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THEORY. HISTORY. /
A LAISSEZ-FAIRE MODEL L



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Free Banking


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FREE BANKING

Theory, History, and a
Laissez-Faire Model

LARRY J. SECHREST

Foreword by Kevin Dowd

The Ludwig von Mises Institute
Auburn, Alabama
2008


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Library of Congress Cataloging-in-Publication Data

Sechrest, Larry J.
Free banking / theory, history, and a laissez-faire model/
Larry J. Sechrest ; foreword by Kevin Dowd.
p. cm.
Includes bibliographical references and index.
ISBN 0-89930-815-5 (alk. paper)
1. Free banking. I. Title.
HG1588.54 1993
332.1—dc20 93-18243

British Library Cataloguing in Publication Data is available.

Copyright © 1993 by Larry J. Sechrest

All rights reserved. No portion of this book may be
reproduced, by any process or technique, without the
express written consent of the publisher.

Library of Congress Catalog Card Number: 93—-18243
ISBN: 0-89930-815-5

First published in 1993

Quorum Books, 88 Post Road West, Westport, CT 06881
An imprint of Greenwood Publishing Group, Inc.

Printed in the United States of America

&

The paper used in this book complies with the
Permanent Paper Standard issued by the National
Information Standards Organization (Z39.48—1984).

10987654321


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To Ayn Rand, Murray Rothbard, and F. A. Hayek
For the inspiration

To Henry G. and Raechel Raish
For the love and support


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CONTENTS

Figures and Tables ix
Foreword by Kevin Dowd xi
Preface XVvii
1. Introduction 1
2. Comparative Statics 13
3. Say’s Law 45
4. Monetary Policy 59
5. Scottish Free Banking 79
6. American Free Banking 95
7. Other Approaches 143
8. Criticisms 157
9. Final Thoughts 175
Appendix: A Mathematical Model of Free Banking 179
Bibliography 187

Index 199


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FIGURES AND TABLES

FIGURES

1. Microeffects of an Increase in k

2. Macroeffects of an Increase in k

3. Microeffects of a Decrease in Goods’ Production Costs
4. Macroeffects of a Decrease in Goods’ Production Costs
5. Microeffects of an Increase in Specie Reserves

6. Macroeffects of an Increase in Specie Reserves

7. Microeffects of an Increase in k/Decrease in k;

8. Macroeffects of an Increase in k/Decrease in k;

9. Effects of an Increase in the Relative Demand for Currency
(Central Banking)

10. Effects of an Increase in the Relative Demand for Currency
(Free Banking)

11. Price Effects of an Increase in Relative Currency Demand
12. Interest Rate Effects of an Increase in k
13. Interest Rate Effects of a Decrease in Goods’ Production Costs

14. Interest Rate Effects of an Increase in k/Decrease in k;

TABLES

1. Bank Failures per Thousand, 1772-1830
2. Wholesale Price Index for Great Britain, 1765-1845
3. Number of Banks in the United States, 1815-1860

29
29
31
32
33
34
36
36

39

40
40
51
51
52

84
86
98


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10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.

22.
23.
24.
25.
26.
27.
28.
29.
30.
31.
32.

Figures and Tables

American Bank Reserve Ratios, 1834-1860

American Bank Reserve Ratios as of January 1, 1860
American Bank Capital Ratios, 1834-1860

Money Supply per Capita, 1835-1860

Money Supply per Capita, 1867-1914

Money Supply per Capita, 1919-1932

Money Supply (M1) per Capita, 1959-1989

Money Supply per Capita (Hepburn Estimate), 1835-1860
Money Supply per Capita (Temin Estimate), 1835-1858
Monetary Base per Capita, 1835-1860

Monetary Base per Capita, 1867-1914

Monetary Base per Capita, 1919-1932

Monetary Base per Capita, 1959-1989

Wholesale Price Index, 1835-1932

Wholesale Price Index, 1959-1989

Consumer Price Index, 1835-1932

Consumer Price Index, 1959-1989

Commercial Paper Rate of Interest at Boston and New York,
1836-1860

Commercial Paper Rate of Interest at New York City, 1866-1914
Commercial Paper Rate of Interest at New York City, 1919-1932
Commercial Paper Rate of Interest at New York City, 1959-1989
Index of Common Stock Prices, 1835-1860

Index of Common Stock Prices, 1866-1878

Standard & Poor’s Index of Common Stock Prices, 1879-1932
Standard & Poor’s Index of Common Stock Prices, 1959-1989
Real National Income per Capita, 1839-1932

Real National Income per Capita, 1959-1989

Index of Industrial Output per Capita, 1829-1932

Index of Industrial Output per Capita, 1959-1989

106
107
108
112
113
114
115
117
118
119
120
121
122
124
125
126
127

128
129
130
131
132
133
134
135
136
137
138
139


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PREFACE TO NEW PRINTING

After the first edition of this book appeared in 1993, I turned away from many of
the banking issues explored herein. Anarchocapitalism, taxation, and public
goods in maritime history occupied most of my professional attention, while at
the same time there was an ongoing personal project, a 1300-page manuscript
analyzing merchant sailing ship performances, on which I have been working for
some 20 years. | continued to think and write about business cycles, but largely
left free banking behind. This was because I thought that the case for fractional
reserve free banking based on a commodity “outside” money had been persua-
sively presented by myself and others such as Lawrence H. White, George Selgin,
and Kevin Dowd. And I still do.

However, one group of economists has continued to reject and attack laissez-
faire banking, at least so long as such banks are based on the holding of less than
100 percent (primary) reserves. This group is principally composed of certain
Rothbardians associated with the Ludwig von Mises Institute, some of whom, by
the way, I am pleased to think of as friends. It includes, among others, Walter
Block, Jorg Guido Hiilsmann, Hans-Hermann Hoppe, William Barnett II, and
especially Jesus Huerta de Soto. In what follows I will explain why I think their
various condemnations of fractional reserve free banking (FRFB), despite their
energetic efforts, remain unconvincing.

Allow me to begin with the last, Huerta de Soto. His massive 876-page trea-
tise, Money, Bank Credit, and Economic Cycles (2006), is intended to be the final
and decisive proof that fractional reserves are incompatible with a) a proper
defense of private property rights, b) morality, and c) a stable economy. With
painstaking effort he investigates legal theory, banking history, business cycles,
and even variations in medieval theological doctrine. There is much to interest the
curious reader, but a great deal is actually irrelevant to the author’s professed
intent. Further, one will repeatedly encounter, along with some careful scholar-
ship, “straw man” arguments, nonsequiturs, and question-begging. Pervading the

1


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2 Preface

early portions of the work is the assertion that ancient Roman law, and medieval
European law based upon it, correctly identified the true nature of demand
deposits (“monetary irregular deposits”) as warehouse contracts involving fungi-
ble goods (though he seems strangely unaware that commodity coins have often
not been fungible due to debasement, or normal wear and tear). Any deviation
from such contractual relations (e.g., fractional reserves) he thus castigates as an
act of fraud or theft on the part of the banker. If that sounds as if the book adopts
a severely moralizing tone, it does. In fact, there is use of the term “sin” when
reviewing various episodes in banking history (pp. 88, 92, 97). And fractional
reserve depositaries are even described as “legal aberrations” possessing no legal
standing, much like human “monsters” with physical deformities (p. 143).
Moreover, Huerta de Soto insists that banks indulging in fractional reserves
inevitably open the Pandora’s Box of monetary inflation, excessive credit cre-
ation, malinvestment, and business cycles (pp. xxvi, 56 n32, 265-395).

He does recognize that loans (mutuum contracts) are also legitimate, but at
the same time insists that all loans must be for a stated time period. Amazingly,
Huerta de Soto declares that loans devoid of such a time stipulation “cannot
exist” (pp. 3-4). And yet they do exist. Prepayment options are common today in
both mortgage contracts and tuition loans to college students. At a number of
points elsewhere in the book, he claims that throughout history the principal, if
not the only, reason for bank failures and bank runs has been fractional reserves.
Here he ignores two crucial facts: a) bank failures have often been the result of
constraining regulations and/or errors in granting loans and b) during bank runs,
consumers have often shifted their checkable deposits from an insolvent fraction-
al reserve bank to some other, solvent fractional reserve bank—instead of simply
holding greater amounts of cash, either at home or in a safety deposit box. It is
precisely this sort of faulty reasoning, born of a plausible premise but impervious
to the facts, which will justifiably fail to persuade many economists.

In effect, Huerta de Soto defines demand deposits as a warehousing contract
and then proceeds to provide many details on how that sort of contract has often
been violated by banks. He never really comes to grips with the nature of FRFB,
nor with its defenders’ arguments (though he attempts to do this in his Chapter 8).
This book chronicles many episodes in banking history, but the conclusions that
are drawn are highly dependent upon the assumptions from which they com-
mence. For example, a speech given by Demosthenes in 362 B.C. is discussed at
some length in order to glean an understanding of ancient Greek banking.
However, when Demosthenes declares that the main reason for bank failures was
the extension of credit to unworthy borrowers, Huerta de Soto suddenly parts
company with him, insisting that he is “mistaken” since the real reason for such
failures was bankers’ failure to hold 100 percent reserves (pp. 48-49). Similarly,
after favorably citing works by scholars Ramon Carande, Abbott P. Usher, and
Raymond De Roover, he asserts that they all have misinterpreted the historical


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Preface 3

evidence insofar as they fail to dwell on what he would, no doubt, describe as the
egregious fraud of fractional reserves (pp. 71 n56, 74, 81).

While discussing theorists of the famed School of Salamanca, he concedes
that some actually favored fractional reserves, but these he dismisses as being
Jesuit “deviationists” (p. 95, n97). He does of course praise those Dominicans of
Salamanca who, he believes, were advocates of 100 percent reserves. However,
it is not entirely clear from the citations provided whether these Dominicans’
criticisms were actually aimed at fractional reserves per se or at “usurious” loan
contracts between bankers and their customers (pp. 85-88). In fact, he comes
rather close, though unintentionally, to conceding the latter (p. 89).

There are also some rather far fetched connections that Huerta de Soto is will-
ing to use as “evidence” in his favor. One particularly notable example has to do
with his judgment of the operations of Spanish banks during the sixteenth centu-
ry. Here he depends largely on the work of Carlo M. Cipolla regarding Italian
banks of that same time period. Amazingly, Huerta de Soto reassures the reader
that the details on Italian banks are “directly applicable” to Spanish banks
because of the close economic ties between the two nations (p. 81). I would grant
that banking practices in one nation might mirror those in another nation, but |
would need more of an explanation than the mere assertion that the two
economies were, in certain ways, interdependent. Great Britain and the United
States have been linked economically for a long time, but does that justify the
conclusion that any analysis of American banking practices would be equally
applicable to Britain?

The foregoing indirectly brings to mind a further possible problem for the
reader, though not necessarily a flaw in the presentation. Huerta de Soto is obvi-
ously multilingual, which is entirely to his credit of course. His sources include
ones which are in English, Latin, Spanish, Italian, and French. However, any
reader fluent in only one of those languages—and who might have reservations
about Huerta de Soto’s evidence—must be left with the nagging question of
whether certain of the cited sources actually do support the book’s arguments.

Above all, Huerta de Soto refuses to even consider the possibility that banks’
customers may have been quite willing to face some risk exposure in exchange
for the benefits of a) the receipt of interest on their deposits and b) having circu-
lating inside money in the form of “payable to the bearer” banknotes (something
100 percent reserve banks are unable to provide, since they must charge security
fees on all demand deposits). Instead, he is driven to a heavily conspiratorial
interpretation of banking history. In his hands any departure from 100 percent
reserve banking is automatically taken to be evidence of malfeasance by bankers,
even when there is no clear data on the details of the contractual relations nego-
tiated by depositors. “[TThe traditional principles of safekeeping on which the
monetary irregular-deposit contract is based were violated from the very begin-
ning [of banking] in a concealed manner. . . . [Governments] supported bankers’
improper activity almost from the beginning” (pp. 37-38). This may accord with


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4 Preface

Murray Rothbard’s view of the political class as some sort of unrepentant cabal,
but it sheds rather little light on the essence of banking.

A clever variation on this same theme of fractional reserve banking as fraud
can be found in Jorg Guido Hiilsmann’s article “Has Fractional-Reserve Banking
Really Passed the Market Test?” (The Independent Review, Winter 2003). The
novelty here is the argument that the “IOUs” of fractional reserve banks (their
issues of banknotes and deposit credits) are naturally differentiable due to the
varying risk characteristics of each bank, and thus such fiduciary instruments will
vary in price, with all being traded at a discount relative to real money (specie)
and money titles (notes issued by 100 percent reserve banks). To overcome this
problem, Hiilsmann claims that FRFB will unavoidably gravitate toward forming
a cartel in which all individual banks agree to “homogenize” inside money by
accepting one another’s IOUs at par. Their goal is to accomplish the “semantic
trickery” (p. 411) of deceiving the public into thinking that the banknotes or
deposit credits issued by fractional reserve banks are no different from money or
money titles.

There are two flaws in this argument. First, if the cartel is voluntary, it will
have little chance of surviving. As Murray Rothbard pointed out in Man,
Economy, and State (pp. 579-86), such cartels are inherently unstable. They
either revert to a multiplicity of competitors or merge into one large firm. If we
are to take Hiilsmann’s hypothesis seriously, then it is incumbent upon him to
explain why cartels are generically unstable, but somehow stable in the context
of fractional reserve banking. On the other hand, if compulsion is involved, what
one has is the imposition of a central bank on the economy. The former case is
ineffective, and the latter has no relevance to the case for FRFB.

Second, Hiilsmann apparently wants the reader to believe that consumers are
somehow steadfastly incapable of differentiating a) money warehouses which
issue money titles and charge their customers fees for the provision of security
(and perhaps transaction services such as accounting entries which transfer funds
from one customer to another) from b) financial intermediaries which issue their
own distinctive inside money (“IOUs”), offer transaction services, and pay inter-
est on their customers’ account balances. In fact, he even claims that Gresham’s
Law becomes operative in this environment (p. 408). That is, he insists that the
“overpriced” IOUs tend to drive the “underpriced” money titles out of circula-
tion.

One immediate problem with this is that, as Murray Rothbard stated emphat-
ically (Man, Economy, and State, p. 783), Gresham’s Law only applies to the case
where one form of money is officially overpriced and the other officially under-
priced, that is, by an act of government. It does not apply to free market relation-
ships. A further, obvious inconsistency is revealed as soon as the reader recalls
that these selfsame bank customers are allegedly able to differentiate among the
IOUs issued by various fractional reserve banks (based on the variation in risk)
and simultaneously unable to tell the difference between a fractional reserve IOU


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Preface 5

and a real money title issued by a 100 percent reserve bank warehouse. This is
nonsensical. It seems comparable to claiming that a person can differentiate
among the numerous breeds of dogs, but cannot tell that a cat is not a dog.

Allow me now to leave aside further specific criticisms of particular works
and instead to emphasize certain commonalities. Found in both of these above-
mentioned essays, and most if not all, other defenses of 100 percent reserve bank-
ing are three problematic assertions. The first is the assumption that any departure
from 100 percent reserves cannot be agreeable to the bank’s customers and thus
constitutes an act of fraud on the part of the banker. As a result, all the historical
episodes in which banks began as money warehouses but later acted as interme-
diaries holding fractional reserves are immediately interpreted as being rooted in
criminality. The obvious alternative possibility, that fractional reserve holding
might have naturally evolved as an improvement on warehousing is rejected out
of hand. This mode of thinking extends to court cases. Any judge who ruled that
interest-bearing demand deposits were a form of loan to the banker becomes an
accomplice to fraud. The idea that such a ruling might have accurately reflected
a common practice, one generated by the fully-informed and voluntary actions of
both banker and depositor, is never investigated seriously.

The second troubling premise is the notion that, once there exists an accepted
medium of exchange used by all in a given society, no changes in the money
stock are ever welfare-enhancing. In other words, at that moment the existing
supply is already optimal. Neither subsequent increases nor subsequent decreas-
es serve any valid economic purpose (other than those deflationary decreases
which are the corrective for prior inflationary increases). That having been said,
they do not quite mean literally all changes in the money supply. Increases in ban-
knotes or deposit credits which stem from an increase in the monetary gold held
in the vaults of the 100 percent reserve banks are seen as natural and harmless.
And they often note that such increases in the specie base have occurred histori-
cally at modest annual rates of 1 percent—5 percent.

This proposition faces a serious difficulty. It can only be correct if it is true
that the purchasing power of a given money stock adjusts immediately to reflect
changing conditions, i.e., all prices must be perfectly flexible in the short run.
And I have long found that latter condition to be highly questionable. Indeed, it
flies in the face of certain crucial aspects of Austrian thought. For instance, all
Austrians describe the market as comprising interactions between forward-look-
ing (i.e., speculative) buyers and sellers whose state of knowledge is always
incomplete, even as they strive for completeness. Moreover, this state of knowl-
edge 1s ever-evolving precisely because the market is a discovery process. But to
discover economic facts requires time. It cannot be anything close to instanta-
neous. And it cannot be devoid of error. Therefore, to conceive of the market as
a discovery process is to cast doubt upon the idea that all prices are fully and rap-
idly flexible. Those who maintain that any supply of money is “optimal” seem, in


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6 Preface

effect, to live in the long run world of full equilibrium, not the real world of con-
stant adjustments and corrections.

Further doubt is raised as soon as one tries to integrate full and rapid price
flexibility with the Austrian theory of business cycles (ABCT). This probably
cannot be done in any plausible way. ABCT is a theory of unsustainable booms—
—followed at some point by inescapable contractions—which are fueled by
excessive credit expansion undertaken by the central bank. Relative prices and the
market rate of interest are modified in a way that is inconsistent with consumers’
time preferences. These monetary effects are far from trivial because they elicit
changes in real factors, in particular, changes in the capital structure. In striking
contrast to mainstream macroeconomists, who usually ignore all issues of the
capital structure (and thus focus on either short run disequilibria or on full, long
run equilibrium), Austrians wisely emphasize the medium run. This is a time peri-
od long enough for a restructuring of capital to take place, but too short for the
resulting malinvestment to be both recognized and corrected.

Money and credit precipitate the problem; while time-consuming alterations
in capital are its manifestation. Furthermore, if the array of relative prices were
to be disrupted only briefly, then the capital budgeting errors that are later iden-
tified as malinvestment would be much less likely to occur in the first place. If
longer-term projects were planned, but then relative prices quickly changed back
so as to reveal them to be errors, many projects would never be undertaken at all,
and others soon thereafter would be liquidated. The unsustainable boom would
never really get underway at all. Once again, some passage of time is needed.
There must be time to plan capital projects, time to put those plans in action, time
during which the deceptive market signals continue to reassure entrepreneurs that
their projects are justified, time for the temporal malinvestment eventually to
reveal itself. ABCT deals not with the artificial world of perfect competition, per-
fect knowledge, and an infallible auctioneer, but with the real world of strategic
action, imperfect knowledge, and fallible entrepreneurs. ABCT would appear to
require that money has powerful, but sometimes sluggish, effects on prices.

The third problem area is a derivative of the issue of price flexibility dis-
cussed above. It is the implicit assumption that the demand for money is, in
effect, irrelevant to a proper analysis of banking. Led by Murray Rothbard, vari-
ous Austrians have addressed a question which will inevitably be asked of any
advocate of 100 percent reserves: What happens if the demand for money rises or
falls? According to these Austrians, a change in the demand for money does not
justify a commensurate change in the supply of money. With a given nominal
supply of money, if the demand rises (falls) all that will occur is that the purchas-
ing power of money (the inverse of the array of goods’ prices) will rise (fall). No
adjustment to the nominal stock of money is needed, so 100 percent reserve hold-
ing by banks creates no difficulty. Perfect price flexibility allegedly ensures that
the real money stock adjusts in the appropriate direction. If that line of reason-
ing is correct, then why does this not work equally easily on the other side of the


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Preface 7

market? That is, with a given nominal demand for money, if the nominal supply
of money rises (falls) why is the corrective not “simply” a fall (rise) in the pur-
chasing power of money?

As questionable as the foregoing perspective is, no short-run alternative solu-
tion would seem to exist for the proponent of 100 percent reserves. Thus, in the
absence of perfect price flexibility for all goods and services, both inputs and out-
puts, only fractional reserve free banks are capable of responding properly to
changes in the demand for money. Chapters 2 and 3, plus portions of Chapters 4
and 8, of the present work will examine that adjustment process in considerable
detail.

I would like earnestly to thank Jeffrey Tucker and the Ludwig von Mises
Institute for their willingness to publish this new edition. Whether or not one
agrees with the conclusions found herein, I believe that it offers a valuable sur-
vey of many of the historical and theoretical issues surrounding laissez-faire
banking. Therefore, I hope that one of its uses may be as a supplemental text in
banking or monetary theory courses.

I greatly appreciate the helpful comments I have received from John P.
Cochran, Steven Horwitz, Lawrence H. White, George Selgin, and Kevin Dowd,
as well as the gracious responses from Jess Huerta de Soto to certain questions
of mine.

Finally, I wish to thank my wife Mary Ann and my son Kyle for their invalu-
able love and support.

Larry J. Sechrest
June 2008


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===== PAGE 20 =====

FOREWORD

Free banking is—or at least ought to be—one of the key economic issues of
our time. There is mounting evidence that the monetary instability created by
the Federal Reserve—persistent and often erratic inflation, the unpredictable
shifts of Federal Reserve monetary policy, and the gyrating interest rates that
accompany both inflation and the monetary policy that creates it—have inflicted
colossal damage on the U.S. economy and on the fabric of American society
more generally. Furthermore, much as the United States has suffered, less for-
tunate countries have suffered far more. Most of us have watched in horror,
for example, as Russia has come out of more than seventy years of Communist
misery only to slide now into the abyss of hyperinflation. Unlike some disas-
ters, monetary instability is entirely avoidable, but to avoid it, we need to make
sure that the monetary system is built on the right foundations—foundations
we are very far from having. On top of these monetary problems, we also
observe in the United States how ill-judged attempts to regulate the banking
system and protect it from the (grossly exaggerated) danger of runs have spawned
a massive apparatus of deposit insurance and regulatory control in the form of
the FDIC, the now-bankrupt FSLIC, and a variety of other bureaucracies. These
agencies were (ostensibly) set up to protect a banking system that, though
weakened by legislative restrictions of various kinds and by misguided Federal
Reserve policies in the 1930s, was still relatively strong, and yet they managed
to convert that system into a chronic invalid made artificially dependent on the
ultimately lethal drug of deposit insurance. In addition to gravely weakening
the banking system and destroying much of it in the process, the deposit insur-
ance system also accumulated staggering losses—losses of hundreds of billions
of dollars and perhaps more—which it then passed back to the long-suffering
federal taxpayer. Politicians and bureaucrats have responded with a series of


===== PAGE 21 =====

Xii Foreword

largely cosmetic reforms that have accomplished virtually nothing and are no-
where near any realistic solution. Once again, what we need are sound free-
banking foundations. We do not have such foundations and are unlikely ever
to get them if things continue as they are.

Larry Sechrest’s book is therefore a timely contribution to a very important
policy debate. It is sad indeed that our political and intellectual leaders have
still to learn the most important and most obvious lesson to be drawn from the
collapse of communism in the eastern bloc—that central planning does not, and
cannot, work. To paraphrase Larry, amidst all the celebration that accompanied
the demise of communism and with all that has been written about the problems
of central planning, our leaders are still afflicted with the craving to practice it,
and they cling to the illusion that though eastern bloc socialism might be dead,
they still believe that all is well with central planning in the West. They know
that central planning failed in the East, but they learned nothing from that
failure, and nowhere is this illusion stronger and more cherished than in the
sphere of money and banking. One suspects that part of the reason the illusion
1s as strong as it is in this area is that even professional economists are by and
large still afflicted with the central planning mentality. We do not talk of mon-
etary central planning, of course—we talk of central banking or monetary pol-
icy—but the goals are the same even if we prefer to use a less sinister label to
describe them. Central banking is central planning. Those of us who support
free banking find it odd that despite all the failures of central planning—the
failures of central planning in the eastern bloc, the failures of monetary central
planning in the West, and other failures besides—so many economists still
cling to it and refuse to consider free banking as a serious alternative. Most
still scoff at the idea and dismiss free banking as inherently unworkable (which
it is not). Alternatively, they reject it on the basis that it was tried and failed
in the past, an argument that is not only not true, but that also has a very
strange logic to it. They point to instances such as the bank failures of the
antebellum United States as evidence that free banking has a poor historical
record—which, in any case, is a highly questionable interpretation. They then
conclude that free banking is inferior to central banking, and lo and behold,
they have managed to demonstrate that the modern system of central planning,
which has produced far more failures, a much weaker banking system, and
massive taxpayer losses into the bargain—a system that is demonstrably infe-
rior by any sensible yardstick—is actually the better system!

Yet as Larry argues, this attitude toward free banking simply will not do.
The free-banking position is not easily dismissed, and it is too radical and far-
reaching to be sensibly ignored. If the free bankers are correct, as I believe
they are, then no amount of tinkering will make much difference to our present
monetary and banking problems, and we will never get far with them until we
start to base reforms on free-banking principles. If the free bankers are not
correct, on the other hand, then it is odd that no one has yet managed to refute
the case for free banking and ensure that the errors of this potentially dangerous


===== PAGE 22 =====

Foreword xiii

point of view are exposed for all to see. Yet instead of either siding with the
free bankers or trying to refute them, most monetary economists seem to prefer
to ignore the free-banking issue altogether and carry on regardless. One can
only suppose they have invested a lot of their human capital into ways of
thinking that would have to be ditched if free-banking theory turned out to be
correct, and only a few can bring themselves to learn again what they thought
they already knew.

Larry Sechrest is one of the few who rise to this challenge without flinching
and try, as it were, to put the shattered pieces of monetary economics back
together again. There is much in this book to appeal to many different readers.
Those interested in public policy, and in monetary and banking policy in par-
ticular, will find a very articulate and insightful discussion of policy issues.
Undergraduates and postgraduates will find new ideas and clear expositions of
many issues that researchers and policy makers are talking about, but that have
not yet found their way into textbooks. Researchers—academic economists,
monetary historians, students of public policy, and others—will find a variety
of theoretical developments, new insights and criticisms of existing work, and
new interpretations of the historical evidence.

This volume stands out from the existing literature in a number of ways.
Although free banking has a number of supporters, different writers often have
very different ideas about what free banking in practice would look like. Most
writers also fail to discuss in any detail how their systems differ from each
other, and the discussions that already exist are often extremely arcane. The
reader who starts on this literature therefore enters a mine field with no real
warning. Amongst other things, the author makes a very useful contribution by
comparing these various systems and offering assessments of them. Some free
bankers think in terms of banks issuing their own inconvertible currencies,
whereas others think in terms of free banks issuing convertible currencies of
one form or other; some free bankers believe that free banks would aim to
stabilize the price level, and others, that they would allow prices to fall with
productivity growth; some free bankers see free banks as mutual fund inter-
mediaries, and others as institutions like conventional present-day banks that
issue both debt and equity; some believe that free banks would operate on a
fractional reserve, others that they would observe a 100 percent reserve ratio,
and so on. The student of free banking needs to get acquainted with these
issues before getting too far into the literature, and this book in my opinion
would be a very good place to start.

It offers, however, much more than an introduction to what other people
have written. An issue often touched upon in the free-banking literature, but
seldom developed in any depth, is the role of the central bank in creating or
aggravating the fluctuations of the business cycle. One finds short discussions
here and there, but Larry offers a much more thorough treatment of it, one that
breaks ground that others had merely staked out. He also offers new empirical
evidence on and new interpretations of the much-discussed historical experi-


===== PAGE 23 =====

X1V Foreword

ences of ‘‘nearly free banking,’ if that is what they were, in Scotland and the
antebellum United States. He argues that these experiences ought not to be
interpreted as laboratory-like experiments of ‘‘pure’’ free banking, and he sug-
gests the delightful metaphor that they are like buildings that were well de-
signed but not actually constructed according to those designs. They therefore
ran into problems, but those problems cannot be traced to design faults. The
design as such (i.e., free-banking theory) was sound, but the construction (i.e.,
the particular legislative frameworks in which banks had to operate) was not.
He also takes issue with those—such as Lawrence H. White and, to a some-
what lesser extent, me—who have interpreted the Scottish experience as a rea-
sonably good, albeit flawed, example of free banking. It is characteristic of
Larry’s intellectual integrity that although he readily admits that it would be
nice, from a free-banking point of view, to point to the Scottish experience as
a case study of free banking in action, and thus gain an edge over anti-free-
banking critics who believe that free banking does not work, yet he simply
does not interpret the evidence that way, and he would rather pass up the
chance of scoring points against the opponents of free banking than compro-
mise his own scholarship. I do not share his interpretation of the Scottish ex-
perience, but I do think this kind of critical reassessment is very important,
and I applaud him for it. If nothing else, it helps protect us against the myth-
making all too prevalent in monetary economics and the associated danger of
imposing our theories too strongly on the data.

In my opinion, Larry’s most important contribution is his analysis of the
impossibility of rational monetary central planning. The problem with central
banking is not that central bankers are ill-intentioned or incompetent people—
my own personal experience suggests that they are quite the contrary—but that
the very institution of central banking imposes on those who have to operate
the system problems to which no feasible solutions exist. They do not have the
information they would need to solve them—they do not have the data, and
they do not have the knowledge of what rational expectations theorists like to
call the “‘structure’’ of the economy. They cannot tell what interest rates ‘‘should’’
be, what monetary target to adopt, and so on, if only because they do not have
the information they would need. They try to answer these questions regard-
less—they feel they have no alternative—and are therefore doomed to failure.
If a system with good and capable people still does not work, one must blame
the system itself for asking them to do the impossible. The same problems
arise, of course, in any system that becomes centrally planned—that is of course
why central planning always fails. The solution—the only solution—is always
the same, regardless of whether we are talking of the (thankfully) now-defunct
Gosplan in Moscow or the Federal Reserve System in the United States: The
central planning apparatus must be dismantled, and market forces allowed in
to do what no central planner can do in their place.

William Gladstone is reputed to have said that monetary economics was the
surest recipe for insanity that he knew of. I am not yet entirely convinced of


===== PAGE 24 =====

Foreword XV

that, but I would certainly agree that monetary economics produces more than
its fair share of confusion and muddled thinking among those of us who study
it. (I speak here primarily of my own experience. I have pulled out my hair
and changed my mind on monetary issues far more often than I would care to
admit.) Those who produce innovative work in areas such as this are probably
even more prone than most to these sorts of problems, and the best any of us
can aim for is a good ‘hit ratio’’ of valid new insights relative to errors and
misinterpretations. We can only hope that those who read our work will pick
out the better ideas and discard the rest, preferably quietly. Yet this kind of
work, risky as it is, is of fundamental importance, and monetary economics
cannot really advance far without it. We need this kind of high-risk intellectual
entrepreneurship—a willingness to stick one’s neck out with new ideas that
may turn out to be brilliantly successful or may leave one falling flat on one’s
face—and we also need critics who can look at the work of others and help sift
out the good ideas from those that are indifferent or just plain wrong. This
book offers both qualities in good measure—the entrepreneurship and the crit-
ical assessment of other work—and I hope it gets the attention it richly de-
serves. I also hope that the critical assessment of others will bear out my belief
that the author achieves a pretty good ratio of hits to misses.

Kevin Dowd


===== PAGE 25 =====



===== PAGE 26 =====

PREFACE

The debate over free banking is one of the most important in economics today.
It is perhaps the penultimate debate between those who advocate free markets
and those who embrace (at least partial) central planning. Macroeconomic mon-
etary policy conducted by a central bank is the last bastion of both method-
ological holism and the ‘‘constructivist rationalism’ such holism often spawns.
To advocate free banking is to mount an assault upon that citadel.

The seminal work in the modern theory of free banking is, of course, that
of the late Friedrich A. Hayek. The second stage of development comprises the
elaborations and modifications of that Hayekian foundation, which have been
offered by Lawrence White, George Selgin, and Kevin Dowd, among others.

This book is an attempt to further the evolution of free-banking theory by
(1) presenting a formal model of the White-Selgin analysis, (2) exploring the
connection between free banking and Say’s Law, and (3) explaining why ra-
tional monetary policy is impossible in a central banking regime. In addition,
the history of free banking in Scotland and the United States is discussed in
some detail. Finally, there are reviews of alternative approaches to, as well as
common criticisms of, free banking. I would hope that both the professional
economist and the interested layperson would find something of value herein.

The present work is a significantly revised version of my doctoral disserta-
tion at the University of Texas at Arlington. I would like, therefore, to express
my thanks to the members of my dissertation committee: Thomas Holland,
Eirik Furubotn, Dan Himarios, Larry Ziegler, Peggy Swanson, and Allan Saxe.

To Kevin Dowd I owe a special debt of gratitude. He was kind enough to
write the foreword to this book. Moreover, I have benefited enormously from
his many insightful comments and suggestions. He has been a friend. I am also


===== PAGE 27 =====

XViii Preface

very grateful to Lawrence H. White for first exciting my interest in this topic
with his Free Banking in Britain.

For offering me their comments and/or copies of their papers, I want to thank
the following (in addition to Dowd and White): Milton Friedman, Robert Higgs,
George Selgin, Leland B. Yeager, Donald R. Wells, Catherine England, Ste-
ven Horwitz, Thomas M. Humphrey, and Sheila Dow.

For their financial assistance, I extend my heartfelt thanks to both the Lud-
wig von Mises Institute and the Institute for Humane Studies. The fellowships
they granted me were instrumental in the timely completion of my Ph.D. stud-
ies.

It should, of course, be understood that the views expressed herein are not
necessarily the views of any of the individuals or institutes mentioned above.

Last, but certainly not least, I want to thank my wife Donna for her unflag-
ging and essential support.


===== PAGE 28 =====

Chapter 1

INTRODUCTION

It is no longer possible to deny that there exist widespread academic concern
for and dissatisfaction with the American financial system. In particular, var-
ious regulatory agencies have been singled out for criticism. The FDIC, the
now-defunct FSLIC, and the Federal Reserve have all come under fire in the
recent past.

It has been demonstrated that the FDIC and FSLIC have contributed to the
banking and savings and loan (S&L) crises by virtue of their role as sources of
“moral hazard.””' Moral hazard is the idea that any entity that is insured against
risk—especially when it does not bear the full costs of the risk—tends to in-
dulge in riskier behavior. The principal problem with FDIC insurance is that
the premiums paid by financial institutions are not adjusted for the riskiness of
the asset portfolios held by those institutions. As a predictable result, many
institutions have acquired assets, for example, made loans that promised high
potential rates of return but also were subject to significant risk. At the first
sign of an economic downturn, many such assets experience rapid declines in
their market value. This may leave the institution insolvent. Thus, deposit in-
surance has contributed to the large number of failures of both S&Ls and banks
during the past decade.

Less thoroughly explored and less commonly discussed has been the insta-
bility brought about by the very existence of the American central bank, the
Federal Reserve. Nevertheless, a growing number of economists have begun to
perceive the Federal Reserve (the ‘‘Fed’”) as an agency more concerned with
its own authority than with the ‘‘general welfare’’ and as an ineffectual, even
counterproductive, monetary authority. The following observations by three Nobel
laureates perhaps convey the depth and breadth of such concerns.

Milton Friedman has stated that ‘‘in my opinion, no major institution in the


===== PAGE 29 =====

2 Free Banking

United States has so poor a record of performance over so long a period . . .
as the Federal Reserve’’ (1985, 5). He goes on to recommend that we ‘abolish
the money-creating powers of the Federal Reserve, freeze the quantity of high
powered money, and deregulate the financial system’ (1985, 12).? Friedrich
Hayek has argued that *‘I do not think it an exaggeration to say that it is wholly
impossible for a central bank subject to political control, or even exposed to
serious political pressure, to regulate the quantity of money in a way conducive
to a smoothly functioning market order’ (1978, 113). James Buchanan, finding
the existing operating structure wholly inadequate, proposes that the salaries of
Fed officials be inversely related to the rate of inflation as a means of promot-
ing monetary stability. He goes on to suggest that ‘if no incentive-motivational
structure is deemed to be institutionally and politically feasible . . . the argu-
ment for more basic regime shift in the direction of an automatic or self-cor-
recting system based on some commodity base is substantially strengthened’’
(1986, 148).

The question remains: Is the problem one of specific policies undertaken by
the Fed (which, presumably, could be curbed by changing the motivational
constraints on the Fed), or is the problem the fact that the United States has a
central bank? In short, are central banks inherently inconsistent with monetary
stability? The overwhelming majority of economists are very reluctant to an-
swer the latter question in the affirmative. Despite the rapidly growing body of
scholarly work on free banking, most still scoff at the idea that money can be
safely and sanely provided in an unfettered market context. This is evidenced,
for example, by the fact that free banking is rarely discussed sympathetically
in textbooks, if it is mentioned at all.?

The position taken by advocates of free banking is that no amount of tink-
ering with the present system will suffice. They insist that only a fundamental
change in the banking structure can solve the monetary problems faced by the
United States or any nation. The purpose of this work is to explore the char-
acteristics of the most radical of alternative regimes: free banking.

DEFINITIONS OF CENTRAL BANKING AND FREE BANKING

Before discussing free banking in any detail, one must first of all define the
term—as well as its opposite, central banking. Central banking is a nonmarket,
centralized approach to monetary matters. A central bank is granted certain
legal powers and privileges that are the means by which it attempts to manip-
ulate selected macroeconomic measures. These measures most often are the
rate of inflation, the rate of unemployment, various market interest rates, and
Gross National Product (GNP). The specific tools by use of which a central
bank may affect the foregoing usually include (as in the case of the Federal
Reserve) the buying and selling of government securities, changes in the rate
of interest charged by the central bank on loans to private depository institu-
tions, and changes in the reserve requirements imposed on these institutions.


===== PAGE 30 =====

Introduction 3

It is crucial to understand that the central bank’s roles as a holder of com-
mercial bank reserves and as a supplier of credit both are derivative. Both
depend largely on the fact that central banks typically are granted a legal mo-
nopoly on the issue of banknotes (Smith 1990, 168). That is, central banking
and legal tender laws go hand-in-hand. Moreover, ‘‘a central bank is not a
natural product of banking development. It is imposed from outside or comes
into being as the result of Government favours’ (Smith 1990, 169).

In contrast, one finds free banking, a term that denotes a market-oriented,
decentralized approach to money. Free banking’s most obvious features are (1)
the absence of any central monetary authority and (2) the issuance of notes as
well as deposit accounts by individual private banks. More generally, under a
free-banking structure, ‘‘banks are free to pursue whatever policies they find
advantageous in the issuing of liabilities and the holding of asset portfolios,
subject only to the general legal prohibition against fraud or breach of con-
tract”’ (White 1985, 117). Furthermore, ‘‘entry into a free banking system is
unrestricted” (Selgin 1988b, 621), and ‘‘loans and securities would not be
subjected to interest controls, nor would investment in any particular industry
be mandated or forbidden . . . banks could even acquire equity positions in
other firms’ (Wells and Scruggs 1986b, 262). Also, such banks ‘‘would be
free to open and close branches wherever they wanted’” (Wells and Scruggs
1986b, 263). Finally, government deposit insurance would be neither necessary
nor desirable, since market forces would encourage consumers to ‘‘find ways
to protect their funds’ privately (England 1988, 772). Thus, a ‘‘pure’ free-
banking system (which has never existed>) would be one in which there were
(1) no governmental restrictions on entry or exit by firms into or out of bank-
ing, (2) no restrictions (other than the enforcement of valid contracts) on the
issuing of notes as well as deposit accounts by financial institutions, (3) no
central bank that acts as an ex ante lender of last resort, (4) no governmental
deposit insurance, (5) no statutory reserve requirements, (6) no minimum cap-
ital requirements, (7) no restrictions on branching, (8) no restrictions regarding
the kinds of activities in which a bank might engage, such as the underwriting
of corporate stock or bond issues, and (9) no interest rate controls. In short,
free banking means the total deregulation of the banking industry. It is the
thorough application of the principles of laissez faire to the one realm of eco-
nomic activity where even most ‘‘free market’ economists have assumed such
principles cannot be applied: money and banking.

One ambiguity must be addressed before progressing. What has just been
described might be called ‘‘true’’ or ‘‘pure’’ free banking, or simply ‘‘laissez-
faire banking.’ Historically, however, what has been called ‘‘free banking’’—
particularly in the United States—has often nor been laissez-faire banking (Smith
1990, 169fn). That is, as will be discussed in Chapters 5 and 6, these historical
episodes exhibited significant departures from the free-banking model. On the
other hand, they all did share the one essential feature of free banking: multiple
private issuers of banknotes. In short, the convention has arisen of classifying


===== PAGE 31 =====

4 Free Banking

historical periods as being (rough) examples of free banking as long as the
issuance of banknotes had not been monopolized during the period in question.
This is not necessarily an error. However, it does raise a potentially trouble-
some question. When an episode of historical free banking possesses some of
the theoretical characteristics but lacks others, does one ascribe its success to
the presence of some or to the absence of the others? Based on these mixed
examples from history, are clear-cut tests of the free-banking model possible?

SPONTANEOUS EVOLUTION OF FREE BANKING

Having established in theory what free banking is, one is driven to inquire
next how such a system might come into being. Perhaps the first work to ad-
dress this issue was that by George A. Selgin and Lawrence H. White (1987).
What follows is a summary of their lucid analysis.

First of all, Selgin and White point out that although there had been a few
articles in recent years dealing with various aspects of unregulated monetary
systems, none (at the time of their writing) had provided a logical evolutionary
explanation of how such a system might develop. They do not suggest that
their approach is the only valid method of explaining the rise of free market
monetary institutions; indeed they explicitly acknowledge the value of optimi-
zation models that incorporate transaction costs and/or informational asymme-
tries. They merely note that theirs is a method that had not been utilized pre-
viously (Selgin and White 1987, 439).

The authors argue that, following the emergence of a standardized commod-
ity money, the evolution of a free-banking regime proceeds through three stages:
(1) “‘the development of basic money-transfer services which substitute for the
physical transportation of specie,” (2) the ‘‘emergence of easily assignable and
negotiable bank demand liabilities’ (often referred to as ‘‘inside money’’), and
(3) the appearance of ‘‘arrangements for the routine exchange (‘‘clearing’’) of
inside monies among rival banks’’ (Selgin and White 1987, 440). Each stage
is allegedly a Smithian ‘‘invisible hand’’ outgrowth of the previous stage, that
is, each new institutional arrangement is the unconscious product of the actors’
conscious concern with promoting their own self-interest.

Their explanation of the origin of money follows closely along that outlined
by Carl Menger (1892). This simply recognizes that money arises in barter
societies because of the inefficiency referred to by W. S. Jevons as the ‘‘double
coincidence of wants.’”’ Durable, highly divisible goods that were consistently
in high demand for their use-value as commodities (gold, silver) came to be
seen as a means of facilitating exchange by reducing search costs. These be-
came money because of their high marketability. Private mints began to pro-
duce coins of standard weights of these metals as a means of reducing the costs
of continual reassessment.

Logically, one next needs to reduce the inconvenience of frequent physical
transfers of coins. This was accomplished—for the first time in history—by the


===== PAGE 32 =====

Introduction 5

money-changers and bill brokers of twelfth-century Genoa who kept ledger
accounts for frequent traders (Selgin and White 1987, 442). Notations in ac-
count books took the place of specie transfers. Thus deposit banking was born.
In this context, Selgin and White point out why fractional reserve banking can
develop in a rational and nonfraudulent manner: ‘‘(1) money is fungible, which
allows a depositor to be repaid in coin and bullion not identical to that he
brought in and (2) the law of large numbers with random withdrawals and
deposits makes a fractional reserve sufficient to meet actual withdrawal de-
mands with high probability’’ (1987, 443). This result is reinforced if one al-
lows for the use of ‘‘option clauses,’ as Selgin and White do.®

The desire for more sophisticated means of fund transfer led to the assigna-
bility and negotiability of deposited money, that is, to the appearance of fully
negotiable banknotes and checkable deposits. To economize on the use of com-
modity money and to reduce the marginal liquidity costs of maintaining large
specie reserves, banks naturally sought some form of regular note-exchange
system, which would, by increasing the frequency with which rival banks’
notes were accepted at par, increase the marketability of their own notes. The
same result might be accomplished in a very different way. Banks might en-
gage in ‘‘note-duelling.’’ That is, they might begin buying a rival’s notes with
the express purpose of presenting them suddenly to the issuer for redemption
in specie, thereby hoping to damage the rival’s reputation or even precipitate
his insolvency. Still, the likely result is widespread mutual acceptance of bank-
notes at par (Selgin and White 1987, 446-47). This is a classic example of the
fact that the unintended consequences of agents’ acts may prove more signifi-
cant and/or more durable than the intended consequences (Menger 1963, 130).

From a periodic note-exchange, it is but a small conceptual step to a formal
clearinghouse function. The clearinghouse, by supervising the multilateral note
and deposit exchange for a group of banks, greatly reduces the time and effort
involved in the many pairwise clearing relations that would otherwise be re-
quired. Furthermore, the clearinghouse can serve as a credit information bu-
reau, can police individual banks so as to ascertain their soundness, and can
provide short-term liquidity to its members in times of financial crisis (Selgin
and White 1987, 450).

Selgin and White conclude that all the essential functions of modern banking
can be explained by a ‘‘spontaneous order’’ process and that nothing in the
institutions that thus freely develop suggests anything about the need for a
central bank (1987, 454). The far more common, contrary view will be exam-
ined in Chapter 8.

TWO FREE-BANKING MODELS

Monetary economics continues to be dominated by the almost unquestioned
assumption that in order to achieve and maintain stability and real growth, all
modern industrial nations must have a central bank that both conducts some


===== PAGE 33 =====

6 Free Banking

macromonetary policy and is the sole issuer of legal currency. Nevertheless, in
recent years, challenges to that orthodoxy have been mounted by a growing
number of theorists.” Perhaps the most influential of these works have been the
books by Friedrich Hayek (1978), White (1984a), Selgin (1988a), and Kevin
Dowd (1989). There are two distinctly different models of free banking to be
found therein. Each will be summarized below. Other approaches to free bank-
ing have been proposed by writers such as David Glasner (1989), Robert
Greenfield and Leland Yeager (1983), W. William Woolsey and Leland Yeager
(1991), Murray Rothbard (1983, 1985), and Ludwig von Mises (1966, 441—
48). Such alternative approaches are the subject matter of Chapter 7.

Competing Paper Currencies

Hayek (1978) has proposed a system of competitively issued, inconvertible
paper currencies. The incentive for the issuing bank is to be able to gain inter-
est-free funds by inducing consumers to hold its currency. The incentive for
the consumer is to gain a currency that possesses stable purchasing power.
Such stability of purchasing power is, allegedly, to be guaranteed by the issuer
and is to be defined in terms of some market basket of widely traded and
homogeneous commodities, such as aluminum, cocoa, coffee, copper, and so
forth (Hayek 1978, 56-57). Variations in the purchasing power of an issuer’s
currency would be constantly monitored by that issuer via computerized data
from currency exchange markets. Appreciations would precipitate increases in
supply; depreciations would bring decreases in supply. The definition of the
market basket might change over time, however, if either consumer preferences
or demand/supply elasticities of the commodities in question were to change
(Hayek 1978, 44).

In this system, there would probably be only a handful of large banks that
issued their own currencies; the majority of institutions would denominate de-
posits and loans in terms of one of those currencies. The small number of
banks-of-issue would be due to the fact that only a few different currencies
would, presumably, be marketable. This follows from Hayek’s apparent belief
that the information and transaction costs to consumers of coping with multiple
currencies rise significantly as the number of such currencies increases (Hayek
1978, 23-24). Since the banks-of-issue would not want ‘‘to repeat the mistakes
governments have made’’ (Hayek 1978, 61), they would not guarantee to bail
out nonissuing banks that had outstanding obligations denominated in the cur-
rencies of the issuing banks. Thus, the large number of nonissuing banks would
be compelled to practice more or less 100 percent reserve banking (Hayek
1978, 61). Such institutions would, therefore, be more like present-day finance
companies than commercial banks.®

Competing Convertible Banknotes

It must be pointed out that although White (1984a) was the first since Vera
C. Smith in 1936 to outline and defend the system described below, it has been


===== PAGE 34 =====

Introduction 7

Selgin (1988a) who has greatly elaborated upon White’s work. The fundamen-
tal aspects of the model—save one—are the same in both versions; the primary
contrast is in terms of the much greater detail offered by Selgin. In particular,
Selgin provides an insightful analysis of the relationships between free-banking
activities and macroeconomic variables, such as national income and the price
level. The one aspect that differs is that White assumes a small, open economy,
because he is examining the Scottish free-banking period and, thus, assumes
that the purchasing power of money is set exogenously by the world price of
gold (1984a, 11), whereas Selgin apparently assumes (it is not stated explicitly)
that he is dealing with a large, closed economy since he allows for endogenous
changes in money’s purchasing power (1988a, 99-102).

In the work of both White and Selgin, banks would, of course, be free to
issue their own distinctive notes as well as deposit accounts. The supposed
attraction for consumers would be the explicit guarantee by the issuing bank to
redeem its notes in gold or silver upon demand of the holder.’ Banks would
compete for consumers’ patronage by providing branch offices in convenient
locations, by remaining open longer hours per day and/or being open more days
per year, and by offering higher rates of interest on deposits and lower rates
on loans (White 1984a, 7-9). Above all, however, banks would vie with one
another in terms of public confidence in the note issue. A bank’s market share
would increase as did consumers’ belief that the bank would never fail to con-
vert its notes (or deposit accounts) into specie on demand.

Unlike Hayek’s model, here the supply of a given bank’s notes would not
vary according to either the exchange rates between currencies or the value of
a particular market basket of commodities. Rather, a bank would regulate its
note issue in response to the extent to which it experienced either “‘reflux’’ or
‘*adverse clearings,’ that is, the return of its notes for redemption, either by
individuals or by other banks (White 1984a, 14-18). Assuming each bank had
a preferred specie/notes ratio (which White and Selgin take to be less than one;
that is, these banks hold fractional reserves), the level of reflux and/or adverse
clearings would determine the size of the bank’s note circulation. The pre-
ferred, or ‘‘optimal,’’ reserve ratio could change of course, as will be discussed
in the next chapter. Indeed, the realization that a free bank’s optimal reserve
ratio is positively related to the income velocity of money will be seen to be
one of Selgin’s key contributions to the literature, as well as a critically impor-
tant aspect of the formal model that will be presented.

Comparison of the Models

Under neither model of free banking is money production a natural monop-
oly, nor is money a public good.'® Issuers do not face marginal costs that
decline throughout the relevant range of output. This follows from the fact that
it is not the mere physical production of the banknote that is important; it is
maintaining it in circulation that requires public acceptance and incurs rising
marginal cost (White 1984a, 5-8). Furthermore, money cannot be a public


===== PAGE 35 =====

8 Free Banking

good, because its benefits are clearly excludable. Person B cannot enjoy the
liquidity services provided by a unit of money that is held by Person A (Selgin
1988a, 154). Additionally, in Hayek’s scheme, as well as in the White-Selgin
model, the nominal money supply for the society is determined at a microeco-
nomic level. Changes in said money supply certainly have important macroeco-
nomic effects. Nevertheless, and in contrast to central banking, the source of
the changes is microeconomic in nature. Both models imply that there is no
role for a central bank that conducts monetary policy on a national basis. Many
economists infer that chaos would inevitably result from the absence of cen-
tralized control. Yet, as Thomas Saving has pointed out, ‘‘competition is per-
fectly compatible with a stable monetary system’’ (1976, 994). The manner in
which such stability might be achieved will be seen later.

The two models differ significantly, however, in regard to one aspect. In
Hayek's system the various currencies (‘‘ducats,”” ‘‘florins,”” ‘‘mengers,’’ etc.)
constitute separate units of account, whereas in the White-Selgin system, the
competing banknotes, although distinct from one another and not necessarily
possessed of equal marketability, nevertheless are assumed to be denominated
in a single unit of account. Thus one might argue that Hayek’s banknotes are
more highly differentiated than are the White-Selgin notes. This is especially
true if, as Hayek suggests, such units were to be trademarks of the issuing
bank (1978, 42). All of this means that, in terms of the conventional market
structures, Hayek’s proposal may imply less ‘perfectly competitive’ firms than
does that of White and Selgin.

LIKELIHOOD OF THE WHITE-SELGIN MODEL

Assuming the complete deregulation of the financial services sector, which
of the two approaches to free banking would be more likely to arise and, more-
over, survive and prosper? At one level, of course, that question is unanswer-
able, since the results would depend on consumer preferences, which cannot
be known to an observer a priori. However, there remain several aspects of the
question that deserve comment nonetheless.

The principal attraction of the Hayekian currencies is, as was seen earlier,
the promise of constant purchasing power. Thus, the critical issues become: (1)
could such banks actually maintain such constancy in the purchasing power of
money,'! and (2) would it be maintained regardless of circumstances? Hayek
himself seems to think that the only safeguard against fluctuations in purchasing
power is the continual monitoring of the currency’s value by consumers (1978,
59). But would such monitoring actually be an effective safeguard? There are
reasons to doubt it.

First of all, what would be the effect on exchange rates between currencies
if all banks-of-issue increased (or decreased) their supplies of notes at the same
time and at the same rate? Exchange rates between the currencies would remain
as before, and no signal would be sent to consumers to alter their money hold-


===== PAGE 36 =====

Introduction 9

ings. As Hayek might point out, however, in his system, such exchange rates
are not the ultimate measure of a currency’s value. The ultimate yardstick for
consumers 1s the price of the chosen basket of commodities in terms of the
currency in question. Yet it is well known that commodity markets generally
adjust to chianging conditions more slowly than do financial markets. Would
the prices of the relevant commodities change rapidly enough to warn consum-
ers of inappropriate bank policies? It is not at all clear that one can answer that
in the affirmative. Furthermore, if the basket of commodities chosen by a bank
does not happen at all times to reflect the preferences of a particular consumer,
it cannot be claimed that that consumer’s purchasing power is being maintained
even if such may be true for other consumers. Finally, one must keep in mind
the possibility that not all consumers want constant purchasing power. Do not
net debtors prefer inflation and net creditors desire deflation? Hayek does not
deny this, but seems to think that those contrary preferences will offset one
another in the market as a whole.

Even if Hayekian free banks could keep constant the purchasing power of
their currencies—which, from the foregoing, seems problematic—the issue re-
mains of whether (aside from the debtor/creditor issue) such constancy is al-
ways desirable. An obvious exception comes to mind. If either the supplies of
inputs increase or there occur technological improvements such that marginal
production costs pervasively decline, is not the proper economic result a gen-
eral fall in prices? Indeed, to maintain a constant price level (and constant
purchasing power of money) under such circumstances means that goods’ prices
are not in line with production costs and, as a result, ‘‘false profit signals’’ are
generated (Selgin 1988a, 101). As will be seen in Chapter 2, free banks of the
White-Selgin sort act so as to allow a general price decline in the face of falling
production costs.

There are several additional reasons why one might expect banks that issue
specie-convertible notes and deposit accounts to triumph over Hayekian banks
in the free market. For example, it would seem plausible that the information
costs to the consumer of constantly monitoring the fluctuating exchange rates
among Hayek’s various paper currencies might be significantly greater than
those involved with holding notes issued by a bank that explicitly guarantees
to redeem its notes in gold on demand. Furthermore, what of transaction costs?
Recall that Hayek’s proposed currencies are denominated in different units of
account as well as being issued by different banks. This would seem to be
significantly less efficient than the White-Selgin model where competitively
issued banknotes are denominated in the same units. Also, considering the long
Western tradition of specie-backed money, it seems clear that if the United
States is fundamentally to reform its monetary system, the direction of that
change is more likely to be toward a specie standard than toward inconvertible
paper currencies. One may note that the 1981 U.S. Gold Commission ap-
pointed by President Ronald Reagan seriously considered a return to gold. Ad-
mittedly, this group never really addressed the topic of free banking. Neverthe-


===== PAGE 37 =====

10 Free Banking

less, that group’s deliberations can be taken as a barometer of the continuing
attractiveness of a specie standard in the minds of many.

