2. The Debate Between Defenders of the Central Bank and Advocates of Free Banking

An analysis of the nineteenth-century debate between defenders of the central bank and advocates of free banking must begin with an acknowledgment of the indisputable, close connection which initially existed between the Banking School and the Free-Banking School, on the one hand, and between the Currency School and the Central-Banking School, on the other.⁵⁵ Indeed it is easy to understand why supporters of fractional-reserve banking, on the whole, initially championed a banking system free from any kind of interference: they wished to continue to do business based on a fractional reserve. Likewise it was only natural for Currency School theorists, ever distrustful of bankers, to naively embrace government regulation in the form of a central bank intended to avoid the abuses the Banking School attempted to justify.

PARNELL'S PRO-FREE-BANKING ARGUMENT AND THE RESPONSES OF MCCULLOCH AND LONGFIELD

We will not embark here on a comprehensive account of the controversy between the Free-Banking and Central-Banking Schools: Vera C. Smith and others have already come up with excellent studies on this topic. Nonetheless a few additional points merit discussion. One thought we must keep in mind is that most advocates of free banking based their doctrine on the spurious, inflationist Banking School arguments covered in the last section. Therefore, regardless of the effects a free-banking system might actually exert on the economy, the theoretical foundation on which most free-banking advocates built their arguments was either entirely fallacious or, at best, highly questionable. Consequently, during this period the Free-Banking School made few contributions of any doctrinal value. One such contribution was the correct acknowledgment that, economically speaking, deposits and unbacked bills play the same role. Another, one of particular analytical interest, was made by Sir Henry Parnell as early as 1827. According to Parnell, a free-banking system would place natural limits on the issuance of banknotes, due to the influence of the corresponding interbank clearing house, which, on the model of the Scottish banking system, Parnell believed would develop wherever banks freely competed in the issuance of banknotes. Parnell argued that banks in a totally free banking system would be unable to endlessly expand their paper-money base without prompting their competitors to demand payment of the bills, in specie, through a clearing house. Thus banks, for fear of being unable to weather the corresponding outflow of gold, would, in their own interest, adopt strict limitations on the issuance of fiduciary media.⁵⁶ Parnell's analysis has considerable merit and lies at the heart of the arguments invoked to date in favor of free banking. His analysis was used and developed even by certain authors of the Currency School (like Ludwig von Mises) who were nonetheless highly skeptical of the central-bank system.⁵⁷

A FALSE START FOR THE CONTROVERSY BETWEEN CENTRAL BANKING AND FREE BANKING

Two distinguished theorists of the Currency School, J.R. McCulloch and S.M. Longfield, challenged Parnell's claim. McCulloch argued that the mechanism Parnell described would not curb inflation if all banks in a free-banking system should collectively yield to a wave of expansion in the issuance of banknotes.⁵⁸ Samuel Mountifort Longfield carried McCulloch's objection even further and contended that even if a single bank expanded its paper-money base, in a free-banking system the rest would inevitably be forced to follow suit lest their financial-market share or their profits drop.⁵⁹ Long-field's argument contains an important kernel of truth, since the liquidation of excess banknotes through a clearing house takes time, and there is always a (perhaps irresistible) temptation to overissue on the assumption that all other banks will sooner or later do the same. In this way the first bank to launch an expansionary policy derives the most profit and eventually establishes a position of advantage over its competitors.

Regardless of the theoretical basis for the arguments of Parnell, or for those of McCulloch and Longfield, one thing seems certain: their debate sparked off a false controversy between central-bank and free-banking supporters. We use the term “false” because the theoretical discussion between these two sides misses the heart of the whole problem. Indeed Parnell is correct when he states that in a free-banking context, the clearinghouse system tends to act as a buffer against isolated cases of expansion in the issuance of banknotes. At the same time, McCulloch, and Longfield as well, are right in pointing out that Parnell's argument fails if all banks simultaneously embark on a policy of expansion. Nevertheless Currency School theorists felt their arguments against Parnell's views lent prima facie support to the establishment of a central bank, which they believed would offer the most effective protection against the abuses of fractional-reserve banking. Parnell, for his part, contented himself with defending free banking, though with the limits the interbank clearinghouse system would set as a safeguard against banks’ reckless expansion of their paper-money base. Nonetheless he failed to realize that, regardless of the arguments of McCulloch and Longfield, a return to traditional legal principles and a 100-percent reserve requirement would be much simpler and more effective than any clearinghouse system. Having overlooked this option, at least with regard to bank deposits, is the most crucial error committed by McCulloch and Longfield's branch of the Currency School as well. By endorsing the creation of a central bank, this faction inadvertently paved the way for the future strengthening of the very inflationary policies its adversaries favored.⁶⁰

