3. The "Theorem of the Impossibility of Socialism" and its Application to the Central Bank

In chapter 2 we saw that throughout history central banks have emerged not as a result of the spontaneous, evolutionary free-market process, but as a consequence of deliberate government intervention in the banking sector. In fact the institution of the central bank is rooted in the failure of public authorities to adequately define and defend depositors’ property rights; in other words, to put an end to bankers’ misuse of the money their customers entrust to them on deposit. This failure gave rise to the development of fractional-reserve banking, a practice which, as we know, permits bankers to create new monetary instruments ex nihilo, and thus to generate large profits. We are already familiar with the harmful effects such banking activity exerts on the economic structure in the form of malinvestment, severe crises, and recessions which should, in principle, justify particularly diligent care on the part of governments to guarantee the fulfillment of traditional legal principles (a 100-percent reserve requirement on demand deposits). Nevertheless throughout history, far from increasing their zeal to ensure compliance with the law in banking, governments have been the first to take advantage of the banking business, granting bankers many privileges. In order to cope with the perpetual fiscal difficulties created by their financial carelessness, governments have not only legalized fractional-reserve banking via the corresponding privilege, but they have throughout history continually attempted to take advantage of this set-up, either by requiring that a large number of the loans created ex nihilo by the fractional-reserve banking system be given to the government itself, or by reserving all or part of the highly lucrative fractional-reserve banking business for themselves.

For their part, private bankers themselves did not fail to notice that their industry underwent recurrent panics and liquidity crises which regularly endangered the continuity of bankers’ lucrative business. Hence private bankers have been the first to request the establishment of a central bank which, as lender of last resort, would guarantee their survival in times of trouble. In this way the interests of private bankers came to coincide with those of the state and its central bank, and a symbiosis formed between the two. The state obtains easy financing in the form of loans and inflation, the cost of which goes unnoticed by the citizens, who do not initially experience a heavier tax burden. Private bankers gladly accept the central bank's existence and the rules it imposes, since bankers realize the entire framework of their business would ultimately collapse without the support of an official institution to provide the necessary liquidity once the “inevitable” bank crises and economic recessions hit.

Therefore we can conclude with Vera Smith that the central bank is not a spontaneous result of the market process. Instead the state has coercively imposed it in order to achieve certain objectives (particularly easy financing and the orchestration of inflationary policies, which are always very popular), all with the acquiescence or support of private banks, which in this area have almost always acted as the government's accomplices in the past.⁷²

The above explains the historical appearance of the central bank, which is founded on the complicity and community of interests which have traditionally united governments and bankers and which fully account for the intimate “understanding” and “cooperation” between these two types of institutions. Nowadays this relationship, with only slight variations, is evident in all western countries and in almost all situations. The survival of private banks is guaranteed by the central bank, and thus this institution, and ultimately the government itself, exercises close supervision and political and economic control over banks. Moreover the central bank is intended to direct the monetary and credit policy of every country, with the aim of achieving certain economic policy goals. In the next section we will see why it is theoretically impossible for a central bank to sustain a monetary and credit system which produces no severe economic maladjustments and disturbances.⁷³

THE THEORY OF THE IMPOSSIBILITY OF COORDINATING SOCIETY BASED ON INSTITUTIONAL COERCION OR THE VIOLATION OF TRADITIONAL LEGAL PRINCIPLES

Elsewhere we have defended the thesis that socialism should be redefined as any system of institutional aggression on the free exercise of entrepreneurship.⁷⁴ This aggression may take the form of direct physical violence (or the threat of it) perpetrated by government authorities or of privileges granted to certain social groups (unions, bankers, etc.) so that they may violate traditional legal principles with state support. To attempt to coordinate society via institutional coercion is an intellectual error, because it is theoretically impossible for an agency in charge of committing this type of aggression (a central planning board) to obtain the information it would need to establish social coordination with its decrees.⁷⁵ The above is true for the following four reasons: first, it is impossible for the agency to constantly assimilate the enormous volume of practical information stored in the minds of different human beings; second, the subjective, practical, tacit, and nonverbal nature of most of the necessary information precludes its transmission to the central organ; third, information which actors have not yet discovered or created and which simply arises from the free market process, itself a product of entrepreneurship subject to the law, cannot be transmitted; and fourth, coercion keeps entrepreneurs from discovering or creating the information necessary to coordinate society.

