2,000 years is likely due to economic efficiency and not to 2,000 years of ignorance or coercion.” Despite what Melvin considers likely, the facts show that government monopolies in money production have everywhere been achieved by coercion: governments have outlawed private coinage, passed forced-tender laws, restricted private and incorporated banking, prohibited branch banking and note exchange, taxed bank notes out of existence, passed bond-deposit legislation, refused to enforce redemption contracts, and imposed exchange controls. All of these measures discouraged private, competitive production of money while encouraging production by governments. Most were undertaken to aid the monetization of government debt, which means they were undertaken precisely because confidence in governments was too low to allow them to obtain funds through normal channels.
Nor has confidence in government currencies been enhanced by their performance over time. The record of all has been one of eventual depreciation. Examples of government-issued currency out-competing privately issued ones without having to outlaw or otherwise restrict them are rare.29 Yet there have been numerous episodes in which private currencies have competed successfully with state issued ones. For instance, the American state-bank note issues of 1863-1865 competed successfully against greenbacks and against the government-bond based issues of nationally chartered banks. The government responded to this successful competition by imposing a prohibitive 10 percent tax on state bank notes. Another example is the plural note-issue episode of Sweden, in which private issues, despite barriers thrown in their way by the Swedish government, successfully challenged the note-issue monopoly of the Riksbank.30
If the reasoning of Klein and Melvin proves anything at all, it proves too much, because most of the costs expended by note-issuing private banks in gaining the confidence of potential customers are also expended by deposit banks: once a bank has established the reliability of its checkable deposits the additional costs of building confidence in its note-issues are not especially great. If governments are more efficient in building confidence, why restrict their prerogative to currency issue? Why not extend it to deposit banking as well? By the same token, why permit traveler’s checks to be competitively supplied if the government should be able to supply them at lower cost?
Yet another point against the natural monopoly argument is that, if it is valid, another argument used historically to justify government regulation and monopolization of currency supply must necessarily be false. This is the argument that free banking leads to a proliferation of banks of issue and to a bewildering variety of note brands. If the natural monopoly argument is correct, then multiplication of bank-note brands could not be a long-run consequence of free banking.
Finally, mention should be made of the view that money production is shown to be a natural monopoly by the fact that consumers benefit from having a common medium of exchange. This confuses two issues, one being whether the market tends to adopt a single unit of account (e.g., an ounce of gold or a pound of silver) and the other being whether the production or issue of material representatives of this standard unit is most efficiently undertaken by one or several firms. Our review of the evolution of money in chapter 2 made clear that adoption of a single standard monetary unit does not imply that production of money is a natural monopoly. The relation between the monetary unit and actual money—its material representatives—can be likened to that of a standard unit of length, such as the yard, and its material embodiment, the yardstick. The yard is a standard unit of measurement throughout the United States; one can call this a “natural monopoly” if one likes, but such a label would be irrelevant since yards are not objects of production or exchange, and what is not produced or exchanged cannot be produced or exchanged inefficiently, by a monopoly or otherwise. The same is true of other standards—such as shoe sizes and rules of spelling. Only when it comes to material embodiments of these standards, namely, yardsticks, shoes, and dictionaries—does the question of natural monopoly arise. In the case of money, it is evident that the existence of a gold standard does not mean that gold coin, and media convertible into gold coin, cannot be competitively produced. The mere fact that the market promotes the emergence of a single monetary standard does not give any validity whatsoever to the natural monopoly argument.
Public Good and Externality Arguments
Two more criticisms of free banking are closely related to the natural monopoly argument. One holds that inside money (and currency especially) is a public good because it exhibits either non-rivalrousness or nonexcludability in consumption, which make its private production in desired quantities unprofitable and hence impossible.31 The other holds that there are externalities in inside-money production because (a) producers do not bear all the costs of it, so that profit-maximizing competitive producers will issue more inside money than the amount that equates marginal social cost with marginal revenues; or (b) that benefits from inside-money issue are not fully reflected in bank earnings, so that competing issuers will underproduce.32
Is it true that inside money exhibits nonexcludability in consumption, so that some people may act as “free riders,” sharing in the benefits from money balances that others have made sacrifices to acquire? Is the use of inside money by any one person nonrivalrous, so that others beside him enjoy the yield of services accruing from his balance (but without reducing his own return)? The answer in both cases is no, because a particular sum of inside money renders its service—increased purchasing opportunities—only to those who actually possess it. Those who refuse to do without other forms of wealth or who do not abstain from consumption (by holding inside money instead of consuming a flow of services from goods) cannot take advantage of the benefits associated with inside money. Of course, the same cannot be said of the standard money unit (the unit of account). But we have already seen that this is irrelevant, since the money unit is not itself an object of production, and since, in any event, the market (rather than government) was responsible for the original emergence of widely used monetary standards.33
Are there, then, costs associated with the issue of inside money that are not borne by competitive suppliers and which therefore imply competitive overproduction? Some possibilities that come to mind are costs of monetary disequilibrium, price-level effects, and fallen confidence. We have already seen in chapters 3 through 9 that free banking promotes neither monetary disequilibrium nor confidence externalities. Moreover, if confidence externalities did arise under free banking they would not necessarily be Pareto-relevant: each bank has an incentive, under the circumstance, to support any solvent rival suffering a run. In this case the externality is appropriable, which means that it is not Pareto-relevant—that is, not a source of market failure—and hence not grounds for rejecting free banking.34 Those price-level effects that free banking would allow are also not Pareto-relevant, so they do not provide a rationale for regulation either.35
Another possible criticism of free banking comes from Milton Friedman’s “optimum quantity of money” argument.36 This holds that the benefits from money holding are maximized when the marginal gain from money holding (the nonpecuniary service yield from an addition to money balances) is just equal to the marginal social costs of producing money balances, which are assumed to be close to zero. But the private cost of adding to money balances is equal to the interest rate on alternative assets, which typically exceeds the near-zero social costs of money production. Under such conditions the public will hold a less than optimal quantity of money. As Friedman observes, the problem can be seen as involving external effects of money holding, since individuals must forego real resources to add to their balances, but produce a windfall gain to other money holders in doing so.
To induce the public to hold an optimal quantity of money, steps have to be taken to eliminate the discrepency between the equilibrium marginal service (liquidity) yield from holding money balances (L) and the social cost of producing such balances (assumed = 0). If rc is the rate of interest on alternative, non-money assets, the suboptimal solution is where L = rc > 0. On the other hand, money holdings will be optimal only if L = 0. The latter result can be achieved in two ways, either of which involves supplementing the nonpecuniary service yield on money holdings with some additional pecuniary return. In the solution recommended by Friedman the additional return takes the form of a capital gain on money holdings, based on a fully anticipated, steady rate of price deflation equal to the real rate of interest on capital . In equilibrium this gives
The other solution is to pay explicit interest to money holders (rm), with the level of prices assumed unchanging, equal to the rate of interest on capital (rc) minus any costs of administering and maintaining the money supply (here assumed = 0). In equilibrium this gives
L = rc - rm = 0.
In the first solution, the addition to real money balances is accomplished by “crying down prices” with a fixed nominal money supply. In the second, the increase consists of an addition to nominal money holdings, with prices unchanged.
The question is, does a free-banking system succeed in promoting optimal money holding by either of these means? The answer is that it succeeds in part, but perhaps not entirely. Only inside money is held in a mature free-banking system, and a large fraction of this money is deposit money. Free banks are driven to pay competitive rates of interest on such deposits, which prevents the deposits from being held in suboptimal quantities.37 This leaves the possibility that bank notes will be held in suboptimal quantities. The problem here is that payment of interest on notes is likely to be impossible because of the high transaction costs involved. Free banks might resort to clever means for getting around this, which would entirely solve the suboptimality problem.38 But suppose they cannot. Then the private cost of holding bank notes would exceed the social costs, and free banks would, in Harry Johnson’s words, “tend to produce a socially nonoptimum overalloction of resources to the provision of deposit money and underallocation of resources to the provision of currency for holding.”
In short, there would be a suboptimal quantity of bank notes, but the loss from this would be partly offset by a supra optimal quantity of deposits. The only net loss would be that stemming from any inelasticity of substitution between deposits and notes. According to Johnson (1973a, 142) this net loss “would probably be a negligible fraction of national income.”
Could government intervention do better? Insofar as the desired solution is payment of interest on holdings of currency, the answer must clearly be no, for government faces the same obstacles in doing this as do private issuers of bank notes. Indeed the government, or its central bank, is less likely to attempt interest payments on currency than private note issuers, since its monopoly privilege places it under less pressure to do so. This is illustrated by the current practice of the some central banks (including the Federal Reserve) of not paying interest on reserve holdings of commercial banks, even though paying interest on reserves is relatively easy compared to paying interest on currency held by the public.
