The Rationale of Central Banking and the Free Banking Alternative

In Germany the question of banking freedom came to the forefront of discussion later even than in France. An early book that had some considerable influence was the account given by F. A. von Gerstner
*63 of the impressions he gathered when travelling in America, and in which he attributed the swift development of American industry and commerce to the banks.
*64 He was responsible for arousing a good deal of false optimism as to the effects of credit expansion, and led some readers to believe that banks were vested with a kind of magic power.

It was not until the ‘fifties that any modern literature on banking and currency of any importance was written, and then within a few years three writers came into the foreground—Otto Hübner, J. L. Tellkampf and Adolf Wagner. The first of these, Hübner, was an active member of the German Free Trade Party. His book
*65 consisted for the most part of a survey, largely historical and statistical, of the chief banking institutions then in existence all over the world. His general conclusions were strongly in support of free banking. Practical experience had shown, he said, that banks were least often insolvent where they were least restricted.
*66 States never gave privileges without demanding a
quid pro quo, and if banks wanted to keep their privileges they had got to fulfil the wishes of the Government. “For exclusively privileged banks,” he said, “insolvency is as a rule the entrepreneur’s best speculation”; foremost in his mind was the case of the Austrian National Bank; without declaring itself insolvent it could never have lent such large sums to the Government, but if it had not lent the Government what it did, its profits would have been much smaller.
*67 The contrast is between privileged banks which are protected by the law from the consequences of their mistakes (if they should become insolvent, the Government gives forced currency to their notes) and the free-banking system where the bankers must bear the results of their own acts. Moreover, the mere fact that the State supports a privileged bank gives it an unwarranted trust.

Hübner did not base his case for free banking on the theories of the banking school—on the contrary: he was the first of a group that became rather fashionable in Germany, that held that only so many notes should be issued as there was metal to back them.
*68 The rule was that banks should not lend more than they receive. It followed that Hübner was also not a member of that division of the free-banking school which looked upon free banking as a means of lowering interest rates. If such a lowering of interest rates were to accompany an increase in the circulation, it would, he said, be an expression of the unhealthiness which such an increase produces.
*69 If it were true that the State could be trusted al ways only to issue notes to the amount of its specie holdings, a State-controlled note issue would be the best system,
*70 but as things were, a far nearer approach to the ideal system was to be expected from free banks, who for reasons of self-interest would aim at the fulfilment of their obligations.

The same rigid interpretation of the currency doctrine found a second supporter in Tellkampf. In his earlier years he had travelled in America, and it was his observations of the abuses of the banking system in that country which were supposed to have led him to his conclusions that the amount of paper should be regulated strictly by the amount of specie deposited in exchange and that the issues should be in the hands of a single bank. He had published these views in America as early as 1842,
*71 but they did not at that time attract much attention. Having returned to Germany he became Professor of Political Economy at Breslau and was also elected to membership of the Prussian Senate, where he took a leading part in the discussions on bank legislation. One of the points with which he was concerned in his first book
*72 was to combat the idea still pervading some circles in Germany that banking possessed the power to effect unlimited increases in real wealth.
*73 On the question of freedom he drew a sharp distinction between note-issuing and deposit banking. It was, in his view, impossible to allow the former to be carried on by all private persons without legal limitation, but he makes an exception to this rule under two conditions. Firstly, the issuers must be subjected to unlimited liability. Limited liability was, he contended, not a right that could be demanded in the name of free trade but a privilege by the granting of which the State had undermined the natural principle of responsibility underlying free trade. Secondly, the note issuers must be free from all obligation to lend to the State.

While Tellkampf looked to centralisation of the note issue as the ultimate end to be sought,
*74 there was at this time in Prussia no prospect of attaining any effective unity in the note issue, and the increase in the number of banks and their unlimited issues in the “Border States” led him to favour Prussia’s setting up her own private banks so as to keep out the notes of these other States. He recommended that these new banks should be set up on the Scotch model,
*75 on the principle that if the shareholders were liable for their obligations to the full extent of their property, self-interest would provide the necessary limitation on note issues.
*76

