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CENTRAL BANKING- WHY NOT?
As an Economics students with fervent Austrian beliefs, the authors of this presentation are thrilled at even hearing the word “central”, whether it is applied in the context of politics, banking, or philosophy.
Central banking is based on a major misconception that knowledge is circumscribable. Embracing Hayek’ theory as it is exposed in the familiar to any cognizable student paper “The Use of Knowledge in Society”, we endorse the conception that absolute knowledge is an oxymoronic expression. Knowledge is dispersed among innumerable individuals and only in their multifaceted interactions can knowledge be transmitted. Any exterior intervention, whether it is called government, institution or Federal Reserve Board of Governors, is a carrier of manipulative forces that only lead to misbalance. The fundamental starting point of our critique of the central banking theory is not only that perfect knowledge of the vicissitudes of the economy is a surrealistic concept but also that, were its existence to be possible, savoir would still not have been collectible by a single institution of human minds. As Hayek put it in “Constitution of Liberty” (1960),
"No human mind can comprehend all the knowledge which guides the actions of society" F. A. Hayek 
Our belief in the inability of the Fed to integrate the economy as a function of the consumers’ preferences is supported by real examples of wrong assumptions of the Fed that have led to severe states of the economy. We exemplify this with a familiar case: cost- push inflation caused by targeting high employment. This is a good illustration of how interventionism leads to more and more interference and the Fed’s attempts to correct its mistakes are actually aggravating them. Also, targets are often inconsistent with each other, and it is usually not unequivocal which target is to be preferred.
Cost-Push Inflation
Mishkin, Frederic. "The Economics of money, banking, and financial markets". Mishkin Economics, Inc.: 1992.pg. 673, fig.28.5
This kind of accomodating policy reflects the reaction of the Fed to workers' desire for higher wages. By constantly shifting out the aggregate demand, activist policymakers create inflation.
Unfortunately, the mistakes of the Fed cannot be encompassed in a brief undergraduate presentation but are rather subject to graduate dissertation.
Another criticism that we would like to address to the central banking system’ s (mal)functioning is the pure focus on ex ante state of the economy without taking into account ex post conditions that are supposedly incorporated into agents expectations, and thus affect their present behavior. Path-dependent strategies are anything but smart and unavoidably distress the economy.
Last but not least, we would like to use Selgin as a reference and list some of the most recurrent mistakes of the Federal Reserve’s control on the money supply. These mistakes are mainly due to the motivation hidden behind these changes, namely:
• To stabilize some index of prices
Our criticism: prices reflect relative scarcity of resources worldwide, and hence, they are the only trustworthy mechanism of information transmission. If prices fluctuate, this is due to a change in the availability of a resource. Intervening to stabilize their movement is a crude attempt to manipulate data and misinform the public
• To peg an interest or discount rate
Our criticism: Similarly, interest rates are “prices” of loans, and reflect most veraciously their private and public demand. Manipulation of the interest or discount rates would mislead entrepreneurs and push them into risky projects, or prevent them from engaging into successful investments that could lead to expansion of the economy.
Example: When the US joined WWII in 1941, military government expenditure went up tremendously. To finance it, the Treasury issued bonds, and the Fed pegged their interest rates at very low values (2.5 on long term t-bonds). Thus, the Fed was serving the political purposes of the government. After the Korean War of 1950, the pegging policy brought about detrimental results, giving rise to inflation and raising CPI by more than 8% for one year.
• To attain full employment
Our criticism: Again, we do not accept “full” (employment), “absolute” (power), “complete” (knowledge) as economically adequate terminology, all these terms indicating over-determination, which is in sharp contrast with our veneration of the perfectly competitive market. (Here, the authors risk contradicting their basic anti-absolutistic linguistic approach but the educated reader will not ignore the fact that even Adam Smith assumes some minimum intervention of the government in his invisible hand theory).
How is the “natural” rate of unemployment to be determined? Economists have not reached an affirmative conclusion on this question. This is why we doubt the precision with which the Fed can determine it, if all the experts in the world are still leading zealous debates on this question.
