Central Banking, Free Banking, and Financial Crises
Roger W. Garrison
 A growing literature
explores the concept of free banking on both a theoretical and an historical
basis. George Selgin [1988] sets out the theory of free banking and makes
a compelling case that, despite the uniqueness of money, the forces of
supply and demand are more conducive to monetary stability, correctly understood,
than are the edicts of a central bank. Larry White [1984], focusing on
the free-banking episode in nineteenth-century Scotland, and Kevin Dowd
[1994], collecting studies of experience with free banking in many countries
and time periods, have shown that this alternative to central banking has
a respectable history.
The aim of this paper is
to get a fix on the possible and currently relevant sources of macroeconomic
instabilities in the economy and to identify the most promising banking
arrangements for dealing with those instabilities. Possible maladies and
remedies can be considered in the context of competing schools of macroeconomic
and monetary thought. Attention is directed to the issue of whether the
perceived problem and/or its solution is inherent in the market economy
or lies outside the market process. This formulation immediately gives
rise to a two-by-two matrix with maladies and remedies represented in one
dimension, market forces and extramarket forces represented in the other.
The fruitfulness of this approach is demonstrated by its ability to sort
out competing schools of thought, put current debate in perspective, and
assess the prospects for a stable macroeconomy�with the Federal Reserve
as currently constituted and with the alternative institution of free banking.
This exercise in comparative-institutions
analysis does not deal with the dynamics of the macroeconomy in transition
between one set of monetary institutions and another or with the political
issues of just how such a transition might be brought about. Nor does it
deal directly with the ultimate nature of the monetary standard. There
is a strong presumption, however, that only a central bank can preempt
a commodity standard with its own fiat money and that banknotes issued
by competing banks in a free-banking system would have to be redeemable
in some real commodity, such as gold, to make them acceptable in a market
where banknote holders can easily express their preferences among issuers.
There is broad agreement among Austrian-oriented writers that a banking
system characterized by (1) central direction and (2) fractional reserve
is not conducive to economic stability. However, there is some disagreement
among the Austrians as to which of the two mentioned characteristics is
fundamentally responsible for the instability. The argument is this paper
follows Ludwig von Mises, as portrayed by White [1992], and takes the centralization
of the current banking system to be the most fundamental issue and the
most appropriate focus for prescribing reform.
The Equation of Exchange
Underlying all theories of money and banking�as well as all prescriptions
of policy and recommendations for reform�is the familiar equation of exchange:
MV
= PQ. For the economy as a whole, buying must equal selling, where
buying is represented by the total supply M of money times the frequency
(the circulation velocity V) with which each monetary unit on average
is spent and where selling is represented by the average price P
of goods times the total quantity Q of goods sold. Although true
by construction, the equation of exchange helps us to keep in view the
interdependencies that characterize the macroeconomy. It is impossible,
for instance, to conceive of a change in only one of the four magnitudes
represented in the equation to change. Any one change implies some offsetting
change or changes on one side or the other of the equation�or possibly
on both sides. For instance, an decrease in money's circulation velocity,
which simply reflects an increase in the demand for money, must be accompanied
by (1) an increase in the money supply, (2) a decrease in prices, or (3)
a decrease in real output sold, or by some combination thereof.
The equation also facilitates
the comparison of competing schools of thought. Considering in sequence
Keynesianism and Early and Late Monetarism can provide a basis for setting
out the distinctive perspective that emerges from the theory of free banking.(1)
The case against central banking and in favor of free banking, then, is
preceded by some history of thought�possibly more than some may think justified.
The comparison of schools of thought is included for two reasons. First,
some writers have recently gotten it wrong, presenting monetarist ideas
under the Keynesian label. Second, the case for free banking contains arguments
that are sufficiently close to Keynes's own that they need to be distinguished
explicitly from his.
Keynes believed that the
economy is chronically unstable because of instabilities associated with
both Q and V. Goods, in the Keynesian construction, are decomposed
into consumption goods C and investment goods I, the latter
being inherently unstable in view of the pervasive uncertainty faced by
the business community�the "dark forces of time and ignorance that envelop
our future" [Keynes, 1936, p. 155]. The strength of the investment sector,
according to Keynes, is highly dependent on psychological factors�"animal
spirits" [pp. 161-62] that motivate each (and, through contagion, all)
of the economy's investors. The occasional waxing and waning of the animal
spirits affect I �and affect C as decisions in the business
community govern incomes and hence spending. Both directly and derivatively,
then, the uncertainty of the future translates into fluctuations in the
economy's output magnitude Q.
The equation of exchange
reminds us that changes in Q cannot be the whole story. If prices
and wages are sticky and the money supply is wholly determined by the monetary
authority, the rest of the story must center on money's circulation velocity
V.
What Keynes called the "fetish of liquidity" is, in this view, nothing
but another perspective on the waning of "animal spirits." Would-be investors
abstain from committing themselves to investment projects, whose profitability
is uncertain, and instead hold their wealth liquid.
The economy, according to
Keynes, is prone to periodic collapse. Pervasive uncertainty inherent in
investment activity and prospects of economic disaster occasionally overwhelm
the business community. Entrepreneurs cease their individual attempts to
outguess one another and begin collectively to guess against the economy.
In droves, they forego real assets in favor of liquidity. Q falls,
and along with it, V. Liquidity, or money (Keynes used the terms
synonymously), constitutes something of a "time out" for the entrepreneur/speculator�somewhat
analogous to rest areas along an interstate highway. Fog on the highway
or the wearing effects of traffic congestion can make the rest areas increasingly
attractive.
