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Monetary Central Planning and the State, Part 39: Free Banking and the Benefits of Market Competition

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One of the strongest arguments that advocates of the free market have made over the last 200 years has been to point out the benefits of competition and the harmfulness of government-supported monopoly. In a competitive market, individuals are at liberty to creatively transform the existing patterns of producing and consuming in ways they think will make life better and less expensive for themselves and other members of society as a whole.

Wherever legalized monopoly exists, the privileged producer is protected from potential rivals who would enter his corner of the market and supply an alternative product or service to those consumers who might prefer it to the one marketed by the monopolist. Innovation and opportunity are either prevented or delayed from developing in this politically guarded sector of the economy. Production methods remain unchanged or are modified only with great delay. Product improvements are slow in being developed and introduced. Incentives for cost efficiencies are less pressing and, when utilized, are often only sluggishly passed on to consumers in the form of lower sale prices.

Those who have the vision and daring to enter the market and successfully innovate and create newer or better products than the existing suppliers are offering are stymied or blocked from doing so in the protected sectors of the economy. They are forced to apply their entrepreneurial drive in less-profitable directions or are dissuaded by the political restrictions from even attempting to do so. The product improvements they would have supplied to the consuming public remain invisible “might-have-beens” lost to society.

Furthermore, as Friedrich A. Hayek especially emphasized, market competition is the great discovery procedure through which it is determined who can produce the better product with the most desired features and qualities and at the lowest possible price at any given time. It is the peaceful market method through which each participant in the social system of division of labor finds his most highly valued use as judged by the relative pattern and intensity of consumer demand for the various goods supplied. Competition’s dynamic quality is that it is a never-ending process. In the arena of exchange, every day offers new opportunities and allows entrepreneurs and innovators to create new opportunities that they are free to test on the market in terms of possible profitability.

Every political restriction or barrier placed in the way of competition, therefore, closes the door on some potential creativity, risk-taking, and entrepreneurial discovery of more efficient and rational uses of men, materials, and money in the interdependent and mutually beneficial relationships of market specialization and cooperation. The choice is always between market freedom and political constraint, between the competitive process and governmentally created monopoly.

Competition in money and banking

This general argument in favor of market competition and against politically provided monopoly is no less valid in the arena of money and banking. Money may be chosen by the participants in the market, or government can impose the use of a medium of exchange on society and monopolize control over its supply and value. The benefit from market-chosen money is that it reflects the preferences and uses of the exchange participants themselves. Participants in the market process will sort out which commodities offer those qualities and characteristics most useful and convenient in a medium of exchange. As the Austrian economists persuasively demonstrated, while money is one of those social institutions that are “the results of human action but not of human design,” it nonetheless remains the spontaneous composite outcome of multitudes of individual choices freely made by buying and selling in the marketplace. (See “Monetary Central Planning and the State, Part 5: The Austrian Economists on the Origin and Purchasing Power of Money” Freedom Daily, May 1997.)

The money monopoly

The alternative is what the American economist Francis A. Walker referred to in 1887 as “political money.” Political money is one that the government determines shall be used as money and whose supply “is made to depend upon law or the will of the ruler.” He warned that under the best of circumstances the successful management of a government-controlled money would “depend upon an exercise of prudence, virtue and self-control, beyond what is reasonably and fairly to be expected of men in masses, and of rulers and legislators as we find them.” Governments would, in the long run, always be tempted to abuse the printing press for various political reasons.

But besides the dangers of political mischief, the fact is that the government monetary monopoly prevents the market from easily discovering whether, over time, market participants would find it more advantageous to use some particular commodity or several alternative commodities as different types of media of exchange to serve changing and differing purposes. The “optimal” supply of money becomes an arbitrary decision by the central monetary monopoly authority rather than the more natural market result of the interactions between market demanders desiring to use money for various purposes and market suppliers supplying the amount of commodity money that reflects the profitability of mining various metals and minting them into money-usable forms.

The results of monetary freedom

But commodity money, as history has shown, has its inconveniences in everyday transactions in the market. There are benefits from financial depositories for purposes of safety and lowering the costs of facilitating transactions. But what type of financial and banking institutions would market participants find most useful and desirable under a regime of money and banking freedom? The answer is that we don’t know at this time precisely because government has monopolized the supplying of money; and it imposes, through various state and federal regulations, an institutional straitjacket that prevents the discovery of the actual and full array of preferences and possibilities that a free market in monetary institutions might be able to provide and develop over time.

The increasing globalization of commerce, trade, and financial intermediation during the past decade has certainly demonstrated that there is a far greater range of possibilities that market suppliers of these services could provide and for which there are clear and profitable market demands than traditionally thought 10 or 20 years ago. But even in this more vibrant global competitive environment, it remains the case that whatever options have begun to emerge have done so in a restrictive climate of national and international governmental regulations, agreements, and constraints.

Suppose that monetary and banking freedom were established. What type of banking system would then come into existence? Some advocates of monetary freedom have insisted that a free banking system should be based on a 100 percent commodity money reserve. (See “Monetary Central Planning and the State, Part 33: Murray N. Rothbard and the Case for a 100 Percent Gold Dollar,” Freedom Daily, September 1999.) Others have argued that a free banking system would be based on a form of fractional-reserve banking, with the competitive nature of the banking structure serving as the check and balance on any excessive note issue by individual banks. (See “Monetary Central Planning and the State, Parts 36 – 38,” Freedom Daily, December 1999 – February 2000.)

Until monetary and banking freedom is established, we have no way of knowing which of the two alternatives would be the most preferred. This is for the simple reason that under the present government-managed and government-planned monetary and banking system, market competition is not allowed to demonstrate which options suppliers of financial intermediation might find it profitable to offer and which options users of money and financial institutions would decide are the ones best fitting their needs and preferences.

Possible scenarios under monetary freedom

Given the diversity in people’s tastes and preferences, the differing degrees of risk people are willing to bear for a promised interest return on their money, and the variety of market situations in which different types of monetary and financial instruments might be most useful for certain domestic and international transactions, it probably would be the case that a spectrum of financial institutions would come into existence side by side. At one end of this spectrum would be 100 percent reserve banks that guaranteed complete and immediate redemption of all commodity money deposits, even if every depositor were to appear at that bank within a very short period of time.

Along the rest of the spectrum would be various fractional-reserve banks at which lower or no fees would be charged for serving as a warehousing facility for deposited commodity money. Their checking accounts might offer different interest payments depending on the fractional-reserve basis on which they were issued and on the degree of risk or uncertainty concerning the banks’ ability to redeem all deposits immediately under exceptional circumstances.

Some banks might offer both types: they might issue some bank notes and checking accounts that were guaranteed to be 100 percent redeemable on the basis of commodity money deposited against them; and they might issue other bank notes and checking accounts that, under exceptional circumstances, were not 100 percent redeemable.

And these banks might offer “option clauses” stipulating that if any designated notes or checking accounts were not redeemed on demand for some limited period of time, the note and account holder would receive a compensating rate of interest for the inconvenience and cost to himself.

Whether most banks would be closer to the 100 percent reserve end of this spectrum or farther from it is not – and cannot be – known until the monetary and banking system is set free from government regulation, planning, and control. As long as the government remains as the monetary monopolist, there is just no way to know all the possibilities that the market could or would generate. Indeed, for all we know, the market might devise and evolve a monetary and banking system different from that conceived even by the most imaginative free-banking advocates.

Competition is thwarted by government monopoly money, and the creative possibilities that only free competition can discover remain invisible “might- have-beens.” How then can the existing system be moved towards a regime of monetary and banking freedom?

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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).