The Theory ofFree Banking Co-published with the Cato Institute THE THEORY OF FREE BANKING Money Supply under Competitive Note Issue George A. Selgin CA10INSTITUTE Rowman & Littlefield PUBLISHERS ROWMAN & LITTLEFIELD PUBLISHERS, INC. Published in the United States of America by Rowman & Littlefield Publishers, Inc. 4720 Boston Way, Lanham, MD 20706 Copyright © 1988 by Rowman & Littlefield Publishers, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior permission of the publisher. Co-published by arrangement with the Cato Institute Library of Congress Cataloging-in-Publication Data Selgin, George A., 1957- The theory of free banking: money supply under competitive note issue / George A. Selgin. Revision of the author's thesis (doctoral-New York University). Bibliography: p. 201 Includes index. ISBN 0-8476-7578-5 (cloth, alk. paper) ISBN 0-8476-7730-3 (pbk., alk. paper) 1. Banks and banking. 2. Money supply. 3. Monetary policy. 4. Banks and banking, Central. I. Title. II. Title: Free banking: Money supply under competitive note issue. I. Title. II. Series. HG1586.S38 1987 332.4-dcl9 87-20Q12 Printed in the United States of America TM The paper used in this publication meets the minimum requirements of §00 American National Standard for Information Sciences-Permanence of Paper for Printed Library Materials, ANSI Z39,48-1984. To My Parents Contents Preface ix Foreword by Lawrence H. White xi PART ONE: SETTING THE STAGE 1 Overview 3 Purpose and Plan of This Study 4 The Historical Background 5 The U.S. Experience 12 2 The Evolution of a Free Banking System 16 Commodity Money 17 The Development of Banks 19 Assignability and Negotiability 20 Benefits of Fiduciary Substitution 21 Regular Note-Exchange 23 Clearinghouses 26 The Mature Free Banking Industry 29 Long-Run Equilibrium 33 PART TWO: FREE BANKING AND MONETARY EQUIUBRIUM 3 Credit Expansion with Constant Money Demand 37 The Rule of Excess Reserves 37 The Principle of Adverse Clearings 40 Note-Brand Discrimination 42 Monopolized Note Issue 47 Illustration: The Post-1910 Australian Inflation 50 4 Monetary Equilibrium 52 The Demand for Money 52 .. The Market for Inside Money and the Market for Loanable Funds 54 Opinions of Other Writers 56 Transfer Credit. Created Credit. and Forced Savings 60 5 Changes in the Demand for Inside Money 64 Increased Money Demand 64 Decreased Money Demand 68 vii Vlll D Contents 6 Economic Reserve Requirements 70 The Conservation Theory 70 Determinants of Reserve Demand 72 Uniform Changes in Money Demand 73 Variability of the Reserve Multiplier 78 Credit Expansion "in Concert" 80 Banks as Pure Intermediaries 82 PART THREE: FREE BANKING VERSUS CENTRAL BANKING 7 The Dilemma of Central Banking 89 The Knowledge Problem 89 The Problem of Money Supply 94 Defects of Monetary Guidelines 96 8 The Supply of Currency 108 The Relative Demand for Currency 109 Currency Supply under Free Banking 111 Monopolized Currency Supply 113 Instruments for Reserve Compensation 115 Historical Illustrations 119 Appendix: Reserve-Compensation Formulae 124 9 Stability and Efficiency 126 Debtor-Creditor Injustice 126 Commodity-Money Supply Shocks 129 Bank Runs and Panics 133 The Efficiency of Free Banking 139 10 Miscellaneous Criticisms of Free Banking 144 Criticisms from Conventional Wisdom 144 Fraud and Counterfeiting 147 Restriction of Economic Growth and Full Employment 149 Money Supply as Natural Monopoly 150 Public Good and Externality Arguments 154 Alleged Need for a "Lender of Last Resort" 158 Expedience 162 11 Free Banking and Monetary Reform 164 Rules, Authority, or Freedom? 164 A Practical Proposal for Reform 168 Conclusion 173 Notes 177 Bibliography 201 Index 213 Preface OST ECONOMISTS BELIEVE that "money will not manage itself." In M this book I challenge that belief. In doing so I also try to add a few reinforcing-rods to the so-called micro foundations of monetary theory. Like most contemporary investigators of free banking, I became interested in the subject after reading F. A. Hayek's Denationalisation of Money (1978). The argument of that monograph, that competition in the issue of money would result in greater monetary stability and order than central banks can achieve, contradicted both traditional interpretations of history (including especially American history) and conventional theory. Challenged by Hayek, I decided to review the development of money and banking institutions in the United States. I became convinced that unwise regulations, rather than the absence of a central bank, could explain most of the shortcomings-past and present-of our monetary system. In the course of investigating this issue I was exposed to some manuscript chapters of Lawrence White's Free Banking in Britain (1984d). One chapter described the successful performance of an unregulated banking system in 19th-century Scotland; this was further evidence against the