THE CASE FOR A CENTRAL BANK

Thus began a prolonged controversy between free-banking champions and central-bank promoters. The latter offered the following arguments to support their case against the position of the Banking and Free-Banking School:

First, a free-banking system, by its very nature, even under optimal conditions, would be prone to occasional, isolated bank crises which would harm customers and holders of bills and deposits. Therefore, under such circumstances, there is a need for an official central bank with the power to step in to protect noteholders and depositors in the event of a crisis. This argument is clearly paternalistic and aimed at justifying the existence of a central bank. It ignores the fact that when support is provided to those hit by a crisis, in the long run such support merely tends to further hamper the smooth running of the banking system, which requires constant and active supervision and confidence on the part of the public. Supervision is relaxed and confidence bolstered when the general public takes for granted the intervention of the central bank to avoid any damage in the case of a bank failure. Moreover bankers actually tend to exercise less responsibility when they too are sure of the central bank's support should they need it. Hence it is quite credible that the existence of a central bank tends to aggravate bank crises, as has been revealed even recently in many cases. The “deposit insurance” system in many countries has played a major role in fostering perverse behavior among bankers and in facilitating and aggravating bank crises. Nevertheless, from a political standpoint the above paternalistic argument can become extremely influential, even nearly irresistible, in a democratic environment. At any rate, this first argument marks the beginning of the false start in the free-banking/central-banking debate, in the sense that the argument would be meaningless if traditional legal principles were respected and a 100-percent reserve requirement were reestablished for banking. Under these conditions, no harm would be done to holders of banknotes and deposits, who would always be able to withdraw their money, regardless of the fate of their bank. Therefore the paternalistic argument that a central bank is necessary to protect the interests of injured parties makes no sense. If we follow the logic of a fractional-reserve banking system, this first argument in favor of a central bank is at least very doubtful, while in the context of a free-banking system based on traditional legal principles and a 100-percent reserve requirement, it is completely irrelevant.

The second argument expressed in favor of central banks rests on the notion that a banking system controlled by a central bank provokes fewer economic crises than a free-banking system. This argument, like the first one, represents an inappropriate approach to the debate. We already know that the fractional-reserve free-banking system may stimulate growth in the money supply in the form of loans, and that this growth invariably distorts the productive structure of capital goods and endogenously and repetitively triggers a reversion process that manifests itself as an economic recession that hits banks particularly hard. In fact it was the very desire to protect banks from the effects of the repetitive crises created by fractional-reserve banking which prompted bankers themselves to demand the establishment of a central bank to loan them money as a last resort. Experience has shown that far from defusing economic crises, the advent of the central bank has exacerbated them. In a fractional-reserve free-banking system (with no central bank), even though the expansionary processes which provoke crises cannot be avoided, the reversion mechanisms which lead to the necessary readjustment and correction of economic errors operate much sooner and more quickly than in the central-bank-based system. Indeed the loss of public confidence is not the only factor to endanger the most expansionist banks, the reserves of which rapidly diminish as the holders of their bills withdraw their countervalue in specie. Interbank clearing mechanisms related to deposits also jeopardize those banks which expand their credit base faster than the rest. Even if most banks expand their deposits and bills simultaneously, the spontaneous processes identified by the theory of economic cycles soon gather momentum and tend to reverse the initial expansionary effects and bankrupt marginally less solvent banks. In contrast, the existence of a central bank, a lender of last resort, may prolong the process of credit and monetary expansion much further in relation to the independent process which would be set in motion in a free-banking system. It is impossible to ignore the contradiction inherent in the institution of the central bank, which was theoretically created to curb monetary expansion, maintain economic stability and prevent crises, but which in practice is devoted to providing new liquidity on a massive scale when banks face crises and panics. If we also consider political influences and the inflationary desires of the public, we will understand why inflationary processes and their distortion of the productive structure have been aggravated and the historical result has been much more severe and profound economic crises and recessions than those which would have arisen in a free-banking system. Therefore we can conclude that this second argument in favor of the central bank is groundless, since the very existence of the central bank tends to exacerbate economic crises and recessions. Nevertheless we must also acknowledge that crises would erupt even in a fractional-reserve free-banking system, though they would not cause as many repercussions as in a monetary system directed by a central bank. We have made this point in previous chapters and will demonstrate it further on. In any case, we do not have to resign ourselves to living with recurrent economic crises and recessions, since the mere re-establishment of general legal principles (100-percent reserve requirement) would prevent a free-banking system from exerting any negative effects on economic processes, and in this way the most common pretext for creating a central bank would disappear.