The origin and essence of
the problem, in the Keynesian view, is to be found on the righthand side
of the equation of exchange (a decreased Q). Keynes works on both
sides of the equation, however, in devising possible solutions to the problem.
For instance, much of Keynes's discussion of monetary reform, which included
support in principle for Silvio Gesell's stamped money as well as for taxing
transactions in securities markets, was aimed at making the time-out option�the
option of getting or staying liquid�more costly. Keynes favored all attempts
to deprive money of its liquidity value only to lament that investors would
find other assets (e.g. gems and precious metals) that provided refuge
from the uncertain future [Keynes, 1936, pp. 353-58].
Reforms in this direction
are analogous to installing toll gates at the rest areas�or possibly eliminating
rest areas altogether. Travelers would make better time between New Orleans
and Atlanta if there were no possibility of stopping along the way. Keynes
did not consider that some would-be travelers might not depart New Orleans
in the direction of Atlanta under such conditions; he did lament that closing
or charging for rest areas might cause travelers to find other places to
stop along the highway.
In lieu of prevention in
the form of making liquidity less attractive or more costly, Keynes recommended
monetary policy to accommodate the demand for liquidity�satiating that
demand if necessary to keep money from competing with real investments
in the collective mind of the business community. To the extent that money-demand
entails a large psychological element, the rest-area analogy holds. A road
sign that reads "LAST REST AREA FOR NEXT 100 MILES" may attract many customers,
whereas the travelers may stop very infrequently if there were rest areas
all along the way.
While increasing the supply
of money to neutralize the effects of a fetishistic demand for liquidity
may be a necessary component of policy prescription, it will not be sufficient,
according to Keynes, to restore conditions of prosperity. This is only
to say that a decreased V is a symptom rather than the essence of
the problem. The solution must involve the substitution of government spending
for private investment spending�accommodated, of course, by money creation.
Fiscal stimulation prods the reluctant travelers along the economic highway.
Keynes viewed fiscal policy as primary; monetary policy as secondary.
In the Keynesian view, then,
the malady is inherent in the market; the remedy entails extramarket forces.
It is in the very nature of things that our weary travelers will, on occasion,
follow one another into the increasingly overcrowded rest areas, where
each traveler is reluctant to resume the journey alone. Restoring and maintaining
stability requires intervening forces in a double-barreled way; the interveners
must work simultaneously on both sides of the equation of exchange. Monetary
reform and fiscal stimulation are intended to keep the travelers out of
the rest areas and to keep them moving along smartly. Central banking is
essential for the task. But ultimately, Keynes [1936, p. 378] called for
a wholesale replacement of our current system with a system of public transportation:
A comprehensive socialization of investment is offered as the only solution
to the problem of unemployment.
Early monetarism, as exposited
by Clark Warburton [1966] in the 1940s and 1950s and as revived in recent
years by Leland Yeager [1986], has a kinship to the equation-of-exchange
perspective on the Keynesian view. Both schools perceive a possible malady
and remedy that fit into the two-by-two matrix in the same way: Market
malady; extramarket remedy. They differ radically, however, in terms of
the specific nature of the problem and the implied judgment about the efficacy
of the market economy. Market participants may opt for more money in preference
to more real output�where the relevant alternatives to holding money are
both investment goods and consumption goods. The demand for money is not
fetishistic, and changes in it are not necessarily contagious, but money
demand can and does change. The velocity of money is not constant in the
same way that Planck's constant and Avogadro's number are.(2)
With a given money supply,
increases in the demand for money put downward pressure on prices.(3)
Except in the fanciful case in which prices adjust fully and instantaneously
to this monetary disturbance, the adjustment process involves quantities
as well as prices. Our highway travelers are trying to stop and rest even
in the absence of adequate rest areas. The unintended consequence is a
general slowdown of traffic. A decreased V impinges on Q
as well as on P�even if the ultimate, or long-run consequence is
a proportionate decrease in P. In principle, a monetary policy that
succeeds in relieving downward pressure on prices by meeting every increased
demand for money with an increased supply will result in greater stability
for the economy as a whole. A constant P becomes, in this view,
the essence of monetary stability. The problem (decreased V) and
solution (increase M) are set out in precisely this way by Paul
Krugman [1993, p. 26-28 and passim]�but with this view offered as
Keynes's understanding of the nature of business cycles! Early Monetarism
is wrongly attributed to Keynes.(4)
Early and Late Monetarists
share an analytical framework as well as a basic judgment about the central
bank's capacity to do good and to do harm. It was Milton Friedman, of course,
who shifted the focus of attention away from problems of monetary disequilibrium
to the general relationship between M and P that endures
over space and time. Empirical studies using data from many different economies
and many different time periods lent support to the proposition that changes
in the lefthand side of the equation of exchange are overwhelmingly attributable
to changes in the quantity of money. Study after study demonstrating the
stability of money demand (a near-constant V) had the effect of
focusing attention on the money supply M as a basis for accounting
for both inflation and deflation. Changes in the money supply are much
more likely to be a problem than to be a solution to a problem. Empirical
and theoretical considerations, as well as considerations from political
economy, underlay this summary judgment. Under typical conditions, in which
money demand remains relatively constant, there is a "long and variable
lag" that separates changes in the money supply and the subsequent changes
in the price level. This empirical fact, coupled with the lack of any timely
and unambiguous indicator of actual changes in the demand for money, weighs
against the prospects for even well-intentioned money-supply management
having a stabilizing effect on the macroeconomy. Dimming the prospects
still further, of course, is the fact that the central bank may intend
to do more than act as a stabilizing agent and that some of its intentions,
such as dealing narrowly in alternating episodes with the problems of inflation
and unemployment and with problems associated with the strength or weakness
of the dollar in international markets, are antithetical to the idea of
a central bank as macroeconomic stabilizer.