view that past unregu­ lated systems had failed. Another chapter presented an abbreviated theory of free banking, explaining how competition could result in a smoothly operating system of money supply. White's study caused my interest in free banking to blossom. It also suggested the need for a more comprehensive, theoretical work~ne that would evaluate free banking both as a system that might have been permitted in the past and as one that might be adopted in the future. I was eventually able to undertake this project as my doctoral dissertation for the Depart­ ment of Economics at New York University. This book is a substan­ tially revised version of that dissertation. ix x 0 Preface I am grateful to Professor White, not only for having inspired the present study, but also for helping to see it through to completion as chairman of my dissertation committee. I also owe a great intellectual debt to Kurt Schuler, whose research on free banking has uncovered many useful facts, which he has generously shared with me, and whose enthusiasm for the subject has been a constant source of encouragement. Finally, for their scholarly input I would like to thank Richard H. Timberlake, Jr., of the University of Georgia; Richard Ebeling, of the University of Dallas; and the members of my disserta­ tion committee: Jesse Benhabib, Clive Bull, and Jonas Prager, all of New York University, and Anna J. Schwartz, of the National Bureau of Economic Research. I have received financial support from several sources, including the Austrian Economics Program at New York University, which provided fellowship support for all of my three and one-half years at N. Y. U. I would like to thank in particular Israel M. Kirzner for his role in securing my participation in the program. The Mises Institute of Auburn University provided me a summer fellowship in 1984, and lowe thanks for this to its Director, Llewellyn Rockwell, Jr. Finally, The Institute for Humane Studies at George Mason University has assisted me by various means, including a Summer Non-Resident Fellowship Award offered to me in 1981, and an in-residence fellow­ ship for the summer of 1985. Most of the present work was composed during the latter summer and also in the spring of 1985, when I was an employee of the Institute, and I am grateful to the staff of the Institute, and to Walter Grinder especially, for turning what might have been a painful task of composition into a pleasant undertaking. In addition to intellectual and financial assistance I have received other help of various sorts from a number of people and institutions. I wish to thank in particular: Karen Cash and Colleen Morreta of the Center for the Study of Market Processes at George Mason Univer­ sity, and Mary Blackwell and Jean Berry of the George.Mason Word Processing Center, for assistance in completion of the final draft of this study; Paula Jescavage, of the Interlibrary Loan Office at Bobst Memorial Library at N.Y.U., for supplying me with hundreds of obscure articles and books; and my brother, Peter Selgin, for his thoughtful editorial advice. Finally, for their companionship and moral support, which sus­ tained me through four difficult years of graduate work, I wish to thank my parents, Paul and Pinuccia Selgin, and my friends Mark Brady, Roy Childs, Charles Fowler, Andrea and Howie Rich, Chris Rowland, and Barbra Schwartz. Foreword HIS BOOK is an important work in monetary theory. As such it T brings to mind a statement by the learned John Hicks in an essay that I always assign to my graduate students in Monetary Theory: "Monetary theory is less abstract than most economic theory; it cannot avoid a relation to reality, which in other economic theory is sometimes missing. It belongs to monetary history, in a way that economic theory does not always belong to economic history." This is so, Hicks continues, for two reasons. First, the best work in monetary theory is often topical, aimed at understanding a monetary problem of the times. Second, monetary institutions are continually evolving, and with them the appropriate theoretical apparatus. * The present work bears out Hicks's generalization both by being topical and by being attuned to institutional evolution. It is topical because the outstanding monetary problem of our time is the failure of central banking to deliver the macroeconomic stability its adher­ ents have promised. The Federal Reserve System, in particular, has not carried its own weight. This book offers a promising alternative. It is attuned to the evolutionary institutional developments not only of the recent past-the increasing competitiveness and partial dereg­ ulation of banking and financial markets-but also of the foreseeable future. A system of free banking of the sort analyzed here is plausibly the logical culmination of movements in the direction of monetary laissez-faire.