The Online Library of Liberty

A project of Liberty Fund, Inc.

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

7

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),

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:

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:

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:

• 1. money supply changes aimed at stabilizing some index of prices;
• 2. money supply changes aimed at pegging some interest or discount rate;
• 3. money supply changes aimed at achieving “full employment”; and
• 4. money supply changes aimed at achieving a fixed percent rate of growth of the monetary base or of some monetary aggregate.

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):

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):

Nor, Hawtrey continues (ibid., 147) does this depend on the assumption that goods have a unitary price-elasticity of demand:

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.

[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.