Furthermore, it appears to a number of Hayek's critics, for example, Roth-
bard (1985, 3-4), that his plan contravenes the evolutionary development of
media of exchange so eloquently stated by Carl Menger (1892) and restated
by, among others, Ludwig von Mises (1971, 30-33), Selgin (1988a, 16-21),
and Karl Warneryd (1989), the latter being in a game-theoretic context. That
is to say, how does one progress, in the absence of legal tender laws that
impose such a result, from commodity-redeemable currencies to complete fi-
duciary substitution—the exclusive use of pure paper (irredeemable) curren-
cies? What ‘‘invisible hand” could bring this about? It is perhaps significant
that Hayek never really comes to grips with this issue. Indeed, in his discussion
of monetary developments, Hayek even grants that “‘it is probably impossible
for pieces of paper or other tokens of a material itself of no significant market
value to come to be gradually accepted and held as money unless they represent
a claim on some valuable object’’ (1978, 27).

Hayek attempts to escape from this conundrum by suggesting that at present
consumers will accept private paper currencies (at least those of stable purchas-
ing power) because they have become accustomed to the paper currencies of
governments and thus do not find the concept of inconvertibility objectionable
(1978, 28). This, however, will just not do. What Hayek must explain is why,
when, and if the government’s monopoly on the production of legal currency
is abolished, people would continue to prefer inconvertible paper money. In
the absence of all legal restrictions on what one may use as ‘‘money,’’ is it not
at least as likely that consumers would gravitate toward precisely that form of
money that they have so often been denied by the passage of legal tender
statutes, namely, commodity-backed currency?

Finally, one must point out that no private system such as Hayek describes
has ever existed. On the other hand, rough approximations to the White-Selgin
model can be found in the histories of a number of countries—the United States,
Scotland, Sweden, Canada, and France, for instance (Selgin 1988a, 7-14).
Clearly, this alone does not prove the desirability of one model over the other,
but it does seem to lend further credence to the proposition that Hayek has
inadequately defended his vision of free banking.

For all the foregoing reasons, this writer believes the approach of White and
Selgin to be by far the more plausible. Therefore, their model of free banking
will be the primary focus of this work. Furthermore, the work of Selgin and
White, taken together, provides a much more detailed look at free banking than
that of Hayek. The nature of those details, as well as a formal model of free
banking on a specie standard, will be examined shortly.

OUTLINE OF THE BOOK

Chapter 2 derives a mathematical model of a free-banking system based on
specie-convertible currency. The explicit equations employed emerge from a


===== PAGE 38 =====

Introduction 11

detailed discussion of (1) the key characteristics of free banks, (2) the applica-
bility of supply and demand analysis to money, (3) the meanings of ‘‘price”’
and ‘‘quantity’’ in the context of money, and (4) the nature of those factors,
changes in which bring about shifts in either the money supply or money de-
mand schedules. Graphical illustrations of those parametric effects are also pre-
sented. Chapters 3 and 4 explore related theoretical issues, namely, (1) the role
of free banking in understanding and applying Say’s Law and (2) the proposi-
tion that central banks are inherently unable to conduct a rational monetary
policy. Chapter 5 both summarizes and critiques White's interpretation of free
banking in Scotland. Chapter 6 is devoted to American free banking. A review
of recent research is provided, as well as some new evidence on the relative
macroeconomic stability of the U.S. free-banking era. Alternative approaches
to free banking are discussed in Chapter 7. Some common criticisms of laissez-
faire banking are examined in Chapter 8. Chapter 9 concludes the work with
suggestions regarding (1) future research, (2) the transition process, and (3) the
social, political, and economic necessity of free banking.

NOTES

1. For an excellent analysis of this issue, one should see Edward J. Kane, The
Gathering Crisis in Federal Deposit Insurance (Cambridge: MIT Press, 1985).

2. Friedman, along with his long-time collaborator Anna J. Schwartz, repeats this
theme in later work (Friedman and Schwartz 1986).

3. An exception is Miller and Pulsinelli (1989). Widely used texts, such as Law-
rence Ritter and William Silber (1989) and Frederic Mishkin (1989), either ignore free
banking altogether or dismiss it brusquely as chaotic and inflationary.

4. This may be a ‘‘discount’’ rate, as in the United States, or a *‘penalty’’ rate, as
in Great Britain.

5. For detailed discussions of a number of approximate free-banking episodes, see
Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992).

6. The option clause is a device by which a bank may delay the redemption of its
notes in exchange for the payment of explicit interest to the noteholder. Option clauses
will be discussed in Chapters 5 and 7.

7. Most of the extant articles and books on free banking are listed in the biblio-
graphic section of this book.

8. It is somewhat ironic that Rothbard (1985) bitterly criticizes Hayek’s proposal,
since their approaches share one striking feature. In both cases, either most banks (Hayek)
or all banks (Rothbard) must make loans out of their own capital rather than out of
funds deposited. This follows from the fact that they practice 100 percent reserve bank-
ing.

9. Such redemption may or may not be immediate. Both White and Selgin see no
problem in permitting banks to issue notes subject to option clauses.

10. One should refer to Chapter 8 for an extended discussion of these points.

11. This one may be taken to be the inverse of the price level. However, there are
two possible interpretations of the concept ‘‘price level.”’ The conventional understand-
ing of the term is that the price level is the weighted average of a large number of
selected relative prices, as embodied, for example, in the CPI (Timberlake 1987, 88—


===== PAGE 39 =====

12 Free Banking

91). An alternative view is that the price level should be thought of in a more micro-
economic way. This approach argues that the price level is nothing more or less than
the array of all relative prices, which, supposedly, no index number can represent mean-
ingfully (Rothbard 1988a, 182-83).


===== PAGE 40 =====

Chapter 2

COMPARATIVE STATICS

The purpose of this chapter is to offer a formal interpretation of the most de-
tailed verbal treatment of free banking extant: George Selgin’s explanation of
such a system structured around a specie-convertible currency (1988a, 1988b,
1990). The key points in Selgin’s argument, as well as the relevant features of
the present work, will be identified. A mathematical model will be constructed
from which comparative static equilibrium conclusions will be drawn. Also,
graphical illustrations of the various parametric effects will be offered. It is
hoped that this effort will both capture the essential elements of Selgin’s model
and facilitate the classroom presentation of same.

THE MEANING OF MONEY

First of all, one must make clear what Selgin (and the present study) means
by the term ‘‘money.’’ His focus is on the classic medium of exchange func-
tion. Thus, he takes money to be the sum of currency held by the public plus
checkable deposits, that is, the total of ‘‘inside money’’—the aggregate de-
mand liabilities of commercial banks. Selgin deals rather little with ‘‘outside
money’ (circulating specie coins), since he believes that “in a mature free
banking system . . . commodity money seldom if ever appears in circulation’’
(1988a, 31). Moreover, he notes that his primary concern will be with the
issuing of private currency (banknotes), since that is ‘‘a relatively unfamiliar
and unexplored possibility, and one that most economists dismiss’’ (1988a, 5).
Besides, the topic of bank competition for checkable deposits has ‘been exten-
sively dealt with elsewhere’ (1988a, 4).


===== PAGE 41 =====

14 Free Banking

KEY CHARACTERISTICS OF FREE BANKING

There are at least three dimensions along which free banks differ signifi-
cantly from commercial banks in a central banking system. First of all, reserve
ratios are not set by law; free banks may hold whatever specie reserves they
deem prudent. Thus, perhaps the most common mechanism by which the nom-
inal supply of money varies is not an exogenous change in the monetary base,
but an endogenous change in the so-called money multiplier. Indeed, Selgin
explicitly allows for the possibility of a constant monetary base (1988a, 167—
69).! Second, since there would be no legal tender laws, free banks must ex-
pend real resources in order to expand the circulation of their currencies. This
implies that free banks face rising marginal costs. Finally, free banking exhibits
a unique relationship with credit markets. Because nontrivial amounts of real
resources are needed for a free bank to increase its liabilities, if that is to occur,
it is necessary for the public to refrain voluntarily from some degree of present
consumption; that is, savings must rise. In contrast to central banking, it is
unlikely that free banking could create an excess of credit.

Optimal Reserve Ratios

Perhaps the single most important theoretical contribution that Selgin makes
is his exhumation and elucidation of a principle largely buried and forgotten by
a world of economists accustomed to central banks and legally imposed reserve
requirements: the realization that, under competitive conditions, changes in the
income velocity of money bring about changes in banks’ demand for reserves
in the same direction (1988a, 70-80). Citing discussions of this principle that
date as far back as F. Y. Edgeworth in 1888, Selgin argues that a bank’s de-
mand for reserves depends not only on the total volume of transactions, but
also on the frequency of those transactions (1988a, 74). One must understand
that in Selgin’s proposed system, reserves are in the form of gold coin, and
they are needed in order to (1) redeem notes and/or demand deposits held by
customers and (2) settle interbank clearing debts.

Item (1) above is the concept of ‘‘reflux’’ utilized by Lawrence White (1984a,
14-18). Item (2) is the closely related concept of ‘‘adverse clearings.’ Both
function as automatic corrective devices, and both arise from attempts by a
single bank to overissue its currency or deposit accounts. However, adverse
clearings exhibit an additional feature. They are, under most conditions, posi-
tively related to both the volume and frequency of monetary transactions in the
geographical area under consideration, but what if all banks in an area experi-
enced ‘‘equal and simultaneous changes’’ in the demand for their respective
liabilities (Selgin 1988a, 73)? Selgin concedes that in that special case (an
unlikely one), all banks would be affected equiproportionally and the compo-
nent of their total demand for reserves, which reflects their relative positions


===== PAGE 42 =====

Comparative Statics 15

(“‘average net reserve demand’’), would not change. Nevertheless, a second
component of total demand for reserves would still be affected. This is the
“‘precautionary reserve demand,’’ and it stems not from the average expected
level of adverse clearings, but from the probability of random fluctuations around
that expected level (Selgin 1988a, 72-74). It is interesting to observe that Don
Patinkin presents the same argument, although he couches the principle in terms
of a consumer’s demand for cash balances to meet personal liabilities (1965,
82-88). The principle applies equally well in both cases.

Thus, for example, a decline in velocity (an increase in its reciprocal, the
Cambridge cash balance equation’s ‘‘k’’) reduces banks’ need for reserves.
This brings about a decline in their preferred (or optimal) reserve ratios, the
money multiplier rises, and the money supply increases so as to maintain mon-
etary equilibrium. Free banks ‘‘passively adjust the supply of inside money to
changes in the demand for it. They are credit transferers or intermediaries, and
not credit creators’ (Selgin 1988a, 82). In other words, in the typical Keynes-
ian scenario of a depression in which a significant ‘‘hoarding’’ of cash balances
occurs (k rises), free banks would tend to respond automatically by increasing
the money supply so that nominal incomes might be maintained.

It would be reasonable at this point to wonder whether such a mechanism
would exhibit sufficiently powerful effects to achieve the kind of countercycli-
cal results Selgin envisions. In short, by how much will banks’ reserve hold-
ings change because of a change in the frequency of transactions? Patinkin,
among others, supplies an answer: An entity’s optimal liquid holdings will
change by a factor equal to the square root of the factor by which transaction
frequency changes (1965, 87).

One might experiment with a hypothetical example. Assume that at time to,
total bank reserves equal $1 billion, the supply of inside money equals $3
billion, and the simple money multiplier, therefore, equals 3. Suppose further
that at time ty, the frequency of transactions is 20/period, but that at t;, this
falls to 15/period. Thus, frequency changes by a factor of .75. Since the square
root of that is .866, the optimal reserves of banks will fall to $.866 billion,
creating excess reserves of $.134 billion. The new money multiplier is the
reciprocal of the new optimal reserve ratio, or 3.464. Thus, the increase in the
money supply should equal excess reserves multiplied by 3.464, or $.464 bil-
lion. In proportional terms, a 25 percent decrease in frequency leads to a 15.5
percent increase in the nominal money supply, and this, it must be remem-
bered, is merely the effect of the decline in the frequency of transactions on
reserves and the money supply. It is likely that the volume of transactions
would also decline and, thereby, amplify such results. Furthermore, Ernst Bal-
tensperger has argued that the effect on reserve holdings of a change in fre-
quency will be larger than the square root rule suggests. He states that ‘‘the
elasticity of demand for precautionary reserves with respect to scale can be
quite different from one-half (the value implied by the standard square root


===== PAGE 43 =====

16 Free Banking

result) and may well be in the neighborhood of one’’ (1974, 210).2 It would
seem that the magnitude of this effect is sufficient to act in the fashion Selgin
suggests.

Marginal Costs

Of considerable importance to the perspective adopted in this book is the
argument that, in contrast to central banking, the short-run marginal costs to
free banks of producing, issuing, and—most significant of all-—maintaining in
circulation their notes are positive and rising. Central banks are usually de-
scribed as facing marginal costs of production and circulation, given the pre-
sumptions of irredeemable paper currency and legal tender laws, that are con-
stant and approximately zero (Meyer 1982, 41). In other words, the short-run
costs of central banks are almost exclusively fixed costs. This is quite plausible.
Such central banks, being legal monopolists, need not (1) redeem their liabili-
ties on demand in terms of some commodity, (2) clear any interbank debts
arising from a note-exchange system, or (3) compete for customers with other
domestic currency suppliers.

The situation is very different for free banks of the sort modeled in this
chapter. Free banks emphatically do have to redeem their liabilities in specie
on demand, clear their interbank debts, and compete for customers. In order to
redeem notes and clear debts with other banks, a free bank must hold some
specie reserves. This fact, if taken alone, might seem to imply that such a
bank’s short-run marginal costs are definitely positive but constant, since, for
any given income velocity of money, the same fractional reserves are held as
backing for each additional unit of currency in circulation. However, it is likely
that the unit cost of acquiring specie rises with the demand for it.> Therefore,
an increased demand for specie as backing for a bank’s expanded circulation
of currency would entail rising marginal (liquidity) costs.

Moreover, it is also true that free banks, if they are to increase the quantity
of their notes in circulation, must compete with one another for customers.
That is, they must attract additional business by offering new or better services
and/or by having longer operating hours. That necessitates either the hiring of
new employees or the more intensive utilization of their present employees. As
David Glasner has remarked: ‘‘Aside from holding non-interest-bearing re-
serves, what other costs does a bank incur? Primarily wages. Banking is a
labor-using activity’’ (1989, 17). If one accepts the validity of the law of di-
minishing marginal returns, it is then necessarily true that a free bank’s incre-
mental labor costs rise as its note circulation increases in the short run.

Last, but not least, to attract additional deposits, a free bank (like present-
day banks) must offer a higher interest rate on said deposits. Thus, interest
expenditures rise at the margin.

The import of all the foregoing seems clear. For a given optimal reserve
ratio, a given reputation for redemption,* given plant and equipment, and given


===== PAGE 44 =====

Comparative Statics 17

technology, the short-run marginal costs of a free bank increase as it issues
more notes. Needless to say, similar costs also apply to a bank’s expansion of
its deposit liabilities. In short, a free bank’s short-run marginal cost schedule
must be positively sloped: (d>C/dM?) > @, where C is total cost and M is the
nominal quantity of money.

This conclusion is one commonly drawn by free-banking theorists. White
refers to ‘‘the rising marginal costs associated with a growing volume of bank-
notes outstanding’’ and ‘‘the rising marginal costs of expanding the bank’s
deposit business’’ (1984a, 6). Selgin (1988a, 96), Kevin Dowd (1989, 45-46),
and Glasner (1989, 18-20) all make similar references to the cost structure of
a free bank that issues specie-convertible liabilities.

Given that the marginal cost schedule is positively sloped and that the mar-
ginal revenue schedule is either horizontal (perfect competition) or negatively
sloped (oligopoly or monopolistic competition), then profit-maximizing free banks
would not, contrary to conventional belief, flood the market with unlimited
quantities of inside money. To argue otherwise is to assume that free banks
would systematically fail to act in their own self-interest. Moreover, it assumes
that consumers are willing to hold money balances whose per-unit purchasing
power is rapidly declining.

Money and Loanable Funds

A third distinctive feature of free banking deals with the relationship between
a competitively issued money supply and the market for loanable funds. Spe-
cifically, the question is whether or not the preservation of monetary equilib-
rium, by means of changes in the supply of loanable funds, is consistent with
voluntary savings. Selgin argues that it is, since the ‘‘aggregate demand to hold
balances of inside money is a reflection of the public’s willingness to supply
loanable funds through the banks whose liabilities are held. To hold inside
money is to engage in voluntary saving’’ (1988a, 54). This is true because to
hold the liabilities of free banks is to choose to refrain from purchasing goods
and services. In effect, as long as the supply of inside money keeps pace with
changes in the demand for inside money, free banks loan out only that which
has been willingly saved. They are ‘‘simply intermediaries of loanable funds’’
(Selgin 1988a, 55).

This relationship further implies that a well-functioning free-banking system
would maintain the market rate of interest on loanable funds at the level Knut
Wicksell called ‘‘a certain rate of interest on loans which is neutral in respect
to commodity prices, and tends neither to raise nor to lower them . . . the
natural rate of interest on capital’ (1936, 102). Since a number of economists
have argued that departures of the market rate from the natural rate constitute
the primary source of business cycles—or ‘‘intertemporal discoordination’’ as
Friedrich Hayek puts it (1935, 85-100)—it would appear that free banking
would minimize such cyclical fluctuations. Real shocks would still occur, but


===== PAGE 45 =====

18 Free Banking

cycles merely resulting from disequilibria in the money and credit markets would
be more or less eliminated.

If one recalls the earlier discussion of the countercyclical effects of a change
in the income velocity of money on free banks’ optimal reserve ratios and,
therefore, on the money supply, such a suggestion becomes plausible. The
details of the relationship between banking and business cycles alone would
constitute a complete work, so they will not be presented here. To pursue the
issue, one might consult Gerald O’Driscoll (1977), Hayek (1933, 1935, 1941),
Ludwig von Mises (1971, 349-66), Milton Friedman (1968), or David Laidler
(1981). However, Chapter 3 is devoted to a limited discussion of some of the
more important aspects of the question.

In mechanistic terms, one may describe the markets for (1) money and (2)
loanable funds under a free-banking structure as follows: The demand for money
and the supply of loanable funds are positively related. Thus, ‘‘an increase in
the demand for money warrants an increase in bank loans and investments. A
decrease in the demand for money warrants a reduction in bank loans and
investments’’ (Selgin 1988a, 55). This makes interest rate signals redundant for
free banks. That is, what is more immediate and more telling in effect is a
change in the demand for money that reveals itself by way of a change in the
level of adverse interbank clearings and, thereby, in the optimal reserve ratio.
If, for example, the demand for money and its purchasing power per unit rise
(the price level falls), then the quantity of money supplied and the supply of
loanable funds will also rise, bringing about a lower market interest rate. If the
demand for money and its purchasing power fall (the price level rises), the
quantity of money supplied as well as the supply of loanable funds will fall,
leading to a higher rate of interest. One may take note from the foregoing that
free banking should be consistent with the long-observed positive relation be-
tween the price level and market interest rates, a phenomenon dubbed the ‘‘Gibson
paradox’’ by John Maynard Keynes (1930, 198-208).

A FORMAL MODEL

Rather little has been done in the way of formalizing free-banking theory.
This is understandable in light of the fact that economists of the Austrian School
have been in the vanguard of such work. The Austrian critique of and aversion
to mathematical modeling is well known.”

Nevertheless, White offers an insightful, but brief, Lagrangian analysis of
free banks (1984a, 3-12), although Selgin’s early work is entirely verbal ex-
cept for bits of algebra regarding money multipliers and the precautionary de-
mand for reserves (1988a, 75-76, 124-25). Bart Taub (1985) provides an analysis
of banks that issue inconvertible paper currencies along the lines of Hayek's
proposal. However, the works by Hayek (1978), Dowd (1988, 1989), Robert
King (1983), Robert Greenfield and Leland Yeager (1983), Glasner (1989),
Donald Wells and Leslie Scruggs (1983, 1984, 1986a, 1986b), and Selgin and


===== PAGE 46 =====

Comparative Statics 19

White (1987) are verbal in method. More recently, mathematical treatments
have been offered by Carl Christ (1989), Larry Sechrest (1990, 24-65), and
Selgin (1991).6

In the following pages, this writer presents a simple comparative statics model
of free banking that utilizes elementary differential calculus, matrix algebra,
and graphs. These have become—for good or ill—some of the standard tools
of the economics profession. Moreover, the methods used should be familiar
to all graduate students as well as to many advanced undergraduate students of
economics. The intent is to supply a model that can readily be used in a class-
room context to explain the essential features of free banking.

One is here reminded of the formalization of Keynes’ ideas provided by John
Hicks (1937). Without that boost, the so-called ‘‘Keynesian revolution’ might
have been stillborn. No claim is being made that the present work will prove
as influential as that of Hicks. Nevertheless, this effort bears the same relation
to that of Selgin (and, to a lesser extent, to that of White) that Hicks’ essay
bears to The General Theory of Employment, Interest, and Money.

Some will question the need for a formal model. In defense of such, one
may argue that a mathematical approach forces one to ‘‘check his premises,’’
that is, to (1) identify those factors that are the variables and the parameters of
the function at hand and (2) ascertain how such factors affect said function. In
the process of doing so, anomalies, contradictions, and hidden assumptions
may be revealed. As for graphs, one need only point out that they have proven
themselves to be excellent expository and pedagogical devices over a consid-
erable span of time.’

Others may find the model insufficiently exotic. No cognizance is taken of
informational asymmetries, transaction costs, moral hazard, externalities, ad-
verse selection, rational expectations, or game theory, to name a few of the
possible approaches that could be taken. The reason is straightforward. None
of the above is necessary in order to capture the basics of free banking.

As Dowd has said, ‘‘Money and the industry that provides it, the banking
system, can be understood using the same kinds of analytical tools which we
apply to other commodities and the industries that produce them . . . there is
nothing fundamentally different about money at all’’ (1989, vii). Selgin seems
to concur when he states that ‘‘nothing about free banking requires it to be
approached with technical sophistication beyond what might be found in a
graduate money and banking textbook’’ (1988a, 5). Regarding his initial inter-
est in free banking, Glasner adds that ‘‘the notion that the analysis of the sup-
ply of money should be carried out within the same framework that we use to
analyze the supply of other goods was a compelling one’ (1989, xiv). In short,
if supply and demand suffice to explain the market for televisions or corporate
bonds or housing, then supply and demand will suffice to explain free banking.

Furthermore, the suggestion that standard price theory is applicable to money
and banking is not unique to advocates of free banking. There exist a number
of such applications in the literature. For example, Jurg Niehans (1978, 166—


===== PAGE 47 =====

20 Free Banking

99) develops a detailed theory of profit-maximizing bank behavior that focuses
on rates of interest paid on deposits and charged on loans. Graphically and
mathematically, Niehans’ effort clearly represents a price-theory approach to
banking. A different treatment using the same methodological tools is that of
Lyle Gramley and Samuel Chase (1965), in which they describe the interac-
tions in a world of four assets (currency and reserve deposit credits issued by
a central bank, demand deposits, time deposits, and private securities) and three
sectors (a central bank, commercial banks, and the public). Other examples
one might mention are Raymond Lombra and Herbert Kaufman (1984), Bruce
Dalgaard (1987, 337-39), John Gurley and Edward Shaw (1960), James Tobin
(1963), and Boris Pesek and Thomas Saving (1967, 79-126; 1968, 144-63).
Particularly striking are the statements by Pesek and Saving that ‘‘commercial
banks are producers and sellers of money’’ (1967, 79), that ‘‘the standard analysis
learned in principles of economics is just as applicable to a bank as to any
other firm in the economy’ (1968, 163), and that ‘‘the equilibrium quantity
and price of any good, including money, depend on both demand and supply”
(emphasis added) (1968, 50). Furthermore, one must not overlook the fact that
both Selgin (1988a, 95-96) and White (1984a, 5-7) explicitly argue that the
first-order condition for profit maximization, that is, production at a level where
marginal cost equals marginal revenue, is as relevant to a free bank as it is to
any other firm.

Finally, it may be observed that some renowned economists have in the past
insisted that money is as subject to supply and demand conditions as is any
other economic good. Arthur C. Pigou stated that the exchange value of money
‘“‘is governed, like the value of everything else, by the general conditions of
demand and supply’ (1917, 39). Similarly, Jean-Baptiste Say asserted that
money ‘‘is a commodity, whose value is determined by the same general laws,
as that of all other commodities; that is to say, rises and falls in proportion to
the relative demand and supply’’ (1971, 226).% John Stuart Mill argued at length
along such lines. Mill saw that

the value or purchasing power of money depends, in the first instance, on demand and
supply. But demand and supply, in relation to money, present themselves in a somewhat
different shape from the demand and supply of other things . . . whoever sells com,
or tallow, or cotton, buys money. Whoever buys bread, or wine, or clothes, sells money.
(1923, 490)

That is precisely the perspective adopted here.

As indicated earlier, an attempt will be made to apply neoclassical price
theory to free-banking firms, a free-banking industry, and the relations between
the industry and the economy as a whole. In all graphical illustrations, the axes
depicted will represent Walrasian price/quantity space, where price is assumed
to be the independent and quantity the dependent variable.

The time period involved is assumed to be the Marshallian short run as op-


===== PAGE 48 =====

Comparative Statics 21

posed to the ‘‘market period’’ or the ‘‘long run’ (Marshall 1949, 330, 378-
79). The very short run, or market period, is rejected, since it is too short to
permit an analysis of how free banks might react to changing conditions. The
long run is similarly rejected, because it allows no differentiation of free bank-
ing from central banking. Given enough time for all adjustments to be made,
there will be neither excess quantity of money supplied nor excess quantity of
money demanded at the existing level of prices, regardless of the banking re-
gime. The critical question to be examined is how free banks react to changes
in economic conditions in the short run. Finally, the following simplifying as-
sumptions will be made: (1) all banks face identical costs, (2) because of the
absence of any legal barriers to entry (or exit), the market structure is one of
perfect competition,” and (3) the society being modeled is a large, closed econ-
omy. Therefore, the purchasing power of money is an endogenous variable.

The Variables

Given that there exist sufficient justification and precedent for a price-theo-
retical approach to free banking, one must next identify the variables, changes
in which bring about movement along either the demand schedule or the supply
schedule. That is, what do the independent variable ‘‘price’’ and the dependent
variable ‘‘quantity’’ represent?

Here the term ‘‘quantity’’ refers to the number of units of inside money
(currency plus demand deposits) held by the public during any given time pe-
riod. The unit of measure is assumed to be the ‘‘dollar.”” '° The objection might
be raised at this point that to use the dollar as a unit is quite arbitrary and that,
therefore, the price of money is indeterminate, being dependent on the defini-
tion of the quantity measure. By that sort of reasoning, however, the price of
almost everything would become indeterminate, since most commodities are
traded in terms of units just as arbitrary as the dollar. For example, why sell
gasoline by the gallon instead of by the liter or potatoes by the pound instead
of by the kilogram? All such units are arbitrary in a sense. Nevertheless, being
reinforced by convenience or custom, they are meaningful to both buyer and
seller. Here the dollar will be taken to be the meaningful unit of money.

What then of price? What, indeed, should one understand the price of money
to be? Most scholarly articles and most textbooks—see Campbell McConnell
(1987, 345-47) and Lawrence Ritter and William Silber (1989, 314-23), for
example—assume without hesitation that the price of money is some interest
rate, this assumption being based on the idea that forgone interest on some
alternative financial asset is the opportunity cost of holding money and, thus,
money’s price. If the interest rate'' is the price of money, then there is a
problem. It is unavoidable that the interest rate is the price of credit, or loana-
ble funds, but how can the interest rate be the price of both money and credit?
Surely to suggest such a thing is erroneously to posit that money and credit are
identical. This is very common, but nonetheless false.


===== PAGE 49 =====

22 Free Banking

As Friedman has stated, ‘“The confusion of money and credit has been a
primary source of difficulty in monetary policy. And recent experience indi-
cates this is still so’’ (1969, 263). Moreover, ‘‘the interest rate is not the price
of money. The interest rate is the price of credit . . . the inverse of the price
level is the price of money’ (Friedman 1972, 201). Robert Greenfield and
Leland Yeager arrive at a similar conclusion while discussing a different topic.
They suggest that ‘‘to suppose the interest rate to be the ‘price of money,’
determined so as to ensure that each existing unit of money is a unit demanded
in cash balances as well—is to blur two analytically distinguishable concepts,
money and credit’ (1986, 371). The pervasiveness of this error may be seen
in the fact that Gurley and Shaw (1960), Tobin (1963), Lyle Gramley and
Samuel Chase (1965), Niehans (1978), Lombra and Kaufman (1984), Dalgaard
(1987), and even White (1984a), Benjamin Klein (1974), and Taub (1985) all
speak of the interest rate as the price of money.

Is Friedman alone in his belief that the price of money is its purchasing
power per unit, that is, the reciprocal of the price level? By no means. Don
Patinkin explains with his usual lucidity that although the ‘absolute price level”
is the price of real money balances, the ‘reciprocal of the price level 1/P can
be considered as the ‘real’ or ‘relative’ price of the good nominal money hold-
ings. Accordingly, we can conceive of a curve which describes the demand for
these holdings as a function of this relative price’’ (1965, 28). Pesek and Sav-
ing refer to ‘‘the realization that the general price level is the reciprocal of the
average relative price of money’’ (1967, 58). Richard Timberlake and Edward
Selby offer a graphical illustration much like that of Patinkin in which the
nominal demand for money is plotted as a function of the ‘‘inversion of a price
index’’ (1972, 83).

As with the works just cited, this book will take the price of nominal money
holdings to be their purchasing power per unit (PPM).!? It is further assumed
that such purchasing power can be measured (at least approximately) by the
reciprocal of the price level (1/P), with that price level represented by the ap-
propriate price index.'?

Insofar as the application of price theory to free banking is concerned, one
must be careful to reason in a fashion that is parallel to, but the inverse of the
ordinary process. That is, individual consumer demand schedules do exist, and
the horizontal summation of such constitutes the market demand schedule (since
money is not a public good). However, such schedules represent, ceteris pari-
bus, not the quantities of some good or service that consumers will purchase at
various money prices, but rather the quantities of nominal inside money con-
sumers choose to acquire by exchanging various amounts of goods or services
for them. The demand schedules are negatively sloped since, ceteris paribus,
as the purchasing power of each dollar falls, consumers must hold more dollars
if they are to maintain the same total purchasing power, that is, command over
the same real goods (Patinkin 1965, 28-31).

On the supply side, one finds that each firm experiences short-run costs that


===== PAGE 50 =====

Comparative Statics 23

rise at the margin and that the horizontal summation of such marginal cost
curves produces a market supply schedule. The marginal cost schedule facing
each firm represents the manner in which its total costs vary as the quantity
supplied changes. In this instance, however, cost is measured not in monetary
terms, but in terms of actual goods or services needed to produce and (more
importantly) maintain in circulation various quantities of money. Thus, the pos-
itively sloped market supply schedule reveals the quantities of money banks
will offer for goods and services at various rates of exchange.

It has been suggested that the methodological heart of neoclassical theory
consists of (1) the identification of certain key concepts (exemplars) and (2) the
consistent application of those concepts to disparate topics so as to form mat-
rices (paradigms) that reveal both gaps in the theory and its essential parallel-
ism (Holland 1987). The present analysis—idiosyncratic though it may ap-
pear—does not violate such parallelism. Specifically, what does a firm give up
and receive when it produces and sells its product? For the typical firm, the
answers are, respectively, marginal cost and marginal revenue, with both couched
in monetary terms since goods trade against money. For a ‘‘money producer’’
(a free bank), however, the firm’s product trades against goods and services,
not money. Thus, for such firms, marginal cost and marginal revenue must be
measured in terms of goods and services rather than in money terms. If the
price of money is its purchasing power, it cannot be otherwise.

At this point, some readers might voice a concern about a particular aspect
of the sort of supply and demand analysis described above. They might ques-
tion whether it is appropriate to use supply and demand schedules at the market
level, or marginal cost and marginal revenue schedules at the level of the firm,
to portray a stock, such as money balances, since such schedules are conven-
tionally taken to represent flows. This is not an insurmountable problem.

Pesek and Saving state in a straightforward fashion that ‘‘the supply of money
at a point in time will consist of (1) the stock existing in the previous period
and (2) any net additions . . . that occur during the period in question. If the
additions to the stock exceed the reductions in the stock, then the stock of
money will be increasing, and if the additions are less than the reductions, it
will be decreasing’ (1968, 50). Furthermore, ‘‘because the current output of
money is a small part of the existing stock of money, the increases in revenue
from producing an additional unit of the money commodity will equal its price’
(Pesek and Saving 1968, 51). Finally, ‘‘the equilibrium stock of money will
occur where the demand for money function intersects the supply of money
function’’ (Pesek and Saving 1968, 52). Obviously, those two economists find
nothing incongruous about the application of supply and demand concepts to
money. Still, they fail to provide any explicit justification for the combination
of stocks and flows—of money or any other traded good—in the same diagram.

For such a justification, one may turn to Patinkin (1965, 516-21), who points
out that if one has a flow (F), a discount rate (r) per time period, and a number
(h) of such time periods per payment interval, then the related stock (Sg) can


===== PAGE 51 =====

24 Free Banking

be expressed as: So=F/rh. It is important to realize that if the definition of the
time period changes (from, say, a week to a day), the values of Sy and F
remain unchanged. All that would occur is that h would rise by a factor of
seven and r would fall to one-seventh of its former value. Yet if h changes
while the time unit remains constant, then F changes proportionally, leaving Sg
unchanged. It is in this sense that stocks are ‘‘time-dimensionless,”’ whereas
flows are not.

Patinkin notes that, properly understood, a flow should not be thought of as
some quantity per unit of time, but rather as ‘‘a quantity whose magnitude is
directly proportionate to h,’’ whereas a stock is not a quantity measured at
some instant in time, but ‘‘a quantity whose magnitude is independent of h.
Clearly, such ‘stocks’ and ‘flows’ can be added together’ (1965, 521). If stocks
and flows can be added together, they must be of the same dimensions. Thus,
one is not remiss in viewing money in a supply and demand context.

The Parameters

In the previous section, the issues of money’s price (PPM) and quantity were
discussed. Briefly, it was seen that an increase (decrease) in the level of goods’
prices, that is, a decrease (increase) in the purchasing power of money, led to
an increase (decrease) in the quantity of money demanded and to a decrease
(increase) in the quantity of money supplied. In short, typical positively sloped
supply curves and negatively sloped demand curves are involved. Thus, changes
in the price level elicit movements along existing nominal money supply (MS)
or nominal money demand (MD) curves.

What, however, are the parameters of MS and MD? That is, what factors
will bring about shifts of the MS or MD schedule? Mirroring Selgin’s treat-
ment, five suggest themselves: (1) the ratio of money desired as a fraction of
income (k), (2) changes in real income (y) that result from an increase in pro-
ductivity, (3) changes in the specie reserves (S) that form the monetary base of
free banking, (4) changes in the composition of currency demand, that is, changes
in the public’s desired ratio of inside to outside money (ki/’k,), and (5) the real
unit cost of specie (Ps) (Selgin 1988a, 96, 98-102, 113, 129-33; 1990; 1991).
These five will be utilized in a simultaneous equation system. Another issue,
the effects of a change in the composition of the public’s demand for money,
that is, a change in the desired ratio of currency to demand deposits (C/DD),
will be examined separately.

The direction of the effect of k, y, S, and Pg on MS or MD is assumed to
be as follows. An increase in k—which is initially taken to mean the ratio of
desired nominal inside money holdings to nominal income, since specie ‘‘sel-
dom if ever appears in circulation’ (Selgin 1988a, 31) in a mature free-banking
system—increases both the demand for money and the supply of it. The impact
on demand follows from the Cambridge cash balance equation (M =kPy), whereas
the effect on supply is derived from the fact that a free bank’s demand for


===== PAGE 52 =====

Comparative Statics 25

specie reserves is inversely related to k. This latter fact, which was explained
in some detail in an earlier section of this chapter, implies that as k rises, the
money supply will also rise, ceteris paribus.

When real output/income rises because of productivity gains, then y rises.
Such an increase in y increases the demand for money (Cambridge cash balance
equation again), but decreases the supply of money. This latter may appear
paradoxical, but it is not. If either the supplies of inputs increase or technolog-
ical improvements occur, then such gains will generally bring about lower money
costs of producing nonmonetary goods and services. Thinking inversely again,
this means that the costs in terms of real goods and services of producing
money and maintaining it in circulation have risen. Therefore, the marginal
cost curves of individual banks and the market supply curve shift up and to the
left.

An increase in S should have no effect on the demand for money, but it will
increase the supply of money. Such a conclusion follows from the simple fact
that, under such a free-banking system, specie represents the monetary base.
Furthermore, just as with a central banking structure, an increase in the mone-
tary base should, ceteris paribus, increase the money supply.

An increase in Pg, the real cost of specie, increases the marginal liquidity
costs of free banks. That is, if Pg rises, their costs in terms of real goods and
services—for any given optimal reserve ratio—of each additional dollar of money
in circulation must rise. So an increase in P; brings about a leftward shift in
each of the marginal cost curves for each bank and the market supply curve.

As a succinct summary of the foregoing, the following relationships are herein
assumed:

oMD oMD oMD oMD oMD

oP ok ay 8S 9p,
IMS oMS MS oMS MS
P25, 0255200, 2259 22
oP ok dy 3S ap,

A Quantity Theory Approach

Regarding model selection, two considerations were of paramount impor-
tance: (1) to utilize the simplest model that produced useful conclusions and
(2) to reflect, as closely as possible, Selgin’s presentation.'* Therefore, a quan-
tity theory approach was chosen. Here the demand for money is a function
only of k, P, and y; interest rates play no role.'®> Both the prices of goods and
the prices of inputs respond to market considerations, that is, they are ‘‘flexi-
ble’ (though not necessarily instantaneously so) rather than ‘‘fixed.”” Aggre-
gate demand and, therefore, nominal income are affected by nominal money
holdings, but real income is determined exogenously.

Two items common to many macromodels are missing from this one: a ‘‘real-


===== PAGE 53 =====

26 Free Banking

balance effect’’ and a bond market. The real-balance effect refers to the idea
that, for given aggregate nominal money holdings, as the price level falls, real
money balances increase and, as a result, consumer expenditures rise as well.
In the system Selgin describes, however, the real-balance effect on expendi-
tures will be small or even nonexistent.

The controversy over whether there will be such an effect in an all-inside-
money regime dates back to the late 1960s. At first it was thought that if there
were no outside money in circulation, then there would be no real-balance
effect (Patinkin 1965, 297). Later it was demonstrated that the inside-outside
contrast was not the determining factor. What was crucial was whether the
money represented net wealth, and, as David Laidler has pointed out, ‘‘regard-
less of whose liability it is, any money which bears interest at a market rate is
not net wealth on the margin, and any money which does not bear such interest
is net wealth’’ (1990, 33). In all modern industrial economies, the money sup-
ply consists primarily of deposits, not banknotes or coins. There is no reason
to think matters would be appreciably different under free banking. Since com-
petition would compel banks to pay interest on deposits,'® only a fraction of
the money supply could constitute net wealth. Furthermore, it is even conceiv-
able, though unlikely, that interest might be paid on banknotes.!” Therefore,
free banking will exhibit a small, or no, real-balance effect.

The bond (or credit) market is ignored (for now), because it is superfluous.
If certain comparative statics properties emerge from a system ‘‘when analyzed
from the viewpoint of the commodity and bond markets, then it must also be
stable—or have these properties—when analyzed from the viewpoint of the
commodity and money markets. Every set of assumptions in the former frame-
work has its exact counterpart in the latter’ (Patinkin 1965, 377). Here the
focus is on the commodity and money markets.

The specification of the model takes the following forms.

Implicitly,
MD =MD(P;k,y)
Y=Y(P;y)
Explicitly,
MD =aP + by + ck (1)
MS =eS + fk — gP, — hP — jy (2)

Y =Py (3)


===== PAGE 54 =====

Comparative Statics 27

where MD, MS, S, k, y, and P are as defined previously. P is the price level,
and Y is nominal national income. Furthermore, a>#@, b>0, ¢>0, e>0, f>0,
g>0,h>0, j>0, 1 >k>0.

Assuming that MD=MS=M and that M, P, and Y are the endogenous
variables of the system, this becomes:

M —aP=by + ck (la)
M+hP=eS+ftk—gP;—jy (2a)
Y—-Py=0 (3a)

Setting this up in the matrix form Ax = d, one has the following:

[1 —a 0] [M™M] [ by+ck
1 h ) P = eS + fk — gP,—jy
| 0 —y 1 | | Y | I 4 |

Solving for the determinant |A|=(h+a)>@. Thus, there exists a unique and
nontrivial solution to the system. Utilizing Cramer’s Rule, one can solve for
M, P, and Y, the equilibrium values of M, P, and Y.

by + ck —a %
= 1A] :
M= Tal = eS + tk —gP, — jy h %)
1%) -y 1
(h+a)
_hby + ckh + aeS + atk — agP; — ajy
(h+a)
1 by +ck 7)
p- 1d = 1 eS + fk — gP,— jy 7)
7) 1%) 1

(h+a)

_eS+tk—gP—jy—by—ck
B (h+a)



===== PAGE 55 =====

28 Free Banking

1 —a by + ck
o_ |A4 :
= = = 1 h eS +fk—gP,—jy
A]
7) -y 1%)
(h+a)

_yeS+yfk —ygP, — jy*— by* —cky
(h+a)

To determine the effects of parametric changes, one may take the partial deriv-
ative of each M, P, and Y with respect to k, y, S, and P;. Please note that
only the basic results are presented here. The details may be found in the
Appendix.

A Change in k. If the fraction (k) of income that consumers desire to hold
as money changes, then,

OM (ch+af)  9P_(f—c)
dk (h+a) "9k (h+a)
To maintain equilibrium,
oMD MS
ok ok
or c=f. Therefore,
dP
—=@
ok
oY _y(f—c) _
ok (h+a)

To summarize,

oM oP aY
—>0, —=0, —=4¢
ok ok ok

This scenario is illustrated in Figures 1 and 2. The demand for nominal
money balances rises as k rises, but the increase in k also reduces the marginal
liquidity costs of free banks, since less specie is needed to cover adverse inter-
bank clearings, the volume and frequency of transactions having declined. This


===== PAGE 56 =====

Comparative Statics 29

Figure 1
Microeffects of an Increase in k
Industry Firm
PPM
PPM MS

M, M: Nominal m, m,

Nominal
Money

Money

increases the money multiplier and, thus, the money supply. In macroterms,
the increased demand for money reduces aggregate demand (AD), but aggre-
gate demand rises again as the supply of money increases. The net result is
that neither the price level nor income changes. However, nominal (and real)
money balances are greater than before. Such an increase in money balances is
in accord with the increase in k that was the premise of the case. In short,
‘free banks maintain constant the supply of inside money multiplied by its
income velocity of circulation’ (Selgin 1988a, 102). That is to say, free bank-

Figure 2
Macroeffects of an Increase in k

Economy Industry

AS
P '
PPM

AD ,
So.

y, Real M, M: Nominal
Income Money



===== PAGE 57 =====

30 Free Banking

ing tends to maintain nominal national income in the face of a change in k.
This result, as noted by Selgin (1988a, 56), may be termed a ‘‘neutral money
policy’’ and has been advocated by economists such as Hayek (1935), William
Hutt (1979), Dennis Robertson (1926), Pigou (1933), Gottfried Haberler (1931),
and J. E. Meade (1933).

A Change in y. Turning to the effects of a change in real output/income
brought about by an increase in productivity,

dM _ (bh—aj)
oy (h+a)

To maintain equilibrium in the market for money,

and

oMD oMS
op op 2 ora=h

Substituting,
oM _ (jh—jh) _
dy (h+a)

oP _ —(j+b) _

a
dy (h+a)

3Y Ph+a)—y(j+b)
ay (h+a)

Following Selgin (1988a, 98-101; 1990, 272), who assumes that aggregate
demand is unit elastic, then

oY 9Y
—_—4—=
oP dy

and since


===== PAGE 58 =====

Comparative Statics 31

then

7 _

dy

Of course, if aggregate demand were elastic then dY/dy >. Furthermore, if
aggregate demand were inelastic, then 3Y/dy <#. Selgin suggests that if “‘the
supply of labor is inelastic with respect to changes in productivity, then . .
changes in the price level should be fully proportionate to opposite changes in
output’’ (1990, 272). That is the case assumed here. Thus,

oY
—_ a
dy
To summarize,
oM oP oY
— =f, —<g, —=0
ay ay ay

These results are portrayed in Figures 3 and 4. The general improvement in
productivity increases aggregate supply (AS) and real income, lowers goods’
production costs, and exerts downward pressure on the price level. The in-
crease in real income elicits an increase in the demand for money as well as a
decrease in the supply of money. The net effects are a general decline in prices,
no change in nominal income, and an increase in real money balances. This

Figure 3
Microeffects of a Decrease in Goods’ Production Costs
Industry Firm
PPM PPM MC
MC |,
PPM , PPM MR |,
PPM ,|- — PPM , ; MR
)
i |
I |
M, Nominal m Nominal

Money Money


===== PAGE 59 =====

32 Free Banking

Figure 4
Macroeffects of a Decrease in Goods’ Production Costs
Economy Industry
P AS y | AS PPM ms 2
2

y, Y, Real Mm Nominal
income Money

last is necessary given that real income rises while k is constant. The reduction
in goods’ money prices raises the marginal costs of banks and, therefore, re-
duces the money supply. One may recall that this follows from the observation
that free banks should perceive their marginal costs in real terms, that is, the
goods and services required to produce an additional dollar and maintain it in
circulation.

Selgin quite appropriately emphasizes at this point that ‘‘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’’ (1988a, 101). This free bank-
ing tends to do.

Two related problems appear in Selgin’s treatment of the above sequence of
events. First of all, as noted earlier, it is unlikely that this would include a real-
balance effect of any consequence. Yet Selgin makes reference to such an ef-
fect (1988a, 101-2). Second, he is certainly correct to conclude that the nom-
inal supply of money must contract in the face of a general productivity gain.
However, he offers no sound explanation of why this would occur—unlike the
present work. The explanation he offers is that ‘‘the nominal supply of inside
money will adjust only in response to any change in spending associated with
some real-balance effect’’ (1988a, 102). That is, if the rate of spending rises
as an expression of a real-balance effect (k falls), then the money supply will
fall, but this comes to nought as an explanation given that the real-balance
effect will be small, if not nonexistent, under free banking.

A Change in S. To continue with the comparative statics analysis, one also
must look at the effects of a change in the quantity of specie that forms the
monetary base:


===== PAGE 60 =====

Comparative Statics 33

aM _ ac

aS (h+a)
Po © pg
0S (h+a)
oY __ye

0S (h+a)

There is nothing unusual here. An increase in specie—if it is held by banks
as reserves—tends, ceteris paribus, to increase the money supply, the price
level, and nominal income. The increased inside money supply results from the
decrease in marginal liquidity costs implied by the greater specie reserves. This
is shown in Figures 5 and 6. Admittedly, to the extent that such a sequence of
events occurs, free banking might justifiably be termed ‘unstable.’

However, there is a distinction to be made that is of some importance. Selgin
explains that a commodity-backed monetary system will be unstable because
of short-run changes in the production of that commodity only if such bursts in
production constitute exogenous supply shocks that are not merely reactions to
a change in demand for the monetary commodity (1988a, 130). Furthermore,
a review of the history of gold production suggests that ‘‘discoveries and im-
provements in extraction techniques are best understood as responses to in-
creased demand for gold rather than as supply shocks’’ (Selgin 1988a, 131).

Redemption Runs. The destabilizing events described above and revealed in
Figures 5 and 6 are the result of exogenous supply shocks. If Selgin’s research
is to be believed, it is far more likely that an increase in the supply of specie
would follow a shift in consumer preferences away from inside money and

Figure 5
Microeffects of an Increase in Specie Reserves
Industry Firm
PPM PPM
MC

/

PPM, — 4 MR
t

PPM, |- — — — PPM, MR,

M, M, Nominal m, m, Nominal
Money Money


===== PAGE 61 =====

34 Free Banking

Figure 6
Macroeffects of an Increase in Specie Reserves
Economy Industry
P PPM

PPM,

PPM, | ~ = ~ >

AD,

y, Real M M Nominal
income Money

toward outside money, that is, gold coin. Michael Bordo (1984, 201), for ex-
ample, seems to concur with this appraisal of the essential stability of gold
production. In other words, an increase in specie would probably be preceded
by a decline in kj, k; being the fraction of income one wishes to hold in the
form of inside money, whereas the fraction of income one wishes to hold in
the form of outside money might be termed k,, with k; +k, =k. The fall in k;
decreases the demand for inside money and, at the same time, also decreases
its supply by virtue of raising the marginal costs of banks.

Two points require clarification. Earlier it was assumed that k represented a
money/income relation that referred only to inside money. Now one encounters
k; and k,, one for inside money and one for outside money. The reason for the
change is quite simple. Emulating Selgin, it was earlier assumed that no outside
money was In circulation, it all being held by banks as reserves, that is, pre-
viously k,=#. The present case is merely one in which outside money demand
grows at the expense of inside money demand. Thus, k,>#. It is, furthermore,
important to recognize this as a classic ‘ ‘redemption run’’ on banks. 8. That is,
consumers liquidate part of their holdings of banknotes and/or checkable de-
posits and demand payment in specie. The conventional textbook explanation
of redemption runs under central banking is that an increase in the demand for
outside money reduces the total reserves of the banking system, which, in turn,
brings about a multiplicative decline in the total money supply and a destabil-
izing deflation in the economy (Jaffee 1989, 341-42).

The increase in free banks’ marginal liquidity costs resulting from a prefer-
ence shift toward outside money is, of course, due both to the higher real unit
cost of specie and to the higher optimal reserve ratio, that is, the higher ratio
of specie held per dollar of inside money in circulation, necessitated by the


===== PAGE 62 =====

Comparative Statics 35

decline in k;. Together these changes suggest a large increase in marginal costs
and a large decrease in the inside money supply. When the supply of specie
subsequently increases—as a result of either improvements in extraction tech-
niques or new discoveries, per Selgin—the marginal costs of inside money fall
and the supply of that inside money rises. However, since by assumption k;
and k, do not change further, the decline in marginal costs should be smaller
than its earlier increase. That is, marginal costs will fall only because of the
lower real unit cost of specie; the optimal reserve ratio will not also be lower.

Recall that it was earlier assumed that no outside money was in circulation.
In such a case, k,=# and k; =k. Mathematically, then, the effects of a change
in k; are such that

OM _ (ch+af)

ok; (h+a)
P_(f-0) _
ok; (h+a)
oY _yi-o_,
ok; (h+a)

Furthermore, for changes in the real cost of specie (Py),

M _ —ag
oP, (h+a)
Pg
oP, (h+a)
aY  -—yg
oP, (h+a)

A decrease in k; that is accompanied by an increase in both k, and the price
of specie P; must, as a first effect, lead to a smaller nominal inside money
supply. As long as the optimal reserve ratio remains less than 1, that is, as
long as free banks hold fractional reserves, it must also be true that the decline
in the inside money supply must exceed the increase in outside money—each
change in specie reserves having a multiplicative impact on the inside money
supply. In short, the total money supply, the price level, and nominal income
must fall.

Such a scenario is depicted in Figures 7 and 8. There one sees the preference
shift away from inside money and toward outside money. Outside money de-
mand (OMD) rises as inside money demand (IMD) falls. Higher liquidity costs
and higher reserve ratios combine greatly to reduce the inside money supply
(IMS). The total money supply falls as does the price level and nominal in-


===== PAGE 63 =====

36 Free Banking
Figure 7
Microeffects of an Increase in k,/Decrease in k;

Outside Money Inside Money

IMS,

OMS,
PPM OMS, PPM
IMS,
PPM, |- — —- NZ — — — /— PPM, | —
PPM, e= = ~ J = — — = — — = - PPM, | ~ —'-
|
OMD, | IMD,
OMD, bo IMD,
1 1 Lo |
OM, OM, OM, Nominal IM, IM, IM, Nominal
Money Money

come. When, after some time lag, the supply of outside money (OMS) in-
creases, liquidity costs fall back, and the inside money supply, the total money
supply, the price level, and nominal income all rise again. As seen earlier,

oM oP oY

—<g, —<0, —<4¢

dP; oP; dP;

Figure 8
Macroeffects of an Increase in k,/Decrease in Kk;

Economy Total Money
P AS, PPM

Real Nominal
Yi Income M, Mm Money


===== PAGE 64 =====

Comparative Statics 37

and

As conveyed by Figures 7 and 8, although the redemption run is indeed
deflationary initially, the supply-side gains in the production of specie lead to
an increase in the inside as well as the outside money supply. This tends to
bring the price level back toward its original state. It therefore appears that free
banking, once again, is self-correcting.

The obvious question arises, however, as to how long it will take for the
specie production gains to take effect. Selgin seems inconsistent in his treat-
ment of this time element. On the one hand, he makes reference to ‘‘short-run’’
changes in the gold supply (1988a, 129), whereas on the other hand he ascribes
these changes to ‘‘discoveries and improvements in extraction techniques’ (1988a,
131). The latter appear to belong more nearly within the domain of the eco-
nomic long run than in the short run.

Why must one wait, however, for the long run to bring forth increased sup-
plies of specie? Could not free banks simply—and quickly—purchase addi-
tional monetary gold from abroad? This is certainly White’s position. He states
that ‘‘as the public desires to hold a greater share of its currency in the form
of specie rather than in notes . . . there will arise a short-run equilibrating
tendency for specie to flow in from outside the region’’ (1984a, 12). Thus, the
self-correction discussed above is likely to be short-run rather than long-run in
nature.

Finally, one cannot help but be mystified by Selgin’s assertion that ‘‘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 con-
clusion that gold output has been unstable’’ (1988a, 130). As seen earlier, it is
precisely the movement along the supply curve of monetary gold that leads to
a destabilizing deflation, and it is the supply curve shift that tends to bring
prices back up to their earlier level. The distinction may not be crucial, but
Selgin seems to have things backward.

Currency Runs. The ramifications of a redemption run have just been ex-
plored in some detail. Yet there remains a similar—but subtly distinct—issue
that must be discussed: the effects of a ‘‘currency run.” This is a shift of
consumer preferences away from deposit account credits and toward currency.
That is, consumers liquidate part (or all) of their demand deposits so as to
acquire cash instead.

Currency runs reveal a dramatic inherent advantage that free banking pos-
sesses over central banking. Under central banking, the liabilities of the central
bank, for example, Federal Reserve notes, are held both by the public as the
sole legal currency and by commercial banks as a part of their reserves. There-
fore, any change in the composition of the demand for money (the ratio of
currency to deposits) will result in a multiplicative change in the money supply


===== PAGE 65 =====

38 Free Banking

in the opposite direction (Mishkin 1989, 317-18). Under free banking, how-
ever, currency is not a reserve asset of the bank but a liability—at least if one
refers to inside currency. Thus, for a free bank to satisfy its customers’ desire
for relatively greater currency holdings and relatively smaller deposit holdings,
it only needs to substitute one liability (its own notes) for another liability
(deposit credits). There need not occur any decrease in reserves or any decrease
in the total money supply.