• To achieve a fixed percent rate of growth of MB or some other money aggregate
Our criticism:Once more, we face the transingent belief of the Fed that they can determine what the most desired condition of the economy is. This mistake is sharpened by the notion that the economy’s development should follow any change in monetary aggregates. If the money aggregates followed the natural interactions in the economy, and thus changed in response to actual processes, they would be useful as a reliable indicator of the economic situation. There is no justification of the Fed transforming the banking system into an absolute monarchy under its omnipotent governance.
FREE BANKING SYSTEM- CHAOS OR HARMONY?
“Government failure might be worse than market failure”
Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1963
After carrying out a substantial research on the history of the American banking system, the prominent economists such as Milton Friedman and Anna Schwartz claim in their book “A Monetary History of the United States” that often “turning to the government as an alternative was a cure that was worse than the disease.” Do self- interested actions create a stable or unstable equilibrium in the monetary market? Before advocating the mechanisms of efficient functioning of the free banking system, a brief description of its structure merits deliberation. As Milton Friedman verbalizes his discontent with the Fed’s actions, “The failure of government to provide a stable monetary framework has thus been a major if not the major factor for our really severe inflations and depressions.”
What is free banking?
“Free banking developed naturally, out of a pure specie monetary system, which had developed naturally out of barter”
Lawrence White, Free Banking as an Alternative Banking System, 1989
Free banking is a system of money exchange with no central bank and no governmental intervention. It is characterized by self-adjustive mechanisms. In the free banking system exchange rates and money supply are determined by the public’s demand for money and the real purchasing power of specie.Interest rates adjust to agents’ demand for funds. Thus, deposits, loans, and credits’ supply is also uncontrolled by any institutional estbalishment. The only laws free banks would then obey are the laws of the free competitive market. Once there is no government, there is no required reserve ratio, and all reserves and capital are free to be put to the best use of the economy.
There are several characteristics of free banking that we would like to emphasize:
• Free communication between lenders and borrowers
• Emergence of a new market: the market of short-term credits. Its logic opposes the credit- rationing model by providing opportunities to anyone to receive a loan and engage in a no-matter-how risky investment, as long as the loan is to be repaid shortly after it has been given out. This solves the problem of excess supply of reserves ( banks can invest them), as well as the problem of excess demand for loanable funds. Consequently, this kind of market leads to a naturally clearing money market.
• Currencies are perfectly competitive and banks are not limited as to their issuance.
• Last but not least, it is assumed that notes are exchanges per se, i.e. that for every agent demanding a note, there is one who is willing to supply it. In "The Origins of Money" Carl Menger explains how this happens through infinite number of transactions, considered to be costless in the model of free banking.
Our recent history has not witnessed a free banking economy, and since free banking system is only an economic model, we should not even expect to observe it in its pure form. White's student and follower, George Selgin suggests that this system should be analyzed in the context of an “imaginary, unregulated society” that he calls Ruritania.
• "Free" Banks:
Bankers, left to choose their own actions, converge into improving the efficiency of all transactions.
Ruritarians trust their own currency- inside money- more than notes of further lands, which impedes the creation of a network. Selgin points out that if a bank accepts a rival bank’s notes, it increases the marketability not only of its own notes but also of the notes of its competitor. This is why reserve requirements went up to 61.2 % in Scotland while banks were aggressively trying to bankrupt their rivals by buying out their notes.
An “invisible hand” created also the clearinghouses where people would meet to “combine and reconcile their claims.” (Selgin)This is where interest rates and reserve requirements were set, their persistence being closely contingent on the profit-maximization strategies of the banks. The clearinghouses were thus performing many of the functions of the Fed today, including lender of last resort. This could be achieved even without the presence of a central authority that would create "monetary disturbances" by changing the money supply.
• Long Run Equilibrium
Equilibrium in the long run is reached when the demand for reserves is equal to the supply of money, both in the market for commodity money and the market for inside money (paralleled by the market for monetary and non-monetary assets nowadays)
Free banking promotes fiduciary substitution- replacement of base money with inside money. Thus, increased demand for money can be met by an increased supply of money.
The costs of maintaining a standard are much lower under free banking.