By far the best known among the German economists of his generation was Adolf Wagner. As strictly as Tellkampf was a follower of the currency tradition, Wagner was an adherent of the banking school. Writing at a time when the currency doctrine was becoming very powerful on the Continent, he set out in this first book
*77 to do two things: The one was to explain the disadvantages from the economic point of view of the ruling system of privileged banks, and the other to examine the basis of Peel’s Act. He had made a very close study of English literature on this and allied subjects and had been especially influenced by the writings of James Wilson. It was through Wagner that the chief accusations that had already been made in England against Peel’s Act and the currency doctrine were made available to German readers. His own opinion was that banks should be allowed to set up without legal hindrance, and he opposed the statutory fixing of note issues or of reserve proportions, thus fully supporting the free-banking position. Peel’s Act he regarded as being unsound, not only because it was based on the mistaken theories of the currency school, but also on the additional ground that the Bank of England had through its privileged position acquired a responsibility to render aid during a crisis by liberal lending, and now Peel’s Act had left its privileges intact but had taken away its obligations.
*78 The defect in the system of the great privileged central banks to which he gave most weight was the misuse the Government makes of the power it exercises over such a bank by encouraging it to discount too cheaply and to invest in too much State paper.
*79 While the Pereire group in France had assessed the fault of a single privileged central bank to be one of keeping discount rates too high, Wagner held it to be the opposite of keeping lending rates too low.

In the more detailed criticism of the currency doctrine which he published a few years later,
*80 prominence was first given in Germany to the theory of ”
bankmässige” cover. This was closely connected up with the celebrated principle of the automatic reflux of notes. The theory was that so long as notes were lent out in true banking business, that is short-term assets, they came back in the natural course of business after the elapse of the loan period and the amount of the issue was supposed for this reason to be constantly subject to check. From this time onwards ”
bankmässige” cover assumed a position of considerable importance in German banking discussions and legislation.

The most interesting treatment of the proposals for free banking in Germany is contained in the discussions of the Congress of the
Deutsche Volkswirte*81 in the early ‘sixties and the separate writings of one of its most prominent members, Otto Michaelis. The Congress set out to formulate a legal framework for free banking. It decided that provided unlimited liability were imposed on banking companies, special legal conditions were unnecessary. If limited liability were the rule, however, it might be necessary to formulate certain legal requirements
(Normativbestimmungen). As to what exactly these conditions should consist of was a matter of some considerable debate, and full agreement was not reached on every point. All the speakers seem to have agreed that no fixed limit should be put on the note issue and that no stipulated reserve proportion should be imposed. They were not quite unanimous on the question whether only certain specified types of assets should be permitted for use as note cover. Max Wirth was of the opinion that all notes should be covered by metal plus ”
bankmässige” bills. He regarded both Government as well as other long-term securities as being too unstable in value to be good note cover.
*82 Michaelis thought that neither lombard loans nor State paper were proper cover for notes, and the New York bond deposit system was on this account indefensible. But although he accordingly believed that it was good counsel to recommend to a bank that notes should be covered by
“bankmässige” bills, he considered that it was not necessary to lay this down as a legislative condition. The Congress was not for the most part in favour of stipulating that bills discounted by a note-issuing bank must have at least two names. Neither did such measures as the placing of restrictions on the amount or type of business other than note issue, legal provisions for the cover of deposits, limitations on the amount of deposit liabilities, or special requirements as to the period of notice for withdrawal of deposits, receive any support. It thus rejected all the Prussian ”
Normativbedingungen” as inappropriate.

The question whether note-holders should be given preferential rights over other creditors (depositors) in the event of a liquidation was answered in the negative. Great importance was attached by all the speakers to the point that the bank should always be obliged to cash notes on the day of presentation on pain of liquidation.
*83 This emphasis on the necessity for the rigid enforcement of the liquidation penalty for a failure to meet obligations was something of a departure from what had been customary in the past. Observations had from time to time been made on the need for the enforcement of quick resumptions of payments, for the imposition of penalties varying with the length of time for which the suspension lasted, and for liquidation after a more or less lengthy period, but it was usually taken for granted that a suspension for a certain length of time was permissible and normal.

Particular emphasis was placed by Michaelis, and the Congress as a whole, on the, up till now, neglected importance of deposit banking, and the Congress resolved that the setting up of discount and deposit banks should be recommended,
*84 and when it again approached the subject two years later,
*85 Michaelis was very much in favour of making the campaign for the development of banking independent of the fight for freedom in note-issuing, because he recognised how remote were the chances of success of the latter. This was in spite of his being in sharp disagreement so far as the theory of the subject was concerned with the common view that notes and deposits were to be rigidly contrasted.