It is simple to convey this contrast in formal terms. Under a central banking
structure, the money supply (MS) may be defined, quite conventionally, as the
sum of currency held by the public (C) plus demand deposits (DD), whereas
the monetary base (MB) equals the sum of currency held by the public plus
reserves held by banks (R). That is, MS=C+DD and MB=C+R. If the
statutory reserve ratio is RR, with RR <1, then RR=R/DD or DD=R/RR.
Therefore, substituting the expression for DD back into the earlier expression
for MS,

MB -C MS
MS=C+=—-— and == = (1- IRR) <

This last is clearly negative as long as RR<1, that is, as long as there is
fractional reserve banking. For example, if the legal reserve ratio is 0.1 and
consumers exchange $1 million in deposit credits for $1 million in currency,
for any given monetary base, the net effect on the money supply will be a
decrease of $9 million. One should be cognizant of the essential problem facing
a central banking system in this context: All currency runs necessarily are also
(deflationary) redemption runs. This is a serious flaw in central banking that is
ineradicable as long as competition in the supply of currency is forbidden.

The absence of such a problem under free banking may be formalized in the
following equally simple way. Assuming, as initially, that no outside money is
in circulation, then the money supply (MS) is the sum of private banknotes (N)
held by the public plus demand deposits (DD), and the monetary base is the
stock of specie (S) held by banks. Thus, MS =N+DD and MB =S. If ORy is
the optimal reserve ratio for notes, ORpp is the optimal ratio for demand de-
posits, Sy the specie reserves for notes, and Spp the specie reserves for depos-
its, then

S S
ORx = ~ and ORpp = on
or
N= ON and DD = SPP

ORnN ORpp


===== PAGE 66 =====

Comparative Statics 39

If one assumes that all free banks exhibit the same optimal reserve ratios for
all deposits and notes, then ORy=ORpp=0R. Keeping in mind that specie
reserves can be used to redeem either notes or deposits, the above expression
for the money supply may be transformed such that

SN+Spp  S
=N+ nN v=
MS=N+DD OR OR
Thus,
oMS
oN

That is, an increased demand for currency (banknotes) has no net effect what-
ever on the money supply. Currency runs pose no threat to free banks and do
not imply deflation for the economy, '® unlike the case of central banking.

The contrasts between central banking and free banking in the context of a
currency run are seen in Figures 9, 10, and 11. The first two of these figures
are adapted from Pesek and Saving (1968, 193). In Figure 9, under central
banking, an equilibrium position is achieved at a point where the desired cur-
rency/demand deposit ratio for consumers equals the currency/demand deposit
ratio for banks, that latter ratio being equal to the statutory reserve requirement
(RR). Assuming that both the legal reserve ratio and the total quantity of cur-

Figure 9
Effects of an Increase in the Relative Demand for Currency (Central Banking)

Central Banking

Currency

Cc
oD {public,)

Cc
DD (public,)

ul (banks) =RR

Demand
DD, DD, Deposits

Source: Reprinted with the permission of Macmillan Publishing Company from The Foundation of
Money and Banking by Boris P. Pesek. Copyright © 1968 by Macmillan Publishing Company.


===== PAGE 67 =====

40 Free Banking

Figure 10
Effects of an Increase in the Relative Demand for Currency (Free Banking)

Free Banking

Currency
— {public,)
7 gt op Co
Cc.
c, Zz

| |
| 1

DD, DD, Demand Deposits

Source: Reprinted with the permission of Macmillan Publishing Company from The Foundation of
Money and Banking by Boris P. Pesek. Copyright © 1968 by Macmillan Publishing Company.

rency in the economy (CC) remain constant, one sees that an increased relative
demand for currency on the part of the public brings about a large decrease in
total demand deposits and a proportionally smaller increase in currency held by
the public. Thus, the net effect is a decrease in the total money supply. Figure
10, on the other hand, reveals that under a free-banking structure, firms can
supply the desired additional currency to consumers without depleting their
reserves and, therefore, without causing a net decrease in the overall money
supply. The decrease in demand deposits may be matched by an increase in

Figure 11
Price Effects of an Increase in Relative Currency Demand

Central Banking Free Banking

PPM MS, PPM MS,

M, M, Nominal M, Nominal
Money Money


===== PAGE 68 =====

Comparative Statics 41

currency so as to avoid any net change. This ability of free banks derives from
(1) their legal right to print their own currencies and (2) the absence of statutory
reserve requirements. Figure 11 simply contrasts the likely deflationary effect
of a net decline in the money supply brought about by a currency run (central
banking) with the absence of such an effect (free banking).

SUMMARY

The purpose of this chapter has been to translate the White-Selgin approach
to free banking into a formal model that, it is hoped, can be used both to
illuminate the essence of that approach and to convey its characteristics to stu-
dents of economics.

The conclusions that emerged from the comparative statics analysis were as
follows. If the Cambridge cash balance k increases, then the money supply as
well as the demand for money increases so that equilibrium money holdings
increase (which is consistent with the rise in k), but neither the price level,
nominal income, nor real income changes. If there are productivity improve-
ments such that real output/income increases, then the demand for money in-
creases while the supply of money decreases. Equilibrium nominal money
holdings are unchanged, while real money balances rise. The price level falls,
but nominal income remains unchanged (assuming aggregate demand is unit
elastic). If there is a sudden increase in monetary gold production that results
in larger specie holdings by banks, then the money supply rises, as do the price
level and nominal income, while real income remains constant. If—as Selgin
argues is much more likely to occur than the preceding—specie productivity
gains follow a shift in consumer preferences toward outside money at the ex-
pense of inside money (a redemption run), then the total money stock, the price
level, and nominal income all first fall and then rise again back toward the
original equilibrium conditions. Finally, if consumer preferences shift toward
currency at the expense of demand deposits (a currency run), then under free
banking, there is no net change in the money supply, the price level, or nomi-
nal income, whereas under central banking, the money supply, the price level,
and nominal income all decline.

In short, free banking appears to be self-correcting in the important sense
that, under several different scenarios, profit-maximizing action on the part of
banks will, even in the short run, tend to maintain nominal national income.
The one clear exception, an unprovoked and unanticipated gold supply shock,
seems seldom if ever actually to occur. In other words, the ‘‘invisible hand’
of Adam Smith is revealed when banking is made truly competitive.

The question remains as to how actual episodes of free banking would per-
form. Regrettably, there are no historical cases of a ‘‘true’’ or ‘‘pure’’ free-
banking regime from which one might draw unambiguous conclusions. How-
ever, there have been several experiments involving multiple issuers of bank-
notes, from which one can glean some provocative material for review and


===== PAGE 69 =====

42 Free Banking

debate. The best documented of these are (1) Scotland (1765-1845) and (2)
the United States (1837-1863). Chapters 5 and 6 are devoted to examinations
of these cases.

First, however, there are certain additional theoretical issues to be addressed.
Chapter 3 discusses Say’s Law, business cycles, and the role of free banking
in reconciling some well-known cycle theories. Chapter 4 argues that central
banks face insurmountable problems that prevent them from maintaining stable
economic conditions.

NOTES

1. The case Selgin discusses is that of freezing the quantity of Federal Reserve
notes. Basing a free-banking system on such a fiat currency appears to be, as he admits,
very much removed from the specie-based system he examines throughout most of his
book. Nevertheless, Selgin insists that the differences are not large.

2. In an earlier article, J. H. G. Olivera demonstrated that the numerical value of
such elasticity must lie between 0.5 and 1.0 (1971).

3. See the discussion of parametric effects later in the chapter. Also, it is difficult
to imagine that the supply of specie would ever be perfectly elastic.

4. A bank’s reputation for redemption is here taken to be an asset of the firm (part
of its ‘‘brand name capital’’) that is developed over the long run and that, therefore, is
a given in the short run. Many economists would, no doubt, argue that ‘ ‘reputation’ is
an ephemeral thing that can vaporize in an instant during a bank ‘‘panic.”’ They err in
reasoning from what is true in central banking to what (they think) would be true of
free banking. Contagion effects, as they are called, are much less likely to occur under
free banking. For evidence on the absence of contagion in American free banking, see
Arthur Rolnick and Warren Weber (1986).

5. For examples of the Austrian position, one should consult Murray Rothbard (1970,
277-78), O’Driscoll and Mario Rizzo (1985, 121), and Mises (1966, 350-57).

6. The reader should not assume that all the economists mentioned in this paragraph
would categorize themselves as Austrians.

7. The author, although in agreement with their policy prescriptions and very sym-
pathetic to their methodological stance, does not accept the categorical dismissal of all
math and statistics espoused by many Austrians. It is ironic that some Austrians con-
demn any mathematical, graphical, or statistical work undertaken by non-Austrians, but
indulge in it themselves on occasion. See Rothbard (1970; 1975) and Roger Garrison
(1978) for examples of the insightful use of graphs and/or statistics by well-known
Austrians.

8. Say took ‘‘money’’ to mean only specie, that is, only outside money.

9. Alternatively, one may think of banking as a ‘‘contestable’’ market (Baumol
1982).

10. In this system, the medium of exchange and unit of account are coextensive. See
Chapter 7 for a discussion of versions of free banking in which they are divorced from
one another.

11. In reality, of course, there is not a single interest rate, but an array of interest rates.

12. Some economists argue that money has neither a market nor a price of its own
(Yeager 1986, 377). Their conclusion stems from the observation that, since money


===== PAGE 70 =====

Comparative Statics 43

trades against goods and services in a multitude of markets, the price of money (its
purchasing power) does not instantaneously adjust to changes in the supply of or de-
mand for money. One need not challenge the accuracy of that observation in order to
maintain that (conceptually) money has a market and a price. This is especially true if
one thinks of the price level as the array of goods’ relative prices rather than as their
weighted average.

13. This is not meant to deny that there are problems inherent in the use of any price
index. All that is being suggested is that the concept ‘‘price level’ is useful peda-
gogically.

14. There are, however, some departures from Selgin, as will be seen.

15. They are not ignored altogether, however. Chapter 3 discusses the interest rate
effects of the parametric changes dealt with here.

16. Legal constraints (the Banking Act of 1933, also known as the Glass-Steagall
Act) are the only reason for the long-standing absence of interest-bearing demand de-
posits in the United States.

17. An obvious possibility would be the issuance of notes subject to an option clause.

18. Since free banks would have a profit incentive to maintain redeemability and to
nurture consumer confidence in that redeemability, it seems unlikely that redemption
runs would occur with any frequency in a free-banking regime.

19. This is certainly true as long as the currency run does not degenerate into a
redemption run. Even then, as discussed earlier, it is likely that free banking would
prove to be self-correcting.


===== PAGE 71 =====



===== PAGE 72 =====

Chapter 3

SAYS Law

The question of which monetary regime is optimal has several facets. Ethically,
the question may be about which regime is consistent with a ‘‘rule of law,”
procedural justice, and individual rights. Socio-politically, one may ask which
regime minimizes rent-seeking behavior on the part of special interest groups.
In a technical economic sense, one may inquire as to which institutional struc-
ture minimizes the destructive effects of business cycles. This chapter will ex-
amine the relationships between free banking and cyclical stability.

BUSINESS CYCLES

Just what are business cycles? At the most basic level, cycles are evidence
of market discoordination.! In the expansionary phase (the ‘‘boom’’), there
exists, in the aggregate, an excess demand for goods. That is, resource owners,
for example, laborers, demand goods whose market value exceeds the value of
the resources the individuals supply. During the contractionary phase (the
‘‘recession’’), there is, in the aggregate, an excess supply of goods. Resource
owners supply resources whose value exceeds the market value of the goods
demanded. The value of resources supplied may be taken to mean those goods
one could potentially purchase with the income generated by the sale or rental
of one’s resources. This Steven Horwitz calls ‘ ‘notional demand’’; he terms the
value of goods actually demanded ‘effective demand’’ (1990, 8). In a barter
economy, there can exist no difference between effective demand and notional
demand. However, when there is one good that is more marketable than any
other and, therefore, is more or less universally accepted as an exchange me-
dium (money), then a rift can develop between effective and notional demands.
Notional demand is translated into effective demand via money. If the money


===== PAGE 73 =====

46 Free Banking

supply is deficient, notional demand exceeds effective demand. If the money
supply is excessive, effective demand exceeds notional demand.

What, then, is necessary in order for effective demand to equal notional
demand? In other words, what is necessary in order to avoid business cycles?
The necessary—but not sufficient—condition is monetary equilibrium. Real factors
may still upset individual markets, but as long as monetary equilibrium pre-
vails, the effects of these real shocks will be minimized. ‘‘What monetary
equilibrium does is to allow for the most coordination possible at the microe-
conomic level by ensuring that the supply of inside money is correct’ (Horwitz
1990, 9).

Two questions could be raised at this juncture. First, how should one define
monetary equilibrium? George Selgin (1988a), Horwitz (1990), Leland Yeager
(1986), and Yeager and Robert Greenfield (1989), for instance, all suggest that
monetary equilibrium exists when the supply of money equals the demand for
money at the prevailing level of prices. For Selgin, at least, this is rather prob-
lematic. To use such a definition seems contrary to his analysis of the effects
of a pervasive productivity gain.? Such a gain in productivity decreased goods’
production costs and, in turn, the price level. Money supply and money de-
mand were not equated at the prevailing level of prices, but at a new, lower
level 3

Perhaps a better definition would be that monetary equilibrium occurs when
the supply of money equals the demand for money, given the underlying state
of general productivity and the concomitant price level. Improvements in pro-
ductivity would warrant a decline in the price level, and retrogressions in pro-
ductivity would require a rise in the price level. If, on the other hand, either
(1) the income velocity of money or (2) the composition of money demand
were to change (with no change in productivity), then no alteration in the price
level would be necessary. Aggregate nominal money balances would remain
constant in the face of either a change in the composition of money demand or
a change in productivity. Money balances would vary inversely with changes
in money’s income velocity.

Second, most economists perceive issues regarding money supply and money
demand as fundamentally and ineluctably macroeconomic in nature. Yet, as
cited above, Horwitz refers to these as problems of microeconomic coordina-
tion. There is a profound clash of perspectives at work here. Those who per-
ceive an economy as blocks of aggregates and the task of the economist as the
manipulation of those aggregates will think of money in a macrocontext. Those
who perceive an economy as a multitude of interacting individuals possessed
of imperfect knowledge and the task of the economist as the understanding of
that interactive discovery process, will think of money in a microcontext. The
perspective adopted here is that money is a microissue that has profound ma-
croimplications.* To pursue this point, one should consider Horwitz’s com-
ments that


===== PAGE 74 =====

Say’s Law 47

it is relative prices that guide actors in their allocative decisions in the market. What

prices do is allow actors to coordinate their actions . . . prices reflect and convey
knowledge . . . competition allows this knowledge to be passed in the market through
acts of buying and selling. . . . What economies ‘‘do’’ is coordinate actions through

prices. With this view, it is easy to see why macroeconomic problems are really mi-
croeconomic problems. (1988, 32)

Macroeconomic discoordination is the result of microeconomic discoordina-
tion. Many factors can bring this about: price controls, trade barriers, licensing
requirements, antitrust statutes, taxes, subsidies, and so forth. However, the
one occurrence that most frequently causes the most severe microeconomic
(and macroeconomic) disruptions is monetary disequilibrium. This brings one
back to an earlier point. To sustain monetary equilibrium is to minimize market
discoordination, minimize the departures of effective demand from notional
demand, and minimize both the frequency and severity of business cycles.

This, however, must be a concept of monetary equilibrium that takes into
account changes in productivity. Otherwise, such ‘‘equilibrium’’ can actually
be disruptive. For instance, if productivity rises, then a price-stabilization ap-
proach to monetary equilibrium would require an increase in the money supply
to prevent a decline in the price level. This would pose at least two problems
for the economy. First, since unit production costs would be falling, this would
manifest itself as an (apparent) increase in firms’ profits. Those extra profits
will be eliminated, however, as marginal factor costs are bid up because of the
rise in marginal productivity. Firms would face a ‘‘signal extraction’’ problem.
The ‘‘hidden inflation’’ caused by the policy of maintaining prices at their
former level would lead producers first to overexpand and then sharply contract
production. Second, a productivity norm (which would be characteristic of free
banking) requires fewer relative price changes than does price level stabiliza-
tion. Selgin constructs a simple example of three factors of production and
1,000 final goods (1990, 275-76). Given certain plausible conditions, the pro-
ductivity norm would require only one adjustment: a decline in the price of that
good regarding which productivity had increased. In contrast, to keep the price
level stable under the same circumstances would necessitate changes in the
prices of 999 final goods as well as the three factors of production. Moreover,
to maintain monetary equilibrium in the context of productivity changes will
tend to keep effective demand equal to notional demand. It is this approach—
and this only—which is fully consistent with Say’s Law.

CLASSICAL ECONOMICS

Surely the single unifying theme of classical economics was that set of prop-
ositions subsumed under the title of ‘‘Say’s Law.’’ Named after the French
economist Jean-Baptiste Say, who did much to popularize the work of Adam


===== PAGE 75 =====

48 Free Banking

Smith in Europe, this principle has twice been the focal point of intense, even
acrimonious, debates in economics.’ First in the 1820s, early proponents of
free markets, such as Say, James Mill, and David Ricardo, defended the valid-
ity of Say’s Law against critics, such as Thomas Malthus, Jean Simonde de
Sismondi, and James Maitland (Earl of Lauderdale).® A century later, in the
1930s, the critics included John Maynard Keynes, John Hicks, Alvin Hansen,
and Joan Robinson. The defenders of Say’s Law at that time included Ludwig
von Mises, F. A. Hayek, Lionel Robbins, D. H. Robertson, and William H.
Hutt.
Thomas Sowell offers a lucid summary of this principle:

The basic idea behind Say’s Law is both simple and important. The production of goods
(including services) causes incomes to be paid to suppliers of the factors (labor, capital,
land, etc.) used in producing the goods. The total price of the goods is the sum of these
payments for wages, profits, rent, etc.—which is to say that the income generated dur-
ing the production of a given output is equal to the value of that output. An increased
supply of output means an increase in the income necessary to create a demand for that
output. Supply creates its own demand. (1972, 4)

Of course, here the terms supply and demand do not refer to the supply of or
demand for a specific good, but to aggregate supply and aggregate demand.
That is, Say’s Law suggests that the supply of goods in general creates demand
for goods in general, or to revert to terminology used earlier, notional demand
creates its own effective demand. There has been little argument over the prop-
osition that notional demand can potentially create its own effective demand
(Sowell 1972, 36). The question has long been: Will notional demand actually
create its own effective demand?’ If so, under what conditions will this be
true?

The contrast between actual and potential results is manifest in the various
forms (or subpropositions) of Say’s Law. Sowell identifies these as Walras’
Law, Say’s Identity, and Say’s Equality (1972, 34-35). Say’s Equality states
that, if there is equilibrium in all markets (goods markets, factor markets, and
the market for money), then the nominal value (money prices times quantities)
of goods supplied will equal the value of goods demanded. This reveals the
classical concern with disproportionality in specific markets, for example, the
labor market (Hutt 1979, 135-77). Say’s Equality establishes that notional de-
mand will equal effective demand if a matrix of equilibria prevails. Say’s Iden-
tity adopts a long-run perspective in which there is neither excess supply of nor
excess demand for money. This proposition asserts, therefore, that the nominal
value of goods supplied is identical to the nominal value of goods demanded.
This, then, is merely a general long-run tendency. Walras’ Law states that the
sum of the value of goods supplied plus money supplied equals the sum of the
value of goods demanded plus money demanded. ‘‘It implies that an excess
quantity of goods supplied is the same as an excess demand for money’’ (Sow-
ell 1972, 34).


===== PAGE 76 =====

Say’s Law 49

Walras’ Law cuts to the heart of the matter. If monetary equilibrium (as
defined earlier) holds, then there can be no monetary disturbances that might
fuel a business cycle. The only possible disruptive influence will be real shocks
that cause temporary disequilibria in specific markets. If monetary equilibrium
is maintained more or less continuously, then such real shocks will have neither
pervasive nor lasting effects. Effective demand will tend to equal notional de-
mand (micro- and macroeconomic coordination will be maximized) as long as
the market for money is in equilibrium. Therefore, properly understood, Say’s
Law is not (and never was) an unconditional proposition, but a conditional one.
Given monetary equilibrium, the expected value of the difference between ef-
fective demand and notional demand equals zero.

The microeconomic aspects of Say’s Law seem to be largely forgotten or
ignored these days, but that was not always the case. Benjamin Anderson,
writing in 1949, commented on Say’s Law in the following manner:

The doctrine that supply creates its own demand . . . assumes a proper equilibrium
among the different kinds of production, assumes proper terms of exchange (that is,
price relationships) among different kinds of products, assumes proper relations between
prices and costs. . . . Moreover, the money and capital markets must be in a state of
balance. When there is an excess of bank credit used as a substitute for savings . . .
or when the total volume of money and credit is expanded far beyond the growth of
production and trade, disequilibria arise. (1979, 385-86)

Anderson touches on several key points. He stresses the microfoundations
upon which Say’s Law was constructed.® He notes that there must be a ‘ ‘proper
relation’’ between prices and costs. The reader will recall that the productivity
norm approach to monetary equilibrium (as under free banking) will maintain
such a proper relation, whereas a stable price level rule will not necessarily do
so. Finally, he emphasizes the importance of ‘‘balance’’ (equilibrium) in the
money and credit markets, and expresses particular concern for the case in
which credit ‘‘substitutes’’ for savings.

TIME AND MONEY

Horwitz suggests that sound macroeconomic analysis must focus on the co-
ordination process that occurs in specific markets (1990). In other words, the
microfoundations must precede the macroconclusions. It is difficult to chal-
lenge such an assertion with any seriousness. Expanding on Roger Garrison’s
reference to time and money as ‘‘the universals of macroeconomics,’’ ? Horwitz
further argues that ‘‘such analysis will have to consider the two most pervasive
economic goods—time and money. A coordination-oriented macroeconomics
would focus on movements in the markets for time . . . and money’’ (1990,
1). In more conventional terms, of what do the market for money and the
market for time consist? The money market involves the supply of and demand


===== PAGE 77 =====

50 Free Banking

for money, the purchasing power of money (its price, the inverse of the price
level), and banking. The time market involves savings and investment, the
natural rate of interest, the supply of and demand for credit, market rates of
interest, and banking. '?

What is unique and important about free banking on a convertible specie
standard is the relationship between the money and time markets.!! As both
Selgin (1988a, 54-55) and Horwitz (1990, 4-6) argue, the demand for inside
money represents voluntary (not forced) savings on the part of consumers. Con-
sumers let their cash balances rise by choosing to refrain from acts of con-
sumption. This is unavoidable as long as consumers must give up real goods
in order to acquire money. In particular, by not redeeming the deposit accounts
or banknotes they hold, consumers leave more specie reserves in the hands of
banks, ‘‘which is equivalent to a very short term act of savings’ (Horwitz
1990, 4). Furthermore, the demand for inside money is equivalent to the supply
of loanable funds. This stems from the fact that banks make loans by crediting
a customer’s deposit account. Unless the customer is (at least briefly) willing
to hold that additional inside money, then no new loan can be created. Thus,
the demand for inside money, voluntary savings, and the supply of loanable
funds all move together.

The supply of inside money ‘‘represents investment’ (Horwitz 1990, 5),
because the ‘‘way that banks add to the money supply is through deposit/loan
creation’’ (Horwitz 1990, 4). Furthermore, those deposits are created in re-
sponse to investors seeking funds. So new inside money will only be created
when investment demand rises. The inside money supply also represents the
demand for loanable funds, since such funds take a monetary form in any
nonbarter economy, and little or no outside money is in circulation (Selgin
1988a, 31). Thus, the supply of inside money, investment, and the demand for
loanable funds all move together.

One may conceive of two markets: (1) the interaction of ex ante savings and
ex ante investment, and (2) the interaction of the supply of and demand for
credit (or loanable funds). The latter will be perceived by banks in the form of
an interaction between deposits and loans. This follows from the realization
that deposits represent the supply of credit and loans represent the demand for
credit. The natural rate of interest is that which equates ex ante savings and ex
ante investment, with savings assumed to be positively related, and investment
negatively related, to that natural rate.'?> The market rate of interest is that
which equates the supply of credit (deposits) with the demand for credit (loans).
It is assumed that deposits are positively related and loans negatively related to
the market rate.

Given the above relationships, one can illustrate the interest rate effects of
those parametric changes dealt with in Chapter 2. Specifically, Figures 12, 13,
and 14 reveal the impacts on the natural rate of interest (i) and the market rate
of interest (i) of, respectively, an increase in k, an increase in productivity
(decrease in goods’ production costs), and a preference shift toward outside


===== PAGE 78 =====

Say’s Law 51

Figure 12
Interest Rate Effects of an Increase in k
Natural Market
Rate Rate
Savings, Deposits,

Deposits,
Savings,
> ch Ga bn m= === — =~ — —-
Investment,
Loans,
| i \ Investment, ' (\ Loans,
t | ! |

money and away from inside money. As k rises (with productivity and real
income constant), both the supply of and demand for inside money rise.
Therefore, savings, investment, deposits, and loans all increase (Figure 12). As
long as monetary equilibrium is maintained, the shifts of each pair of schedules
will be equiproportional, since the time markets reflect the money market. The
natural and market rates of interest remain constant and equal to one another.
Also, these rates of interest keep pace with the price level, which also does not
change in this instance. If productivity increases (with k constant), then (1) real
income and nominal money demand rise and (2) the nominal money supply
and the price level fall. As a result, in the markets for time, savings and de-

Figure 13
Interest Rate Effects of a Decrease in Goods’ Production Costs
Natural Market
Rate Rate
Savings, Deposits,
Savings, Deposits,
NT investment, Mee TT 7 TORT ONT TTT
Loans,
Investment,

S,1


===== PAGE 79 =====

52 Free Banking

Figure 14
Interest Rate Effects of an Increase in k,/Decrease in k;
Natural Market
Rate Rate
Savings, Deposits,
Savings, Deposits,
I ED CI CI LT el Gh CE
Investment, Loans,
| Investment, | | Loans,
| ] i |
(S.1). (s,h, S| (DL). (DL), D,L

posits rise, while investment and loans decline (Figure 13). Both the natural
and market rates decline and remain equal. If consumer preferences shift toward
outside money (a redemption run), then there is a net decline in the inside
money supply and inside money demand, with the price level exhibiting no net
change. Thus, savings, deposits, investment, and loans all decline, and the
natural and market rates remain, once again, constant and equal (Figure 14).

In short, under free banking, the time and money markets will remain in
equilibrium individually and in relation to one another. Interest rates will track
changes in the price level, and neither excess money nor excess credit will be
created. There will be neither inflation nor unjustified deflation. Producers’ prof-
its will be neither artifically expanded nor artificially contracted. Perhaps most
important of all, the market rate of interest will keep pace with the natural rate.

These conclusions bring one to confront the issue of business cycle theories.
Reflecting upon free banking, two very provocative theses emerge. The first
suggests that the dominant approach to business cycles is not instructive or
even meaningful in a free-banking context. The second proposes that certain
alternative approaches are, at root, either different facets of the same theory or,
at least, complementary theories.

KEYNESIANS, MONETARISTS, AND AUSTRIANS

The set of propositions and policies known as Keynesianism completely
dominated macroeconomics from the late 1930s to the mid-1970s. It took the
appearance of inflationary recessions (‘‘stagflation’’) during the 1970s to impel
the economics profession to question the validity of those propositions.'4 Even
now, most economists seem to take for granted much of that which comprised


===== PAGE 80 =====

Say’s Law 53

Keynesian thought. !® It is impossible in a short space to present Keynesianism
in a fashion that does it complete justice (the same, of course, is true of the
other schools of thought discussed below). Nevertheless, in order to grasp why
the Keynesian critique of capitalism is irrelevant to free banking, one must
have some idea of the fundamentals of that critique.

Keynesianism proposes that consumers may exhibit a sudden increase in their
demand for money (‘‘hoarding’’) as a result of, say, a lack of confidence re-
garding future economic conditions.'® Thus, consumption expenditures decline
since consumers are saving more in the form of cash balances. Ex ante savings
exceed ex ante investment. This has effects in both goods markets and factor
markets. Consumer demand has fallen off, so producers experience an un-
wanted, ex post increase in inventory investment. That is, excess inventory
accumulates. Assuming that nominal wage rates and goods’ prices are generally
“‘rigid downward,’’ two things result: (1) producers cannot sell their surplus,
so (2) they cut back on production by laying off workers. The free market has
failed, and Say’s Law is invalid. The government must come to the rescue via
either fiscal or monetary policy. It may increase its expenditures so as to stim-
ulate product demand and, thereby, the demand for labor,!” or it may increase
the money supply such that the price level rises. This will reduce the real wage
rate and increase the demand for labor. !8

With free banking, however, an increase in the demand for inside money
brought about by an increase in k will be matched by an increase in its supply.
Equilibrium in the markets for money and time will be maintained. The Keynesian
story of excess savings or underconsumption seems not to apply. As Horwitz
puts it:

The only way general underconsumption could occur under free banking is if a signifi-
cant loss of confidence in the banking system led to an unexpected demand to redeem
liabilities in the reserve money. Such runs have been extremely rare in competitive
systems. . . . Keynes’s essential complaint is actually against not an oversupply of
goods but an undersupply of money. . . . Keynes's complaints should not have been
directed against Say’s Law and the market per se, but against central banks. . . .
Keynesian concerns are, at best, valid only in the absence of monetary competition.
(1989, 429)

Two schools of economic thought that have presented powerful challenges
to the Keynesian orthodoxy are the monetarists and the Austrians. Both espouse
free markets, and both insist that disruptions in the market for money are the
primary cause of business cycles. However, they differ—often bitterly—over
certain specifics of policy as well as over fundamental methodological issues.”
Nevertheless, it will be seen that monetarists and Austrians tell business cycle
stories that are either parallel or complementary, rather than contradictory.

Monetarism proposes that the demand for money is a stable and predictable
function of certain variables: permanent income, the ratio of human to nonhu-


===== PAGE 81 =====

54 Free Banking

man wealth, the expected rate of inflation, and expected interest rates (Fried-
man 1971, 11-14). Furthermore, real output is, in the long run, determined by
‘“‘real factors’’ (supplies of material resources, size of the labor force, per-
capita productivity, etc.). However, in the short run, real output may be af-
fected by monetary conditions.

Since the demand for money is stable, any significant fluctuations in the
money supply are likely to result in monetary disequilibrium and bring about
macroeconomic disruption. Business cycles begin with an increase in the money
supply such that the money supply exceeds money demand at the existing level
of prices. As moneyholders spend their excess cash balances, prices rise. If the
resulting actual rate of inflation exceeds the expected rate of inflation forecast
by workers, then real wage rates fall, the demand for labor rises, and unem-
ployment declines below the natural rate (assuming nominal wage rates are bid
up by an amount less than the actual rate of inflation).?° In order to maintain
the low rate of unemployment, the rate of money growth and, thus, the rate of
inflation must not only continue, but accelerate. Eventually the monetary au-
thorities will become concerned about the rapidly rising inflation and begin to
reduce the rate of growth in money (if they do not, then hyperinflation is in-
evitable). As the growth in money slows down, the rate of inflation falls. This
fools workers in the opposite direction. The actual rate of inflation is less than
the expected rate, real wage rates rise, and unemployment increases. In order
temporarily to enjoy low unemployment, the society must first endure rising
inflation and then, later, high unemployment.?! The expansion necessitates the
contraction. Stability is regained when the actual rate of unemployment once
again equals the natural rate of of unemployment.

The monetarist focus is primarily on the markets for labor, goods, and money.
In what seems to be a contrasting approach, Austrians concentrate on the mar-
kets for time, goods, and money. The basic Austrian analysis is as follows.

Money enters the economy not as ‘ ‘helicopter money,’ that is, not as equi-
proportional increases in everyone's nominal cash balances, but in specific mar-
kets such that it brings about changes in relative prices. These relative price
changes can be disruptive even if the overall price level does not change. The
most important relative price is the price of credit—the market interest rate—
which affects the extent to which there is intertemporal coordination.?? If the
central bank increases the supply of bank reserves and, thus, the monetary
base, and assuming that an increase in money demand did not precede the
increase in reserves, then the result will be both an excess supply of money
and an excess supply of credit.?? Since goods markets often adjust more slowly
than do financial markets, the market interest rate will tend to fall quickly,
while prices of goods will rise, but more slowly.

The decline in the market interest rate is not a reflection of a decline in
consumer time preferences, that is, consumers’ desired rate of consumption
versus savings. Such a decline in the rate of time preference would have been
manifested by an increase in the demand for money (increase in voluntary sav-


===== PAGE 82 =====

Say’s Law 55

ings). What this means is that the natural rate of interest has not changed. Here
is the crucial point for Austrians: Business cycles are the result of differences
between the market rate of interest and the natural rate.

The lower market rate induces entrepreneurs to undertake additional invest-
ment projects.?* Since voluntary savings have not increased, ex ante investment
must exceed ex ante savings, but ex post, the two must be equal. This neces-
sitates the appearance of ‘‘forced savings.’ ‘‘The forced savers are the existing
holders of money. Their ability to consume is impaired by the influx of new
purchasing power represented by the excess supply of money’ (Horwitz 1990,
12). The demand for capital goods has increased, but the demand for consumer
goods has not declined, because the boom in capital goods leads to greater
incomes for the resource owners in that sector. This increase in incomes is
spent primarily on consumer goods. The economy appears to be ‘‘booming.”’
Sooner or later, however, entrepreneurs discover that the real resources neces-
sary for their capital projects will not be forthcoming. Also, the prices of inputs
rise as firms bid for factors of production. Profits, which at first appeared ro-
bust, begin to dwindle. The supply of credit declines, and interest rates rise,
further reducing profitability. Projects are cancelled, workers are laid off, losses
are incurred, and the recession follows. According to this Austrian malinvest-
ment approach, the seeds of the recession may be found in the expansionary
period, the fluctuations in the prices and production levels of capital goods will
be greater than the fluctuations in the consumer goods sector, and stability
returns when the market rate of interest once again equals the natural rate.

Both monetarists and Austrians place the primary blame for business cycles
on central banks and their predilection for expansionary monetary policy. Mon-
etarists emphasize the relations between the money supply and inflation, real
wage rates, and unemployment. Austrians emphasize the effects of the money
supply on credit markets, interest rates, and the structure of production. Both
build their theories around unobservable variables: monetarists are concerned
about departures from the natural rate of unemployment, and Austrians about
departures from the natural rate of interest. Are these not two sides of the same
coin? If the market rate of interest is less (greater) than the natural rate of
interest, then surely it is also true that the actual rate of unemployment is less
(greater) than the natural rate of unemployment. As unanticipated monetary
expansion produces inflation, lower real wage rates, and increased employ-
ment, it must also bring about lower interest rates and greater production of
both capital and consumer goods. Furthermore, when economic agents even-
tually perceive conditions correctly, the resulting increase in the expected rate
of inflation will both (1) raise real wage rates and reduce employment, and (2)
raise the market interest rate and reduce production. These may be argued to
be two halves of the same basic theory. At the very least, they are complemen-
tary.

Any significant commonality between these two theories is usually denied
vigorously by both sides. Nevertheless, this is not the first work in which par-


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56 Free Banking

allels have been drawn between Austrians and monetarists. Horwitz (1990) deals
sympathetically with both, and suggests that Austrians offer the more compel-
ling analysis of inflation, but monetarists the better analysis of deflation. Thomas
M. Humphrey goes so far as to declare that ‘‘monetarist and Austrian theories
of the business cycle share many of the same or similar characteristics. Because
of this, the two approaches should be seen as complementary rather than as
competing’’ (1984, 19). More recently, Humphrey (1990) has argued that Knut
Wicksell’s interest rate model (which forms the basis of much Austrian think-
ing) is quite similar to the monetary model of Irving Fisher (one of the most
influential monetarists). Finally, it is interesting to notice that David Laidler, a
well-known monetarist, describes ‘‘new-classical’’ economists? both as econ-
omists who wished ‘‘to restate monetarist analysis with greater rigour than its
pioneers’” (1990, 57) and as ‘‘neo-Austrians’’ (1982, 77-83).

SUMMARY

This chapter has discussed several related issues: Say’s Law, business cy-
cles, and free banking. Business cycles were identified as fundamentally a problem
of microeconomic discoordination, which resulted in a disparity between effec-
tive demand and notional demand. Say’s Law, or more precisely that version
of it known as Walras’ Law, identified the likely source of the discoordination:
money. The nature of free banking makes it manifestly clear that in a free
market context, the markets for money and time are interwoven. That is, money
affects both the markets for various present goods and services, and the inter-
temporal market for present goods versus future goods. It was argued that free
banking not only will tend to keep money in equilibrium, but also to keep the
market interest rate equal to the natural rate. Finally, certain strong parallels
were drawn between the monetarist and Austrian business cycle theories. It was
suggested that these two theories are more nearly reinforcing than conflicting,
despite the common belief to the contrary.

Chapters 2 and 3 have tried to present a theoretical foundation for the prop-
osition that free banking tends to maintain monetary equilibrium, or alterna-
tively, one might say that free banking minimizes business cycles (the expected
value of the difference between effective demand and notional demand is zero).
Can central banking do likewise? That is the topic addressed in Chapter 4.

NOTES

1. The discussion that follows owes much to the work of Steven Horwitz (1988,
1989, 1990). Horwitz has very skillfully articulated several ideas on which the author
had himself been working independently.

2. See Chapter 2.

3. Of course, one might ask when this price level prevails. If money supply and
money demand were to be equated at the price level that existed when the productivity


===== PAGE 84 =====

Say’s Law 57

gains were first experienced, then money holdings would be excessive, and the spending
of the excess would prevent the price level decline. Money supply and money demand
must be equated at that price level that reflects the decrease in production costs caused
by the gains in productivity. Selgin’s is a ‘ ‘productivity norm’’ policy, not a policy of
strict price level stabilization. His operative definition of ‘‘monetary equilibrium’ should
take account of the distinction. Those who opt for a stable price level as the preferred
policy goal will want to retain a definition that makes no mention of productivity fluc-
tuations.

4. One should note that the formal model of the previous chapter dealt with both
micro- and macroaspects of the various parametric effects. Nevertheless, considerable
aggregation was, admittedly, involved in the model. Much of the beauty of the complex
matrix of individual interactions was traded for the crude simplicity of a mathematical
model. Such a procedure seems fully justified pedagogically, at least as long as one
does not fail to make it clear that the aggregates are the abstraction and the individuals
are the reality.

5. Thomas Sowell (1972) presents a detailed, but very readable analysis of (1) the
various interpretations of Say’s Law and (2) the controversies surrounding it, particu-
larly those of the early nineteenth century.

6. Later in that century, one of the most famous critics of Say’s Law appeared—
Karl Marx.

7. Alternatively, one might phrase this as: Will ex ante production actually equal ex
post demand? As will be seen, there is a temporal aspect to this crucial question.

8. As Sowell puts it, ‘‘Classical economists referred to the restoration of equilib-
rium in terms of internal proportions, not aggregate quality (or value) of output’ (1972,
36). Their primary concern was with microeconomic coordination rather than with the
interactions of aggregates.

9. The author would be sorely tempted to add knowledge as the third universal. Is
not economics fundamentally about the generation and use of knowledge, and is not
time the dimension along which one searches for knowledge, and money the medium
that conveys knowledge?

10. It should not be supposed that the discussion that follows reflects in every partic-
ular Horwitz’s presentation of these issues.

11. It is assumed that there exist no legal constraints that artifically segment deposi-
tory institutions into ‘‘commercial banks,’ ‘‘thrifts,”” and ‘‘credit unions.’’ Therefore,
the term ‘‘bank’’ here may be taken to represent any financial intermediary that accepts
deposits. One should see Nicholas Lash (1987) for a succinct survey of restrictions on
the financial services industry.

12. This is the conventional definition of the natural rate. An alternative, but equiv-
alent, definition states that the natural (or ‘‘pure’’) rate is that which equates the supply
of present goods (demand for future goods) with the demand for present goods (supply
of future goods) (Rothbard 1970, 319-23).

13. See the discussions in Chapter 2 regarding this as well as the other two paramet-
ric effects dealt with here.

14. Some economists never found Keynes’ thinking to be persuasive. These men—
Mises, Hayek, Hutt, Robertson, et al.—defended Say’s Law and free markets from the
first appearance of Keynes’ General Theory of Employment, Interest, and Money in
1936. In the last twenty years, criticism of Keynes has become both more common and


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58 Free Banking

more diverse. The recent critics of Keynes include Milton Friedman, Murray Rothbard,
and Robert Lucas, among many others.

15. The past tense is employed here because the appellation ‘‘Keynesian’’ has fallen
out of favor. Those who subscribe to (modified versions of) Keynes’ ideas now call
themselves ‘‘neo-Keynesians’’ or ‘‘post-Keynesians.’’

16. The same general scenario can, per Keynes, be precipitated by a sudden decline
in ex ante investment because of a loss of confidence on the part of entrepreneurs.

17. One may legitimately question whether the demand for goods is necessarily and
proportionately a demand for labor.

18. This assumes a stable relationship between inflation and unemployment, that is,
a stable Phillips curve tradeoff.

19. For example, one may say that, generally, Austrians favor free banking on a
gold standard, and monetarists favor central banking with fiat currency but subject to
some sort of strict monetary growth rule. As for methodology, Austrians are very skep-
tical of the use of mathematical models and econometric testing of hypotheses, whereas
monetarists routinely construct formal models and undertake statistical tests.

20. This will likely be the case if either (1) workers form their inflationary expecta-
tions adaptively, that is, based purely on past trends, or (2) labor contracts are typically
negotiated for long time periods, for example, for a two-year period.

21. In other words, the negative relation between inflation and unemployment applies
to the short run, but becomes a positive relation in the long run.

22. Significant portions of the Austrian theory can be traced back to the work of
Knut Wicksell.

23. As seen earlier, in an all-inside-money regime, an excess supply of money would
represent an excess demand for credit, and such excesses would only be temporary
phenomena.

24. Non-Austrians seem often to misunderstand this point. They interpret this to mean
that business cycles are caused only by ‘‘low’’ interest rates (thought of in absolute
terms). Austrians insist that what they mean is simply interest rates that are lower than
they would have been in the absence of the monetary expansion (in relative terms).
From an empirical standpoint, the problem is that the Austrians’ benchmark of stability,
the natural rate of interest, is unobservable, but then, is not the natural rate of unem-
ployment also unobservable?

25. New-classical economists assume that individuals’ expectations are formed ‘‘ra-
tionally’’ (people cannot be systematically deceived regarding the actual rate of infla-
tion) and that markets clear continuously (economic agents never fail to take advantage
of opportunities to increase their utility). These assumptions lead such economists to
propose that government policies will seldom have any impact on real variables, such
as the rate of unemployment or real output.


===== PAGE 86 =====

Chapter 4

MONETARY POLICY

At one level, the collapse of socialism seems, indeed, to be all around us. The
Soviet Union and East Germany no longer exist. Poland and Romania have
overthrown their Socialist hierarchies. The Berlin Wall is in pieces; the Iron
Curtain seems irreparably torn. In many parts of the world, the rhetoric—if not
the action—is that of the free market. Even the most dedicated leftists have
ceased praising the traditional Socialist paradigm, that is, what one might refer
to as ‘‘state socialism’ or ‘‘comprehensive planning.”’ Of course, the eco-
nomic fallacies that doom state socialism to failure were unmasked long ago
by Ludwig von Mises (1981)! and Friedrich Hayek (1944; 1945). More recent
critiques include those by Don Lavoie (1985), Hans-Hermann Hoppe (1989),
and Hayek (1988). As a result, these fallacies, which lie at the heart of social-
ism, are now widely discussed, although they are, perhaps, still not thoroughly
understood. What is being overlooked in the celebration of the retreat from
state socialism is the fact that the thirst for planning continues to afflict many
politicians, bureaucrats, and economists. The species socialism may be dead,
or at least gravely ill, but the genus collectivism is alive and well.?

One manifestation of that collectivist spirit is what may be described as
‘“‘noncomprehensive planning.’ Unlike pure socialism, where the professed goal
is to control every minute aspect of the economy, noncomprehensive planning
hopes only to control one key sector or a few sectors, in order to direct the
general path of the economy. By far the most important example of noncom-
prehensive planning is the monetary policy conducted by central banks.

Every first-semester economics student learns that money is unique in that it
plays a role in virtually every transaction in a market economy. The phenomena
affected by changes in the supply of or demand for money include interest
rates, prices, wage rates, consumption and investment decisions, national in-


===== PAGE 87 =====

60 Free Banking

come, exchange rates, and the external trade balance. Furthermore, theorists as
diverse as Milton Friedman (1959; 1968), Murray Rothbard (1975), Friedrich
Hayek (1933; 1935; 1941), and Clark Warburton (1951; 1962; 1966) have pointed
to monetary disturbances as the prime source of business cycles. It would seem
clear that fluctuations in money reverberate throughout the economy.? In short,
the advocates of a centrally dictated monetary policy are in one sense too mod-
est. To advocate such nominally noncomprehensive planning is, in fact, tanta-
mount to proposing that there be bureaucratic influence upon the great majority
of economic events. In another sense, they are, perhaps, too boastful. They
seem always to assume that the relevant economic knowledge is (or will be)
available to the monetary authorities.

The intent of this chapter is to argue that central banks are not only unwill-
ing, but also—and this is the more radical proposition—unable to follow a
rational monetary policy. First of all, several alternative monetary frameworks
will be compared. Only one, the maintenance of monetary equilibrium under a
productivity norm, will be seen to be optimal. Second, the insights of public
choice theory will be utilized in order to reveal the typically perverse incentives
of all monetary authorities. Finally, the work of various Austrian economists
will form the foundation of an ‘impossibility argument.’’ It will be shown that,
no matter what its incentives may be, no monetary authority can possess the
economic knowledge it would have to have in order to maintain monetary equi-
librium.

ALTERNATIVE POLICY GOALS

A multitude of possible monetary approaches have been proposed in recent
decades. Most of these can be categorized as either a ‘‘rules’’ approach or a
‘‘discretionary’’ approach. That is, either bind the central bank to a specific
objective from which it must not depart or grant the central bank the broad
powers to follow any path it chooses to certain macroeconomic results. Enor-
mous controversies have been generated regarding the alleged superiority of
one over the other. As will be seen, the rules versus discretion controversy is
not really relevant. To survey all such proposals would require a book-length
treatment and, therefore, will not be undertaken here. Five of the more com-
mon proposals will be examined: (1) countercyclical actions to offset variations
in employment and output, (2) the maintenance of a stable price level, (3) a
constant rate of money growth rule, (4) a fractional-reserve gold standard, and
(5) the maintenance of monetary equilibrium.

Countercyclical Policy

The objections to countercyclical actions have become familiar fare. It has
been argued that attempts at stabilization will, more often than not, prove to
be destabilizing. This seeming paradox has usually been explained by noting


===== PAGE 88 =====

Monetary Policy 61

(1) the long and variable time lags between the initiation of presumably coun-
tercyclical monetary actions, for example, the purchase or sale of government
securities, and the resultant effects on the economy, and (2) the unreliability of
econometric forecasting. Friedman has quite pointedly stated (and this hints at
part of the argument in a later section) that even if the monetary authority were
to choose a relatively noncontroversial task, such as achieving the natural rate
of interest or the natural rate of employment, still the problem remains that

it cannot know what the ‘‘natural’” rate is . . . And the “‘natural’’ rate will itself change
from time to time. But the basic problem is that even if the monetary authority knew
the ‘‘natural’’ rate, and attempted to peg the market rate at that level, it would not be
led to a determinate policy. (1968, 10)

He concludes that countercyclical policy generally leads to either accelerating
inflation or accelerating deflation, thus exacerbating the business cycle.

Hayek offers the related observation that ‘the present unemployment is the
direct and inevitable consequence of the so-called full-employment policies
pursued for the past twenty-five years’’ (1979a, 39). Hayek’s assessment is
grounded in the Austrian theory of the business (or trade) cycle,* which argues
that monetary expansion leads to malinvestments that must eventually be lig-
uidated. When they are, unemployment rises. Many years of continuing expan-
sion would create both a pervasive honeycomb of malinvestments and a chronic
unemployment problem.

One should not overlook the ‘‘new-classical’’ position on countercyclical
policy (Lucas 1973; 1975; Sargent and Wallace 1976). Theirs is a world in
which agents utilize all available information and, as a result, cannot be sys-
tematically fooled by government actions. Any attempt to exploit a ‘‘Phillips
curve tradeoff’’ by rapidly increasing the rate of inflation is doomed to failure.
Individuals learn how policy makers react to certain economic conditions, and
they adjust their inflationary expectations accordingly. Central bank manipula-
tions of the money supply affect the price level, but have no net effect on real
output or employment. In the new-classical approach, countercyclical actions
are pointless.’

Considering the foregoing, one is driven to conclude that attempts at coun-
tercyclical policy (despite their enormous political popularity) have failed to
attain their avowed object and/or often proven to be counterproductive.

Price-Level Stability

To maintain a stable price level has long been a popular proposal among
many monetary economists. One of the most influential expositors of this no-
tion was surely Irving Fisher (1920; 1963). At first glance, the concept appears
unassailable. Nevertheless, despite its popularity, the idea of price level stabi-
lization is not without its problems. Even such an ardent admirer of Fisher as


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62 Free Banking

Milton Friedman has declared that seeking a stable price level is a suboptimal
monetary goal. His major point seems to be that the connection between mon-
etary movements and the price level, although a strong relation, is ‘‘not so
close, so invariable, or so direct that the objective of achieving a stable price
level is an appropriate guide to the day-to-day activities of the authorities’’
(Friedman 1962, 242).6

Moreover, it has been argued that to maintain a certain price level regardless
of other conditions could introduce serious micro- and macroeconomic distur-
bances. George Selgin (1988a, 98-100; 1990) considers a constant price level
in the context of a general increase in productivity. If the income velocity of
money is constant, real income rises because of the productivity gains, unit
costs. of production fall, and the price level is to be held constant, then the
money supply must rise. This causes nominal producer revenues to increase.
Extranormal profits are made. In the opposite case of a decline in productivity,
the money supply would have to fall, bringing about lower nominal revenues.
Unusually low (perhaps negative) profits would be experienced.” To put this
in the terms used in Chapter 3, when productivity rises, effective demand ex-
ceeds notional demand; when productivity falls, notional demand exceeds ef-
fective demand (given a stable price level rule). A policy of maintaining a
stable price level will, on occasion, be inconsistent with Say’s Law (Selgin
1990, 281).

It must not be forgotten that price-level stabilization has little hope of even
limited success unless a price index can be constructed that is a reliable and
unambiguous indicator of actual prices. No thoughtful economist would deny
that price indexes are less than perfect reflections of the structure of relative
prices, but are they sufficiently reliable to be useful? Here there is a consider-
able divergence of opinion. Some few have argued that all index numbers are
illegitimate and deceptive aggregations. Such economists insist that the price
structure can never be revealed by a single number—however meticulous is its
construction—but that, indeed, only the ‘‘array of prices in all their specificity’
will suffice (Rothbard 1988a, 182-83; Mises 1966, 220-23).

Others have suggested that the practical problems associated with the con-
struction of a meaningful price index are so nearly insoluble that one must
despair of success in this endeavor. For example, Selgin has identified three
key problem areas: (1) how to decide which goods to include in, and which
goods to exclude from, the index, (2) what measure of central tendency to use
in order to reduce the individual measures to a single number, and (3) how to
assign weights to the specific prices (1988a, 97-98).

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 equi-
librium, the others cannot be. (Selgin 1988a, 98)


===== PAGE 90 =====

Monetary Policy 63

It is appropriate also to ask whether a stable price-level approach would
suffer from the presence of nontrivial time lags regarding policy makers’ re-
sponses. Ideally, one would need a price index that could be reconstructed and
recalculated rapidly enough for the monetary authority to respond to every eco-
nomic event of significance. Given the magnitude of the task, this would seem
to be unlikely.

Richard Timberlake takes what one might describe as a cautiously optimistic
position regarding the price index issue. He declares that ‘‘the conceptual va-
lidity of a price index seems logical . . . the validity of the concept cannot be
denied because of the imperfection of the method used to measure it’” (1987,
89). A price index ‘should be used, however, with caution and with an under-
standing of its frailties’ (Timberlake 1987, 91). As is well known, those
““frailties’’ include, for example, the quality, substitution, and housing biases
from which the CPI suffers. Even elementary textbooks discuss such index
number problems.

Timberlake’s point is well taken. Index numbers can be conceptually useful.
However, the issue at hand is not whether a price index is of value heuristically
or pedagogically; the question is whether stabilization of a price index is both
feasible and desirable as a benchmark for monetary policy. One must answer
that question in the negative. The practical problems of constructing a proper
index are enormous, and, in the context of productivity gains (or losses), a
price-level rule could be destabilizing. A stable price level is certainly prefer-
able to the inflation that seems always to accompany ‘‘full-employment’’ poli-
cies. Nevertheless, it remains a suboptimal monetary goal.

Constant Money Growth

If a price-level rule is less than ideal, then what of a constant rate of growth
in money rule? This idea is, of course, closely associated with the work of
Milton Friedman (1959, 77-99; 1962, 242-43; 1985, 5-7). The common form
of the proposal is that the central bank, by means of manipulations of the
monetary base via open market operations, should maintain a fixed rate of
growth in some selected measure of the money stock, say M1. The goal is to
produce a pervasively stable set of long-run economic conditions, with short-
run fluctuations assumed to more or less offset one another. Friedman, as well
as a number of other monetarists, proclaims this approach to be the optimal
central bank policy in a world characterized by general uncertainty.

Nevertheless, a constant money growth rule (CMGR) faces several obstacles
and objections. Most fundamentally, one must ask what measure of ‘‘money’’
is to be used. This is critically important, since the quantitative relation be-
tween the monetary base and M1, M2, and M3 is different in each case. That
is, the respective money multipliers differ both conceptually and numerically.
The linkage between the purchases undertaken by the central bank’s open mar-
ket trading desk and the growth of money can be quite sensitive to how one


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64 Free Banking

defines money. Furthermore, it does not suffice to suggest that one simply
always use that definition of the money stock that correlates most closely with
some other macroeconomic variable, such as GNP or national income. To switch
back and forth between various money measures would be likely to introduce
considerable additional instability by means of increasing the uncertainty in the
minds of market participants.® The growth path of, say, GNP is not likely to
be invariant relative to one’s measure of money.

Moreover, switching monetary targets under a CMGR might gain nothing in
another way. In order for a CMGR to work as planned, two conditions must
be met. The intermediate target chosen (M1, M2, M3) needs both to have
strong and predictable effects on some ultimate target like GNP and to be sys-
tematically affected by changes in the operating target (the monetary base).’
Only then can the central bank hope to smooth the long-run path of the econ-
omy by engaging in open market purchases of government securities, which
change bank reserves and the monetary base. To switch money measures might
improve the link between intermediate and ultimate targets, but the relation
between operating target (the monetary base) and intermediate target (money)
might well degenerate. For example, M2 might be more closely correlated with
GNP than is M1 at the same time that M1 is more closely correlated with the
monetary base than is M2. Changing targets from MI to M2 might achieve
nothing.

A CMGR also is not necessarily consistent with Say’s Law. If the money
supply increases by some fixed percentage that approximates the long-run av-
erage rate of change in productivity, then disequilibria may result. If, for ex-
ample, productivity increases significantly so that production costs generally
decline, then effective demand will exceed notional demand unless the rate of
monetary growth falls.'® If productivity declines and production costs rise, no-
tional demand will exceed effective demand unless the rate of money growth
rises. Over the very long run, a CMGR would indeed keep average money
growth in line with the average change in productivity, but this is not sufficient
to escape business cycles.

Two assumptions that may be essential to a CMGR have been challenged.
First, those who adopt this Friedmanite position appear always to assume that
changes in the money stock are, in the long run, neutral with respect to real
magnitudes (O’Driscoll and Shenoy 1976).!! In contrast to this, one finds the
literature of the Austrian school, in which it is argued that monetary manipu-
lations are neutral in neither the short run nor the long run (Mises 1966, 538—
86; Rothbard 1975, 11-38; Garrison 1978; Hayek 1933).