We can locate Monetarism
in our two-by-two matrix by noting that both malady and remedy are in the
extramarket category. In fact, Monetarism consists, by and large, of (1)
the recognition that the central bank is a destabilizing force and (2)
the recommendation that it not be a destabilizing force. Adherence
to a monetary rule according to which the money supply is increased at
a slow, steady, and preannounced rate is likely to engender more macroeconomic
stability than central bank activism can achieve�no matter how well-intentioned
and expertly conceived. Actual experience both before and after the heyday
of Monetarism suggests that the same understanding that gives rise to Monetarists'
view of the central bank also accounts for the central bank's inability
and unwillingness actually to adopt and abide by a monetary rule. The so-called
Monetarist experiment begun in October of 1979 under the chairmanship of
Paul Volcker, for instance, was Monetarist only in a limited and perverse
sense. The Federal Reserve did shift its attention from interest rates
to monetary aggregates, a move that would be preliminary to actually adopting
a rule for monetary growth. But its policies following this shift made
for even greater variation in the money supply (and in the rate of interest)
creating significantly greater macroeconomic instability than had been
experienced before. Ultimately, a monetary rule, however widely and forcefully
recommended, is at odds with the even more widely perceived view that the
Federal Reserve Chairman is the second most powerful individual in the
country.
Free Banking
The basic case for free banking is the general case for decentralization
of economic activity. The uniqueness of money does not immunize it against
the forces of supply and demand and does not make the invisible hand of
the marketplace any less beneficial to society. Quite to the contrary,
our rest-area analogy suggests that market forces have special advantages
in adjusting money supply to money demand. While the market cannot respond
on a daily basis, supplying rest areas anywhere along the highway that
they happen to be demanded by today's travelers, free banking can and automatically
would supply liquidity along the economic highway anytime and anywhere
it is demanded. The case for decentralization is strengthened by comparing
free-banking dynamics to central-bank policies that we have actually experienced
and even to the policies of an idealized non-politicized central bank whose
sole objective is that of maintaining macroeconomic stability. A comparison
favoring free banking follows from two propositions. First, the failure
in fact of the central bank to adopt a monetary rule (and the unlikelihood
of its adopting such a rule in the future) weigh in favor of decentralization.
What the Federal Reserve lacks the will and ability to do can be done automatically
by the impersonal forces of supply and demand governing banknote issue.
Second, the difference between the implicit rule that the decentralized
banking system follows and the simple monetary rule of slow and steady
growth of the money supply gives free banking higher marks as a stabilizing
force in the economy. In the final analysis, the simplicity of the monetary
rule derives from the judgment that discretionary moves are more likely
to destabilize than to stabilize. The monetary rule is imposed, then, in
the spirit of the unspoken maxim of yesteryear's medical profession: "Maintain
good bedside manners, and strive to do no harm."
Free banking automatically
discriminates between real disturbances and monetary disturbances, reacting
only to the latter [Selgin, 1988, pp. 64-69]. The "automaticity" implies
both a timeliness and an absence of political pressure�features that are
forever denied to central banking. Under steady-state conditions in which
the economy is experiencing no growth and no changes in the demand for
money, the simple monetary rule and the implicit free-banking rule are
the same: zero growth in the money supply. The consequences are also the
same: a constant price level. Under more typical conditions of some positive
rate of real economic growth and some variability in the demand for money,
the two rules differ. The simple monetary rule is based on a long-range
estimate of secular growth and of secular movement in money demand. An
estimated growth rate of three percent and an estimated upward trend in
money demand (downward trend in velocity) of two percent translate into
a money growth rate of five percent. Strict compliance with the rule would
mean that movements in the price level would exhibit no long-run trend.
Actual deviations from trend in either output or in velocity, however,
would result in upward or downward pressure on the general level of prices.
Accordingly, the rule itself might be adjusted to allow for the differential
harmfulness of inflation and deflation. Ingrained notions that prices and
wages are stickier downwards than upwards and that unemployment bites harder
into economic prosperity than does inflation may justify�narrow political
motives aside�a rule of increasing the money supply at some rate slightly
in excess of five percent. A mild inflation might be considered cheap insurance
against any actual deflation.(5)
The implicit rule automatically
implemented by free banking is the old central-bank maxim (usually observed
in the breach): "Print money to hold but not money to spend." If the holders
of banknotes issued by a particular bank are willing to hold still more,
it is in the interests of the bank to increase its issue. The fact that
the bank's customers are holding rather than spending implies the absence
of inflationary pressures. In this context, the bank need not even consider
whether the increased demand for its own notes is a general increase in
the demand for money or a increase in the demand for its banknotes relatively
to the demand for other banknotes. However, if an individual bank increases
its issue even in the absence of any increase in demand to hold its banknotes,
then the extra spending of them will soon impinge on the bank's reserves.