In an article published in 1865,
*86 Michaelis argued that by establishing unity in the note issue, one of the most important checks on over-expansion was removed. With a large number of banks the average period of circulation of notes was shortened; each note had more chance of coming back to the issuer for cash payment. Now in the case of deposit credits, he says, the limits to expansion are even narrower. The test of cashability comes very early; a check is not likely to change hands many times by endorsement and will often be paid in immediately to his bank by the person in whose favour it is drawn. Every check drawn in favour of someone outside the circle of customers of that bank on which it is drawn will be paid in at another bank, thus giving the latter a claim on the former, and unless it is balanced by a counterclaim, the one will lose cash to the other. While admitting to this extent a certain difference between checks and notes (the latter were likely to remain for a longer average period in circulation outside the banks before being paid in), and this was the only distinction of any importance that had yet been recognised, Michaelis did not see in it sufficient reason for withholding freedom from the note-issuing business while allowing it to deposit banking. In both cases, so long as there were a number of banks, a strict control would be exercised by and among the banks themselves. In both cases monopoly increased the circulation period and deferred the test of cashability.

Michaelis was convinced that there exists in a multiple banking system an automatic mechanism which checks any tendencies to expansion of the note issue. And this, he said, will work so long as there are some or even one of the banks that does not expand.
*87 He thus regards it not only as a means of checking any single bank getting out of step with the rest, but as a mechanism which, since not all banks without
any exception are likely to set the process of expansion going at the same time, will keep the whole system under control. Longfield’s objection would, if it is valid, apply
a fortiori to this case, but it remained more or less unknown.

To those who argued in favour of unity because it widened the area over which the notes of any bank could be used, Michaelis replied that it was a positive advantage from the point of view of limiting the note issue if the territorial area of circulation of the notes of any bank were small, since it made their return to the issuer more frequent.
*88

It was at about this time that the first publication
*89 appeared of a writer who has, perhaps, received far less attention than his work merited. We refer to Philip Joseph Geyer. He was, in common with Tellkampf, an adherent of the stricter form of the currency theory. He started off from the thesis that the amount of money in circulation should always remain constant,
*90 and that the movement away from an approximation to such a state of affairs had been caused by the issue of bank notes not covered by specie. He held that only fully-covered note issues are a “real” economic factor, uncovered note issues merely bring “artificial” capital
(künstliches Kapital) into operation, and if more artificial capital comes forward than there is real
(natürliches) capital lying idle, a crisis results from the phenomenon of overproduction.
*91 While being violently opposed to freedom of note issue, he was very much in favour of giving freedom to set up deposit banks which would collect and use the idle real savings. He speaks of such a process making the uncovered note issue unnecessary.

After the crisis of 1857 and the operations as lender of last resort then carried out by the Bank of England, there had been noticeable even in Germany something of a change of emphasis in the arguments for central banking. The advocates of a strong central bank ceased to support it merely because they thought it was the only way of keeping note issues within the necessary bounds and increased the emphasis on panic financiering. This attitude was clearly stated by Professor Nasse in a pamphlet he published early in 1866.
*92 Whereas small note issuers were always discredited during a crisis, the notes of a central bank could continue to satisfy the internal currency demands. Therefore, by avoiding the necessity of providing for an internal drain of metal on top of the external drain, central banking rendered the crisis less serious. For these reasons Nasse welcomed the idea of the Prussian Bank becoming a central bank and opposed Peel’s Act, which takes from such a bank the possibility of filling up the gaps made in the credit system of a country by a crisis. His attack on the principle of Peel’s Act was directed against a Bill just introduced into the Prussian legislature by Michaelis for the fixing of the fiduciary issue of the Prussian Bank.