This is precisely the essence of the argument Mises originally raised in 1920 on the impossibility of socialism and, in general, of state intervention in the economy. The argument theoretically explains the failure of economies of the former Eastern bloc, as well as the growing tensions, maladjustments and inefficiency which stem from the interventionist welfare state characteristic of western economies.

Likewise, the granting of privileges which conflict with traditional legal principles prevents coordinated cooperation among the different agents in society. Indeed traditional legal principles are essential to the coordinated, peaceful exercise of entrepreneurship. Their systematic violation hinders the free creativity of entrepreneurs, as well as the creation and transmission of the information necessary to coordinate society. When these principles are disregarded, social maladjustments remain hidden and tend to worsen systematically.⁷⁶

The inevitable outcome of states’ systematic coercion of society and of the concession of privileges against traditional legal principles is widespread social disorder and lack of adjustment in all areas and at all levels of society which are affected by such coercion and privileges. In fact both coercion and privileges encourage inaccurate information and irresponsible acts, and both lead to the corruption of individual behavioral habits subject to the rule of law, favor the development of the underground economy and, in short, cause and sustain all sorts of social maladjustments and conflicts.

THE APPLICATION OF THE THEOREM OF THE IMPOSSIBILITY OF SOCIALISM TO THE CENTRAL BANK AND THE FRACTIONAL-RESERVE BANKING SYSTEM

One of the central theses of this book is that the theorem of the impossibility of socialism, and the Austrian analysis of the social discoordination which inevitably follows institutional coercion and the granting of privileges at variance with the law, are directly applicable to the financial and banking system which has evolved in our economies. This system is based on private fractional-reserve banking and is controlled by an official institution (the central bank) which has become the architect of monetary policy.

Indeed the modern financial and banking system of market economies is entirely based on systematic coercion against the free exercise of entrepreneurship in the financial sector and on the concession to private banks of privileges which conflict with traditional legal principles and allow banks to operate with a fractional reserve.

We need not dwell on the juridical nature of the “odious” privilege involved in fractional-reserve banking, since we studied this aspect in detail in the first three chapters. As to the systematic exercise of coercion in the field of banking and finance, it is easy to understand that such manipulation is carried out via the legal tender regulations which compel the acceptance, as a liberatory medium of exchange, of the monetary unit issued by the monopolistic central bank.⁷⁷ The institutional coercion the central bank applies also manifests itself in an entire network of administrative banking legislation designed to rigorously control the operations of banks and, on a macroeconomic level, to define and implement the monetary policy of each country.⁷⁸

In short we can hardly avoid concluding that “the organization of the banking system is much closer to a socialist economy than to a market economy.”⁷⁹ Therefore in banking and credit matters, our situation matches that which prevailed in the socialist countries of the former Eastern bloc, which attempted to coordinate their economic decisions and processes through a system of central planning. In other words “central planning” has become commonplace in the banking and credit sector of market economies, so it is natural that in this area we should see the same discoordination and inefficiency which plagues socialism. Let us now examine three separate instances of interventionism and/or privileges in the organization of banking. The theorem of the impossibility of socialism applies in each, namely: (a) the most widespread case of a central bank which oversees a fractional-reserve banking system; (b) the case of a central bank which manages a banking system that operates with a 100-percent reserve ratio; and finally, (c) the case of a free-banking system (with no regulation and no central bank) which nevertheless exercises the privilege of maintaining only a fractional reserve.

