Foreword by Kevin Dowd

Free banking is—or at least ought to be—one of the key economic issues of our time. There is mounting evidence that the monetary instability created by the Federal Reserve—persistent and often erratic inflation, the unpredictable shifts of Federal Reserve monetary policy, and the gyrating interest rates that accompany both inflation and the monetary policy that creates it—have inflicted colossal damage on the U.S. economy and on the fabric of American society more generally. Furthermore, much as the United States has suffered, less fortunate countries have suffered far more. Most of us have watched in horror, for example, as Russia has come out of more than seventy years of Communist misery only to slide now into the abyss of hyperinflation. Unlike some disasters, monetary instability is entirely avoidable, but to avoid it, we need to make sure that the monetary system is built on the right foundations—foundations we are very far from having. On top of these monetary problems, we also observe in the United States how ill-judged attempts to regulate the banking system and protect it from the (grossly exaggerated) danger of runs have spawned a massive apparatus of deposit insurance and regulatory control in the form of the FDIC, the now-bankrupt FSLIC, and a variety of other bureaucracies. These agencies were (ostensibly) set up to protect a banking system that, though weakened by legislative restrictions of various kinds and by misguided Federal Reserve policies in the 1930s, was still relatively strong, and yet they managed to convert that system into a chronic invalid made artificially dependent on the ultimately lethal drug of deposit insurance. In addition to gravely weakening the banking system and destroying much of it in the process, the deposit insurance system also accumulated staggering losses—losses of hundreds of billions of dollars and perhaps more—which it then passed back to the long-suffering federal taxpayer. Politicians and bureaucrats have responded with a series of largely cosmetic reforms that have accomplished virtually nothing and are nowhere near any realistic solution. Once again, what we need are sound free-banking foundations. We do not have such foundations and are unlikely ever to get them if things continue as they are.

Larry Sechrest’s book is therefore a timely contribution to a very important policy debate. It is sad indeed that our political and intellectual leaders have still to learn the most important and most obvious lesson to be drawn from the collapse of communism in the eastern bloc—that central planning does not, and cannot, work. To paraphrase Larry, amidst all the celebration that accompanied the demise of communism and with all that has been written about the problems of central planning, our leaders are still afflicted with the craving to practice it, and they cling to the illusion that though eastern bloc socialism might be dead, they still believe that all is well with central planning in the West. They know that central planning failed in the East, but they learned nothing from that failure, and nowhere is this illusion stronger and more cherished than in the sphere of money and banking. One suspects that part of the reason the illusion is as strong as it is in this area is that even professional economists are by and large still afflicted with the central planning mentality. We do not talk of monetary central planning, of course—we talk of central banking or monetary policy—but the goals are the same even if we prefer to use a less sinister label to describe them. Central banking is central planning. Those of us who support free banking find it odd that despite all the failures of central planning—the failures of central planning in the eastern bloc, the failures of monetary central planning in the West, and other failures besides—so many economists still cling to it and refuse to consider free banking as a serious alternative. Most still scoff at the idea and dismiss free banking as inherently unworkable (which it is not). Alternatively, they reject it on the basis that it was tried and failed in the past, an argument that is not only not true, but that also has a very strange logic to it. They point to instances such as the bank failures of the antebellum United States as evidence that free banking has a poor historical record—which, in any case, is a highly questionable interpretation. They then conclude that free banking is inferior to central banking, and lo and behold, they have managed to demonstrate that the modern system of central planning, which has produced far more failures, a much weaker banking system, and massive taxpayer losses into the bargain—a system that is demonstrably inferior by any sensible yardstick—is actually the better system!

Yet as Larry argues, this attitude toward free banking simply will not do. The free-banking position is not easily dismissed, and it is too radical and far-reaching to be sensibly ignored. If the free bankers are correct, as I believe they are, then no amount of tinkering will make much difference to our present monetary and banking problems, and we will never get far with them until we start to base reforms on free-banking principles. If the free bankers are not correct, on the other hand, then it is odd that no one has yet managed to refute the case for free banking and ensure that the errors of this potentially dangerous point of view are exposed for all to see. Yet instead of either siding with the free bankers or trying to refute them, most monetary economists seem to prefer to ignore the free-banking issue altogether and carry on regardless. One can only suppose they have invested a lot of their human capital into ways of thinking that would have to be ditched if free-banking theory turned out to be correct, and only a few can bring themselves to learn again what they thought they already knew.

Larry Sechrest is one of the few who rise to this challenge without flinching and try, as it were, to put the shattered pieces of monetary economics back together again. There is much in this book to appeal to many different readers. Those interested in public policy, and in monetary and banking policy in particular, will find a very articulate and insightful discussion of policy issues. Undergraduates and postgraduates will find new ideas and clear expositions of many issues that researchers and policy makers are talking about, but that have not yet found their way into textbooks. Researchers—academic economists, monetary historians, students of public policy, and others—will find a variety of theoretical developments, new insights and criticisms of existing work, and new interpretations of the historical evidence.