• Competition vs Monopoly
The advantages of competition over the monopoly are clear to any economist. Some advocates of central banking would claim though that central banking leads to economies of scale because costs decrease simultaneously with the issuance of notes. We prove below that this is only to a point at which money’s purchasing power starts decreasing. Free banking system achieves equilibrium by using prices as the most effective transmitter of information; and competition in the market as a pitiless disciplining device. Unfortunately, there is no rivaling institution to discipline the Fed.
Money Supply Under a Free Banking System
Selgin proposes the following mathematical formulation of the money supply in a free banking system versus the one in a central banking system.
Central Banking Mc=MB- C (1-r)
r= commercial bank reserves/commercial bank liabilities= (Specie held by the public+ Currency +Deposits)/ Deposits=(Money Base-Currency)/Demands
We substitute into the equation of Money supply and we get Mc= {MB-C(1- r)}/r money supply is a function of the relative demand for currency. There is competition of the use of currency for banks’ purposes and for private purposes
Free Banking
Mf= MB/r
Setting Mc= Mf leads to the following equation
Bc= Bf+ C (1-r)
M=S+C+D Money= Specie + Currency + Deposits
R=S/ (C+D)
Mf= C+D=Bf/r
• How do banks choose the amount of loans?
The constraint is given by the fundamental accounting law A=L
S+B=N+D+K
(Specie+Bills)= (Notes+Deposits+Equity Capital)
(definition given by Lawrence White)
This law posits that if banks want to make additional loans (B ?), they have to either attract depositors and note holders, or lose specie (N?, D ?, or S ?). An increase in bills will be profitable to the bank but it would also entail operating, liquidity and interest-payment costs. After a point of optimization, the costs will start increasing faster than the revenues, and a profit-maximizing bank will stop expanding.
What are the regulatory forces that bring the bank back to equilibrium if its stock is more than the optimization stock? If agents start redeeming their notes, the bank’s specie will decrease. If agents make deposits at another bank, this will lead to an adverse clearings balance against the bank’s notes. To settle the balance, the bank will transfer specie to the other banks. Meanwhile though, the bank will be losing reserves. If agents are intending to spend the overissued notes, prices will be going up until people change their preferences (demand for money), and the notes are returned to the bank that had created them. In order to return to the equilibrium, the bank must reverse the process by pursuing a restrictive policy, selling off bills for specie, and benefiting from positive clearings against other banks. Thus, the bank will restore its optimum level.
Milton Friedman exemplifies this with the case of gold, estimated to cost 2.5% of GNP in the central banking system, and 0.014 % under free banking. If banks are to choose freely the value of notes, there will be less circulation of gold.
US history did in fact witness free banking in practice. This happened after the federal withdrawal from banking legislation in 1836, followed by free banking reforms in Michigan and New York. These laws postulated that any owner of capital could establish a bank; notes were secured with holdings of bonds. Moreover, bonds were redeemable: were a bank to bankrupt, the noteholders would claim its assets. Unquestionably, such a provision secured a stable monetary system acting in the interests of the market agents. Preserving people’s trust also meant that banks had to hold a sufficiently high capital ratio.
ARE WE FREE TO CHOOSE A FREE BANKING SYSTEM?
If free banking is that efficient as the authors of this project (as well as many acknowledged economists) believe it, why wasn’t it proposed as a reform to the banking system? Our personal response is that, free banking was efficient precisely because it was free, it evolved naturally, and it was not imposed by external forces. It will not be a feasible alternative nowadays because we live in a world of political affairs where banking is simply another tool in the hands of political leaders. Meanwhile, we should not underestimate the expected social reaction- free banking is not incorporated in our thinking, and we are used to intervention. Expectations for federal action are built-in in our decision-making processes. Changing preferences would evolve over a long time period that would not be profitable to politicians. It would eventually create a Pareto improvement in the economy but we should also be concerned about how future- oriented private agents are. Thus, the cost- benefit analysis shows free banking as a better banking system in the long run but as an unstable and practically unfeasible system in the short run.
As students in a liberal arts college, we are free to endorse the free banking system as a theory; as students of Prof. McPhail and Prof. Farrant, we are offered the knowledge to defend it. As long as knowledge is uncircumscribable, and that is exactly the assumption underlying our theory, no system is absolutely superior. This is why we wanted to present an alternative of the money and banking system we have been studying.