The third argument in favor of a central bank is that in supplying the liquidity necessary, it provides the best way to deal with crises once they have hit. Again it is evident that the failure to clearly identify the essential root of the economic problems of banking leads theorists to err substantially in their approach to the debate between central-banking and free-banking supporters. Although interbank clearing mechanisms and continuous public supervision would tend to limit credit expansion in a fractional-reserve free-banking system, they would be unable to prevent it completely, and bank crises and economic recessions would inevitably arise. There is no doubt that crises and recessions provide politicians and technocrats with an ideal opportunity to orchestrate central-bank intervention. Therefore it is obvious that the very existence of a fractional-reserve banking system invariably leads to the emergence of a central bank as a lender of last resort. Until traditional legal principles are reestablished, along with a 100-percent reserve requirement in banking, it will be practically inconceivable for the central bank to disappear (in other words, it will inevitably arise and endure).

At the same time, the establishment of a central bank to meet crises tends to worsen economic recessions. The existence of a lender of last resort aggravates expansionary processes and makes them much more rapid and lengthy than they would be in a fractional-reserve free-banking system (i.e., with no central bank). Therefore it is paradoxical to claim that the correct treatment of economic and bank crises depends on the existence of a central bank, when the central bank is ultimately the main culprit in dragging out and exacerbating crises. Nevertheless let us remember that even if the introduction of a fractional-reserve free-banking system were to tame crises somewhat, it could not completely eliminate them, and the different economic agents involved (mainly the bankers and citizens potentially harmed in each crisis) would inevitably urge the establishment of a central bank. The only way to end this vicious circle is to recognize that the origin of the entire problem lies in fractional-reserve banking. In fact the reestablishment of a 100-percent reserve requirement would not only avoid bank crises and recurrent economic recessions, but it would also invalidate this third argument, one of the stalest invoked to justify the existence of the central bank.

Finally, two additional, subsidiary arguments in favor of the central bank have been expressed. The first refers to the supposed “need” for a “rational” monetary policy imposed from above through the central bank. The second argument is related to the first and centers around the need to establish an adequate policy of monetary cooperation among different countries. Supposedly this goal also requires the existence of different, coordinated central banks. We will examine the theoretical impossibility of implementing a monetary and banking policy in a centralized, coercive manner through a central bank in a forthcoming section, where we will apply the theory of the impossibility of socialism to the banking and financial sector. Therefore we will refrain from analyzing these last two arguments in depth here.

THE POSITION OF THE CURRENCY SCHOOL THEORISTS WHO DEFENDED A FREE-BANKING SYSTEM

Unfortunately, due to their inability to equate the economic effects of deposits with those of banknotes, and to their naiveté in proposing the creation of a central bank to check the abuses of fractional-reserve banking, Currency School theorists were unable to foresee that the remedy they prescribed would necessarily prove much worse than the sickness they had correctly diagnosed. Only a handful of Currency School theorists understood that their goals of monetary stability and solvency would be at much greater risk if a central bank were created, and as a lesser evil and in order to prevent abuses as far as possible, these theorists recommended the maintenance or establishment of a free-banking system with no central bank. Nonetheless most Currency School writers who defended free banking were not deceived as to the expansionary possibilities of such a system, and they always maintained that the final solution to the problems posed would only be achieved with the prohibition of the issuance of new fiduciary media (i.e., with the prohibition of credit expansion unbacked by an increase in real voluntary saving). In proposing a system in which banks could freely issue bills and deposits, they basically hoped that interbank clearing mechanisms, customer supervision and control through the market, and the immediate failure of banks which lost public confidence would serve to more effectively limit the issuance of unbacked banknotes and deposits.⁶¹ By this indirect route, they planned an effective move toward the objective of a 100-percent reserve requirement (for both bills and deposits), an aim to be pursued by all legal means available in each historical context.

This idea was first defended in France by Victor Modeste.⁶² With the same goal in mind, Henri Cernuschi, on October 24, 1865, before a commission appointed to investigate banking activities, stated:

I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.⁶³

Cernuschi's doctrine had only two flaws: it referred merely to banknotes and ignored bank deposits. And furthermore, it was not so radical as Modeste's who considered fractional-reserve free banking a fraudulent business that should not be allowed at all.

