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Monetary Central Planning and the State, Part 34: Free Banking and the Political Case against Central Banking

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When Ludwig von Mises made the case for free banking in his monograph Monetary Stabilization and Cyclical Policy in 1928, he argued that the inflations and depressions that the major industrial countries had experienced in the 19th and early 20th centuries might not have occurred “if there had been no deviation from the principle of complete freedom in banking and if the issue of fiduciary media [bank notes in circulation not fully covered by specie reserves held by the banks that had issued them] had been in no way exempted from the rules of commercial law.” The booms and busts of the business cycle could finally be reduced or eliminated only “through the establishment of completely free banking.” But Mises admitted that “the time is not yet ripe – not now and not in the immediate future” for the free banking alternative, given the ideological and interventionist trends through which the 20th century was passing. (See “Monetary Central Planning and the State, Part 31: Ludwig von Mises on the Case for Gold and a Free Banking System” in Freedom Daily, July 1999.)

But in the wake of the disasters and disappointments with Keynesian economic policies in the 1970s, the intellectual climate became conducive for rethinking the “unthinkable,” and, beginning in the 1980s, there emerged a new monetary literature that challenged the assumptions of and justifications for central banking. This new generation of monetary economists were most often influenced by the earlier writings of the Austrians – Mises, Friedrich Hayek, and Murray Rothbard.

Among the leading members of the new free banking school are: Lawrence H. White, who has written Free Banking in Britain: Theory, Experience, and Debate, 1800 -1845 (1984), Competition and Currency: Essays on Free Banking and Money (1989), and The Theory of Monetary Institutions (1999); George A. Selgin, who published The Theory of Free Banking: Money Supply under Competitive Note Issue (1988) and Bank Deregulation and Monetary Order (1996); Kevin Dowd, who authored Private Money: The Path to Monetary Stability (1988), The State and the Monetary System (1989), and Laissez-Faire Banking (1993); and Steven Horwitz, who wrote Monetary Evolution, Free Banking & Economic Order (1992). Kevin Dowd also edited a collection of essays by a group of free-market monetary theorists under the title The Experience of Free Banking (1992).

They mounted a forceful attack against the rationale for a central banking system, arguing that economic instability and monetary imbalance were more likely under monetary central planning than the free banking alternative. Lawrence White insisted that a central banking system necessarily ran an inescapable danger from political abuse. First, governments and central banks were always tempted to capture the profits from “seigniorage.” Seigniorage represents the difference between what it costs the monetary authority to produce a unit of money and the value of that monetary unit in terms of its purchasing power over goods and services in the market.

For example, if printing a one-dollar bill costs 25 cents, the government is then able to acquire on the market, by being the first to spend that new dollar, 75 cents of goods and services over the costs of manufacturing that unit of money. The government can tax the public 25 cents to buy the raw materials to run a dollar off the printing press and then siphon off an additional 75 cents of the private sector’s production of goods and services when it spends that paper dollar in the marketplace. Inflationary profits are there to be made by the government and its central bank as long as the cost of manufacturing a unit of money is less than what that unit can buy in the market.

In the case of the U.S. Federal Reserve System, which is required to return all profits from its activities as a “gift” to the U.S. Treasury, this creates an incentive for the central bank to pad its operating costs in the form of larger staffs, higher salaries, more expensive facilities, and more frequent and more costly travel and other business expenses. Its seigniorage profits are partly hidden “on the books” in the form of increased expenditures to manage the monetary and banking system of the United States.

White also emphasized the temptation of using a “politicized money supply regime” to try to initiate a “political business cycle” that runs “the danger of destabilization of real output and employment in pursuit of reelection.” Since the monetary central planners are politically appointed to the management of the central bank, they are open to pressure and bias to assist those in political power by attempting to create “good times” as an election is approaching. Monetary central planners, like any other type of central planner, of course, lack the perfect knowledge to manipulate the money supply with the “scientific precision” necessary to stimulate the desired amount of production and employment when it would be most optimal in an electoral cycle. And market participants always have incentives to try to correctly anticipate future monetary policy to adjust their production and pricing decisions so as not to be negatively affected by manipulations of the money supply.

But, paradoxically, precisely because neither the monetary central planners nor the private actors in the market possess the knowledge to estimate perfectly and to anticipate how, when, and to what degree an increase (or a change in the rate of increase) in the money supply will have its full impact on prices, productions, and employment, the central bank authority can introduce a degree of “surprise” into the market economy. This surprise element can make agents in the private sector confuse a monetary manipulation for real, profit-creating opportunities in the market that induce investment and production activities that only much later will be discovered to be the false stimuli of the artificial boom.

Because politics can influence the monetary policy decisions of the central bank, the case has often been made that the best answer to this dilemma is to make the central bank as independent as possible. If the executive or legislative branches of government cannot directly pressure the monetary central planners, they will be able to deliberate on the best monetary policy for the long-run good of the nation.

White responded to this argument by pointing out:

“Being answerable to no one is certainly a comfortable situation. For this reason the officials of any central bank are themselves likely to be found in the forefront of those advocating independence for the agency.

“An independent central bank’s private constituency – presumably the large commercial banks – will generally have a private agenda which is not identical with the preferences of the common holders of money [the ordinary private citizens in the market]….

“In any event, the prospect of a central bank beholden to the commercial banks is not much cheerier than that of a central bank beholden to Congress.”

Furthermore, he argued the degree to which a central bank can ever actually be independent of the executive and legislative branches of government is very limited. “Congress created the Federal Reserve System, and can rewrite its mandate at any time as it has in the past,” White pointed out. “Knowing this, the Federal Reserve’s management cannot afford to be unresponsive to congressional pressures. The same is undoubtedly true of any other legislatively created central bank.”

British free banking advocate Kevin Dowd has both echoed and extended the political argument against central banking. Controlling the money supply offers the political authorities immense power over the distribution of the wealth and income of the citizenry of a country and the productive uses to which those citizens can be induced to apply the resources, capital, and labor at their disposal. As a result, changes in various political coalitions in the halls of power constantly create new motives and incentives to try to change the way wealth and income are distributed in the society and the types of production and employment activities various special interest groups desire to have stimulated.

Nor should periods of relatively low price inflation be taken as an indication that fears about political manipulation of the monetary system are misplaced or exaggerated. Said Dowd:

“Changes in the value of the [monetary] standard reflect changes in the balance of political power between those groups which benefit from inflation and those which lose from it. Among other things, this implies that the current relatively low rate of inflation merely reflects the strength of the present anti-inflation coalition – itself the consequence of the fright that most people experienced during the last bout of high inflation – and there is every reason to expect inflation to rise again as that coalition begins to lose its grip. Unless something is done to change the monetary regime, people’s memories of high inflation are likely to recede over time, and with this their fear of inflation. The way would then be open for policies that would lead to a new bout of high inflation.

“Even if the current ruling group were fully aware of the dangers of price instability, and totally committed to stable prices, it generally lacks the power to pre-commit future governments to maintain price stability. However much the private sector may believe in the “good intentions” of the present British government, the latter can make no guarantees binding its successors, or even its own future actions.

“The only way this can be avoided is to remove the power to meddle with the [monetary] standard, and that in turn requires that the [monetary] standard be effectively depoliticized.”

But even if it were possible to completely remove politics from the central banking system and its decision-making process, making the monetary central planners free from both governmental and private-sector pressures and biases in setting and implementing monetary policy, the advocates of free banking have argued that those monetary central planners would still be unable to successfully manage the monetary system in a manner equal to or better than a fully market-based private, free banking system.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).