The sustainable level of note issue is demand-determined. In a decentralized
and competitive environment, each individual bank can be expected to forego
the short-term gains that overissuing its own banknotes might entail in
order to avoid the long-term losses that the market process would inevitably
impose.
In contrast to the simple
monetary rule, which is devised to accommodate real economic growth by
checking deflationary pressures whatever their source, the implicit free-banking
rule involves no change in the money supply in response to a change in
real output. This difference in the two rules reflects the automatic discrimination,
inherent in free banking, between real and monetary disturbances. An increase
in the demand for money puts downward pressure on product and factor prices
in general. If there were no money-supply response, a general decline in
economic activity would follow, since prices and wages could not fully
and instantaneously adjust themselves to the new market conditions. Goods
in general would go unsold; production would be cut; workers would be laid
off. Such quantity effects can be self aggravating, as the Early Monetarists
emphasized. With a less-than-perfectly flexible price system, general deflationary
pressures can push the economy below its potential during the period in
which prices are adjusting to the higher monetary demand. And the fact
that some prices and some wages are more flexible than others mean that
the adjustment period will involve changes in relative prices that reflect
no changes in relative scarcities. These are precisely the kinds of problems
that are highlighted by modern monetary-disequilibrium theorists, e.g.
Yeager [1986], and that are avoided by free banking's responsiveness to
increases in money demand.
Suppose, however, that with
an unchanging demand for money, the economy experiences economic growth.
Despite the implications of the familiar neoclassical growth models, the
economy's output does not undergo a general change; there is no disembodied
growth that might be explained in terms of an economywide technology shock.
Rather, the outputs of various goods increase as a result of an increased
availability of particular resources used in producing them or the discovery
of a new technique that converts particular inputs into a particular output
more efficiently. Downward pressure on the prices of the particular goods
that account for the economy's growth will be felt primarily in the markets
for those very goods. Relative prices adjust to reflect the fact that these
goods are now more abundant. The market process at work here is the one
that gets emphasis in the sophomore-level economics of supply and demand.
Perversities that dominate in the context of an increase in money demand
get little or no play in the context of economic growth. The increased
Q,
which simply reflects a positive net change in the sum of all the economy's
individual qs, is accompanied by a decrease in the corresponding
ps. It would be misleading here to evoke the fears of "deflationary
pressures." The individual ps become adjusted to their corresponding
qs on a market-by-market basis. The fact that this new constellation
of ps average to a lower P than before has no special claim
on our attention. There is no downward pressure on
P over and above
the forces of supply and demand that operate separately in the affected
markets and reflect the underlying economic realities. There are no perversities
inherent in this sort of a relative (and absolute) adjustment.
In terms of the equation
of exchange, we can say that free banking adjusts M so as to offset
changes in V; but allows changes in Q to be accommodated
by changes in P. Economic growth does involve price deflation in
a literal sense (the price level falls as output increases) but does not
involve any macroeconomic malady that is commonly associated with the term
"deflationary pressures." In effect, by distinguishing between malignant
and benign deflation, free banking provides a much stronger check against
inflation than that provided by the simple monetary rule.(6)
It would be misleading to classify free banking in terms of malady and
remedy because the malady never gets a chance to show itself. Significantly,
though, there are no extramarket forces at work here either creating problems
or fixing them.
Central Banking and the Debt Bomb
The case for a decentralized banking system, which by and large parallels
the case for markets and against central planning agents, is a strong one.
The central bank cannot outdo free banking or even match its performance
as a macroeconomic stabilizer. It lacks the ability to distinguish on a
timely basis between movements in V and movements in Q, it
lacks the incentives to act in ways that would promote stability, and as
a key player in a political environment, it actually responds to incentives
in ways that foster instability. None of these characteristics, however,
is at odds with our understanding of the origins of the Federal Reserve
System�especially as exposited by Rothbard [1994], whose story does not
place great emphasis on the lofty goal of macroeconomic stabilization.
It is commonly understood,
now, that the Federal Reserve accommodates the Treasury by monetizing the
government's debt. That is, it injects credit markets with new money so
as to relieve the upward pressure on interest rates that Treasury borrowing
would otherwise entail. And with telling exceptions, the Federal Reserve
maintains an easy-money policy in the year-and-a-half before each presidential
election.(7) The so-called political business
cycles have now become a integral part of the macroeconomic landscape.
Further, the Federal Reserve is called upon to deal with other real or
perceived problems having little to do with macroeconomic stability. It
is expected, for instance, to lower interest rates when the housing market
is in a slump and to strengthen or weaken the dollar in response to movements
in exchange rates or trade flows. All these attempts to manipulate employment
rates, interest rates, and exchange rates interfere with the Federal Reserve's
ability to achieve and maintain macroeconomic stability or even to refrain
from inducing instability. If the simple monetary rule fairs poorly in
comparison with the implicit rule of free banking, it fairs well in comparison
with the actual policies of the Federal Reserve.