It is also assumed that aggregate money demand is a stable and predictable
function. If this were not the case, then sudden fluctuations in the demand for
money would bring about considerable instability in the form of monetary dis-
equilibrium, despite the slow and steady growth in the money supply. The
stability of money demand is, of course, open to question, especially if one is
concerned with short-run as well as long-run conditions. For example, if the


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Monetary Policy 65

interest rate on CDs rises relative to that on NOW accounts, then depositors
will tend to transfer funds to CDs. That is, the demand for money—as mea-
sured by M1—will decline relative to the demand for ‘‘near money’ (M2). To
maintain a constant rate of growth in M1 would result in an excess supply of
money. ‘‘Portfolio preferences could shift between actual money and near-moneys
with extreme sensitivity to interest rates, causing important inflationary or de-
flationary effects even with the money supply constant’ (Yeager 1968, 59).

Moreover, even if total money demand (however measured) remains abso-
lutely constant, changes in the composition of money demand can have dis-
equilibrating effects in the context of a CMGR. Specifically, consumers’ de-
sired holdings of currency relative to demand deposits may change. If, for
example, consumers decide to hold relatively greater quantities of currency, the
result—in the absence of an offsetting increase in the monetary base—will be
a multiplicative decline in the money supply (Friedman 1959, 66-67).

This is necessarily true of any central banking system in which there exist
(1) fractional reserves and (2) a monopoly issuer of legal currency (Selgin 1988a,
113—15).!2 This fundamental problem arises because the single legal currency
serves both as hand-to-hand currency for the public’s daily transactions and as
part of the reserves of the banking system. Thus, an increase in currency de-
mand constitutes a drain on reserves, which, through the familiar money mul-
tiplier process, brings about the net decrease in the money supply. The only
solution is for the monetary authority to vary the monetary base as the com-
position of money demand varies.'*> That, however, violates the essential idea
of a CMGR (Friedman 1985).

Finally, Hayek has made an interesting observation about the Friedmanite
proposal of a CMGR. Apparently inspired by a comment made by Walter Ba-
gehot, Hayek expresses concern that panic conditions may occasionally be un-
avoidable under such a monetary rule. As he puts it, ‘‘I would not like to see
what would happen if under such a provision it ever became known that the
amount of cash in circulation was approaching the upper limit and that there-
fore a need for increased liquidity could not be met’’ (emphasis added) (1978,
77).

If there existed no superior approach, a CMGR—despite its flaws—might be
a wise choice, but there is a preferable alternative. A CMGR is clearly subop-
timal. Regarding the ‘‘discretion versus rules’ debate over the proper conduct
of monetary policy, Selgin speaks to the core issue:

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. Never-
theless, central banking, even when it is based on a monetary rule, is decidedly inferior
to free banking as a means for preserving monetary equilibrium. (emphasis in original)
(1988a, 106)


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66 Free Banking

A Gold Standard

There have been, and are, a number of different gold standards one might
propose: a gold coin standard with 100 percent reserves, a gold coin standard
with fractional reserves, a bullion standard with no coin in use, a gold ex-
change standard with general convertibility, or a gold exchange standard with
convertibility limited to official institutions, such as under the Bretton Woods
agreement (Bordo 1984, 198-99). The bullion standard constrains consumer
choice by eliminating the possibility that consumers may seek liquidity in coin
form. Furthermore, both versions of a gold exchange standard significantly vi-
olate the central idea of a gold standard: that there exists one base money (gold)
that functions as both the reserves of banks and the basis for international trans-
actions and (occasionally) is held by consumers. The gold/dollar exchange stan-
dard of Bretton Woods represented a serious dilution of the gold standard con-
cept. Therefore, only the first two proposals will be considered here.

First consider a central banking system with 100 percent gold reserves. Com-
mercial banks may issue deposit credits, but not currency (banknotes).'* The
legal currency is issued by the central bank on a one-for-one basis with the
existing stock of monetary gold (specie). The key virtue of such a system is
that, allegedly, neither an excess of money nor an excess of credit could be
created.!> Also, changes in the composition of money demand would not bring
about net changes in the money supply. Certainly, it is true that banks could
not make loans (issue deposit credits) that exceeded the total of gold they held
either in their own vaults or on deposit with the central bank. However, it
seems equally clear that both the supply of money and the supply of credit
would periodically be deficient. Imagine that money demand increases because
of population growth (with no change in per-capita productivity). Unless the
supply of specie reserves increased proportionately, there would be excess money
demand, and notional demand would exceed effective demand. The inside money
supply would be far too ‘‘inelastic’’ to respond properly to such an event.
Here, again, one sees the false dichotomy of rules versus discretion. In order
to curb excessive monetary growth, it is not necessary to make the money
supply unresponsive to all changes in economic conditions.

Two further problems should be mentioned. First, with 100 percent reserves,
banks cannot make loans from their deposits. Every dollar deposited must be
held, ready to be redeemed, at all times. This severely restricts the available
credit in the society. One could make a very plausible argument that much of
the real economic growth that has occurred would have been impossible in a
world of 100 percent reserve banking. Furthermore, banks resent such an im-
position. Reserves are not interest-bearing assets'$; to require banks to hold
such reserves is, in essence, to place a tax on banking, and the higher the
reserve percentage, the greater the tax burden.

Second, a gold standard with 100 percent reserves is an inefficient use of
resources. As many economists have argued, for example, Friedman (1959, 4-


===== PAGE 94 =====

Monetary Policy 67

6), such a system would require that a significant fraction (perhaps 2.5 percent)
of GNP be devoted to the production of money. This is a telling point, although
some advocates of gold have tried to rebut it by arguing that the benefits of
stability outweigh the losses in terms of resources. This latter is an argument
not without merit. However, strictly speaking, such a defense of gold only
applies to free banking with fractional gold reserves.

As another variant of the gold standard, one must also consider the possibil-
ity of a free-banking regime with 100 percent reserves. This seems unlikely to
occur, since none of the historical examples of free banking were based on 100
percent reserves. Nevertheless, the proposal needs to be addressed, and it will
be addressed (along with other versions of free banking) in Chapter 7. Suffice
it to say at present that free banking with 100 percent reserves seems not to be
justified on either economic or ethical grounds. As for free banking with frac-
tional gold reserves, nothing more need be said at this time. It has been ex-
amined and defended throughout Chapters 2 and 3.

This leaves only a gold coin standard with fractional reserves and a central
monetary authority. The so-called ‘‘heyday of the classical gold standard’ (1879—
1914) is the best example of such monetary regimes in operation. Within the
constraints of gold, the Bank of England directed monetary actions in the United
Kingdom and the Treasury functioned as a quasi-central bank for the United
States (Timberlake 1978). As Michael Bordo has stated in an excellent statis-
tical review of that time, ‘‘one dominant feature of the classical gold standard
was long-run price stability’’ (1984, 222). In theoretical terms, the expected
long-run rate of inflation was approximately equal to zero. This fostered stable
long-run contractual arrangements, greater saving and investment, and strong
long-run economic growth. However, at least when compared with the heavily
managed post—World War II period, the classical gold standard exhibited greater
short-run instability of real output, employment, and prices (Bordo 1984, 225)."7
One might say that the classical gold standard worked quite well, but it was
not perfect.

There are two serious shortcomings of a centrally managed gold standard.
First, to work efficiently, such a system requires that a (temporarily) inflation-
ary country must lose specie because of the concomitant trade deficit. A (tem-
porarily) deflationary country must gain specie because of its trade surplus.
This makes for a system that is (1) integrated internationally and (2) self-cor-
recting. However, central banks may thwart this process by indulging in *‘ster-
ilization.”” That is, central banks are able in the short run to offset the effects
of international gold flows on their domestic money stocks. This they undertake
in an attempt to insulate the domestic economy from actions abroad. Steriliza-
tion reduces the equilibrating virtues of a gold standard.

Second, from a purely domestic standpoint, central banks—even on a gold
coin standard—may not respond appropriately to a change in the demand for
money. If the fraction of income consumers wish to hold as money (the Cam-
bridge k) changes, then the money supply should change in the same direction.


===== PAGE 95 =====

68 Free Banking

This occurs under free banking because free banks have clear market signals to
guide their actions. The signals conveyed by the processes of reflux and ad-
verse clearings lead free banks to monetary equilibrium.'® Assuming that cen-
tral banks are nonprofit, ‘‘public-interest’’ agencies, consumer demands for re-
demption (reflux) may not constrain central bank actions. This is obviously true
when central banks decide to suspend payments (refuse to honor redemption
demands), and suspension was not unknown among central banks on a gold
standard. Furthermore, central banks experience no adverse clearings.'® That
is, they do not have to settle accounts with other banks vis-a-vis either notes
or checks (at least not domestically). As a result, short-run monetary imbal-
ances become likely.

Monetary Equilibrium

It has been shown above that the first four frameworks for monetary policy—
discretionary countercyclical actions, a stable price level, a constant money
growth rule, and a centrally managed gold standard—all suffer from theoretical
and/or practical flaws. The optimal monetary policy is one that seeks always to
maintain monetary equilibrium (subject to a productivity norm), in both the
short run and the long run. Many distinguished economists have endorsed this
productivity norm approach to monetary equilibrium: Alfred Marshall, Francis
Edgeworth, Ralph Hawtrey, Arthur Pigou, Dennis Robertson, Erik Lindahl,
Gunnar Myrdal, Ludwig von Mises, F. A. Hayek, Gottfried Haberler, Fritz
Machlup, and Frank Taussig, for example (Selgin 1990, 270-71). Further-
more, monetary equilibrium is the only one of the alternatives that meets all
three of the criteria for successful policy suggested by Friedman: (1) to prevent
money itself from being the cause of economic disturbances, (2) to provide a
stable economic environment, and (3) to offset major disturbances that arise
from nonmonetary sources (1968, 12-14). Free banking with fractional gold
reserves provides just that.

As explained in earlier chapters, free banking maintains the money supply
equal to money demand, the market rate of interest equal to the natural rate,
and effective demand equal to notional demand. Under free banking, nominal
national income remains constant. Hoarding of cash balances does not lead to
deflation and depression, changes in productivity are accommodated so that
producers’ revenues stay in line with producers’ costs, and changes in the com-
position of money demand do not cause changes in the money supply. The
goal of monetary equilibrium is intrinsically a countercyclical policy, but one
that is motivated purely by the self-interest of each market actor. It is the
expression of an Hayekian ‘‘spontaneous order.” Moreover, free banking re-
veals that the clash over ‘‘rules versus discretion’’ is not ultimately germane to
the issue. Neither rules nor discretion is superior. Free banking is superior to
a central bank that adopts either approach.

One may find it illuminating to realize that the other policy goals that have


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Monetary Policy 69

been reviewed are all surrogates for monetary equilibrium. It has just been
pointed out that to maintain monetary equilibrium is to take countercyclical
action. Regarding a stable, and therefore predictable, price level, James Bu-
chanan acknowledges that ‘‘such predictability implies, of course, continuous
monetary equilibrium. And if this were accomplished, the actual course of change
in the absolute price level would become largely irrelevant’ (1962, 161). The
CMGR of Friedman is clearly aimed at the achievement of approximate mon-
etary equilibrium in the long run, though not in the short run. Furthermore, the
classical gold standard was, of course, a system in which monetary disequili-
bria were corrected via supposedly automatic changes in international gold flows.
To put 1t briefly, one may say that as long as there is continuous monetary
equilibrium, all other monetary goals are superfluous.

Despite all the foregoing, the productivity norm is not without its critics.
One in particular should be given serious consideration: Kevin Dowd. Not only
are his arguments articulate and forceful, but he also is himself a well-known
advocate of free banking. Dowd does not condemn laissez-faire approaches to
banking, but he does question the alleged superiority of the productivity norm
(1991e). He identifies three arguments that have been used to support the con-
tention that the productivity norm is superior to a stable price level: equity,
price-adjustment costs, and stabilization.?!

The equity argument proposes that the results of unexpected changes in pro-
ductivity should be shared by both debtors and creditors. This would be true
of a productivity norm. Under a stable price level rule, both gains and losses
would accrue only to entrepreneurs (debtors). Dowd grants that at one level the
whole equity issue is something of a red herring. ‘To avoid getting bogged
down in interminable arguments over the ‘just’ division of the gain or loss ex
post, all one needs to do is take the analysis one step back and allow agents to
trade claims to the (as yet) uncertain outcomes’ (1991e, 16). That is, let agents
contract in accordance with their preferences regarding risk. All that is neces-
sary is to enforce all valid contracts. Dowd adds the penetrating observation
that ‘‘we cannot take contract form as fixed, and then compare how that fixed
contract performs across the two price-level regimes. The choice of contract
depends on the regime itself’ (emphasis in original) (1991e, 17). This suggests
a fundamental question: If the likely form of free banking is that based on
fractional specie reserves and that version of free banking naturally follows the
productivity norm, then is not Dowd’s point moot? The choice may be either
free banking and the productivity norm, or central banking and (among other
possibilities) a stable price level. Free banking under a price-level rule may not
be on the menu.

Dowd pursues his point about price-regime preferences. He offers two rea-
sons why a productivity norm would not be chosen (1991e, 17-18). First, he
emphasizes the costs of dealing with a less predictable price level. That such
costs exist cannot be in doubt. One must ask, however, whether it is more
costly to deal with unpredictable commodity prices or with unpredictable wage


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70 Free Banking

rates. The productivity norm takes nominal wage rates as given; the price level
rule takes commodity prices as given (Dowd 1991e, 24). Given the choice, is
it not plausible that most individuals would prefer stable nominal wages to a
stable price level???

Second, he argues that a productivity norm would discourage innovation and
productivity improvements on the grounds that gains would not fall entirely on
the entrepreneurs (debtors), whose actions often affect productivity. However,
workers also affect productivity.?? In addition, they, as the ultimate creditors,
would be denied a share of the gains from productivity improvements under a
stable price-level rule. As a result, the flow of funds so essential for financing
research into more productive processes might decline. Both debtors and cred-
itors may need to benefit from innovation. It would seem that neither regime is
obviously preferable insofar as the encouragement of productivity improve-
ments is concerned.

The second argument for the productivity norm is that it entails lower price-
adjustment costs. Dowd declares that this is true—but only if both the costs of
price adjustment are fixed costs and productivity shocks are discrete events that
do not occur continuously (1991e, 20-21). He suggests that both of these con-
ditions are questionable and, therefore, concludes that a price-level rule is su-
perior.

Dowd argues that if one considers factors, such as the timing of purchases,
inventory decisions, and the risk involved with a greater price variance, it will
become plausible that price-adjustment costs are largely variable costs. This is
a good point, but several counterpoints must be made so as to present the
complete picture. First, as discussed earlier, a price index that is fully consis-
tent with monetary equilibrium is probably impossible to construct. Second, a
change in that ‘‘ideal’’ price index does not necessarily impose an additional
net cost on all market participants. For certain individuals, the relevant specific
price(s) may not change despite the change in the aggregate price level. Price-
level variance is not synonymous with (specific) price variance.?* On the other
hand, any monetary regime that disrupted the structure of relative prices in
order to maintain the price level would bring about monetary disequilibria. If
one perceives business cycles as rooted in microeconomic discoordination, then
it is the price-level rule that may become suspect. Finally, price changes in
response to a productivity shock may be thought of by economic agents as
neither wholly unpredictable nor costly. As Dowd himself argues, gains in
productivity are often the conscious goal of entrepreneurs (1991e, 18). Imagine
a firm that strives to increase productivity so that it may lower its production
costs, lower its product price, and gain market share at the expense of its rivals.
It would be odd to argue that such a firm experiences an increase in costs. Any
price-adjustment costs are clearly overwhelmed by the lower production costs.
Price-adjustment costs should not be taken out of the context in which they
arise.

As for the frequency of productivity shocks, Dowd seems to allow that this


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Monetary Policy 71

depends largely on personal interpretation (1991e, 20fn). He sees such events
as occurring more or less all the time, whereas Selgin speaks as if they occur
only occasionally. The difference may lie in the contrast between product-spe-
cific shocks, which appear very frequently, and pervasive shocks, which affect
a number of goods and appear much less frequently.? It would seem clear that
the latter pose the greater danger to market coordination if they elicit an inap-
propriate monetary response. In the context of infrequent, pervasive productiv-
ity shocks, the productivity norm is superior to the price-level rule.

The third argument for preferring the productivity norm to a stable price
level is the claim that it is more likely to achieve macroeconomic stability
(minimize cyclical fluctuations). This Dowd disputes as well. Yet he grants
that the core distinction is that ‘‘prices were given under the stable price re-
gime, and nominal wages were given under the productivity norm’ (1991e,
24). Which would consumers prefer, a stable price level and flexible nominal
wages, or a flexible price level and stable nominal wages? This is, presumably,
a testable proposition. However, there seems already to be considerable evi-
dence that the latter would be their choice. For example, many consumers (as
workers) willingly contract for nominal wages that are fixed for periods of a
year or more.?%

Dowd raises fundamental questions about the productivity norm vis-a-vis a
stable price level. His arguments are lucid and insightful; they bring to the fore
certain subtle aspects of the productivity norm position. Nevertheless, in the
end, his critique is not quite persuasive. The productivity norm remains the
preferable approach to monetary policy.

THE INCENTIVES OF MONETARY AUTHORITIES

Assuming the maintenance of monetary equilibrium subject to a productivity
norm is the theoretically optimal goal of monetary policy, it is nonetheless the
case that two critical questions remain unanswered. First, are monetary author-
ities likely to eschew other possible goals in deference to that optimal end?
Second, even if monetary authorities sincerely wish to achieve continuous mon-
etary equilibrium, do they possess the requisite knowledge? The first, a prob-
lem of incentive structures, will be discussed here. The second, a problem of
economic epistemology, will be dealt with in the next section.

James Buchanan suggests that three basic models of a central monetary au-
thority are possible: (1) a monolithic authority that is subject to neither consti-
tutional nor electoral constraints, (2) a monolithic agent subject to direct elec-
toral pressure, and (3) a monolithic agent free from direct electoral pressure
but bound by certain general constitutional rules (1986).

The first, which Buchanan calls a ‘‘benevolent despot,’’ has no incentive to
follow any policy that is not utility-maximizing in his own terms. Thus, a
policy of revenue-maximizing inflation will be the nearly certain result. “‘In
this model, it is evident, quite apart from any historical record, that the despot


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72 Free Banking

will find it advantageous to resort to money creation over and beyond any
amount that might characterize the ‘ideal’ behavior’’ (Buchanan 1986, 141).
To increase ‘‘social welfare’’ will not be the object of monetary actions in such
a regime.?’ The second possibility, where voters may exert direct pressure on
the monetary authority, suffers from the well-known problem of having to sat-
isfy the median voter (assuming a simple majoritarian decision mechanism).
That voter tends to be ‘‘myopic’’ regarding inflation. That is, he has an incen-
tive to place great weight on the short-term gains in terms of employment that
he may experience and to have little concern for the long-term harm done to
the economy as a whole (Buchanan 1986, 143). The predictable result is an
economic environment that is unstable and inflationary.

Electoral impatience, of course, is incompatible with meaningful economic reform, and
in particular with a consistent anti-inflation policy. Political leaders who seek to apply
policy in a consistent manner invariably lose out to ‘‘reflationists’’ and price controllers.
Thus, anti-inflationary efforts are undermined at every turn over the long haul . . .
once employment and productivity figures begin to appear. (Smith 1988, 157)

The third case may be thought of as approximating the structure of the Fed-
eral Reserve System. The members of the Board of Governors are not permit-
ted to use their monetary powers to increase their personal wealth, and they
are generally expected to follow ‘‘socially desirable’’ macroeconomic policies.
Otherwise, they appear to possess a high degree of independence (as is often
argued). This arrangement, Buchanan claims, reduces the sense of responsibil-
ity experienced by such monetary decision makers, because they neither enjoy
the full benefits nor suffer the full costs of specific policies (1986, 145). This,
in turn, leads to decisions that are less well considered, based on less infor-
mation, and more sensitive to transient whims and fads than they would be
under a more appropriate incentive structure. ‘Viewed in this perspective, and
in application to the Federal Reserve agency in the United States, and perhaps
notably after the removal of international monetary restraints, there should have
been no surprise that the behavior exhibited has been highly erratic’” (Buchanan
1986, 146).

Buchanan concludes that monetary disequilibrium is the likely result under a
central authority modeled in any of the aforementioned three patterns. He thinks
the only solution might be to index the salaries of those employed by the cen-
tral bank, so that any departure from a stable price level would impose personal
losses on those responsible (1986, 148). This proposal is flawed, however, in
that it assumes that continuous monetary equilibrium is synonymous with a
perfectly stable price level. Under most circumstances, they are the same, but
in the face of productivity shocks, they clearly differ.

Richard Wagner (1986) offers a variation on Buchanan’s theme. He argues
that the Fed is best understood as an exercise in congressional rent-seeking. In
his view the Federal Reserve is a creature of Congress—specifically, an agent


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Monetary Policy 73

of the House and Senate banking committees—and exists for the express pur-
pose of achieving certain distributional effects by means of counterfeiting
(monetary expansion). ‘‘The Fed would seem to be principally involved in the
supply of counterfeiting, and to do so by virtue of a license from Congress’’
(Wagner 1986, 531).

Whatever particular interpretation of central bank behavior one employs, one
thing seems clear in the light of public-choice theory: *® No monetary authority
is likely to adopt any policy that might be termed ‘socially optimal.’’ Realis-
tically, that is, monetary equilibrium will never be the preferred goal of central
banks.

THE KNOWLEDGE PROBLEM

The ultimate challenge to the possibility of rational monetary policy being
undertaken by a central bank is neither procedural nor political, but epistemo-
logical in nature. Even if one grants that the monetary authority has both ac-
cepted the premise that monetary equilibrium is the theoretically optimal policy
goal and adopted that goal as the guiding principle for its actions, it still does
not follow that said authority will be able to achieve its objective. Indeed, it
will here be argued that no central authority can ever possess sufficient eco-
nomic knowledge to reach such an objective.

It is essential to understand that the problem facing monetary authorities is
not simply one of insufficient data or inadequate data processing. It is far more
fundamental. The problem springs from two interrelated sources: (1) confusion
regarding the nature of economic knowledge and (2) a failure to perceive the
market as a process of discovery.

That economic knowledge is not a monolithic whole susceptible to manipu-
lation by some bureaucratic entity has been well expressed by Hayek:

[TThe concrete knowledge which guides the action of any group of people never exists
as a consistent and coherent body. It only exists in the dispersed, incomplete, and
inconsistent form in which it appears in many individual minds, and the dispersion and
imperfection of all knowledge are two of the basic facts from which the social sciences
have to start. (1979b, 49-50)

Not only is knowledge widely dispersed, but it is also resistant to aggregation.
Objective data, such as changes in specific prices, are not the basis for human
action. Humans act upon their interpretations of those data, and each interpre-
tation may be different. ‘‘A rise in the price of a given commodity, for ex-
ample, will have different meanings depending on the ‘elasticity of expecta-
tions’ of the receiver. A price rise may signal higher or lower future prices
when the subjective context of the data is taken into account’ (O’Driscoll and
Rizzo 1985, 41).

Furthermore, knowledge may be inarticulate in form. That is, underlying


===== PAGE 101 =====

74 Free Banking

much that can be articulated, one finds the implicit or ‘‘tacit’’ definitions and
rules of presentation without which explicit statements cannot be made (Lavoie
1985, 59-63), and some knowledge seems difficult to articulate at all—how to
ride a bicycle, for instance.” If any significant portion of knowledge is im-
plicit, subjective, and (perhaps) meaningless when aggregated, however, then
how can any centralized agency ever collect—much less understand and use—
such knowledge? Data are available in abundance, but since ‘knowledge is not
the same as data’’ (Lavoie 1985, 57), the collection of mere data does not
necessarily constitute an increase in one’s store of knowledge.

Inextricably interwoven with the above conception of economic knowledge
is the understanding of the market as a discovery process. Such an understand-
ing may ensue from the following line of reasoning. Humans, being finite and
fallible, act in order that they may remove or reduce some dissatisfaction in
their lives. In contrast to humans, ‘‘a perfect being would not act’ (Mises
1976, 24).>° To achieve this reduction of dissatisfaction, individuals engage in
a great variety of market transactions with a multitude of other individuals. The
intent is, generally, to benefit (to profit) from those interactions. The most
common—though not the only—guides for such actions are prices.

However, “‘prices are useful guides or signals because, and insofar as, they
reveal discrepancies, previous maladjustments, and errors. . . . Prices reveal
what people want relatively more urgently now, and in the future, not what
they would want in a hypothetical and unattainable equilibrium’ (O’Driscoll
and Rizzo 1985, 106). Furthermore, the knowledge of prices is ‘‘of temporary
and fleeting significance’’ and tends to be profitable precisely to the extent that
and only so long as ‘‘others do not also know it’’ (O’Driscoll and Rizzo 1985,
103). That is to say, useful economic knowledge is essentially a private knowl-
edge of disequilibrium conditions. Knowledge is never a ‘‘given’’ for any eco-
nomic agent except in the Walrasian world of eternal general equilibrium, and
in that context, such ‘‘knowledge”’ is not really economic in nature, but merely
engineering knowledge about physical production relations. In the real world,
individuals must discover the relevant facts by means of trial and error, which
means that the generation of knowledge is only truly effective in the absence
of artificial distortions and constraints, that is, under competitive conditions. It
would seem obvious that every intervention by a monetary authority distorts
not only current conditions, but also individuals’ expectations of future condi-
tions, and the more extensive the intervention, the more one finds that re-
sources are diverted to learning about the interventionists rather than about
market participants. Finally, the relevance of any particular bit of information
cannot be established independently of the values, goals, and expectations of
the actor. Economic knowledge is, to some irreducible extent, idiosyncratic
(Butos 1986, 851).

If true economic knowledge is widely dispersed, at least partly tacit in na-
ture, discovered by trial and error in a free market context, and both goal- and
agent-specific, then central monetary authorities are confronted by an insur-


===== PAGE 102 =====

Monetary Policy 75

mountable obstacle. They attempt to aggregate data that cannot, when aggre-
gated, represent meaningful economic knowledge, and, on the basis of that
data, they undertake macroeconomic actions designed to achieve goals that (even
when desirable) can only be attained at a microeconomic level.

To put 1t bluntly, one must conclude that the optimal goal of monetary equi-
librium is likely within a free-banking structure but probably impossible for a
central bank.?! Free banks have the advantage of market signals that are both
more reliable and more rapid than any mechanism available to a central bank.
For example, consider the processes of ‘‘reflux’’ and ‘‘adverse clearings.” One
may recall that whenever an individual free bank expands its outstanding lia-
bilities (either notes or deposit credits) beyond the desired cash balances of its
customers, the excess will be returned for redemption. This depletes the bank’s
reserves and, for any given reserve ratio deemed optimal by the bank’s officers,
forces a contraction in the supply of the distinctive money issued by that bank.
Furthermore, if the income velocity of money changes—tesulting, perhaps, from
consumers’ changing expectations regarding future commodity prices—free banks’
optimal reserve ratios will change in the same direction, which means that the
money supply will change in the opposite direction. Market forces at the local
level push the banking system toward monetary equilibrium.

To compare the decentralized adjustment mechanisms of free banking to the
tools of central bank policy is something akin to placing a scalpel rather than
a blunt instrument in the hands of a surgeon. The typical central bank tools—
changes in legal minimum reserve ratios, changes in the discount rate, and
open market purchases or sales of government securities—are creatures of ag-
gregation. As such, they attempt to correct at the national level what may only
be an imbalance at the local level.

For example, assume that the income velocity of money falls for the society
as a whole, because it falls in one geographical area but remains constant else-
where.?? The central bank, if it detects the change at all, will increase its open
market purchases (or, alternatively, lower either the legal reserve ratio or the
discount rate) and thus increase the overall money supply.?? This may or may
not reestablish monetary equilibrium in the area where velocity fell, but it will
introduce an excess supply of money into the rest of the nation, which condi-
tion must be corrected by further macromanipulations, and so forth. To reiter-
ate, monetary disequilibrium is a problem that has profound macroeconomic
effects but that must be solved at the microeconomic level.

SUMMARY

For decades it seems to have been a tenet of faith among most economists
that a central monetary authority is essential to a stable and efficient economic
system. They perceived such authorities as benevolent, public-spirited benefac-
tors whose prowess was limited only by data processing considerations. This
chapter has presented a radically different position. First of all, several plausi-


===== PAGE 103 =====

76 Free Banking

ble frameworks for monetary policy were reviewed. Only monetary equilibrium
subject to a productivity norm was seen to be defensible as a rational goal. The
alternatives that were constdered—discretionary countercyclical actions, a stable
price level, a constant money growth rule, and a centrally managed gold coin
standard—were not without some merit. However, all were seen to be ‘‘sec-
ond-best’’ solutions. This is largely due to the fact that those alternatives are
macroapproaches to what is fundamentally a microproblem.

Second, it was demonstrated that monetary authorities are very unlikely ever
to aim for any policy goal that might be construed as ‘‘socially optimal.”
Public-choice theory seems to present an irrefutable argument that central banks
are either rent-seekers or the agents of those who seek political rents. To aim
for monetary equilibrium at all times would be to forgo such rents.

Finally, it was argued that, even if a central bank both identified continuous
monetary equilibrium as the rational policy goal and was willing to seek that
goal, it could not possess the knowledge necessary for such a task. The more
common, contrary assumption is based on two errors: (1) a misunderstanding
of the nature of economic knowledge and (2) a misunderstanding of the market
process. Continuous monetary equilibrium becomes feasible only in a decen-
tralized, competitive environment in which profit and loss signals nurture a
‘‘spontaneous order.’’ Free banking is the ‘‘first-best’’ solution to monetary
problems.

NOTES

1. Mises’ critique of central planning first appeared in 1922 in German. It was later
(1936) translated into English.

2. In most of the non-Communist nations during the post—World War II period, this
collectivism has appeared in the form of what is variously called ‘the mixed economy,’
‘‘democratic socialism,’ or ‘‘welfare state capitalism.’’ Its defining characteristics are
(1) nominal private property, (2) extensive regulation regarding the use of that ‘‘pri-
vate’ property, and (3) a tripartite coalition of government, business, and labor that
seeks to direct the economy. See Hayek (1944) for a discussion of the origins of this
approach.

3. See Chapter 3 for a detailed discussion of this.

4. It should be pointed out that Hayek contributed mightily to the development of
the Austrian theory. Indeed, it might be—and has been—referred to as the ‘‘Mises-
Hayek theory of the trade cycle.”

5. This is a severely simplified summary of the new-classical position. The rational
expectations/new-classical treatment is both quite sophisticated mathematically and, in
some respects, rather elegant. Perhaps the most laudable thing about the new-classicals
is their recognition of the fact that a sound macroeconomics must be consistent with
microeconomic principles.

6. This may seem like a critique of the free-banking model in Chapters 2 and 3.
However, the author would argue that Friedman’s comments apply only to central bank-
ing—which, of course, is what Friedman had in mind anyway. Under free banking, the
quantity of money is strongly related, even in the short run, to the velocity of money,


===== PAGE 104 =====

Monetary Policy 77

goods’ production costs, bank reserves, the price of specie, and interest rates. The
connection between prices and money is thus more robust under free banking than under
central banking.

7. Selgin assumes that the changes in nominal revenues are not perfectly anticipated
by all economic agents.

8. This would exacerbate the problem the CMGR is intended to attenuate.

9. One must assume that Friedman’s overall object is to minimize (over the long
run) either the net departures from the natural rate of unemployment or the net depar-
tures of GNP from its trend. Of course, these may amount to the same thing.

10. See Chapters 2 and 3.

11. It is only fair to point out that this may not be an entirely accurate picture of the
‘““monetarist’’ position. Thomas Humphrey (1984, 17) argues that several renowned
monetarists have, indeed, acknowledged the nonneutrality of money. For example, Irv-
ing Fisher ‘‘recognized how interest rate changes can alter the time structure of produc-
tion and thus the composition (mix) of output.”’ In addition, Clark Warburton saw that
““‘due to the lag of wages and other costs behind prices and the resulting impact on
profits, monetary changes have real effects.’’

12. See Chapter 2.

13. This is the ‘‘only solution’’ only if one takes the central bank for granted.

14. The alternative—{ree banking with 100 percent reserves—is discussed next.

15. Tangential to this are the claims that commercial banks would be less prone to
failure and the central bank could exercise tight control over the money supply.

16. They do not bear explicit interest. During deflation, reserves do bear implicit
interest in the form of a greater purchasing power per dollar. Also, it is conceptually
possible for central banks to pay interest on the reserves they hold on behalf of com-
mercial banks. Nevertheless, this is rarely done by central banks.

17. Some of this ‘‘instability’’ may be spurious. See Christina Romer (1986a; 1986b).

18. See Chapters 2 and 3.

19. This assumes a legal tender currency, issued exclusively by the central bank.

20. It was the sterilization by central banks that often prevented or delayed such
corrective movements.

21. Dowd’s comments are sympathetic criticisms of certain aspects of Selgin’s work
on free banking. By implication, therefore, they are also criticisms of the present work.

22. This would seem particularly true if workers could, by their own efforts, increase
per-capita productivity and reap the gains of lower commodity prices (higher real wages)
under a productivity norm.

23. One may think here of worker investments in ‘‘human capital,” for example.

24. Perhaps to think of the price level as a portfolio of specific prices would be
helpful. The variance of the price level depends on both the variances and covariances
of the individual prices.

25. Pervasive shocks would also be less predictable than product-specific shocks. The
degree of predictability is also of concern to Dowd.

26. One might respond to this by suggesting that nominal wage contracts involve
lower transaction costs than do, say, commodity futures contracts. That is, futures mar-
kets are not generally accessible to consumers. Might the lower costs, however, not be
the result (rather than the cause) of more widespread use, that is, the result of consumer
preference?

27. This is not to suggest that ‘‘social welfare’’ is a meaningful concept as it is


===== PAGE 105 =====

78 Free Banking

usually employed, only that the central authority will act in response to one’s own
preferences rather than those of the citizenry.

28. For the seminal work in public-choice economics, see Buchanan and Tullock
(1962).

29. Note in this vein how it is common to encounter financial analysts who say they
simply ‘‘feel’’ stock prices will rise (or fall) but who may not be able to identify exactly
why they ‘‘feel’” this will occur.

30. This may be the only interface between modern economics and theology, but it
is an intriguing one.

31. If monetary equilibrium were achieved in a central banking regime, it would be
by accident. The argument here is that it is impossible for a central bank consistently to
either (1) attain such equilibrium or (2) know that it has been attained. The requisite
knowledge is simply not available to such an agency.

32. Monetary economists usually do not pay much attention to this, but it is never-
theless true that the velocity of money does vary from region to region and industry to
industry. See Richard Selden (1962).

33. One may question whether the central bank will react in a timely fashion even if
it does detect the change, and any significant time lag might exacerbate the imbalance.


===== PAGE 106 =====

Chapter 6

SCOTTISH FREE BANKING

The three previous chapters have presented a number of theoretical arguments
for free banking. One must turn now to the historical side of this issue. This
chapter is devoted to a look at Scottish free banking. Chapter 6 will examine
the American experiment with multiple issuers of notes. These are probably the
best-known and best-documented cases of free banking. However, the reader
should be aware of a problem that persists with any review of these periods.
There is much anecdotal evidence extant, but rather limited hard data—espe-
cially in the Scottish case. Therefore, some of the implications of the model
presented earlier simply cannot be tested in any direct way, and the empirical
conclusions that can be reached must in some instances be rather tentative be-
cause of the nature and age of the data. Despite such difficulties, the impor-
tance of these episodes makes their investigation imperative.

There was a time when knowledge of free-banking regimes had almost dis-
appeared from economic history. This was, of course, prompted by the theo-
retical conviction that central banking was natural and necessary, because free
banking was believed to be chaotic and inflationary. The recent rebirth of in-
terest in the theory of multiple note issuers’ has also inspired much historical
investigation. Work by, among others, Hugh Rockoff (1975; 1985), Arthur
Rolnick and Warren Weber (1982a; 1982b; 1985; 1986), Lars Jonung (1989),
Kevin Dowd (1992), and Donald Wells and Leslie Scruggs (1986a) has signif-
icantly expanded the understanding of such systems. For example, it is now
known that banking with multiple note brands has been much more common
than most would think. There appear to have been at least sixty episodes of
approximate free banking, that is, cases where banks were allowed to issue
their own notes (Dowd 1992, 2).2 Perhaps the most influential of all such ex-


===== PAGE 107 =====

80 Free Banking

aminations of historical free banking has been the work of Lawrence H. White
on Scottish banking (1984a, 1984b, 1989a, 1991).

Friedrich Hayek had earlier presented a theoretical case for thinking that free
banking would work. White’s Free Banking in Britain appeared in 1984 and
argued that free banking had already worked in Scotland during an earlier pe-
riod. A convincing ‘‘test case’’ for free banking seems to have been overlooked
for generations.®> White’s conclusions have elicited intense interest, and deserve
to be examined seriously and carefully.

WHITE’S INTERPRETATION

Free banks began to appear after the charter of the monopolistic Bank of
Scotland expired in 1716. The first was the Royal Bank of Scotland in 1727.
The competition that arose between the two rivals quickly brought benefits to
the public in the form of ‘‘the cash credit account, a form of overdraft ac-
count’ (White 1984a, 26). This expanded the bank’s note circulation at the
same time that it ‘‘allowed an individual to borrow against his human capital
at lower transactions costs and so enable him to undertake productive projects
that otherwise would have been unprofitable’’ (White 1984a, 27). During the
1740s and 1750s, a number of small banking concerns appeared, but the most
important entrant of the time was the British Linen Company (later the British
Linen Bank) in 1746.*

There was nearly complete freedom of entry into banking during this era.
After 1765, the only legal restrictions were (1) shareholders faced unlimited
liability regarding creditors’ claims on the bank,’ (2) banks could not print
notes of denominations smaller than one pound-sterling, and (3) option clauses
were illegal. Despite these constraints, banking in Scotland prospered, and the
economy grew. By 1844, there were ‘‘19 banks of issue in Scotland with 363
branches, providing one bank office for every 6,600 persons in Scotland, as
compared with one for 9,405 in England and one for 16,000 in the United
States’” (White 1984a, 34). Even though there existed some economies of scale,
there seemed to be no tendency for the system to collapse into a single entity.
Moreover, economic growth seemed robust. Citing Rondo Cameron, White
declares that ‘‘Scotland’s per capita income was no more than half that of
England’s in 1750 but nearly equal it by 1845’ (1984a, 24).

An important feature of the Scottish system was the weekly note-exchange.
This developed spontaneously in the late 1760s. Banks realized that in order to
maximize the market for their own notes, they would need to accept their ri-
vals’ notes at face value. That is, if consumer X is presently holding notes
issued by bank A, he is unlikely to open an account with bank B unless B is
willing to credit him with the face value of the banknotes he possesses. This
note-exchange process involved the weekly clearing of interbank holdings of
one another’s notes. It served not only to increase the marketability of bank-


===== PAGE 108 =====

Scottish Free Banking 81

notes relative to specie, but also to check any attempt at overissue on the part
of an individual bank (White 1984a, 20-22).

According to White, the virtues of the Scottish system were undeniable.
Counterfeiting was ‘‘not a significant problem in the Scottish experience’ (White
1984a, 40), for example. This he attributes to the care the free banks took in
designing elaborate and distinctive notes and the rapidity with which—because
of the note-exchange process—notes were returned to their issuer. By way of
contrast, counterfeiting of Bank of England notes was a chronic problem in
England, especially during the 1797-1821 suspension of specie payments.
Noteholder losses in Scotland were also relatively small. The total loss to the
public brought about by bank failures amounted to 32,000 pounds-sterling for
the period 1695 to 1841, whereas the losses in England for the year 1840 alone
were twice as great (White 1984a, 41). This was an innovative system as well.
The British Linen Bank of Edinburgh established the first branch bank in the
early 1760s. The Union Bank of Glasgow made the first public disclosure of a
bank’s annual balance sheet in 1836.

Bank failure was not common according to White. The only major bank
failure during the entire period was that of the Ayr Bank in 1772. It tried to do
what could not be done in this system. It attempted to expand the circulation
of its notes beyond the demand. Indeed, the Ayr Bank overextended itself to
the tune of about 667,000 pounds-sterling. Nevertheless, this failure did not
result in a general bank panic. In fact, the Edinburgh banks experienced a
perceptible increase in specie demand for only one day. The reason was that,
because of the rapid note-exchange mechanism, no other major banks were
caught holding large amounts of the Ayr Bank’s notes. Furthermore, because
of the unlimited liability provision, all the bank’s creditors were paid in full by
the bank’s 241 shareholders (White 1984a, 31-32).

On top of everything else, the ‘Scottish free banking system proved far
hardier during periods of commercial distress than did its English counterpart’
(White 1984a, 44). Throughout the long Napoleonic Wars, for example, the
Scottish economy allegedly experienced milder cyclical fluctuations than did
that of England. This White attributes in part to its superior banking system.
The empirical support for White’s conclusions consists of data on comparative
failure rates for Scottish versus English banks over the period 1809-1830. This
reveals that on average Scottish banks failed at the rate of 4.0 per thousand,
whereas English failures were 18.1 per thousand (White 1984a, 48).

White admits the danger of basing broad conclusions on a single historical
example. Nevertheless, he believes Scottish free banking to be illustrative of
certain basic principles.

[Blecause we lack knowledge of any other truly free banking systems of significance,
the Scottish experience, interpreted in the light of our theoretical constructions, must
largely inform our understanding of what we should generally expect from free banking.


===== PAGE 109 =====

82 Free Banking

Though perhaps not conclusive, Scotland’s experience is certainly consistent with the
hypothesis that monetary freedom is workable and self-regulating. (White 1984a, 137)

Finally, White notes that free banking ended not because of dissatisfaction
on the part of either the consumers or the bankers in Scotland. Both seemed
quite pleased with—even protective of—the system. The demise of Scottish
free banking was imposed from above for political reasons. The English Parlia-
ment passed the Bank Charter Act in 1844 and the Scottish Bank Act in 1845.
These effectively ended freedom of entry and the competitive issuance of notes,
and put the Scottish banks under the aegis of the Bank of England.

A CRITIQUE OF WHITE

The increasing attention devoted to free banking in the last few years has
certainly been both invigorating and long overdue. Moreover, much of the credit
for this reanimated interest must be given to White for his research into Scottish
banking. However, despite its stimulating content, White’s work is not without
some questionable elements. The present section will enumerate some of the
reasons for such skepticism.® In general, it is not that White's facts are false.
The doubts that arise stem principally from the belief that White has either
misinterpreted the facts or failed to include certain countervailing facts.

One should understand, first of all, that this controversy is not merely some
trivial dispute over an arcane bit of history with no relevance for the present
day. In many writers’ minds, the theoretical case for free banking has been
intimately tied to the alleged success in Scotland. White himself contends that
free banking in Scotland ‘‘provides unique evidence on the workability of mon-
etary freedom’ and ‘‘may also help us answer other questions concerning the
stability or efficiency of an unregulated monetary system’’ (1984a, 137, 141).

Furthermore, White’s interpretation of Scottish banking has gained a wide
circulation. Among those who have cited White favorably, one finds Milton
Friedman and Anna Schwartz (1986, 49-51), George Selgin (1988a, 7, 81,
140; 1989, 450), Catherine England (1988, 795-96), Karen Palasek (1989,
400), Gerald O'Driscoll and Mario Rizzo (1985, 10, 225), Murray Rothbard
(1983, 185), Gerald O’Driscoll (1986, 601-2), David Glasner (1989, 37), Dowd
(1989, 153-57; 1992, 1), and Roger Miller and Robert Pulsinelli (1989, 211-
12). As for objections, until recently, there had been few. Jack Carr and Frank
Mathewson (1988), Larry Sechrest (1988; 1990; 1991), Rothbard (1988b), and
Tyler Cowen and Randall Kroszner (1989) have posed challenges to White's
historical work, whereas Charles Munn (1985) and Charles Goodhart (1987)
have offered short critical reviews.

The issues to be raised here are (1) bank failure rates, (2) economic growth,
(3) note convertibility, (4) restrictions on small-denomination notes, (5) the
Usury Law as a constraint on competition, and (6) the privileges of the char-
tered banks. The contention is that, although Scotland did allow a multiplicity


===== PAGE 110 =====

Scottish Free Banking 83

of note issues, it nevertheless was not the close approximation to ‘‘pure’’ free
banking that White seems to think it was.”

Much of the evidence presented in what follows will be drawn from the
survey of Scottish banking written by S. G. Checkland (1975). This work White
has called *‘S. G. Checkland’s authoritative chronicle of the industry’’ (1984a,
33). Moreover, White himself has declared that Checkland ‘‘is, of course, the
authority on the facts’ (letter to Peter Lewin and the author, April 30, 1986).

Bank Failures and Stability

Certainly one of the key dimensions along which one would want to measure
the success of any banking system is the rate of firm failure.® White obviously
agrees for he bases most of his case for Scottish stability on the allegedly lower
rate of failure experienced by Scottish banks relative to English banks (1984a,
48). Not surprisingly, he concludes from this that Scottish banks were substan-
tially less failure-prone and calls the Scottish system one of ‘ ‘remarkable mon-
etary stability’’ (1984a, 23).

First of all, White seems slightly to miscalculate the averages. From his own
table, the figures work out to be 4.46 and 17.54, respectively, rather than 4.0
and 18.1. More importantly, White’s figures cover only a small portion of the
period in question. He himself has stated that ‘‘the act of 1765 left Scotland
with free banking’ (1984a, 30). A longer time series would seem desirable,
especially in light of the Ayr Bank failure of 1772. That episode White de-
scribes as minor insofar as the system as a whole was concerned (1984a, 32).
Checkland agrees that little permanent damage was done (1975, 133-34), but
does point out that ‘‘no less than thirteen Edinburgh private bankers fell with
the Ayr Bank, never to rise again’ (1975, 132). There were also several Scot-
tish failures between 1773 and 1808. If one includes these data, one finds that
for the period 1772-1830, the average annual failure rates per thousand for
England and Scotland are 14.90 and 14.88, respectively (see Table 1). The rate
for Scotland is thus not statistically different from that for England at the 99
percent confidence level.

White has recently attempted to rebut this point. He suggests carrying the
series back to 1716 and thereby achieving a failure rate for Scotland of 7.98
(White 1991, 811-12). This, however, is inconsistent with his own declaration
that the free-banking era started in 1765 (1984a, 30). Indeed, since White puts
such great emphasis on the note-exchange process as a foundation of the Scot-
tish success, one would think that he might identify the beginning of free bank-
ing with the development of that process, that is, about 1770.° White also
suggests that one should be more concerned with economic significance than
with statistical significance and that raw failure rates per se are not necessarily
very important (1991, 813). Both points are well taken. However, how does
one determine what an ‘ ‘economically significant’ rate of bank failure may be?
For example, the average annual rate per thousand for U.S. banks between


===== PAGE 111 =====

84 Free Banking

Table 1
Bank Failures per Thousand, 1772-1830

Year England Scotland | Year England Scotland

1772 I 451.6 1802 7.6 0)
1773 cook 0 1803 14.6 0
1774 cok 0 1804 14.5 0
1775 I 0 1805 11.4 0
1776 ees ® 47.6 1806 4.2 0
1777 I 0 1807 5.8 0
1778 eek 0 1808 5.2 54.1
1779 ceo ® 0 1809 5.7 0
1780 eek 0 1810 25.6 27.0
1781 PN 41.7 1811 5.1 0
1782 ce. k 0 1812 20.6 0
1783 ceo 0 1813 8.7 14.3
1784 25.2 0 1814 28.7 0
1785 I 0 1815 27.3 9.0
1786 ceo 0 1816 44.5 14.1
1787 I 0 1817 4.0 0
1788 cook 0 1818 3.9 0
1789 coo ¥ 0 1819 16.5 0
1790 I 0 1820 5.2 13.2
1791 coo ¥ 0 1821 12.8 66.7
1792 I 0 1822 11.6 13.0
1793 17.9 90.9 1823 11.6 0
1794 3.7 0 1824 12.8 0
1795 ceo ¥ 0 1825 46.4 12.0
1796 6.6 0 1826 53.1 11.1
1797 17.4 0 1827 11.9 0
1798 12.8 0 1828 4.5 0
1799 ce ¥ 0 1829 4.4 11.4
1800 8.1 0 1830 20.9 0
1801 10.4 0

Sources: Lawrence H. White, Free Banking in
Britain: Theory, Experience, and Debate, 1800-1845
(New York and London: Cambridge University Press,
1984) 48. Sidney G. Checkland, Scottish Banking:
A History, 1695-1973 (Glasgow, Scotland: Collins,
1975) 132, 177-78. Leslie S. Pressnell, Country

Banking in the Industrial Revolution (Oxford:
Clarendon Press, 1956) 11, 537-38.

Notes: mean (England)= X, = 14.90
mean (Scotland)= X, = 14.88
standard deviation (England)= o, = 12.09
standard deviation (Scotland)= 0, = 60.01


===== PAGE 112 =====

Scottish Free Banking 85

Table 1— Continued

observations (England)= n, = 37
observations (Scotland)= n, = 59
To test the hypothesis that X, = X,,

2

og, op)
Ou = —+ —— = 8.061
n, n,
X,-X, 14.90 - 14.88
Zz = = = .00248
0,10 8.061

Therefore, one cannot reject the hypothesis at the
99 percent confidence level.
In contrast, using White’s figures,

X, = 17.54 o, = 14.33, n, = 22
X, = 4.46 og, = 5.98, n, = 22
0, 0)
Oxix2™= — + — = 3.31
n, m
X,-X, 17.54 - 4.46
Z = —— = = 3.95
Or1x2 3.31

Thus, one must reject the hypothesis at the
99 percent confidence level.

*No data are available.

June 30, 1921 and June 30, 1929 was 22.23 (Upham and Lamke 1934, 247),
higher than either the English or Scottish rates noted above. Furthermore, the
1920s are conventionally perceived as having been both prosperous and stable.
Is 22.23 a “‘significantly’’ high rate of failure? Finally, if White did not think
failure rates so important, why did he make the contrast between the two coun-
tries a prominent part of his defense of Scottish free banking?

To pursue the issue of stability, one may note that there occurred a number
of financial crises during the free-banking period: in 1772, 1778, 1787, 1793,
1797, 1802-1803, 1809-1810, 1818-1819, 1825-1826, 1836-1837, and 1839
(Checkland 1975, 213-14, 403), nor does one get an impression of much sta-
bility if one examines wholesale prices for Great Britain during the 1765-1845
period (see Table 2).'° Checkland offers a summary judgment of the Scottish
system when he says that ‘‘[i]n principle, it should have been capable of sta-
bility or, at least, of fairly easy contraction. In reality, it was not’’ (1975, 214).


===== PAGE 113 =====

86 Free Banking

Table 2
Wholesale Price Index for Great Britain, 1765-1845 (1770 = 100)

Year Index | Year Index | Year Index

1765 106 1792 123 1819 178
1766 107 1793 135 1820 160
1767 109 1794 137 1821 139
1768 108 1795 160 1822 123
1769 99 1796 162 1823 137
1770 100 1797 148 1824 142
1771 107 1798 150 1825 157
1772 117 1799 174 1826 139
1773 119 1800 210 1827 138
1774 116 1801 217 1828 134
1775 113 1802 170 1829 134
1776 114 1803 173 1830 132
1777 108 1804 173 1831 132
1778 117 1805 189 1832 128
1779 111 1806 187 1833 124
1780 110 1807 183 1834 121
1781 115 1808 201 1835 118
1782 116 1809 216 1836 132
1783 129 1810 213 1837 131
1784 126 1811 202 1838 137
1785 120 1812 228 1839 145
1786 119 1813 235 1840 143
1787 117 1814 215 1841 137
1788 121 1815 181 1842 124
1789 117 1816 166 1843 111
1790 124 1817 184 1844 113
1791 125 1818 194 1845 116

Source: Brian R. Mitchell, European
Historical Statistics: 1750-1970, 2nd
ed. (London: Macmillan Press, 1978) 388.

Economic Growth

What of White's claim that ‘‘the period of Scottish free banking coincided
with a period of impressive industrial development. . . . The growth of Scot-
land’s economy in the century prior to 1844 was more rapid even than En-
gland’s’’ (1984a, 24)? This conclusion is based on the statement of economic
historian Rondo Cameron to the effect that ‘‘it would not be unreasonable to
infer . . . that in 1750 per capita income of Scotland was no more than half
that of England, but that by 1845 it very nearly equaled England’s’’ (1967,
94). This inference is not based on unambiguous data. Cameron himself admits


===== PAGE 114 =====

Scottish Free Banking 87

that ‘‘there are no separate statistics of national income for Scotland for this
period’’ (1967, 94). Conclusions of the sort in which Cameron and White in-
dulge must, therefore, be based on indirect evidence. Admittedly, some such
evidence does exist.

For example, both Richard Hildreth (1968, 16) and T. S. Ashton (1969, 70-
75) suggest that the banking industry in Scotland contributed significantly to
that country’s expansion. White cites Adam Smith as an additional proponent
of this view (1984a, 24). However, this writer can find no such assertions in
the Wealth of Nations.'' Indeed, the opposite seems more nearly to be Adam
Smith’s position.!? Smith states that ‘‘Scotland, though advancing to greater
wealth, is advancing more slowly than England’’ (1937, 189). He also makes
references to the ‘‘imprudence’’ of Scottish banks (1937, 288) and ‘that excess
of banking, which has of late been complained of both in Scotland and in other
places’ (1937, 302). It would seem clear that the issues of cyclical stability
and economic growth will not be resolved until separate series on Scottish
prices, interest rates, and national income are either discovered or generated.
Until then, White’s conclusions must remain quite tentative.

Banknote Convertibility

White goes so far as to define free banking as ‘‘the unrestricted competitive
issue of specie-convertible money by unprivileged banks’’ (1984a, ix). More
recently, he has reaffirmed that redeemability is an essential characteristic of
competitive inside money (1989b, 368fn). Thus, if convertibility was not, in
fact, consistently practiced in Scotland, then one may conclude that a signifi-
cant element of free banking was absent.!* Of course, it is well known that
before 1765 immediate redemption did not always occur because banks some-
times invoked the ‘‘option clause’’; that is, they delayed redemption in ex-
change for the payment of explicit interest to the noteholder. Did strict con-
vertibility hold, however, after 1765? Damaging to White’s case is this declaration
by Checkland:

The Scottish system was one of continuous partial suspension of payments. No one
really expected to be able to enter a Scots bank . . . with a large holding of notes and
receive the equivalent immediately in gold or silver. At best they would get a little
specie and perhaps bills on London. (1975, 185)

Checkland also suggests that ‘‘much emphasis was laid on the loyalty of the
banks’ customers—requests for specie met with disapproval and almost with
charges of disloyalty’’ (1975, 184). Frank W. Fetter agrees: ‘‘To a large degree
there was a tradition, almost with the force of law, that banks should not be
required to redeem their notes in coin’ (1965, 122). To this, Henry Meulen
adds the observation that a Scottish bank usually ‘‘paid notes instead of gold
to any depositor who might call, and thus was able to operate with a smaller


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88 Free Banking

reserve of gold than would otherwise have been necessary’ (1934, 136). Ad-
ditional comments along these lines may be found in both Checkland (1975,
186, 222, 438) and Meulen (1934, 129).

Curiously, White (1989a, 36) claims that statements such as the foregoing
have been rebutted by Kevin Dowd (1989). In fact, Dowd agrees that ‘‘Scottish
notes were imperfectly convertible, even after the passage of the 1765 Act”
(1989, 156). What Dowd does dispute is that such inconvertibility represented
a significant departure from free banking (1989, 156-57).'* Yet both White
(1984a, 6-19) and Selgin (1988a, 94-96) have argued forcefully that free banks
issuing debt-based, that is, specie-convertible, notes and deposit credits are
constrained from overissuing such liabilities by the fact that these firms face
rising marginal costs. Furthermore, said marginal costs rise largely because of
liquidity costs, that is, the costs of acquiring and holding specie for the purpose
of redemption. This redemption may occur in the course of either interbank or
bank-customer transactions (the processes of adverse clearings and reflux).

