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Monetary Central Planning and the State, Part 37: Free Banking and the Market Demand for Money

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One of the primary benefits of economic freedom is that it decentralizes the negative effects that may arise from ordinary human error. Every one of us makes decisions that we hope will produce outcomes we desire.

Yet the actual outcomes from our actions often fail to match up to the hopes that motivated them. A businessman who misreads market trends in planning his private company’s production and marketing strategies may experience losses that require him to cut back his activities, resulting in some of his employees’ losing their jobs and in resource suppliers’ experiencing fewer sales because the loss-suffering businessman reduces his orders for what they have for sale.

But the negative ripple effects from his entrepreneurial mistakes are localized within one corner of the overall market. Other sectors of the market will not be directly penalized or subject to the unfortunate effects of his poor judgment. Profit-making enterprises can freely go about their business hiring, producing, and then selling the goods which they have more correctly anticipated the consuming public actually desires to buy.

Under central planning, however, errors committed by the cen-tral planners are more likely to have an impact on the economy as a whole. Every sector of the economy is directly interlocked within the centrally planned blueprint for the allocation of resources, the quantities of different goods and services to be produced, and the distribution of the output to the consuming public.

Centralized failures in resource use or production decisions more directly affect every sector of the economy, since nothing can happen in any of the government-run industries independently of how the central planners try to fix their mistakes. Everyone more directly feels the consequences of the central planners’ errors and must wait for those planners to devise a revised central plan to correct the problem.

Central Banking vs. Competitive Banking

Monetary central planning suffers from the same sort of defect. Changes in the money supply emanate from one central source and are determined by the monetary central planners’ conceptions of the “optimal” or desired quantity of money that should be available in the economy. Their central decision can indirectly influence the pattern of interest rates (at least in the short run) and the market structure of relative prices and inevitably bring about changes in the general value, or purchasing power, of the monetary unit. The monetary central planners’ policies work their way through the entire economy, possibly bringing about a cycle of an inflationary boom followed by general economic downturn or even depression.

Halting the inflation and bringing an unsustainable boom to an end depends upon the monetary central planners’ discovery that things “may have gone too far” and a decision by them to reverse the course of monetary policy. Many, if not most, sectors of the market will then have to modify and correct investment, production, and employment decisions that had been made under the false, inflationary price signals the central planners’ monetary policy has artificially created. Capital, wealth, and income spending patterns in the market will have been misdirected and partly wasted because of the errors committed by the monetary central planners.

The opponents of central banking have argued that the occurrence of such errors would be less frequent and discovered more quickly under competitive free banking. Any private bank that “overissued” its currency would soon discover its mistake through the feedback of a loss of gold reserves through the interbank clearing process. The bank would realize the necessity of reversing course to ensure that its gold-reserve position was not seriously threatened and of avoiding the risk of losing the confidence of its own customers because of heavy withdrawals by depositors.

Moreover, the effect of such a private bank’s following a “loose” and “easy” monetary policy would be localized by the fact that only its banknotes and check money would be increasing in supply because of the additional spending of those to whom that bank had extended additional loans. It could neither force an economywide monetary expansion throughout the entire banking system nor create an economywide price-inflationary effect. Any negative consequences, while being unfortunate, would be limited to a relatively narrow arena of market decisions and transactions.

The Demand for Money

The free-banking advocates have also argued that a system of competitive free banking would more smoothly adjust the supply of money to changes in the demand for money, while at the same time ensuring a continuing coordination of savings choices and investment decisions throughout the economy by means of localized adjustments in private bank-lending policies.

The demand for money takes two forms in the decisions of market participants. The distinction between the two has been usefully explained by Murray N. Rothbard in his treatise, Man, Economy, and State (1962). There is first of all a “pre-income demand for money.” This represents the amount of money individuals desire to acquire for all purposes – consumption, investment, and cash balance holdings.

Each person decides what quantity of his goods, labor services, resources, and other factors of production he wants to offer to the market as the means of earning money income. Each of us makes this choice in the context of the value to us of all the things that a sum of money earned can buy on the market in comparison with the opportunity cost of all the other non-money-earning ways we might use our labor, time, and resources.

