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Monetary Central Planning and the State, Part 36: Free Banking and the Competitive Limits to Monetary Expansion

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It was in 1754 that the Scottish philosopher David Hume published his Political Discourses, containing his famous essay “Of the Balance of Trade,” in which he refuted the mercantilist argument that unless the government regulated the international commerce of a country, that country might lose its supply of the precious metals — gold and silver — owing to an unfavorable balance of trade.

The mercantilists feared that in importing attractively cheap goods from foreign nations in excess of its own exportable goods, the home country would have to pay for these net purchases through the export of gold and silver in order to settle its international accounts for buying those goods, which would result in a decrease in the amount of its “treasure” of specie money.

Hume responded by formulating what has become known as the “specie-flow mechanism.” If the government in the home country were to increase its supply of paper currency, over time prices in the home country would begin to rise. That would make it attractive for people in the home country to buy less-expensive foreign substitute goods in place of the now more-costly ones at home. It would make goods manufactured at home less attractive for foreigners to buy as well. Imports into the home country would increase and exports out of the home country would decrease, resulting in an “unfavorable” balance of trade.

If the paper currency was redeemable in gold or silver, residents in the home country would redeem their paper currency for the precious metals and export them to pay for the net purchase of desired imports, and the home country would have a net loss of its specie money. But Hume argued that this was only the first step in a sequence of reactions in the market set in motion because of the domestic paper-money inflation. Unless the home government were to run the risk of losing its entire supply of gold and silver reserves, it would have to reverse its expansion of paper money, bringing about a monetary contraction and a decline in prices in the home country.

At the same time, the foreign nations experiencing a net inflow of gold and silver by selling more goods to the home country would see a rise in their own domestic prices due to the influx of additional sums of gold money into their economies. The fall in prices in the home country and the rise in prices in the foreign countries would bring about a reverse movement in gold and silver as residents in the home country now purchased more less-expensive domestically produced goods and residents in foreign nations increased their demand for exportable goods from the home country, since their own manufactured goods would have become more expensive. Gold and silver would flow out of foreign nations and back to the home country until prices had once more risen in the home country and fallen back in the foreign nations, bringing about a balance of trade between the different countries of the world.

Market-based changes in prices and international buying and selling would ensure a “natural” distribution of the precious metals among countries without government interference or regulation of foreign trade. The lesson the classical economists of the 19th century drew from Hume’s specie-flow mechanism was that the only “good” that governments could do was to restrain their own temptations for “excess” issues of paper currencies by adhering to a gold standard with paper currency redeemable on demand and by keeping international trade free from regulation and control.

Gold-backed, redeemable money and free trade were the two institutions to ensure a sound and stable monetary order in the classical-liberal world of the 19th and early 20th centuries. As long as these were the “rules of the game” followed by governments and central banks, the classical economists and liberals were certain this was the best arrangement to be hoped for in an imperfect world.

But, as the advocates of free banking pointed out, even this institutional regime still had a looseness that permitted a potentially long lag between an abuse of the printing press and the resulting full effects on prices and trade that would generate a “brake” on the inflationary process. (See “Monetary Central Planning and the State, Part 35: Free Banking and the Economic Case against Central Banking,” Freedom Daily, November 1999.) Or as Kevin Dowd summarized the problem in The State and the Monetary System (1989):

“With a monopoly bank there will therefore be a greater, and more persistent, over-issue before demands for redemption bring it into line. This, in turn, seems to imply that the over-issue will be that much more disruptive, and that interest rates, prices and output will move further out of line before being checked by the bank’s measures to counter its loss of reserves…. Eventually, of course, the pressure of direct redemption would suffice to stop them, but the process of checking the over-issue would obviously take longer.”

