The Rationale of Central Banking and the Free Banking Alternative
1. Biographical and bibliographical facts come mainly from articles assembled by Ente per gli Studi Monetari, Bancari e Finanziari "Luigi Einaudi," 1984, especially those by Rosaria Giuliani Gusman and Gottfried Haberler; from Verena Veit-Bachmann's article on Friedrich Lutz; and from a letter and enclosure dated 26 June 1989 written by Mrs. Brenda K. Fowler, the sister of Vera Smith Lutz. l am grateful to Mrs. Fowler for going to the trouble of preparing her valuable information.
4. Under complete freedom good banking depends not only on the ability of the bankers, but also on the public's having sufficient knowledge and experience to detect the good from the bad, the genuine from the fraudulent.
14. It also secured the final abolition of the Usury Laws. The Bank had been exempted from them so far as borrowing was concerned, in 1716, but it was not until 1833 that it was free to charge what rates it thought fit for loans it granted itself.
20. Their chief claims were the following: (a) to be allowed to discount paper payable not only in their own town, but also in any town having a bank; (b) to be able to discount bills having two signatures only, the present requirement being three; (c) to be authorised to issue notes for 100 frs.
21. Up till 1847 the Bank had not been allowed to issue notes in Paris for less than 500 frs. At the Comptoirs in the provinces it could, like the departmental banks, issue them for as low as 250 frs. In 1847 the same minimum denomination was made to apply to Paris, where provincial notes for that amount had in any case been circulating previously.
23. In times of strain it always meant that some form of rationing had to be resorted to. M. Rouland, Governor of the Bank of France, remarked before the Commission of Enquiry (1865) that when the Bank kept its rate of discount fixed it often had to reject demands for discounting at that rate in considerable proportions. So he states that in 1812, 30 percent of the total demands were rejected, in 1832, 14 percent and in 1841 and 1842, 6 percent. See "Dépositions de MM. les délégués et les régents de la Banque de France," p. 116.
25. The most common rule was that note issues should not exceed double the amount of the bank's capital. Such provisions were, however, usually purely nominal; the limits they imposed were never likely to be reached. See Gallatin, "Considerations on the Currency and Banking System of the United States," 1831, p. 65.
26. Only in England and Scotland were joint stock companies generally subjected to unlimited liability. In America, as well as on the Continent, the principle of limited liability became the general rule right from the beginning.
29. The New England banks fulfilled their engagements. All the banks to the south and west failed. See Gallatin, "Considerations on the Currency and Banking System of the United States," p. 42. Most failures in these and the following years took place where entry into the banking trade was most restricted. Carey gives figures of failures from 1811 to 1830. In New England as a whole the number of banks between 1811 and 1830 averaged 97 and the total failures were 16. In New York the banks averaged 26 and there were 11 failures. In Pennsylvania there were 29 banks with 19 failures, and the proportion of loss increases as you go further to the west and south.
37. This was yet another occasion when the penalty of liquidation for suspension went to the winds. Under the 1846 Constitution of New York State it was forbidden to the Government to pass any law directly or indirectly sanctioning suspensions of specie payments, but in the 1857 crisis the authorities refrained from selling out the stocks deposited by the suspending banks and withdrawing their notes; the Courts in New York distinguished between what they called momentary suspensions of specie payments and real insolvency.
39. The notes were lawful money and legal tender in payment of all debts, public and private, within the United States, except for duties on imports and interest on the public debt, which were expressly made payable in coin.
47. The "Dritteldeckung" (cash reserve of one-third), which from this time on wards was a common provision in the laws on German banks of issue, seems to have been the adoption by legal prescription of the conventional practice said by Horsley Palmer to have been followed by the Bank of England before the Commission of 1832 in England. Palmer's pamphlet on the policy of the Bank of England prior to the crisis of 1836-7, which we mentioned in a previous chapter, was translated into German under the title "Die Ursachen und Folgen der Wirksamkeit der Bank von England in dem Zeitraume vom 10 Oktober 1833 bis 27 Dezember, 1836" (1837).
