6. Conclusion: The Banking System of a Free Society

The theory of money, bank credit, and financial markets represents the greatest theoretical challenge confronting economists as we enter the twenty-first century. In fact it is no stretch to claim that once the theoretical gap embodied by the analysis of socialism was filled, perhaps the most important, yet least-understood field was that of money. For, as we have attempted to reveal in detail throughout this book, this area is fraught with methodological errors, theoretical confusion and, as a result, systematic government coercion. The social relationships in which money is involved are by far the most abstract and obscure, and the knowledge generated through them is the most vast, complex, and difficult to grasp. Consequently the systematic coercion of governments and central banks in this field is by far the most damaging. In any case the intellectual delay in the theory of money and banking has severely affected the development of the world economy, as we see from the acute, recurrent cycles of boom and recession which continue to grip market economies at the dawn of the new millennium.

Nevertheless economic thought on banking issues is quite long-standing, and as we have seen, can be traced back even to the scholars of the School of Salamanca. Closer to our time, we find the controversy between the Banking and Currency Schools, a debate which laid the foundation for the development of subsequent doctrine. We have made an effort to demonstrate the absence of complete agreement between the Free-Banking School and the Banking School, on the one hand, and between the Central-Banking School and the Currency School, on the other. Many free-banking advocates did base their position on the fallacious, unsound inflationary arguments of the Banking School, and most Currency School theorists did plan to reach their objectives of financial solvency and economic stability via the inception of a central bank to curb abuses. However, from the very beginning, certain able Currency School theorists found it impossible and utopian to believe the central bank would do anything but further aggravate the problems that had emerged. These scholars were aware that the best way to limit the creation of fiduciary media and to achieve monetary stability was through a free-banking system governed, like all other economic agents, by the traditional principles of civil and commercial law (i.e., a 100-percent reserve requirement on demand deposits). Paradoxically, nearly all Banking School defenders ended up cheerfully accepting the establishment of a central bank which, as lender of last resort, would guarantee and perpetuate the expansionary privileges of the private banking system. Meanwhile private bankers sought with increasing determination to participate in the lucrative “business” of generating fiduciary media by credit expansion without having to give too much thought to problems of liquidity, due to the support offered at all times by the central bank, the lender of last resort.

Furthermore, although Currency School theorists were correct in almost all of their theoretical contributions, they were unable to see that every one of the drawbacks they rightly perceived in the freedom of private banks to issue fiduciary media in the form of banknotes were also inherent in the “business” of granting expansionary loans against demand deposits at banks, though in this case the drawbacks were more concealed and surreptitious, and hence much more dangerous. These theorists also committed an error when they claimed the most appropriate policy would be to introduce legislation to abolish merely the freedom to issue banknotes unbacked by gold and to set up a central bank to defend the most fundamental monetary principles. Only Ludwig von Mises, who followed the tradition of Modeste, Cernuschi, Hübner, and Michaelis, was capable of realizing that the Currency School's prescription of a central bank was a mistake, and that the best and only way to uphold the school's sound monetary principles was through a free-banking system subject without privileges to private law (i.e., with a 100-percent reserve requirement).

The failure of most Currency School theorists was fatal. These theorists were responsible for the fact that Peel's Act of 1844, despite the honorable intentions behind it, failed to eliminate the creation of fiduciary deposits, though it prohibited the issuance of unbacked banknotes. Moreover members of the Currency School also defended the institution of a central-banking system which, mainly due to the negative influence of Banking School theorists, would eventually be used to justify and promote policies of monetary recklessness and financial excess, policies much more foolish than those theorists originally sought to remedy.

Therefore the central bank, understood as a central planning agency in the field of money and banking, cannot be considered a natural product of the evolution of the free market. On the contrary, it has been dictatorially imposed from the outside as a result of governments' attempts to profit from the highly lucrative possibilities of fractional-reserve banking. In fact governments have deviated from their essential role, as they have ceased to adequately define and defend the property rights of bank depositors, and they have taken advantage of the practically unlimited possibilities of money and credit creation which the establishment of a fractional-reserve ratio (on bills and deposits) has opened up for them. Thus in the violation of the private-property-law principles which apply to demand deposits, governments have largely found their longed-for philosopher's stone, which has provided them with unlimited financing without requiring them to resort to taxes.

The construction of a true free-banking system must coincide with the reestablishment of a 100-percent reserve requirement on amounts received as demand deposits. The original neglect of this obligation led to all the banking and monetary issues which have given rise to the current financial system, with its high level of government intervention.

The idea is ultimately to apply a seminal idea of Hayek's to the field of money and banking. According to this idea, whenever a traditional rule of conduct is broken, either through institutional government coercion or the granting of special privileges by the state to certain people or organizations, sooner or later grave, undesirable consequences always ensue and cause serious damage to the spontaneous process of social cooperation.

As we saw in the first three chapters, the traditional rule of conduct transgressed in the banking business is the legal principle that the safekeeping obligation, an essential element in a non-fungible deposit, manifests itself, in the contract governing the deposit of a fungible good (for example money), in the requirement that a reserve of 100 percent of the fungible good (money) received on deposit be maintained constantly. Hence any use of such money, specifically the granting of loans against it, implies a violation of this principle and thus, an illegitimate act of misappropriation.