It would at first sight seem a little strange that such a Bill should be sponsored by Michaelis, who had always been in favour of the fullest freedom for note-issuing banks and a minimum of legislative interference. His attitude is, however, perfectly consistent with his general thesis. Where there are a large number of banks, there is an automatic check on the note issue; in the case of a privileged monopoly this mechanism is absent and therefore some external limit must be imposed.
*93

Nasse agreed with Michaelis that note cover should as far as possible be kept ”
bankmässige” (short-term commitments). This excluded Government securities and was in direct opposition to the basis of Peel’s Act, under which the fiduciary issue could be backed only by Government securities.
*94

Geyer and Tellkampf both elaborated their views further in 1867.
*95 Geyer summarises the faults of the present banking system under two heads: first, that it provides the material for trade crises and production cycles by producing “artificial capital” up to a point where there is an excessive amount of capital in existence, and, secondly, that having produced the crisis, it intensifies it by contracting credit and causing forced sales. His explanation of the original of the boom came very close to the modern “over-investment” theories of the Austrian school, but he failed to give any acceptable explanation of the more immediate cause of the crisis and depression. His reasoning here develops into an under-consumption theory. The over-supply of capital results in the over-production of consumption goods, which he believes cannot be absorbed by the market, because the demand for consumption goods will only increase with a fall in their price, and while it is true that cheaper capital reduces interest charges, this is so small an item as to be hardly perceptible in the final price of goods ready for consumption.

He approaches the theory of banking somewhat along the lines of the modern theory of the equation between investment and real savings. The difficulties which accompany the solution of the bank question lie not so much in the theory, he says, as in the practice.
*96 The theory is clear, that the uncovered note issue should be brought into equilibrium with the amount of capital lying idle, but as we do not know the amount of this idle capital, it is impossible to effect an equilibrium. He concluded that it is advisable to give up altogether the issue of uncovered notes and that the idle capital could better be collected by extending deposit banking. In the period of change-over, the reduction of artificial bank money should follow in step with the increase in deposits, and to accomplish this it is necessary that the note issue should be centralised and confined to a single institution. He realised that even given this unity in the note issue there would still be international complications; it would be pointless as well as difficult for any one country in isolation to give up “artificial bank capital,” since it would be affected by the creation of bank capital in other countries and would probably be unable to hold out against the lower discount rates elsewhere.

Peel’s Act was not a commendable solution to Geyer’s problem because it did not carry the currency principle to its logical conclusion. It should either forbid uncovered notes altogether or else arrange that they should be equal to the idle money capital. Since it did neither of these things it could not prevent crises, and once crises arose, it led to further complications by provoking panics instead of easing credit conditions so as to reduce trade losses.

The attitude taken up by both Geyer and Tellkampf in demanding the total abolition of the fiduciary issue ignored several important aspects of the monetary problem. Starting, as they do, from a situation where the existing money supply already contains notes in large proportion not covered 100 percent by metal, they underestimate the difficulties of the deflationary process which would be involved in getting back to their “ideal” situation, and which would entail a much more violent and lasting disturbance than any which was likely to occur from the movement they fear in the opposite direction. And, what is more important, perhaps, the objective would have no real value, since there is no special sanctity of any specific figure for the total quantity of money. All that is important are fluctuations in this total quantity, and all that Geyer’s theory required was that no
further increases should take place, so that the economic system, once having got into equilibrium with the amount of money in existence at the moment, will not be required to readjust repeatedly in the future.

In confining their considerations to bank-notes and the effect of these on the total quantity of money, they ignore also complications introduced by the existence of demand deposits and the effects of changes in their velocity. We start from a position where we have a volume of demand deposits which have arisen, not (or not all) from payments into the banks of an equivalent amount of cash, but from the redeposit of loans (also not backed 100 percent by cash) made previously by the banks, and these demand deposits alter the volume of effective circulating media of exchange by changes in their velocity of circulation (number of checks drawn per period of time).

The criterion of keeping the amount of the circulation constant may at times, then, positively require the amount of currency in the form of bank-notes to increase. Such would, for instance, be the case where a decline in the activity of deposits (increase in the average period for which they remain idle) requires the banks to make fresh loans if they are to keep the effective circulation the same as it was before, and the new borrowers prefer bank-notes to demand deposits. Once the deposits have been created, it is immaterial so far as the economic results are concerned what part of them is changed into currency, and the only deciding factor would seem to be the choice of the public as to which they prefer, deposits on current account or bank-notes.