There is also a “postincome demand for money.” Having chosen to earn a certain money income, we must then decide how much of it to spend immediately on various consumption and investment purposes and how much of it to hold as a cash balance over a period of time to facilitate or take advantage of future desired or possible spending opportunities. Each of us decides, in other words, how much of our earned money income we wish to hold as an average cash balance over the period of time between receiving one paycheck and receiving the next.

We not only save when we directly invest a portion of our income or wealth in a business enterprise or when we lend a portion of our income or wealth to someone else (either directly or indirectly by depositing a sum of our income in a “savings account” with a financial institution). We defer consumption, i.e., we do not immediately demand goods and services against which our money income could make purchases in the market, when we choose to hold an average cash balance rather than spend it. Our demand for money as a postincome demand to hold an average cash balance is therefore also a decision to save.

Thus, our willingness to supply goods, services, labor, and resources to the market reflects our pre-income demand for money. And our preference to hold an average cash balance and spend our previously earned income at a certain rate over a period of time on consumption and investment opportunities reflects our postincome demand for money. And any choice to increase or decrease our average cash-balance holding represents our decision to decrease or increase the rate at which we spend our earned income on consumption or investment activities during an income period. Expressed differently, an increase or decrease in our average cash-balance holding during a period of time reflects our decision to change our average rate of saving out of income during that same period of time.

Cash Holdings under Free Banking

In a market-based free-banking system, depositors could choose to hold their desired average cash balances either in the actual commodity money (gold, perhaps) or in banknotes or checking-account balances representing the amount of commodity money they had deposited with a financial institution, or in a combination of the two. In a developed monetary and banking system, it probably would be the case that most people would, for convenience’ sake, deposit their commodity money in a financial institution. They would use bank-notes or checking accounts issued to them by private banks as the claims against their gold deposits as money-substitutes in most transactions (to the extent to which each of these private banks had a market reputation that their banknotes and checks were “as good as gold,” meaning they were trusted as being redeemable on demand at face value).

Suppose that some depositors banking with the “Adam Smith Bank” desired to maintain the same average cash balance but to hold a larger percent of their cash balance in the form of actual gold coins or bullion. They would turn in banknotes or cash checks equal to the amount of gold they wished to redeem. And an equivalent sum of these money-substitutes would then be withdrawn from circulation by the Adam Smith Bank. But the average rate of spending as reflected in the demand for consumer goods and direct investment purchases would not have changed, though a larger percentage of transactions might now occur in the form of gold coins or bullion.

The reverse would happen if depositors desired to hold a larger portion of their unchanged average cash balance in the form of banknotes or checking accounts; they would deposit a chosen amount of their gold coins or bullion with the private bank of their choice. And there would be a larger sum of Adam Smith banknotes and checks in circulation and possibly used in transactions on the market.

However, suppose that some persons wished to increase their average cash-balance holding. This would mean that during the income period they desired to decrease their rate of spending on consumer goods and direct investment purchases. They could do so by redeeming a portion of their banknotes and checking-account balances for gold and holding a larger portion of their now higher average cash balance in the form of actual commodity money; or they could merely decrease their rate of spending in the form of banknotes and checks written and as a result hold “on hand” a larger portion of their earned money income in the form of Adam Smith banknotes and checking-account balances during the income period.

That would also mean that these depositors were increasing their savings, i.e., deferring the amount of their more immediate demand for consumer goods their earned income would enable them to purchase on the market. The increased preference for savings would be reflected in the market in: a fall in the rate of interest; the freeing of labor and resources employed in the consumer goods sectors (since the demand for consumer goods would have decreased owing to the desire to spend less and save more in the form of cash balance holdings); an increase in borrowing stimulated by the decline in the rate of interest; and a redirection of labor and resources to more longer-term investment projects that would bring forth more, better, and less-expensive consumer goods in the future.

How precisely would this market adjustment and reallocational process work itself out under a system of free banking?

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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).