There's a lot we could say about this debate that we just don't have time to get into, unfortunately,
but for those of you who aren't familiar with this period of economic history,
in the 19th century in Britain, there was a heated discussion that spanned several decades
between two schools of thought that became known as the currency school and the banking school,
and to some extent there's also a free banking school, but that's not relevant for my paper.
But basically what they debated was how to regulate the Bank of England and other banks
and the banks of issue so as to mitigate if not eliminate financial crises and prevent the inflationary over issue of bank notes.
So what matters for us is that in the process of doing this, they discussed several important problems in monetary theory that appear again and again in the history of thought.
So I'd like to just talk a little bit about some of these problems and how they influenced monetary theory just after the turn of the century.
In particular, I'm speaking of Mises, who I assume all of you know, Joseph Schumpeter, student of Boehm-Bawerk, but also heavily influenced by the Lausanne School, and Rudolf Hilferding, the Austro-Marxist economist.
All three came from similar backgrounds. They were all students in Boehm-Bawerk seminar at the University of Vienna.
And they all published important books relating to the currency banking debate in consecutive years.
Hilferding's Finance Capital appeared in 1910, Schumpeter's Theory of Economic Development in 1911, and Mises' Theory of Money and Credit in 1912.
In terms of their relationships to the earlier schools, Mises is essentially a disciple of the currency school,
Hilferding is an orthodox banking school theorist within a broader Marxist framework,
and Schumpeter is somewhere in between taking little bits and pieces from each school.
So, we'll begin with Mises and the Currency School. As I said, the doctrines of the Currency
School were developed in early 19th century Britain principally by Lord Overstone, George
Norman and Colonel Robert Torrens. And they built their system around the idea that additional
legal restrictions are necessary in addition to convertibility to ensure that banks couldn't
The Central Doctrine of the Currency School became known as the Currency Principle, which states that the quantity of notes in circulation should be made to adjust in volume exactly as a purely metallic currency would, or in other words, there is always a danger of an overissue of bank notes, which should therefore be strictly regulated, so regulated that the notes might become mere tokens for metallic money. So the idea is that there has to be some sort of restriction on the creation of bank notes.
to prevent inflationary overissue and avoid or at least mitigate business cycles.
And by the way, when I say inflationary, I mean in the sense that Mises uses inflation in The Theory of Money and Credit.
So the currency school had several ideas about monetary rules that could be imposed to limit the powers of banks,
mostly revolving around some sort of fixed, absolute amount of species and securities
that should be held in reserve by the Bank of England at all times.
The rule they finally settled on was sort of a variation on 100% reserve banking,
but it applied only to bank notes and not to bank deposits.
So the currency school writers were also early quantity theorists as opposed to the banking school and Hilferding,
we'll talk about it in a minute, but the currency school theorists, whereas Mises described them
The current school writers, especially Torrens, believed that the overissue of banknotes led to financial crises but they didn't really have a very clear idea of how business cycles worked.
They knew that overissuing banknotes caused rises in prices, changes in the rate of interest, the export of gold, and they knew that financial crises were somehow related to these events,
They didn't really have a cogent theory of boom and bust in a way so they essentially had the beginning and the end but not the middle part.
Especially towards the end of the debate actually, this became a serious problem for them.
There was a lot of equivocation among the currency school about the claims they had made about the relationship of banks to the business cycle and so on.
So it represents a serious theoretical hole in their system.
So in this regard, Mises of course makes a great contribution with The Theory of Money and Credit,
which appropriately enough in the original German actually translates to The Theory of Money and Fiduciary Media,
which of course is what this debate revolves around.
Mises takes some of these ideas that were used by the currency school and incorporates them to a more comprehensive theory of money and cycles,
and of course the result is Mises' early business cycle theory which of course explains how the divergence of interest rates induces malinvestment and so on and so forth.
Now while accepting, Mises did accept much of the currency school's doctrine, but he was fond of pointing out that there were two great errors in the currency cycle.
He was fond of pointing out that there were two great errors in the currency school's system.
