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Monetary Central Planning and the State, Part 35: Free Banking and the Economic Case against Central Banking

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A fundamental insight of the classical economists beginning with Adam Smith was the possibility for social order without political design. Adam Smith’s metaphor, of men pursuing their individual interests being guided as if by an invisible hand to serve a purpose that was no part of their respective intentions, demonstrated that human society did not need governmental controls and commands and indeed would be greatly harmed if government attempted to direct men in their market pursuits.

Yet there was one area in which the classical economists believed a role for government was essential: the control of the money supply. Even the gold standard of the 19th century was a government-managed monetary system. (See “Monetary Central Planning and the State, Part 30: The Gold Standard as Government-Managed Money,” Freedom Daily, June 1999.) And in the 20th century, governments have centrally planned the national monetary systems all around the world through the issuance of fiat, or paper, currencies.

Yet monetary central planning has many of the same problems and limitations as all other forms of central planning. Bringing out the parallels between central planning in general and monetary central planning has been an important theme taken up by both Lawrence H. White and George Selgin. In his study of Free Banking in Great Britain (1984), White drew attention to the fact that in the 19th century, advocates of free banking emphasized the problem of the “overissuing” of currency under central banking. Even under the gold standard, if there is a single issuer of a currency within a country, there is limited feedback to inform that bank that it is “excessively” increasing the money supply.

Imagine that there are several private banks that issue bank notes and checking accounts to their depositors for gold originally deposited with them. But assume that the gold holdings are centralized and held in the vault of the central bank; that is, any gold received by one of the private banks is redeposited by it with the central bank.

At the same time, each of the private banks therefore acquires a right to demand currency notes issued by the central bank with a face value equal to its gold deposit. And it is these central bank currency notes that the private banks issue to private citizens who have been the original gold depositors. Any checking accounts opened with them by private citizens on the basis of gold deposits can be “cashed” for the central bank currency notes as well.

Suppose that a depositor with private bank A writes a check for $100 for some commodity he has purchased in the market, and that the seller of this good deposits the check in his private bank B. Bank B now credits his account in the amount of an additional $100, against which the depositor may demand central bank currency notes or writes checks himself.

Bank B will send the deposited check back to bank A for payment. The central bank will deduct $100 worth of gold from bank A ‘s account with the central bank and will credit the account of bank B with an equivalent amount. The total money supply, represented by the amount of central bank currency notes in circulation and checking account money against which central bank currency notes can be demanded, will not have changed. And all the gold will have remained in the vault of the central bank, with the title to $100 of that gold merely having been changed on the central bank’s ledger book.

Now suppose that the central bank decides to expand the money supply to finance a government budget deficit (perhaps owing to a war crisis). The government issues a $1,000 bond that is bought by one of the private banks. Against the bond, the private bank extends a $1,000 loan to the government in the form of a checking account that the government can now use to purchase various goods in the market.

To this point there is nothing inherently inflationary in the process. With available but limited gold funds on deposit with the central bank, the private bank has merely extended a loan to the government at the expense of some potential borrower in the private sector who can’t match the interest payment offered by the government.

But now the central bank offers to buy the government bond from that private bank and credit that private bank’s account with the central bank for the amount of $1,000. That means that the private bank will have an additional $1,000 available to extend additional loans to others in the market in the form of additional central bank currency notes or a checking account that can be “cashed” for $1,000 in currency notes. No additional or new gold has been deposited into the banking system, yet there is now an extra $1,000 of central bank currency or checking account money in the economy.

There is now $2,000 worth of central bank money in circulation on the basis of $1,000 of gold in the vault of the central bank. Currency and checking deposit claims to that gold now exceed the amount of gold available to meet those claims. An inflationary “overissuance” of the money supply has occurred that, under a gold standard, eventually will have to be reversed.

But the critics of central banking argued that such an excessive increase in the money supply could continue for some time before the central bank would be forced to bring it to an end.

As the additional $1,000 of new central bank money comes into the economy in the form of additional loans from private banks, the extra $1,000 will be competing against the previously existing money supply for available goods and services offered on the market. Over time the prices of those goods and services within country A will start to rise owing to the increased number of dollars bidding for them. The rising cost of domestically manufactured goods will make less-expensive foreign goods appear more attractive to buyers in country A. But since the national central bank currency of country A is normally not usable for buying goods in other countries, the private citizens of country A will begin to redeem their bank notes and checking accounts for gold, which they will then want to export as payment for the less-expensive foreign goods available in countries B and C.

The private banks in country A will turn in central bank currency notes for gold to pay out to their depositors. Only now, after an “overissuance” of the money supply and an inflationary process may have continued for some time, will the central bank be faced with significant and increasing demands for quantities of gold from its vault for export.

And the greater has been the currency creation and price inflation, the heavier will become the redemption demand for gold. Indeed, precisely because increases in the money supply do not immediately and simultaneously raise all prices in the market, the monetary expansion can continue for some time before a wide-enough circle of goods will have risen sufficiently in price that the central bank finally faces an emerging and growing “gold drain” that may threaten to reach “dangerous” proportions.

The loss of gold and threatened additional losses of gold will eventually force the central bank to stop and reverse its monetary expansion, if it is not to run the risk of a panic and the danger of not being able to maintain its adherence to the gold standard. However, the “negative feedback” of significant gold losses may take so long to materialize and for anyone to respond to it under a central banking system that that country’s market econ-omy can face a high degree of inflationary instability followed by a price deflation and depression when the central bank reverses the monetary expansion with a monetary contraction to stay on its government centralized gold standard.

How is this problem of monetary management under central banking – even under a gold standard – similar to the problem of central planning in general? This theme was highlighted by Selgin in his 1988 volume, The Theory of Free Banking. The function of a price system in a competitive free market is to serve as a method of communication. Any system of division of labor naturally creates with it a vast network of consumers and specialized producers who must somehow be able to inform each other about their changing patterns of demand and willingness and abilities to supply for purposes of mutual coordination of multitudes of millions of individual plans. Free-market prices are delicate and sensitive signal switches that record any and every change in the patterns and intensities of supply and demand. Those changing prices create the profit opportunities and loss penalties that serve as the incentives for individuals to modify what and how much they demand and supply of the various goods desired on the market and brought to it.

In principle the monetary and banking system should be open to the same free-market competitive pricing system and operate under it to inform the demanders and suppliers of money and the managers of a private banking system about the changing desires and abilities to demand and supply various forms and quantities of money and money-substituting media of exchange. The free-market competitive pricing system should also see to it that the banking system successfully brings together borrowers and lenders to properly coordinate the plans of savers and investors for a fairly smooth meshing of consumption and production activities throughout the economy. But under central banking, as was explained, an “excessive” expansion of the money supply lacks a sensitive and fairly rapid feedback mechanism to inform the central monetary managers that the system is threatened with instability. Instead, it can be open to abrupt, significant, and prolonged disruptions of inflationary periods followed by deflationary downturns. In other words, a centralized monetary system can be open to monetary changes and fluctuations introduced by the central monetary authority that do not reflect changes in market supply and demand conditions. Once introduced, the result can be extended periods of inflation and deflation, even under a gold standard managed by a central bank.

Could the free market do better? Yes, say the proponents of free banking, and they have tried to explain how.

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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).