In the absence of convertibility, free banks would experience a much-relaxed
constraint on overissuance. For example, when discussing free banking in
Michigan, Dowd seems to concede this when he states that ‘the suspension of
convertibility removed the main check against over-issue, and so a monetary
explosion was to be expected’ (1989, 137). It would seem clear that converti-
bility is essential to any (specie-based) system that merits being characterized
as free banking.

Small-Denomination Notes

In 1765, the British Parliament imposed on Scotland legislation that prohib-
ited not only the option clause, but also the issue of notes smaller than one
pound-sterling. The option clause has often been discussed—see Dowd (1991h),
White (1984a), or Selgin (1988a), for example—but the prohibition of small-
denomination notes seems to have received little attention.

Three aspects of this are of importance. First of all, one needs to realize that
the one-pound note of 1765 had roughly the purchasing power of $180-$200
in the United States today.!> This figure may be achieved by discovering that
British prices are presently ninety to 100 times the level of 1765 (Mitchell
1988, 719-34) and observing recent exchange rates of about $2.00 per pound.
The implication is that after 1765 many day-to-day transactions could not be
conducted in terms of banknotes; recourse to coins was necessary. Further-
more, the control of coinage rested with the Royal Mint and the Bank of En-
gland (Clapham 1958, Vol. II, 51-53). In other words, Scottish banks were
systematically excluded from competition by means of notes for the business
of those whose currency needs were relatively small in scale.

This restriction likely had two further effects. It may have served as a barrier
to entry for small banks, since it could deny them the ‘‘niche strategy’ of
catering to small entrepreneurs and to the less wealthy consumers. Further-


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Scottish Free Banking 89

more, since small-denomination notes always tend to circulate more rapidly
than those of large denominations (White 1984a, 8), it would seem that the
Act of 1765 must have reduced to some extent the effectiveness of the reflux
process. That is, it may have raised the average period of circulation for Scot-
tish banknotes and, thereby, increased the possibility of inflationary overissues.
Consistent with this hypothesis, one finds Adam Smith’s observation in 1776
that in Scotland, ‘‘the circulation has frequently been over-stocked with paper
money’ (1937, 286). One may add to this the facts that (1) food prices fell
from 1717 to 1750 but rose strongly in the latter part of the eighteenth century,
as did coal, cattle, and grain prices, and (2) Scottish net exports declined after
1775 and were generally negative from 1780 to 1805 (Lythe and Butt 1975,
102, 103, 113, 116, 117, 162, 247). All of this suggests—but does not prove—
the existence of an inflationary monetary expansion.

Interest Rate Ceilings

In 1714 the Usury Law, to which the Scottish banks were subject, estab-
lished a legal maximum rate of 5 percent to be charged by financial institutions.
The last remnants of this law did not disappear until 1854 (Clapham 1958,
Vol. II., 224). Of these facts, there can be no doubt. However, White has
questioned, first of all, whether the 5 percent ceiling applied to one of the key
sources of revenue for Scottish banks: the discounting of commercial bills of
exchange (letter to Peter Lewin and the author, April 30, 1986). It did indeed.
The Usury Law was applicable to ‘‘the entire bill market’ until 1833, when
ninety-day bills were made exempt (Homer 1963, 205).

Also, in the same letter cited above, White wonders if this ceiling was ever
a binding constraint. If one takes that phrase to denote a circumstance in which
market rates of interest are driven above the maximum legal rate, then one
must apparently answer in the affirmative. S. G. E. Lythe and J. Butt, while
discussing Scottish finance in the eighteenth century, note that ‘‘the price for
capital might be higher than the legal maximum bank rate’’ (1975, 155). Since
consols '® issued by the British government were not subject to the Usury Law
(Homer 1963, 205), one might take the yield on consols to be a reflection of
market conditions. That yield exceeded 5 percent in the years 1781, 1782,
1784, and 1796-1799 (Homer 1963, 161-62). During the long Napoleonic
Wars (1793-18135), effective market rates were often above the maximum legal
rate (Homer 1963, 186, 205).!7 Short-term market rates also rose above 5 per-
cent during the years 1836, 1837, and 1839-1841 (Homer 1963, 208). How-
ever, it is unclear whether the latter posed an impediment to bank competition,
since bills of exchange and promissory notes were exempt from the Usury Law
after 1833 (Checkland 1975, 192, 443). It is possible that short-term rates were
greater than 5 percent during part of 1826 as well: The average of such rates
for that year was 4.5 percent (Mitchell 1988, 683).

It would seem that the interest rate ceiling must, in fact, have been a con-


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90 Free Banking

straint on bank competition during at least part of the 1765-1845 period.
Checkland concurs when he states that ‘‘the Usury Law limited competition for
deposits’ and that its effect on “‘any form of advance was seriously inhibitive’’
(1975, 432, 192). This assessment is echoed by Meulen (1934, 92).

Privileged Banks

One may recall White’s definition of free banking as a system of ‘‘unprivi-
leged private banks.’ Yet there were two tiers to the Scottish system: (1) three
chartered ‘public’ institutions (the Bank of Scotland, the Royal Bank, and the
British Linen Bank) and (2) the various private banks and joint stock banking
companies. Since the three public banks enjoyed limited shareholder liability
while the others were all subject to unlimited liability, Checkland concludes
that the former ‘‘were in a preferred position relative to all others’ (19735,
235). The state had created these public banks and ‘‘continued to confirm their
preferred position through their limited liability and through their public iden-
tity and perpetual succession’’ (Checkland 1975, 275). It would thus seem that
the nonchartered banks faced a significant regulatory barrier to entry: unlimited
liability. '® This did not prevent the formation of a number of private banking
concerns, but it imposed a constraint on such firms that was not applicable to
the three chartered banks.

White contests this. He asserts that unlimited liability must not have been a
binding constraint on the private banks, because they ‘‘chose to retain unlim-
ited liability in the 1860s and 70s even after limited liability became available
to them’ (1984a, 143). To argue thus is less than convincing. Institutional
structures must be viewed contextually. The fact that Scottish banks of the
1860s seem not to have seen unlimited liability as an odious imposition does
not prove that it was not considered to be such in, say, 1780 or 1810. By 1860,
the tradition of unlimited liability may have become so deeply entrenched that
to abandon it would have shaken consumer confidence. Despite this, unlimited
liability may still have been a barrier to entry during the eighteenth and early
nineteenth centuries. In addition, there is a powerful counterpoint that one must
consider. Since the three public banks expended real resources in order to (1)
obtain their charters and (2) prevent other banks from gaining charters, one
must conclude that a limited liability bank charter was perceived as conferring
some significant advantage upon its holder (Cowen and Kroszner 1989, 226).

A specific manifestation of said advantage was the fact that ‘‘there was a
long-standing government instruction to the officers of the customs to accept
only the notes of the chartered banks in payment of duties, and to ‘refuse the
Notes of every other bank without exception’ *’ (Checkland 1975, 186). In
short, an artificial demand for the notes of the public banks was established by
fiat. Yet one might wonder if the payment of customs duties was of a magni-
tude sufficient to produce a significant gain for those institutions. One possible


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Scottish Free Banking 91

indication is the proportion of total government revenues represented by cus-
toms duties. One finds that customs duties averaged 22.3 percent of annual
government income over the period 1765-1801 and 27.6 percent from 1802 to
1845 (Mitchell 1988, 576-77, 581-82).!° The collection of customs duties—
and therefore the benefit to the public banks—seems not to have been trivial.

Dependence upon the Bank of England

Several writers have argued that the Scottish system was not true free bank-
ing because it was crucially dependent upon the Bank of England. That is, it
has been claimed that the private Scottish banks depended upon the three public
banks, and those three in turn relied upon the Bank of England for their liquid-
ity needs (Rothbard 1988b;2° Sechrest 1988; Cowen and Kroszner 1989; Dow
and Smithin 19922). These arguments have been based on various statements
by historians of the period.

For example, Checkland declares that ‘‘by 1810, the Bank of England, short
of the state itself, was the effective final arbiter of the supply of liquidity, both
for England and Scotland’’ (1975, 276). Meulen notes that ‘it transpired that
at times when gold was being drained both from Scottish and English banks
the Scottish bankers had not restricted their note issue, but had withdrawn gold
from the Bank of England to support their credit system’ (1934, 141). Fur-
thermore, the 1810 Bullion Committee’s report stated that ‘‘the circulation of
the Bank of England had an important influence on the circulation of the coun-
try banks and of the Scottish banks’ (quoted in Fetter 1965, 50). Finally, ‘the
three chartered banks of Scotland kept their reserves largely in deposits with
the Bank of England’’ (Fetter 1965, 34).

White has offered a rebuttal to the foregoing that is quite plausible even if
not conclusive (1989a, 20-34). He seems to make three key assertions. First,
White points out that the evidence for the pyramiding of Scottish bank notes
on a base of Bank of England notes is sketchy and circumstantial.?? There seem
to be no unambiguous data that could resolve the question. Second, he grants
that England and Scotland formed an integrated economic whole,?* but denies
that this means that the Scottish system was a satellite of the Bank of England.
As he puts it, one would not conclude that the U.S. banking system was a
satellite of the English system just because actions by the Bank of England had
spill-over effects in America. Finally, White offers evidence that the Bank of
England did not explicitly consider itself to be a lender of last resort during the
Scottish free-banking period. He argues persuasively that there is an important
distinction between an ex ante lender of last resort and an ex post source of
liquidity. One might call the former structural dependence and take it to be
indicative of central banking. One might call the latter circumstantial reliance
and perceive it as being consistent with free banking.


===== PAGE 119 =====

92 Free Banking

SUMMARY

Lawrence H. White’s very valuable research into Scottish free banking has
generated much interest and some controversy. His work has explicitly sug-
gested that the Scottish experience can tell us a great deal about how a true
free-banking system would perform. To many writers, Scotland has come to
represent the paradigmatic ‘‘test’” of free banking.

However, on closer inspection, one finds some serious flaws in the Scottish
system. The failure rate (1772-1830) for Scottish banks was not lower than
that for English banks. Banknotes were not consistently convertible into specie
on demand. The prohibition of small-denomination notes not only curtailed
mutually beneficial transactions between banks and their customers, but also
may have diluted the constraints on overissue. The Usury Law limited compe-
tition in credit markets. The three chartered banks held privileged positions
within the system, and Scotland seems to have avoided neither the inflation nor
the numerous crises that plagued the English.?* Doubts about White's interpre-
tation of the Scottish experiment with free banking seem justified.?® Finally, it
is interesting to notice that White himself seems to be retreating a bit from his
original position. Instead of speaking of free banking as lasting from 1765 to
1845, he now appears only to defend the period 1810-1844 as exemplifying
free banking (1989a, 15, 16, 35).

NOTES

Portions of this chapter are reprinted, by permission, from Cato Journal 10 (Winter
1991): 799-808.

1. The key works are probably Hayek (1978), White (1984a), Selgin (1988a), and
Dowd (1989).

2. All of these included other restrictions on bank activity, however.

3. One of the rare exceptions was Vera C. Smith (1990).

4. These three large, chartered banks—the Bank of Scotland, the Royal Bank, and
the British Linen Bank—were distinct from other Scottish banking concerns and were
referred to as ‘ ‘public banks.”” Whether these three were legally privileged is one of the
controversies to be addressed.

5. This was true of all except the Bank of Scotland, the Royal Bank, and the British
Linen Bank. The shareholders of those three were subject to limited liability.

6. The author would like to emphasize that he has great respect for White's work
in general, but is unable to dispel certain doubts about White’s view of Scottish free
banking. Moreover, these doubts only very slowly displaced an initial enthusiasm for
White's conclusions.

7. Simply put, the question is ‘*how good’’ a test of free banking was the Scottish
case. This is important, but it is, admittedly, a question of degree rather than of kind.

8. Most assume that success is achieved by a low rate of failure. A few econo-
mists—particularly Murray Rothbard—argue that high failure rates are desirable as an
indication of market restraint.

9. That is one of the reasons why the author started his series with 1772.



===== PAGE 120 =====

Scottish Free Banking 93

10. It would have been far preferable to present data for Scotland alone, but such a
series seems not to exist.

11. Neither edition of the Wealth of Nations possessed by the author is that which is
cited by White. It is possible that some small—but in this case important—difference
exists between the editions consulted.

12. It would be fair to keep in mind that Smith was writing in 1776. His comments
do not, therefore, necessarily apply to the mature Scottish system. On the other hand,
White seems willing to consider 1716 as the beginning of free banking (1991, 811-12).
From that perspective, Smith’s comments would apply.

13. Arguments in defense of option clauses and indirect convertibility within the
context of free banking will be discussed in Chapter 7.

14. This is not surprising, since Dowd is not reasoning from the same model that
White employs.

15. Cowen and Kroszner (1989, 224) cite an estimate of $200.

16. Consols are bonds that never mature but pay interest to the holder forever.

17. Considering the substantial inflation in Britain during the period, it is hardly
surprising that this should be the case. See Brian Mitchell (1988, 720).

18. See Carr and Mathewson (1988) for more on this issue.

19. These figures are for Great Britain as a whole; separate series for Scotland do
not exist.

20. Rothbard’s essay, though shrill in tone, nevertheless raises some worthwhile points.
Most important of these is his claim that White has misinterpreted the theoretical debate
over free banking. To the author’s knowledge, Rothbard is the only one who has chal-
lenged White on this issue.

21. Sheila Dow and John Smithin also argue that the Scottish system exhibited a
strong tendency toward concentration. This they applaud, for they ascribe the degree of
success the Scots enjoyed to the lack of competition in the conventional sense.

22. White allows for the possibility that such pyramiding might have occurred during
the 1797-1821 period (1989a, 22).

23. White recognizes that his earlier work may have led readers to conclude that he
believed Scotland to be an entirely autonomous economy relative to England (1989a,
33).

24. This brings one back to a key theoretical issue. Is a properly functioning free-
banking system not capable of at least mitigating the effects of external shocks? The
author would argue that true free banking is capable of this. To test the stability of the
Scottish system in a clear fashion, one would need separate series for Scottish prices,
interest rates, industrial production, employment, and national income. To repeat, these
do not appear to exist.

25. The author’s position has long been that the theoretical case for free banking
need not rely on evidence from ambiguous historical cases like that of Scotland.


===== PAGE 121 =====



===== PAGE 122 =====

Chapter 6

AMERICAN FREE BANKING

The previous chapter presented reasons why one should question Lawrence H.
White’s popular portrait of Scottish free banking. Scottish banking seems to
have been both less free and less successful than White’s work would lead one
to believe. Here free banking in the United States will be examined. Once
again, reasons will be given for rejecting the popular view, but in the other
direction. American free banking will be shown to have been significantly safer
and more stable than is usually believed to have been the case.

THE STANDARD STORY

The conventional viewpoint regarding the American free-banking period (1837-
1863)! has been that it was ‘a failure,”” ‘‘chaotic,”’ rife with fraud in the form
of ‘‘wildcat’’ banking, and a ‘‘hindrance to economic development’ (Rockoff
1975, i). Bruce R. Dalgaard describes the time as one in which ‘‘significant
numbers of unstable banks had an image of ‘fly-by-night’ operations out to
obtain quick deposits before closing shop and disappearing with depositors’
funds . . . many banks failed . . . excessive creation of bank notes and un-
sound bank practices caused or aggravated financial panics during this period’
(1987, 95-96). Rollin G. Thomas insists that the ‘‘system of free banking led
to many abuses. Principally, it facilitated the development of wildcat banking
. . . the situation was further disturbed by the fact that counterfeiting of bank
notes became popular. The multitude of issues made the practice easy . . . the
widespread adoption of free banking led to complete chaos in many areas’
(1946, 244-46). Furthermore, Phillip Cagan opines that ‘‘the nation could not
so easily have achieved its rapid industrial and commercial expansion during


===== PAGE 123 =====

96 Free Banking

the second half of the 19th century with the fragmented currency system it had
during the first half’ (1963, 20).

The abuses allegedly perpetrated by some of these note-issuing free banks
were indeed extreme. Charles J. Bullock claims that often ‘banks were located
in inaccessible places, on some bottomless prairie road, or in the depths of
forests, where it would prove as difficult as possible to find the ‘offices’ at
which the notes were payable’ (1900, 84). He adds that ‘‘in Ohio, Indiana,
and Missouri, between 1855 and 1859, certain persons who presented notes for
redemption were threatened with lynching or a coat of tar and feathers’ (1900,
85).2 A. Barton Hepburn asserts in reference to the state of New York from
18383 to 1850 that ‘thirty-two banks failed, entailing a loss upon note holders
of $325,487, some paying as low a percentage as thirty cents on the dollar’
(1903, 137-38).

In summary then, the conventional critique of American free banking is that
(1) the multiplicity of notes led to fraud, with consumers often accepting at
face value notes that were redeemable—if at all—at a fraction of that face
value; (2) short-lived ‘‘wildcat’’* banks established by unscrupulous persons
were commonly encountered; (3) there were high rates of bank failure with
concomitantly large losses to noteholders; (4) the system more likely hindered
than fostered economic development via the allocation of financial capital; and
(5) free banking was both highly inflationary and highly unstable, for example,
conducive to indiscriminate bank panics that had negative spill-over effects on
real variables.

As will be seen, each of these charges has been subjected to criticism by
recent researchers. What emerges is a very different image. Free banking in
the United States—though certainly blemished—was far less chaotic than has
been believed. Moreover, the imperfections that did exist were largely the re-
sult of regulatory restrictions.

SOME BASIC FACTS

To set the context for the discussion that follows, several bits of information
must be conveyed. First of all, what were the basic provisions of the free-
banking laws? One must realize that these statutes were enacted at the state
level; each state made slightly different stipulations. Two things were universal:
a bank must redeem its notes in specie on demand of the noteholder and either
state or federal bonds must be purchased by the bank and held as security for
its outstanding notes.’ Failure to redeem its notes brought about closure of the
bank and liquidation of its assets. Noteholders were meant to be protected fur-
ther by being granted first lien on bank assets. Some states—but not all—also
required that free banks have some minimum level of capital. For example,
this was $100,000 in New York, and $25,000 in both Wisconsin and Minne-
sota (Rolnick and Weber 1982a, 21). Other states required a minimum ratio of
specie to notes. This seems not to have been considered an essential item,


===== PAGE 124 =====

American Free Banking 97

however. New York imposed a 12.5 percent minimum reserve ratio in 1838
but repealed it in 1840, whereas Indiana eliminated a similar requirement in
1855 after having introduced it three years earlier (Rolnick and Weber 1982a,
21). Finally, although the precise conditions varied from state to state, free-
bank stockholders faced limited liability. In some cases, this was twice the
amount of their investment and might extend beyond the time they sold their
stock.

Free banking was not permitted in all states. Some continued to require banks
to petition the state legislature for permission to operate. That is, some states
continued to require that a bank be chartered. This chartering system was one
that had proven susceptible to extensive political abuse, however. Indeed, the
favoritism and corruption associated with the chartering of banks was what had
prompted the introduction of free banking in the late 1830s (Hepburn 1903,
136).

The extent of free banking may be indicated by the fact that, out of thirty-
three states in the Union as of 1860, eighteen had free-banking statutes (Rock-
off 1975, 3). Moreover, the expansion of American banking was largely due
to the spread of free banking. In 1835, when all banks still had to have char-
ters, there were 704 banks in the United States. In 1845, with two free-banking
states, there were still only 707. By 1855—with fourteen free-banking states—
there were 1,307 banks (see Table 3).

RECENT RESEARCH

Some of the most thorough and extensive modern research on American free
banking has been that by Arthur J. Rolnick and Warren E. Weber. Their mo-
tivation is made clear: ‘‘The conclusion that when banking was left on its own
it failed has very significant implications for regulatory policy and to a great
extent influences policy today. Surprisingly, though, this conclusion is based
on very casual empiricism’’ (emphasis added) (Rolnick and Weber 1982b, 10).
As will be seen, they find ‘‘considerable evidence to question the prevailing
views on free banking’ (1982b, 10).

Failures, Longevity, and Noteholder Losses

In order to examine some of those ‘ ‘prevailing views,’’ Rolnick and Weber
collected data from the state auditors’ reports for four free-banking states: New
York, Minnesota, Indiana, and Wisconsin. These states allowed free banking
for various time periods and, as a result, had various numbers of free banks
that were formed under their statutes. New York had 449 banks (1838-1863),
Minnesota had 16 (1858-1863), Indiana had 104 (1852-1863), and Wisconsin
had 140 (1852-1863) (Rolnick and Weber 1982b, 19-20). This gives a total
of 709 free banks. Of these, redemption information is available for 678, and
the findings? ‘Close to fifty percent of the free banks in the states we investi-


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98 Free Banking

Table 3
Number of Banks in the United States, 1815-1860

Year Banks Year Banks
1815 208 1845 707
1816 246 1846 707
1820 307 1847 715
1829 329 1848 751
1830 330 1849 782
1834 506 1850 824
1835 704 1851 879
1836 713 1853 750
1837 788 1854 1,208
1838 829 1855 1,307
1839 840 1856 1,398
1840 901 1857 1,416
1841 784 1858 1,422
1842 692 1859 1,476
1843 691 1860 1,562
1844 696

Source: A. Barton Hepburn, History of Coinage and
Currency in the United States and the Perennial
Contest for Sound Money (New York: Macmillan, 1903)
118, 153, 174.

Notes: mean (1815-1849) = 630
mean (1850-1860) = 1,224
standard deviation (1815-1849) = 208.5
standard deviation (1850-1860) = 281.9
coefficient of variation (1815-1849) = 0.331
coefficient of variation (1850-1860) = 0.230

No data are available for 1817-1819, 1821-1828,
1831-1833, or 1852.

Coefficient of variation equals standard deviation
divided by the mean.

gated failed, but less than a third of these banks failed to redeem their notes at
par’ (Rolnick and Weber 1982b, 11).6 Overall, then, less than one-sixth of the
free banks in these four states failed to redeem their notes at par value.
Pursuing the issue of bank failures, it is interesting to compare free-bank
rates of failure with failure rates of American banks during other time periods.
For example, during the 1811-1830 period, there were 495 state-chartered/
state-regulated banks. One-third of them failed (Gilbart 1967, 48-52), and this


===== PAGE 126 =====

American Free Banking 99

was largely a period of peace and prosperity for the country. Closer to the
present day is the 1921-1929 period. This was a time of real economic growth,
low unemployment, and low rates of inflation’ in which banking was regu-
lated, there was a lender of last resort, and the Federal Reserve was undertak-
ing expansionary open market operations. Nevertheless, out of 29,669 banks,
5,411 failed (Upham and Lamke 1934, 247). In addition, it is well known that
in mid-1929, there were about 25,000 U.S. banks. By mid-1933, almost 10,000
of them were gone. It is ironic to note in the context of the foregoing that Hugh
Rockoff has referred to a failure rate of 15 percent as “‘high’” (1985, 886).

As for the longevity of free banks, it is clear that many economists share
Rockoff’s belief that it was common for a free bank to last for only a month
or two (Rockoff 1975, 8-9). Rolnick and Weber find little support for this.
They conclude that ‘‘our data suggest that the conventional view is overstated.
In our free banking states, only sixteen percent of the free banks were in busi-
ness under a year, while the average number of years in business was over
five’’ (1982b, 13). The longer-term banks were to be found in New York and
Wisconsin.® ‘New York free banks were in existence a mean of 7.9 years . . .
and Wisconsin free banks were in existence a mean of 4.3 years’’ (Rolnick and
Weber 1982b, 14). Furthermore, these figures have a downward bias, since
they do not include free banks that, after 1863, continued in business as char-
tered state or national banks (Rolnick and Weber 1982b, 14).

Perhaps the most fundamental concern for individual consumers is the safety
of those banknotes they choose to hold, and the usual portrait of free banking
has been one in which such safety was ephemeral to say the least. What have
Rolnick and Weber discovered? They ‘‘found that the most exaggerated views
about free banks were those concerning the safety of the bank notes and the
losses to noteholders . . . some have claimed that the losses to noteholders ran
into the millions for individual states. Our data, however, tell a much different
story” (1982b, 15).

Rolnick and Weber calculated two different measures of note safety. The
first is the ‘‘expected value of a randomly selected bank note held until 1863,’
which they arrive at by multiplying the note circulation of each free bank by
the rate at which those notes were ultimately redeemed and then dividing that
number by the total circulation of all free banks (1982b, 15). By this measure,
the free banks in New York were the safest since their notes’ expected value
never fell below $.97 per dollar. In Indiana, the lowest expected value was
$.92 in 1853, and in thirteen out of fifteen other years, the expected value was
$.98 or better (1982b, 15-16, 22-23). Minnesota fared worst. For the first six
months of free banking in that state, the expected value of notes was no better
than $.50 per dollar. However, over the succeeding four years, that is, until
the end of free banking in 1863, the expected value did not fall below $.81.

Their other measure is an estimate of the total losses imposed on notehold-
ers. This ‘‘was obtained by multiplying the last circulation for each bank which
failed below par by one minus its redemption rate’’ (Rolnick and Weber 1982b,


===== PAGE 127 =====

100 Free Banking

16). They found that ‘‘the total losses to noteholders under free banking in the
four states for which we have compiled data ranged between $1.6 and 2.1
million’ (1982b, 17). In other words, there were significant losses in some
cases, but the magnitude of such losses was far less than previously believed.
It must be pointed out that Rockoff has challenged the validity of Rolnick and
Weber’s work (Rockoff 1985). This, however, seems a weak challenge, since
Rockoff offers very little data to support his claims.

Free-Banking Fraud

Very much a part of the traditional picture of free banking has been the
allegation of widespread fraud. This allegation usually stems from what is a
correct observation about the free-banking laws. It was true that such banks
were required to buy state bonds (at market value) and deposit them with the
state auditor as security for their notes, and then were allowed to issue notes
in an amount equal to the face value of the bonds. The difference between the
market and face values was often significantly large because of questionable
state fiscal policies that led to a depreciation of the bonds. Supposedly, an
unscrupulous banker would begin operations and, for a time, studiously redeem
his notes on demand so as to foster public confidence in his bank. Then, when
he had obtained an extensive circulation for his notes, he would suddenly cease
redemption in specie—something made easy by locating his ‘‘office’’ in some
remote area—and disappear. Where lay his gain? To the extent that he had
persuaded consumers to exchange their specie for his notes at face value, he
will have profited at their expense. This follows from the fact that said banker
likely paid less than face value for the bonds. Therefore, his gain was the
difference between (1) the dollars in gold he received in exchange for his notes
and (2) the dollars in gold he expended in order to acquire the state bonds, less
some small operating expenses.

This is essentially the explanation for free-bank failures offered by Rockoff
(1975, 94-129). In effect, Rockoff contends that conscious attempts by bank-
ers to defraud consumers were the source of most such failures. This kind of
fraud was only possible when the bankers could purchase state bonds at market
value but could issue notes based on the face value of those bonds. The obvious
implication of Rockoff’s hypothesis is that free-bank failures should have oc-
curred only in states that exhibited this market value/face value differential.

Rolnick and Weber disagree with Rockoff’s analysis. Their counterhypoth-
esis is that free banks failed not because of fraud made possible by the counting
of state bonds at face value, but rather because fluctuations in the market prices
of those bonds often left free banks severely undercapitalized. They argue that
this, coupled with the requirement that free banks redeem their notes and de-
posit accounts in specie, brought about the failures (Rolnick and Weber 1982a,
15, 19). The implication here is that free-bank failures should be most strongly


===== PAGE 128 =====

American Free Banking 101

correlated with declines in the market prices of the state bonds held—regardless
of whether note issuance was based on market values or face values.

To test the two hypotheses, Rolnick and Weber offer data on bank failures
and bond prices for four states: New York, Wisconsin, Minnesota, and Indiana
(1982a, 22-30). They find little support for Rockoff’s position, since the ma-
jority of below par failures in those states occurred after the state laws were
modified so as to restrict banks to note issues based on the market values of
bonds held. For example, ‘‘over half of New York’s below par failures oc-
curred after the market valuation restriction had been incorporated into its free
banking legislation’’ (Rolnick and Weber 1982a, 15). Furthermore, ‘all 37 of
Wisconsin's below par failures occurred in 1860 and 1861 when the market
valuation criterion was in effect” (Rolnick and Weber 1982a, 15). Half the
Indiana failures were after the statutory change. Only the Minnesota data were
ambiguous.

In contrast, they uncover substantial evidence that supports their theory re-
garding the source of free-bank failures. Plotting bond prices and bank failures,
they observe that by ‘‘examining the data on below par failures during 1852
1863 for New York, Indiana, and Wisconsin, it can be seen that all but two of
the 59 below par failures occur in’’ periods of substantial declines in the prices
of bonds (Rolnick and Weber 1982a, 17). For Minnesota, the figure is two out
of eleven below par failures (1982a, 25). Therefore, they conclude that free-
bank failures were due not to fraud, but to the legal requirements that notes be
backed by state bonds and notes be redeemed on demand in specie. The first
imposed an unnecessarily risky portfolio on free banks; the second prevented
free banks from passing capital losses on to noteholders (1982a, 19).® Rolnick
and Weber conclude the investigation with a provocative line of thought:

Our results also suggest that the so-called free banking acts were not really free. That
is, this experience cannot be interpreted as a test of laissez-faire banking. . . . It is
doubtful such a system would have evolved on its own. We suspect banking would have
been a much safer business under a truly laissez-faire environment. (1982a, 19-20)

Notes as Mutual Fund Shares

A parallel issue regarding the likelihood of free-banking fraud is that of whether
or not notes were typically accepted at face value by consumers. It would seem
that the profitability of fraud is directly proportional to the frequency with which
such acceptance occurs. The usual argument has been ‘‘that the public were
either naive or misinformed. They accepted free bank notes at par even when
it was apparent that the notes were risky’’ (Rolnick and Weber 1985, 34). Such
gullibility is assumed, for example, by Rockoff (1975, 107-10).

Once again, Rolnick and Weber challenge the conventional argument. They
suggest ‘‘that free bank notes were demanded because they were priced to
reflect the expected value of their backing’’ (1985, 34). In other words, they


===== PAGE 129 =====

102 Free Banking

hypothesize that some free banks essentially acted as mutual funds, with their
notes treated like mutual fund shares, that is, discounted to reflect perceived
risk.

It is intriguing to notice in light of this that several recent writers have pro-
posed laissez-faire systems in which mutual fund shares might replace tradi-
tional hand-to-hand currency. These writers include Fischer Black (1970), Eu-
gene Fama (1980), and David Glasner (1989, 195-200).

To examine this issue empirically, Rolnick and Weber work from a data set
based on free banking in the same four states relied upon previously—New
York, Indiana, Wisconsin, and Minnesota. In the first three, the ‘‘intended
objective of the free banking laws was achieved: free bank notes there were
relatively safe and circulated close to par’’ (Rolnick and Weber 1985, 7). They
base this judgment on measurements of expected rates of return (1985, 8). In
New York, the loss per annum was only 0.03 percent or less for fifteen out of
eighteen years. For Wisconsin, losses were zero except for 1860 and 1861,
when all of that state’s bank failures occurred. Indiana’s losses were nearly
zero, except for 1853 and 1854, when they were 7.47 percent and 4.95 percent,
respectively.

The experience in Minnesota was, however, radically different. Rolnick and
Weber estimate the annual rate of loss there to range from a low of 12.43
percent in January of 1860 to a high of 54.38 percent for January of 1859
(1985, 10). They ascribe this difference from the other three states to a peculiar
feature of banking in Minnesota. In that state, ‘‘railroad bonds’’ could be used
as security for a free bank’s notes (1985, 13-16). These were technically Min-
nesota state bonds, but, in fact, they were backed only by the railroads’ ques-
tionable ability to repay the bondholders. The whole arrangement came into
being as an indirect means by which the state legislature could help finance
railroad development. The critical point is that these bonds were obviously
risky and, thus, so too were any notes backed by them. To illustrate this,
~ Rolnick and Weber point out that these railroad bonds could be sold in Chicago
only when discounted by 50 percent and when banks holding these bonds failed,
the redemption rates on the notes of such banks were no better than 21.25 cents
per dollar (1985, 15).

Obviously, ‘‘what needs to be explained for Minnesota is why people were
willing to hold notes that were backed by such risky assets’’ (Rolnick and
Weber 1985, 15). Their answer is that such notes were both initially issued
and subsequently traded below par. Essentially, then, these banks ‘ ‘were acting
as mutual funds by intermediating the large-denomination ($1,000) railroad bonds,
with the bank notes serving as shares in the mutual funds’’ (1985, 15). Rolnick
and Weber emphasize that ‘‘the evidence from the auditor records, legislative
testimony, and newspaper accounts about these banks’’ supports the idea that
the public were well informed regarding the riskiness of the situation (1985,
26).

The lesson from Minnesota’s free-banking period is potentially very impor-


===== PAGE 130 =====

American Free Banking 103

tant. Here was a newly formed, frontier state with a largely rural populace.
Despite this, it proved impossible to circulate free-bank notes at par value when
they were backed by risky assets. This suggests that laissez-faire banking is not
necessarily plagued by an informational asymmetry that encourages fraud. The
significance of such evidence lies in the fact that many apologists for central
banking base part of their case on the assumption that such asymmetries are
universal and ineradicable. See, for instance, Charles Goodhart (1988, 33-34,
63-66).

Bank Panics

Here Rolnick and Weber try to answer two important questions: What is
meant when the claim is made that banking is ‘ ‘inherently unstable,’’ and were
free banks in the United States inherently unstable? They remark that there
exists ‘‘no agreement on a precise definition of inherent instability in banking’
(emphasis in original) (1986, 881). They opt for what they deem to be the
conventional view. That is, they take inherent instability to mean that bank
panics can occur without economy-wide real shocks. Such panics allegedly
occur because of either ‘‘intrinsic’’ or ‘‘extrinsic’’ uncertainty (Rolnick and
Weber 1986, 881-82). Intrinsic uncertainty arises when, as a result of some
local real shock, the value of some banks’ assets falls and some noteholders
demand redemption in specie. If information is distributed unequally among
the noteholders, the differences between sound and unsound banks will not be
clear, and a general run may result. Extrinsic uncertainty occurs when some
pervasive, economy-wide real shock changes individuals’ demand for bank-
notes relative to specie. The trouble spreads as noteholders begin to doubt the
solvency of the banking system.

Rolnick and Weber gathered data for the period 1841-1861 in order to test
for instability. First they isolated clusters of bank failures, and noted the pres-
ence or absence of any local real shocks so as to answer the question of whether
instability stems from intrinsic or extrinsic uncertainty. Their assumption was
that, if a local shock coincided with a cluster of failures, such failures should
be attributed to intrinsic uncertainty (1986, 883). Fully 85 percent of the fail-
ures appeared consistent with the intrinsic uncertainty proposition (1986, 885).
They explain that these failures seem to have followed whenever free banks
became grossly undercapitalized because of devaluations of the state bonds such
banks held as security (Rolnick and Weber 1986, 884-85). These devaluations
resulted from default on debt by the states, the onset of the Civil War, or, in
the case of Minnesota (discussed earlier), the failure of several railroads.

To see if instability was inherent in free banking, Rolnick and Weber deter-
mine whether failures in one state led to failures in other states (the so-called
contagion effect). This is the test suggested by Milton Friedman and Anna
Schwartz (1963, 308). They find no evidence of contagion (1986, 885-86).
Specifically, in the period July-December 1854, one-fourth of all the free banks


===== PAGE 131 =====

104 Free Banking

in Indiana failed, yet only one out of 232 in New York failed and none in
Wisconsin. Between June and September 1859, over half of the Minnesota free
banks failed, but not one of the 390 such banks in New York, Indiana, and
Wisconsin closed its doors. Between June of 1860 and June of 1861, more
than a third of the Wisconsin free banks failed; only one free bank in New
York and one in Indiana did likewise.

Rolnick and Weber suggest that the lack of contagious panics may be due to
the informational nature of the bond requirement. For example, noteholders in
New York knew that a drop in Indiana state bond prices would have no appre-
ciable effect on the safety of New York free banks. !? They further propose that
any regulatory structure that does not provide information on the market value
of a bank’s assets will prove incapable of preventing bank runs (Rolnick and
Weber 1986, 889).

The Allocation of Funds

As Rockoff has put it, a ‘‘fundamental question concerning free banking
might appear to be whether permitting free entry produced a more efficient
allocation of capital’’ (1975, 50). There are indeed several bits of evidence that
seem to support the belief that free banking did produce such an allocation.
For example, in the West (everything from Ohio to the Pacific Ocean), the
source of the people’s enthusiasm for free banking was ‘‘that they perceived
serious difficulties with allocations of bank capital achieved under state owned
or state chartered banking systems’ (Rockoff 1975, 50). The states in which
such difficulties had manifested themselves included Indiana, Tennessee, Ohio,
and Missouri (Rockoff 1975, 55-56).

Qualitive evidence like that just cited is not really sufficient. One would hope
for quantitative data on the basis of which one might accept or reject the prop-
osition of free-banking allocative efficiency. Rockoff suggests that one may
assume such efficiency if there is evidence of competitive conditions.!! Fur-
thermore, he unearths three kinds of data that may serve to indicate the degree
of competitiveness: (1) profit rates, (2) the number of banks per 100,000 inhab-
itants, and (3) the number of unincorporated banks (1975, 57-64). In Kentucky
and Indiana, he finds ‘‘high’’ bank profit rates prior to the introduction of free
banking. More telling are the data for Ohio. There profit rates fall significantly
as soon as free banking is adopted, suggesting a more competitive market.
Figures for bank-to-population density are quite ambiguous. The critical factor
seems to be the degree of urbanization rather than the presence of free banking,
since ‘‘this measure of competition is highest in New England and lowest in
the South and West’’ (Rockoff 1975, 60). The numbers of private (unincorpor-
ated) banks are generally greater in free-banking states and lower in the others,
suggesting that the level of competition was greater in those free-banking states. '?
Rockoff tentatively concludes that ‘‘New York City benefited from free bank-
ing in its competition with Boston and Philadelphia for financial leadership,


===== PAGE 132 =====

American Free Banking 105

and that in the West free banking was, or at least appeared to be, a way of
slowing the vexatious problem of how to allocate bank capital in a region of
new settlement’ (1975, 67).

Noteholder Safety

The degree to which a holder of free-bank notes experienced the risk of loss
is, of course, one of the important issues regarding free banking. Earlier it was
seen that noteholder losses may have been much smaller than was previously
believed to be the case (Rolnick and Weber 1982b). Confirmation of such re-
sults may be found in the works of A. Barton Hepburn and Charles Conant.

Hepburn lists the total losses to noteholders in the state of New York from
1838 to 1861 as $398,336 (1903, 137-38). Conant helpfully adds that the total
note circulation in New York during that time period was approximately $314
million (1927, 375). This represents an average loss per dollar held of a min-
uscule 0.127 percent. New York did indeed have one of the best free-banking
systems—of that there is no doubt. Nevertheless, such small losses seem utterly
incongruous in the context of the usual image of free banking. Moreover, this
just deals with nominal balances. Over the 1838-1860 period, the purchasing
power of each dollar in the United States rose, on average, by 15.6 percent.'?
In other words, in New York noteholders on average experienced a net gain in
terms of real balances, despite the losses resulting from free-bank failures. For
a modern comparison, one may look at the 1968-1990 period. Federal Reserve
noteholders suffered losses in purchasing power of almost 75 percent over that
span,’ and that does not take into account the enormous cost to taxpayers of
closing insolvent financial institutions.

Pursuing the issue of free banks’ safety, one must ask what factor might be
of primary importance to the typical noteholder. Rolnick and Weber are largely
concerned with assets held in the form of state bonds. They suggest, as seen
earlier, that when the market value of such bonds fell, free banks tended to
fail. However, state bonds surely represented secondary reserves to free banks.
Their primary reserves consisted of outside money, that is, specie. It was their
ability to redeem notes (or demand deposits) in gold or silver coin that was the
first line of defense against a bank run.'> Therefore, an examination of reserve
ratios should shed some light on the question of free-bank safety.

Table 4 presents data on the reserve ratios for the American banking system
for the period 1834-1860. Only four states had adopted free banking before
1850—one in 1837,'¢ two in 1838, and one in 1849. Thirteen additional states
embraced free banking between 1850 and 1858, whereas one (Pennsylvania)
did not permit free banking until 1860. Therefore, two subperiods might be
recognized. From 1834 to 1849, there was a specie standard and banks often
issued their own notes,!” but a bank had to be chartered by the state in which
it operated. From 1850 to 1860, freedom of entry and exit was added to the


===== PAGE 133 =====

106 Free Banking

Table 4
American Bank Reserve Ratios, 1834-1860 (all banks)

Year Reserve Ratio Year Reserve Ratio
1834 15.48% 1848 20.56%
1835 22.83 1849 21.02
1836 14.11 1850 18.59
1837 13.52 1851 17.30
1838 16.64 1852 15.48
1839 20.59 1853 17.28
1840 18.04 1854 16.50
1841 20.00 1855 14.50
1842 18.87 1856 14.68
1843 28.96 1857 12.90
1844 30.54 1858 22.34
1845 25.11 1859 23.83
1846 21.03 1860 18.12
1847 18.72

Sources: William Graham Sumner, A History of
American Currency (New York: Greenwood Press, 1968)
188. Amasa Walker, The Science of Wealth: A Manual
of Political Economy (New York: Kraus Reprint
Company, 1969) 162.

Notes: mean (1834-1849) = 20.38%
mean (1850-1860) = 17.41%
standard deviation (1834-1849) = 4.62
standard deviation (1850-1860) = 3.14
coefficient of variation (1834-1849) = 0.227
coefficient of variation (1850-1860) = 0.180

idea of note-issuing banks on a specie standard. This was the heyday of free
banking.

As can be seen, the average reserve ratios for the two subperiods do not
differ greatly. They are 20.38 percent for 1834-1849 and 17.41 percent for
1850-1860. Also, one may note that the year-to-year variations (as measured
by the coefficient of variation) are smaller for 1850-1860. One might protest,
however, that these time-series data combine both free banks and chartered
banks. Perhaps a cross-sectional approach would be preferable.

Table 5 provides that sort of comparison. There the states are divided into
free-banking and chartered banking categories. One can see that the disparity
between the average reserve ratios remains about the same: 14.9 percent for
free banking and 17.2 percent for chartered banking. The variations for the
free-banking states are slightly greater than those for the chartered banking
states.


===== PAGE 134 =====

American Free Banking 107

Table §
American Bank Reserve Ratios as of January 1, 1860 (by state)

Free Banking Chartered Banking
State Reserve Ratio State Reserve Ratio
Louisiana 38.6% Missouri 37.0%
Georgia 23.7 Kentucky 23.4
Tennessee 23.0 North Carolina 22.1
Indiana 22.3 Maryland 21.4
Alabama 22.2 Pennsylvania* 21.3
Iowa 20.0 Virginia 16.7
New York 15.6 South Carolina 15.5
Ohio 15.2 Maine 10.0
Massachusetts 15.1 Delaware 9.9
Florida 10.5 Rhode Island 6.3
New Jersey 8.9 New Hampshire 5.7
Connecticut 7.5
Wisconsin 5.5
Vermont 4.2
Michigan 4.0
Illinois 2.3
mean = 14.9% mean = 17.2%

Source: Amasa Walker, The Science of Wealth: A
Manual of Political Economy, 1969, 163.

Notes: standard deviation (free banking) = 9.45
standard deviation (chartered banking) = 8.78
coefficient of variation

(free banking) = 0.634
coefficient of variation
(chartered banking) = 0.510

*Pennsylvania did not adopt free banking until after
this date.

Clearly, chartered banks held slightly greater primary reserves. Whether or
not the difference implies that chartered banks were significantly safer may be
impossible to resolve. The common belief about free banking has been that the
absence of government supervision led to fraud, inflation, and chaos, but if
that were so, surely one would find that free banks often held very small specie
reserves. Otherwise, how could free banking be (allegedly) so attractive to
dishonest operators? Also, how could free banks manage to issue such exces-
sive quantities of notes that serious inflation resulted? Such allegations should
be questioned. It would appear plausible that holding a free bank’s notes in
antebellum America was no riskier than holding a chartered bank’s notes.

At present, a common measure of a financial intermediary’s prudence is its
capital/asset ratio. Table 6 provides information on such a ratio for the period


===== PAGE 135 =====

108 Free Banking

Table 6
American Bank Capital Ratios, 1834-1860 (ratio of capital stock to sum of loans
and discounts)

Year Capital Ratio Year Capital Ratio

1834 61.7% 1848 59.5%
1835 63.3 1849 62.4
1836 55.1 1850 59.7
1837 55.4 1851 55.1
1838 65.4 1852 ceo
1839 66.5 1853 50.8
1840 77.4 1854 54.1
1841 81.1 1855 57.7
1842 80.3 1856 54.2
1843 89.9 1857 54.2
1844 79.6 1858 67.7
1845 71.4 1859 61.2
1846 63.1 1860 60.9
1847 65.4

Source: Charles A. Conant, A History of Modern
Banks of Issue (New York: G.P. Putnam’s Sons, 1927)
391.

Notes: mean (1834-1849) = 68.6%
mean (1850-1860) = 57.6%
standard deviation (1834-1849) = 9.88
standard deviation (1850-1860) = 4.67

coefficient of variation (1834-1849) = 0.144
coefficient of variation (1850-1860) = 0.081

*No data are available.

1834—1860.'® Chartered banks show an average capital ratio of 68.6 percent.
Free banking exhibits an average of 57.6 percent. Again, this difference may
not be large enough to suggest any significant differences in bank management
policies. Furthermore, the ratios under free banking fluctuate noticeably less
than they do under chartered banking. The coefficients of variation are 0.081
and 0.144, respectively.

The data on reserve ratios and capital ratios may not be conclusive, but they
are suggestive, particularly when considered in conjunction with the conclu-
sions of those researchers whose work was reviewed above. That is, free bank-
ing does not seem to have been the disaster it is usually thought to have been,
despite the larger number of banks and the greater variety of banknotes that
accompanied it.


===== PAGE 136 =====

American Free Banking 109

SOME STYLIZED MACROECONOMIC FACTS

Recent research has argued that the traditional image of American free bank-
ing is seriously flawed. Both the prevalence of counterfeiting '* and fraud, and
the magnitude of noteholder losses seem to have been badly overstated. Fur-
thermore, the deficiencies of free banks are now thought to have stemmed largely
from the legal requirement that such banks hold suboptimal asset portfolios of
state bonds as security for their note issues and the restrictions on branching
(White 1986).%°

Such research is wonderfully illuminating, but it is more or less microecon-
omic in nature. It is neither inferior nor defective; it is simply incomplete?! It
does not address the fundamental macroeconomic question: How stable was the
economy as a whole? The traditional story about American free banking sug-
gests a period of rapid and erratic money growth, that is, a monetary series
that exhibited both severe fluctuations and a strongly positive secular trend.
From that premise, one would be likely to infer that wholesale and consumer
prices, interest rates, and stock prices exhibited a high degree of instability as
well, and that little real economic growth occurred.

In contrast to the above, one finds the following provocative assertion by
Richard Timberlake:

The banking and monetary system on the eve of the Civil War had enjoyed fifteen years
of relative stability . . . records for the period 1845-1860 imply an economic tranquil-
ity. . . . Growth in bank credit and the stock of money was as orderly as it had been
or would be in any other period of United States financial history. . . . Only the panic
of 1857 rippled the surface, and even this event was short-lived and relatively harm-
less. . . . The Civil War put an end to these idyllic conditions. (1978, 84-85)

Which of these views is more nearly correct? The purpose of this section is to
offer a tentative answer to that question.

The Data

Ideally, one would like to test the key implications of the model in Chapters
2 and 3. Those were that (1) nominal national income is maintained at all
times, (2) the price level is stable except in the face of per-capita productivity
changes, and (3) the market rate of interest remains equal to the natural rate.
Sadly, there are insufficient data to test those specific propositions. One must
be content with a ‘‘second-best’’ approach that is more general. Namely, the
limited data compel one to investigate merely the question of general stability.

In order to examine the issue of relative macroeconomic stability during the
free-banking period, data are offered on the monetary base per capita, the money
supply per capita, wholesale prices, consumer prices, the commercial paper
rate of interest, common stock prices, real income per capita, and industrial


===== PAGE 137 =====

110 Free Banking

output per capita. Data on unemployment rates are not included, because there
seem to be no such series that reliably extend back beyond about 1890.23 The
stability of each of the first six series is calculated (using three different mea-
sures). Average annual rates of growth in income and industrial output are
provided. Six different regimes in U.S. banking history are then compared in
terms of the stability of monetary growth, commodity prices, interest rates, and
stock prices, and the rate of real economic growth. The six regimes are the
time of state chartering of banks (1835-1849),2* the heyday of free banking
(1850-1860), the Greenback era (1866—1878), the classical gold standard (1879-
1914), the early days of the Federal Reserve, that is, prior to the domestic
abandonment of the gold standard (1919-1932), and the modern Fed system
(1959-1989). The war years 1861-1865 and 1915-19182° are excluded from
consideration.

Several empirical issues must be addressed before proceeding to the results.
First, some explanation of the three stability measures is in order. The mea-
sures used are the coefficient of variation (CV), the mean absolute percentage
change (MAPC), and the mean net percentage change (MNPC). The standard
deviation (or, alternatively, the variance) of a distribution is perhaps the most
commonly used measure of stability. However, the standard deviation is not
reliable when one is comparing the relative variation of distributions that have
very different mean values. In such a case, one needs the coefficient of varia-
tion, which equals the standard deviation divided by the mean.

There is still a potential problem with the CV. It will not always distinguish
between a series that has sharp period-to-period fluctuations but little secular
trend, and a series with small period-to-period fluctuations but a strong (posi-
tive or negative) secular trend. Therefore, to make that distinction, the MAPC
and MNPC are used.?® The MAPC sums the absolute values of the percentage
changes and divides by the number of periods. This gives a measure of short-
run (period-to-period) stability. The MNPC is the absolute value of the sum of
the percentage changes (positive changes net of negative changes) divided by
the number of periods. It provides a measure of long-run stability in the sense
that a mean-reverting series possesses long-run stability. In short, MAPC indi-
cates the magnitude of the fluctuations, whereas MNPC indicates the magnitude
of the secular trend.

Second, one must reiterate that the free-banking period is here taken to be
1850-1860 instead of 1837-1863. The justification is twofold: (1) As was
mentioned in an earlier section, only four states—Michigan (1837), New York
(1838), Georgia (1838), and Alabama (1849)—adopted free-banking statutes
prior to 1850, and (2) the years of the Civil War are being excluded for the
usual reason that wars grossly distort fundamental economic relationships.’
Since a number of states never adopted free banking, however, on what grounds
can one propose that free banking dominated the 1850-1860 period?

In 1860, the United States was composed of thirty-three states. Of those,
eighteen had some variant of free banking (Rockoff 1975, 3). Indeed, there


===== PAGE 138 =====

American Free Banking 111

were fourteen free-banking states by 1853 (out of thirty-one states altogether).
Moreover, several of the most populous states were among those that embraced
free banking: New York, Massachusetts, Pennsylvania, Ohio, Illinois, and In-
diana, for example (Rockoff 1975, 4).2% To be precise, out of a total resident
population of 31,513,000 in 1860, 21,218,000 (67.3 percent) lived in free-
banking states. 2’ Finally, one should not overlook the fact that the prime finan-
cial center of the United States—New York 3—was in a state that had an ex-
cellent free-banking system that had been in operation since 1838. It would
seem plausible that free banking did come to dominate the American monetary
system between 1850 and 1860.

One will notice that in the accompanying tables, both the money supply and
the monetary base are measured in per-capita terms. Considering the span of
time covered—150 years—during which there were enormous population changes,
a per-capita measure seems preferable to measuring the total money supply.>
Furthermore, these per-capita figures are broken down into both nominal and
real balances. In addition, three different estimates for the period from 1835 to
1860 are cited. The desire is to gain a clear and comprehensive view of mon-
etary movements, particularly for the free-banking era.

The commercial paper rate of interest is taken to represent ‘‘interest rates,’’
because it is one of the few interest rate series for which one can find data as
far back in time as the 1830s3? and that is still of economic significance today.

Regarding stock prices, the reader may wonder why two different indexes
are used. For the periods 1835-1860 and 1866-1878, the index is constructed
from railroad common stock prices, whereas for all later periods, the well-
known Standard and Poor index is used. The reliance upon railroad stock prices
in the early periods is due to the fact that, although a crude index of industrial
(mostly mining) stocks could have been constructed as far back as 1857, rail-
. road stocks were of greater economic importance (Macaulay 1938, 139fn). In-
deed, ‘‘until about 1909 the railroad stock market was the American security
market par excellence’’ (Macaulay 1938, 139).

Data on both consumer prices and wholesale prices are presented. Greater
credence is given to the wholesale price figures, however. It has been widely
observed that, with regard to the nineteenth century, the extant information on
wholesale prices is both more extensive and more reliable than that on con-
sumer prices. Thus, in the tables to follow, all real magnitudes are derived
from nominal magnitudes by using the wholesale price index.

Finally, per-capita figures for real national income and industrial production
are included in order to compare rates of growth under the various monetary
regimes.

The Results

Tables 7-10 provide figures for the money supply per capita (both nominal
and real). The nominal money balances are on page 114.


===== PAGE 139 =====

112 Free Banking

Table 7
Money Supply per Capita, 1835-1860 (currency plus deposits)

Year Nominal Real Year Nominal Real

1835 $14.52 $13.50 | 1848 $14.55* $16.49
1836 14.55% 11.86 | 1849 17.04% 19.32
1837 13.93% 11.26 | 1850 15.49 17.16
1838 14.81% 12.52 | 1851 16.96 19.01
1839 12.32% 10.23 | 1952 18.12 19.15
1840 10.65% 10.42 | 1853 19.62 18.81

1841 9.89% 10.00 | 1854 19.15 16.50
1842 8.12% 9.21 | 1855 19.52 16.50
1843 9.58% 11.89 | 1856 20.36 18.04

1844 10.36* 12.51 | 1857 16.43 13.76
1845 11.24* 12.60 | 1858 23.13% 23.13
1846 12.14 13.61 | 1859 21.23% 20.78
1847 12.49 12.90 | 1860 17.61*%*% 17.61

Sources: Milton Friedman and Anna J. Schwartz,
Monetary Statistics of the United States (New
York: National Bureau of Economic Research, 1970)
220-24. U.S. Bureau of the Census, Historical
Statistics of the United States, Colonial Times to
1970 (Washington, D.C.: Government Printing
Office, 1975) Series A 6-8.

Notes: Estimates are as of the end of the year
unless otherwise indicated.

Currency is taken to be the sum of bank-
notes and specie, as held by the public.

The nominal data were adjusted using the
price indexes from Table 17.

* Represents an average of upper and lower
estimates.