The first error was that the currency school falsely believed that a central bank was the only method of limiting the inflationary overissue of notes.
And the second error was that the currency school didn't realize that bank notes and demand deposits actually performed the same economic function.
So, this second problem, the distinction between notes and deposits, was corrected by the banking school, who realized that notes and deposits are money substitutes in the same sense and perform the same economic function, but whereas the currency school had supported legal restrictions on note issues, the banking school thought that additional regulations were neither necessary nor desirable. The reason for opposing legal restrictions is summed up in the so-called banking principle, which holds that the amount of paper notes and
Circulation is adequately controlled by the ordinary processes of competitive banking and if the requirement of convertibility was maintained could not exceed the needs of business for any appreciable length of time.
This notion of the impossibility of overissue is supported primarily by what became known as the law of reflux.
This notion was invented by John Fullerton who was a leader of the banking school and was later adopted by other banking school theorists like Thomas Took and John Stuart Mill.
The law of reflux is the idea that the quantity of money always conforms to the needs of trade, that is the business demand for money.
And thus over issues are impossible because the supply of money substitutes will either expand or contract with the demands of business.
So this elasticity is the fundamental characteristic of bank note issue and therefore no regulation of the currency is necessary to prevent over issues.
So yeah, I think the principle is relatively straightforward. The idea is that in order to issue loans, somebody has to accept them. So if the demands of businesses don't require additional credit, any notes printed in excessive demand will simply flow back to the bank. So there can't be any inflationary issue of bank credit. And it's not that the banks don't inflate, it's that they can, even if they try their little hearts out. Now obviously there are a lot of problems with this, but the main one on
This implies that demand for money is somehow independent of the bank's policies.
I mean, of course it's the case that businessmen have to be willing to borrow from banks in order for the banks to be able to lend,
but obviously the bank's lending policies are seriously going to affect the demands of business through interest rates.
But this brings us to Hilferding who picks up on this banking school position and adopts it really without any changes.
Actually, Hilferding was following Marx on this. They had both accepted many of the doctrines of the banking school.
I think Marx somewhere describes Hilferding as one of the best bourgeois economists.
Now, of course, Hilferding and Marx had also both denied the quantity theory of money
and accepted the banking school's belief that the quantity of money is determined endogenously by business demand.
So, it's not really, I suppose, surprising that they would have denied the quantity theory and picked up on this banking school doctrine, which is much more compatible with the labor theory of value.
So, banking school theorists had also denied that monetary factors influence business cycles, holding that crises emerge in the so-called real economy.
Hilferding agreed and attributes crises to either supply or demand shocks, which in the Marxist vocabulary means that because of problems inherent in the anarchy of capitalist production, discrepancies tend to appear between the production of producers' goods and consumers' goods.
But interestingly, Hilferding takes this faulty starting point and lays out a sort of overinvestment theory of business cycles that emphasizes the heterogeneity of capital and the intertemporal misallocation of capital.
He actually reaches some conclusions that are very similar to Mises, but especially the younger Hayek.
But his whole outlook on the process of the cycle is completely different from Mises and very much flawed.
In fact, Hilferding reviewed The Theory of Money and Credit when it came out.
Actually, his review was really just three or four pages of diatribe against Menger, Boehm-Bawerk and Wieser and the marginal utility theory.
but at the end he sneaks some paragraphs in where he criticizes Mises for accepting the currency school's doctrine and denying and accepting the quantity theory of money and denying that banks exercise any real control over the money supply or interest rates and Hilfering just denies this without really explaining why.
and I'll be explaining why, but it's actually, Hilferding is not all bad. In Finance Capital, he actually does have some intriguing things to say about how banking institutions affect the rest of the economy.
He talks quite a bit about how the banks, by issuing credit to businesses and combining banking capital with industrial capital, encourage the dependence of business on the banks and gradually the banks consolidate a sort of monopoly position for themselves and for their favorite firms.
And this is actually, this idea is how Hilferding avoids Marx's traditional problem of explaining how under capitalism business cycles would become more frequent and more severe,
leading eventually to the collapse of the system and the replacement by socialism.
