Chapter 8: Central and Free Banking Theory

This chapter contains a theoretical analysis of the arguments raised for and against both central and free banking throughout the history of economic thought. To begin we will review the theoretical debate between those in favor of a privileged banking system, i.e., one not subject to traditional legal principles and therefore capable of expanding credit (the Banking School), and those theorists who have always contended that banks should follow universal rules and principles (the Currency School).¹ The analysis and evaluation of the theoretical contributions of both schools will also provide us with a chance to study the controversy between supporters of the central bank and defenders of a free banking system. We will see that at first members of the Currency School by and large defended the central bank, and Banking School theorists favored a free banking system, yet in the end the inflationist doctrines of the Banking School prevailed, ironically under the auspices of the central bank. Indeed one of the most important conclusions of our analysis is that the central bank, far from being a result of the spontaneous process of social cooperation, emerged as the inevitable consequence of a fractional-reserve private banking system. In a fractional-reserve context it is private bankers themselves who eventually demand a lender of last resort to help them weather the cyclical economic crises and recessions such a system provokes. We will wrap up the chapter with a look at the theorem of the impossibility of socialist economic calculation. When applied to central bank operations, this theorem explains the problems of administrative banking laws as we know them. Finally we will argue that current free-banking advocates usually make the mistake of accepting and justifying fractional-reserve practices and fail to see that such a concession would not only inevitably lead to the resurgence of central banks, but would also trigger cyclical crises harmful to the economy and society.