** Incorporates estimate of specie as of

June 1860.
Nominal Money Balances: Real Money Balances:
CV (1835-1849) = 0.1913 CV (1835-1849) = 0.1990
CV (1850-1860) = 0.1132 CV (1850-1860) = 0.1280

MAPC (1835-1849) = 10.378 MAPC (1835-1849) = 10.981
MAPC (1850-1860) = 11.607 MAPC (1850-1860) = 14.847
MNPC (1835-1849) = 1.855 MNPC (1835-1849) = 3.460
MNPC (1850-1860) = 1.415 MNPC (1850-1860) = 1.325


===== PAGE 140 =====

American Free Banking 113

Table 8
Money Supply per Capita, 1867-1914 (currency plus commercial bank deposits)

Year Nominal Real Year Nominal Real
1867 $35.16 $20.18 1891 $ 62.44 $71.28
1868 32.55 19.16 1892 68.07 83.11
1869 32.37 19.93 1893 62.54 74.54
1870 32.30 22.25 1894 61.87 82.16
1871 33.95 24.28 1895 64.34 83.89
1872 37.72 25.80 1896 60.18 82.44
1873 37.72 26.38 1897 62.09 84.82
1874 36.15 26.68 1898 69.90 91.85
1875 37.61 29.64 1899 80.67 98.50
1876 36.13 30.54 1900 83.82 95.14
1877 34.97 30.68 1901 94.56 108.81
1878 32.53 33.26 1902 101.17 109.37
1879 33.71 34.82 1903 105.69 112.80
1880 39.40 36.65 1904 109.34 116.57
1881 46.16 41.66 1905 120.16 127.29
1882 49.11 42.30 1906 127.14 130.94
1883 51.96 47.85 1907 131.13 128.06
1884 49.91 49.91 1908 127.69 129.24
1885 50.07 54.78 1909 138.88 130.90
1886 53.21 60.33 1910 142.85 129.28
1887 55.37 60.58 1911 149.09 146.31
1888 55.57 60.08 1912 157.21 144.89
1889 57.35 65.84 1913 159.90 145.76
1890 61.98 70.27 1914 163.24 152.56

sources: Milton Friedman and Anna J. Schwartz, A
Monetary History of the United States, 1867-1960
(Princeton: Princeton University Press, 1963)704-8.
Historical Statistics of the United States, 1975,
Series A 6-8.

Notes: The nominal data were adjusted using the
price indexes from Table 17.

Nominal Money Balances: Real Money Balances:
CV (1867-1878) = 0.0594 CV (1867-1878) = 0.1748
CV (1879-1914) = 0.4500 CV (1879-1914) = 0.3832

MAPC (1867-1878) = 4.248 MAPC (1867-1878) = 5.680
MAPC (1879-1914) = 5.972 MAPC (1879-1914) = 5.631
MNPC (1867-1878) = 0.566 MNPC (1867-1878) = 4.761
MNPC (1879-1914) = 4.737 MNPC (1879-1914) = 4.482


===== PAGE 141 =====

114 Free Banking

Table 9
Money Supply per Capita, 1919-1932 (currency plus commercial bank deposits)

Year Nominal Real

1919 $207.41 $ 95.27
1920 220.71 91.01
1921 195.27 127.38
1922 195.79 128.89
1923 202.92 128.43
1924 205.91 133.62
1925 220.13 135.38
1926 220.81 140.55
1927 217.30 144.96
1928 217.25 143.02
1929 216.96 144.93
1930 206.47 152.15
1931 190.54 166.27
1932 165.20 162.28

Sources: Milton Friedman and Anna J. Schwartz, A
Monetary History of the United States, 1867-1960,
1963, 709-13. Historical Statistics of the United
States, 1975, Series A 6-8.

Notes: The nominal data were adjusted using the
price indexes from Table 17.

Nominal Money Balances:

CV = 0.0728
MAPC = 4.471
MNPC = 1.547

Real Money Balances:
CV = 0.1525

MAPC = 5.971
MNPC = 4.653

Using CV Using MAPC Using MNPC

(1867-1878) 0.0594 (1867-1878) 4.248 (1867-1878) 0.566
(1919-1932) 0.0728 (1919-1932) 4.471 (1850-1860) 1.415
(1850-1860) 0.1132 (1959-1989) 4.838 (1919-1932) 1.547
(1835-1849) 0.1913 (1879-1914) 5.972 (1835-1849) 1.855
(1879-1914) 0.4500 (1835-1849) 10.378 (1959-1989) 4.731
(1959-1989) 0.4898 (1850-1860) 11.607 (1879-1914) 4.737


===== PAGE 142 =====

American Free Banking 115

Table 10
Money Supply (M1) per Capita, 1959-1989 (an average of monthly observations)

Year Nominal Real Year Nominal Real

1959 $797.93 $836.40 | 1975 $1322.72 $756.27
1960 785.65 822.67 | 1976 1383.77 756.57
1961 788.56 829.19 | 1977 1474.64 759.34
1962 795.78 839.43 | 1978 1578.53 754.19
1963 808.56 855.62] 1979 1681.65 714.08
1964 828.45 874.82] 1980 1764.94 656.60
1965 853.20 883.23 | 1981 1869.80 637.29
1966 882.86 884.63 | 1982 1972.63 659.08
1967 909.14 909.14 | 1983 2170.20 716.00
1968 963.52 940.02 | 1984 2300.82 741.48
1969 1010.38 948.71 | 1985 2487.86 805.65
1970 1035.13 937.62 | 1986 2792.57 931.48
1971 1090.32 957.26 | 1987 3056.29 993.27
1972 1154.77 969.58 | 1988 3156.88 986.22
1973 1226.91 907.48 | 1989 3154.89 939.23
1974 1276.39 797.25

Sources: Board of Governors of the Federal
Reserve System, Division of Research and
Statistics. U.S. Bureau of the Census,
Statistical Abstract of the United States
(Washington, D.C.: Government Printing Office,
1990) 7.

Notes: The nominal data were adjusted using the
price indexes from Table 18.

The current definition of Ml was used
throughout the data set.

Nominal Money Balances:
CV = 0.4898

MAPC = 4.838

MNPC = 4.731

Real Money Balances:

CV = 0.1210

MAPC = 3.790
MNPC = 0.525


===== PAGE 143 =====

116 Free Banking

Free banking performs rather well when stability is measured by either the CV
or the MNPC, but very poorly per the MAPC. Actually, the model would lead
one to expect something like this. That is, significant period-to-period changes
in the money supply were often the means by which nominal national income
was kept constant in that model. There should be no strong secular trend, how-
ever, and there 1s not (see the MNPC). The modern Fed does rather poorly,
ranking sixth, third, and fifth in terms of the CV, the MAPC, and the MNPC,
respectively. A surprise may be the classical gold standard. The traditional
argument has been that the growth in money under such a structure must be
quite stable because of the inelastic nature of the supply of gold. Yet these
figures reveal a definite positive trend as well as some considerable period-to-
period variation.

To see how robust these results are for free banking, two other series are
offered, one from A. Barton Hepburn and one from Peter Temin. These are
Tables 11 and 12, respectively. Once again, the tables show both nominal and
real balances, but the summaries which follow are for nominal balances. Per
Hepburn:

Using CV Using MAPC Using MNPC
(1835-1849) 0.2253 (1835-1849) 11.762 (1835-1849) 0.265
(1850-1860) 0.1069 (1850-1860) 9.930 (1850-1860) 5.401

Per Temin:

Using CV Using MAPC Using MNPC
(1835-1849) 0.1926 (1835-1849) 10.762 (1835-1849) 0.116
(1850-1858) 0.0867 (1850-1858) 10.460 (1850-1858) 4.159

With both the alternative series, free banking exhibits greater stability per the
CV and the MAPC, and less stability per the MNPC, than with the Friedman
and Schwartz data used originally. Overall, one might say that according to the
Friedman and Schwartz series, free banking exhibited relatively less short-run
stability and relatively more long-run stability than with the Hepburn and Temin
series. However, the results remain broadly similar in all three cases.

Tables 13-16 contain figures for the monetary base per capita. As with the
money supply data, the following figures are for nominal balances.

Using CV Using MAPC Using MNPC

(1919-1932) 0.0439 (1867-1878) 3.187 (1919-1932) 0.460
(1850-1860) 0.0543 (1919-1932) 3.572 (1850-1860) 1.446
(1867-1878) 0.1018 (1879-1914) 3.900 (1879-1914) 2.376
(1879-1914) 0.2218 (1850-1860) 4.625 (1867-1878) 3.187
(1835-1849) 0.2533 (1959-1989) 5.420 (1835-1849) 3.549
(1959-1989) 0.5279 (1835-1849) 9.453 (1959-1989) 5.259


===== PAGE 144 =====

American Free Banking 117

Table 11
Money Supply per Capita (Hepburn Estimate), 1835-1860
(currency plus deposits)

Year Nominal Real Year Nominal Real

1835 $14.82 $13.78 | 1848 $13.17 $14.93
1836 20.20 16.48 | 1849 12.37 14.03
1837 19.31 15.62 1850 14.75 16.33
1838 15.31 12.94 | 1851 17.02 19.08
1839 15.88 13.19 | 1852 cee A
1840 13.38 13.09 | 1853 17.83 17.10
1841 12.18 12.32 | 1854 20.90 18.00
1842 10.79 12.24 | 1855 20.23 17.10
1843 8.97 11.13 | 1856 20.56 18.21
1844 10.32 12.47 | 1857 21.66 18.14
1845 11.00 12.33 | 1858 17.45 17.45
1846 11.97 13.42 | 1859 19.36 18.94
1847 13.13 13.56 | 1860 19.77 19.77

Sources: A. Barton Hepburn, History of Coinage and
Currency in the United States, 1903, 118-20, 153-

54, 174. Historical Statistics of the United
States, 1975, Series A 6-8.

Notes: Currency is taken to be the sum of bank-
notes and specie, as held by the public.

The nominal data were adjusted using the
price indexes from Table 17.

*Incomplete data.
Nominal Money Balances:

CV (1835-1849) = 0.2253
CV (1850-1860) = 0.1069
MAPC (1835-1849) = 11.762
MAPC (1850-1860) = 9.930
MNPC (1835-1849) = 0.265
MNPC (1850-1860) = 5.401

Real Money Balances:

CV (1835-1849) = 0.1005
CV (1850-1860) = 0.0554
MAPC (1835-1849) = 7.103
MAPC (1850-1860) = 7.747
MNPC (1835-1849) = 0.548
MNPC (1850-1860) = 3.834


===== PAGE 145 =====

118 Free Banking

Table 12
Money Supply per Capita (Temin Estimate), 1835-1858
(currency plus deposits)

Year Nominal Real Year Nominal Real

1835 $16.40 $15.26 | 1847 $13.13 $13.56
1836 17.90 14.60 | 1848 12.13 13.75
1837 14.64 11.84 | 1849 14.54 16.49
1838 14.76 12.48 | 1850 17.15 18.99
1839 12.89 10.71 | 1851 cee ceo ®
1840 10.86 10.63 | 1852 18.10 19.13
1841 9.81 9.92 | 1853 21.22 20.35
1842 8.61 9.76 | 1854 20.29 17.48
1843 10.23 12.69 | 1855 20.63 17.44
1844 10.94 13.21 | 1856 21.66 19.19
1845 11.94 13.39 | 1857 17.15 14.36
1846 12.84 14.39 | 1858 19.05 19.05

Sources: Peter Temin, The Jacksonian Economy (New
York: W. W. Norton, 1969) 71, 159. Historical
Statistics of the United States, 1975, Series A
6-8 Ld

Notes: Currency is taken to be the sum of bank-
notes and specie, as held by the public.

The nominal data were adjusted using the
price indexes from Table 17.

*No data provided.
Nominal Money Balances:

CV (1835-1849) = 0.1926
CV (1850-1858) = 0.0867
MAPC (1835-1849) = 10.762
MAPC (1850-1858) = 10.460
MNPC (1835-1849) = 0.116
MNPC (1850-1858) = 4.159

Real Money Balances:

CV (1835-1849) = 0.1492
CV (1850-1858) = 0.0942
MAPC (1835-1849) = 8.707
MAPC (1850-1858) = 13.059
MNPC (1835-1849) = 1.247
MNPC (1850-1858) = 3.184


===== PAGE 146 =====

American Free Banking 119

Table 13
Monetary Base per Capita, 1835-1860

Year Nominal Real Year Nominal Real

1835 $4.33 $4.03 1848 $5.36 $6.08
1836 4.73 3.86 1849 6.57 7.45

1837 5.50 4.45 1850 7.58 8.39
1838 5.36 4.53 1851 7.91 8.87
1839 4.98 4,14 1852 8.72 9.22
1840 4.37 4.28 1853 8.54 8.19
1841 4.53 4.58 1854 8.68 7.48
1842 4.88 5.53 1855 8.40 7.10
1843 5.27 6.54 1856 8.54 7.56
1844 4.92 5.94 1857 8.55 7.16
1845 4.77 5.35 1858 8.17 8.17
1846 5.64 6.32 1859 7.58 7.42
1847 5.09 5.26 1860 7.54 7.54

Sources: Milton Friedman and Anna J. Schwartz,
Monetary Statistics of the United States, 1970, 220-
24. Historical statistics of the United States,
1975, Series A 6-8.

Notes: The nominal data were adjusted using the
price indexes from Table 17.

Nominal:

CV (1835-1849) = 0.2533
CV (1850-1860) = 0.0543
MAPC (1835-1849) = 9.453
MAPC (1850-1860) = 4.625
MNPC (1835-1849) = 3.549
MNPC (1850-1860) = 1.446

Real:

CV (1835-1849) = 0.1984
CV (1850-1860) = 0.0845
MAPC (1835-1849) = 12.246
MAPC (1850-1860) = 7.625
MNPC (1835-1849) = 5.288
MNPC (1850-1860) = 0.463


===== PAGE 147 =====

120 Free Banking

Table 14
Monetary Base per Capita, 1867-1914

Year Nominal Real Year Nominal Real

1867 $22.80 $13.09 1891 $22.27 $25.42
1868 20.28 11.94 1892 23.28 28.42
1869 19.49 12.00 1893 22.61 26.95
1870 19.00 13.09 1894 22.98 30.52
1871 18.96 13.56 1895 21.59 28.15
1872 18.63 12.74 1896 19.74 27.04
1873 18.21 12.73 1897 21.11 28.84
1874 18.19 13.42 1898 23.42 30.78
1875 17.19 13.55 1899 24.14 29.47
1876 16.37 13.84 1900 25.68 29.15
1877 16.08 14.11 1901 26.68 30.70
1878 15.88 16.24 1902 27.07 29.26
1879 15.93 16.46 1903 27.99 29.87
1880 18.60 17.30 1904 29.28 31.22
1881 20.55 18.55 1905 29.47 31.22
1882 21.28 18.33 1906 30.75 31.67
1883 21.89 20.16 1907 32.97 32.20
1884 21.47 21.47 1908 34.88 35.30
1885 21.76 23.81 1909 34.51 32.53
1886 20.63 23.39 1910 34.38 31.11
1887 21.23 23.23 1911 34.93 34.28
1888 21.64 23.39 1912 35.10 32.35
1889 21.34 24.50 1913 35.19 32.08
1890 21.66 24.56 1914 35.64 33.31

Sources: Milton Friedman and Anna J. Schwartz, A
Monetary History of the United States, 1867-1960,
1963, 799-801. Historical Statistics of the United
States, 1975, Series A 6-8.

Notes: The nominal data were adjusted using the
price indexes from Table 17.

Nominal: Real:
CV (1867-1878) = 0.1018 CV (1867-1878) = 0.0808
CV (1879-1914) = 0.2218 CV (1879-1914) = 0.1831

MAPC (1867-1878) = 3.187 MAPC (1867-1878) = 4.878
MAPC (1879-1914) = 3.900 MAPC (1879-1914) = 4.905
MNPC (1867-1878) = 3.187 MNPC (1867-1878) = 2.168
MNPC (1879-1914) = 2.376 MNPC (1879-1914) = 2.171


===== PAGE 148 =====

American Free Banking 121

Table 15
Monetary Base per Capita, 1919-1932

Year Nominal Real

1919 $63.34 $29.10
1920 67.51 27.84
1921 60.25 39.30

1922 57.09 37.58
1923 59.64 37.75
1924 60.24 39.09
1925 60.66 37.31
1926 60.67 38.62
1927 60.25 40.19
1928 59.11 38.91
1929 58.47 39.06
1930 56.36 41.53
1931 59.01 51.49
1932 62.37 61.27
Sources: Milton Friedman and Anna J.

Schwartz, A Monetary History of the United
States, 1867-1960, 1963, 801-4. Historical

Statistics of The United States, 1975, Series
A 6-8.

Notes: The nominal data were adjusted using
the price indexes from Table 17.

Nominal: Real:

CV = 0.0439 CV = 0.1982
MAPC = 3.572 MAPC = 9.144
MNPC = 0.460 MNPC = 6.614

Here free banking does very well in the long run, but only moderately well in
the short run. The early Fed exhibits consistent stability (ranking first or second
in each case), whereas the modern Fed ranks either fifth or sixth by all three
measures.

Some might argue at this point that the long-run stability of the money sup-
ply under free banking seems to be attributable to the stability of the commod-
ity base—gold—and thus is not indicative of the monetary stability of free
banking per se. Throughout this book, however, the model of free banking that
has been defended is that based on a specie standard. It has furthermore been
suggested that the two may be inseparable (White 1985, 124-26). The most
likely form of free banking in the future—and the only form that has existed in

the past®*—is that which issues inside money redeemable in some commodity,


===== PAGE 149 =====

122 Free Banking

Table 16
Monetary Base per Capita, 1959-1989

Year Nominal Real Year Nominal Real
1959 $244.62 $256.42 1975 $453.35 $259.21
1960 240.75 252.09 1976 481.42 263.21
1961 238.75 251.05 1977 514.33 264.85
1962 242.29 255.58 1978 555.66 265.48
1963 247.93 262.36 1979 593.72 252.11
1964 256.77 271.14 1980 638.05 237.37
1965 266.01 275.37 1981 671.71 228.94
1966 276.93 277.48 1982 707.25 236.30
1967 287.45 287.45 1983 763.39 251.86
1968 303.16 295.77 1984 819.28 264.03
1969 317.60 298.22 1985 873.73 282.94
1970 331.01 299.83 1986 941.70 314.11
1971 350.24 307.50 1987 1,025.02 333.12
1972 370.84 311.37 1988 1,093.50 341.61
1973 399.28 295.33 1989 1,128.76 336.04
1974 429.50 268.27

Sources: Board of Governors of the Federal Reserve
System, Division of Research and Statistics. U.S.
Bureau of the Census, Statistical Abstract of the
United States, 1990, 7.

Notes: The nominal data were adjusted using the
price indexes from Table 18.

Nominal: Real:

CV = 0.5279 CV = 0.1051
MAPC = 5.420 MAPC = 3.383
MNPC = 5.259 MNPC = 1.208

usually gold. In such a context, the stability of the commodity base is an at-
tribute of free banking itself.
Tables 17 and 18 present data on the wholesale price index:

Using CV Using MAPC Using MNPC

(1850-1860) 0.1000 (1879-1914) 4.316 (1879-1914) 0.387
(1879-1914) 0.1245 (1959-1989) 4.695 (1835-1849) 1.095
(1835-1849) 0.1468 (1850-1860) 5.822 (1850-1860) 1.425
(1866-1878) 0.1718 (1866-1878) 5.922 (1959-1989) 4.399
(1919-1932) 0.2184 (1835-1849) 6.195 (1919-1932) 4.876
(1959-1989) 0.4847 (1919-1932) 7.916 (1866-1878) 5.159


===== PAGE 150 =====

American Free Banking 123

Furthermore, Tables 19 and 20 deal with the consumer price index:

Using CV Using MAPC Using MNPC

(1850-1860) 0.0436 (1879-1914) 1.326 (1879-1914) 0.128
(1879-1914) 0.0506 (1850-1860) 2.722 (1850-1860) 0.775
(1919-1932) 0.0791 (1866-1878) 3.375 (1835-1849) 1.433
(1835-1849) 0.0865 (1835-1849) 3.790 (1919-1932) 1.584
(1866-1878) 0.1156 (1919-1932) 4.859 (1866-1878) 3.375
(1959-1989) 0.5174 (1959-1989) 4.994 (1959-1989) 4.994

The classical gold standard and the free-banking era clearly dominate the other
periods with regard to commodity prices. That such stability characterized the
1879-1914 period has, of course, long been recognized. It is not often noticed
that the 1850-1860 period also exhibited a high degree of price stability. As
one can see from the above figures, the modern Fed performs very poorly,
whereas the early Fed was only marginally better.

Tables 21-24 reveal the quarter-by-quarter movements in the commercial
paper rate of interest:

Using CV Using MAPC Using MNPC

(1879-1914) 0.2138 (1919-1932) 0.405 (1850-1860) 0.002
(1866-1878) 0.2804 (1879-1914) 0.673 (1879-1914) 0.017
(1850-1860) 0.2945 (1959-1989) 0.686 (1959-1989) 0.019
(1919-1932) 0.3071 (1866-1878) 1.145 (1836-1849) 0.022
(1959-1989) 0.4264 (1850-1860) 1.666 (1866-1878) 0.041
(1836-1849) 0.5507 (1836-1849) 2.520 (1919-1932) 0.065

The only period to rank near the top of the lists both short run and long run is
the classical gold standard. The time of state chartering of banks does quite
badly, whereas free banking exhibits large quarterly fluctuations but by far the
smallest secular trend.

Tables 25-28 review common stock prices:

Using CV Using MAPC Using MNPC

(1866-1878) 0.1379 (1866-1878) 7.251 (1866-1878) 0.222
(1835-1849) 0.1916 (1850-1860) 9.591 (1835-1849) 0.844
(1850-1860) 0.2270 (1879-1914) 10.020 (1919-1932) 1.685
(1879-1914) 0.2769 (1835-1849) 11.398 (1850-1860) 2.233
(1919-1932) 0.4568 (1959-1989) 11.480 (1879-1914) 2.709
(1959-1989) 0.5468 (1919-1932) 21.167 (1959-1989) 6.683


===== PAGE 151 =====

124 Free Banking

Table 17
Wholesale Price Index, 1835-1932 (1860 = 100)

Year Index | Year Index Year Index Year Index

1835 107.5 | 1858 100.0 | 1886 88.2 | 1909 106.1
1836 122.6 | 1859 102.2 | 1887 91.4 | 1910 110.5
1837 123.7 | 1860 100.0 | 1888 92.5 | 1911 101.9
1838 118.3 | 1866 187.1 | 1889 87.1 | 1912 108.5
1839 120.4 | 1867 174.2 | 1890 88.2 1913 109.7
1840 102.2 | 1868 169.9 | 1891 87.6 | 1914 107.0
1841 98.9 | 1869 162.4 | 1892 81.9 | 1919 217.7
1842 88.2 | 1870 145.2 1893 83.9 | 1920 242.5
1843 80.6 | 1871 139.8 | 1894 75.3 1921 153.3
1844 82.8 | 1872 146.2 | 1895 76.7 | 1922 151.9
1845 89.2 | 1873 143.0 | 1896 73.0 | 1923 158.0
1846 89.2 | 1874 135.5 | 1897 73.2 | 1924 154.1
1847 96.8 | 1875 126.9 | 1898 76.1 | 1925 162.6
1848 88.2 | 1876 118.3 1899 81.9 | 1926 157.1
1849 88.2 | 1877 114.0 | 1900 88.1 | 1927 149.9
1850 90.3 | 1878 97.8 1901 86.9 | 1928 151.9
1851 89.2 | 1879 96.8 | 1902 92.5 | 1929 149.7
1852 94.6 | 1880 107.5 | 1903 93.7 1930 135.7
1853 104.3 | 1881 110.8 1904 93.8 | 1931 114.6
1854 116.1 | 1882 116.1 | 1905 94.4 1932 101.8
1855 118.3 | 1883 108.6 | 1906 97.1

1856 112.9 | 1884 100.0 | 1907 102.4

1857 119.4 | 1885 91.4 | 1908 98.8

Source: Historical Statistics of the United States,
1975, Series E 40-63.

Notes: The war years 1861-1865 and 1915-1918 are

excluded.

CV (1835-1849) = 0.1468 MNPC (1835-1849) = 1.095
(1850-1860) = 0.1000 (1850-1860) = 1.425
(1866-1878) = 0.1718 (1866-1878) = 5.159
(1879-1914) = 0.1245 (1879-1914) = 0.387
(1919-1932) = 0.2184 (1919-1932) = 4.876

MAPC (1835-1849) = 6.195
(1850-1860) = 5.822
(1866-1878) = 5.922
(1879-1914) = 4.316
(1919-1932) = 7.916


===== PAGE 152 =====

American Free Banking 125

Table 18
Wholesale Price Index, 1959-1989 (1967 =100)

Year Index Year Index
1959 95.4 1975 174.9
1960 95.5 1976 182.9
1961 95.1 1977 194.2
‘1962 94.8 1978 209.3
1963 94.5 1979 235.5
1964 94.7 1980 268.8
1965 96.6 1981 293.4
1966 99.8 1982 299.3

1967 100.0 1983 303.1
1968 102.5 1984 310.3
1969 106.5 1985 308.8
1970 110.4 1986 299.8
1971 113.9 1987 307.7
1972 119.1 1988 320.1
1973 135.2 1989 335.9
1974 160.1

Source: Various issues of the Survey of
Current Business.

Notes: CV = 0.4847
MAPC = 4.695
MNPC = 4.399

Here the Greenback era totally dominates. Free banking does fairly well, bet-
ter, for example, than the classical gold standard by all three measures. The
modern Fed brings up the rear, with the early Fed doing slightly better.

In addition to the issue of relative stability, one might want to compare rates
of economic growth across the various monetary regimes. Tables 29 and 30
show real national income per capita for selected years. For comparative pur-
poses, one may consider the following figures for the average annual percent-
age change:

(1869-1879) = + 3.49
(1959-1989) = + 2.57
(1879-1907/1911) = + 2.10
(1839-1849) = + 1.61
(1849-1859) = + 1.37
(1919-1932) = + 0.68


===== PAGE 153 =====

126 Free Banking

Table 19
Consumer Price Index, 1835-1932 (1860=100)

Year Index | Year Index | Year Index Year Index

1835 114.8 | 1858 96.3 1886 100.0 1909 100.0
1836 122.2 | 1859 100.0 | 1887 100.0 | 1910 103.7
1837 125.9 | 1860 100.0 | 1888 100.0 | 1911 103.7
1838 118.5 | 1866 163.0 | 1889 100.0 | 1912 107.4
1839 118.5 | 1867 155.6 | 1890 100.0 | 1913 110.0
1840 111.1 | 1868 148.1 | 1891 100.0 | 1914 111.5
1841 114.8 | 1869 148.1 | 1892 100.0 | 1919 191.9
1842 107.4 | 1870 140.7 | 1893 100.0 1920 222.2
1843 103.7 | 1871 133.3 1894 96.3 1921 198.5
1844 103.7 | 1872 133.3 1895 92.6 1922 185.9
1845 103.7 | 1873 133.3 1896 92.6 | 1923 189.3
1846 100.0 | 1874 125.9 1897 92.6 | 1924 189.6
1847 103.7 | 1875 122.2 1898 92.6 1925 194.4
1848 96.3 | 1876 118.5 | 1899 92.6 | 1926 196.3
1849 92.6 | 1877 118.5 | 1900 92.6 | 1927 192.6
1850 92.6 | 1878 107.4 | 1901 92.6 1928 190.0
1851 92.6 | 1879 103.7 | 1902 96.3 1929 190.0
1852 92.6 | 1880 107.4 1903 100.0 | 1930 185.2
1853 92.6 | 1881 107.4 1904 100.0 | 1931 168.9
1854 100.0 | 1882 107.4 1905 100.0 1932 151.5
1855 103.7 | 1883 103.7 1906 100.0

1856 100.0 | 1884 100.0 | 1907 103.7

1857 103.7 | 1885 100.0 | 1908 100.0

Source: Historical Statistics of the United States,
1975, Series E 135-66.

Notes: The war years 1861-1865 and 1915-1918 are

excluded.

CV (1835-1849) = 0.0865 MNPC (1835-1849) = 1.433
(1850-1860) = 0.0436 (1850-1860) = 0.775
(1866-1878) = 0.1156 (1866-1878) = 3.375
(1879-1914) = 0.0506 (1879-1914) = 0.128
(1919-1932) = 0.0791 (1919-1932) = 1.584

MAPC (1835-1849) = 3.790
(1850-1860) = 2.722
(1866-1878) = 3.375
(1879-1914) = 1.326
(1919-1932) = 4.859


===== PAGE 154 =====

American Free Banking 127

Table 20
Consumer Price Index, 1959-1989 (1967 = 100)

Year Index Year Index
1959 87.3 1975 161.2
1960 88.6 1976 170.5
1961 89.6 1977 181.5
1962 90.6 1978 195.4
1963 91.8 1979 217.4
1964 93.0 1980 246.7
1965 94.5 1981 272.4
1966 97.3 1982 289.1

1967 100.0 1983 298.4
1968 104.2 1984 311.1
1969 109.8 1985 322.2
1970 116.3 1986 328.4
1971 121.3 1987 340.4
1972 125.3 1988 354.2
1973 133.1 1989 371.3
1974 147.7

Source: Various issues of the Survey of
Current Business.

Notes: CV = 0.5174
MAPC = 4.994
MNPC = 4.994

Free banking seems to do rather feebly in relative terms. However, one should
note that (1) the Greenback era experienced its rapid growth at least in part
because it was a period of recovery from a devastating war and (2) the massive
expansion of the public sector in recent decades has surely introduced an up-
ward bias into such measures of growth for the 1959-1989 period. A direct
measure of production might be preferable. Tables 31 and 32 display indexes
of industrial production per capita for selected years. The summary of the av-
erage annual percentage changes appears as follows:

(1829/1839-1839/1849) = + 4.73
(1839/1849—1849/1859) = + 4.31
(1879-1914) = +2.81
(1959-1989) = + 2.45
(1866-1878) = + 1.87
(1919-1932)= — 2.24


===== PAGE 155 =====

128 Free Banking

Table 21
Commercial Paper Rate of Interest at Boston and New York, 1836-1860
(an average of observed rates, by quarter)

| Quarter Rate Quarter Rate Quarter Rate Quarter Rate

1836Q1 10.7 1842Q2 8.0 184803 14.5 1854Q4 12.3
1836Q2 14.5 1842Q3 7.4 184804 15.5 1855Q1 10.2
1836Q3 20.5 184204 6.7 184901 12.0 1855Q2 7.6
1836Q4 28.0 1843Q1 5.7 1849Q2 10.5 1855Q3 7.2
1837Q1 18.7 1843Q2 4.7 1849Q3 8.3 185504 10.9
1837Q2 22.7 184303 3.8 184904 9.5 1856Q1 10.2
1837Q3 7.3 184304 3.8 185001 8.9 1856Q2 7.7
1837Q4 8.0 1844Q1 4.2 1850Q2 8.2 1856Q3 7.8
1838Q1 12.7 1844Q2 5.0 1850Q3 7.5 1856Q4 9.8
1838Q2 10.4 1844Q3 5.1 185004 7.5 1857Q1 9.3
1838Q3 6.3 184404 5.1 185101 7.4 1857Q2 7.8
1838Q4 7.1 1845Q1 5.7 185102 7.7 1857Q3 14.3
183901 7.5 1845Q2 5.8 185103 11.5 1857Q4 13.3
1839Q2 8.0 184503 6.0 185104 12.2 185801 6.4
1839Q3 14.3 184504 6.8 1852Q1 7.8 1858Q2 4.6
183904 23.1 184601 8.0 1852Q2 5.9 1858Q3 4.2
1840Q1 10.0 1846Q2 10.2 185203 6.0 185804 4.7
18400Q2 7.8 184603 5.3 185204 6.0 1859901 5.6
184003 6.4 184604 6.7 185301 9.2 1859Q2 6.4
184004 6.5 1847Q1 9.7 1853Q2 9.1 185903 7.0
1841Q1 6.5 1847Q2 7.7 1853Q3 9.8 1859Q4 7.4
18410Q2 6.2 1847Q3 7.8 1853Q4 12.9 1860Q1 7.1
184103 6.2 184704 13.0 1854Q1 8.5 1860Q2 4.8
18410Q4 8.3 1848Q1 15.5 1854Q2 10.7 1860Q3 5.8
1842Q1 10.5 1848Q2 15.0 1854Q3 10.0 1860Q4 9.6

Source: Walter B. Smith and Arthur H. Cole,
Fluctuations in American Business, 1790-1860
(Cambridge, Mass.: Harvard University Press, 1935)
192-94.

Notes: CV (1836Q1-1849Q4) = 0.5507
CV (1850Q1-1860Q4) = 0.2945
MAPC (1836Q1-1849Q4) = 2.520
MAPC (1850Q1-1860Q4) = 1.666
MNPC (1836Q1-1849Q4) = 0.022
MNPC (1850Q1-1860Q4) = 0.002


===== PAGE 156 =====

American Free Banking 129

Table 22
Commercial Paper Rate of Interest at New York City, 1866-1914 (an average of
observed rates, by quarter)

| Quarter Rate Quarter Rate Quarter Rate Quarter Rate

186601 7.32 | 187802 4.57 | 189003 5.46 | 190204 5.90
186602 6.10 | 187803 4.01 | 189004 6.66 | 1903Q1 5.07
186603 5.68 | 187804 5.21 | 189101 5.36 | 190302 5.02
1866Q4 6.34 1879Q1 4.40 189102 5.32 1903Q3 5.79
186701 7.22 | 187902 4.71 | 189103 5.71 | 190304 5.89
1867Q2 7.07 | 187903 5.08 | 189104 5.16 | 190401 4.78
1867Q3 6.72 | 187904 6.05 | 1892Q1 3.94 | 1904Q2 3.86
186704 8.30 | 188001 5.40 | 189202 3.19 | 190403 3.91
1868Q1 7.08 | 1880Q2 5.08 | 189203 4.05 | 1904Q4 4.27
1868Q2 6.78 | 1880Q3 4.91 | 189204 5.27 | 1905Q1 3.91
1868Q3 6.62 | 188004 5.52 | 189301 5.62 | 190502 3.90
186804 8.56 | 1881Q1 5.39 | 189302 6.97 | 190503 4.35
186901 8.47 | 188102 4.25 | 189303 9.92 190504 5.45
186902 9.11 | 188103 4.88 | 189304 4.65 | 1906Q1 5.12
1869Q3 10.25 | 188104 6.27 | 1894Q1 3.27 | 1906Q2 5.34
186904 10.83 | 188201 5.54 | 1894Q2 2.98 | 190603 5.99
187001 7.96 | 188202 5.01 | 189403 3.12 | 190604 6.27
1870Q2 6.34 | 188203 5.67 | 189404 2.81 | 1907Q1 6.09
1870Q3 6.94 | 188204 6.35 | 1895Q1 3.54 | 1907Q2 5.62
187004 7.76 | 1883Q1 5.75 | 1895Q2 3.12 | 1907Q3 6.27
1871Q1 6.70 | 1883Q2 5.55 | 189503 3.48 | 190704 7.39
187102 5.78 | 188303 5.46 | 189504 4.55 | 190801 5.74
1871Q3 5.65 | 188304 5.73 | 1896Q1 5.68 | 1908Q2 4.01
187104 9.75 | 188401 4.75 | 189602 4.68 | 1908Q3 3.76
1872Q1 8.16 | 1884Q2 5.18 | 189603 7.05 | 1908Q4 3.98
187202 7.29 | 188403 5.65 | 189604 5.81 | 190901 3.58
1872Q3 8.00 | 188404 5.23 | 189701 3.21 | 190902 3.40
187204 11.08 | 1885Q1 4.55 | 189702 3.39 | 190903 3.87
1873Q1 9.59 | 188502 3.73 | 1897Q3 3.74 | 190904 5.06
1873Q2 8.78 | 188503 3.64 | 189704 3.66 | 1910Q1 4.56
1873Q3 9.26 188504 4.31 1898Q1 3.67 191002 4.81
187304 13.60 | 188601 4.03 | 189802 4.55 | 191003 5.45
187401 6.53 | 188602 4.05 | 1898Q3 3.80 | 191004 5.24
1874Q2 5.82 | 188603 4.98 | 189804 3.25 | 1911Q1. 3.98
187493 5.77 | 188604 5.98 | 189901 3.27 | 1911Q2 3.65
187404 5.81 | 188701 5.22 | 189902 3.53 | 191103 4.17
1875Q1 5.45 | 1887Q2 5.24 | 189903 4.32 | 191104 4.31
1875Q2 4.80 | 188703 6.49 | 189904 5.50 | 191201 3.9%
1875Q3 5.05 | 188704 6.04 | 1900Q1 4.74 | 191202 4.11
187504 6.44 | 188801 5.22 | 1900Q2 3.88 | 191203 5.03
1876Q1 5.72 | 188802 4.82 | 1900Q3 4.19 | 191204 5.88
1876Q2 5.10 | 188803 4.57 | 190004 4.73 | 191301 s.16
1876Q3 4.05 | 1888Q4 4.93 | 1901Q1 3.82 | 1913Q2 5.58
187604 5.66 | 188901 4.47 | 190102 3.96 | 191303 5.95
187701 4.83 | 188902 4.01 | 190103 4.58 | 191304 5.64
187702 4.15 | 188903 4.95 | 1901Q4 4.17 191401 4.07
187703 5.39 | 188904 6.03 | 190201 4.28 | 191402 3.83
1877Q4 6.35 | 1890Q1 5.29 | 190202 4.48 | 191403 5.83
1878Q1 5.43 | 1890Q2 5.06 | 190203 5.02 | 191404 5.43



===== PAGE 157 =====

130 Free Banking

Table 22— Continued

Source: Frederick R. Macaulay, Some Theoretical
Problems Suggested by the Movements of Interest
Rates, Bond Yields, and Stock Prices in the United
States since 1856 (New York: National Bureau of
Economic Research, 1938) A 144-56.

Notes: CV (1866-1878) = 0.2804
CV (1879-1914) = 0.2138
MAPC (1866-1878) = 1.145
MAPC (1879-1914) = 0.673
MNPC (1866-1878) = 0.041
MNPC (1879-1914) = 0.017

Table 23
Commercial Paper Rate of Interest at New York City, 1919-1932 (an average of
observed rates, by quarter)

| Quarter Rate Quarter Rate Quarter Rate Quarter Rate

191991 5.29 | 192203 4.13 1926Q1 4.34 | 192903 6.13
1919Q2 5.34 | 192204 4.67 1926Q2 4.13 1929Q4 5.67
191903 5.38 | 1923Q1 4.75 1926Q3 4.34 193001 4.63
191904 5.46 | 192302 5.13 192604 4.54 193002 3.71
192001 6.42 | 192303 5.21 | 1927Q1 4.17 1930Q3 3.08
192002 7.80 | 192304 5.17 192702 4.17 193004 2.92
192003 8.13 | 192401 4.88 | 192703 4.08 193101 2.67
1920Q4 8.09 | 192402 4.42 192704 4.00 193102 2.21
1921Q1 7.71 | 1924Q3 3.29 192801 4.04 193103 2.00
1921Q2 7.09 | 192404 3.34 | 192802 4.54 1931Q4 3.67
1921Q3 6.17 | 1925Q1 3.75 192803 5.38 1932Q1 3.80
192104 5.50 | 1925Q2 3.92 1928Q4 5.42 1932Q2 3.13
1922Q1 4.88 | 192503 4.04 1929Q1 5.59 1932Q3 2.29
192202 4.42 | 192504 4.38 192902 6.00 | 193204 1.71

Source: Board of Governors of the Federal Reserve
System, Banking and Monetary Statistics, 1914-1941
(Washington, D.C.: Government Printing Office,
1943) 449-51.

Notes: CV = 0.3071
MAPC = 0.405
MNPC = 0.065


===== PAGE 158 =====

American Free Banking 131

Table 24
Commercial Paper Rate of Interest at New York City, 1959-1989 (an average of
observed rates, by quarter)

Quarter Rate Quarter Rate Quarter Rate Quarter Rate

1959Q1 3.30 1966Q4 6.00 197403 11.53 198202 13.48
1959Q2 3.60 | 196701 5.45 | 197404 9.05 | 1982Q3 11.55
195903 4.19 1967Q2 4.72 1975Q1 6.56 198204 8.81
195904 4.76 | 1967Q3 4.97 | 197502 5.92 | 1983Q1 8.34
1960Q1 4.69 | 196704 5.30 | 197503 6.67 | 198302 8.61
1960Q2 4.07 | 1968Q1 5.58 | 1975Q4 6.12 | 1983Q3 9.44
196003 3.37 | 196802 6.08 | 197601 5.29 | 1983Q4 9.19
196004 3.27 | 196803 5.96 | 197602 5.57 | 1984Q1 9.45
196101 3.01 196804 5.96 1976Q3 5.53 1984Q2 10.77
196102 2.86 | 196901 6.66 | 197604 4.99 | 1984Q3 11.15
1961Q3 2.90 | 1969Q2 7.54 | 1977Q1F 4.81 | 1984Q4 9.26
196104 3.06 | 196903 8.49 | 197792 5.24 | 198501 8.69
196201 3.24 196904 8.62 197703 5.81 1985Q2 7.91
1962Q2 3.20 | 1970Q1 8.55 | 197704 6.59 | 1985Q3 7.72
196203 3.33 | 197002 8.17 | 1978Q1 6.80 | 198504 7.70
196204 3.26 | 197003 7.84 | 1978Q2 7.20 | 1986Q1 7.41
196301 3.31 197004 6.29 197803 8.08 198602 6.54
196302 3.32 | 1971Q1 4.59 | 1978Q4 9.90 | 198603 5.89
196303 3.70 | 1971Q2 5.04 | 197901 10.10 | 1986Q4, 5.73
1963Q4 3.91 | 197103 5.74 | 197902 9.85 | 1987Q1 5.95
196401 3.95 | 197104 5.07 | 197903 10.60 | 198702 6.85
196402 3.93 | 197201 4.06 | 197904 13.10 | 198703 7.03
196403 3.91 | 1972Q2 4.58 | 1980Q1 14.25 | 1987Q4 7.54
196404 4.06 197203 4.93 198002 10.75 198801 6.71
1965Q1 4.30 | 1972Q4 5.33 | 1980Q3 9.65 | 1988Q2 7.25
1965Q2 4.38 197301 6.30 198004 14.51 198803 8.16
196503 4.38 | 1973Q2 7.47 | 1981Q1 14.52 | 1988Q4 8.59
1965Q4 4.47 197303 9.87 198102 15.35 198901 9.45
1966Q1 4.97 | 197304 8.98 | 198103 16.21 | 198902 9.29
196602 5.43 | 197401 8.30 | 198104 12.94 | 198903 8.39
1966Q3 5.79 | 1974Q2 10.46 | 1982Q1 13.70 | 1989Q4 8.06

Source: Various issues of the Survey of Current
Business.

Notes: CV = 0.4264
MAPC = 0.686
MNPC = 0.019


===== PAGE 159 =====

132 Free Banking

Table 25
Index of Common Stock Prices, 1835-1860 (1853 =100)

Year Index Year Index Year Index

1835 109.7 1844 84.2 1853 100.0
1836 97.7 1845 87.9 1854 85.2
1837 80.5 1846 86.1 1855 74.3
1838 74.4 1847 89.4 1856 69.9
1839 73.5 1848 80.8 1857 59.4
1840 67.4 1849 81.4 1858 55.0
1841 64.3 1850 84.9 1859 50.0
1842 49.0 1851 92.4 1860 59.6
1843 55.6 1852 98.7

Source: Walter B. Smith and Arthur H.
Cole, Fluctuations in American Business,
1790-1860, 1935, 183-84.

Notes: Composed entirely of railroad
stocks, which were the most
important stocks of the time.

CV (1835-1849) = 0.1916
CV (1850-1860) = 0.2270
MAPC (1835-1849) = 11.398

MAPC (1850-1860) = 9.591
MNPC (1835-1849) = 0.844
MNPC (1850-1860) = 2.233

In terms of industrial production, free banking exhibits strong growth, being
exceeded only by the era of chartered banking, which preceded it. Of course,
the early years of the Fed—including as they do the onset of the Great
Depression >*—show a net decline in industrial production.

A Tentative Judgment

Overall, what picture of free banking is painted by the data presented in this
section? One sees that money supply fluctuations were often large in the short
run but showed little secular trend over the long run. This pattern was repeated
for interest rates. Regarding both consumer prices and wholesale prices, free
banking was among the top three periods by every measure. Stock prices dur-
ing the heyday of free banking were only modestly stable, however. In relative


===== PAGE 160 =====

American Free Banking 133

Table 26
Index of Common Stock Prices, 1866-1878 (1900 = 100)

Year Index Year Index Year Index

1866 58.28 1871 76.57 1876 64.44
1867 59.20 1872 80.66 1877 49.55
1868 66.63 1873 77.00 1878 53.68
1869 72.48 1874 72.69
1870 73.50 1875 70.67

Source: Frederick R. Macaulay, Some
Theoretical Problems Suggested by the
Movements of Interest Rates, Bond Yields,
and Stock Prices in the United States since
1856 (New York: National Bureau of
Economic Research, 1938) A 144-47.

Notes: Composed entirely of railroad
stocks, which were the most important
stocks of the time.

Cv = 0.1379
MAPC = 7.251
MNPC = 0.222

terms, free banking was accompanied by little growth in real national income
but substantial growth in industrial production.

One might think about two benchmarks: the classical gold standard (1879—
1914) and the modern Fed (1959-1989). The former is often lauded as a period
of considerable stability and prosperity. The latter should—if the apologists for
central banking are correct—possess all the virtues that have so often been
alleged to have been absent from free banking. Free banking exhibited greater
long-run stability of the money supply, interest rates, and stock prices than
either the classical gold standard or the modern Fed. The variability of (1)
consumer prices (both short- and long-run) and (2) wholesale prices (long-run)
was less under free banking than during the years 1959-1989. Also, the growth
rate of industrial production exceeded that of either the classical gold standard
or the modern Fed.

One must be cautious in drawing conclusions from the data presented here.
First of all, much of those data have been resurrected from the rather distant
past and, as such, their reliability is open to question. However, as a partial
counterpoint, it may be noted that the results for the money supply under free
banking remain robust for three different estimates of that series. Second, the
American experiment with free banking was not a pure test of the application
of laissez-faire principles to banking. Be that as it may, and assuming the data


===== PAGE 161 =====

134 Free Banking

Table 27
Standard & Poor’s Index of Common Stock Prices, 1879-1932 (1941-1943 = 100)

Year Index Year Index Year Index

1879 41.2 1896 42.3 1913 85.1
1880 52.1 1897 44.5 1914 80.8
1881 62.5 1898 50.5 1919 87.8
1882 59.0 1899 62.9 1920 79.8
1883 56.3 1900 61.5 1921 68.6
1884 47.4 1901 78.4 1922 84.1
1885 46.0 1902 84.2 1923 85.7
1886 53.6 1903 72.1 1924 90.5
1887 55.3 1904 70.5 1925 111.5
1888 52.0 1905 89.9 1926 125.9
1889 53.2 1906 96.4 1927 153.4
1890 52.7 1907 78.4 1928 199.5
1891 50.3 1908 77.8 1929 260.2
1892 55.5 1909 97.1 1930 210.3
1893 47.8 1910 93.5 1931 136.6
1894 43.9 1911 92.4 1932 69.3
1895 45.3 1912 95.3

Source: Historical Statistics of the
United States, 1975, Series X 492-98.

Notes: The war years 1915-1918 are
excluded.

CV (1879-1914) = 0.2769
CV (1919-1932) = 0.4568
MAPC (1879-1914) = 10.020
MAPC (1919-1932) = 21.167
MNPC (1879-1914) = 2.709
MNPC (1919-1932) = 1.685

are reasonably accurate, it appears that American free banking was indeed con-
sistent with a significant degree of (particularly long-run) macroeconomic sta-
bility, contrary to popular belief.

The impression has been assiduously cultivated by the opponents of a banking currency
that the early American banks issued a volume of circulating notes enormously in excess
of the legitimate demands of business. This impression is absolutely unfounded and the
proof is afforded by the figures. (Conant 1927, 394)

CONCLUSION

Neither the Scottish nor the American episode of free banking was a case of
true laissez-faire banking. They were only approximations to the model. The


===== PAGE 162 =====

American Free Banking 135

Table 28
Standard & Poor’s Index of Common Stock Prices, 1959-1989 (1941-1943 = 100)

Year Index Year Index

1959 573.8 1975 861.6
1960 6558.5 1976 1020.1
1961 662.7 1977 982.0
1962 623.8 1978 960.2
1963 698.7 1979 1030.1
1964 813.7 1980 1187.8
1965 881.7 1981 1280.4
1966 852.6 1982 1197.1
1967 919.3 1983 1604.1
1968 987.0 1984 1604.6
1969 978.4 1985 1868.4
1970 832.2 1986 2363.4
1971 982.9 1987 2868.3
1972 1092.0 1988 2657.9
1973 1074.3 1989 3228.4
1974 828.4

Sources: Historical Statistics of the
United States, 1975, Series X 492-98.
Various issues of the Survey of Current
Business.

Notes: CV = 0.5468
MAPC = 11.480
MNPC = 6.683

various shortcomings of and restrictions upon Scottish free banking were enum-
erated in Chapter 5. As for the United States, there were few interest rate
controls, impositions of unlimited liability, prohibitions of small-denomination
notes, or specially privileged banks. However, the American free banks labored
under two key restrictions that were absent from the Scottish system: (1) They
were required to hold state bonds as security for their note issues, and (2) they
were subject to severe limitations on both intrastate and interstate branching.
These restrictions had potentially adverse effects on both the assets and liabili-
ties of banks.

The bond security requirement forced a connection between banks’ issuance
of notes (their chief liability) and the holding of state bonds. Although the
‘‘ostensible aim of the restriction was to reduce the noteholders’ exposure to
losses, its actual impact may well have been the reverse’ (White 1986, 892).
This seemingly paradoxical result stemmed from the following: (1) Allowing
free banks to buy state bonds at market value and then to issue notes based on
the face value of those bonds encouraged some degree of fraud, a possibility
discussed earlier in this chapter; (2) the bond security requirement forced free


===== PAGE 163 =====

136 Free Banking

Table 29
Real National Income per Capita, 1839-1932 (in 1860 prices)

Year Income Percent
Change

1839-1840 $101.45 2  ——e-——--
1849-1850 119.02 +17.3
1859-1860 136.45 +14.6
1869 107.65 -21.1
1879 151.72 +40.9
1889 198.88 +31.1
1897-1901 238.33 +19.8
1907-1911 283.30 +18.9
1919 308.53 + 8.9
1929 476.18 +54.3
1932 336.78 -29.3

Sources: National Bureau of Economic Research,

Trends in the American Economy in the Nineteenth
Century (Princeton: Princeton University Press,
1960) 360. Historical Statistics of the United

States, 1975, Series F 6-8, F 250-261.

Notes: Nominal income was adjusted using the price
indexes from Table 17.

Average Annual Percentage Change:

(1839-1849) = +1.61
(1849-1859) = +1.37
(1859-1879) = +0.53
(1869-1879) = +3.49
(1879-1907/1911) = +2.10
(1919-1932) = +0.68

banks to be exposed unnecessarily to the risk of falling state bond prices; that
is, it caused them to hold suboptimal asset portfolios; and (3) since free banks
could only issue notes in proportion to their existing bond holdings, in the short
run, they sometimes could not deal with a currency run by merely issuing more
notes—they might have to pay out specie in order to satisfy consumer demand
for cash (White 1986, 892-94). This last item is a particularly important vio-
lation of the model in Chapters 2 and 3. In that model, an advantage of free
banking over central banking was the capacity of individual banks to issue
notes on short notice so as to keep currency runs from becoming redemption
runs. In practice, the bond restriction significantly reduced such a theoretical
advantage.


===== PAGE 164 =====

American Free Banking 137

Table 30
Real National Income per Capita, 1959-1989 (in 1967 prices)

Year Income Percent Change

1959 $2,363 =  —-=--
1969 3,595 +52.1
1979 3,713 + 3.3
1989 5,065 +36.4

Sources: Various issues of the Survey of Current
Business. Statistical Abstract of the United
States, 1990, 7.

Notes: Nominal income was adjusted using the
price indexes from Table 18.

Average annual percentage change
(1959-1989) = +2.57

Donald Wells and Leslie Scruggs point out the very real practical benefit that
accrues to banks and their customers when banks are granted the legal right to
issue notes. Oddly enough, the event they cite is the liquidity crisis of the
winter of 1914-1915 (1986a, 907-8). Banks were at that time permitted to
issue currency under the provisions of the Aldrich-Vreeland Act of 1908 (amended
in 1913 and 1914). The result was that ‘‘currency was issued in exchange for
deposits when the public demanded it, and was extinguished when demand
subsided. Banks were able to conserve their gold certificates and greenbacks as
reserves by paying out the bank notes for use as hand-to-hand currency . . .
the Aldrich-Vreeland Act worked far better than the Fed did in the early 1930s”
(Wells and Scruggs 1986a, 908).

The other major distorting restriction on American free banks was the wide-
spread prohibition on establishing branch offices. White explains that restric-
tions on branching not only prevent banks from holding properly diversified
asset portfolios, but they also affect banks’ liabilities. This follows from the
fact that ‘‘a branched bank is less susceptible to random withdrawals or even
runs by depositors in any area because it has a broad source of deposits (it can
rely on the law of large numbers) and can transfer reserves from surplus to
deficit branches. A unit bank rests on a narrower and less stable base’’ (White
1986, 895-96).3% Stephen Williamson concurs: ‘‘The unit banking restriction
results in a banking system in which banks are less diversified than they would
be otherwise. These banks are therefore more sensitive to idiosyncratic shocks,
and they experience runs and fail with higher probability’’ (1989, 22).

The negative impact of branching restrictions may be seen by comparing the
American and Canadian systems. Canadian banks in the period 1870 to 1913


===== PAGE 165 =====

138 Free Banking

Table 31
Index of Industrial Output per Capita, 1829-1932 (1899 =100)

Year(s) Index Percent Change
1829-1839 11.4%

1839-1849 18.1% + 58.8
1849-1859 27.6% + 52.5
1866 43.0 + 55.8
1879 54.7 + 27.2
1914 144.2 +163.6
1919 163.2 + 13.2
1929 229.7 + 40.7
1932 121.6 - 47.1

Sources: Historical Statistics of the United
States, 1975, Series A 6-8. Edward Ames, "Trends,
Cycles, and Stagnation in U.S. Manufacturing since
1860" (Oxford Economic Papers, Vol. XI, No. 3,
October 1959) 272. W. W. Rostow, The Process of
Economic Growth (London: Oxford University Press,
1960) 350.

Notes: *Represents the annual average for the
period.

Average Annual Percentage Change:

(1829/39-1839/49) = +4.73
(1839/49-1849/59) = +4.31
(1866-1879) = +1.87
(1879-1914) = +2.81
(1919-1932) = -2.24

were subject to no branching restrictions (Williamson 1989, 23). American
banks of the same period (the National Banking System era) could rarely estab-
lish branch offices. The numbers of failures in the two systems were dramati-
cally different. ‘‘Canada had 23 bank liquidations while, at the same time, the
United States had 3,208’ (Williamson 1989, 24). Furthermore, it is well known
that between 1921 and 1933, a time of continuing limitations on branching,
almost 15,000 American banks failed. In stark contrast, ‘‘between 1923 and
1985, no Canadian banks failed’ (emphasis added) (Williamson 1989, 24).
Wells and Scruggs summarize the costs of antibranching statutes very well
when they note that to limit banks’ ability to branch is to encourage the for-
mation of banks that are small, inefficient, poorly diversified, undercapitalized,
and unstable (1986a, 900).


===== PAGE 166 =====

American Free Banking 139

Table 32
Index of Industrial Output per Capita, 1959-1989 (1987 =100)

Year Index Percent Change

1959 51.26

1969 76.75 +49.73
1979 92.89 +21.03
1989 105.99 +14.10

Sources: Various issues of the Survey of Current
Business. Statistical Abstract of the United
States, 1990, 7.

Note: Average annual percentage change
(1959-1989) = +2.45

It is obvious from the above that American free banks were burdened with
important restrictions and, thus, did not constitute a pure laissez-faire banking
system. One begins to marvel at how relatively well free banking in the United
States did perform in the context of such constraints.

NOTES

1. The beginning of the period dates from Michigan's adoption of the first free-
banking statute in 1837. The end of the era is usually identified with the passage of the
National Currency Act of 1863.

2. Insofar as free banking is concerned, this statement must be discounted some-
what. The reason is that, although Ohio and Indiana did adopt free banking in the early
1850s, Missouri never enacted a free banking law (Rockoff 1975, 3).

3. This was the year New York first allowed free banking.

4. Hepburn suggests that this term originated because the notoriously unsound banks
in Michigan often used ‘‘a dog in red color and the wild cat’ as decorative devices on
their notes (1903, 138).