These political factors
are well recognized by modern Fedwatchers. Less well recognized are the
cumulative effects of decades of deficit accommodation and macroeconomic
manipulation. With federal indebtedness now measured in the trillions of
dollars and increasing annually by hundreds of billions, the need for a
stabilizing monetary system is all the more important. The debt bomb is
not ignored by Wall Street. An explosive ending to this era of fiscal irresponsibility
may or may not be in the making, but the bomb's incessant ticking has its
own effect on the stability of securities markets.(8)
A consideration of the actions of the Federal Reserve in recent years aimed
at dealing with so-called mini-crashes in the financial sector provide
a further basis for assessing the prospects of centrally produced macroeconomic
stability. From the narrow perspective of the financial sector the issues
of malady and remedy look deceivingly like those identified by Keynes:
market maladies and extramarket remedies. An activist central bank is seemingly
justified by its indispensable role in taming an otherwise wild financial
sector. But a fuller understanding of the situation suggests that it is
an unbridled Treasury rather than unbridled capitalism that lies at the
root of the economy's current problems. And it is the Federal Reservevits
very existence�that removed the bridle. On this understanding, the malady
and remedy are both in the extramarket category, but the diagnosis and
prescription are not as simple as the Monetarists would have us believe.
Increasingly, the significance
of the Federal Reserve in the context of the macroeconomy derives from
its ability to monetize government debt. This is not to say that the actual
rate of debt monetization dominates the Federal Reserve's current agenda
but rather that the very potential for debt monetization is taking on increasing
significance. How has the federal government been able to get away with
such a chronically and conspicuously large budgetary imbalancevand with
no sign of meaningful fiscal reform�without subjecting itself to the substantial
penalty imposed automatically by credit markets? Why is there no default-risk
premium on Treasury bills? Excessive debt accumulated by individuals, corporations,
or even municipalities are eventually dealt with when the borrowers lose
their creditworthiness and face prohibitive rates of interest. This salutary
aspect of the market process is short-circuited in the case of Treasury
debt by the very existence of a central bank. The Federal Reserve in its
standby capacity as a buyer of government debt keeps the default-risk premium
off Treasury bills. The potential for debt monetization allows federal
indebtedness to rise unchecked to levels that would have been thought fanciful
only a few administrations back and to remain high and rising into the
foreseeable future.
The potential for
debt monetization, critical for maintaining an uneasy balance between economic
and political reality, gives rise to speculation about the timing and extent
of actual debt monetization. At issue here are prospective movements,
possibly dramatic ones, in the inflation rate, interest rates, and exchange
rates, which in turn can have dramatic effects in securities markets. The
attractiveness of securities can be differentially affected by the inflation
that would result from actual debt monetization or by the movements in
exchange rates that reflect the Treasury's greater or lesser reliance on
foreign credit markets or by movements in interest rates brought about
by changes in the Treasury's domestic borrowing. At some point, uncertainties
about the timing and extent of debt monetization may dominate securities
markets. In this case, the dense fog that drives our travelers off the
economic highway and into the rest areas is not inherent in the market
economy at all but rather is emitted by the Fed-backed Treasury.
It has become conventional
wisdom in recent years that there is some link (though a poorly defined
one) between chronically high budgetary deficits and instability of securities
markets [Feldstein, 1991, p. 8 and passim]. (9)
And it is taken for granted that it is the Federal Reserve's responsibility
to deal with that instability, providing on a timely basis whatever liquidity
is demanded so as to keep the occasional sharp declines of security prices,
the mini-crashes, from affecting the performance of the macroeconomy. The
implicit objective, here, seems to be that of building a firewall between
the financial sector and the real economy, allowing both to lead their
separate lives. Ironically, it is largely the existence of the Federal
Reservevits potential for debt monetizationvthat enables the Treasury to
borrow almost limitlessly thus creating the very instability that is to
be kept in check by that same Federal Reserve.
Short-term success of the
Federal Reserve in maintaining the firewall between the financial and real
economy depends critically on the wisdom and credibility of the Federal
Reserve Chairman. Prospects for longer-term success is problematic despitevor
possibly because ofva sequence of short-term successes. Considerations
of the nature of the Federal Reserve's role in the context of possibly
volatile swings in the demand for liquidity suggest that continued central
management of the economy's money supply does not offer the best hope for
macroeconomic stability.
Suppose that the Treasury
or the White House urge that the Federal Reserve become more accommodating
and that the Federal Reserve Chairman expresses reluctance. Will the urgings
get more intense? Will the reluctance fade? Speculation about the ultimate
outcome will likely show up on Wall Street as an increased trading volume
and an increased volatility of security prices. Traders who have little
confidence in their own guesses about a possible change in the Federal
Reserve's policy stance are likely to get out of the market. Securities
prices weaken as these traders begin to liquidate, causing others to follow
suit. Now, even those traders who do have guesses about the Federal Reserve
begin guessing instead about the market's reaction to the uncertainty.
The scramble to get out of the market manifests itself as a liquidity crisis.
Abstracting from the fact that this instability has its origins in extramarket
forces, we notice that the nature of this destabilizing speculation is
exactly as described by Keynes [1936, 153-58].
In dealing with the liquidity
crisis, the Federal Reserve is immediately pitted against itself. It must
expand the money supply to accommodate the increased demands for liquidityvand
by the right amount in a timely fashionvwhile maintaining its credibility
that it will not expand the money supply in response to the urgings from
the White House. Fedwatchers are going to need some tea leaves here to
determine just exactly what the Federal Reserve is and is not doing. Once
again, the equation of exchange provides a sound basis for sorting it all
out. M is being increased to offset a downward movement in V.
If the increase in M is too little, the net downward movement in
MV
will result in the dreaded deflationary pressures which will impinge only
partly on P and hence partly on Q. The Federal Reserve's
firewall is too weak; the liquidity crisis spills over into the real economy.