51. It started the practice of lending out part of its deposits on current account. Much of the progress in Prussia during these years had been due to the efforts of one man, David Hansemann. It was under his leadership as President of the Bank that the Prussian Bank changed its policy. He had also been responsible as Finance Minister for obtaining the 1848 concessions for the formation of private note-issuing banks and for securing the royal consent to the foundation of the Schaffenhausen'schen Bankverein as a joint stock company. It was again he who, a few years later, founded the Disconto-Gesellschaft.
55. "The General Principles and Present Practice of Banking in England and Scotland: with Observations on the Justice and Policy of an Immediate Alteration in the Character of the Bank of England, and the Measures to be pursued in order to effect it."
64. "A Plain Statement of the Power of the Bank of England and the Use it has made of it; with a Refutation of the objections made to the Scotch System of Banking, and a Reply to the Historical Sketch of the Bank of England," 1832.
65. It would be more practical to assume that the proportions in which notes are returned to each bank are the same as the proportions existing between the circulations outstanding of the different banks.
66. 0p. cit., pp. 8-9. "It is said by those who are hostile to interference that coins are legal tenders whereas notes being destitute of that privilege, those who suspect them are at liberty to refuse them; but whatever notes may be in law, they are in many districts practically and in fact legal tenders, and could not be rejected without exposing the parties to much inconvenience. It should also be observed, that labourers, women, minors and every sort of person, however incapable of judging the stability of banking establishments, are dealers in money and are consequently liable to be imposed upon."
69. The figure he suggested was that loans should not extend beyond twice the amount of bank capital. This would in itself act as a check on issues, but he recommended that in addition there should be a specific restriction of the note issue to two-thirds of the bank's capital.
75. "Checks differ from bank issues in that the bank-note is taken in payment solely from the general confidence reposed in the banks, the check from the special confidence placed in the drawer." See Gallatin, "Suggestions on the Banks and Currency of the Several United States, etc.," 1841, p. 13.
103. "It is... not difficult to see that it becomes a most essential thing to the continued prosperity of a country that its floating capital, on which the continued reproduction of commodities of everyday use depends, as well as the continuous employment of labour, should not be withdrawn from those necessary purposes and converted into fixed capital in a greater degree than the surplus accumulation of the country, after replacing the whole fund needful to continue the production of such commodities... will admit. If the floating capital of the country is thus misdirected into fixed capital, it is quite plain that the ultimate result must be, that as the labour employed in the works representing the fixed capital does not reproduce the commodities which are consumed in supporting it, or any commodity which can be exchanged either with the home or foreign producers of such commodities, they must become scarce and dear, and ultimately the fund for the employment of labour must be diminished.
"It is quite true that for a time, while the process of the conversion of floating into fixed capital was proceeding, there would be a momentary appearance of great prosperity.... The production of commodities required for daily use would be unequal to the consumption; they would continue to rise in price... The ultimate effect of such a disturbance or misdirection of the floating capital of the country would be to create a great scarcity of it which will be evinced by the high rate of interest." (Op. cit., pp. 127-8.)
104. Speaking of the railway development and the conversion of floating capital into fixed which this entailed, Wilson says that it is clear that "the first effect of this process would be to render capital scarce and in proportion to raise the rate of interest; and that the next effect would be by rendering commodities of consumption scarce, to increase their demand, and to afford thus a stronger inducement to continue capital in its existing channel than to divert it into a new one.” The inevitable result would be that a great majority of the railway schemes must be abandoned (op. cit., p. 148).
1. Lettres sur l'Amérique du Nord," 1836. "A long time must elapse before we can enjoy in France a system of credit as extensive as that which exists in England and the United States. We are in that respect in a state of barbarism" (Vol. II., p. 248).
11. A view that was also supported later (1862) by Juglar in his "Des Crises Commerciales et leur Retour Périodique en France, en Angleterre et aux Etats-Unis," in which, while noting the marked correlation between the increase in the volume of discounts and of the note issue on the one hand, and in prices and the diminution of the metallic reserves on the other, he regards such movements as the results of other underlying factors rather than as the causes; he says: "Les excès de l'émission ne sont pas la cause principale des crises" (p. 34).
16. "Réorganisation des Banques: Légalité et Urgence d'une Réforme," 1861; "Réorganisation du systéme des banques: Banque de France, Banque de Savoie," 1863, both ascertained later to have been written by the Pereire brothers.