(a) A system based on a central bank which controls and oversees a network of private banks that operate with a fractional reserve

The system made up of a central bank and private banking with a fractional reserve is the most disruptive example of “central planning” in the financial sphere.⁸⁰ Indeed this system is founded upon a privilege which private bankers enjoy (the use of a fractional-reserve ratio) and which naturally causes distortions in the form of credit expansion, malinvestment and recurrent cycles of boom and recession. Moreover the entire system is orchestrated, managed, and supported by a central bank which acts as lender of last resort and exercises systematic, institutional coercion in the field of banking, finance and money.

In providing banks with the necessary liquidity in times of crisis, the central bank tends to counteract the mechanisms which work in a free market to spontaneously reverse the expansionary effects of banking. (Such mechanisms consist precisely of the rapid failure of the most expansionary and least solvent banks.) Consequently the process of deposit creation and credit expansion (i.e., without the backing of real, voluntary savings) may be prolonged indefinitely, thus aggravating its distortion of the productive structure and exacerbating the inevitable economic crises and recessions it creates.

The system of financial planning which rests on the central bank cannot possibly eliminate recurring economic cycles. The most it can do is to delay their appearance by creating new liquidity and providing support to endangered banks in times of crisis, at the cost of aggravating the inevitable economic recessions. Sooner or later, the market always tends to spontaneously react and to reverse the effects of monetary aggression unleashed on it, and therefore deliberate attempts to prevent such effects via coercion (or the granting of privileges) are condemned to failure. The most these attempts can achieve is the postponement, and consequent worsening, of the necessary reversion and recovery, or economic crisis. They cannot prevent it. In a fractional-reserve free-banking system (with no central bank), the reversion tends to occur much earlier, due to spontaneous interbank clearing processes (though the productive structure is still somewhat distorted). The creation of a central bank to act as lender of last resort and supply the liquidity necessary in times of crisis tends to neutralize the market's spontaneous reversion and recovery processes, and as a result expansionary policies can become much more lasting and damaging.⁸¹

The central bank, as the “financial central-planning board,” embodies an intrinsic contradiction. Indeed, as F.A. Hayek has revealed, all central banks face a fundamental dilemma, since they invariably wield great discretionary power in the administration of their policies, yet they do not have all the information they need to reach their objectives. The central bank exercises its power over private banks mainly by threatening to not provide them with the liquidity they need. And at the same time it is believed that the chief duty and purpose of the central bank consists precisely of not refusing to supply the liquidity necessary when bank crises hit.⁸²

The above accounts for the great difficulty central bankers face in eliminating economic crises, despite their effort and dedication. It also explains the tight control the central bank maintains over private banking, through administrative legislation and direct coercion.⁸³

Moreoever, like Gosplan, the most important economic-planning agency of the now extinct Soviet Union, the central bank is obliged to make an unceasing effort to collect an extremely vast quantity of statistical information on the banking business, the different components of the money supply, and the demand for money. This statistical information does not include the qualitative data the central bank would need to harmlessly intervene in banking affairs. For such information is not only extraordinarily profuse; but what is more important, it is also subjective, dynamic, constantly changing, and particularly difficult to obtain in the financial sector. Hence it is painfully obvious that the central bank cannot possibly acquire all the information it would need to act in a coordinated manner, and its inability to do so is one more illustration of the theorem of the impossibility of socialism, in this case applied to the financial realm.

Knowledge of the different components of the supply of and demand for money is never available for objective accumulation. On the contrary, it is of a practical, subjective, diffuse nature and is difficult to articulate. Such knowledge arises from economic agents’ subjective desires, which change constantly and depend largely on the evolution of the money supply itself. We already know that any quantity of money is optimal. Once any changes in the money supply have exerted their effects on the relative-price structure, economic agents can take full advantage of the purchasing power of their money, regardless of its absolute volume. It is when the quantity and distribution of money changes, via the expansion of loans (unbacked by saving) or the direct spending of new monetary units in certain sectors of the economy, that a serious disturbance occurs and widespread maladjustments and discoordination appear in the behavior of the different economic agents.

