The Rationale of Central Banking and the Free Banking Alternative
By Vera C. Smith
The Rationale of Central Banking invites us to reassess our monetary institutions and give reform proposals due consideration. The decades since it first appeared in 1936 have restored its themes to relevance. Government-dominated monetary systems have continued to perform poorly. Other experience, as well as the work of James Buchanan and the Public Choice School, has heightened skepticism about government generally. People are now willing to discuss what Vera Smith set out to examine: “the relative merits of a centralized monopolistic banking system and a system of competitive banks all possessing equal rights to trade” (p. 3)…. [From the Preface, by Leland B. Yeager]
First Pub. Date
Indianapolis, IN: Liberty Fund, Inc. Liberty Press
The text of this edition is under copyright.
The Post-1848 Discussions in England
The account we have so far given of the development of English thought on the merits and demerits of a free-banking system, as compared with one in which the note issue was monopolised, brought us up to James Wilson’s contribution at the close of the ‘forties. In England, at least after 1844, if not before, the only practical problem was always whether,
given central banking, there should be limitations or no limitations on the amount of the note circulation. The question of whether there should be freedom or privilege in the issue of notes was scarcely ever raised. But the discussion of its latter problem on a much more extensive scale by the economists and financial experts on the Continent could not fail entirely to draw the attention of their English contemporaries.
The economic literature of the ‘fifties in England showed an almost complete neglect of this problem: there were not many more than a couple of references to it. Of these one was due to R. H. Mills, professor in one of the Irish Universities, who treated the subject in the course of a series of lectures which were later published.
*1 In his view, “a violent expansion and contraction of the currency… is the inevitable result of a system which has still many advocates and which has but late been checked… that of allowing a number of banks of issue to subsist in the country.”
*2 In support of this statement he quotes verbatim the argument given by Longfield, and this citation appears to be right up to the present day
*3 the only instance of any mention of Longfield’s point, in spite of its being the most important single controversial point in the theory of the problem.
The other reference to which we have referred came from the pen of Herbert Spencer,
*4 and is a denunciation of all State interference in banking and a plea for the strict application of the laws of bankruptcy to banks which suspend cash payments. He believed that this would be a sufficient and effective check against over-issues.
In the ‘sixties several circumstances combined to bring the controversy again into the open. The currency disorders in the United States of America, and the publication of Coullet’s book, “La Circulation Monétaire,” in France in 1865, invited comments in
The Economist This journal, following in the tradition of Wilson, under the editorship of his son-in-law, Walter Bagehot, continued to make frequent reference to the superior qualities of a plural banking system. The evidence given before the French Banking Commission and the not very encouraging first experiences of the new National Banking system in America provided the occasion for further remarks to the same effect from time to time in 1867.
The French influence was particularly strong. Bonamy Price, Professor of Political Economy at Oxford, drew attention to the points of disagreement between the leading protagonists, Wolowski and Chevalier.
*5 In addition, direct connections were established between the English and French economists via the
Enquête. Bagehot was called to give evidence before the Commission in person, and written memoranda were submitted by Hankey, Newmarch, Patterson and J. S. Mill. Wolowski visited London in 1866 and attended the meeting of the Political Economy Club, where Bagehot was reading a paper on whether it was better “to entrust the principal custody of the bullion reserves against banking liabilities to a single bank or to distribute it between several banks.”
The English reaction to the adoption by the Bank of France of the policy of moving the rate of discount in response to changes in its reserve position was, in general, one of approval. It was hailed by
The Economist as the recognition at long last of a principle which this journal had been advocating in its pages for many years. The theory of discount rate, though as yet imperfectly understood as to the details of ail its effects, and especially of its effects on the price and income structure of the country concerned, had received fairly general acceptance in England under the influence of the writings of MacLeod
*7 and Goschen,
*8 who had at least made it clear to the banking world that the discount rate could be used to influence the balance of payments and gold flows.
Goschen made a direct attack on the low discount rate school in France,
*9 and insisted that the higher rate of discount which had prevailed over the preceding few years must be interpreted as the result, not of the artificial tampering with the natural state of things as Pereires claimed, but as the result of the free play of natural forces which had raised the demand for free capital and therefore its price.
Nevertheless, the views of the Pereire group in France were not without protagonists in England. Best known among them was a journalist named Patterson, who gained sufficient recognition to be invited to submit a memorandum to the French Commission.
*10 He extended to the case of the Bank of England the view that it was the monopoly of the note issue and the monopolist’s attempt to maximise profits which caused it to raise the rate of interest. Changes in the rate of discount were an unmixed evil to be avoided at all costs except in so far as under a free and competitive system of note issue they would become “natural.”
*11 The monopoly of the Bank of England was attacked also by Guthrie.
*12 Although in many respects a crank, he called attention to one important aspect of a free-banking multiple reserve system. He submitted that under free banking, where each bank would be obliged to hold its own gold reserves, there would be a much closer connection between note issues and gold reserves, and that over-issues and the drains of bullion to which they led could be checked before they became dangerous. Should the tendency show itself, he said, “�All the banks, being at the same time dealers in bullion and in discounts
and holding only the quantily of bullion required as the basis of their own trade, would at once feel the withdrawal of gold from their coffers and be
all constrained immediately without reference either to their issues or deposits to reduce the amount of their discounts in proportion to the cash they hold.”
*13 This would mean that in a free-banking system banks could not escape from a strict adherence to the rules of the gold standard and the currency principle, but the whole tenour of these remarks was in curious contradiction to a thesis of the same author’s, that it was a mistaken policy for the Bank of England to keep a fixed price for gold instead of allowing its price to vary just like that of any ordinary commodity in response to changes in supply and demand. The monopoly of the Bank of England was, according to Guthrie, the primary cause of commercial crises. MacLeod also stated this view but did not effectively substantiate it.
