Central Banking, its Problems, and the Alternative of Free Banking

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Every so often an unexpected financial crisis erupts after a long period of peace and stability. Who do we blame for this crisis? The politicians will tell you that the free market has failed and that banks and other financial institutions must be regulated accordingly. Even in academia, the idea of a failing free market is often entertained; in school, we were told that the great depression was caused by either: overproduction, banks overlending, the stock market crashing or a combination of the three. However, we as libertarians know that the instability in our economic system has its roots in the most reckless institution that has existed throughout American history; that is the Federal Reserve Bank.

How did the Fed cause the Great Depression?

There are plenty of theories on how the Federal Reserve Bank caused the Great Depression. The most common explanation you will hear from free-market circles is the Austrian Business Cycle which states that an expansion of credit via manipulation of interest rates creates a misallocation of resources or “malinvestment” as it’s called by Austrian economists. In other words, when the central bank artificially lowers interest rates below the market rate, entrepreneurs invest in more roundabout production processes (Hayek used the phrase “capitalistic methods of production”) meaning goods require more intermediate phases to be complete thus they take a longer time to be prepared until they are ripe for consumption (it’s important to note that the reason why entrepreneurs invest in more roundabout production processes is to increase real output). Since the low-interest rates aren’t the result of a greater amount of savings, it means consumers prefer goods now rather than later. This creates a conflict between buyers and sellers, where buyers want to consume goods now and sellers don’t have those goods because producers are still producing them. Once entrepreneurs realize the current production structure is unstable they will quickly liquidate their assets causing a credit crunch which reestablishes the relationship between consumer time preferences and interest rates.

While such an explanation is plausible it doesn’t explain the Great Depression accurately considering how inflation was (mostly) low for the majority of the 1920s. A better explanation of 1929 depression was the one provided by economists Ralph Hawtrey and Gustav Cassel. According to Hawtrey and Cassel, the cause of the depression can be linked back to the early 1920s (late 1910s) where most countries had returned to the gold standard after going off it to finance the war. This had lead to an increase in the monetary demand for gold, thus causing deflation rates that were in the double digits. Furthermore, by the end of WWI, the U.S. held 40 percent of the world’s gold reserves meaning it had significant control over the global financial system; this would soon lead to its demise. To stabilize the system, Hawtrey and Cassel advocated that the Fed follow an easier money policy prevent further deflation in Britain, which it did in 1927 when it lowered its discount rate from 4 percent to 3.5 percent. However, despite there efforts, the Fed set it’s discount rate back to 4 percent in fear of an inflated stock market. When the stock market kept growing, the Fed continued to raise it’s discount rate from 4 percent to 5 percent in the summer of 1928 and 6 percent in 1929. This lead to the stock market finally crashing and the economy going into a recession.

Why does the Fed fail?

There is no doubt that the central banks all over the world have made significant policy errors, but why? Wouldn’t a regulating bank prevent private banks from engaging in risky financial activities and causing an economic collapse? When we ask these questions, we must consider a central bank, not as a regulating body, but as a monopoly on the banking system. In any market, the goal of a firm is to match the supply of their product with the demand for that product to maximize consumer satisfaction. Similarly, since the role of the central bank is to supply the public with money, the amount of money supplied must adequate to satisfy the public’s demand for money. You may be asking: What exactly is the demand for money? The demand for money in economics is the demand to hold real cash balances (that is the demand to hold cash balances relative to the general level of prices). When there is an excess demand for money, people desire to hoard cash; conversely, when there is an excess supply of money, people desire to spend more of their money balances. Like the demand for a company’s products, the demand for money requires relevant knowledge found through profit signals to be accurately speculated. The Fed cannot calculate the public’s demand for money because it has no such mechanism to acquire information related to the desire to hold cash.

The free market alternative to central banking

There have been several proposed schemes to replace central banking with a more stable system. One such system proposed by Milton Friedman is a computerized system where increases in the money supply would be determined electronically. The problem with Friedman’s policy is that it assumes the demand for money is predictable. In other words, the amount of money people desire to hold is not the would lead to an unstable level of spending. A feasible system would be one that creates a stable level of spending; a system where changes in the demand for money are accompanied by changes in the quantity of money. A free banking system would accomplish just that.

Under laissez-faire banking systems, reserves would either consist of some scarce commodity or a fixed supply of physical currency. Instead of lending out reserves, banks would lend out paper money substitutes to avoid the possibility of a bank run. These paper notes also serve as a way to control inflation. Suppose bank A increases the supply of their notes above the demand to hold said notes. Assuming that the banking system is competitive, A’s notes will be deposited to other rival banks. Those rival banks can exchange A’s notes for its reserves, leaving A in a less profitable position. Historically, clearinghouses have spontaneously developed to make this process easier by allowing banks to conduct transactions multilaterally. Free banking can also prevent depressions caused by an excess demand for money. If individuals choose to hoard cash, then the total amount of clearings will fall meaning banks won’t have to worry about losses attributed to notes or checks being deposited to rival banks.

America’s “free banking era” and the myth of “wildcat banking”

Critics of free banking often like to point at the instability of the American experience in the 19th century. However what they fail to realize is that the American system was regulated not to a great extent, but the regulations themselves had a significant impact. It’s better to refer to the American system as “bond-collateral” banking rather than “free” or “laissez-faire” banking, do to the “bond-deposit” requirements placed on private banks by state governments. These were laws that forced banks to buy state bonds so that state governments would be able to have enough funds. Specifically, the system allowed banks to issue 90 dollars in notes for every 100 dollars in bonds bought. When the Civil War commenced, the bond collateral system was extended to the federal level as a way to fund war efforts. The problem with this is system is that it imposes costs on private banks, costs that depend on the face value of the bonds bought. This problem became apparent in 1882, when the federal government ran a surplus and the national debt began to fall; as a result of which, the supply of bonds fell thus raising their face value making it more difficult for private banks to buy bonds leading to a deficiency in notes issued and the money supply to contract.

Conclusion

It’s easy for the common person to assume that the banking system is naturally unstable because they assume that the banking system is completely driven by greed and ignore the regulating private institutions (referring to clearinghouses) that exist or have existed to keep banks in check. Furthermore, they fail to see the important distinctions between the modern banking system and a free banking regime and because of this, some critics of the current system see it’s failures as proof that it is in desperate need of regulation. If they understood the history of banking regimes in great detail instead of the heavily generalized version often taught in schools then they would advocate for a system where the government doesn’t have significant leverage.

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Bhavin Patel is a senior in high school as well as a geolibertarian (Georgist libertarian). He plans to major in computer science and minor in economics when he gets into college.