Therefore it is unsurprising that the central-bank system of our analysis is marked by having triggered the most severe intertemporal discoordination in history. We have seen that the monetary policies adopted by central banks, especially that of England and the Federal Reserve of the United States, with the purpose of “stabilizing” the purchasing power of the monetary unit, encouraged a process of great credit and monetary expansion throughout the “roaring” twenties, a process which led to the most acute economic depression of the last century. Following World War II, economic cycles have been recurrent, and some have approached even the Great Depression in severity: for example, the recession of the late seventies and, to a lesser extent, that of the early nineties. These events have occurred despite many political declarations concerning the need for governments and central banks to conduct a stable monetary policy, and despite the massive efforts made, in terms of human, statistical, and material resources, to realize this objective. Nevertheless the failure of such efforts could not be more obvious.⁸⁴

It is impossible for the central bank, as a financial central-planning agency, to somehow carry out the exact function private money would fulfill in a free market subject to legal principles. The central bank not only lacks the necessary information, but its mere existence tends to amplify the distorting, expansionary effects of fractional-reserve banking, giving rise in the market to severe intertemporal discoordination which, in most cases, not even the central bank is able to detect until it is too late. Even central-bank defenders, like Charles Goodhart, have been obliged to admit that, contrary to the implications of their equilibrium models, and despite all efforts made, in practice it is almost impossible for central-bank officials to adequately coordinate the supply of and demand for money, given the highly changeable, unpredictable, seasonal behavior of the multiple variables they work with. For it is exceedingly difficult, if not impossible, to manipulate the so-called “monetary base” and other aggregates and guides, such as the price index and rates of interest and exchange, without instigating erratic and destabilizing monetary policies. Furthermore Goodhart acknowledges that central banks are subject to the same pressures and forces that influence all other bureaucratic agencies, forces which have been studied by the Public Choice School. Indeed central-bank officials are human and are affected by the same incentives and restrictions as all other public officials. Therefore they may be somewhat swayed in their decision-making by groups with a vested interest in influencing the central bank's monetary policy. These include politicians eager to secure votes, private banks themselves, stock-market investors and numerous other special interest groups. Goodhart concludes:

There is a temptation to err on the side of financial laxity. Raising interest rates is (politically) unpopular, and lowering them is popular. Even without political subservience, there will usually be a case for deferring interest rate increases until more information on current developments becomes available. Politicians do not generally see themselves as springing surprise inflation on the electorate. Instead, they suggest that an electorally inconvenient interest rate increase should be deferred, or a cut ‘safely’ accelerated. But it amounts to the same thing in the end. This political manipulation of interest rates, and hence of the monetary aggregates, leads to a loss of credibility and cynicism about whether the politicians’ contra-inflation rhetoric should be believed.⁸⁵

Acknowledgment of the harmful behavior (analyzed by the Public Choice School) of central-bank officials and of the “perverse” influence politicians and interest groups exert on them has led to the consensus that central banks should be as “independent” as possible of the political decisions of the moment and that this independence should even be incorporated into legislation.⁸⁶ This constitutes a small step forward in the reformation of the financial system. However, even if rhetoric for the independence of central banks finds its way into legislation or the constitution itself, and even if it is effective in practice (which is more than doubtful in most cases), many public-choice arguments regarding the behavior of central-bank officials would remain unrefuted. Moreover, and more importantly, the central bank would continue to generate massive, systematic intertemporal maladjustments even when appearing to pursue a more “stable” monetary policy.⁸⁷