So if any improvement is to be had from the government it must come through a policy of price deflation. Here, too, the revenue or seignorage-maximizing interests of a monopoly supplier of currency run counter to the policy in question. Putting this consideration aside, what gains can be expected from a policy of price deflation aimed at promoting an optimal use of currency? One possibility is that the cost, per real unit of money balances, of increasing aggregate holdings by crying down prices is lower than the cost of doing so by increasing the nominal supply of interest-bearing money units. This would make a central-bank administered deflationary policy superior to free banking even if the latter could pay interest to holders of bank notes. William Gramm (1974) has shown, however, that there is no justification for such a view. Starting with the assumption of a fractional-reserve banking system, Gramm argues, in essence, that the costs associated with creation of real money balances are proportionate to the real value of bank reserves multiplied by the rate of interest. Assuming that the reserve ratio (= m/M, where m is the nominal quantity of the reserve commodity and M is the nominal supply of bank money) is constant, an increase in the real supply of money requires either 1) an increase in M with a proportionate increase in m or 2) a lowering of P with both M and m held constant. In either case, the change in total (opportunity) costs associated with the production and maintenance of the additional real balances is the same. If this cost is represented by the formula rpm, where r is the rate of interest and p is the value of the reserve commodity (= 1/P), then in the former case rpm rises because of an increase in m, whereas in the latter case it rises by the same amount because of an increase in p. Thus Gramm concludes that there is no cost advantage to be had by crying down prices instead of increasing the money supply by means of an increase in the nominal quantity of money.
In fact Gramm’s assumption of a constant reserve ratio, which is crucial to his result, is itself question begging: as we have seen, an increase in the nominal supply of bank money that accommodates an increase in demand under free banking does not require a proportionate increase in the nominal quantity of bank reserves. The circumstance is one that would permit the free-banking reserve ratio to fall. Thus Gramm’s analysis overstates the costs of private production of money balances under laissez faire. It must also be admitted, however, that it is equally unrealistic to assume a constant reserve ratio for the case where M is constant but P is allowed to fall: a fall in the price-level reduces the nominal volume of bank transactions while simultaneously increasing the relative value of commodity money. This would give banks an excess supply of reserves, which would be aggravated by increased production of the money commodity combined with a reduced nonmonetary demand for it. Thus, crying down prices in the face of an increased demand for money balances does not, in a commodity-standard system, really achieve equilibrium in the market for money balances, for although the public may become satisfied with its nominal holdings of bank money, the banks find themselves holding excess reserves.39 Furthermore, there is no way, in a closed system, for these excess reserves to be eliminated except by an increase in bank loans and investments which leads to an increased nominal quantity of bank money and to an increase in the price level sufficient to restore the volume of bank transactions (plus the level of industrial demand for the money commodity) to where there no longer is any surplus of commodity money.
Thus we may conclude that the maximum potential advantage to be expected from a policy of deflation to promote currency holding would be no greater than the small social cost under free banking from consumers’ holding too many deposits and too few bank notes. Yet even this small advantage is unlikely to be achieved in practice, since it would be more than offset by the significant external diseconomies involved in any deflationary process. As S. C. Tsiang notes, these diseconomies would include “impairment of the efficiency of the financial market in channeling savings toward investment” and other consequences of monetary disequilibrium.40
These arguments have been dealt with cursorily here, because most of them have been critically treated elsewhere,41 and also because many of them are rather inappropriate when applied to inside money, which is after all not a commodity “produced” in the usual sense of the term but a vehicle of credit representing outside money lent to banks at call. In the case of such credit instruments the overriding consideration should be whether the supply of them agrees with the public’s demand for them at a given level of nominal income. The public goods and externality arguments are significant only insofar as they imply over- or underproduction in terms of this criterion. Since, as we have seen, the amount of inside money issued by a free banking system tends to conform to the demand for inside money, to say that a free bank will not produce a desirable amount of inside money is tantamount to saying that the demand for money is too intense or too meager, implying over- or underconsumption of inside money balances. The only argument that could possibly justify such a complaint is the one just discussed concerning the alleged nonoptimality of money holding under laissez faire. As we have seen, it is not convincing when applied to a free-banking system.
Alleged Need for a “Lender of Last Resort”
A final alleged shortcoming of free banking is its lack of a “lender of last resort.” Some remarks have been made about this in earlier parts of this study.42 The present section recapitulates and expands upon some of them.
To appreciate the significance of the lender of last resort doctrine to the theory of free banking, one must understand, first, its historical origin and, second, precisely what it is that a lender of last resort is (or was originally) supposed to lend. The doctrine originated in the English banking crises of the 19th century; its principal architects were Henry Thornton and Walter Bagehot.43 It was designed to resolve problems peculiar to a system where one note-issuing bank had (limited) monopoly privileges. The existence of such privileges, which involved restrictions on the note-issue powers of other banks, caused the Bank of England to become a supplier of high-powered money: since paper currency by the 19th century had already begun to surpass coin as a preferred medium of exchange, banks unable to issue their own notes, including all banks within a 65 mile radius from the center of London except the Bank of England, were willing to hold Bank of England notes in place of specie reserves. Thus Bank of England notes were used to settle clearings among other banks, and the Bank became the sole significant repository for the system’s specie.
These circumstances allowed the Bank of England considerable leeway in its issues of inside money. Its issues, unlike those of other banks, were not limited by internal adverse clearings. The principal check against the Bank’s overissues was a drain of reserves to foreign countries sponsored by the price-specie-flow mechanism. So the Bank of England was in a sensitive position: if it overissued, it lost specie abroad, which eventually necessitated either contraction or suspension of payments. If it underissued, it made the conversion of deposits to notes at other English banks impossible. The Bank Act, in attempting to thwart overissue, also made note shortages more likely. It placed absolute limits on other banks’ authorized note issues, while at the same time prohibiting the Bank of England from adding to its note issues without also increasing its specie reserves by the same amount. Bagehot, in arguing that the Bank of England should function as a lender of last resort, was reacting to this. He recommended that the Bank be allowed to increase its circulation to meet “internal drains” of high-powered money from the reserves of other banks, which drains were mainly caused by depositors’ desire to obtain hand-to-hand media. Like the currency drains in America under the National Banking System, they were not due to any desire on the part of depositors to withdraw outside money per se. The dependence of other banks upon the Bank of England in such drains was entirely due to their inability to issue notes of their own, which placed them at the mercy of their privileged rival. Had it not been for restrictions on their rights to issue notes, the less-privileged banks could have met their depositors’ requests by simply swapping their own note liabilities for what had formerly been their deposit liabilities, leaving their reserves untouched. They would not have had any need for a “lender of last resort.”
This is not to deny that the classical developers of the lender of last resort doctrine spoke mainly of the need for central banks to supply ultimate money of redemption to distressed banks whose customers had lost confidence in them. A bank threatened with a redemption run cannot satisfy its panic-stricken clients by offering them its own notes.44 Nevertheless, there is reason for regarding currency runs as of more fundamental importance than redemption runs, as redemption runs seem often to have been set off by the failure of certain banks to meet currency runs. As Bagehot observed (1874, 265-66), panic was especially likely to result if, by its refusal of assistance during a currency run, the Bank of England caused “the failure of a first-rate joint stock bank in London.” The London joint-stock banks had substantial deposit liabilities, and their power to issue notes was, even before 1844, nil. During the “autumnal drain” of currency they were especially dependent upon the resources of the Bank of England.
Crucial to the present argument is Jevons’s finding that, in the course of the autumnal drain, public holdings of coin and bank notes—including notes issued by the “country” banks—moved together.45 There was not a rush for gold or Bank of England notes as such, but rather a rush for all types of currency. The pressure upon the Bank of England came when banks had exhausted their own authorized note issues together with available reserves of high-powered money. The facts confirm that panics were themselves a consequence of restrictions upon free note issue. The situation was similar to the one faced by banks in the United States during the post-Civil War era, except for the difference in note-issue restrictions in the two systems.46
In short, monopolization of note issue is simultaneously the source of the special powers of central banks and the source of difficulties that central banks are supposed to correct. The Bank of England became a last resort source of currency for the simple reason that the first resort, competitive note issue, was outlawed.
Of course, redemption runs need not always be precipitated by prior currency shortages. So a question still remains as to whether central banks can prevent such autonomous runs.47 Here it must be remembered that restrictions upon note issue also led to the centralization of gold reserves—the “one-reserve” system criticized by Bagehot. Gold actually became somewhat less accessible as a result of monopolized note issue than it might have been if banks issued notes competitively. Still, the Bank of England possessed a genuine advantage over free banking, since its issues could be used to settle clearings among other banks. This made it possible for the Bank of England to use its excess reserves to make emergency loans to other banks so that they could in turn satisfy the redemption demands of the public. Another advantage the Bank of England had was that its notes were often less susceptible to a general decline in confidence.
On the other side of the ledger we must consider the following: (a) under free banking redemption runs would be rare, so that the advantages to be had by having a central bank are not necessarily great; (b) special methods for dealing with runs could also be had in a free banking system; and (c) the welfare losses from over- and underissue are likely to outweigh the potential gains from having a central bank. Concerning (a), it was shown in chapter 9 that information externalities which might give rise to a rash of bank runs are less likely to arise under free banking than under central banking. Runs that begin at a small number of bank offices can also be contained there by assistance from other branches of the affected banks. Historically, there have been relatively few bank panics in countries with branch banking as compared with those where branching has been restricted. We have already noted the cases of Sweden, which had no bank failures at all during its era of competitive note issue, Canada, which had fewer bank runs or failures than the U.S. in the decades before 1935 (when it set up a central bank), and Scotland, which had isolated bank failures but no bank panics for the entire span of its free-banking episode.48
Even where branch banking is absent, a bank in need of temporary assistance can, if it is the victim of an isolated run, usually obtain it at a price. Rival banks—barring an implausible conspiracy—will lend to it so long as they are satisfied that it is solvent. It is generally agreed that central banks should employ a similar criterion.49 Notwithstanding this there is the obvious risk that a central bank, especially if it is a public institution not restricted by considerations of profit (or an issuer of fiat money having little to lose by making bad loans), will offer to assist truly insolvent banks whose misfortunes are due to poor management. This generates a moral hazard, encouraging bankers to take unwarranted risks, which in turn increases the probability of future failures.50
Some writers have argued that the existence of government deposit insurance, by providing an independent source of relief to deposit holders and by reducing the likelihood of runs leading to full-scale panic, renders the lender of last resort function of central banks unnecessary.51 If the argument is correct, it applies with even greater force to a system of private bank-liability insurance, which may also reduce the risk of moral hazard by charging insurance premiums reflecting the quality of individual bank asset portfolios.