If the increase in M is too great, then, willy-nilly, the Federal
Reserve is succumbing to the urgings of the executive branch to further
accommodate the Treasury's borrowing. The extent of the accommodation,
as measured by the net upward movement in MV, will in time show
up as inflation, which was one of the prospective eventualities that underlay
the speculation and the liquidity crisis.
As complicated and convoluted
as this reckoning is, it constitutes only half of the story. Removal of
the liquidity from the financial market in a timely manner is as important
as its timely injection. The failure of the Federal Reserve to move against
an increasing V that characterizes the end of the liquidity crisis
accommodates the Treasury and puts upward pressure on prices. Possibly
more critical are the repercussions of the excess liquidity in international
money markets. Overaccommodation can weaken the dollar. If this weakness
is perceived as the beginning of a trend, the result may be heavy selling
of dollars and dollar-denominated assets. Thus, a botched attempt to deal
with a liquidity crisis can provoke a currency crisis. The Federal reserve
must somehow defend the real economy against this double-edged sword.(10)
The Federal Reserve may
be allowed some scope for error. The same difficulties that it faces in
knowing just what to do and just when to do it provide a shroud of uncertainty,
even after the fact, about just what it didvand all the more so about what
it intended to do. But several considerations combine to suggest that,
in the long run, the Federal Reserve is playing against high odds.
First, right or wrong, the
financial markets will make their moves ahead of the Federal Reserve. Changes
in the demand for liquidity and in the strength of the dollar are determined
as much if not more by anticipations about what the Federal Reserve will
do rather than what it has just done. This consideration is what gives
great importance to the Chairman's credibility. And his credibility reflects
more than his personal integrity and his reputation for reasonableness
and consistency. It is affected as well by the economic constraints he
faces and political pressures he feels.
Second, each episode will
have characteristics of its own depending upon all the contemporaneous
political and economic factors. Goals of the Federal Reserve over and above
the particular goal of accommodating the Treasury serve as a background
against which expectations are formed. The Federal Reserve may be pursuing
a strategy of gradual monetary ease to promote more rapid economic growth
and then subsequently a strategy of gradual monetary tightening to stave
off inflationary pressures. It may be possible to maintain credibility
while increasing the monetary aggregates at an accelerated rate in the
first episode but not possible while reversing the direction of change
(relative to trend-line monetary growth) in the second episode.
Third, even if the Federal
Reserve generally wins its battles against liquidity crises, it will find
that winning streaks are difficult to maintain indefinitely. And perversely,
a sequence of wins can create a false sense of confidence on Wall Street
that the Federal Reserve is always willing and able to deal effectively
with liquidity crises. Such confidence might cause investors to maintain
a generally lower level of liquidity in their portfolios than if they had
serious doubts about the streak continuing. Lower liquidity levels generally
can mean more dramatic increases in the demand for liquidity during a crisis.
For the Federal Reserve, the winning streak gets increasingly more difficult
to maintain.
Temporarily and partially
offsetting all these reasons for pessimism about prospects for enduring
macroeconomic stability is the widespread belief that the particular individuals
that have served as Federal Reserve Chairman are "geniuses." Dating from
the summer of 1979 Paul Volcker and, after him, Alan Greenspan have risen
to the occasion whenever crisis threatened. It may indeed be difficult
to name two other individuals who could have done better. "Genius" might
involve overstatement; "seasoned," "savvy," and "nimble," may be more to
the point. But there is a greater point to be made here. Any governmental
institution whose success depends critically on the caliber of the individual
in charge cannot be considered a lasting source of stability for the economy.
Even geniuses can err. More importantly, in some episodes where expectations
turn pessimistic, the monetary ease needed to deal with a liquidity crisis
may be more than enough to trigger a currency crisis. Foreign and domestic
traders may leave no room for the Federal Reserve Chairman to exercise
his genius. And further, geniuses are not necessarily succeeded by geniuses.
Alan Greenspan's second four-year term expires in March of 1996. (An unsuspenseful
reappointment, of course, would the focus of speculation another four years
into the future.) How much confidence will Wall Street have in his successor?
How much confidence will it have in the Federal Reserve in the days or
weeks before a successor is named? Suppose that the Treasury is putting
pressure on the Federal Reserve for greater accommodationvpossibly because
our trading partners are reluctant to extend our government further credit
until they know who is replacing Greenspan. What would happen to the demand
for liquidity? And how would the lame-duck Federal Reserve Chairman respond
so as to maintain his own credibility as well as that of his successor-to-be-named-later?
Even mildly cynical or pessimistic answers to these questions may suggest
that this financial crisis may burn through the firewall. The real economy
would then become an innocent victim as the central bank attempts its extramarket
remedy to the extramarket malady in the form of a fiscally irresponsible
Treasury.
Free Banking as Both Prevention and Cure
The merits of free banking during periods of economic tranquility are
identified on the basis of the theory of competition as applied to the
banking industry and the experience provided by a key episode in nineteenth-century
Scotland and more recent episodes involving other countries with partially
free banking. Assessing the likely performance of free banking during twentieth-century
financial crises in the United States necessarily involves some speculative
reasoning. It is worth noting, however, that the most prominent nineteenth-century
defender of free banking argued his case partly on the basis of the ability
of competitive forces to "meet an incipient panic freely and generously"
[Bagehot, 1873, p. 104].