Oddly enough, the controversy over the independence of central banks has provided the context for the discussion on which structure of incentives would best motivate central-bank officials to develop the correct monetary policy. Thus, in connection with the “financial central-planning agency,” the sterile debate about incentives has revived, a debate which in the 1960s and 1970s prompted theorists from the economies of the former Eastern bloc to expend a veritable river of ink. In fact the proposal of making the salary of central-bank officials conditional upon their performance with respect to set goals of price stability is strongly reminiscent of the incentive mechanisms which were introduced in socialist countries in an unsuccessful attempt to motivate the managers of state companies to act more “efficiently.” Such proposals for reforming the incentive system failed, just as the latest, similar, well-intentioned propositions regarding the central bank are bound to fail. They will be unsuccessful because from the start they ignore the essential fact that the officials responsible for government agencies, whether state-owned companies or central banks, cannot in their daily lives escape from the bureaucratic environment in which they work, nor can they overcome the inherent ignorance of their situation. János Kornai makes the following appropriate, critical comments concerning attempts to develop an artificial incentive system to make the behavior of functionaries more efficient:

An artificial incentive scheme, supported by rewards and penalties, can be superimposed. A scheme may support some of the unavowed motives just mentioned. But if it gets into conflict with them, vacillation and ambiguity may follow. The organization's leaders will try to influence those who impose the incentive scheme or will try to evade the rules.... What emerges from this procedure is not a successfully simulated market, but the usual conflict between the regulator and the firms regulated by the bureaucracy.... Political bureaucracies have inner conflicts reflecting the divisions of society and the diverse pressures of various social groups. They pursue their own individual and group interests, including the interests of the particular specialized agency to which they belong. Power creates an irresistible temptation to make use of it. A bureaucrat must be interventionist because that is his role in society; it is dictated by his situation.⁸⁸

(b) A banking system which operates with a 100-percent reserve ratio and is controlled by a central bank

In this system the distortion and discoordination which arise from the central bank's systematic attack on the financial market would be lessened, since private banks would no longer enjoy the privilege of functioning with a fractional reserve. In this sense bank loans would necessarily reflect economic agents’ true desires with regard to saving, and the distortion caused by credit expansion (i.e., unbacked by a prior increase in real, voluntary saving) would be checked. Nevertheless we cannot conclude that all discoordination generated by the central bank would disappear, since the mere existence of the central bank and its reliance on systematic coercion (the imposition of legal-tender regulations and a set monetary policy) would still have a damaging effect on the processes of social coordination.

In this example the most critical discoordination would be intratemporal, rather than intertemporal,⁸⁹ because new money created by the central bank and placed in the economic system would tend to affect the relative-price structure “horizontally.” In other words it would tend to engender a productive structure which, horizontally speaking, would not necessarily coincide with the one consumers wish to sustain. A poor allocation of resources would ensue, along with a need to reverse the effects new injections of money would exert on the economic system.⁹⁰

Furthermore, although we cannot refer to any true instance in which a central bank has overseen a system of private banks which have operated with a 100 percent reserve, such a system would also be subject to the political influences and lobby pressures studied by the Public Choice School. It would be naive to believe that central bankers with the power to issue money would desire and be able to develop a stable, undistorted monetary policy, even if they supervised a private banking system which functioned with a 100-percent reserve requirement. The authority to issue money poses such an overwhelming temptation that governments and special interest groups would be unable to resist taking advantage of it. Therefore, even if the central bank did not compound its errors through a fractional-reserve banking system, it would still face the constant risk of succumbing to pressure from politicians and lobbyists eager to take advantage of the central bank's power in order to accomplish the political goals deemed most appropriate at any particular moment.

In short we must acknowledge that because the privilege of fractional-reserve banking is absent in the model covered in this section, most of the intertemporal discoordination behind economic cycles is absent there as well. Nevertheless multiple possibilities of intratemporal discoordination remain, owing to the injection into the economic system of new monetary units created by the central bank, and regardless of the specific method used to inject this new money into society (financing public spending, etc.). In addition, the effects examined by the Public Choice School would play a key role in these intratemporal maladjustments. Indeed it is almost inevitable that the central bank's power to issue money should be politically exploited by different social, economic, and political groups, with the resulting distortion of the productive structure. Though monetary policy would certainly be more predictable and less distorting if private banks maintained a 100 percent reserve, theorists who defend the conservation of the central bank under these circumstances are naive in that they consider that the government and different social groups would desire and be able to develop a stable, and (as far as possible) “neutral,” monetary policy. Even if banks kept a 100 percent reserve, the very existence of the central bank, with its tremendous power to issue money, would attract all sorts of perverse political influences like a powerful magnet.⁹¹