Concerning category (b), free banks could receive last-resort aid in the form of clearinghouse certificates and loan certificates, which are a short-lived form of emergency high-powered money. They might also resort to “option clauses” of the sort employed in Scotland for a short period during the free-banking era. Such clauses would provide a safety outlet for banks in case of a liquidity crisis, reducing the likelihood of runs by allowing a contractual suspension of payment. This would give banks time to contract their balance sheets. It would also be much more equitable than any non-contractual suspensions of payment, since bank customers would need to agree to the option clause arrangement ahead of time and since it would pay them interest in proportion to the duration of any suspension.
All these considerations militate against the view that central banking is superior to free banking for minimizing the harmful effects from bank runs and failures. Along with them we must reckon the additional burdens that central banks are likely to introduce—category (c) above—which have been alluded to frequently in the present study. They are the burdens of inflation and deflation, absolute as well as relative, with their damaging effects upon economic activity. The ability of central banks to aid other banks in distress—even where the distress is not due to previous central-bank misconduct—should only count as an advantage if there is reason to believe that it will be exercised at the right time and place. That central banks do not suffer when they bail out banks that really should be allowed to fail adds another dimension to the “knowledge problem” they confront, giving further reason to suspect that they will not behave properly.
Although opposed to the Bank of England’s monopoly in principle Bagehot (1874, 69) saw no point in trying to dismantle it: for better or worse, it had become an object of veneration. To oppose it was, in his view, to invite “useless ridicule.” Moreover, he observed, it would take years before a new, safer banking system could grow.
Considerations such as these are no less weighty today. Indeed, despite their poor performance, support for central banks has grown along with the belief that they combat the inherent instability of decentralized banking. Furthermore, the transitional costs of adopting free banking seem greater than ever, since modern banking systems, based on fiat monies and floating exchange rates, appear further removed from the theoretical ideal of free banking than any of their 19th-century predecessors.
The popularity of central banking today rests, however, on the public’s insufficient awareness of the advantages of free banking. Far from requiring theorists to dismiss the topic as a “dead issue,”52 the situation calls for them to perform their principal duty, which is to inform people about things that are not already obvious to them. Of course a theoretical possibility, once brought to the attention of the public, may be ignored or rejected; but it is irresponsible for theorists to write off an idea because they see little prospect of its ready acceptance. Issues do not die; they are just neglected!
That political decision makers are especially prone to ignore radical alternatives is also no reason to quell discussion of them. As an English statesman and writer once observed, that politicians are mainly concerned with “tasks of the hour” is “all the more reason why as many other people as possible should busy themselves in helping prepare opinion for the practical application of unfamiliar but weighty and promising suggestions, by constant and ready discussion of them upon their merits.”53
The matter of transition costs cannot be so tersely dealt with. Real doubts must exist concerning whether there is any way to convert existing banking arrangements so as to make them perform in the manner described in the theory of free banking. The only way to dispel such doubts is to offer an actual plan, showing how the conversion might be achieved without difficulties or costs so great as to render the plan unacceptable. This task is undertaken in the next chapter.
Free Banking and Monetary Reform
Rules, Authority, or Freedom?
So long as the money supply is centrally controlled, the central authority must either actively manipulate the money supply or it must adhere to a predetermined monetary rule.1 That these are the only options for monetary policy is the view that has been handed down by several generations of economists. Implicitly or explicitly theorists have rejected the alternative of free banking. This is also true of many Chicago-School economists—the best-known proponents of monetary rules and opponents of monetary discretion—who otherwise argue for a free society based upon free markets.2 For the cause of free banking the last fact is especially significant, because it means that a large and highly respected body of theorists, who might most readily have concurred with the arguments for free banking, have instead aligned themselves with advocates of monetary centralization.
Why have Chicago economists denied the efficacy of the free market in the realm of money and banking? To begin, they have doubted the very desirability of commercial banks issuing fiduciary media. Lloyd Mints (1950, 5 and 7) saw no benefits at all in such institutions; and although Simons (1951) and Friedman (1959, 8; 1953, 216-20) may not have shared this extreme position, they at least considered fractional-reserve banking to be “inherently unstable.” Such a perspective does not incline its holders toward the view that banking should be entirely unregulated, except in peculiar cases (such as Mises’s) where it is believed that free banking will somehow lead to the suppression of fractionally-based inside monies.
It has already been argued (in chapter 2) that fractional reserve banking is beneficial, contrary to Mints’s position. It was also argued, in chapters 8 and 9, that there is no “inherent instability” in free banking. In fact, the particular sort of instability emphasized by Mints and Friedman—changes in the volume of money due to changes in the form in which the public wishes to hold its money—arises only in systems lacking freedom of note issue.3 The problem is indeed inherent in systems with central banking and monopolized currency supply, but it is not inherent to all fractional-reserve banking.
Elsewhere various Chicago economists—especially Milton Friedman (1959, 4-9)—have criticized free banking on the grounds that it leads to unlimited inflation, involves excessive commodity-money resource costs, and encourages fraud. For these and other reasons they have claimed that the issue of currency is a technical monopoly which must be subject to government control. Each of these arguments has been critically examined and found wanting. The Chicago School’s dismissal of free banking was, in short, premature.
We are today in a much better position than the Chicago economists once were to consider free banking as an alternative monetary policy, distinct from reliance upon either rules or authorities. The best way to appreciate the advantages of this alternative is to view it in light of arguments on both sides of the rules-versus-authorities debate. Jacob Viner (1962, 244-74) provides an excellent summary of these arguments. According to him, the Chicago pro-rules position is that rules provide “protection . . . against arbitrary, malicious, capricious, stupid, clumsy, or other manipulation . . . by an ‘authority’ ” and that they guarantee a monetary policy that is “certain” and “predictable” (ibid., 246).4
The principal argument for discretion is, on the other hand, the ipso facto deficiency of regulatory policies that “attempt to deal by simple rules with complex phenomena” (ibid.). A monetary rule necessarily precludes “the possibility of adaptation of regulation by well-intentioned, wise and skillful exercise of discretionary authority to the relevant differences in circumstances” (ibid.). Viner lists four considerations that stand in the way of the successful use of any monetary rule. They are (a) the existence of a multiplicity of policy ends, which no simple rule can fulfill; (b) the presence of more than one monetary authority or regulatory agency (which makes it difficult to assign responsibility for enforcement of a rule); (c) the existence of several instruments of monetary control (which complicates execution and enforcement of a rule even when there is a single monetary authority); and (d) the possibility that a satisfactory rule may not exist even if policy is aimed at a single end and is implemented by a single authority using a single instrument of control.
Although all these considerations are relevant, let us abstract from (a), (b), and (c) by assuming, first, that the sole end of monetary policy is to maintain monetary equilibrium (i.e., to adjust the nominal quantity of money in response to changes in demand); second, that responsibility for control of the money supply is vested with a single authority, namely, the “well-intentioned” directors of a central bank; and third, that open-market operations are the sole means for centrally administered changes in the money supply. This limits the problem to one of finding a satisfactory monetary rule. The difficulty here is that even a clearly defined policy end may involve “a quantity of some kind which is a function of several variables, all of which are important and are in unstable relation to each other” (ibid.). When this is true “there will be no fixed rule available which will be both practicable and appropriate to its objective” (ibid.).
Suppose the desired end is the accommodation of the demand for money, which is indeed “a quantity . . . of several variables . . . in unstable relation to each other.” No simple monetary rule such as stabilization of a price index or a fixed percent money growth rate can fully satisfy this end. In fact the constant growth rate rule, which is now most popular, abandons any effort to accommodate seasonal and cyclical changes: it regards only secular changes in demand as predictable enough to be the basis for a steadfast formula.
And yet, as far as the desires of some advocates of monetary rules are concerned, the fixed money growth-rate proposal—especially when it is defined in terms of some monetary aggregate—is not strict enough. It still permits the monetary authority actively to conduct open-market operations to meet the prescribed growth rate. A pre-set schedule of open-market bond purchases cannot always be carried out, because the relevant money multipliers (which determine the effect of a given change in the supply of base money upon the supply of broader money aggregates) are not constant or fully predictable.5 There will, therefore, always be occasions under such a rule when some discretion will have to be tolerated so that open-market purchases do not miss their target. On the other hand, if such discretion is permitted, it can be abused, and so, to state once more the warning of Henry Simons, it would make the supposed rule “a folly.”
It is apparent, then, that if we must have a central monetary authority we must choose between the dangers of an imperfect and perhaps ill-maintained rule and the dangers of discretion and its possible abuse. This choice has been made somewhat less difficult in recent years, because the authorities’ abuse of their discretionary powers has been such as to overshadow the potential damage that might result from blind adherence to some pre-set formula. In the United States the loss of faith in authority has given rise to a new proposal that is the ultimate expression of Simons’s anti-discretion position. The proposal is that the supply of base money should be permanently frozen—that is, that the Federal Reserve System should cease open-market operations entirely.6 Here at last is a rule calculated to prevent mischief: all that needs to be done to guarantee its strict observation is to close the Fed! Milton Friedman, who for years advocated a constant M-1 growth-rate rule, is now the most prominent champion of this frozen monetary base proposal.