At each stage in history, bankers have promptly become tempted to breach this traditional rule of conduct and make self-interested use of their depositors' money. At first they did so secretively and with a sense of shame, since they were still aware of the dishonest nature of their behavior. Only later did bankers manage to make the violation of the traditional legal principle an open and legal practice, when they obtained from the government the privilege of using their depositors' money, almost always in the form of loans, which initially were often granted to the government itself. Thus arose the relationship of complicity and the coalition of interests which have become customary between governments and banks and explain the current “understanding” and “cooperation” between these two types of institutions. Such a climate of collaboration is evident, with only subtle differences, in all western countries under almost all circumstances. For bankers soon realized that the violation of the above traditional legal principle led to a financial activity which earned them fat profits, but which in any case required the existence of a lender of last resort, the central bank, to provide the necessary liquidity in the moments of crisis which experience taught would always reappear sooner or later. The central bank would also be responsible for orchestrating increases in joint, coordinated credit expansion and for imposing on all citizens the legal tender regulations of its own monopolistic currency.

Nevertheless the unfortunate social consequences of this privilege granted to bankers (yet to no other institution or individual) were not entirely understood until Mises and Hayek developed the Austrian theory of economic cycles, which they based on the theory of money and capital and we analyzed in chapters 5 through 7. In short, Austrian theorists have demonstrated that the pursuit of the theoretically impossible (from a legal-contractual and technical-economic standpoint) goal of offering a contract comprised of fundamentally incompatible elements, a contract which combines ingredients typical of mutual funds (particularly the possibility of earning interest on “deposits”) with those typical of a traditional deposit contract (which by definition must permit the withdrawal of the nominal value at any time) will always, sooner or later, trigger certain spontaneous readjustments. Initially these readjustments take the form of the uncontrolled expansion of the money supply, inflation, and generalized poor allocation of productive resources on a microeconomic level. Eventually they manifest themselves in a recession, the elimination of the errors exerted on the productive structure by credit expansion, and massive unemployment.

It is important to understand that the privilege which allows banks to operate with a fractional reserve represents an obvious attack by government authorities on the correct definition and defense of depositors' private-property rights, when respect for these rights is essential to the proper functioning of any market economy. As a result, a typical “tragedy of the commons” effect invariably appears, as it does whenever property rights are not adequately defined and defended. This effect consists of an increased inclination on the part of bankers to try to get ahead of their competitors by expanding their own credit base sooner and more than their rivals. Consequently the fractional-reserve banking system always tends toward more or less rampant expansion, even when it is “monitored” by central bankers who, contrary to what has normally occurred in the past, seriously (and not just rhetorically) concern themselves with setting limits.

In short, the essential goal of monetary policy should be to subject banks to the traditional principles of civil and commercial law, according to which each individual and company must fulfill certain obligations (100-percent reserve requirement) in strict keeping with the terms agreed to in each contract.

At the same time, we should be strongly critical of most of the literature which, following the publication in the late seventies of Hayek's book, Denationalization of Money, has defended a model of fractional-reserve free banking. The most important conclusion to draw from all of this literature is that its authors too often fail to realize that they frequently commit the old errors of the Banking School. As we explained in chapter 8, this is true of the works of White, Selgin, and Dowd. There is nothing wrong with their attention to the advantages of an interbank clearing system in terms of self-control in credit expansion, and in this sense their system would produce better results than the current central-banking system, as Ludwig von Mises originally pointed out. However fractional-reserve free banking is still a second best which would not keep a wave of excessive optimism in loan concession from triggering the joint action of different banks. At any rate, these authors fail to see that as long as the fractional-reserve privilege remains, it will be impossible in practice to dispense with the central bank. In brief, as we have argued in this book, the only way to eliminate the central planning agency in the field of banking and credit (the central bank) is to do away with the fractional-reserve privilege private bankers currently enjoy. This is a necessary measure, though it is not sufficient: the central bank must still be completely abolished and the fiduciary money it has created up to now must be privatized.

In conclusion, if we wish to build a truly stable financial and monetary system for the twenty-first century, a system which will protect our economies as far as humanly possible from crises and recessions, we will have to: (1) ensure complete freedom of choice in currency, based on a metallic standard (gold) which would replace all fiduciary media issued in the past; (2) establish a free-banking system; and, most importantly, (3) insist that all agents involved in the free-banking system be subject to and comply with traditional legal rules and principles, especially the principle that no one, not even a banker, can enjoy the privilege of loaning something entrusted to him on demand deposit (i.e., a free-banking system with a 100-percent reserve requirement).

Until specialists and society in general fully grasp the essential theoretical and legal principles associated with money, bank credit, and economic cycles, we may realistically expect further suffering in the world due to damaging economic recessions which will inevitably and perpetually reappear until central banks lose their power to issue paper money with legal tender and bankers lose their government-granted privilege of operating with a fractional reserve. We now wrap up the book as we began it, with this opinion: Now that we have seen the historic fall of socialism, both in theory and in practice, the main challenge to face both professional economists and lovers of freedom in this new century will be to use all of their intellectual might to oppose the institution of the central bank and the privilege private bankers now enjoy.