(c) A fractional-reserve free-banking system

The third and last system we will analyze in light of the theory of the impossibility of socialism is a privileged free-banking system, i.e., one with no central bank, but with permission to operate with a fractional reserve. The theory of the impossibility of socialism also explains that the concession of privileges which allow certain social groups to violate traditional legal principles produces the same widespread discoordination as socialism, understood as any system of regular, institutional aggression toward the free exercise of entrepreneurship. We have devoted a significant portion of this book (chapters 4–7) to examining how the infringement of traditional legal principles in connection with the monetary bank-deposit contract offers banks the possibility of expanding their credit base even when society's voluntary saving has not increased. We have also seen that as a consequence, discoordination arises between savers and investors and must reverse in the form of a bank crisis and economic recession.

The main clarification to be made concerning a fractional-reserve free-banking system is that the spontaneous market processes which reverse the distorting effects of credit expansion tend to begin sooner in this system than in the presence of a central bank, and therefore abuses and distortions cannot become as severe as they often do when a lender of last resort exists and orchestrates the entire expansionary process.

Thus it is conceivable that in a free-banking system, isolated attempts to expand bank credit would be curbed relatively quickly and spontaneously by customers’ vigilance toward banks’ operations and solvency, the constant reassessment of the trust placed in banks, and, more than anything, the effect of interbank clearing houses. In fact any isolated bank expanding its credit faster than the sector average or issuing notes more rapidly than most would see the volume of its reserves drop quickly, due to interbank clearing mechanisms, and the banker would be forced to halt expansion to avoid a suspension of payments, and eventually, failure.⁹²

Nonetheless, even though this definite market reaction tends to check the abuses and isolated expansionary schemes of certain banks, there is no doubt that the process only works a posteriori and cannot prevent the issuance of new fiduciary media. As we saw in chapter 2, the emergence of fractional-reserve banking (which in its early days was unaccompanied by a central bank) marked the beginning of substantial, sustained growth in fiduciary media, first in deposits and loans unbacked by saving, and later, in banknotes unbacked by reserves of specie. This process has continually distorted the productive structure and generated cycles of boom and recession which have been historically recorded and studied in many situations in which private banks have functioned with a fractional reserve and without the existence and supervision of a central bank. Some of the earliest of such studies can be traced back to the economic and bank crises which hit fourteenth-century Florence. Just as the theory of free banking indicates, the great majority of these expansionary banks did eventually fold, but only after issuing fiduciary media for a varying length of time, an activity which never failed to exert crippling effects on the real economy by provoking bank crises and economic recessions.⁹³

Not only is fractional-reserve free-banking incapable of avoiding credit expansion and the appearance of cycles, but it actually tempts bankers in general to expand their loans, and the result is a policy in which all bankers, to one extent or another, are carried away by optimism in the granting of loans and in the creation of deposits.⁹⁴ It is a well-known fact that whenever property rights are not adequately defined—and this is the case with fractional-reserve banking, which by definition involves the violation of depositors’ traditional property rights—the “tragedy of the commons” effect tends to appear.⁹⁵ Thus a banker who expands his loans brings in a handsome, and larger, profit (if his bank does not fail), while the cost of his irresponsible act is shared by all other economic agents. It is for this reason that bankers face the almost irresistible temptation to be the first to initiate a policy of expansion, particularly if they expect all other banks to follow suit to one degree or another, which often occurs.⁹⁶

The above example differs only slightly from Hardin's classic illustration of the “tragedy of the commons,” in which he points to the effects an inadequate recognition of property rights may exert on the environment. Unlike in Hardin's example, in fractional-reserve free banking a spontaneous mechanism (interbank clearing houses) tends to limit the possibility that isolated expansionary schemes will reach a successful conclusion. Table VIII-2 outlines the dilemma banks encounter in such a system.