Thus monetary policy has reached an impasse. Under a strict monetary rule, and especially in the case of the base-freeze proposal, the really desirable end of monetary policy—achieving monetary equilibrium—has to be sacrificed to the much lower, cruder end of merely preventing the authorities from introducing more instability into the system than might exist in the absence of any intervention, capricious or otherwise. Is such an inflexible arrangement the best that can be hoped for? So long as one clings to the assumption of centralized control and centralized currency supply, there is reason to believe that it is. We have seen, in chapter 7, why discretion, even in its best guise, is likely to hurt more than it helps.
But centralized control need not be taken for granted. The supply of currency could instead be placed on a competitive basis. This solution, unlike solutions based on centralized control, can achieve monetary stability while simultaneously eliminating government interference. Free note issue combines all the virtues of Friedman’s proposal—which completely eliminates the danger of capricious manipulation of the money supply—with those of a system capable of meeting changing demands for money. Freedom of note issue resolves the “inherent instability” that afflicts centralized systems of fractional-reserve banking. By supplying an alternative form of pocket and till money—competitively issued bank notes—to accommodate changing public demands, free banking reduces the public’s reliance upon base money as currency for use in everyday payments. In this way base money is allowed to remain in bank reserves to settle clearing balances. Fiat base money can thus be made to play a role similar to the one played by commodity money in the “typical” free banking system which has been given prominence through most of this study. Base money never has to move from bank reserves to circulation or vice-versa, so that, in such a system, there is no question of any need for reserve compensation to offset the ebb and flow of currency demand.
Free banking on a fiat standard may seem far from the sort of free banking discussed in previous chapters, but the difference is not really so great. True, the preceding pages discussed mainly a commodity standard, because this is the type that would most probably have evolved had banking been free all along; but events have been otherwise. For better or worse our monetary system is at present based on a fiat-dollar standard, and the momentum behind any existing standard is an argument for its retention. Existence of a fiat standard is, however, no barrier to the adoption of free banking. As far as banks today are concerned, fiat dollars are base money, which it is their business to receive and to lend and to issue claims upon. For most of the 20th century the only claims allowed (we are as usual considering ones redeemable on demand only) have been checkable deposits. What is proposed, therefore, is that commercial banks be given the right to issue their own notes, redeemable on demand for Federal Reserve Dollars, on the same assets that presently support checkable deposit liabilities.7 Once the public becomes accustomed to using bank notes as currency, the stock of high-powered money can be permanently frozen according to a plan such as Friedman’s without negative repercussions due to changes in the relative demand for currency.
This simple proposal does not involve any interference whatsoever with the dollar as the national monetary unit. Yet, it would make it possible for Federal Reserve high-powered money to be used exclusively as bank reserves, for settling interbank clearings, while allowing bank notes to take the place of Federal Reserve Dollars in fulfilling the currency needs of the public.8
A Practical Proposal for Reform
How can this proposal be implemented, and how can it be combined with a plan for freezing the monetary base? A reasonable starting point would be to remove archaic and obviously unnecessary regulations such as statutory reserve requirements and restrictions on regional and nationwide branch banking. The majority of nations with developed banking industries have not suffered from their lack of such regulations, evidence that their elimination in the United States would not have grave consequences. In fact, branch banking has significant micro- and macroeconomic advantages over unit banking, and its absence is probably the most important single cause of the relatively frequent failure of U. S. banks.9 As for statutory reserve requirements, it has already been shown (in chapter 8) that they are impractical as instruments for reserve compensation. Apart from this, they serve no purpose other than to act as a kind of tax on bank liabilities. Furthermore, their existence interferes with banks’ ability to accommodate changes in the demand for inside money. If the monetary base is frozen this restrictive effect is absolute. On the other hand, elimination of statutory reserve requirements, unless it proceeds in very small steps, could open the door to a serious bout of inflation. A solution would be to sterilize existing required reserves the moment the requirements are removed. This could be done as follows: suppose the statutory reserve requirement is 20 percent. Presumably banks operate with reserves of, say, 25 percent—only the excess 5 percent are an actual source of liquidity to the banks. It could then be announced that after a certain date there will be no further rediscounts by the Federal Reserve Banks (thus encouraging banks to acquire adequate excess reserves). Then when the deadline arrives reserves held for statutory purposes could be converted to Treasury bills—a non-high-powered money obligation—and the statutory reserve requirements could at the same moment be eliminated.10
In addition to reserve requirements and restrictions on branch banking, restrictions on bank diversification such as the Glass-Steagall Act should also be repealed. This would allow banks to set up equity accounts, reducing their exposure to runs by depositors, and opening the way to the replacement of government deposit insurance by private alternatives.
While these deregulations are in progress, Congress can proceed to restore to every commercial bank (whether national or state chartered) the right to issue its own redeemable demand notes (which might also bear an option-clause) unrestricted by bond-deposit requirements or by any tax not applicable to demand deposits. This reform would not in any way complicate the task facing the still operating Federal Reserve Board; indeed, it would reduce the Fed’s need to take account of fluctuations in the public’s currency needs when adjusting the money supply. The multiplier would become more stable and predictable to the extent that bank notes were employed to satisfy temporary changes in currency demand.11 Over time banks would establish the reliability of their issues, which need not be considered any less trustworthy by the public than traveler’s checks.
For competitively issued notes to displace base money from circulation entirely the public must feel comfortable using them as currency. This might be a problem: the situation differs from the case of a metallic base money, which is obviously a less convenient currency medium for most purposes than bank notes redeemable in it. There is no obvious advantage in using paper bank notes instead of equally handy paper base dollars. Nevertheless, imaginative innovations could probably induce the public to prefer bank notes. The existing base-money medium could as a deliberate policy be replaced by paper instruments of somewhat larger physical size, fitting less easily into wallets and tills. Bank notes, on the other hand, could be made the size of present Federal Reserve notes. The appearance of base dollars could also be altered in other ways, for instance, by having them engraved in red ink. In this form they might seem even less familiar to currency users than the newly available bank notes. Finally, base dollars could be made available only in less convenient denominations. Two-dollar bills would work, since they already have an established reputation for not being wanted by the public, but larger bills would be most convenient for settling interbank clearings. Banks, of course, should be allowed to issue whatever note denominations they discovered to be most desired by their customers.12
Other innovations need not be a matter of public policy but can be left to the private incentive of banks. Banks could stock their automatic teller machines with their own notes, and bank tellers could be instructed to give notes to depositors who desire currency, unless base dollars were specifically requested. Banks might also conduct weekly lottery drawings and offer prize money to persons possessing notes with winning serial numbers.13 The drawings would be like similar lotteries now held by several daily newspapers. They would make notes more appealing to the public, as they would constitute an indirect way of paying interest to note holders, just as interest is now paid on some checkable deposits.
A combination of measures such as these would almost certainly lead to near-complete displacement of base dollars from circulation. Once this stage was reached—say, once 5 percent or less of the total of checkable deposits and currency in circulation consists of base dollars14 —a date could be chosen upon which the supply of base money would be permanently frozen. When this date arrived, outstanding Federal Reserve deposit credits would be converted into paper base dollars, and banks that held deposits with the Fed would receive their balances in cash. Banks could then exercise their option to convert some of this cash into specially created Treasury obligations (see note 12). At this point the Federal Reserve Board and Federal Open-Market Committee could be disbanded. This would end the Fed’s money creating activities. The System’s clearing operations could be privatized by having the twelve Federal Reserve Banks and their branches placed into the hands of their member-bank stockholders.15 The frozen stock of base dollars could then be warehoused by the newly privatized clearinghouse associations. Dollar “certificates” or clearinghouse account entries could be used to settle interbank clearings, thereby saving the dollar supply from wear and tear. Only a small amount of base dollars would actually have to be kept on hand by individual banks to satisfy rare requests for them by customers. In the unlikely event of a redemption run, a single bank in distress could be assisted by some of its more liquid branches or by other banks acting unilaterally or through the clearinghouse associations; some banks might also have recourse to option clauses written on their notes. Finally, bank liabilities might continue to be insured (by private firms), although there might not be any demand for such insurance under the more stable and less failure-prone circumstances that free banking would foster.
The above discussion assumes that base money dollars will continue to command a saleability premium and that they will therefore continue to be used to settle clearing balances among banks absent any legal restrictions compelling their use. Such need not be the case, however. Indeed, it should be emphasized that, although the above reform is designed so that a continuation of the present paper-dollar standard is possible under it, the reform is not meant to guarantee the permanence of that standard. Some other asset might replace paper dollars as the most saleable asset in the economic system and hence as the ultimate means of settling debts. This would drive the value of paper dollars to zero (since there is no nonmonetary demand for them), rendering the dollar useless as a unit of account. In this event a new unit of account, linked to the most saleable asset in the system, would evolve, thus bringing the dollar standard to an end. As Vaubel (1986) emphasizes, one aim of a complete free-banking reform should be the elimination of any barriers standing in the way of the adoption of a new monetary standard. Fiat currencies issued by other governments or even by private firms (including composite currencies like the ECU), if they were judged more advantageous by the public, could then replace the present dollar standard. Also, the way would be opened for the restoration of some kind of commodity standard, such as a gold standard. This does not mean that a change of standard would be likely; however, if many people desired it, it could occur. A well-working free banking system can grow on the foundation of any sort of base money that the public is likely to select, and competition in the supply of base money is no less desirable than competition in the supply of bank liabilities, including bank notes, redeemable in base money.