Hilferding says, well, since the banks are constantly consolidating their position, all that we need to do is just wait it out for a little while until the banks control essentially everything,
And then we can just have the state take over the banks and we'll get the end of capitalism and the rise of socialism through a sort of bloodless revolution in the banking sector.
So that's intriguing.
Interestingly, Schumpeter actually criticized Hilferding on this later on in the history of economic analysis.
But as I say, the lady doth protest who much me thinks because Schumpeter had said some very similar things
But if you're familiar with Schumpeter's book, The Theory of Economic Development, you know that he builds a theory of the static economy, and then uses the idea of the entrepreneur to explain how innovations disturb the static equilibrium.
But if you're familiar with Schumpeter's book, The Theory of Economic Development, you know that he builds a theory of the static economy and then uses the idea of the entrepreneur to explain how innovations disturb the static equilibrium and shift the entire economy to a new equilibrium for him.
This is important because in Schumpeter's schema, the only way to stimulate economic change is for the banks to create new credit that the entrepreneurs can use to finance their innovations.
And the reason this is relevant is because since entrepreneurs can only produce in the future, this is lagged between the introduction of new credit and the introduction of the new goods that the entrepreneurs produce.
So this is one difference between Schumpeter and the banking school because whereas Fullerton and Took and the other banking school theorists held that the quantity of money is determined endogenously,
Schumpeter is emphasizing the role of banks in creating money exogenously, and he actually
says that the only real purpose of banks is to create credit for the entrepreneurs.
So in this sense of exogenous money, he's closer, I think, to the currency school.
But then, on the other hand, he's close to the banking school because he does see banks
is expanding credit only in relation to the needs of business, and in this case the needs
of the entrepreneurs. But then he clearly supports the idea of the quantity of money
affecting prices independently, which the banking school emphatically denied because
the banking school denied all forms of the quantity theory. And then again, on the other
hand, the currency school would argue that Schumpeter's innovative bank credit creation
Creation is inflationary, where Schumpeter develops a rationale for why that's not necessarily
the case.
He claims that the whole operation from credit creation ultimately up through the entrepreneur's
new production can be either inflationary or deflationary, depending on the circumstances,
but he doesn't really take a clear stance, although on this argument he is more convincing
than the simple reflux explanation that the banking school used.
He also improves on the banking school in some ways, because he does actually admit
that expanding the supply of credit will, at least in the short run before the introduction
of new goods, be inflationary, which is something, again, that the banking school denied because
of this idea of the reflux, and the banking school denied this because they didn't take
into account the length of time that it would take for the reflux to work. It's obviously
not instantaneous so even if it was the case that this reflux operates all the
time there's still a lag between the time when the new money goes out and when
it is redundant and returns to the bank. So and then finally the last thing I
mentioned is that Schumpeter's innovation-based theory of the business
cycle is very similar to Hilferding's in the sense that both cycles begin with
radical changes in the economy in Schumpeter's case the entrepreneur not
a simple demand or supply shock or something like this but and so in this
regard again it's a real theory of the business cycle which is much more close
is much closer to the banking school as opposed to monetary explanations of the
currency school so yeah so I suppose that was a little bit too quite a bit to get
through in just a few minutes but I hope I've laid out some of the simpler basic
Connections between these two periods, these two debates in the history of thought. I'd just like to conclude by saying that there is actually some current relevance to this. It's not just a bland exercise in the history of economic thought. The central issue that came out of the currency banking debate, this question about whether or not we need special legal restrictions on bank notes or on bank issues in general, is also at the center
of the debate between the 100% reserve free bankers and the fractional reserve free bankers.
Now I realize that that debate is so 1988, but it is actually important. And even though
the dispute has taken many twists and turns through ethical and juridical arguments over
the years, I just wanted to emphasize the importance of the strictly economic arguments
and at the core of this dispute is the same issue that was being discussed by the currency and banking schools and in my opinion fruitful continuation of this discussion should revolve around investigating this economic question further. So, thank you.