The less extreme currency school writers, as well as the banking school, regarded notes as rendering a service in what they called “economising specie,” which is usually to be interpreted as “providing easier credit.” Geyer and Tellkampf, adherents of the very strictest currency doctrine, look upon them only as a more convenient form in which money can be carried about or transported. It is noticeable also that where people like Tooke and Wagner saw as the sole evil of increasing the amount of currency the possibility that it might depreciate its value (raise the price level), and therefore concluded, that since an increase in its volume had frequently taken place without causing a decrease in its purchasing power, it was not always an evil,
*97 Geyer did at least see that changes in the quantity of circulating media produced changes in the structure of production with certain undesirable repercussions.

In his later work Tellkampf still considered that if the plan of unifying the note issue and restricting it to the amount of specie deposited could not be put into operation, then the next best alternative was the Scotch system, and he seems to have regarded this as a very good second best.

The discussions conclude in Germany with a few publications at the beginning of the ‘seventies, just prior to the foundation of the Reichsbank. Among these was a pamphlet by Leopold Lasker,
*98 who alleged, probably not unjustifiably,
*99 that it had still not been conclusively shown why banking should be made the exception from the rule of private enterprise in all branches of economic life, and that no case had yet been made out against ”
Bankfreiheit.” Two treatises on banking and credit were also published in these years by Wagner and Knies
*100 respectively. These two were supporters of opposite sides in the controversy, but Wagner had by now obviously come under the influence of the historical school and therefore was no longer so uncompromisingly in favour of the free-banking system, and insisted that there could be no absolute solution in favour of one system; all systems can be justified in the appropriate circumstances. He had, however, abandoned few of the essentials of his old position, and the bias is still towards the free-banking ideal.

One of the theories he sought to destroy was the idea that note-issuing brought in a fabulous profit. This idea was one of the grounds of objection to free banking held by Knies, who wrote that the creation of bank-notes must be subject to special regulations,
*101 because their creation was costless. Wagner pointed out the existence of costs of management, and especially the costs of the substantial capital that was necessary for a note-issuing business.

Neither did Wagner admit that it was necessary to single out banking from among all other branches of industrial activity and subject it to unlimited liability provisions. But he allowed that it might be an advantage to reform the whole of the company law so as to enforce special requirements for different types of undertaking, and with this idea in mind he set out to formulate the ”
Normativbedingungen” that might be applied to the case of banking. Accordingly, he suggested that the bank’s capital should be required to attain a certain figure, that there should be a limit on the lowest denomination for notes, that there should be a regular exchange of notes once or twice a week between banks, and that the principle of publicity should be enforced. Such regulations as these he regarded as being perfectly compatible with the idea of full ”
Bankfreiheit.” Other clauses frequently to be found in bank laws, such as regulated the business of the banks, fixed the relation between the amount of the note issue and the amount of the bank’s capital or determined the form of the note cover, were not compatible with full ”
Bankfreiheit,” but if complete ”
Bankfreiheit” was looked upon with suspicion, some clauses of this kind might be conceded.

In common with Michaelis, he placed emphasis on the necessity for a speedy liquidation of insolvent banks. If a note when presented for redemption is not paid at the bank’s chief place of business or at its redemption counters and branches, and within a short period—three days is the time he suggests—the bank can still not pay its obligations, any creditor of the bank should be allowed to bring a demand before the courts for its liquidation. The only extenuating circumstances should be cases of
forces majeures, such as a foreign invasion.
*102

Wagner took sides against Michaelis on the question of whether, once it was decided to impose reserve requirements for the note issue, it was better to use the Continental or German method
(“Dritteldeckung,” or one-third specie cover) or the Peel system (fixed fiduciary issue). Knies and Michaelis both favoured the Peel system. Wagner preferred the ”
Dritteldeckung,” because, although it was true that the figure of one-third was purely arbitrary, it is far less rigid than the Peel system or the American bond deposit system.

Commenting on the 1866 experiences in Germany, which had turned the thoughts of many people towards a consideration and affirmation of the advantages of a central bank, Wagner agrees that it had evidenced advantages. He submits, however, that they were not necessarily such as could only be gained by privileged or entirely monopolistic central banks, and that not only the Prussian Bank but also similar great banks in important cities such as the Frankfurt, Leipzig and Bremen banks, smaller central banks or central banks of second order as they might be called, had given support to reputable firms at the height of the crisis.
*103

The partial recantation of Wagner, the once relentless champion of
Bankfreiheit, may be fairly regarded as the end of the active opposition to central banking in Germany.