Rationale for Freedom in Banking

I thought after obliquely mentioning it in my last post, the concept of Freedom in Banking deserves more elaboration. I initially became enthusiastic about the idea based on a simple idea, which we may call a principle of economics:

Free and voluntary exchange, coordinated by an unrestrained system of prices, is the most effective way to bring production of goods and services-the ends of suppliers-into harmony with consumer demand.

If one holds that this is true for all “ordinary” goods and services, it becomes very strange indeed to simultaneously maintain that the provision supply of money to meet the public at large’s demand for money holdings, and a medium of exchange, is somehow best served by a government sponsored monopoly. That being said, most economists have tended to take for granted the need for regulation of the banking system, and government control of the money supply-Even Milton Friedman, who once remarked that the if the government were put in charge of the Sahara Desert there would be a sand shortage in a few years, generally took central monetary control for granted. Rothbardians, because they believe fractional reserve banking to be fraud, want de facto regulation of banking through a private court system-Any bank holding less than 100% reserves against it’s outstanding liabilities would be prosecutable as criminal. (As an aside here, most Austrians seem to believe fractional reserve banking is the inherent problem (that is, the root cause monetarily induced business cycles) but the Rothbardians distinguish themselves by believing it to be criminal. For Mises, fractional reserve banking was a creature created by government intervention, so in terms of policy he favored laissez faire. While he was almost certainly wrong to believe fractional reserve banking would not survive under free banking, he got the remedy right anyway. For my part I favor the views of those more like Larry White or George Selgin, who would have it that monetary instability comes from central banking, not fractional reserves per se) And it should go without saying that the Left, especially those who belong to the Conspiracy School of Economics, favor government reflexively.

Despite such opposition from practically all sides, I still defend the case for monetary laissez faire. Why? Let’s sketch a brief outline:

1. To begin with, not only is it not clear that a Central Bank, a government created monopoly, is an improvement over freedom in banking, it isn’t clearly an improvement even over a system like that which immediately preceded the creation of our current one in the United States-itself an un-free system, with restrictions on branching and taxes and regulations that basically limited note issue to what could be backed 100% with a particular kind of Government bond.

2. A so called “demand side recession” can only occur if there is an excess-that is, unmet-demand by the public to hold money balances. Otherwise, the observation of Jean-Baptiste Say applies: people supply goods and services only because they want to acquire money to purchase goods-that is, only because they they want to demand things: Supply creates it’s own demand. The virtue of a free banking system of competitive note issue is that it automatically achieves this monetary neutrality, ie monetary equilibrium. How, exactly? Without getting into too much detail, essentially: for a given quantity of reserves (the quantity is determined by the base regime. A stable quantity would be easy to achieve, we could have monetary policy set by a computer, or we could even close the Fed’s open market operations entirely, and freeze the monetary base-something Milton Friedman favored later in his life), banks will expand and contract lending to maintain a constant nominal income MV-to put it another way, the Banking system accommodates increases and decreases in the public’s desire to hold inside money. In loanable funds market terms, the supply of loans increases in response to an increase in voluntary savings and contracts in response to a decrease-thus achieving the Wicksellian Natural Rate of Interest, the displacement from which is at the core of the Austrian Business Cycle Theory. In other words, competitive forces automatically achieve two results which different economic schools of thought consider necessary to avoid or ameliorate business cycles, without the need for government intervention at all; One which Monetarists and certain Keynesians would be keen on is automatic “rule” that amounts, essentially, to NGDP targeting, Austrians should like that it should maintain the interest rates that would clear credit markets on the basis of voluntary savings-and thus prevent systematic malinvestment of capital. Essentially the only recessions we’d have to worry about any more would be “real shocks” of the sort a modern, large economy is not particularly susceptible to-but which, at any rate, no government policy could ever avoid, for the same reason even a completely free economy could not avoid them: they’re just bad luck. The theoretical basis for these arguments can, if anyone is interested, be found here.

Also, the question could be raised, since I mentioned it above, what the “optimum” monetary base regime is. Monetarists would tend to favor, generalizing here, anything from a Monetary base growth rate that would maintain 0% consumer price inflation, to a small positive rate of consumer price inflation. I tend to lean away from this view as excessively inflationary, but I demur on how much productivity and growth based deflation is optimal. I will simply observe that if population is stable, Selgin’s productivity norm converges to the frozen base proposal. To the extent that we may expect our population levels to stabilize in the future, we can treat the productivity norm as a transitionary regime towards eventually freezing the base.

EDIT: Some of the above requires some alteration from a more detailed examination of the “math” behind the logic linking freedom in banking to a “stable” nominal income. I was a bit mislead by almost interchangeable use of “stability” and “constancy” of MV when the monetary base is frozen. Strictly speaking the growth rate of MV is only zero under certain other assumptions, or families of sets of assumptions, about interest rates versus penalties for reserve shortages, the number of banks, and the ratio of number of clearing transactions of a certain “real” value to the number of equivalent transactions of a particular “real” value in the economy. That being said, it would be relatively trivial to write a computer program to manage the size of the monetary base to maintain an approximately fixed nominal income. Which means you could close the Fed and the FOMC.

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