5. These bonds usually had to be deposited with the state auditor.

6. The precise figures are 47.8 percent (339) failed and 30.7 percent (104) of those
did not redeem their notes at par. That is, 14.7 percent of the total banks failed below
par.

7. That is if one defines inflation in the conventional way as a rise in the price
level. It is perhaps preferable to define inflation as an excess supply of money.

8. In New York, there were fifty-five free banks that lasted fifteen years or more.

9. Capital gains and losses would be shared with noteholders if banknotes were, for
example, mutual fund shares rather than debt instruments.

10. Despite this apparent benefit, it should not be forgotten that the bond requirement
seriously compromised the safety of U.S. free banks by imposing on them an inade-


===== PAGE 167 =====

140 Free Banking

quately diversified asset portfolio. The health of free banks was, to a considerable ex-
tent, tied to the degree of fiscal responsibility exhibited by the various state legislatures.

11. Of course, there are economists—even Nobel prize winners—who reject the idea
that free markets are efficient. The author is not among them. This writer perceives free
markets as both just and efficient, though not perhaps in the Pareto-optimal sense.

12. It is clear that Rockoff is thinking in terms of the conventional ‘‘perfect compe-
tition’’ model in which there are a large number of firms, there is ease of entry and
exit, and the long-run expected rate of economic profit is zero.

13. See Historical Statistics of the United States, 1975, Series E 135-66.

14. See the Economic Report of the President, 1991.

15. This is not to deny that banks need to be adequately capitalized. However, given
that option clauses were not used in the United States and free banks were required by
law to redeem in specie on demand, it seems clear that the more crucial factor was
adequate primary reserves.

16. This was Michigan, which repealed its free-banking law in 1839, but reintro-
duced free banking in 1857.

17. This is one reason why one might argue that ‘‘free banking’’ lasted from the late
1830s until the Civil War. The problem with that is that the necessity of a charter must
have curtailed the flexibility of the currency supply, as well as distorting it in the direc-
tion of politically favored persons. Given that both transportation and communication
were somewhat primitive and the states prohibited branching, an adequate supply of
notes required a large number of banks. This obviously would not be true today.

18. One suspects that these data are based on book values rather than market values,
but the source gives no indication. The difference could be large and therefore quite
important.

19. See Chapter 8.

20. The effect of the antibranching statutes will be discussed later in this chapter.

21. Nothing said here is meant to disparage microeconomics. Indeed, the author would
argue that a macroeconomics that is not firmly rooted in microprinciples is no economics
at all.

22. The author reasons within a monetarist/Austrian context in which monetary insta-
bility has both nominal and real effects. See Chapter 3.

23. See Christina Romer (19862).

24. This represents the interval between (1) the demise of the second Bank of the
United States as the government's fiscal agent (and embryonic central bank) and (2) the
proliferation of free banking in the 1850s.

25. The United States did not, of course, enter the war formally until April of 1917,
but the American economy was disrupted long before then. See Benjamin Anderson

(1979, 25-43).
J ZX =X
t=1

26. Symbolically, these are:
n

cv= ———
X

n

2

MAPC = =!

(Xe 0X1]

n


===== PAGE 168 =====

American Free Banking 141

except for interest rates, where

n

2

MAPC = =!

XX]

PA (0, SD SE) SY

MNPC= | +!
n
except for interest rates, where
DX =X)
MNPC= |=t——
n

27. One could make the argument that wars should be included because they are
made possible (or more likely) by changes in the institutional structure. That is, wars
may be—at least in part—the product of the particular monetary regime. For example,
the Civil War prompted the rejection of free banking, and World War I brought on the
abandonment of the classical gold standard.

28. Very few free banks seem to have been established in Massachusetts and Penn-
sylvania, however.

29. See Historical Statistics of the United States, 1975, Series A 6-8, A 195-209,
and Rockoff (1975, 3). Based on a linear interpolation of census figures, in 1853
13,888,700 (54.0 percent) of the 25,736,000 residents lived under free banking.

30. New York’s rivals were Boston and Philadelphia.

31. Total figures are available from the author upon request.

32. Such data extends into the eighteenth century (Smith and Cole 1935).

33. See Kevin Dowd (1992, 3), for example.

34. Some economists seem to think of the depression as some sort of ‘‘natural disas-
ter.”’ Given that very strange premise, they argue that the depression years should not
be included in any series on the basis of which comparative economic judgments are to
be made. That is nonsense. The Federal Reserve clearly played a large role in the
precipitation of the depression and should be called to task for it.

35. A “‘unit bank’’ is one that has no branch offices.


===== PAGE 169 =====



===== PAGE 170 =====

Chapter 7

OTHER APPROACHES

All influential economic theories surely pass through four stages. Initially, the
new idea is treated with skepticism, perhaps even with scorn. It strikes many
theorists as being outlandish or irrelevant. A few, however, think they perceive
something of value. They are challenged and excited by the prospect of ex-
ploring new territory. Thus the second stage is born. A variety of researchers
begin to investigate, interpret, and modify the idea. It becomes, in short, a
viable research topic. Such research leads to either the conclusion that the idea
is irremediably defective and must be discarded, or the refinement of the idea
and its eventual acceptance into the received canon of the discipline.! Finally,
a theory that has survived and gained acceptance will find expression in some
institutional structure or policy.

The theory of free banking has advanced well into stage two. A growing
number of economists are energetically exploring its characteristics. Moreover,
a variety of approaches to (or models of) free banking have emerged. This is
healthy and natural, but it does breed controversy. The purpose of this chapter
is to review several of the alternative approaches to free banking.

BASIC DIFFERENCES

There have been developed, as the author sees it, three basic models of free
banking. Within each general approach, variations can be found. Therefore,
the reader must not infer that every individual named below necessarily advo-
cates precisely those attributes that are listed for each respective basic model.?

The issues regarding which the differentiation has occurred seem to be (1)
direct convertibility versus either indirect convertibility or inconvertibility, (2)
money as a debt instrument versus money as an equity instrument, (3) whether


===== PAGE 171 =====

144 Free Banking

or not the medium of exchange (MOE) should also be the medium of account
(MOA) or the medium of redemption (MOR),? (4) a stable price-level rule
versus a productivity norm, (5) whether or not the holding of reserves is rele-
vant to the performance of free banks, and (6) if reserves are important, whether
or not the reserve ratio should be 100 percent.

The White-Selgin Model

As has been made abundantly clear, this model is the focus of the present
book. It has been formalized, extended, and slightly modified by the author,
but it is essentially the White-Selgin (WS) model whose virtues have been
extolled throughout this work. The WS model concerns a commodity-backed
currency that is directly convertible into that commodity. The media of ex-
change, for example, private banknotes, are denominated in the unit of ac-
count, for example, dollars. The medium of account (gold) is also the medium
of redemption. Inside moneys—notes or deposit credits issued by private banks—
are liabilities of the issuing banks. The holding of a reserve of outside money
is essential for meeting redemption demands by customers as well as for set-
tling adverse clearing balances with other banks. However, it is argued that
both withdrawals and deposits are randomly distributed in a mature free-bank-
ing system. Therefore, fractional reserves are adequate to meet all plausible
conditions. This would be reinforced by the likely presence of option clauses.
Finally, the price level would be stable, except when there occur pervasive
changes in per-capita productivity. The price level would fall when such pro-
ductivity rose, and rise when such productivity fell.

The advantages of the WS model over the alternatives are said to be quite
significant. First of all, it is the one model of free banking that is most like
banking as it exists now. It would strike most consumers as the least alien of
the free-banking proposals.* Related to that point is the fact that all the histor-
ical experiments with free banking looked more or less like the WS model.
Inside money redeemable in specie was issued by private banks, which held
fractional reserves. The other major advantage is that it adheres to the produc-
tivity norm rather than a stable price-level rule. As such, it is less likely to
suffer business cycles.’

The Rothbard-Mises Model

For presentations of the Rothbard-Mises model (RM), one should see Murray
Rothbard (1983, 87-124; 1984b; 1985; 1992) or Ludwig von Mises (1966,
441-48; 1971, 395-99). Other economists who adopt the RM model include
Joseph Salerno, Hans-Hermann Hoppe, Mark Skousen, and Gary North (Roth-
bard 1992, 99).

This approach is very similar to the WS model in several respects. It pro-
poses that banks issue inside money directly convertible into gold coin on de-


===== PAGE 172 =====

Other Approaches 145

mand (but without delay; i.e., option clauses would be illegal). Banknotes would
be bank liabilities, the MOE, MOR, and MOA would be the same, and the
price level would be inversely related to aggregate production. The most dra-
matic difference between the RM and WS models is that in the former, banks
would be required by law to hold 100 percent reserves at all times. This would,
of course, force banks to operate like modern consumer finance companies
rather than like conventional commercial banks. Loans could be made only out
of the bank’s capital instead of out of deposits. Both the supply of credit and
the profits of banks would clearly be sharply reduced.

The justification given for this constraint on banking activity is the assertion
that fractional reserves are inherently fraudulent.

It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme,
a fraud in which fake warehouse receipts are issued and circulate as equivalent to the
cash supposedly represented by the receipts . . . fractional reserve banking is at one
and the same time fraudulent and inflationary; it generates an increase in the money
supply by issuing fake warehouse receipts for money. . . . Commercial banks—that
is, fractional reserve banks—create money out of thin air. Essentially they do it in the
same way as counterfeiters. (Rothbard 1983, 97-98)

Rothbard adopts this position because he insists that banknotes and deposit
credits are (or should be) warehouse receipts, both legally and economically.
That is, he perceives the proper role of banks to be that of a warehouse rather
than a financial intermediary. The act of depositing funds in a commercial bank
and receiving in return either banknotes or a deposit credit is not, to Rothbard,
a credit transaction. The depositor is not loaning his or her funds to the banker,
but merely hiring the banker’s vault as a place of safekeeping for valuable
assets. Rothbard declares that depositing money in a bank should be perfectly
analogous to storing one’s furniture in a warehouse (1983, 88-89). In other
words, the banker should be dealt with as a bailee rather than as a debtor
(Rothbard 1992, 98fn). It is crucial to realize at this point that in the RM
model, a change in inside money demand does not reflect a change in consumer
time preferences (a change in the rate of saving), and it will not bring about a
change in the supply of credit. This stands in sharp contrast to the WS model
as it was presented in Chapter 3.

The bank run plays a special role according to Rothbard. Unlike the over-
whelming majority of economists, he views bank runs favorably. They function
as a constraint on inflationary monetary expansion under free banking (1983,
112). They also ‘‘instruct the public in the essential fraudulence of fractional
reserve banking’’ (1983, 113). Rothbard seems literally to believe that if one
observes a period during which there occur very few bank failures, then this is
sure to be a time of inflationary monetary expansion. A case in point is that of
Scottish free banking (1765-1845). In discussing Lawrence White's work on
Scotland, Rothbard contends that a low rate of bank failure ‘‘might indeed


===== PAGE 173 =====

146 Free Banking

mean that the banks are doing better, but at the expense of society and the
economy faring worse. Bank failures are a healthy weapon by which the market
keeps bank credit inflation in check . . . a lower rate of bank failure can
scarcely be accepted as any sort of evidence for the superiority of a banking
system’’ (emphasis in original) (1988b, 230).

Those who embrace the RM model ® seem always possessed of an intense,
almost obsessive concern with monetary expansion. The author is not here im-
plying that inflationary expansions should be of no concern to monetary theo-
rists. Far from it. Such phenomena have very grave, often disastrous, conse-
quences. It is just that those who advocate the RM model seem to ‘‘throw the
baby out with the bath water’’ in their quest for limitations on such expansions.
They also, as a result, give rather too little attention to unjustified contrac-
tions.’

The sources of this focus on expansionary bank policies include the propo-
sition that precious metal coins (or bullion) are the only ‘‘true’’ money, a con-
comitant suspicion regarding banknotes, and an unusual view of what consti-
tutes the optimal supply of money.® The core proposition of the RM model is
that money, correctly understood, is a commodity such as gold or silver and
that the names of the various monetary units (dollar, pound, peso, etc.) “‘in-
variably originated as names for units of weight of a money commodity’
(Rothbard, 1984b, 9). According to such a perspective, the ‘‘dollar’’ is—or
should be—analogous to common units of measure, such as the liter, the meter,
and the kilogram. That is, the dollar should be defined—once and for all—as
a specific fraction of an ounce of gold. Moreover, Rothbard argues that that
was once the standard textbook approach (1984b, 10). Reasoning on the basis
of that perspective, Rothbard defines inflation as any increase in inside money
that is not matched by an equal increase in specie (1984b, 16).

If only specie is ‘‘money,’’ banknotes are not money, but merely money
substitutes. How do they come to be used as a medium of exchange, then?
Mises explains this via his ‘‘regression theorem’’ (1971, 97-123). This analy-
sis concludes that all present moneys must have originated as some highly
marketable commodity that initially had a significant nonmonetary use. ‘‘Money
cannot originate as a new fiat name, either by government edict or by some
form of social compact’ (Rothbard 1984b, 10). However, this does not mean
“that fiat money, once established on the ruins of gold, cannot then continue
indefinitely on its own’’ (Rothbard 1984b, 11). Banknotes, whether convertible
or inconvertible, whether produced privately or by the state, are all derivations
from the one true money—gold.®

Mises suggests that private banknotes not only tend to be dangerously infla-
tionary, but also may not be necessary. He favorably quotes Thomas Tooke’s
claim that ‘‘free trade in banking is free trade in swindling’’ and comments on
that “‘state of affairs under which everybody is free to issue banknotes and to
cheat the public ad libitum’ (1966, 446). His curious position is that banks
should be allowed to issue notes in order that consumers’ use of banknotes will
diminish, if not disappear altogether. Mises does not deny the obvious conve-


===== PAGE 174 =====

Other Approaches 147

nience offered by paper banknotes vis-a-vis precious metal coins. Nevertheless,
he declares that ‘‘banknotes are not indispensable. All the economic achieve-
ments of capitalism would have been accomplished if they had never existed’
(1966, 447).

The third reason for the RM focus upon monetary expansion is an idiosyn-
cratic definition of the ‘‘optimal supply of money.” Some have argued that the
optimal supply occurs when the rate of deflation is such that the nominal rate
of interest is zero (Friedman 1969). Others might suggest that any supply is
optimal that equals the demand for money at the existing price level.

Rothbard, on the other hand, declares that the optimal supply is that mini-
mum necessary to establish the money commodity as the accepted medium of
exchange (1988a, 180). Any increase in the money stock in excess of that
minimum will exhibit zero ‘‘social’’ marginal utility. In fact, such an increase
will do only harm. ‘“There is never any social benefit to increasing the quantity
of money. . . . Monetary calculations and contracts are distorted, and the early
recipients of the new money, as well as debtors, gain income and wealth at the
expense of later recipients and of creditors’’ (Rothbard 1988a, 180). Further-
more, it is unnecessary to increase the money supply to match an increase in
money demand brought about by population growth. All that will occur then is
that prices will fall so as to raise each dollar’s purchasing power (Rothbard
1983, 47). In other words, Rothbard assumes that, although the nominal money
stock is constant, real money balances will rise because of perfectly flexible
prices (1983, 34—41).1°

Two final features of the RM model are the absence of option clauses and
the implication that the price level will be inversely related to the level of
production. Considering the model’s view of outside money as specie and in-
stde money as redeemable in specie (for which redemption purpose, 100 per-
cent reserves are maintained), it may not be surprising that option clauses be-
come superfluous. In the RM model, they are neither permissible nor useful.
The defining characteristic of (inside) money is ‘‘whether a certain claim is
withdrawable instantly on demand’’ (emphasis in original) (Rothbard 1983, 255),
and there will be ‘‘no provision for emergency suspensions of redeemability’”
(Rothbard 1983, 263).

Rothbard states that ‘‘changes in prices in general . . . are determined by
changes in the supply of and demand for money . . . an increased supply of
goods will, other things being equal, increase the demand for money and there-
fore tend to lower prices’’ (emphasis in original) (1975, 15). That is, Roth-
bard’s concern seems to be with aggregate production. One should note that
this differs from the WS concern with changes in per-capita productivity that
lower goods’ unit production costs. !!

Problems with the RM Model

[3 4

In general, one may say that the RM model is, as the saying goes, an ‘‘in-
genious solution to a nonexistent problem.’’ If free banking on a specie stan-


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148 Free Banking

dard but with fractional reserves (WS) were chaotic and inflationary, then the
RM approach might deserve serious consideration. However, Chapters 2, 3,
and 4 have argued—one would hope persuasively—that the WS model is non-
inflationary, responsive to consumer preferences, consistent with microeco-
nomic principles, and resistant to business cycles. The RM model is clearly
inferior.

The best that can be said for the RM model is that in the long run, it is
noninflationary. It does not, for example, allow for any ready response to con-
sumer demand. If the income velocity of money falls (rises), the money supply
will not increase (decrease) to match the increase (decrease) in money demand.
In the absence of perfectly flexible prices in all markets, departures from the
natural rate of unemployment would ensue. Furthermore, the market rate of
interest might depart from the natural rate. Assume the velocity of money falls
(the Cambridge k rises). That is, assume consumer time preferences shift toward
greater saving (higher money balances). The increase in saving drives the nat-
ural rate of interest lower.!? However, the money supply is fixed in the short
run. No new loans or deposits will be created. The market rate of interest will
exceed the natural rate.!> A recession or depression will be the result; notional
demand will exceed effective demand; Say’s Law will be violated.

It would appear that the RM model tries to sever that link between the mar-
ket for money and the market for time, which is crucial to the success of the
WS model, as was examined in Chapter 3. This follows from Rothbard’s view
of money balance decisions as distinct from decisions regarding saving versus
consumption.

[A consumer] allocates between the various categories on the basis of two embracing
utilities: his time preferences decide his allocation between consumption and investment
(between spending on present vs. future consumption); his utility of money decides how
much he will keep in his cash balance. In order to invest resources in the future, he
must restrict his consumption and save funds . . . saving and investment are always
equivalent. . . . The demand for money is completely unrelated to the time-preference
proportions people might adopt. (emphasis in original) (Rothbard 1975, 40)

For Rothbard, there are three separate allocative channels for one’s income:
consumption, cash balances, and savings-investment (these two are always equal).
As suggested above, this reasoning leads to a model in which discoordination
can arise between the money and credit markets, and it raises a troublesome
question. How can one deny that to refrain from consumption expenditures in
order to increase one’s money balances is to engage in voluntary saving? Yet
this is what Rothbard apparently does deny.

Paradoxically, the RM model does not honor consumer preferences. Choices
as to reserve ratios, redemption contracts, and the nature of the base money
surely should be left to the unconstrained '* interaction between banks and their
customers if one claims to be proposing a truly free market approach to bank-


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Other Approaches 149

ing.!> The RM model declares that to have a nonfraudulent banking system,
one must have a specie base, 100 percent reserves, and immediate redemption
upon demand. It is furthermore important to realize that much of Rothbard’s
argument on behalf of such a system is legalistic rather than economic in na-
ture.

The British Court decisions cited and criticized by Rothbard, to the effect that bank
notes do not contractually bind their issuers to holding 100 percent reserves, seem em-
inently reasonable given the inscription actually found on the face of a typical British
bank note. . . . There is no promise made about reserve-holding behavior. There is
nothing to indicate that the note constitutes a warehouse receipt or establishes a bailment
contract. . . . Nothing in a free banking system prevents an individual who desires
100 percent reserve banking from explicitly contracting for it. . . . Fractional reserves
do not constitute breach of contract. (White 1985, 120-21)

Rothbard might be well advised in this case to heed his own statement to the
effect that ‘‘[free market action] is optimal, not from the standpoint of the
personal ethical views of an economist, but from the standpoint of the free,
voluntary actions of all participants and in satisfying the freely expressed needs
of the consumers’’ (1970, 887).

Finally, the RM model may imply a waste of resources as well as being
unnecessarily restrictive insofar as economic growth is concerned. Many have
argued that 100 percent specie reserves require an inordinate use of real re-
sources. Of course, if the RM model led to monetary equilibrium and the
avoidance of business cycles, the benefits might justify the expenditure, but it
does not. The supply of money is entirely too inflexible to maintain monetary
equilibrium. Indeed, the RM structure reminds one somewhat of the National
Banking System in which notes were issued in strict proportion to bank hold-
ings of government bonds. That rigidity made it impossible for banks to re-
spond appropriately to seasonal fluctuations in the demand for currency. The
result was a series of financial crises (Sprague 1910).

Also, what of economic growth? If the RM model were implemented, then
the long-run growth in money and credit would mirror changes in the stock of
monetary gold. Averaged over a considerable span of time, the rate of change
in that gold stock might approximate the rate of change in the demand for
money, but that will not suffice. First of all, monetary equilibrium cannot be
maintained or business cycles avoided, if the money supply is incapable of
rising or falling in response to short-run conditions. RM theorists usually keep
in mind the need for macroconclusions to rest on a bedrock of microprinciples.
What they tend to forget is that long-run results are merely a summation of
short-run actions.

Second, economic growth will not be sustained without parallel growth in
both money and credit (in the aggregate if not per capita). Yet this basic insight
is rejected by the RM model. ‘‘The notion of ‘normal’ credit expansion is


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150 Free Banking

absurd. Issuance of additional fiduciary media, no matter what its quantity may
be, always sets in motion those changes in the price structure the description
of which is the task of the theory of the trade cycle’ (Mises 1966, 442fn). The
RM model does not aim for monetary equilibrium or achieve it.

The Black-Fama-Hall Model

As W. William Woolsey and Leland B. Yeager (1991, 2) explain, the Black-
Fama-Hall (BFH) system is so named to ‘‘acknowledge ideas borrowed,
altered, and recombined from writings of Fischer Black, Eugene Fama, and
Robert Hall.”’ Leland Yeager has been one of the principal exponents of this
approach, along with his long-time collaborator Robert Greenfield and, more
recently, W. William Woolsey (Greenfield and Yeager 1983; Yeager 1985;
Yeager 1986; Yeager and Greenfield 1989; Woolsey and Yeager 1991). Two
other well-known proponents of a laissez-faire approach to banking—David
Glasner (1989) and Kevin Dowd (1989)—embrace significant aspects of the
model. One might also point out that Friedrich Hayek’s seminal work on free
banking (1978) anticipates certain features of the BFH approach.

In the BFH model (because of his extensive work in this area, one is tempted
to call it the Yeager model, but here the conventional terminology will be
retained), distinctive inside moneys are issued by private banks. These are either
indirectly convertible into some outside asset(s) or are inconvertible. The hold-
ing of reserves is largely irrelevant to bank success (Woolsey and Yeager 1991,
8). The MOE is not the same as the MOA. The MOR may be different from
both the MOA and the MOE. These inside moneys might be either equity
instruments in the form of checkable mutual fund shares, or debt instruments
in the form of notes, coins, or demand deposits. An early misunderstanding
arose in this regard as a result of the statement that ‘‘the BFH system would
indeed lack money as we now know it’’ (Greenfield and Yeager 1983, 303).
What would be lacking would be base money as we now know it. That is, the
government ‘‘would be forbidden to issue money’’ (Yeager 1985, 104). It is,
however, fair to say that early work on the BFH system tended to concentrate
on the model as one of an advanced and sophisticated payments system in
which most, if not all, transactions were accomplished via checks or electronic
transfers.

More recently, BFH theorists have granted the importance of hand-to-hand
currency. Yeager allows that ‘‘some institutions would presumably issue notes
and even coins denominated in the BFH unit’’ (1985, 104). Indeed, under a
BFH structure, ‘‘apart from crucial differences in the unit and in the media for
redeeming their obligations, financial institutions would be practicing some-
thing similar to free banking under a gold standard’’ (Yeager 1985, 105).

The differences between the BFH and WS models ought not to be mini-
mized. The differences Yeager refers to are certainly crucial. Paramount among
them is the fact that in the BFH approach, the ‘‘unit of account would no


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Other Approaches 151

longer coincide with the unit of the medium of exchange. . . . The govern-
ment would define the new unit . . . in terms of a bundle of commodities so
comprehensive as to have a nearly stable value against goods and services in
general’ (Yeager 1985, 104). This ‘‘value unit,”’ in which all prices would be
stated, would consist of the market values of specific quantities of specific
widely traded commodities. For example, 1 unit might equal the market values
of 5 ounces of commodity A plus 9 square feet of commodity B plus 6 gallons
of commodity C. This would remain the definition of the value unit forever. !¢

Arbitrage would alter the relative prices of those individual commodities that
comprise the bundle, so that the bundle’s value would always equal 1 unit.
Media of exchange would take whatever form was found to be mutually ac-
ceptable to both banks and their customers. However, these exchange media
would all be denominated in the one common unit of account. Redemption
could be made by using any asset, the quantity of which possessed a market
value equal to the required number of standard units (or commodity bundles).
It would be unlikely that consumers would actually seek redemption in terms
of the components of the standard bundle, since most of those would be sub-
stances of no use to the typical consumer. More likely would be indirect con-
vertibility in terms of some familiar asset, such as gold.

Kevin Dowd and David Glasner adopt somewhat different positions regard-
ing the issue of a stable unit of account. Although not objecting to the idea of
a commodity bundle, Dowd suggests that the definition of the MOA be revised
periodically. This he justifies on the grounds that ‘‘a commodity index that
seemed ideal ex ante might turn out to be less satisfactory than it was antici-
pated to be. Furthermore, there is always the possibility that certain goods
might cease to exist at all”’ (1989, 99). Glasner, on the other hand, is con-
cerned that a stable price level may lead to sharp fluctuations in employment.
Therefore, he opts for stabilizing an index of wages. ‘‘A dollar would always
be convertible into the amount of purchasing power that would buy a stipulated
amount of labor power . . . a labor standard would imply a gently falling
output-price level and very low nominal interest rates’ (Glasner 1989, 240). It
is obvious that Glasner’s position bears some strong similarities to George Sel-
gin’s espousal of a ‘‘productivity norm,’’ ‘‘neutral money’’ policy.

The advantages claimed for the BFH system are truly impressive (Greenfield
and Yeager 1983). It would provide a stable unit in which prices would be
quoted. This would foster more reliable economic calculation, reduce uncer-
tainty in credit markets, and encourage long-term contracts. Since inflation would
be a thing of the past, implicit taxation by means of monetary expansion would
be avoided. Fiscal restraint would be increased. Competition in financial ser-
vices would both stimulate innovations and curb the waste of resources brought
on by attempts to escape regulatory restrictions. Bank panics would be un-
known. Since there would exist no outside money that was held as a reserve
asset by banks, then there would also exist no redemption runs. An increased
demand for currency by consumers would not bring about a multiplicative de-


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152 Free Banking

crease in the total money supply. Banks would be ‘‘run-proof.’’ Also, ‘‘since
media of exchange would bear interest or dividends at competitive rates,” the
optimal quantity of money—as defined by Milton Friedman (1969)—would be
held (Yeager 1985, 105).!7 Finally, ‘‘monetary disequilibrium as we have known
it could no longer occur . . . painful macroeconomic disorders would be prac-
tically forestalled’’ (Yeager 1985, 105). The supply of money would automat-
ically adjust to the demand for money. Effective demand would tend always to
equal notional demand.

Before discussing problems with the BFH, it might be helpful to digress
briefly and mention those premises that inspire the model. First of all, BFH
advocates think it ‘‘absurd’’ for the value of the unit of account (e.g., the
purchasing power of the dollar) to depend on the supply of and demand for the
medium of exchange. They seek a stable unit of account. Second, they insist
that monetary equilibrium has proven so elusive because money has no market,
and no single price, of its own.'® Money trades against all other goods and
services. As a result, a change in either money supply or money demand may
not be reflected in the value of the unit of account. Prices are pervasively
‘“‘sticky,”’ and therefore, monetary disequilibrium may persist for long periods
because its elimination requires changes in a multitude of specific prices. Fi-
nally, the persistence of monetary disequilibrium brings about major macroeco-
nomic disruptions that inflict substantial suffering on the populace. The only
viable solution seems (to the proponents of BFH) to be a system that stabilizes
purchasing power by separating the MOA from the MOE. This stability is in
part dependent upon the fact that the components of the MOA are distinctly
nonmonetary in nature, whereas the MOE may take the traditional forms of
checks, banknotes, and coins.

Problems with the BFH Model

Despite the care and elegance with which the BFH model has been devel-
oped, there remain serious questions about its desirability. Some of these have
been addressed—with at least some success—by defenders of BFH. Others
have not been adequately dealt with at all.

One of the early criticisms of the BFH system was that it must suffer from
the well-known inefficiencies of barter because of (1) the abolition of base
money and (2) the separation of the unit of account from the medium of ex-
change (O'Driscoll 1986; White 1984c). Allegedly, however, the BFH is not
really barter. There is, indeed, a separation of the sort described. However,
this does not imply that ‘‘people would be making and receiving payments,
awkwardly, in miscellaneous commodities and securities with fluctuating val-
ues that would have to be transferred into numbers of Units on each occasion.
Instead, people would be using coins, banknotes, and checking accounts fur-
nished by banks and denominated in Units” (Yeager and Greenfield 1989, 414).

Closely related to the above is the suggestion that the BFH model must be


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Other Approaches 153

defective, because it violates the evolutionary process by which money came
into being in the first place (Menger 1892). The historical origin of money as
the single most marketable commodity in society has, to many, implied the
corollary proposition that there will be no separation of the unit of account
from the medium of exchange.

[A] unit of account emerges wedded to a general medium of exchange. Prices are uni-
versally posted in the characteristic units of a medium or set of media that sellers are
routinely prepared to accept in exchange. This process is self-reinforcing: a buyer or
seller who communicated bid or ask offers in nonstandard units would impose calcula-
tion costs on potential trading partners. For this reason the unit of account remains
wedded to the medium of exchange. (White 1984c, 711)

Greenfield and Yeager point out that all existing monetary systems are the
products of legislation and regulation to a large extent (1983, 303). Some major
nonevolutionary, legislative change will be required if a laissez-faire system is
to come into existence. Therefore, they see nothing contradictory about con-
structing an ‘‘ideal’’ system—even though nothing like it has ever actually
existed.

The defenders of the BFH model are obviously correct when they bring one’s
attention to the constructivist nature of present monetary systems, and there is
no a priori reason to deride any idea merely because it is unusual. However,
the critics of BFH have a point. It has become a commonplace to observe that
the study of monetary economics is (or should be) eminently practical. As
ingenious as the BFH system may be, is it consistent with consumers’ revealed
(or demonstrated) '° preference? Furthermore, considering the widespread con-
fusion about and criticisms of BFH on the part of professional economists, are
the advocates of such a system likely ever to convince either lawmakers or
voters/consumers of its supposed virtues? One must answer both questions in
the negative.’

Bennett McCallum (1985) offers two criticisms of the BFH model. He first
suggests that it is really only a version of the old idea of a composite-commod-
ity standard. The composite-commodity standard retains a base money in units
of which inside money is denominated. Price stability is supposedly attained
by anchoring the base money to a basket of commodities via redemption in
terms of those commodities. However, the BFH system claims to do away with
base money altogether. Moreover, the BFH commodity bundle would only
‘‘define the unit of account, and define it independently of any particular me-
dium of exchange’ (Yeager and Greenfield 1989, 417).

Some still question whether the redemption unit might not itself become base
money 2! (Meltzer 1989, 427). One might also wonder whether the system will,
as Yeager and Greenfield assume, converge on a single unit of account (Meltzer
1989, 426-27). There would be no legal barrier to competitive units of ac-
count, but convergence is assumed in BFH because ‘‘government would exert


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154 Free Banking

a nudge against the inertia of old practices by conducting its own transactions
and accounting in the new unit’ (Yeager 1985, 104). Is there not a danger
inherent in letting government define the unit of account, even if it is legally
applicable only to the government’s own records? Furthermore, how is this
necessarily consistent with consumer preferences? How can the advocates of
BFH be so sure that either consumers or bankers want an MOA that is neither
the MOE nor the MOR?

McCallum also asserts that the price level would be indeterminate in a BFH
system. Yeager and Greenfield reply that it ‘‘would provide determinacy by
defining the unit of account with a commodity bundle. . . . This definition
would be made operational by indirect convertibility’’ (1989, 417). The issue
of indirect convertibility has proven controversial. Several writers have claimed
that it ‘‘would cause severe monetary instability’” (Woolsey and Yeager 1991,
1). The ‘‘paradox’’ of indirect convertibility asserts that extreme inflations and
deflations will occur as a result of redemption in a medium different from the
medium of account.

Assume the commodity bundle (MOA) is initially worth one noninflated dol-
lar and the redemption medium (MOR) is gold. Imagine that an inflating bank’s
notes have fallen in market value to $.90 per dollar of face value. An arbitra-
geur then buys a depreciated dollar, using $.90 issued by a noninflationary
bank. He turns around and presents the $1.00 to the inflating bank and demands
redemption. If the bank redeems the note with $1.00 worth of gold, then the
arbitrageur may buy $1.11 face value of depreciated notes. These he may re-
deem for $1.11 worth of gold and buy $1.23 face value of depreciated notes,
and so forth. The system quickly collapses.??

There is, however, a flaw in such a scenario, which Woolsey and Yeager
quite persuasively explain. ‘‘The paradox occurs, we emphasize . . . only if
the bank calculates the amount of gold required in redemptions not at a genuine
market price but at the very ‘price’ of gold implied by its own redemptions.
Hence, the paradox is easily avoided’ (1991, 11). One may-—and should—
have other reservations about the BFH model, but indirect convertibility does
not seem to lead to the severe instability that has been hypothesized.

Last, but not least, one may point out that the basic objective of the BFH
model—a money that possesses stable purchasing power—has been shown to
be a suboptimal goal (see Chapter 4). The details of the argument will not be
repeated here. However, the principal proposition was that a stable price-level
policy would—in the face of pervasive productivity shocks—Ilead to departures
of effective demand from notional demand, that is, to business cycles.

SUMMARY

The three basic models of free banking—WS, RM, and BFH—have been
reviewed and compared. Their similarities and differences were noted in terms
of (1) convertibility, (2) reserve holdings, (3) whether or not the MOA, MOE,


===== PAGE 182 =====

Other Approaches 155

and MOR were the same, (4) media of exchange as debt versus equity, and (5)
a stable price level versus a productivity norm. Although all three are interest-
ing attempts to apply laissez-faire principles to money and banking, only one
(WS) seems superior on all counts. The WS model avoids both the confusing
complications of the BFH approach and the reserve-holding rigidity of the RM.
It is both simple and efficient. It also remains consistent with Say’s Law under
all circumstances. Moreover, the WS model is the least alien form of free
banking that has yet been proposed. If free banking is ever again to be a reality,
the overwhelming probability is that it will be instituted along the lines of the

White-Selgin model.

NOTES

1. This process does not necessarily proceed along perfectly rational lines, nor is it
always unaffected by the political and ethical beliefs of the researchers involved. A case
in point might be the ‘‘Keynesian revolution’ of the late 1930s.

2. Some may even disagree with the segmentation into three models.

3. ““The MOE refers to the debt instruments which are transferred in the exchange
process, the MOA refers to the commodities in terms of units of which prices are
quoted’ (Dowd 1989, 84). The unit of account means the unit used in stating prices.
The MOR is that asset used by banks to redeem inside money. For example, in the
United States, under the classical gold standard, the gold-backed paper dollar was the
MOE, gold was both the MOA and the MOR, and the dollar was the unit of account.
The MOA, MOR, and MOE were really indivisible or coextensive.

4. Practically speaking, this could prove to be overwhelmingly important. From a
political standpoint, free banking (in any of its guises) is going to be a difficult idea to
““sell’” to the public. Furthermore, to dwell on the fact that the hostility toward free
markets in banking is largely due to the economic ignorance of the populace and/or
propagandistic pronouncements by various public agencies is not very helpful. The
‘strangeness’ of free banking needs to be minimized if free banking is to become a
reality.

5. See Chapters 3 and 4.

6. All who embrace the RM model are Austrian economists, but not all Austrians
adopt the RM approach.

7. It is in regard to this that the monetarists have presented a somewhat more robust
exposition (Horwitz 1990, 17-20).

8. Of course, an important additional source is the Mises-Hayek (or Austrian) trade
cycle theory, which identifies monetary and credit expansions as the root cause of most,
if not all cycles.

9. Actually, Rothbard has proposed a ‘‘parallel standard’ in which both gold and
silver would be used and there would be freely fluctuating exchange rates between the
two forms of base money (1984b, 8). This should be distinguished from historical bi-
metallism, in which the gold/silver exchange rate was set by law. Under bimetallism if,
for example, the demand for gold rose relative to the demand for silver, then the market
price of gold in terms of silver would exceed the official price. Gold would be officially
undervalued, and silver officially overvalued. Gold coins would disappear from circu-
lation, but silver coins would remain in circulation. This is the phenomenon with which


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156 Free Banking

Gresham’s Law deals. It is an application of the theory of price controls to the realm of
money.

10. Rothbard seems never to make explicit his assumption of price flexibility, but
more or less perfectly flexible prices are clearly what he has in mind.

11. See Chapters 2 and 3.

12. Of course, at this point, Rothbard would reject the scenario, since he does not
take an increase in money demand to represent increased saving.

13. This is literally the defining characteristic of a recession that is used by Austrians,
such as Rothbard (Mises 1971, 346-66; Rothbard 1975, 12-25).

14. Here ‘‘unconstrained’’ is taken to signify a market context in which only acts of
force or fraud are outlawed.

15. Please note that the WS model does not impose gold-backed inside money with
fractional reserves on the society. It merely argues that both history and logic suggest
that such are likely to be the characteristics of future free banking.

16. Both Glasner and Dowd suggest departures from this. See later discussion.

17. This seems to presuppose that all inside money would be equity-based.

18. This writer would suggest that the monetary disequilibria of recent decades is the
product of the institutional structure (central banking) rather than the inescapable result
of something inherent in money itself. That is, price ‘stickiness’ (as well as price
‘“‘rigidity’’) may be largely the product of decades of discretionary monetary policy.
Thinking in terms of price indexes instead of specific prices also may help foster the
belief that the market for money is ‘‘just a figure of speech, not a reality’’ (Yeager
1985, 104).

19. The distinction is made by Rothbard (1977), for example.

20. It will be difficult enough to convince the average consumer of the benefits to be
gained from free banking generally. It will be enormously more difficult to persuade
consumers that they should (1) redeem the media of exchange in assets, such as gold or
‘‘investment-grade securities,”” but denominate their accounts in units of ‘standard
commodity bundles’’ (Yeager and Greenfield 1989, 413).

21. In fact, it is likely that, if gold is used as the MOR, the system will soon evolve
into one of direct convertibility. There is a wealth of logical and historical evidence that
suggests that a single commodity will dominate a basket of commodities. It would be
ironic indeed if the BFH model were tried and it transmuted into the WS model.

22. The process works in the opposite direction, too. However, the effects are
‘‘asymmetrical because there is a limit, namely zero, to how low reserves of the re-
demption medium can fall but no definite limit to how high they can rise’’ (Woolsey
and Yeager 1991, 4).


===== PAGE 184 =====

Chapter 8

CRITICISMS

The body of conventional literature on monetary matters has, for many years,
included several propositions that explicitly challenge the viability and/or desir-
ability of free banking. Chapters 2, 3, and 4 presented a detailed theoretical
case for free banking on the grounds that it would maintain nominal national
income, reflect consumer preferences in the time and money markets, keep the
market rate of interest equal to the natural rate, achieve continuous monetary
equilibrium, and avoid business cycles. Despite those arguments, in order to
complete the discussion, one must address the standard criticisms. That is, one
must examine the key points in the case against free banking. The issues so
often raised in opposition to private money and laissez-faire banking include
the following claims: (1) that money is a ‘‘public good’ and thus cannot be
profitably produced in a free market; (2) that there exist significant ‘‘external
effects’ such that private money balances would be suboptimal; (3) that money
production is a natural monopoly, that is, that marginal and average costs de-
cline over the relevant range of output; (4) that competition in money will lead
to massive inflation; (5) that free banking is inefficient in that it represents a
waste of resources; (6) that privately produced moneys suffer from serious
counterfeiting problems; (7) that central banking arose in response to true con-
sumer needs, that is, that it is central banking rather than free banking that
represents the natural evolution of money markets; and (8) that a lender of last
resort (a central bank) is necessary in order to prevent or mitigate financial
crises.

MONEY AS A PUBLIC GOOD

The precise meaning of ‘‘public good” (sometimes called ‘‘collective good’’)
is still the subject of controversy.! No doubt, the most common interpretation


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158 Free Banking

of the concept is that any good that possesses both ‘‘nonrivalrousness’’ and
‘“‘nonexcludability’’ is a public good. Nonrivalrousness means ‘‘that a given
quantity of a public good can be enjoyed by more than one consumer without
decreasing the amounts enjoyed by rival consumers’’ (Hyman 1987, 114).
Nonexcludability ‘ ‘implies that it is too costly to develop a means of excluding
those who refuse to pay from enjoying the benefit of a given quantity of a
public good’’ (Hyman 1987, 115). If something is a public good, the implica-
tion is that ‘‘free riders’ will exist, that is, that some people will be able to
benefit from the good without having to bear the cost of its acquisition. If
money is a public good, then free banking may be decidedly inferior to central
banking.

First of all, one must realize that, despite the pervasive use of the term both
within and without the economics profession, the concept of public goods may
be questionable. At the most fundamental level, one may ask: Where is the
‘public,’ the ‘‘collective,”’” which demands the good in question? ‘‘Only an
individual exists . . . there is no existential referent of the ‘collective’ that
supposedly wants and then receives goods’ (Rothbard 1970, 884).2 Two of the
most frequently cited examples of public goods—national defense and police
protection—are problematic. Murray Rothbard brings up a thorny problem that
besets these two. He points out that neither can really be ‘collectively’ de-
manded, since pacifists do not want national defense and criminals do not want
police protection (1970, 884). Some would, of course, reply that these groups,
especially the pacifists, represent small minorities within society; the vast ma-
Jority may have intense desires for defensive agencies. Be that as it may, one
cannot conclude that there is an unambiguous ‘‘collective’’ demand. To do so
is to indulge in the fallacious technique of making interpersonal comparisons
of utility.

Rothbard furthermore questions the notion of public goods as having an in-
divisible supply, from the benefits of which no one can be excluded. ** ‘[N]ational
defense’ 1s surely not an absolute good with only one unit of supply. It consists
of specific resources committed in certain definite and concrete ways. . . . A
ring of defense bases around New York, for example, cuts down the amount
possibly available around San Francisco’ (1970, 885).

An additional facet of the issue should be mentioned. The whole discussion
of public goods, external effects, and free riders presupposes knowledge of the
‘‘optimal’’ production level for the good in question. This cannot be known
outside the artificial world of a perfectly competitive general equilibrium.
Moreover, any inefficiencies that do arise may be the result of the failure (not
of the market, but of the legal authorities) to either define or enforce property
rights (Cordato 1992, 16-23).

For the sake of argument, one may grant that public goods exist. Some
economists conclude that money is a public good, because ‘‘any one agent,
holding cash balances of a given average size, is less likely to incur the costs
of temporarily running out of cash, the larger are the average balances of those


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Criticisms 159

with whom he trades’’ (Laidler 1977, 321fn). If that were sufficient to establish
money as a public good, however, would not all goods be public goods? Surely,
the greater the stocks held by bookstores, for example, the less likely every
purchaser of books is to ‘‘run out of books.”” Does that mean that books are
public goods? Obviously not. David Laidler, among others, simply overlooks
the essential question regarding public goods: Can person A benefit from a
particular quantity of good X possessed by person B, even when B might prefer
that A not receive that benefit? Regarding money, the answer is no.

[A] particular sum of inside money renders its service—increased purchasing opportu-
nities—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 ben-
efits associated with inside money. (Selgin 1988a, 154)

In short, since only the owner of any given sum of money can benefit from its
liquidity services, then money is neither nonrivalrous nor nonexcludable (Vau-
bel 1986, 934). Thus, it cannot be a public good on those grounds.

Others perceive money as a public good, because the various specific mon-
eys serve as units of account—the dollar, the pound-sterling, the yen, and so
forth. That is, the unit of account is also the unit of the medium of exchange.
The argument here is that using a particular unit of account creates a positive
externality by way of conveying valuable information that all may use. ‘‘Uni-
formity in quoting prices, maintaining accounts, and stating forward contracts
has the same virtues as uniform standards for switching and transmitting tele-
phone calls’ (Hall 1984, 306), but this does not constitute a serious challenge
to free banking of the sort (WS) modeled and defended in this book. At best,
all it demonstrates is that ‘‘government should suggest a unit of account and
publish a price index for it, but not that it should supply money’’ (Vaubel
1986, 935).

One might say that quoting prices in, and transacting with, a single money eliminates
some formidable accounting and transaction costs. . . . But just to avoid the inconve-
nience of multiple monetary units, money does not have to be supplied monopolisti-
cally. If many suppliers of money were making their moneys convertible into the same
asset, all the moneys would be exchangeable at a one-for-one rate. The benefits of a
single monetary unit could be secured without monopoly. (Glasner 1989, 28)

It must be admitted that the unit of account argument would be germane in the
context of a proposal such as Friedrich Hayek’s (1978). There banks issued
their own distinctive banknotes, and each bank might use a different unit of
account. This is yet another reason why a Hayekian system is unlikely to exist
(see Chapter 1). A single unit of account is superior to a multiplicity of such
units. Throughout this study, free banking has implied multiple currencies all


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160 Free Banking

convertible into the same commodity and all denominated in the same unit of
account.

Karl Brunner and Allan Meltzer (1971) offer a variation on this theme when
they argue that money is itself a substitute for information because it (poten-
tially) reduces transaction costs. Since information is presumed to be a public
good, then money must be, too. This argument fails also. It is clear that ‘‘to
show that X is a substitute for a public good is not sufficient to prove that X is
a public good . . . what has to be shown is not that money is a substitute for
information but that it provides the public good of information’ (Vaubel 1986,
935).

Even if money does, however, provide information (or knowledge), a prob-
lem remains: Is economic knowledge a public good?? Superficially, it appears
to be, since it seems nonrivalrous and nonexcludable. Nevertheless, it is not.
The common supposition that all ‘‘true’’ knowledge, that is, correct factual
statements, must be a public good arises from a strong positivistic turn of mind.
That is to say, whosoever argues that economic knowledge is public in nature
forgets that what is important (economically, at least) is not if the data are
‘“‘correct’’ or not, but in what manner they are perceived to be useful by some
specified economic agent. How else is it possible for two different market par-
ticipants with identical endowments to examine the same price data series (for
some commodity such as copper, say) and yet reach opposite conclusions (one
buys copper; one sells copper)?

Gerald O’Driscoll and Mario Rizzo argue similarly that economic knowledge
is fundamentally subjective in nature. What is perceived as ‘‘knowledge’’ de-
pends upon the circumstances, values, and goals of the perceiver (1985, 35-
50). As they suggest, there can be no such thing as public knowledge—all
useful economic knowledge is private by its very nature.

SUBOPTIMAL MONEY BALANCES

Related to the public good argument is the oft-repeated assertion that a free
market in money will lead to suboptimal money holdings by the public.* This
has been most forcefully proposed by Milton Friedman (1969, 16-48). Fried-
man argues that optimal real money balances will be held only if it is true that
the marginal nonpecuniary yield from money (MNPS,,) is equal to the nominal
rate of return on interest-bearing assets (ry), with that rate equal to zero. That
is, optimality follows from MNPS,=r,=@ (Friedman 1969, 36). If
MNPS,, =r1,>>0, then suboptimal money balances result. Friedman’s concern
stems from his contention that the marginal private cost of increasing one’s
cash balances (assumed equal to the rate of return on nonmoney assets) will be
greater than the marginal social cost of producing greater money balances (as-
sumed equal to zero). It is clear that Friedman further assumes a fiat currency
rather than a commodity-backed currency. He offers two solutions: (1) a fully
anticipated, steady rate of price-level deflation that provides a pecuniary yield


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Criticisms 161

on money halances or (2) the payment of explicit interest on money balances.
Both are intended to offset the difference between private and social marginal
COStS.

There are problems with Friedman’s analysis. First of all, the private cost of
acquiring money is not the forgone interest that one would have gained from
some alternative financial asset. The cost of acquiring money (its price) is the
goods and services one forgoes. That is—as Friedman himself elsewhere de-
clares (1972, 201)—the price of money is its purchasing power in terms of real
goods (see Chapter 2). It is the cost of holding money that is correctly identi-
fied as the forgone interest income from alternative assets (Selgin 1988a, 52-
53). Indeed, to forgo income from interest-bearing assets is the cost of holding
any non-interest-bearing asset, but most assets are never used directly to ac-
quire goods and services. Money is the intermediary; the cost of acquiring
money is measured in real goods or services.

Also, one might question whether the concept of marginal ‘‘social’’ cost is
even meaningful. Friedman assumes that his use of the concept is noncontro-
versial and, furthermore, that such costs are objective and quantifiable. Others
disagree. Steven Cheung argues that most applications of the concept have been
inappropriate because of either invalid specifications of the constraints involved
or incorrect observations of events (1980, 51). He further suggests that the
frequent misuse of ‘‘social cost’’ has ‘hindered the advancement of economics
as a behavioral science’’ (1980, 51). James Buchanan reminds one that ‘‘cost
is subjective; it exists only in the mind of the decision-maker or chooser . . .
the opportunity cost involved in choice cannot be observed and objectified”’
(Buchanan and Thirlby 1981, 15). Stephen Littlechild insists that ‘social cost
and production are not objective concepts’’ (1978, 88). O'Driscoll and Rizzo
reinforce this position: ‘‘Cost, just like utility, is defined over projected want
satisfaction and not directly over the commodities themselves. . . . Commod-
ities are only way-stations to the ultimate satisfaction of basic wants’’ (1985,
47). As long as social cost is neither objective nor quantifiable, Friedman’s
optimum quantity of money rule remains questionable.

Kevin Dowd—himself an advocate of a stable price-level rule—makes two
interesting comments on Friedman’s analysis. First of all, he estimates ‘‘the
welfare loss under a zero-inflation regime implied by an inability to pay interest
on currency holdings’ (1991e, 7). This he finds to range from .00007 percent
to slightly over 0.1 percent of 1991 Gross Domestic Product (GDP) for the
United Kingdom (1991e, 9). Since this might be taken as a measure of the
potential gain from achieving optimal money balances, it appears that such
gains are trivially small. Second, Friedman seems to have realized how rela-
tively small the gains would be, for ‘‘his own results did not persuade him to
abandon the goal of price stability for the further benefits of optimal deflation’’
(Dowd 1991c, 12).° The argument for optimal money balances cannot be very
compelling when its own advocate opts for a different approach.

Furthermore, it is interesting to notice that Friedman’s analysis—by his own


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162 Free Banking

admission—is based in part on the existence of ‘ ‘perfect capital markets’ as
that term is used in the pioneering work of Franco Modigliani and Merton
Miller (Friedman 1969, 35fn). Modigliani and Miller (MM) assume that (1) all
transactions are costless, (2) debt is riskless, (3) capital markets are perfectly
competitive, (4) all individuals and firms are able to borrow and lend at the
same rate of interest, and (5) all firms can be sorted by risk class, with all the
firms in each class exhibiting identical return distributions (1958). From these
assumptions, MM conclude that in the absence of taxes, ‘‘the market value of
any firm is independent of its capital structure’” (1958, 268). In other words,
the method of firm financing is irrelevant. If corporate taxes exist (as they do)
and firms are allowed to deduct interest payments on debt as expenses, then
MM propose that firm value is maximized at the point of 100 percent debt
financing.

Does this proposition accurately predict actual firm behavior? Charles Haley
and Lawrence Schall point out that ‘‘firms do not increase debt to the upper
limit possible even though interest is tax-deductible’’ (1979, 290). The flaw
may lie in the extremely artificial assumptions of the MM model. In reality,
transactions are not costless, capital markets are not perfectly competitive (in-
formation is not costless and extranormal profits can be made), not everyone
can borrow and lend at the same interest rate, and firms cannot readily be
sorted into risk classes (Haley and Schall, 1979, 289-90). This is unstable
ground upon which Friedman builds his argument.

Finally, George Selgin, without questioning the concept of ‘‘social cost,”
offers a reply to Friedman. He points out that under free banking, competition
would, of course, compel the payment of interest on deposits.® However, in-
terest payments on banknotes might indeed prove impossible because of high
transaction costs. Therefore, ‘‘there would be a suboptimal quantity of bank-
notes, but the loss from this would be partly offset by a supraoptimal quantity
of deposits. The only net loss would be that stemming from any inelasticity of
substitution between deposits and notes’’ (emphasis in original) (Selgin 1988a,
156).7 Selgin goes on to ask whether government intervention might perform
better. He thinks not. A central bank “‘is less likely to attempt interest pay-
ments on currency than private note issuers, since its monopoly privilege places
it under less pressure to do so’’ (1988a, 156). In short, free banking would
come closer to an ‘‘optimal quantity’’ of money than would central banking.®

BANKING AS A NATURAL MONOPOLY

A standard proposition of modern microeconomic theory is that if there exist
significant economies of scale, that is, if long-run average costs decline over
the range of output demanded in the market, then only one firm will survive.
Such a firm would be a ‘‘natural monopoly.’’ It has often been argued that
banking may be a natural monopoly, and if so, the most efficient approach is
to restrict competition and allow only a single issuer of banknotes, the central


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Criticisms 163

bank. In short, if there are large cost economies in banking, then free banking
may not be an optimal solution.

The most basic rebuttal to the natural monopoly argument is to point out that
costs cannot be known to the producer (much less to the economist) prior to
the process of production and a firm’s costs are likely to change when the
market structure changes. From this it follows that

a governmental producer of money is not an efficient natural monopolist unless he can
prevail in conditions of free entry. . . . The only operational proof that a common
money is more efficient than currency competition and that the government is the most
efficient provider of the common money would be to permit free currency competition.
(Vaubel 1986, 933, 935)

That is, free banking is the necessary precondition for discovering whether or
not banking is a natural monopoly. In the absence of such competition, those
who claim that banking is a natural monopoly are guilty of making an unsup-
portable assertion.

Are there any logical reasons for expecting economies of scale in banking?
There are two: economies of scale in reserve holding and economies of scale
resulting from diversification (Dowd 1991b). The first is based on the widely
accepted principle that reserves change with the square root of a bank’s liabil-
ities. This suggests that the optimal reserve ratio will decline as the bank ex-
pands, which further suggests that the bank’s average costs will fall. However,
these economies are extremely small. Citing David Glasner, Dowd states that
‘‘a bank with only $10,000 of liabilities would exhaust 99 percent of the pos-
sible savings in holding reserves’ (1991b, 4). Furthermore, this estimate may
exaggerate the benefits if reserves are interest-bearing or small banks can pool
their reserves instead of merging (Dowd 1991b, 4). A second source of scale
economies could be asset diversification. A large bank might experience lower
average transaction and delegation costs because of its large and well-diversi-
fied portfolio of assets. Once again, however, these gains appear far too small
to lead to natural monopoly (Dowd 1991b, 7).

One approach to the natural monopoly argument is actually to estimate cost
functions for commercial banks. A number of studies have tried to ascertain
whether or not banking exhibits either economies of scale (cost savings result-
ing from a larger scale of operation) or economies of scope (cost savings re-
sulting from producing multiple products that share common inputs). The ob-
vious problems with all such contemporary studies are that they are not estimating
costs in a free-banking environment and they base their calculations on ac-
counting costs rather than economic costs. The ideal study would be one that
estimated economic cost functions in a laissez-faire context, but since true free
banking has never existed, those recent studies, although a ‘‘second-best’’ ap-
proach, may be helpful.