Whatever the problems and
limitations inherent in free banking or in market economies generally,
competition that characterizes a decentralized system wins out over the
policy edicts of a central bank largely because of the absence of key perversities
that are inherent in central control. The advantages of decentralization
are partly in the form of prevention, partly in the form of cure.
One of the major sources
of today's macroeconomic instability, the excessive federal debt and deficits,
would be largely absent under free banking. Without a central bank to keep
the default-risk premium off Treasury bills, the federal government, like
overextended firms and even fiscally irresponsible municipalities, would
have had to deal with its fiscal imbalance long ago. Free banking, which
is free not to monetize Treasury debt, could accomplish what debt-limitation
ceilings, the Gramm-Rudman deficit-reduction plan, or even a balanced-budget
amendment cannot accomplish. Without a chronically high and growing debt
and the attendant speculation about the changing particulars of deficit
accommodation, financial crises are less likely to occur.
If a financial crisis does
occur, the provision of supernormal amounts of liquidity is forthcoming
under free bankingvbut without the destabilizing speculation about the
particular movements in the money supply. Questions about the "will" or
"intent"vor "genius"vof the banking system as a whole simply do not arise.
The supply of liquidity automatically follows demand upward during the
financial crisis and downward as crisis conditions fade. It is true that
some banks will be more responsive than others at meeting the occasional
supernormal demands for liquidity. One of the beneficial aspects of competition
in any sector of the economy is that those firms who best satisfy ever-changing
demands prosper relative to their competition and are thus put in charge
of greater resources. With free banking, then, success breeds success.
A sequence of crises gives increased responsibility to those very banks
that are best at dealing with crises.
To this point the advantages
of free banking over central banking are set out in terms of the likelihood
of our needing a firewall between the financial and real sectors of the
economy and the ability of each banking institution actually to provide
that firewall. The firewall metaphor, however, presumes that no systematic
adjustments are needed in the real economy. But it is entirely possible
and even likely that whatever caused the crisis conditions to prevail in
the financial sector also caused non-financial resources to be misallocated.
Simultaneous financial and real crises, as might be brought about by the
ill-conceived policies of an administration bent on growing the economy,
could not be quelled by a firewall. Quite to the contrary, the reallocation
of resources in the economy would require a well-functioning market process,
which includes movements in resources that reflect movements in securities
prices. Here, the implicit monetary rule observed by free banking takes
on a special significance. Movements on the lefthand side of the equation
of exchange (an increasing V) are effectively countered; movements
on the righthand side (in the ps and hence in P) are not.
If the economy's real sector is out of balance, it needs help from the
financial sector to regain its balance. In such circumstances, "firewall"
is the wrong metaphor; "penny in the fusebox" would be more accurate. Only
free banking can allow the financial sector to guide the real sector while
preventing the demands for liquidity from degrading the market's performance.
A Summary View
In the Keynesian view, the central bank is a part of an extramarket
remedy to a market malady. Investment markets are inherently unstable;
government control of the economy's money supply is an important element
in macroeconomic stabilization policy. The case against central bankingvand
for free bankingvreverses the characterization of both remedy and malady.
Free banking is a part of a market remedy to an extramarket malady. Even
this stark reversal understates the case for free banking. It would remain
valid even if we take the dramatic and chronic fiscal irresponsibility
of the Treasury as given. Periodic crises that will inevitably occur in
such a debt ridden economic environment would be more ably countered by
the market forces of free banking than by the policy moves of a central
bank. But the extent of the Treasury's fiscal irresponsibility is itself
dependent upon whether the Treasury can count on an accommodating central
bank. Free banking limits the scope of this potential source of instability
while at the same time enhancing the market's ability to deal with whatever
instabilities that may persist.
References
Bagehot, Walter. Lombard Street: A Description of the
Money Market. London: Henry S. King, 1873.
Ball, L., G. Mankiw and D. Romer. "The
New Keynesian Economics and The Output-Inflation Trade-off." Brookings
Papers on Economic Activity 1, 1988: 1-65.
Dowd, Kevin, ed., The Experience
with Free Banking. London: Routledge, 1992.
Feldstein, Martin, ed., The Risk
of Economic Crisis. Chicago: University of Chicago Press, 1991.
Figgie, Harry E. Jr., Bankruptcy
1995: The Coming Collapse of America and How to Stop It. Boston: Little,
Brown and Company, 1992.
Friedman, M. The Optimum Quantity
of Money and Other Essays. Chicago: Aldine, 1969.
__________. The Counter-Revolution
in Monetary Theory. London: Institute of Economic Affairs, 1970.
Garrison, Roger W. "Public-Sector Deficits
and Private-Sector Performance," in Lawrence H. White, ed., The Crisis
in American Banking. New York: New York University Press, 1993, pp.
29-54.
__________. "The Federal Reserve: Then
and Now," Review of Austrian Economics, 8 (1), 1994: 3-19
Keynes, J. The General Theory of
Interest, Employment, and Money. New York: Harcourt, Brace, 1936.
Krugman, Paul, Peddling Prosperity:
Economic Sense and Nonsense in the Age of Diminished Expectations.
New York: W. W. Norton and Co., 1994.
Rothbard, Murray N. The Case Against
the Fed. Auburn, AL: Ludwig von Mises Institute, 1994.
Selgin, George A. The Theory of
Free Banking: Money Supply under Competitive Note Issue. Totowa, NJ:
Roman and Littlefield, 1988.