This volume stands out from the existing literature in a number of ways. Although free banking has a number of supporters, different writers often have very different ideas about what free banking in practice would look like. Most writers also fail to discuss in any detail how their systems differ from each other, and the discussions that already exist are often extremely arcane. The reader who starts on this literature therefore enters a mine field with no real warning. Amongst other things, the author makes a very useful contribution by comparing these various systems and offering assessments of them. Some free bankers think in terms of banks issuing their own inconvertible currencies, whereas others think in terms of free banks issuing convertible currencies of one form or other; some free bankers believe that free banks would aim to stabilize the price level, and others, that they would allow prices to fall with productivity growth; some free bankers see free banks as mutual fund intermediaries, and others as institutions like conventional present-day banks that issue both debt and equity; some believe that free banks would operate on a fractional reserve, others that they would observe a 100 percent reserve ratio, and so on. The student of free banking needs to get acquainted with these issues before getting too far into the literature, and this book in my opinion would be a very good place to start.

It offers, however, much more than an introduction to what other people have written. An issue often touched upon in the free-banking literature, but seldom developed in any depth, is the role of the central bank in creating or aggravating the fluctuations of the business cycle. One finds short discussions here and there, but Larry offers a much more thorough treatment of it, one that breaks ground that others had merely staked out. He also offers new empirical evidence on and new interpretations of the much-discussed historical experiences of “nearly free banking,” if that is what they were, in Scotland and the antebellum United States. He argues that these experiences ought not to be interpreted as laboratory-like experiments of “pure” free banking, and he suggests the delightful metaphor that they are like buildings that were well designed but not actually constructed according to those designs. They therefore ran into problems, but those problems cannot be traced to design faults. The design as such (i.e., free-banking theory) was sound, but the construction (i.e., the particular legislative frameworks in which banks had to operate) was not. He also takes issue with those—such as Lawrence H. White and, to a somewhat lesser extent, me—who have interpreted the Scottish experience as a reasonably good, albeit flawed, example of free banking. It is characteristic of Larry’s intellectual integrity that although he readily admits that it would be nice, from a free-banking point of view, to point to the Scottish experience as a case study of free banking in action, and thus gain an edge over anti-free-banking critics who believe that free banking does not work, yet he simply does not interpret the evidence that way, and he would rather pass up the chance of scoring points against the opponents of free banking than compromise his own scholarship. I do not share his interpretation of the Scottish experience, but I do think this kind of critical reassessment is very important, and I applaud him for it. If nothing else, it helps protect us against the myth-making all too prevalent in monetary economics and the associated danger of imposing our theories too strongly on the data.

In my opinion, Larry’s most important contribution is his analysis of the impossibility of rational monetary central planning. The problem with central banking is not that central bankers are ill-intentioned or incompetent people—my own personal experience suggests that they are quite the contrary—but that the very institution of central banking imposes on those who have to operate the system problems to which no feasible solutions exist. They do not have the information they would need to solve them—they do not have the data, and they do not have the knowledge of what rational expectations theorists like to call the “structure” of the economy. They cannot tell what interest rates “should” be, what monetary target to adopt, and so on, if only because they do not have the information they would need. They try to answer these questions regardless—they feel they have no alternative—and are therefore doomed to failure. If a system with good and capable people still does not work, one must blame the system itself for asking them to do the impossible. The same problems arise, of course, in any system that becomes centrally planned—that is of course why central planning always fails. The solution—the only solution—is always the same, regardless of whether we are talking of the (thankfully) now-defunct Gosplan in Moscow or the Federal Reserve System in the United States: The central planning apparatus must be dismantled, and market forces allowed in to do what no central planner can do in their place.

William Gladstone is reputed to have said that monetary economics was the surest recipe for insanity that he knew of. I am not yet entirely convinced of that, but I would certainly agree that monetary economics produces more than its fair share of confusion and muddled thinking among those of us who study it. (I speak here primarily of my own experience. I have pulled out my hair and changed my mind on monetary issues far more often than I would care to admit.) Those who produce innovative work in areas such as this are probably even more prone than most to these sorts of problems, and the best any of us can aim for is a good “hit ratio” of valid new insights relative to errors and misinterpretations. We can only hope that those who read our work will pick out the better ideas and discard the rest, preferably quietly. Yet this kind of work, risky as it is, is of fundamental importance, and monetary economics cannot really advance far without it. We need this kind of high-risk intellectual entrepreneurship—a willingness to stick one’s neck out with new ideas that may turn out to be brilliantly successful or may leave one falling flat on one’s face—and we also need critics who can look at the work of others and help sift out the good ideas from those that are indifferent or just plain wrong. This book offers both qualities in good measure—the entrepreneurship and the critical assessment of other work—and I hope it gets the attention it richly deserves. I also hope that the critical assessment of others will bear out my belief that the author achieves a pretty good ratio of hits to misses.

Kevin Dowd