Of course this reform is radical, and it is not likely to be adopted in the near future. Nevertheless, there are no great logistic or material barriers standing in the way of the adoption of free banking; the transition costs of a well-framed free banking reform are negligible—with benefits as great as the potential for undesirable fluctuations in the dollar supply if it is not undertaken. Therefore, although political reality renders such reform unlikely in the near future, it would be unfortunate if this were made the excuse for avoiding the vigorous discussion that might minimize the waiting time for its implementation. The present banking system is likely to generate a need for drastic change sooner or later, and if reform is delayed until a time of crisis, there can be no question of any smooth, costless transition to a well-working, deregulated system. On the contrary, an occasion of panic is likely to breed the sort of “temporary” makeshift measures that end in more regulation and centralization, leaving the banking system in an even less satisfactory state, and still further removed from the practical and theoretical ideal of perfect freedom.
[* ] It is assumed that under central banking commercial banks convert all specie holdings into deposits or notes of the central bank.
[1.] The inherent inadequacy of knowledge conveyed through the price system is, of course, only one source of entrepreneurial error. Knowledge conveyed in market prices may also be ignored or misinterpreted.
[2.] For one thing, inventory shortages and surpluses tell nothing about whether the entire set of goods being produced is the most desirable one as far as consumers are concerned. Only rivalrous competition among producers tends to provide such information.
[3.] See Don Lavoie (1985, 129-32).
[4.] See Trygve J. B. Hoff (1981, 125-27).
[5.] Here, and throughout the remainder of this section, I assume that decentralized markets exist for all goods and services other than money.
[6.] I wish to emphasize once again that there is no “nominalist” fallacy involved in this prescription; admittedly, ceteris paribus, a higher level of prices demands a higher nominal supply of money, and so one may be led to the conclusion that any “excess supply” of money that causes prices to rise is therefore self-justifying. This is true once prices have risen; but price-level adjustments do not occur instantaneously. General price adjustments are long run consequences of monetary disequilibrium. Once this is taken into account the concepts of “excess [nominal] supply” of (or “excess [nominal] demand” for) money can be viewed as potential short-run states of affairs and not just as analytical conveniences.
[7.] This conclusion must be modified somewhat if the issuing bank has purchased assets earning fixed nominal rates of interest. Then the bank’s marginal costs include any reduction in the real yield (or market price) of its assets due to inflation. This cost does indeed rise at the margin, but it is unlikely to rise so rapidly as to encourage a non-inflationary policy.
[8.] To refer to our earlier discussion, this policy of having a demand-elastic supply of money is roughly equivalent to one that maintains constant the supply of money multiplied by its income velocity of circulation.
[9.] Most prominent among earlier proponents of price-level stabilization were members of the Stockholm school, including Knut Wicksell and Gustav Cassel; American “quantity theorists” (for want of a better label), such as Irving Fisher, Lloyd Mints, and Henry Simons; and Cambridge economist A. C. Pigou. An example of a contemporary advocate of price-level stabilization is Robert E. Hall. See his 1984, esp. 309-13, and also 1982, 111-22. Two excellent critical works on price-level stabilization are Gottfried Haberler (1931) and R. G. Hawtrey (1951).
[10.] Notice that I am concerned at this stage of my inquiry only with the argument for price-level stablization that views it as a procedure for maintaining monetary equilibrium. Later on I will have occasion to discuss what, if any, advantages price-level stabilization offers as a means for protecting debtors and creditors from the consequences of changes in the value of money.
[11.] The last two problems are emphasized by Ludwig von Mises (1978, 87-88). See also Robertson (1964, chap. 2).
[12.] The experiment in price-level stabilization of the 1920s is a good example of how the use of a wrong index of prices may deceive the authorities into believing that theirs is a noninflationary credit policy. Most price indices used at that time did not include prices of stock-certificates and real estate. On this see C. A. Phillips, T. F. McManus, and R. W. Nelson (1937, passim), and also M. H. de Koch (1967, 133).
[13.] Apart from those that might occur because of changed distribution of demand caused by the fact that the price-elasticity of demand of some goods now available in greater or lesser abundance is non-unitary.
[14.] This is also the conclusion of the writers whose views on monetary equilibrium are cited in chapter 4. Among advocates of price-level stabilization, Mints (1950, 129-30) admits that prices may fall on account of increases in productive efficiency. He dismisses the difficulty that this poses after noting that “there is no [policy] criteria [sic] which would indicate the ‘right’ rate of decline in commodity prices.” This is quite true as far as any central-banking policy is concerned. Still, the argument bolsters the case for free banking more than it aids the cause of price-level stabilization. For Mint’s views on free banking, see ibid., 5-7.
[15.] The use of an index of prices of factors of production to detect such relative inflation would be a potential solution if construction of such an index were practicable. The difficulties here far exceed those of constructing a consumer-price index because of the immense number of factors of production, many of which have no readily ascertainable market price. In addition, those factor prices that can be observed may themselves be influenced by changes in the efficiency of production.
[16.] To use the apt phrase employed by Allen G. B. Fisher (1935, 205).
[17.] We are, for simplicity’s sake, assuming unitary price-elasticities of demand.
[18.] At the moment I am not considering the possibility of changes in the supply of commodity money.
[19.] Obviously I am assuming in this case that the demand for inside money is constant.
[20.] Friedman estimates the length of this lag in the United States monetary system to be somewhere between 4 and 29 months.
[21.] See for example Raymond E. Lombra and Herbert Kaufman (1984); Raymond E. Lombra and Raymond G. Torto (1975); and Henry C. Wallich (1981). An example of interest-rate pegging was the policy of the Federal Reserve from 1942 to 1951, the year of the Treasury Accord.
[22.] The monetary authority could use interest-rate movements as a guide to changes in the demand for money if it could somehow tell whether movements in the market rate of interest were also movements in the natural or equilibrium rate. Unfortunately, the natural or equilibrium rate of interest is not something that can be observed or measured. For this reason it can never serve as a practical guide for monetary policy.
[23.] As L. White notes (1984a, 272), “the desirability of controlling [a monetary aggregate] rather than the monetary base is unclear . . . there is the uncomfortable possibility that attempting to control an aggregate containing some measure of inside monies necessarily implies inefficient restrictions on the intermediary functions of banks.” See also the following note.
[24.] See Sherman J. Maisel (1973, 255-80). These criticisms assume that target growth rates can be successfully achieved, whereas in truth their achievement—in the case of wider monetary aggregates—is sometimes difficult. Only the size of the monetary base is subject to direct and certain control.
[1.] Throughout this chapter it is assumed that the variance of bank clearings is not affected by a change in the form (notes or deposit-credits) of outstanding liabilities so long as the average holding time (turnover period) of the liabilities is the same. This is equivalent to assuming that precautionary reserve demand for outstanding note liabilities will be the same as for an equal amount of demand-deposit liabilities with the same average rate of turnover.
[2.] Under central banking with fiat money the distinction between currency demand and outside-money demand is blurred: there is no observable difference between the two, since the ultimate money of redemption is also the only currency in the system. Nevertheless it is still possible conceptually to distinguish the desire to acquire hand-to-hand media from the desire to withdraw savings from the banking system. Under central banking with a commodity standard, the former manifests itself in increased demand for the notes of the central bank, whereas the latter involves redemption of those notes for the money commodity.
[3.] According to Bowsher (1980, 11-17), the ratio of currency to demand deposits rose in part because of a fall in the importance of demand deposits relative to savings accounts. Nevertheless the trend is surprising in view of the development of alternatives to currency, such as credit cards, and of the substantial increase in interest rates which are a measure of the opportunity cost of holding cash. Many economists attribute this growth in demand for currency to the expansion of the “underground” economy.
[4.] Agger, p. 87. To consider only currency demand and not outside-money demand is not to neglect the usual consequences of a falling off in business confidence. Historically, when a general decline in confidence has led to increased outside-money demands it has been because of banks’ failure to meet depositors’ increased demands for currency through increased issues of inside money. For evidence of this see below. The problem of banking panics is dealt with later in this chapter.
[5.] Somers (1873, 204-25) writes with regard to conditions in 19th-century England that “when the situation is so bad that distrust or panic sets in it is the withdrawal of deposits [by their conversion into currency], and not the cashing in of notes, that gives the fatal blow to a tottering establishment.”
[6.] See Cagan (1958); also Agger (1918, 78-86), and Frank Brechling, (1958, 376-393). Brechling investigates fluctuations in the relative demand for currency in twelve countries and reports both significant across-country variation and significant short-run fluctuations within individual countries. He concludes that the assumption of a constant short-run cash preference ratio, which is determined predominantly by custom and institutional factors, is not supported by the empirical evidence and should be abandoned. Another study, also involving twelve countries, which reaches similar conclusions is Joachim Ahrensdorf and S. Kanesthasan (1960, 129-132).
[7.] Agger (1918, 87). The surrounding general discussion (pp. 76-90) is one of the best on this whole subject.
[8.] See ibid. 76; and also Francis Dunbar (1917, 17-18).