__________. "Monetary Equilibrium and
the 'Productivity Norm' of Price-Level Policy, in Richard M. Ebeling, ed.,
Austrian Economics: Perspectives on the Past and Prospects for the Future.
Hillsdale, MI: Hillsdale College Press, 1991, pp. 433-464.
Warburton, C. Depression, Inflation,
and Monetary Policies: Selected Papers: 1945-53. Baltimore: Johns Hopkins
University Press, 1966.
White, Lawrence H., "Mises on Free
Banking and Fractional Reserves," in John W. Robbins and Mark Spangler,
eds., A Man of Principle: Essays in Honor of Hans F. Sennholz. Grove
City, PA: Grove City College Press, 1992, pp. 517-533.
__________. Free Banking in Britain:
Theory, Experience, and Debate, 1800-1845. New York: Cambridge University
Press, 1984.
Yeager, Leland B. "The Significance
of Monetary Disequilibrium," Cato Journal 6(2), 1986: 369-99.
Notes:
1. The comparison of schools facilitated
by the equation of exchange is wholly independent of the unique qualities
of Austrian macroeconomics, which features the intertemporal allocation
(and possible misallocation) of resources and requires theorizing at a
lower level of aggregation.
2. We should note, however, that even
before the impact of Milton Friedman's empirical work was fully felt, the
Early Monetarists held that the typical and most significant reductions
in MV were attributable to reductions in M and not in V.
3. Here and throughout the paper, the
phrases "increase in the demand for money" and "decrease in the velocity
of money" are used interchangeable. Although this usage is not unconventional,
some monetary theorists take money demand to be defined by the equation
of exchange itself. That is, M d = (1/V)PQ,
in which case any change on the righthand side of the money-demand
equation would constitute a change in the demand for money.
4. Even worse, the school of thought
whose sails have most recently caught the academic wind calls itself New
Keynesianismvseriously missing the mark with both parts of its name. Gregory
Mankiw and others [Ball, et al, 1988] remain largely agnostic about the
specific source of change on the lefthand side of the equation of exchange.
Their theorizing holds up whether it is M or V that decreases.
The Keynesian label is adopted simply on the basis of their recognition
that prices do not change instantlyva basis that actually distinguishes
their (and many other) arguments only from extreme versions of New Classicism.
The "New" is added in recognition that the assumption of sticky prices
is replaced with "sophisticated" reasons for prices not adjusting instantaneously.
But Early Monetarism as initially set out and in modern expositions does
not fail to include reasons for the behavior of those who set prices. New
Keynesianism is Early Monetarism offered with the aid of now fashionable
modeling techniques, which involve mathematically tractablevif largely
implausiblevconstraints on price- and wage-adjustments.
5. By wholly ignoring the discoordinating
consequences of deflationary pressures and factoring in the effect of an
anticipated price-level decline on the real value of money holdings, Friedman
(1969, pp. 45-47) argues for a theoretically optimal growth rate for M
that is considerably lower (2% instead of 5%) than that implied
by secular changes in Q and in V.
6. Selgin [1991] distinguishes clearly
between what I have called malignant and benign deflation. It is interesting
to note that free banking, which relieves only the malignant deflationary
pressures, may get close to Friedman's theoretical optimum, which assumes
those pressures away. (See footnote 5.)
7. The telling exceptions are the elections
involving Presidents Ford, Carter, and Bush. In 1976 Ford simply did not
play the game. He did not press Federal Reserve Chairman Arthur Burns,
who had helped Nixon get re-elected four years earlier. With Ford perceived
as a non-starter, Carter boasted that his administration would "hit the
ground running," which in terms of monetary policy meant that the expansion
was started much too early. By re-election time (1980), the stimulative
effects of the monetary expansion had receded into history and inflation
was upon us. With equally bad timing, but in the opposite direction, Bush
tried to play the game in 1992 but started the expansion too latevafter
finally realizing that he couldn't ride through the election on his victory
in the Persian Gulf. The monetary stimulant was felt during the first few
months of the Clinton administration. Starting too late, too early, and
not at all, these three incumbent campaigners had one thing in common:
they lost.
8. There are a number of books written
in the spirit of Bankruptcy 1995 (1992) offering calculations of
one sort or another about when the debt bomb will blow. Will it be when
interest payments dominate the growth path of the debt? Or when interest
payments exceed tax revenues? Calculations based on these and related eventualities
are almost surely irrelevant. In informal discussion, I have designated
all such calculations as establishing what I define to be the "Gore Point"vthe
point at which even Al Gore perceives the debt as a problem. (A colleague
has suggested as an equally apt name the"Barro Point," in honor of Robert
Barrow, who persistently downplays all the worries about government indebtedness.)
The important point here is that financial markets do not await the education
of Al Gore. Much of the instability currently observed on Wall Street is
attributable to the chronically large debt and deficit.
9. This is not to suggest that deficit-induced
instabilities are the only macroeconomically significant ones. Instabilities
emanating directly from the Federal Reserve and instabilities associated
with perverse banking regulations and deposit-insurance pricing also have
a claim on our attention. But, arguably, the deficit-induced instabilities
deserve more attention than they have so far received. See Garrison [1993
and 1994].
10. The idea that the Federal Reserve's
attempt to deal with a domestic liquidity crisis may trigger an international
currency crisis in this way is drawn from Lawrence Summers' discussion
of the "Macroeconomic Consequences of Financial Crises" in Feldstein, 1991,
pp. 153-56.
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