17. See also Gustave Marqfoy, "La Banque de France dans ses rapports avec le crédit et la circulation," 1862, in which it is contended that it is the duty of the Bank of France to keep the price of credit invariable by counteracting by its own lending any tendency to a rise in the rate of interest on the market.
23. The low discount rate school in France made frequent reference to the words of Napoleon written to his Minister of Finance, Mollien, in 1808: "Ce que vous devez dire au gouverneur de la Banque et aux régents, c'est qu'ils doivent écrire en lettres d'or dans le livre de leurs assemblées ces mots: Quel est le but de la Banque de France? D'escompter les crédits de toutes les maisons de commerce à 4%."
35. Article "Les Banques de France et de Savoie," in the Journal des Economistes, 2me série, Vol. 121., January, 1864. See also his book, "Les Circulations en Banque ou l'Impasse du Monopole, Emission et Change," 1865.
48. Courcelle-Seneuil, "Le Billet de Banque n'est pas Fausse Monnaie" in the same journal, September 15th, 1866. See also a letter by Du Puynode in the same number, a reply by Modeste in the October number and an article by Mannequin in the December number.
50. Op. cit., pp. 78-80: "Les billets ( ordre et les lettres de change les effets de commerce proprement dits, les promesses de payer a une date fixe et à une personne désignée, ne peuvent circuler, nous l'avons démornré, qu'entre individus qui se connaissent, il y a examen du titre cédé, discussion de sa valeur, endos, garantie nouvelle et additionelle donnée par le cédant au cessionnaire.... Quand ces promesses demeurent impayées à l'échéance, les détenteurs se reprochent à eux-mêmes leur imprévoyance ou leur peu d'aptitude aux affaires.... Ce que nous disons des effets de commerce ordinaires peut s'appliquer exactement aux dépôts chez les banquiers. Nulle raison générale ne pousse les particuliers a faire le dépôt de leurs fonds chez un autre. Le choix parfaitement libre d'un dépositaire est toujours determiné par des considerations individuelles.... Si les billets à vue et au porteur ne circulaient comme les autres effets de commerce que dans un petit nombre de mains, si leur transmission pouvait être précedé d'un examen détaillée et accompagnée d'une garantie du cédant au cessionaire, les pouvoirs publics n'auraient pas à intervenir pour les réglementer.... Mais chacun sait qu'il n'en est point ainsi.”
55. "On a Porté l'abus à ce point, que la facilité d'émission dont les banques étaient investies fut pour le gouvernernent la planche aux assignats; de là résultait bientôt l'insolvabilité de la banque." Quoted by Wolowski, "La Banque d'Angleterre," p. 199.
58. Op. cit., p. 125: "C'est l'huile qui manque pour graisser la machine, l'eau qui fait défaut pour alimenter la chaudière; toutes les entreprises s'en ressentiront; les plus solides marcheront avec difflculté; les moins forts s'arrêteront; les faibles s'éclateront."
61. "Ils raisonnent comme s'il était indifférent aux banques de faire faillite, c'est à dire comme si elles devaient être dirigées uniquement par des personnes décidés à faire une banqueroute frauduleuse. Il nous semble que les personnes de ce caractère, bien que trop nombreuses, sont une exception dans le monde commercial, et que ce ne sont pas celles qui commandent habituellement la confiance publique."
64. "Drei Gegenstände sind es vorzüglich, welchen die Vereinigten Staaten ihren Wohlstand verdanken: die Schulen. . . ; die Banken, 800 an der Zahl, welche jedermann mit Leichtigkeit Geldmittel, seinem Vermögen angemessen, darbieten, und ihn in die Lage setzen, an Spekulationen jeder Art Theil zu nehmen: endlich Eisenbahnen, Canäle und Dampfschiffahrt..." Op. cit., p. 1.
69. Op. cit., Vol. I., p. 73. "Die Papier ohne Metallhinlage, die Erhöhung der Preise aller Dinge, sind ein scheinbarer Vermögenszuwachs, der genossen und verzehrt wird. Da dies Vermögen aber eben nur scheinbar, da es kein Kapital, kein ersparter Überschuss, ist, so wirkt sein verzehrter Betrag, schliesslich als ein Deficit zwischen Haben und Soll. Man hat keinen Vermögenszuwachs, sonder, das alte Vermögen verzehrt.”