While the French Currency School was establishing this position in favor of free banking and a 100-percent reserve ratio, a number of German economists, among them Hübner and Michaelis, were carrying out a more in-depth theoretical analysis which led to the same conclusions. In the United States, the panic of 1819 had sparked the formulation of a doctrine against both fractional-reserve banking and the establishment of a central bank, and this doctrine strongly influenced the above school of German-speakers. As we already know, in the U.S., Condy Raguet and others (William M. Gouge, John Taylor, John Randolph, Thomas Hart Benton, Martin Van Buren, etc.) developed a body of monetary doctrine highly critical of banking.⁶⁴ These men correctly identified fractional-reserve banking as the ultimate cause of crises and concluded that a return to a 100-percent reserve ratio was the only way to eradicate them.⁶⁵ Tellkampf, who had visited the U.S. as a young man, witnessed the abuses and highly damaging effects of fractional-reserve banking there and was imbued with the rigorous monetary doctrine being developed in America at the time. When he returned to Germany and was appointed professor of economics at Breslau, he wrote several papers in which he called for a ban on banks’ issuance of fiduciary media.⁶⁶ Otto Hübner also shared some of the views of Tellkampf and the American school. Hübner observed that the less regulated banks were, the less frequent their solvency problems tended to be. He felt the choice was between a system of privileged banks protected by a central bank and apt to encourage irresponsible practices, and a free-banking system with no central bank to confer any privileges or protection. In this second system, each bank would necessarily be responsible for its own policies, and consequently bankers would act in a more prudent way. According to Hübner, the final objective should be an end to the issuance of banknotes not backed 100 percent by specie. Nevertheless, in light of the current situation, he believed the fastest and most effective way to move toward the ideal system was through free banking, in which each bank would be required to fulfill its obligations entirely.⁶⁷

As early as 1867, the notable theorist Philip Joseph Geyer formulated a theory to explain economic cycles (a precursor to the theory proposed in this book) which Mises and Hayek would later carry to its logical conclusion. In fact Geyer impeccably summarises the defects of the fractional-reserve banking system and describes how it provokes economic crises. According to Geyer, the banking system produces “artificial capital” (künstliches Kapital), which refers precisely to fiduciary media generated by banks and unbacked by real wealth from voluntary saving. Geyer explains why a boom follows and must inevitably reverse in the form of a bank crisis and an economic recession.⁶⁸ Finally, like Hübner, Otto Michaelis defended a free-banking system as a means to curb abuses and move toward the ideal of a 100-percent reserve requirement.⁶⁹

The tradition of Modeste, Cernuschi, Hübner, and Michaelis was continued by Ludwig von Mises, who in 1912 conclusively upheld the tenets of the Currency School. He not only asserted that both banknotes and deposits were fiduciary media, but he also grounded monetary theory on that of marginal utility and Böhm-Bawerk's theory of capital. The result was, for the first time, a complete, coherent and integrated theory of economic cycles. Thus Mises realized that English Currency School theorists were mistaken in recommending a central bank and that the best, in fact the only, way to achieve the school's goals of monetary solvency was through the establishment of a free-banking system subject, without privileges, to private law (i.e., to a 100-percent reserve requirement). Furthermore Mises recognized that in the end most advocates of Banking School principles cheerfully accepted the establishment of a central bank which, as lender of last resort, would guarantee and perpetuate the expansionary privileges of private bankers. These individuals made an increasing effort to shirk their commitments and devote themselves to the lucrative “business” of creating fiduciary money via credit expansion, and central-bank support allowed them to do so without having to worry too much about liquidity problems. Not surprisingly, Mises is especially critical of the fact that Peel's Bank Charter Act of 1844, despite the excellent intentions with which it was drafted, failed to ban the expansionary creation of fiduciary deposits as it did with banknotes. Mises also condemns the use of the law to constitute and reinforce a central-bank system which, as we know, was eventually used to justify and promote policies of monetary chaos and financial excess much more damaging than the ones it was designed to prevent.

Mises's essential contribution to the study of money and economic cycles appears in his work, The Theory of Money and Credit, first published in 1912.⁷⁰ It was not until eight years later, in 1920, that he expounded his famous theorem of the impossibility of socialist economic calculation, initiating the important debate that would surround this topic in the following decades. No explicit evidence suggests Mises was aware that the fundamental arguments he raised in 1920 on the impossibility of socialism were also directly applicable to fractional-reserve banking, and especially to the establishment and operation of a central bank. However in the next section we will defend the thesis that our analysis on fractional-reserve banking and the central bank is simply a specific case which arises when the general theorem of the theoretical impossibility of socialism is applied to the financial sphere.⁷¹