Loretta Mester explains that ‘‘early cost studies treated financial services as


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164 Free Banking

a single product . . . many of these studies found that the average cost of
production falls as more is produced—that is, there are economies of scale’
(1987, 15-16). However, banks are not single-product firms; they offer loans,
investments, deposit accounts, and currency of a sort (traveler’s checks). That
variety of products makes it possible for them to enjoy economies of scope as
well as scale. More recent studies have often therefore modeled banks as mul-
tiproduct firms. The results have been consistently the same. Economies of
scale seem very small, although some studies find evidence that they do exist.
See George Benston, Allen Berger, Gerald Hanweck and David Humphrey
(1983), Benston, Hanweck, and Humphrey (1982), Berger, Hanweck, and
Humphrey (1986), Thomas Gilligan and Michael Smirlock (1984), or Gilligan,
Smirlock, and William Marshall (1984). Mester concludes that ‘there is no
evidence that larger firms have a cost advantage over smaller firms’ (1987,
24).

For example, Jeffrey Clark (1984) estimates the output elasticity of cost,
(aC/0Q) (Q/C), for a sample of 1,205 banks using both log linear and general-
ized functional form cost functions. If such elasticity is significantly less than
1, one can conclude that scale economies do exist. Clark finds that the measure
of this elasticity is ‘‘never below 0.95. Thus economies of scale in the banking
industry appear to be small and operating efficiency is unlikely to be substan-
tially improved by an increase in bank size’’ (1984, 67). To this may be added
the research of David Humphrey, who similarly estimates cost elasticities for
13,000 commercial banks, grouped by asset size. Based on his results, Hum-
phrey asserts that ‘‘there appears to be no strong reason to constrain bank merg-
ers or inhibit nationwide banking for fear of conferring important cost advan-
tages on large banks . . . reliance on the cost or scale economy argument is
not supported by the data developed here or in other recent studies’ (1987,
37).

The economies of scale that do exist seem to disappear rather quickly. After
surveying nine studies of banking costs, Clark declares that the economies are
gone by the time a bank has acquired $100 million in total deposits (1988, 26).
*“The conclusion seems to be that increasing returns to scale exist but are lim-
ited, and it is surely significant that not a single study finds evidence that bank-
ing is a natural monopoly’’ (Dowd 1991b, 14). The natural monopoly argument
as a critique of free banking appears to rest on a weak empirical foundation.

FREE BANKING AND INFLATION

Many economists have assumed that laissez-faire banking and inflation (per-
haps even hyperinflation) are intimately bound together. In this context, one
might mention Friedman (1959, 7), Boris Pesek and Thomas Saving (1968,
86-87), and Pesek (1968), among numerous others. This belief appears to be
based on the premises that (1) consumers are willing to use any banknotes that
are issued; that is, they are indiscriminate; (2) there are no mechanisms within


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Criticisms 165

free banking that would constrain the overissue of notes; (3) the relevant mar-
ginal costs of a note-issuing bank are its marginal production costs (which are
admittedly small, though positive, for commodity-backed paper banknotes); (4)
profit-maximizing free banks would supply a quantity of notes at which mar-
ginal production cost equals marginal revenue; (5) marginal revenue in this
context is measured in terms of the purchasing power of money; and (6) there-
fore, free banking would produce a money supply such that the purchasing
power per monetary unit was quite small; that is, there would be substantial
inflation.

This sounds convincing, but it is fallacious nonetheless. First of all, to pro-
pose that consumers would voluntarily use any currency that had depreciated
in value (purchasing power) is to suppose that consumers would not act in their
own self-interest.” One of the fundamental tenets of economics is that individ-
uals seek to maximize their total utility. There is no reason to assume that
money is the sole exception to that principle. The only way in which an inflated
currency can remain in circulation is to have its use mandated by law—to pass
legal tender laws. Inflation is far more likely under central banking than under
free banking for that reason.

Second, there are strong forces within a free-banking system that operate in
an anti-inflationary manner. These are the processes of reflux and adverse clear-
ings (see Chapter 2). Both serve to curtail any attempt by a bank to expand its
liabilities in excess of the demand for same. Furthermore, as also discussed in
Chapter 2, the key cost to a free bank is not the cost of producing banknotes,
but the cost of maintaining them in circulation. These marginal costs are clearly
positive and rising. Thus, a free bank will indeed supply a quantity such that
marginal cost equals marginal revenue (purchasing power), but that does not
imply inflation.

Benjamin Klein offers a compelling reason why free banks will avoid an
excessive production and circulation of money: ‘‘[I]f information about future
performance is costly, information is a valuable product. The brand name of a
firm is then not only an identification mark but also a capital asset’ (1974,
432). Furthermore, the value of such a capital asset possessed by a free bank
would ‘‘be related to the anticipated predictability of the future price level in
terms of the money’’ (emphasis in original) (Klein 1974, 433). For a free bank
to inflate would be to destroy one of its important assets. What of its other
assets? Donald Wells and Leslie Scruggs suggest that ‘‘another major factor
that would prevent a bank of issue from inflating its currency would be the fact
that the great majority of its assets would be denominated in its own banknotes;
thus the bank of issue could be a leading victim of its own overissuance’’
(1983, 84).

In theory, then, one would expect free-banking regimes to exhibit no infla-
tionary secular trends of any consequence. What of the historical evidence? If
one examines the two best-known cases of multiple note issues—Scotland and
the United States—one finds some ambiguity in the case of Scotland and a


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166 Free Banking

clear answer for the United States. With Scotland, there is both anecdotal and
circumstantial evidence of some inflation (see Chapter 5). However, the lack
of data series for Scotland separate from Great Britain as a whole makes any
conclusion very hazardous. As for the United States, the data exist and lead
one to conclude that very little inflation occurred. Specifically, from 1850 to
1860 (the heyday of free banking), wholesale prices rose by 10.74 percent, an
average of only 1.025 percent per year (see Table 17). Consumer prices rose
by 7.99 percent, an average of a mere 0.772 percent per year (see Table 19).
By comparison, one finds from Tables 18 and 20 that from 1959 to 1989
wholesale prices rose 252.1 percent (4.29 percent per year), and consumer
prices rose by 325.3 percent (4.94 percent per year). Kevin Dowd gives a
succinct summary of the historical evidence when he declares that the ‘‘claim
that competition among unregulated banks would lead to an explosive money
supply and rapid inflation thus has no support in the historical record, and
indeed, inverts the truth that rapid inflations have always been associated with
government interventions to suppress competition’’ (1992, 3).

FREE-BANKING INEFFICIENCY

Milton Friedman is one of the best-known proponents of yet another criti-
cism of free banking, at least of that based on a specie standard. He asserts
that such a system is horribly inefficient, because it requires the use of signifi-
cant amounts of real resources in order to supply the metallic outside money
(1959, 4-6; 1962, 220-21). “The use of so large a volume of resources for
this purpose establishes a strong social incentive in a growing economy to find
cheaper ways to provide a medium of exchange’’ (Friedman 1959, 5). He goes
on to estimate the annual cost of a gold standard as 2.5 percent of the American
national product (1959, 5).

Lawrence White responds to this criticism in two ways. First of all, he points
out that Friedman makes the unjustified assumption of a ‘‘pure commodity
standard,’’ that is, a system of banknotes backed 100 percent by gold coin
(1984a, 148). That is, Friedman assumes that free banking will follow the
Rothbard-Mises (RM) model (see Chapter 7), but none of the approximate free-
banking experiments, for example, those in Scotland, the United States, France,
Canada, and Sweden, were systems of 100 percent reserves. To make the as-
sumption Friedman makes is to bias the case against free banking. White re-
calculates the cost of a laissez-faire, specie-backed system using 1982 data on
M1 and GNP and reserve ratios comparable to those actually observed in Scot-
land (about 2 percent). He arrives at ‘‘an estimate of annual resource costs of
between 0.01 and 0.03 percent of gross national product’’ (1984a, 148). White
further opines that ‘‘this figure is insignificant in comparison with plausible
estimates of the GNP losses due to monetary instability’ (1984a, 149fn). Even
if, instead, one uses the much higher reserve ratios for American free banks (a
mean of 14.9 percent per Table 5), one still gets an estimate of roughly 0.04


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Criticisms 167

to 0.1 percent of GNP per annum. Either way, Friedman's figures are badly
overstated.

In addition, White is sensitive to an insight that seems to have escaped Fried-
man’s notice altogether:

The forced substitution of fiat for convertible currency, like the Ricardian forced substi-
tution of convertible currency for coin, is by no means efficient when it contravenes
consumer preference for what is considered a more trustworthy currency. Lowering
production costs does not constitute efficiency when the resulting product is one of
lower quality in consumers’ eyes. The actual forced movement in the twentieth century
from a gold-convertible dollar to an inconvertible dollar must have represented a ‘‘neg-
ative social saving.’ (1984b, 296)

In other words, utility losses may occur at the microlevel even when certain
(apparent) monetary gains are achieved at the macrolevel. Friedman's error lies
in adopting what White has brilliantly termed a ‘‘macroinstrumental’’ approach
as opposed to a ‘‘microsovereignty’’ approach (White 1985, 114-15). The for-
mer means letting the economic analyst determine what is ‘‘desirable’’; the
latter means letting the consumer decide.

FREE BANKING AND COUNTERFEITING

A very common belief regarding free banking has been that it is conducive
to counterfeiting. Most economists would not question the assertion that, for
example, during the American free-banking period, ‘‘counterfeiting was ram-
pant’’ (Kemmerer and Jones 1959, 195). Counterfeiting was not unheard of in
free-banking systems, but was it a severe and chronic problem? The facts seem
to suggest otherwise.

““The Scottish free banking system . . . seems to have provided few oppor-
tunities for profit through fraudulent note issue. Counterfeiting was rare’” (White
1984a, 140). Henry Meulen agrees that ‘‘experience has demonstrated to the
Scottish people that forgeries of the paper of its private banks are rarer than
counterfeit sovereigns: the issuers of the paper are on the spot, and are inter-
ested in preventing forgeries of their own notes; whereas the government acts
slowly and ponderously from a distance’’ (1934, 69).

What about the United States? Is it not true that American free banking
witnessed massive quantities of forged notes? Perhaps not. The widespread
belief in the magnitude of such counterfeiting stems from a misunderstanding
of the various ‘banknote reporters’’ published at the time. These were period-
icals (usually weekly) that listed each free bank, the discount (if any) then
prevailing on the bank’s notes and any known counterfeit notes. A perusal of
such banknote reporters conveys the impression of an enormous number of
counterfeit notes.

Such an impression is erroneous, however. Hugh Rockoff explains that ‘‘his-


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168 Free Banking

torians have not understood that the reporters listed all counterfeits and all
banks which had failed, even if the notes had been removed from circulation
years before. . . . In other words, the reporters contained cumulative indexes
of bank failures and counterfeits, not annual indexes’’ (emphasis in original)
(1975, 23). He mentions, for example, a banknote reporter from 1849 that still
listed a bank in Savannah, Georgia that had closed ten years earlier (1975, 25-
26). Robert King suggests that the unreliability of such data may make it im-
possible ever to construct an accurate series on American counterfeit notes (1983,
155). In short, the precise extent of counterfeiting experienced under free bank-
ing in the United States may never be known. Nevertheless, one thing appears
to be true: the frequency with which counterfeiting occurred has in the past
been exaggerated.

As for other episodes of free banking, one should see the detailed surveys in
Dowd (1992). Generally, counterfeiting seems to have been a minor problem.
In Scotland, banks sometimes even honored forged notes that were innocently
offered for redemption or deposit (White 1984a, 40). In Canada, ‘‘since all
banks had an interest in preventing forgeries, it was only natural that an orga-
nization like the Canadian Bankers Association (CBA) would emerge to look
after this common interest’ (Wells 1989, 16).

Does theory suggest that free banks ought to have a problem with counterfeit
notes? No, since the likelihood of successful counterfeiting varies directly with
the average period of circulation; that is, notes that return to the issuer very
slowly are more likely to be forgeries. Central banking systems are inherently
inferior in this regard. If there are both legal tender laws and a monopoly issuer
of currency, then notes tend to circulate for long periods before they are re-
turned to the issuer (Selgin 1988a, 149). This encourages attempts at counter-
feiting. Free banks should, in contrast, have their notes returned frequently via
the mechanisms of reflux and adverse clearings. Indeed, the more intense the
competition, the more rapidly free banks would return their rivals’ notes for
redemption. As a result, the average period of circulation for free-bank notes
should be quite short, and the likelihood of counterfeiting should be small (White
1984a, 140).

CENTRAL BANKING AS A SPONTANEOUS EVOLUTION

Recently the view has been expressed that competitive banking is neither a
natural development from market forces nor an efficient approach to the sup-
posedly unique problems of banking. It has been proposed instead that central
banking is both superior to free banking and, moreover, the result of an evo-
lutionary process rather than a legal imposition that constrains the market. The
most vigorous expositor of this idea is probably Charles Goodhart, a former
economic advisor for the Bank of England. Goodhart’s argument boils down
' to the following propositions: (1) Centralized control of banking is necessary
and desirable because of instability resulting from ‘‘contagion effects,” the


===== PAGE 196 =====

Criticisms 169

impracticability of private deposit insurance, and the ‘moral hazard’ problem;
and (2) central banks came into existence as a natural reaction to the deficien-
cies of competition (1988, 6-11, 103-4).

Goodhart believes free banking necessarily suffers from panics that arise from
‘‘contagion effects.”’ Yet Arthur Rolnick and Warren Weber found very little
evidence of contagion in American free banking between 1841 and 1861 (1986),
and one would expect even less in a true laissez-faire system. If the common
elements that link commercial banks together in a central banking scheme—
centralized reserves, a lender of last resort, a uniform currency, and deposit
insurance—were eliminated, then each bank would have to be judged on its
own merits. The liquidity or solvency of one bank would have little or no
bearing on the soundness of any other bank.'® ‘‘Contagion’’ may be largely a
product of those restrictions on the free market that comprise central banking.

Goodhart further asserts that private deposit insurance is impractical. Eu-
genie Short and O'Driscoll (1983), Catherine England (1988), and Selgin (1988a,
135-36) flatly disagree. Glasner (1989, 195-200) and Dowd (1991d, 6-8) both
argue that deposit insurance (private or governmental) is unnecessary. Glasner
observes that private moneys in the form of mutual fund shares are immune to
bank runs, because the holders of such moneys have equity claims, not debt
claims. A bank run would simply diminish the wealth of those who possessed
the mutual fund shares. Dowd makes a compelling case for believing that cap-
ital adequacy is a viable (and perhaps superior) alternative to deposit insurance.
As Dowd puts it, ‘“‘runs can be eliminated when equity-holders maintain a
sufficient capital buffer to provide depositors with credible reassurance that
their deposits are safe’’ (1991d, 8).'!

England insists that unregulated systems with private insurance would exhibit
greater stability than our present system and suffer from little informational
asymmetry. This conclusion follows from her beliefs that without federal reg-
ulation and insurance, the value to depositors of information about specific
institutions would increase, leading to both greater demand for and greater sup-
ply of such information, and banks would become more heterogeneous, making
easier the differentiation between safe and unsafe institutions (England 1988,
785-86).

Goodhart also feels that ‘the avoidance of moral hazard requires a degree of
regulation and interventionist control over the freedom of bankers’ (1988, 104).
This is indeed a peculiar suggestion; regulation appears to be the chief source
of moral hazard problems rather than the means for their elimination. As
O’Driscoll has stated: “The FDIC's pricing of deposit insurance creates a sub-
sidy to risk taking, a subsidy that can only be captured insofar as banks actually
make their asset portfolio riskier’’ (1988, 663). Can the FDIC solve the prob-
lem it has created? No. Since regulatory agencies are by nature noncompetitive,
non-profit-maximizing entities (a fact Goodhart praises), they are incapable of
discovering the appropriate risk premium.’? Only a market participant has access
to such information because it is information generated by a trial-and-error,


===== PAGE 197 =====

170 Free Banking

market process. Thus, it is that ‘‘a rational system of risk-based insurance pre-
miums offered monopolistically by a public agency is simply impossible’
(O’Driscoll 1988, 667).

Finally, Goodhart proposes that central banks are a natural evolution, an
‘‘obvious solution’’ to the flaws of unregulated banking. What are the facts?
Has the legal creation of central banks been motivated by a desire to increase
the public welfare (Goodhart’s position) or by a desire to extract privileges for
special-interest groups?

‘“The Federal Reserve Act was the result of a movement led by bankers . . .
hoping to offset the decentralization of banking toward small banks and state
banks. The expansion and domination of banking by big city bankers was pos-
sible only with the aid of the federal government’ (Kolko 1963, 243). Fur-
thermore, ‘‘the Federal Reserve was designed to act as a government-sponsored
and -enforced cartel promoting the income of banks by preventing free com-
petition from doing its constructive work on behalf of the consumer’ (Rothbard
1984a, 135). Roland Vaubel states that central banks have nor attained their
privileged status as a result of out-competing all other banks: ‘‘The Bank of
England, for example, was granted its monopoly not because it was gaining
ground in the market but because it was losing out to the other joint-stock
issuing banks which had emerged after the Bank’s joint-stock monopoly had
been abolished in 1826’ (1986, 933fn).

Glasner offers that *‘the state monopoly over money emerged not to increase
the efficiency of the monetary system but to help the state protect its sover-
eignty’’ (1989, 38). One might add that central banks have consistently been
utilized by the state as a source of credit.!®> Even a cursory perusal of history
reveals that nation-states, in order to finance wars or massive domestic projects,
have found it ‘‘necessary’’ to reduce (or eliminate altogether) competition in
banking. Central banks have been the principal tool of governmental expan-
sion. It is no accident that the twentieth century—the ‘‘century of collectiv-
ism’’—is also the century in which central banking became the norm. Richard
Wagner sums these points up neatly when he argues that ‘‘the support for
central banking seems more likely to be explained by the economic theory of
rent-seeking than by the theories of market failure and public goods’’ (1986,
519).

A LENDER OF LAST RESORT

One of the objections to free banking that is most frequently cited is the
assertion that banking is inherently ‘‘unstable’’ or ‘‘fragile,’”’ and therefore,
there must exist some agent outside the market process itself that will come to
the aid of individual banks in times of crisis. The problem is said to stem from
the fact that banks—unique among financial institutions—perform two different
roles. They are both (1) financial intermediaries and portfolio managers, and
(2) suppliers of transaction services (Goodhart 1988, 86-87). This allegedly


===== PAGE 198 =====

Criticisms 171

leads to a fatal flaw. Namely, bank illiquidity can bring about bank insolvency,
and the failure of one bank may very well precipitate a run on all banks. In
other words, bank runs are inescapable (without a lender of last resort) and
potentially disastrous.

A central bank as the ultimate source of liquidity, as the lender of last resort
(LOLR), is proposed as the solution to the weaknesses of banking. It would
indeed be foolish to claim that commercial banking in the United States, for
example, is fundamentally sound, but what is the source of the problem? Are
regulation and centralized control the cure—or the disease?

Dowd points the way to an answer when he says that ‘‘the experience of
relatively free banking . . . appears to lend no support to the claim that sys-
tems without a state-sponsored LOLR are more prone to crises . . . the bank-
ing system is quite capable of protecting its liquidity provided it is left free to
evolve the means to do so’ (1989, 39). The necessary means to achieve such
protection most fundamentally requires that each bank be free to supply notes
to the market as the demand arises. As seen in Chapter 2, a bank that can issue
notes is likely to be able to keep a currency run from becoming a redemption
run. When private banknotes are forbidden, every increase in the demand for
currency relative to deposits drains reserves from the system and brings on
large decreases in the money supply.

If freedom of note issue were accompanied by direct—but delayed—con-
vertibility in the form of option clauses, bank panics might be altogether un-
known. ‘Option clauses give note-issuing banks that operate on fractional re-
serves an effective means of protecting themselves against bank runs’ (Dowd
1991h, 761). The reason is disarmingly simple. In the absence of option clauses,
a depositor who had the slightest doubt about the bank’s ability to redeem
would be motivated to go ahead and demand redemption for fear of not being
first at the redemption window. The sudden ‘‘panic’’ behavior on the part of
depositors (each of whom is concerned about his or her place in the redemption
line) exhausts the liquidity of the bank. This may force the bank to absorb
‘“firesale’’ losses on assets that are sold in order to accommodate the redemp-
tion demands. In short, insolvency may result. '*

On the other hand, the presence of an option clause forestalls the entire
process. Its effect 1s to reward the depositor—via explicit interest payments—
for delaying the demand for redemption. Option clauses ‘‘convert speculative
demands for redemption from the destabilizing force they are under full con-
vertibility to a stabilizing force that protects the banks’ reserves when they are
run down’ (Dowd 1991h, 764).

The problem, however, goes beyond prohibitions of private banknotes and
option clauses. The justification for central banks has dwelt on the ‘‘financial
weaknesses’ of commercial banks. Those weaknesses, however, prove on close
inspection to be largely, if not entirely, the result of a maze of regulations and
restrictions.'> For example, in the United States, banks have been prevented
from reducing risk by means of the diversification of their assets and/or liabil-


===== PAGE 199 =====

172 Free Banking

ities. The restrictions on diversification have taken the form of antibranching
laws (the National Banking Act of 1864 and the McFadden Act of 1927), as
well as the stipulation that commercial banks could not underwrite corporate
stock and bond issues (the Glass-Steagall Act of 1933). Furthermore, the flat-
rate insurance premia of the FDIC’s deposit insurance have even encouraged
banks to undertake ever-riskier portfolio strategies. Indeed, the very existence
of an LOLR itself encourages more risk-taking, especially when loans are of-
fered by that LOLR at subsidy rates of interest rather than penalty rates. ‘‘In
doing so they in effect act as lenders, not of last, but of first resort’ (Selgin
1989, 442). Ceilings on deposit rates of interest (the Glass-Steagall Act and the
Banking Act of 1935) and limitations on bank mergers (the Bank Merger Act
of 1966) further harmed banks by reducing their responsiveness to changes in
market conditions. Regulation is and has been the problem, not the solution.

SUMMARY

It has long been thought that there exist compelling reasons why private
money production by unregulated banks ‘ ‘simply cannot work.” These include
the beliefs that money is a public good, private money will be held in subop-
timal quantities, banking is a natural monopoly, laissez-faire banking is una-
voidably inflationary, specie-based currencies imply an inefficient use of re-
sources, multiple currencies encourage counterfeiting, and only a central bank
can prevent periodic financial crises. To these may be added the more recent
argument that central banks are a natural development necessitated by the in-
stability of decentralized, competitive banking. As was seen above, all such
criticisms of free banking are, despite their evident popularity, of questionable
merit.

NOTES

1. Some economists emphasize the ‘‘joint supply’ aspect. This is the proposition
that if the good is produced at all, it will be produced in a quantity sufficient to benefit
all persons. National defense is supposedly the premier example of such production.
Others focus on the proposition that, once it is produced, the marginal cost of a public
good is zero.

2. This perspective is totally foreign to many economists. That is, many adhere—
implicitly if not explicitly—to a methodological holism rather than to methodological
individualism.

3. See Chapter 4 for a discussion of this issue. The core of the problem seems to
lie with the unthinking assumption that data are the same as knowledge (or information)
in economics. Only those who embrace an individualistic method will apprehend the
distinction.

4. The relationship between the two arguments consists of the fact that both involve
certain supposed external effects.

5. This is true despite the fact that Friedman's estimate of the potential gains from


===== PAGE 200 =====

Criticisms 173

achieving optimal money balances is considerably higher than Dowd’s (Dowd 1991e,
10).

6. Such payments on demand deposits were ended in the United States only when
they were prohibited by the Banking Act of 1933 (perhaps better known as the Glass-
Steagall Act).

7. One might see both as suboptimal quantities from a utility perspective, but Sel-
gin’s point is well taken nevertheless.

8. See Glasner (1989, 238) and Selgin (1990, 281) for further discussion.

9. That self-interest can, of course, follow either an ethic of rational selfishness or
an altruist ethic. In other words, ‘selfishness’ and ‘‘self-interest’’ are not synonyms.
Noneconomists frequently fail to make the distinction. However, in neither context would
a depreciated currency seem desirable.

10. This would remain true even if there were a private clearinghouse. Clearing-
houses are organizations that exist primarily in order to facilitate the settling of interbank
debts. They are likely to arise spontaneously (and did in actual historical cases). Clear-
inghouses would probably evolve certain functions in addition to interbank clearings.
They might serve as credit information bureaus, monitor questionable practices on the
part of the member banks, and assist members by supplying short-term credit (Selgin
1988a, 28-29). Despite a superficial similarity, clearinghouses are not central banks.
They are, however, capable of performing all the beneficial functions of a central bank.

11. Dowd has long argued that bank reserves are less important to bank safety than
is bank capital. This would depend, at least in part, on whether convertibility was direct
or indirect.

12. See Chapter 4 for discussion of a similar point.

13. There is a kind of symbiosis at work here. The central bank is granted certain
legal privileges—such as establishing its currency as legal tender—in exchange for which
it assists the state in achieving certain policy goals.

14. Under free banking, failure would still be unlikely, because banks would have
an incentive (in the absence of government deposit insurance) to maintain adequate
capital. The topic of capital adequacy is a familiar theme in Dowd’s work and one that
deserves more attention. Dowd develops his ideas along these lines most effectively
when he critiques the Diamond-Dybvig model of bank instability (1991c, 1991d). The
Diamond-Dybvig (DD) model (1983) has proven extremely influential and is often taken
to be the definitive proof of the proposition that banking is inherently unstable. Briefly,
the DD model states that (1) depositors’ demands for liquidity are unpredictable, (2) a
bank’s liabilities (demand deposits) are more liquid (possess a shorter time to maturity)
than its assets (its loans outstanding), and (3) therefore, bank runs will occasionally
occur unless there exists government deposit insurance and/or a lender of last resort in
the form of a central bank. Dowd’s very effective rebuttal makes four key points. First,
the DD model assumes that all investors exhibit the same attitude toward risk, which
ignores the fact that some investors prefer debt and some prefer equity. Second, the
‘‘banks’’ in the DD approach do not resemble real-world banks at all; they are a kind
of mutual fund. Third, DD assume that government has access to both certain technol-
ogy and resources that are unavailable to the private sector. Finally, DD overlook the
fact that banks (even with fractional reserves) can forestall runs and panics by holding
an adequate capital buffer.

15. See Selgin (1989) for an excellent review of such arguments.


===== PAGE 201 =====



===== PAGE 202 =====

Chapter 9

FINAL THOUGHTS

This book has had two basic goals: (1) to summarize and critique some of the
more important theoretical and empirical research on free banking, and (2) to
present some of the author’s own thoughts on the theory and history of free
banking. One hopes that the former has been accomplished in a manner that is
both fair to those other researchers at the same time that it offers a clear and
insightful exposition to the reader. As for the latter, all writers aim for a pre-
sentation that is persuasive. This writer is no exception. If this book builds a
persuasive case for free banking, he will be delighted. If it is merely thought-
provoking, he will still be more than pleased. Only a few last comments are
needed to complete the task.

A METAPHOR

In order to illustrate the point to be made here, a brief digression is first
necessary. Assume that an architect has designed a new office building. As-
sume further that the design is considered completely satisfactory—indeed, ex-
cellent—by those who commissioned its execution. Then the structure is built,
subject to the local laws and regulations. Those legal constraints require that
the builder use only local materials and local labor in the construction. Imagine
that those local sources involve inferior materials and laborers of questionable
skill. The result is predictable. The elevators do not fit flush with the floors,
electrical appliances experience short circuits, doors do not close properly, the
roof leaks when it rains, and so forth. In short, the office building is something
of a failure; it pleases neither the owners nor the tenants. Would anyone blame
the architect under such circumstances? Clearly not. The design was sound; it
was the transformation of the design into three-dimensional physical form that


===== PAGE 203 =====

176 Free Banking

proved inadequate, and the critical fact is that such inadequacy stemmed from
violations of the design.

Now think of the free-banking theory of Chapters 2, 3, and 4 as constituting
the ‘‘design.’’ Alleged applications of that model (the ‘‘building’’) were the
subject of Chapters 5 and 6, namely the free-banking experiments in Scotland
and the United States. As was made clear, neither of those experiments was
entirely successful—although at the macrolevel, the American system seems to
have worked surprisingly well considering the institutional restrictions im-
posed. The essential parallel to the architectural metaphor is simply that, since
the assumptions of the model were violated in practice, the resulting product
was of course flawed. Furthermore, just as with the example of the building,
the misapplication of a sound design should lead one to condemn the structure
rather than its design; that is, the deficiencies of either Scottish or American
free banking cannot with fairness be used as grounds for condemning true lais-
sez-faire banking.

POSSIBLE FUTURE RESEARCH

Free banking is a subject that lies on the frontiers of monetary economics,
and as such, it holds out the promise of potentially great rewards to those
willing to explore its boundaries. To approach the issue of a future research
agenda, one might think in terms of theoretical work, historical investigations,
and practical implementations. The theoretical dimensions of free banking that
need further attention include (1) the relationship between free banking and
business cycles (does free banking constitute the final vindication of Say’s Law,
as was suggested in Chapter 37), (2) the possibility of private deposit insurance
(is it necessary, and if so, is it practicable?), (3) the issue of informational
asymmetries (why are they likely to pose a smaller problem under free banking
than under central banking?), and (4) the effects of option clauses and adequate
capital (can they eliminate bank runs completely?).

As to historical research, much more can be done if only the relevant data
series can be found or constructed. It would be of obvious benefit, for example,
to possess information on national income, unemployment, the money supply,
interest rates, and the price level for Scotland (1765-1845) separate from Great
Britain as a whole. At the microlevel, information on redemption rates on Scot-
tish banknotes as well as the gold price of such banknotes could prove invalu-
able. An attractive replication project might be to scrutinize several of the free-
banking states in the American South along the lines of Arthur Rolnick and
Warren Weber's examinations of New York, Indiana, Wisconsin, and Minne-
sota. There are several candidates: Georgia adopted free banking in 1838, Ten-
nessee in 1852, Louisiana and Florida in 1853, and Alabama in 1849. Finally,
detailed investigations should be undertaken into the nature and performance
of free banking in such other countries as France, Canada, Sweden, Switzer-
land, China, Australia, New Zealand, South Africa, Spain, and Italy (Selgin


===== PAGE 204 =====

Final Thoughts 177

1988a, 7-12). This work has already begun (see, for example, Selgin 1987;
Jonung 1989; and Dowd 1992).

A crucial question remains: How is the transition to free banking to be ac-
complished? Only a few works have specifically addressed this issue, and those
treatments are all too brief. Donald Wells and Leslie Scruggs propose the fol-
lowing steps: (1) termination of the Fed's monetary powers, that is, the end of
both open market operations and discounting; (2) movement of the Treasury’s
accounts to commercial banks; (3) phasing out over time the Fed’s check clear-
ing system so as to encourage the reestablishment of private clearinghouses;
(4) repeal of all legal tender laws; (5) establishment of freedom of entry and
exit in banking; (6) removal of all reserve requirements, capital requirements,
and restrictions on branching; and (7) granting to private institutions the right
to 1ssue their own notes (1986b, 264-65).

George Selgin adopts a more cautious approach. He suggests that, after banks
have been freed from reserve requirements and limitations on branching, the
stock of Federal Reserve notes be frozen. Subsequently, banks could redeem
their liabilities in either those Federal Reserve notes or in some commodity,
such as gold, depending on consumers’ preferences (1988a, 168-71).

Selgin goes on to claim that ‘there are no great logistic or material barriers
standing in the way of the adoption of free banking; the transaction costs of a
well-framed free banking reform are negligible’’ (1988a, 171). This seems a
bit naive. Surely there are those-—the employees of the Federal Reserve System
and the FDIC, for example—who see the complete deregulation of the Ameri-
can financial system as a direct threat to their status and standard of living.
Such persons may perceive the transition to a laissez-faire financial environ-
ment as extremely costly.

Richard Wagner is closer to the mark when he argues that “‘those who are
interested in monetary reform should recognize that the circumstances they are
concerned about reflect the outcome of people’s pursuit of their interests within
our existing constitutional order. Monetary reform without political reform to
redress the rent-seeking excesses of prevailing political institutions seems likely
to be a short-lived aberration’’ (1986, 536).

Much more thought needs to be given to both the enabling conditions and
the ramifications of a transition to free banking. Until the pervasive addiction
to the welfare state has ended and a belief in laissez-faire capitalism has taken
root, free banking may remain a political impossibility. The implementation of
free banking could prove to be a task that is as much philosophical as it is
technical.

A LAST WORD

Friedrich Hayek declares that ‘‘[w]hat we now need is a Free Money Move-
ment comparable to the Free Trade Movement of the 19th century’ (1978,
129). He is absolutely correct. Without free banking, inflation and periodic


===== PAGE 205 =====

178 Free Banking

crises will remain the order of the day. Moreover, as long as money remains a
tool of the state, that tool will continue to serve the state as a well-spring of
income redistribution, social engineering, and military adventurism. A laissez-
faire approach to money and banking is more than merely conducive to effi-
ciency and stability. It is likely to prove to be the necessary precondition for
prosperity, justice, and peace.


===== PAGE 206 =====

APPENDIX: A
MATHEMATICAL MODEL OF
FREE BANKING

The specification of the model takes the following forms:

Implicitly,
MD =MD(P;k,y)
MS =MS(P;S k,P,,y)
Y= Y(Py)
Explicitly,
MD =aP + by +ck (1)
MS =eS+fk—gP,—hP—jy (2)
Y= Py (3)
where

MD =the nominal demand for money
MS =the nominal supply of money
k =the fraction of income consumers desire to hold as money
y =real national income (output)
S =the specie reserves of banks
P =the price level
P, =the real unit cost of specie

Y = nominal national income


===== PAGE 207 =====

180 Appendix

Itis assumed thata > #3, b>4,c>0,e>0,{>0,g>06,h>0,]>0,1>k>
9. In equilibrium MS=MD=M. Taking M, P, and Y as the endogenous variables of
the system, this becomes:

M—aP=by+ck (1a)
M+ hP=eS + fk — gP, — jy (2a)
Y—-Py=60 (3a)

Setting this up in the matrix form Ax =d, one has the following:

1 —a ) M by +ck
1 h 2 P = eS + fk — gP,— jy
7} -y 1 Y )

solving for the determinant |A|=(h+ a) >@. Thus, there exists a unique and nontrivial
solution to the system. Utilizing Cramer’s Rule, one can solve for M, P, and Y, the
equilibrium values of M, P, and Y.

by +ck —a |)
M= ih = eS+ fk —gP,—jy h 9
@ -y |
(h+a)
hby + ckh + aeS + afk — agP; — ajy
(h+a)
1 by + ck é
p= Ad | eS + fk — gP, — jy 0
Al
2 9g 1
(h+a)
_ eS +fk—gP,—jy—by—ck
(h+a)
1 —a by + ck
v- IM = 1 h eS + fk —gP,— jy
9 -y )

(h+a)


===== PAGE 208 =====

Appendix 181

yeS + yfk — ygP, —jy>— by? — cky
(h+a)

To determine the effects of parametric changes, one may take the partial derivative
of each M, P, and Y with respect to k, y, S, and P,.
If k changes,

oM _ (ch+af)
ak  (h+a)

dk (h+a)

oP _(-9

To maintain monetary equilibrium,

oMD oMS
——=—— That is, c=f
dk dk

Therefore,

dP _(f-c) _

ok (h+a)
and

oY _yf-o _

ok (h+a)
To summarize,
M_ oP aY
_ —_—= _—
dk ok 8, ok g
An increase in k increases both the demand for money and the supply of money. The

price level and nominal income do not change.
If y changes,

aM _ (bh aj)
ay BN (h+a)

To maintain equilibrium, one must take account of shifts of the curves, that is,

oMD  oMS
——+——=4#0,0rb=j
oP ay


===== PAGE 209 =====

182 Appendix

As well as movements along the curves, that is,

oMD oMS
op Pp gd, ora=h
Substituting,
M _ (jh—jh) _
ay (h+a) BN
dP _ —(j+b)
ay (h+a)
dY _ (eS+ fk —gP,—2jy—2by —ck)
ay (h+a)
_ (eS +1k—gP;—jy) — jy — 2by — ck)
(h +a)
Since
(eS + tk —gP,—jy)=(M+hP), (Eq. 2a),
then
dY M-+hP—jy—by—(by+ck)
ay (h+ a)
Since
(by + ck) =(M —aP), (Eq. 1a),
then

3Y M+hP—jy—by—M+aP)

ay (h+a)
_(hP+aP—jy—by) P(h+a)—y(j+b)
- (h+a) B (h + a)

Following George Selgin (1988a, 98-101; 1990, 272), if one assumes that aggregate
demand is unit elastic, dY/0P+aY/dy = @, and since aY/dP=@, then 3Y/dy=@. This
means that P(h+ a) =y(j +b), which is to say that the price level times its effects on
MS and MD equals real output times its effects on MS and MD. One may note that if
aggregate demand were elastic, then 3Y/dy >@, and if aggregate demand were inelastic,
then 8Y/dy <@. To summarize,


===== PAGE 210 =====

Appendix 183

A pervasive increase in productivity will drive production costs and the price level
down. Nominal money demand rises, while the nominal money supply falls. Nominal
money holdings remain the same, as does nominal income.

If S changes, then

aM ac
dS (h+a)
oP €

—_— >
dS (h+a)
Y _ ye
dS (h+a)

If there occurs an unanticipated increase in the supply of specie (monetary gold), then
the money stock, the price level, and nominal national income all rise. It is more likely,
however, that such a change in the production of specie would be preceded by an
increase in the demand for same. In other words, first k, rises and k; falls. This consti-
tutes a redemption run.

For changes in k;,

OM (ch +af)
dk, (h+a)

®P_ (=o) _
ok, (h+a)
NY _yf-o
ok, (h+a)

For changes in the real cost of specie (P;),

oM_ —ag
oP, (h+a)
P__"E
oP, (h+a)
a _ _—ye
oP, (h+a)

The relative demand for specie rises, driving up its price (Ps). The desired ratio of
outside money to inside money, kk;, also rises. The inside money supply falls by a


===== PAGE 211 =====

184 Appendix

larger proportional amount than the outside money supply rises. The price level and
nominal income decline. Subsequently, the supply of specie increases. This increases
both the outside and inside money supplies, the price level, and nominal income.

A currency run occurs when consumers choose to liquidate part or all of their deposit
accounts in order to acquire currency. Currency runs pose a deflationary threat to central
banking systems, because all currency runs are also redemption runs. This follows from
the facts that (1) there is a single monopoly issuer of currency, and (2) in such a system,
the legal tender currency serves both as currency for the public and as part of the
reserves of commercial banks.

Under central banking,

MS=C+DD and MB=C+R,

where
MS =the money supply
C =currency held by the public
DD = demand deposits
MB =the monetary base
R=bank reserves (vault cash plus deposits with the central bank)

R R
If the statutory reserve ratio is RR, then RR= bp DD = RR’ Substituting the expres-

R
sion for DD back into the earlier expression for MS, MS=C ETS Since R=MB-C,

MB-C M
( ) ang M5 =(1-1/RR) <0.

then MS=C + RR 3C

This last is clearly negative as long as RR <1, that is, as long as there is fractional
reserve banking. Also, [1 — I/RR|>1 if RR<.5, which is very likely. For example, if
the legal tender reserve ratio is 0.1 and consumers exchange $1 million in deposit credits
for $1 million in currency, for any given monetary base, the net effect on the money
supply will be a decrease of $9 million.

Under free banking,

MS=N+DD and MB=S

where

MS =the inside money supply
N = privately issued banknotes
DD =demand deposits
MB =the monetary base
S =banks’ specie reserves

If ORy is the optimal reserve ratio for notes, ORpp is the optimal reserve ratio for
demand deposits, Sy the specie reserves for notes, and Spp the specie reserves for
demand deposits, then


===== PAGE 212 =====

Appendix 185

S S
ORy= N and ORpp= oD
or
_ Sk _ Spo
N= OR and DD = ORop

If all free banks exhibit the same optimal reserve ratios for each deposits and notes,
then ORy=0Rpp, =O0R.

Keeping in mind that specie reserves can be used to redeem either notes or deposits,
the above expression for the money supply may be transformed such that

Sx+Spp  S
MS=N+DD=—7+-=—
OR OR
Thus,
oMS
oN

An increased relative demand for currency (versus deposits) has no net effect on the
money supply under free banking. It is not necessary for a currency run to become a
redemption run, as is the case under central banking.


===== PAGE 213 =====



===== PAGE 214 =====

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===== PAGE 225 =====



===== PAGE 226 =====

INDEX

Adverse clearings, 7, 14, 15, 68, 75, 144 Banks: chartered, in Scotland, 90-91, 92

Aldrich-Vreeland Act, 137 nn.4, 5; chartered, in United States,
Architectural metaphor, 175-76 97, 105-8, 110; labor-intensity, 16;
Austrians: business cycle theory, 53-56, money producers, 20-23

58 nn.22, 24, 155 n.8, 156 n.13; char- Barter, 152
acteristics, 42 n.5, 58 n.19; free bank- BFH (Black-Fama-Hall) model, 150-55,

ing, 18, 144-50, 155 n.6 156 nn.20, 21
Bimetallism, 155 n.9
Bank Charter Act of 1844, 82 Bordo, Michael D., 34, 67
Bank failures: Canada, 138; capital ade- Branching, by banks, 3, 80, 109, 137-
quacy, 169, 173 n.14; option clauses, 38, 172

171; Rothbard, 145-46; Scotland, 81, Bretton Woods agreement, 66
83-85; United States, 95-101, 103-4, British Linen Bank, 80, 90, 92 nn.4, 5

137-38 Buchanan, James M., 2, 69, 71-72, 78
Banking Act of 1933, 43 n.16, 172, 173 n.28, 161

n.6 Business cycles: Austrian theory, 53-56,
Banking Act of 1935, 172 58 nn.22, 24, 61, 155 n.8, 156 n.13;
Bank Merger Act of 1966, 172 classical economics, 48-49, 57 n.8;
Banknotes: convertibility, 87-88, 96, definition, 45-46; Keynesian theory,

143-44; counterfeiting, 81, 95-96, 53; monetarist theory, 53—56, 77 n.11

109, 167-68, 172; distinctive, 7-8;

excess supply of, 17, 89, 95, 109, Cambridge cash-balance equation, 24-25

134; fraud, 95-96, 100-101, 145; Capital ratios, 107-8

small-denomination, 80, 88-89 Capital requirements, 3, 96
Bank of England, 67, 82, 88, 91, 168, Central banking: counterfeiting, 73; defi-

170 nition, 2-3; monetary policy, 59-61,
Bank of Scotland, 80, 90, 92 nn.4, 5 63-68, 71-76, 78 nn.31, 33; as natu-

Bank panics, 103-4, 170-71 ral evolution, 168—70


===== PAGE 227 =====

200 Index

Checkland, Sidney G., 83, 85, 87, 90- Equity-based money, 101-3, 139 n.9,
91 143
Civil War, 109-10, 140 n.17, 141 n.27
Clearinghouses, 5, 173 n.10 FDIC (Federal Deposit Insurance Cor-
CMGR (constant money growth rule), poration), 1, 169, 172, 177
63-65, 69, 76, 77 nn.8, 9 Federal Reserve: comparative perfor-
Collective demand, 158 " mance, 110, 116, 121-33; criticisms
Commodity money, 146 of, 1-2; erratic behavior, 72; Great
Comprehensive planning, 59 Depression, 141-42 n.34; note issue,
Contagion effects, 103-4, 169 137; special interests, 170, 177
Countercyclical actions: central banks, Fiduciary substitution, 10
60-61; free banks, 15-16, 41, 68 First-best solution, 76
Credit markets, 50-52 Forced savings, 55
Currency runs, 37-41, 43 n.19, 136, 171 Fractional reserves: American banking,
CV (coefficient of variation), 110-35, 96-97, 105-6; central banking, 38;
141 n.26 criticism by Rothbard, 145, 148-49;

development, 5; gold standard, 66-67;
optimal reserve ratio, 14-15; WS
model, 144

Free banking: bond-security requirements,
96, 100-101, 109, 135, 139-40 n.10;
business cycles, 41-42, 47, 49-52,
176; definition, 3—4; evolution, 4-5;
historical examples, 10, 168, 176; in-
terest rates, 17-18, 50-52; key charac-
teristics, 14—18; models, 5-10, 21-41,
143-55; need for, 177-78; stability, in
Scotland, 83-85; stability, in United
States, 95, 103-4, 116, 121-33; the-
ory, 143; transition to, 177

Free nders, 158

Friedman, Milton: business cycles, 18,
60; citation of White, 82; comment on
Federal Reserve, 1-2; criticism of
Keynes, 57-58 n.14; gold standard,
166-67; inflation, 164; monetary his-
tory, 103; monetary policy, 60-65; op-
timal money supply, 160-62, 172-73
n.5; price of money, 22

Economic growth: Scotland, 80, 86-87; FSLIC (Federal Savings and Loan Insur-

DD (Diamond-Dybvig) model, 173 n.14

Debt-based money, 88, 139 n.9, 143

Demand for money: changes in, 59; for-
mal model, 19-26, 50, 56-57 n.3; sta-
bility of, 64-65

Demand for reserves, 14-15

Democratic socialism, 76 n.2

Deposit insurance: government, 1, 3,
172; private, 169

Deregulation, 3, 8

Discoordination, of markets, 17, 45-47

Diversification, 137-38, 171-72

Dowd, Kevin: analysis of money, 19; cri-
tique of DD model, 173 n. 14; econo-
mies of scale, 163-64; free banking,
6, 11 n.5, 93 n.14, 177; inflation, 166;
optimal money balances, 161; option
clauses, 171; price index, 151; produc-
tivity norm, 69-71; Scottish banking,
88

United States, 95-96, 110 ance Corporation), 1

Economic theories, 143 Future research, 176-77

Economies of scale, 80, 162-64

Economies of scope, 163-64 Gibson paradox, 18

Effective demand, 45-49, 56, 66, 148, Glasner, David, 6, 16, 19, 82, 102, 151,
152 170, 173 n.8

Efficient allocation, of capital, 104-5 Glass-Steagall Act (Banking Act of

Epistemology, 71, 73 1933), 43 n.16, 172, 173 n.6


===== PAGE 228 =====

Index 201

GNP (Gross National Product), 2, 64 Knowledge, 160

Gold standard, 66-68, 110 Knowledge problem, 60, 73-76

Great Depression, 141-42 n.34

Greenback era, 110, 125, 127 Laidler, David, 18, 26, 56, 159
Greenfield, Robert, 22, 46, 150-54 Laissez-faire banking, 69, 101, 134, 139,
Gresham’s Law, 155-56 n.9 163, 172

Laissez-faire principles, 3, 133, 155, 177
Hayek, Friedrich A.: business cycles, 18, Legal tender, 3, 10, 16, 77 n.19, 139,
155 n.8; central banks, 2, 61; comment 165, 173 n.13
on Friedman, 65; defense of Say’s Limited liability, 90, 92 n.5, 97
Law, 48, 57 n.14; free banking, model = LOLR (lender of last resort), 170-72
of, 6-10, 11 n.8, 80, 150, 159; gov-
emment planning, 59, 76 n.2; knowl- McFadden Act of 1927, 172

edge, 73; market discoordination, 17; Malinvestment, 55, 61
monetary reform, 177; neutral mone- MAPC (mean absolute percentage
tary policy, 30, 68 change), 110-35, 141 n.26
Historical data, for Scotland, 84-86 Marginal costs, of free banks, 7, 16-17,
Historical data, for United States: com- 20-23, 33-36, 88, 165
mercial paper rate of interest, 123, Marginal revenue, of free banks, 17, 20,
128-31; commodity prices, 121-27; 23, 165
common stock prices, 123, 125, 132- Market coordination, 46-47, 49, 54
35; industrial production, 131-33, Market process, 74
138-39; monetary base, 116-23; Mean-reverting series, 110
money supply, 111-16; real national Methodological holism, 172 n.2
income, 125, 128, 136-37 Methodological individualism, 172 n.2
Horwitz, Steven, 45-47, 49-50, 53, 56, Mises, Ludwig von: banknotes, 146-47;
57 n.10 business cycles, 18, 155 n.8; criticism
Human capital, 77 n.23 of Keynes, 57-58 n.14; defense of
Say’s Law, 48; mathematics, 42 n.5;
Indirect convertibility, paradox of, 154 productivity norm, 68; regression theo-
Inflation, 17, 67, 85, 96, 139 n.7, 164- rem, 146; socialism, 59
66 Mixed economy, 76 n.2
Information, 73-76, 103, 160, 169, 176 MNPC (mean net percentage change),
Inside money, 4, 13, 17, 26, 34-38, 50 110-35, 141 n.26
Interest rates: cost of holding money, MOA (medium of account), 144-45,
161; demand for money and, 65; free 150-54, 155 n.3
banking and, 7, 14, 17-18, 49-52; MOE (medium of exchange), 13, 42
market rate, 17-18, 50-56, 58 n.24, n.10, 144-46, 150-54, 155 n.3, 159
59, 89, 148; natural rate, 17, 50-52, Monetarists, 53-56, 58 n.19
55-56, 57 n.12, 58 n.24, 61, 148; Monetary authorities, models of, 71-72
price of credit, 21-22, 54 Monetary base, 14, 38, 63-65
Investment, 50-52 Monetary discretion, 60, 66, 68
Monetary equilibrium: business cycles
Joint supply, 172 n.1 and, 46-52; definitions, 46; free bank-
ing and, 21-41, 68-69
Keynes, John Maynard, 18, 57-58 Monetary neutrality, 64
nn.14, 15, 16 Monetary rules, 60, 66, 68

Keynesian revolution, 19, 155 n.1 Money market, 49


===== PAGE 229 =====

202 Index

MOR (medium of redemption), 144-45, 21-22; rigidity, 156 n.18; stickiness,
150-51, 154-55, 156 n.21 156 n.18; theory, 22-23
Moral hazard problem, 1, 169 Productivity, changes in, 30-32, 69-71

Mutual fund shares, 101-3, 139 n.9, 143  Profit-maximizing decisions, by free
banks, 17, 41, 165

National Banking Act of 1864, 172 Property rights, 158
National Banking System, 138, 149 Public choice theory, 60, 71-73, 76, 78
National Currency Act of 1863, 139 n.28
National defense, 158, 172 n.1 Public goods, 157-60, 170
Natural monopoly, 162-64, 172 Public welfare, 72
Neo-Austrians, 56
Neo-Keynesians, 58 n.15 Rational expectations, 58 n.25, 76 n.5
Neutral money policy, 30, 32, 151 Real balance effect, 25-26, 32
New-classical economists, 56, 58 n.25, Real money balances, 29, 31, 41
61, 76 n.5 Real wage rates, 54-55
Nominal money balances, 29, 41, 111, Redemption runs, 33-37, 43 n.19, 136,
116 171
Noncomprehensive planning, 59 Reflux, 7, 14, 68, 75
Nonexcludability, 158-60 Rent seeking, 72-73, 90-91, 170, 177
Nonrivalrousness, 158-60 Reserve ratios, 105-7, 166
Note-exchange system, 4-5, 80-81, 83, Reserve requirements, 2-3, 66, 96-97
92 n.9 Risk taking, 1, 172
Noteholders, losses of, 81, 99-100, 105 Rizzo, Mario, 73-74, 82, 160-61
Notional demand, 45-49, 56, 66, 148, RM (Rothbard-Mises) model, 11 n.8§,
152 144-50, 155 nn.6, 9, 156 nn. 10, 12,
166
O'Driscoll, Gerald P., Jr., 73-74, 82, Rockoff, Hugh, 79, 100-101, 104-5,
160-61, 169 140 n.12, 167-68
Optimal reserve ratio, 7, 14-16, 35, 38- Rolnick, Arthur J., 79, 96-105
39 Rothbard, Murray N.: bank failures, 92
Option clauses: RM model, 145, 147; n.8, 145-46; business cycles, 60; de-
theory of, 5, 11 n.6, 171; use in Scot- mand for money, 148, 156 n.12;
land, 80; WS model, 144 Hayek, criticism of, 10, 11 n.8; index
Outside money, 13, 33-38 numbers, 11-12 n.11; inflation, 146;
Keynes, criticism of, 57-58 n.14;
Patinkin, Don, 15, 22-24, 26 math and statistics, 42 nn.5, 7; optimal
Per-capita measurement, 111 supply of money, 147; price flexibility,
Perfect capital markets, 162 156 n.10; public goods, 158; White,
Perfect competition, 8, 140 n.12 criticism of, 93 n.20
Phillips curve, 58 n.18 Royal Bank of Scotland, 80, 90, 92 nn.4,
Post-Keynesians, 58 n.15 5
PPM (purchasing power of money), 22,
24, 29, 31-34, 36, 40 Savings, 17-18, 50-52, 148

Price: adjustment costs, 69-70; indexes, Say’s Equality, 48
11-12 n.11, 62-63, 70; level, 22, 42—  Say’s Identity, 48
43 nn.12, 13; level stability, 9, 61-63, Say’s Law, 11, 47-49, 56, 57 nn.5, 6,
69-71, 85-86, 121-25; of money, 64, 148, 155, 176


===== PAGE 230 =====

Index 203

Schwartz, Anna J., 82, 103 Treasury, Department of, 67
Scottish Bank Act of 1845, 82

Scruggs, Leslie S., 3, 79, 137, 165, 177 Unemployment, 53-55, 61, 110

Self-interest, 173 n.9 Unit bank, 142 n.35
Selfishness, 173 n.9 Unit of account, 8, 152-53, 159
Selgin, George A.: bank evolution, 4-5; Unlimited liability, 80, 90
CMGR, 65; comment on Friedman, Usury Law, 89-90, 92
162; liquidity services, 159; model Utility, of money, 148

comparisons, 7-8, 13-20, 24-26, 29--
37; price indexes, 62; productivity
norm, 30-32, 46-47, 56-57 n.3, 62,
151; regulatory problems, 173 n.15;

Velocity, of money, 15, 75, 78 n.32, 148

transition to free banking, 177 Wage rate stability, 69-71
Signal-extraction problem, 47 Walrasian equilibrium, 74
Social cost, 161 Walras’ Law, 48-49
Socialism, 59 Weber, Warren E., 79, 96-105
Social welfare, 77-78 n.27 Wells, Donald R., 3, 79, 137, 165, 168,
Specie-convertible money: BFH model, 177

151; interest rates and, 50; redemption ~~ White, Lawrence H.: bank evolution, 4
runs, 33-35; RM model, 144-47, 166; 5; comments on Friedman, 166-67;

United States, 96; WS model, 9, 13— criticism by Rothbard, 145-46; La-

14, 144 grangian analysis, 18; price of money,
Spontaneous order, 5, 68 22; Scottish banking, 11, 80-92, 93
Sterilization, 67 nn.11, 12, 20, 22, 23, 95, 167
Stocks and flows, 23-24 Woolsey, W. William, 150, 154

Supply of money: formal model, 19-26, ~~ World War I, 140 n.25, 141 n.27

50, 56-57 n.3; inflation and, 17, 121, WS (White-Selgin) model, 7-10, 144—

123; optimal, 146, 152, 160-62; sub- 45, 148, 150, 154

optimal, 160-62, 172, 173 n.7

Yeager, Leland B.: demand for money,

Theology, economics and, 78 n.30 65; free-banking model, 6, 150-54,
Time: lags, 36-37, 61, 78 n.33; market, 156 nn.18, 20, 22; monetary equilib-

49; preference, 145, 148 rium, 46; price of money, 22


===== PAGE 231 =====



===== PAGE 232 =====

About the Author

LARRY J. SECHREST is Director of the Free Enterprise Institute and Assis-
tant Professor of Economics in the Department of Business Administration at
Sul Ross State University. He is an Adjunct Scholar of the Ludwig von Mises
Institute as well as a former Fellow of both the Mises Institute and the Institute
for Humane Studies. His work has appeared in such publications as the Cato
Journal, the Review of Austrian Economics, the South African Journal of Eco-
nomics and Management Sciences, Magill’s Survey of Social Science: Econom-
ics, and the Journal of Economics.


===== PAGE 233 =====



===== PAGE 234 =====

= 88354