72. "Über die Neuere Entwicklung des Bankwesens in Deutschland mit Hinweis auf dessen Vorbilder in England, Schottland und Nord-Amerika und die französische Société' Générale du Crédit Mobilier," 1856.
76. Note that Tellkampf was responsible in co-operation with E. J. Bergius for translating under the title "Geld und Banken" (1859) MacCulloch's "Treatise on Metallic and Paper Money and Banks," in which the currency doctrine is defended.
82. This discussion in detail of note cover was a new departure in the discussion of banking, and was probably due to two factors peculiar to Germany: firstly, the extreme fluctuations that certainly did take place in the securities of all the German States, including Prussia; and secondly, the fatal experiences in the outlying States of the attempt to use crédit mobilier assets as note cover.
83. Michaelis says: "Das einzige reelle Sicherungsmittel ist das bei der Bank stets wache Gefühl der Notengefahr. Man sage daher, so viel Noten als einer Bank jeden Tag zur Einlösung präsentiert werden, so viel muss sie an dem Tag der Präsentierung unter allen Umständen einlösen, und wenn sie das nicht tut, so ist sie bankrott." See "Vierteljahrschrift für Volkswirtschaft und Kulturgeschichte," 1863, Vol. III., p. 251. It is important that it should be clear that this does not mean that a bank would never be able to tide over a temporary embarrassment, or, alternatively, that it would be compelled, in order to be perfectly secure, to keep reserves of 100 percent. It is, indeed, to be expected that the volume of notes flowing back to any bank will, from time to time, surpass the normal anticipated movement plus a certain allowance for some margin of deviation for which the bank can be expected to provide adequate reserves. But if such a surprise demand for cash suddenly arises and the bank's position is such as to allow it to meet all its obligations, provided it had the time to call in loans and so liquidate its position, it will surely be able to borrow for the necessary period from the market. A bank which is solvent to the extent that it could meet its liabilities within a reasonably short period, but was suffering from insufficient liquidity at the moment, should not experience difficulties in arranging such a loan.
87. "Nehmen wir an, das alle nebeneinander bestehenden Banken gleich leichtsinnig in der Ausdehnung ihres Notenumlauf wären, so würde durch solche gegenseitige Abrechnung im Ganzen eine Kompensation, nicht eine Realisation der Notenversprechungen staffinden. Da indess die verschiedenen Banken verschiedenen Grundsätze verfahren, so führt diese Abrechnung zur Notwendigkeit barer Ausgleichungen sobald nur eine unter ihnen ist, die im Verhältniss zu ihren Umsätzen wenig Noten im Umlauf hat. Denn diese eine empfängt immer mehr fremde Noten als andere Banken von den ihrigen empfangen haben können..." Article "Noten und Depositen," pp. 130-131, in Faucher's "Vierteljahrschrift," 1865; also republished by Michaelis in his "Volkswirtschaftliche Schriften," Vol. II., 1873.
88. "Je grösser der territoriale Umlaufsbezirk der Noten einer Bank, um so leichter sammelm sich also Notenmassen im Verkehr an, auf deren Rückkehr die Bank nicht vorbereitet ist, je kleiner derselbe, um so öfter kommen die Noten in den Fall, gegen Bar umgewechselt werden zu müssen, weil sie um so öfter in Hände kommen die Zahlungen aus dem Umlaufsbezirk heraus zu machen haben"—Article above quoted, p. 132. Actually the principle of limiting the area served by one bank would lead to conditions of monopoly rather than of competition. The more natural system would be a branch system in which the area over which the notes of any bank circulate is wide and in which branches of different banks compete in the same district. If Michaelis' other check—namely, the clearing mechanism which he supposed to function between banks in the same district—works, then inter-bank control will not be lacking in effectiveness in such a system.
94. The reason, as Nasse explains, was that Prussian Government securities were far less stable than English ones, and in case of need could often only be realised at a considerable loss. He even suggested that it might be advisable for the Prussian Bank to invest its spare funds in English Treasury Bills.