The reason, which Dowd and other free-banking proponents have pointed out, was that with gold reserves concentrated in the hands of the central bank, any apparent “overissuance” by one of the commercial banks would result merely in a redistribution of titles to gold among the commercial banks belonging to the central banking system when the banks “cleared” their accounts with each other. The actual gold held in the vaults of the central bank might remain uncalled-upon for a long period of time before the paper-money expansion had sufficiently raised prices in general that it finally resulted in a demand for gold withdrawals by depositors who wanted to finance increased imports of less-expensive goods.

However, the free bankers have argued, the situation would be significantly different in a monetary system without a central bank and a centralized concentration of gold reserves. Each private bank would offer its facilities as a depository for customer gold and any other precious metals that the market had chosen as useful media of exchange. The bank would issue its own notes to depositors as claims to those deposits or credit depositors’ checking accounts against which they could write checks issued by that bank. The depositors would then proceed over time to use those notes and checks to purchase goods and services, to the extent that sellers were willing to accept the notes and checks as a result of that bank’s brand-name recognition and trustworthiness among transactors in the market.

Sellers would deposit the notes and checks they had accepted in trade in their own accounts in other banks. The private banks would periodically have “clearing” procedures in which they settled their accounts with each other (which historically developed long before government central banking ever appeared on the scene). Any bank that found itself owing net amounts to other banks, over and above what the other banks owed them, would have to settle through an actual transfer of gold or whatever other precious metals were used as the ultimate market-based money. That bank’s gold reserves would immediately and precisely be reduced by the actual amount it had to transfer to those banks with which it had an “adverse” balance. And at the same time, the gold reserve position of other banks would increase precisely to the extent that they received net transfers.

The gold positions of these private banks would be a continuously close mirror image of the spending and receipt patterns of their respective depositors. The banks would be mere repositories serving the needs of their depositors who found it convenient to house their commodity money with them for safety and ease of use through the market-accepted substitutes of private bank notes and checks. Changes in the net income and net gold-owning positions of the banking customers would be quickly reflected in net transfers of gold among the private banks in the clearing process.

Now suppose that one of these private banks decided to issue a quantity of notes or checks in excess of depositors’ gold in their vaults in the form of loans to potential borrowers to earn additional interest-income from the transaction. The borrowers would use the notes or checks to purchase the goods and services for which they wanted loans to begin with. Those notes and checks would be deposited by market sellers in their own banks, and those banks would present them for redemption at the next interbank clearing session. The bank that had undertaken the overissue of notes and checks would be faced with a net obligation to pay a sum of gold out of its reserves to other banks, and within a relatively short period after having issued the excess supply of its notes and checks.

The loss of gold would be an immediate and direct signal, a rapid negative feedback, that it had undertaken a “monetary policy” that might threaten its financial solvency, its customer confidence, and its market reputation if it persisted in its private “monetary expansion.” If this private bank were to persist in its “easy-money” policy, it would risk losing its gold reserves at each bank clearing session, arouse concerns among depositors that might result in their transferring their deposits to other, financially sounder banks, and a growing hesitancy on the part of sellers in the market to accept its notes and checks in trade at their face value.

As George Selgin explained in The Theory of Free Banking (1988):

“It means that a solitary bank in a free banking system cannot pursue an independent loan policy. A “cheap-money” policy in particular would only cause it to lose reserves to rival banks. Also, no bank would be able, by overissuing, to influence the level of prices or nominal income to any significant degree, since the clearing mechanism rapidly absorbs issues in excess of [market] demand, punishing the responsible bank.”

Could a private bank in a free banking system attempt to expand its notes and checks on the market in excess of its depositors’ demand for them? Yes. Could it long persist in that practice? It is highly unlikely precisely because that bank, within a short period of time, would feel the consequences of its actions. Nor could it force other banks to follow the same course of action, and thus it could not by itself have a significant effect either on the general level of prices or on the market structure of relative prices because of its singular monetary and lending policy. Thus, the lag between an overissuance of private bank notes and the resulting negative feedback on that bank’s gold reserves would be much shorter and much more localized in its effects than under a central 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).