TABLE VIII-2

This table reflects the existence of two banks, Bank A and Bank B, both of which have two options: either to refrain from expanding credit or to adopt a policy of credit expansion. If both banks simultaneously initiate credit expansion (assuming there are no other banks in the industry), the ability to issue new monetary units and fiduciary media will yield the same large profits to both. If either expands credit alone, its viability and solvency will be endangered by interbank clearing mechanisms, which will rapidly shift its reserves to the other bank if the first fails to suspend its credit expansion policy in time. Finally it is also possible that neither of the banks may expand and both may maintain a prudent policy of loan concession. In this case the survival of both is guaranteed, though their profits will be quite modest. It is clear that given the choices above, the two banks will face a strong temptation to arrive at an agreement and, to avoid the adverse consequences of acting independently, initiate a joint policy of credit expansion which will protect both from insolvency and guarantee handsome profits.⁹⁷

The above analysis extends to a large group of banks which operate in a free-banking system and maintain a fractional reserve. The analysis shows that under such circumstances, even if interbank clearing mechanisms limit isolated expansionary schemes, these spontaneous mechanisms actually encourage implicit or explicit agreements between the majority of banks to jointly initiate the process of expansion. Thus in a fractional-reserve free-banking system, banks tend to merge, bankers tend to arrive at implicit and explicit agreements among themselves, and ultimately, a central bank tends to emerge. Central banks generally appear as a result of requests from private bankers themselves, who wish to institutionalize joint credit expansion via a government agency designed to orchestrate and organize it. In this way, the “uncooperative” behavior of a significant number of relatively more prudent bankers is prevented from endangering the solvency of the rest (those who are more “cheerful” in granting loans).

Therefore our analysis enables us to conclude the following: (1) that the interbank clearing mechanism does not serve to limit credit expansion in a fractional-reserve free-banking system if most banks decide to simultaneously expand their loans in the absence of a prior rise in voluntary saving; (2) that the fractional-reserve banking system itself prompts bankers to initiate their expansionary policies in a combined, coordinated manner; and (3) that bankers in the system have a powerful incentive to demand and obtain the establishment of a central bank to institutionalize and orchestrate credit expansion for all banks, and to guarantee the creation of the necessary liquidity in the “troublesome” periods which, as bankers know from experience, inevitably reappear.⁹⁸

The privilege which allows banks to use a significant portion of the money placed with them on demand deposit, i.e., to operate with a fractional-reserve, cyclically can result in a dramatic discoordination of the economy. A similar effect appears when privileges are granted to other social groups in other areas (unions in the labor market, for example). Fractional-reserve banking distorts the productive structure and provokes widespread, intertemporal discoordination in the economy, a situation bound to spontaneously reverse in the form of an economic crisis and recession. Although in a fractional-reserve free-banking system independent reversion processes tend to curb abuses sooner than in a system controlled and directed by a central bank, the most harmful effect of fractional-reserve free banking is that it provides banks with an immensely powerful incentive to expand loans jointly and, particularly, to urge authorities to create a central bank aimed at offering support in times of economic trouble and organizing and orchestrating widespread, collective credit expansion.