[9.] By assumption only the composition of money demand is varying; the depositor is not seeking to reduce his average money holdings or to take his business to some other bank. For present analytical purposes—and not necessarily because it is realistic to do so—it is desirable to abstract from these other possibilities. I have already shown how a free banking system would respond to them.
[10.] To repeat, the notes are not useful as a basis for credit expansion, so that their return to their issuer should not provoke any addition to loans.
[11.] Thus the equilibrium stockpile of notes on hand depends on (1) the probability density function over levels of currency demand; (2) the difference between the price of notes ordered in normal course and that of notes ordered on a “rush job” basis; and (3) the interest cost of paying the former price sooner. The setup is identical to the choice of optimal (base money) reserves and investments. An expansion of note issue will result in clearing debits—debits that, under free banking, have to be settled in outside money—unless it is consistent with the currency needs of the public.
[12.] “Generally speaking, an increase in the supply of money in the form of check-currency [deposits] must normally appear as part of a composite supply, in which other types of currency are represented; . . . the absence of these other types may effectually prevent the issue of check-currency itself.” See Arthur Marget (1926, 255).
[13.] According to Somers (1873, 207-8), “when [the unrestricted right of note issue] is stopped, and notes are only authorized from a central source, the facility a bank may enjoy in supplanting itself with currency for the uncertain demands upon it can only be in proportion to its proximity to the Issue Department.”
[14.] The amount of “reserve compensation” needed will be less than the actual increase in currency demand.
[15.] Thus McLeod writes (1984, 65-66fn) that a system of competing banks of issue (where no distinction is made between note and deposit liabilities as far as reserve needs are concerned) “has certain practical advantages if, as is usually the case, there are seasonal fluctuations in the public’s demand for notes relative to deposits. In [a system with monopolized currency supply] the peak seasonal demand for notes withdraws reserves from the banks and causes a seasonal credit stringency, and in a managed money system the central bank or other monetary authority must consciusly act to offset any such tendency.” The same is true concerning cyclical but nonseasonal changes in the relative demand for currency.
[16.] See for example Cagan (1958) and Milton Friedman (1959, 66-67).
[17.] Friedman revealed an awareness that the problem stems from monopolization of the currency supply when he noted (1959, 69) that it might be solved by allowing competition in note-issue. At the time, however, Friedman was less sympathetic (and, one might add, less understanding) toward free banking than he is today, and he described the solution of competitive note-issue as “the economic equivalent to counterfeiting.” Compare Friedman (1953, 220).
[18.] The formulae assume that commodity (outside) money does not circulate. Derivations appear in an appendix to this chapter.
[19.] By “known” I mean that the total quantity of currency demanded is known; I do not mean that the distribution of this demand—how changes in it will affect the reserve position of particular deposit banks—is known. To assume otherwise would be to grant too much in favor of the case for central banking. I have also chosen to deal only with the three more popular instruments of control. I leave it as an exercise to the reader to contemplate the practicability of other procedures not considered here.
[20.] Obviously these welfare changes affect not just the banks but also their borrower customers. In the event of a severe currency drain, depositors at some banks may also become victims of a restriction of payments.
[21.] For further comments on the shortcomings of statutory reserve requirements as instruments for monetary control see Friedman (1959, 45-50).
[22.] Compare Caroline Whitney (1934, 159-60).
[23.] For a general discussion of the disadvantages of rediscount policy as a means for monetary control see Joseph Aschheim (1961, 83-98).
[24.] This possibility does not violate the assumption of a fixed total demand for money so long as there is an equal increase in money demand elsewhere in the system.
[25.] See Currie (1934, 113).
[26.] See Friedman (1959, 40ff).
[27.] Particularly significant is Jevons’s finding that, in the course of the “autumnal drain,” coin and bank notes—including notes issued by “country” banks—moved together. This confirms the view that there was no rush for gold or Bank of England notes as such, but rather a rush for all types of currency. The pressure upon the Bank of England came when the other banks had exhausted their own authorized note issues.
[28.] Unfortunately Jevons believed as well that emergency currency supplied by the Bank of England would also be withdrawn from the system once it was no longer needed in circulation. This was incorrect. Bank of England notes might eventually return to those banks from which they were withdrawn (assuming no change in banks’ shares in the deposit business); but having come this far they went no further—they were retained as vault cash instead of being returned to the Bank of England for redemption and so their total supply would not fall to its original level. Instead, the notes were once again used as reserves to support further lending until the Bank of England made some conscious effort to contract their supply.
[29.] Jevons’s article first appeared in the Journal of the Statistical Society of London, vol. 29 (June 1866), pp. 235-53.
[30.] See the discussion of Bagehot’s views in Vera Smith (1936, 121ff) and in L. White (1984d, 145).
[31.] Conant (1905, 128). But compare Paul M. McGouldrick (1984, 311-49), who claims that the Reichsbank carried on a successful, countercyclical policy throughout most of the period in question.
[32.] For a general discussion of this episode, see Milton Friedman and Anna Jacobson Schwartz (1963, chapter 7).
[33.] See also James M. Boughton and Elmus R. Wicker (1984).
[34.] In view of this, it would have been better had state authorities declared a mere restriction of payments, prohibiting withdrawals of currency and coin, instead of outright holidays. This would have allowed checking-account transactions to continue, and would not have provoked as complete a flight to currency in neighboring states.
[35.] State bank note issues had ceased following a prohibitive 10 percent Federal tax on them in 1865.
[36.] See Friedman and Schwartz (1963, 169). Forced par collection, lack of branch facilities for convenient redemption, and the fact that bond-secured notes were perceived as being a lien on the Federal government rather than on their nominal issuers encouraged National banks to hold and reissue notes of their rivals instead of seeking actively to redeem them. Thus these notes were, unlike bank notes in an unregulated system, a kind of high-powered money. Their supply would not contract in response to any fall in the demand for currency, and their issue on more liberal terms (short of complete deregulation) might have led to serious inflation. This was, however, not a problem of practical concern in the latter part of the 19th century. On the downward-inelasticity of National bank notes see Charles F. Dunbar (1897, 14-22).
[37.] On this see Richard H. Timberlake, Jr. (1978, 124-31).
[38.] See Vera Smith (1936, 133-34).
[39.] Although many contemporary writers saw free note issue as a potential cure for the problems of the National banks, most believed that some agency was needed for supplying the system with emergency reserves. See for example Victor Morawetz (1909); Alexander Dana Noyes (1910); and John Perrin (1911). These writers, as well as O. M. W. Sprague (1910), tended to view reserve losses (and consequent monetary contraction) as a distinct problem rather than as a consequence of restrictions on note issue.
The evidence contradicts the view that media not backed by bonds or not centrally issued would have been unacceptable for supplying depositors’ demands during crises. For example, Canadian bank notes flowed readily into northern states to fill the void created by insufficient National bank note issues, even though Canadian notes were not backed by any special collateral. [See Joseph F. Johnson (1910, 118).] Also, clearinghouse certificates and loan certificates were issued in various places and were accepted even though they were of questionable legality. Finally, cashier’s checks and payroll checks of well-known firms were issued in small, round denominations to serve as currency. The only shortcoming of such emergency currency was that there was not enough of it. Nonetheless what there was showed every sign of being acceptable to the public, and there is every reason to think that freely issued bank notes would also have been accepted. On emergency currencies issued during the Panic of 1907 see A. Piatt Andrew (1908). On clearinghouse note issues see Richard H. Timberlake, Jr. (1984).
[40.] On the supply of currency in the (pre-1935) Canadian banking system see James Holladay (1934) and L. Carroll Root (1894).
[1.] See Irving Fisher (1896).
[2.] See Haberler (1931, 14); Tjardus Greidanus (1950, 239); and Lloyd Mints (1950, 133-34). A very early presentation of this argument is L. S. Merrian (1893).
[3.] The original advocates of this reform were Benjamin Graham (1937, 1944) and Frank D. Graham (1942, 94-119). See also F. A. Hayek (1948a). Critical assessments of these proposals include W.T.M. Beale, Jr., M. T. Kennedy, and W. J. Winn (1942), and Milton Friedman (1953).
[4.] Admittedly Hayek (1948a, 211) views the reform more as a means for avoiding short-run disequilibrium due to the lack of immediate adjustment of the supply of commodity-money (under a single-commodity standard) to changes in the demand for “highly liquid assets” (i.e., money balances), than as a means for preventing debtor-creditor injustice. Nevertheless, in this respect also the multiple-commodity standard is not superior to free banking since, in the latter, the supply of inside money tends to be elastic with respect to the demand for money balances.
[5.] One must also assume that there is no autonomous shift in nonmonetary demand for the money commodity.
[6.] As is done, for example, by Hall (1982, 113-14). Hall’s reference to the recent instability of the price of gold is especially inapt, since this instability is more a reflection of the unreliability of the fiat dollar standard than anything else. Hall admits (p. 114) that the value of gold would not have fluctuated so widely had the United States remained on a gold standard. Nevertheless he states (without citing any evidence) that “large changes in the price level would certainly have occurred.”
[7.] See Frank Walter Paish (1950, 156-63).
[8.] For one example of this claim, see Roy W. Jastram (1977, 186-87).
[9.] See Rockoff (1984, 623-26).
[10.] Ibid., 628-31. See also Phillip Cagan (1965, 59ff). Cagan concludes (p. 64) that gold supply in the late 1800s “was not an exogenous variable.”