95. P. J. Geyer, "Theorie und Praxis des Zettelbankwesens nebst einer Charakteristik der Englischen, Französischen und Preussischen Bank," 1867; J. L. Tellkampf, "Die Prinzipien des Geld-und Bankwesens," 1867.
100. A. Wagner, "System der deutschen Zettelbankgesetzgebung unter Vergleichung mit der Ausländischen, zugleich ein Handbuch des Zettelbankwesens," 1870-73. C. G. A. Knies, "Geld und Kredit" (two volumes), 1873-79.
5. See Fraser's Magazine, 1868, "The Controversy on Free Banking between M. Wolowski and M. Michel Chevalier." Bonamy Price's own treatment of the problem contributed nothing very new. See his "Principles of Currency," 1869.
20. In Germany the Prussian Bank was not yet a bankers' bank holding the bulk of the cash of the other banks, and therefore differed in this respect from the Banks of England and France. See Nasse, "Die Preussische Bank, etc.," p. 59.
24. The fact that in England the Bank does not lend directly to the banks (by rediscounting) but to the bill brokers is immaterial. It provides the bill brokers with the wherewithal to make repayments to the banks.
33. It has sometimes been supposed, on an analogy with the English system, that by controlling the amount of note issue, control was at the same time established over the total amount of bank credit created. But the analogy was incomplete. In England, Bank of England notes formed the legal tender cash of the other banks. In the case of a National Bank the bank's own notes were not legal tender cash. It was liable to pay cash for notes equally with deposits, and it was against the two together that it had to provide adequate cash reserves and the numerical relation between them was flexible within wide limits. The danger was that the banks might overstep these limits and find themselves with a level of deposits involving a much higher demand for hand-to-hand currency than they had the means to supply.
35. Up to 1874 notes were redeemable at the counter of the issuing bank and at some bank in one of the cities designated as redemption cities. After 1874 they were redeemable at the bank's own counter and at the Treasury.
37. The Comptroller of the Currency in his report for 1907 (pp. 73-4) remarks: "The only way in which bank credits can be properly protected from sudden and unexpected calls, when all may be involved at the same time, is by a system of note credits which can be at any time immediately exchanged for the deposit credits. They are essentially the same thing, and should be daily and hourly if necessary, convertible from one to the other at the option of the creditor who is the depositor or note-holder. The bank of issue should be required, and must in self-defence, keep the same reserves against notes as against deposits. If this is done, there is no expansion or inflation when a note is paid out to a depositor and no contraction when a note is returned to the bank for deposit. With a given amount of reserve money a given total of deposits and notes can be maintained, and it makes no difference to the bank or anyone else but the customer who uses either at his option, whether the deposit remains in the bank as a credit to be checked against or is taken away in the shape of a circulating note."
38. Up to 1874 National Banks in New York had to hold in lawful money in their own vaults 25 percent of deposits plus circulation. Banks in other cities designated "redemption" cities or "reserve" cities as they were later called, must also hold 25 percent, but half of this might be held on deposit in New York. All other banks had to keep 15 percent, of which three-fifths might be on deposit with approved banks in any of the "reserve" cities. After 1874 this legal reserve requirement was revised to apply to deposits only and not to note circulation as well. After 1887 Chicago and St. Louis were given the position of "central reserve" cities, the same as New York.
42. It is not likely that banks would deposit with each other except in so far as it might be necessary for one bank to keep balances in a place where it had no branch for making payments in that place. The amount of such balances would normally be small.
46. It was part of the services of the Federal Reserve System to secure the payment of checks at par. The twelve Federal Reserve Banks and their branches hold the reserves of the member banks, and these act as clearing balances. Checks can be presented at the nearest Federal Reserve Bank, and if the check is drawn on a bank which is a member of the same Federal Reserve district, funds are already available. Where checks move out of the district, the Federal Reserve Bank pays the cost of any necessary currency shipments. The system also exerts pressure on non-member banks because Federal Reserve Banks will not collect checks on banks which refuse to clear at par.
48. See, for example, "The Discount System in Europe," by Paul M. Warburg (U.S. Monetary Commission). See also "Interviews on the Banking and Currency Systems of England, Scotland, France, Germany, Switzerland and Italy" (U.S. Monetary Commission).