CONCLUSION: THE FAILURE OF BANKING LEGISLATION

Society's market process is made possible by a set of customary rules of which it is also the source. These rules constitute the behavioral patterns embodied in criminal law and private contract law. No one has deliberately formulated them. Instead such rules are evolutionary institutions which emerge from practical information contributed by a huge number of actors over a very prolonged period of time. Substantive or material law, in this sense, comprises a series of general, abstract rules or laws. They are general because they apply equally to all people, and they are abstract because they establish only a broad scope of action for individuals and do not point to any concrete result of the social process. In contrast to this substantive conception of law, we find legislation, understood as a set of coercive, statutory, and ad hoc orders or commands which are the materialization of the illegitimate privileges and the systematic, institutional aggression with which the government attempts to dominate the processes of human interaction.⁹⁹ This concept of legislation implies the abandonment of the traditional notion of the law (explained above), and the replacement of it with “spurious law” composed of a conglomeration of administrative orders, regulations and commands which dictate exactly how the supervised economic agent should behave. Thus to the extent that privileges and institutional coercion spread and develop, traditional laws cease to act as standards of behavior for individuals, and the role of these laws is taken over by the coercive orders and commands of the regulatory agency, in our case, the central bank. In this way the law gradually loses its scope of implementation, and as economic agents are robbed of the criteria of substantive law, they begin to unconsciously alter their personalities and even lose the custom of adapting to general, abstract rules. Under these conditions, to “elude” commands is in many cases simply a matter of survival, and in others it reflects the success of corrupt or perverse entrepreneurship. Hence, from a general standpoint, people come to see deviation from the rules as an admirable expression of human ingenuity, rather than a violation of a regulatory system which seriously jeopardizes life in society.

The above considerations are fully applicable to banking legislation. Indeed the fractional-reserve banking system, which has spread to all countries with a market economy, primarily entails (as we saw in the first three chapters) the violation of an essential legal principle in relation to the monetary bank-deposit contract and the granting of an ius privilegium to certain economic agents: private banks. This privilege allows banks to disregard legal principles and make self-interested use of most of the money citizens have entrusted to them via demand deposits. Banking legislation mainly constitutes the abandonment of traditional legal principles in connection with the monetary demand-deposit contract, the heart of modern banking.

Furthermore banking legislation takes the form of a tangled web of administrative orders and commands which emanate from the central bank and are intended to strictly control the specific activities of private bankers. This welter of injunctions has not only been incapable of preventing the cyclical appearance of bank crises, but (and this is much more significant) it has also fostered and aggravated recurrent stages of great artificial boom and profound economic recession. Such stages have regularly seized western economies and entailed a great economic and human cost. Thus:

Each time a new crisis hits, a complete set of new laws or amendments to prior ones is swiftly enacted under the naive assumption that the former laws were insufficient and that the new, more detailed and all-encompassing ones will better avoid future crises. This is how the government and the central bank excuse their unfortunate inability to avert crises, which nevertheless arise again and again, and the new regulations last only until the next bank crisis and economic recession.¹⁰⁰

Therefore we can conclude that banking legislation is condemned to failure and will continue to be so unless the present form is thoroughly abolished and replaced by a few simple articles to be included in the commercial and penal codes. These articles would establish the regulation of the monetary bank-deposit contract according to traditional legal principles (a 100-percent reserve requirement) and would prohibit all contracts which mask fractional-reserve banking. In short, in keeping with Mises's view, the above proposal entails the substitution of several clear, simple articles, to appear in the commercial and penal codes, for the current web of administrative banking legislation, which has not achieved the objectives set for it.¹⁰¹

It is interesting to note that modern defenders of fractional-reserve free banking wrongly believe, due in part to their lack of legal preparation, that a 100-percent reserve requirement would amount to an unfair administrative restriction of individual freedom. Nevertheless, as the analysis of the first three chapters shows, nothing could be further from the truth. For these theorists do not realize that such a rule, far from being an example of systematic, administrative government coercion, merely constitutes the recognition of traditional property rights in the banking sector. In other words, theorists who endorse a fractional-reserve free-banking system, which would infringe traditional legal principles, fail to see that “free trade in banking is synonymous with free trade in swindling,” a famous phrase attributed to an anonymous American and reiterated by Tooke.¹⁰² Moreover if a free-banking system must ultimately be defended as a “lesser evil” in comparison with central banking, the motive should not be to permit the exploitation of the lucrative possibilities which always arise from credit expansion. Instead free banking should be seen as an indirect route to the ideal free-banking system, one subject to legal principles, i.e., a 100-percent reserve requirement. All legal means available in a constitutional state should be applied at all times in the direct pursuit of this goal.