[11.] Paish (1950, 150-51), though he asserts (without citing any evidence) that 19th-century gold discoveries were largely accidental, agrees that institutional conditions in this century make present-day discoveries much likelier to be demand induced.
[12.] Thus the fears of some economists that a gold standard would be more prone to supply shocks today than it was in the 19th century seem unfounded. Rockoff (1984, 641) says, “It would be unwise . . . to infer from the stability and elasticity of the supply of gold in the nineteenth century that a gold standard would work similarly today.” Yet why assume from such favorable experience that present-day experiences would be unfavorable?
[13.] According to Cagan (1965, 59), all major changes in the gold stock during the gold-standard era “can be associated with important changes either in the value and therefore production of gold or in government policies affecting the gold stock.”
[14.] Wicksell wrote in 1906 (1935, 122), that “nowadays we never hear of a ‘run’ on gold by the public, but frequently of a run by business men and bill brokers to get bills discounted at the Central Bank, in case the bank reserves or the unused portion of the statutory note issue falls [sic] unusually low and the private banks begin to restrict credit in consequence.”
[15.] This is the view taken by Gary Gorton (1985a, 177-93). An alternative theory is offered by Douglas W. Diamond and Philip H. Dybvig (1983), who treat bank runs as randomly occurring, “bubble” phenomena. As Gorton notes, the empirical evidence contradicts the view that bank runs are random events.
[16.] According to Checkland (1975), tables 2, 3, 9, 11, and 16. The figure includes banks with unknown fates.
[17.] L. White (1984d, 41). The estimate was made in 1841. There were no losses to liability holders from 1841 to 1845.
[18.] The possibility of private liability insurance is examined in Eugenie D. Short and Gerald P. O’Driscoll, Jr. (1983). See also Edward J. Kane (1983).
[19.] On the difficulty of establishing risk-based premiums for non-competitive, government-provided deposit insurance see Kenneth Scott and Thomas Mayer (1971).
[20.] This is based on a suggestion by John J. Merrick and Anthony Saunders (1985, 708).
[21.] This has been suggested by Bert Ely (1985).
[22.] See L. White (1984d, 29-30), and Checkland (1975, 67-68 and 254-55). Contrary to Checkland’s suggestion (p. 254), the option clause does not normally impede the equilibrating mechanism of competitive note issue. It merely forestalls a note-redemption run against any bank. However, in Scotland prior to 1765 (when the option clause was outlawed) usury laws placed a ceiling of 5 percent on interest payments on unredeemed notes. This may have been too low to discourage banks from abusing the option to suspend. Absent usury laws competition would have driven the option-clause interest rate to a punitive level.
[23.] The notice of withdrawal clause is also rarely taken advantage of in practice.
[24.] See Gary Gorton (1985a).
[25.] Gorton explains (1985c, 278) that “a demand deposit, unlike a bank note, is a ‘double claim’ since it is a claim on a specific agent’s account at a specific bank. Markets for double claims would be extremely ‘thin,’ and it would likely be very costly for brokers to invest in information gathering on every depositor.”
[26.] See Gary Gorton (1985b, 272), and Gibbons (1858, 394). Rolnick and Weber (1985, 209) report that in the U.S. from 1837 to 1863 bank runs were usually not “contagious.” This is consistent with the limited role played by deposit liabilities during this period and with the fact, also reported by Rolnick and Weber (1986, 877-90), that note holders were well informed about the assets securing most bank notes.
[27.] John Law, third Lettre sur le Nouveau Systeme des Finances, 1720; cited in Charles Rist (1966, 59).
[28.] Keynes (1936, 130).
[29.] Milton Friedman (1962, 221).
[30.] As we observed in chapter 2, banks might even settle clearings without resort to reserves of commodity money. This limiting case—which requires a high degree of confidence on the part of both bankers and the public—limits the role of the money commodity to that of unit of account, and therefore reduces resource costs associated with its use to zero. Such complete fiduciary substitution also renders the banking system more vulnerable to instability. The use of fiat currency as base money is another way of eliminating reserve-resource (opportunity) costs in a free banking system. A practical reform based on this approach is discussed below in chapter 11.
[31.] See Munn (1981, 141); also Checkland (1975, 382). Checkland observes that “Because of the place of the note issue in the economy, Scotland was a country almost without gold.” He cites the letter of a Scottish banker who says that the “first object” of any person who gets hold of a (gold) sovereign “is to get quit of it in exchange for a bank note.” Checkland notes further that “It was difficult for the Scottish bankers facing the inquiry of 1826 to think in terms of a gold circulation or of a substantial gold reserve, for they know very little of such a system.”
[32.] “If confidence for fiduciary [fiat] money costs as much to produce as the commodity, the social savings [from replacing commodity-money backed liabilities with fiat money] would be zero” (Benjamin Klein 1974, 435fn).
[33.] Rist warned of this ( 1966, 330). He saw it happen in the 1930s; he would undoubtedly have experienced a certain mournful satisfaction at being vindicated had he lived to see it reoccur in the past fifteen years.
[34.] The price of gold as this is being written (July 1985) is approximately $350. According to Lawrence H. White (1985), after allowing for inflation, “this is equivalent to more than $110 per ounce at 1967 prices, at which time the official price of gold was $35 per ounce, and more than $51 per ounce in 1929 terms, when gold was $20.67 per ounce.”
[35.] Another argument concerning the inefficiency of free banking, which claims that it is inefficient because it leads to suboptimal holdings of money balances, is considered below in chapter 10.
[1.] The criticisms discussed in this section are so much a part of received doctrine that it is unnecessary to cite particular occurrences of them in the literature.
[2.] The French case is conspicuous in this respect. It is discussed in the introduction and also in Nataf (1983). On the free vs. central banking debate in England see L. White (1984d, chapters 3-4). For debates in other nations see V. Smith (1936).
[3.] See the works by Rockoff and Rolnick and Weber cited in chapter 1.
[4.] Spencer’s argument for private coinage appears in his Social Statics (1896, 225-28).
[5.] See above, chapter 2, and also George MacDonald (1916, 7).
[6.] In the 1920s Bechtler dollars were still being accepted at par by North Carolina banks. See Woolridge (1970, 65) and Griffen (1929). Chapter 3 of Woolridge’s book is an excellent and entertaining survey of private issues of token (fractional) coinage in the U.S. For a good review of private coinage of fullweighted coins in the U.S. see Brian Summers (1976, 436-40).
[7.] It is noteworthy that in the 2nd. ed. of his Inquiry into the Currency Principle (1844) Tooke wrote that de facto convertibility into gold “together with unlimited competition as to issue” is sufficient to prevent an excessive issue of paper currency (155). He also pointed with approval to the example of Scotland (156). On the change in Tooke’s views on free banking, see Arie Arnon (1984).
[8.] Milton Friedman (1959, 6-7). In a more recent article (Friedman and Schwartz, 1986) Friedman reconsiders this and other arguments offered in his earlier work. He and Anna J. Schwartz write that under current conditions “The possibility—and reality—of fraud . . . seems unlikely to be more serious for hand-to-hand currency than for deposits” (51). They conclude that there is “no reason currently to prohibit banks from issuing hand-to-hand currency” (52). However they regard the possibility as a “dead issue” since it has no support from “banks or other groups.”
[9.] See the references cited in chapter 1.
[10.] Besides the passage from Friedman cited previously, see Robert G. King (1983, 136).
[11.] Emmanuel Coppieters (1955, 64-65), cited in L. White (1984d, 40). It is also relevant that the Scottish banks had a policy of accepting counterfeit money at par, in order to encourage its discovery and to assist the capture of its producers. This also eliminated any possibility of losses to note holders arising from this kind of fraud.
The average period of circulation of a Federal Reserve dollar from the time of its issue to the time of its return to a Federal Reserve bank is approximately 17 months. (See the Federal Reserve Bank of Atlanta, Fundamental Facts About U.S. Money.) The average period of circulation of twenty-dollar bills—which are most frequently counterfeited—is considerably longer. Approximately one-fifth of all exposed counterfeit currency is discovered at the Federal Reserve banks. (Source: Personal communication, Federal Reserve Bank of Richmond.)
[12.] Thus for example King (1983, 136) writes that “holders of circulating notes are unlikely to closely monitor the activities of a note issuer because notes represent a small fraction of an individual’s wealth and are held only for a brief period.” This, he says, will lead to banks “printing more notes than can be redeemed by securities” thereby “inflicting capital losses on noteholders if simultaneous redemption occurs.” This statement has several flaws in addition to the general criticism made in the text above. First of all, the reference to “simultaneous redemption” is gratuitous, since this would obviously lead to “capital losses” even in fractional-reserve banking systems lacking competitive note issue. Also, overissue is not a matter of “printing” too many notes but rather one of putting too many into circulation by making excess loans and investments. Finally, the passage implies that notes that can be “redeemed by securities” of their issuer do not represent an overissue. This is meaningless since almost any issue of notes by a bank involves a like purchase of securities.
[13.] Individuals could entirely reject other notes, or they could agree to accept the notes at a discount (as they did in the U.S. in the 19th century, when merchants had “note reporters”), depending upon the extent of their distrust of them. Either practice would discourage attempts to put untrustworthy notes into circulation.
[14.] In contradiction to King (1983, 136).
[15.] See for example Allan H. Meltzer (1983, 109-10), and the reference to Crouzet below.