49. It must be understood that the use of the term "free banking" in the subsequent analysis is not synonymous with that particular system of so-called free banking which was put into practice in the United States of America in the middle of last century. As was pointed out in the previous chapter, the American system was characterised by certain features which render it quite inappropriate as an example of the working of free banking in the more general sense.
54. Professor Mises has recently defended free banking along these lines in his "Geldwertstabilisierung und Konjunkturpolitik," 1928. Professor Neisser has, in reply to Mises, taken up the counter argument that the "automatic mechanism" of credit control does not, in most circumstances, work. See his article "Notenbankfreiheit?" in the Weltwirtschaftliches Archiv. , October, 1930.
57. It is immaterial to the general conclusion what assumption we make regarding the way in which the increased lending takes place. We may assume (a) that A gives out all the additional loans at the same date, and that they are all of the same échéance; (b) that it gives them all out at the same date, but that they are distributed over different periods of échéance; or (c) that it increases its loans gradually over a period of time. In all cases A receives back sooner or later the reserves it previously lost. See the illustration in an appendix to this chapter [pp. 197-200].
58. The same principles apply in the case of an accretion of cash to one bank and the demonstration (cf. Phillips, "Bank Credit") that the bank in question cannot expand its loans to anything approaching the extent represented by the amount of liabilities the additional reserves would support on the basis of the old reserve ratio, because withdrawals of cash will take place to other banks.
59. Neisser seems to have neglected this factor, although he would need to assume it in order to prove that there is a basis for distinction between the check case and the note case; cf. his article, pp. 454-5.
63. The only chance the minority have of escaping is if they have been able to select their assets so carefully that they are easily realisable even in the crisis, and if their more liquid position is sufficient to retain the confidence of the public, so that instead of their having deposits withdrawn they actually receive new deposits transferred to them from other banks.
64. Going off the gold standard assists the commercial banks in a direct way, as it no doubt did in this country in 1931. The withdrawal of balances to abroad, in so far as it takes place via an export of gold, sees a reduction in the reserves of the banks at the Bank of England unless the latter is in a position to offset, which it cannot do if the external drain of gold is exceptionally heavy. If it goes off the gold standard there is no need for any offsetting. The exporter of capital cannot withdraw gold from the Bank; he must buy foreign exchange at an enhanced rate, and there is merely a transfer between deposits at the banks from his account to the account of the seller of foreign exchange and the bankers' balances at the Bank of England suffer no net change.
66. The case might be analysed along Pigovian lines (see "Economics of Welfare," 4th Edition, Part II., Chapter IX., Section 10) as one where uncompensated damage is inflicted by the guilty banks on their innocent rivals, and as such giving grounds for some kind of intervention.
68. L. von Mises, "The Theory of Money" and "Geldwertstabilisierung und Konjunkturpolitik"; F. A. von Hayek, "Monetary Theory and the Trade Cycle" and "Prices and Production"; J. M. Keynes, "Treatise on Money"; G. Myrdahl, "Der Gleichgewichtsbegriff als Instrument der geldtheoretischen Analyse," and T. Koopmans, "Zum Problem des ‘neutralen' Geldes," in "Beiträge zur Geldtheorie," edited by F. A. von Hayek.
79. See, e.g., Fullarton, "On the Regulation of Currencies," pp. 138-41; A. Wagner, "Beiträge zur Lehre von den Banken," p. 126; J. S. Mill, "Principles of Political Economy," Vol. II., Bk. II., pp. 204, 210-11.
80. Between November, 1925, and March, 1935, the monthly figures of the average percentage of cash to deposits held by the London Clearing Banks showed an absolute range of between a maximum of 12.0 percent and a minimum of 10.0 percent. During the same period the Bank of England "proportion" showed a range of 65.5 to 11.5 percent, and, even ignoring these extremes, fluctuations between 50 and 30 percent, or even 25 percent, may be considered as quite a normal spread.
83. See the Chicago 100 percent Plan for Banking Reform, an account of which is given by A. G. Hart in an article entitled "The Chicago Plan" of Banking Reform in the Review of Economic Studies, February, 1935.