[16.] According to Cameron (1967, 94ff) the Scottish economy grew more rapidly during the century prior to 1844 than the English economy during the same period. Adam Smith, among others, argued that free banking made a significant contribution to Scotland’s economic growth. See L. White (1984d, 24).
[17.] See Hugh Rockoff (1974, 141-67).
[18.] Schumpeter, however, in his Theory of Economic Development (1983), argues that entrepreneurial activity depends on banks’ issues of “abnormal credit” giving rise to forced savings. Schumpeter was influenced by the real-bills doctrine, and so he associated abnormal credit and forced savings with bank issues not based on commodity bills. Conversely, he regarded credit based on commodity bills as sufficient only for maintaining an economy in a stationary state. Neither proposition is correct: there is no definite limit to the amount of credit that can be granted on the basis of the supply of commodity bills, since the latter supply is itself a nominal magnitude influenced by the terms of bank lending. Thus credit based on “real bills” may finance entrepreneurial ventures away from the stationary state, including some that inflict forced saving on the public. On the other hand, credit based on assets other than commodity bills (which may also finance economic development) need not give rise to forced savings, so long as it is based on increased abstinence of holders of inside money. It follows that economic development can take place whether or not banks restrict their lending to commodity bills, and it can also take place without forced savings.
[19.] Returning once again to the example of Scotland, as of 1872 (after the free-banking era, but at a time when Scotland still had 10 competing banks of issue) per-capita loanable funds administered by the Scottish banks exceeded per-capita funds granted by banks in England, and this without any evidence of credit creation (Somers 1873, 86-87). This supports the argument in chapter 9 that free banking systems are more efficient in the administration of loanable funds than centralized banking systems.
[20.] See for example Milton Friedman (1975); Robert E. Lucas, Jr. and Thomas J. Sargent (1978); and F. A. Hayek (1975a, 15-29).
[21.] A good discussion of the proper role of monetary policy in preventing unemployment appears in Lloyd Mints (1950, 15-51).
[22.] The best example of this argument is Michael Melvin (1984). See also Benjamin Klein (1978, esp. 76-78). Other examples can be found in Roland Vaubel (1984a, 45ff).
[23.] On the distinction between subadditivity of costs and decreasing average costs see William W. Sharkey (1982, 7).
[24.] It is reasonable to assume, as a general rule, that the costs of market-building increase as the boundaries of the market extend further from the source of issued notes.
[25.] It also requires that the economy be a closed one in which there is zero demand for commodity money by the public.
[26.] Africa, Asia, and South America are not considered because relatively little is known about their banking history.
[27.] This is not to say that there were not also measures taken that had the effect of artificially limiting the extent of consolidation of banking and note issue. Most obvious of these were laws preventing branch banking, such as have long existed in the United States.
In view of this, Melvin’s claim (1984, 9) that “We observe government produced money, not because of barriers to entry, but because government produced money is socially efficient” is questionable. Of course any institution that survives must be “socially efficient” in some broad sense; but the persistence of a government monopoly does not prove that it has been more effective than competition in satisfying consumer wants. The historical evidence suggests other reasons for government involvement in this area.
[28.] But see Sharkey for exceptions.
[29.] One exception is reported by Tuh-Yueh Lee (1952). Lee writes that “the currency notes issued by the Bank of China [originally established as the Chinese Government Bank in 1904 and renamed after the Revolution of 1911] begot such confidence and were held in such high esteem that even the farmers who traditionally demanded solid cash (silver dollars) came to accept [the notes] in payment for their products although they still obstinately declined the issues of any other bank.”
[30.] See above, chapter 1.
[31.] Examples of the use of these arguments against free banking are given in Vaubel (1984a, 28-45). Although most of these examples refer explicitly to outside money only, many imply that the arguments in question also apply to redeemable bank notes.
[32.] Analytically, the “nonrivalrousness in consumption” (public good) and “positive externality” (underproduction) arguments are not really distinct; their separation here is based on convention rather than logic.
[33.] See above, chapter 1.
[34.] See Vaubel (1984a, 32).
[35.] See chapter 9.
[36.] Milton Friedman (1969). See also Paul A. Samuelson (1969).
[37.] See Harry G. Johnson (1973b, 91-92).
[38.] One possibility is discussed below in chapter 11.
[39.] Recall our statement of the conditions of long-run equilibrium in a fractional-reserve banking system, given in chapter 2.
[40.] S. C. Tsiang (1969). See also the discussion of consequences of monetary disequilibrium above, chapter 4.
[41.] See Vaubel (1984a).
[42.] See above, chapters 8 and 9.
[43.] See Thomas M. Humphrey (1975); and Thomas M. Humphrey and Robert E. Keleher (1984).
[44.] Recall the distinction drawn in chapter 9 between a redemption run and a currency run.
[45.] Jevons (1884, 171 and 186, Table 6). “Country” banks included both private and joint-stock banks located outside of the 65-mile radius marking and Bank of England’s region of note-issue monopoly.
[46.] On currency supply under the National Banking System see above, chapter 8.
[47.] This topic was dealt with in the third section of chapter 9.
[48.] There was a run for a few days in Scotland following the collapse of the Ayr Bank.
[49.] See for example Hawtrey (1932, 228 and 259).
[50.] Bailouts that reduce potential losses to bank shareholders and management also encourage a happy-go-lucky attitude in consumers of bank services.
[51.] See for example Friedman and Schwartz (1963, 440-41).
[52.] As Friedman and Schwartz (1986, 52) do.
[53.] John Viscount Morley (1898, 98).
[1.] Some material in this chapter has appeared previously, in somewhat altered form, in G. A. Selgin, “The Case for Free Banking: Then and Now,” Cato Institute Policy Analysis (October 21, 1985).
[2.] See in particular Henry C. Simons (1951); Lloyd W. Mints (1950); and Milton Friedman, (1959). Again we must note Friedman’s recent reconsideration of his former views, in “Has Government Any Role in Money?” Friedman’s current policy recommendations place him in fundamental agreement with reform suggestions made in this chapter. Whether other monetarists will follow him (and Anna J. Schwartz, who co-authored the above mentioned article) in this change of heart remains to be seen.
[3.] See above, chapter 8. It should be noted however, that Mints regarded prohibition of competitive note issue as an “unnecessary legal restriction.” “I can see no reason,” he wrote (1950, 187-88), “why, if fractional reserves against deposits are desirable, they are not equally desirable for notes. . . . In fact, the prevailing arrangement . . . operates to prevent a complete interconvertibility of notes and deposits” the consequence being “the preverse behavior of the volume of bank loans.” As I mentioned in chapter 8, Friedman also, in his earlier writings, recognized free note issue as a possible solution to what he nevertheless insisted on calling the “inherent instability of fractional reserve banking.” Yet Friedman originally rejected this solution, in one place because it “has little support among economists, bankers, or the public” (1953, 220), and elsewhere for reasons summarized in the text above.
[4.] Ibid. Some rational-expectations theorists also defend a monetary rule as providing greater predictability. However, in their models rules are often only “weakly superior to” (i.e., no worse than) all possible discretionary policies.
[5.] An example of a variable causing changes in the money multiplier is the relative demand for currency, which was discussed at length in chapter 8.
[6.] See for example Milton Friedman (1984a, 1984b) and Richard H. Timberlake, Jr. (1986, 760-62).
[7.] Strictly speaking, issue of bank notes by commercial banks is not presently illegal; however, such issue must still meet the bond-deposit requirements established under the National Banking System or the 10 percent tax on state bank notes. Since all bonds eligible as security for circulating notes were retired before 1935 (or had the circulation privilege conferred upon them withdrawn), note issue, while not illegal, is nevertheless impossible under existing law. Restoration of commercial bank note-issuing privileges merely requires repeal of the bond deposit provisions in the original National Banking statutes and of the prohibitive tax on state bank notes.
[8.] Thus, in contradiction to Friedman (1984a, 47), competition in note issue need not represent an effort to replace the “national currency unit.”
[9.] On unit banking as a source of financial instability in the United States and its role in turn-of-the-century monetary reform see Eugene Nelson White (1983).
[10.] Since Treasury bills bear interest, this reform would eliminate an important source of interest-free funds to the government. Since approximately $48 billion are held today to meet statutory requirements, their conversion into Treasury bills would involve a maximum gross loss to the Treasury of $2.88 billion, assuming that Treasury bills pay 6 percent interest. The net loss would be less, however, since increased bank earnings would also generate additional tax revenue.
[11.] Contrary to this view is the view, cited by Friedman (1984a, 49) of the “new monetary economists,” who argue that prohibiting bank-note issues actually stabilizes the demand for high-powered money.
[12.] Some of these suggestions would automatically be realized if Friedman’s recommendation—that the frozen stock of base dollars be converted into Treasury notes—were adopted. It would be safest, however, to have base dollars in a form capable of circulating, later allowing banks the option of converting some or all of them into special interest-earning Treasury obligations created for the purpose. The new Treasury obligations could be offset by cancelling an equivalent value of Treasury obligations held by the Federal Reserve banks.
[13.] This idea is suggested in J. Huston McCulloch (1986).
[14.] The figure is now (1985) approximately 35 percent. (Source: Federal Reserve Bank of St. Louis, U. S. Financial Data, March 28, 1985, 3-4.)
[15.] As is recommended by Richard H. Timberlake, Jr. (1986, 760). See also Joanna H. Frodin (1983). As Timberlake notes, privatization of the clearing system would probably result in an arrangement similar to what existed in the pre-Federal Reserve era.