Another feature of Continental thought at this time which had its counterpart in England was the attack on all fiduciary issues, led by Cernuschi and Modeste in France, and Tellkampf and Geyer in Germany. The English sponsor of these doctrines was Edmund Philipps.
*15 He was chronologically prior to the Continental exponents except for Tellkampf, but attracted much less attention. He believed that so long as the Bank of England issued more notes than it had gold to redeem, it would be forced on occasions to suddenly call in its notes and raise discount rates, and he went so far as to suggest that if the Bank of England would not accept a charter under the condition that convertibility in his sense should be maintained, any of the joint stock banks would be pleased to do so.
*16 This kind of argument never gained any following in England, however, and passed practically unnoticed.
Let us now revert to the more general aspects of the question of unity as against plurality in the note issue. Bagehot’s remarks before the French Commission were confined to the specific questions relating to the French case. The French system was inferior to the English system, he said, because in England each little town had its two or three banks and these provided facilities for the collection and utilisation of savings such as did not exist in France. On being asked whether unity or plurality in the banking system would be the best system for England, he replied that the question was at the moment indifferent to her, because the result that the multiplicity of banks serves to obtain had already been reached: the collection of idle savings and the prevention of “their going to waste” was already well accomplished. On the theoretical question, he added, he was not required to speak.
It was the opinion of J. S. Mill, as expressed in his written memorandum to the
Enquête, that the importance of the choice between unity and plurality of banks had been exaggerated. It had been generally assumed that a plural banking system would increase credit facilities, and this assumption had been the reason both for the praise of the partisans and for the opposition of the enemies of a plural system. But Mill thought that, in fact, the system would realise neither the benefits claimed by the one side nor the inconveniences envisaged by the other, because after a period of adjustment, we should, he believed, find the note circulation distributed among a certain number of banks who would collectively conduct themselves in much the same way and provide just about the same credit facilities as the single bank under the old system. No one bank could augment its issues except momentarily, because of losing its reserves to other banks, and an increase in credit would take place only when it was provoked or favoured by general causes acting on all banks at once, and every time such causes came into play they exerted an exactly similar influence on the single bank in a unitary system. There would consequently be no very great practical difference between the two systems.
That Bagehot, on the other hand, thought that there would be very real and important differences between the two systems became clear in his writings in
The Economist and in his book “Lombard Street,” which he published in 1873. In the first place, it was the advantage of the multiple system of local issues that it produced a much more rapid development of banking over the country. A diffused system of note issue prepares the way for deposit business by establishing the credit of the banker. It is much easier to establish this by way of note issue, because the initiative is more on the side of the banker than in pure deposit banking. Moreover, such a system was better adjusted to loan business, because the partners in provincial banks usually belong to the district and have local knowledge which puts them in a better position to estimate the risks involved in lending to particular enterprise of individuals. Whatever had been the faults of the country note-issuing bankers, and acknowledging that we might not wish to see their return, they had done us a great service in the beginning. It was because we in this country had had a diffused system of note issue in the early days that we had outstripped other countries in all types of banking business. Admittedly, after a country has once succeeded in developing a paper currency and the other banking business to which this is an introduction—by whatever means this has been accomplished and however slowly or rapidly—the case for a multiple system of note issue ceases to be of so much practical importance, and Bagehot always refers to the question as being one of deciding whether it is advisable,
in the abstract, and when we begin de novo to grant a monopoly. Accordingly, there was in his view no case for the Pereire plan of setting up a second bank of about equal strength alongside the Bank of France, in Paris, because Paris had already become accustomed to a note circulation, and in any case he thought the plan deserving of grave suspicion, since it came from the same people who objected to a rise in the discount rate. So far as provincial banking was concerned, it was plain that facilities were poorly developed as compared with England and Scotland, and this must be attributed to the lack of country issues in France. Nevertheless, he did not feel justified in advocating a return to a system similar to the old departmental banking system, because, he remarks rather cynically, “we may lay down a principle that every credit currency permitted in France should be such as
could be made legal tender the day after a revolution.”*19 Considering the problem quite apart from such questions of expediency, however, he was convinced that a country starting
de novo would do better to have a multiple reserve system, such as that of New York, rather than the English or French system
*20 of a privileged monopoly which was essentially a single reserve system. It was not yet generally understood that the Banking Department of the Bank of England did in fact hold the only reserve of ready cash against the banking liabilities of the country, and it was important to make clear the effects of this on the position of the Bank. We had in England evolved a system in which not only practically the whole of the gold reserve
(i.e., the reserve against notes), but also the whole of the banking reserve
(i.e., the reserve against deposits) of the country was kept by a single institution. This had grown out of the privileged position in which that institution, the Bank of England, had been placed by Government interference in banking. “The natural system—that which would have sprung up if the Government had left banking alone—is that of many banks of equal or not altogether unequal size.”
*21 Instead of that, we had a central bank, and a central banking system had certain characteristics, liable to become dangerous if not very carefully handled, which distinguished it from decentralised multiple reserve system. The two respects in which the centralised system showed the most marked difference were, firstly, in the effect on the total cash reserves of the banking system as a whole, and secondly, the reliance on a “lender of last resort.”
The commercial banks under this system, instead of keeping each its own gold reserves, keep their reserves in Bank of England notes or in claims, in the form of deposits at the Bank, on Bank of England notes. Each bank in estimating the proper distribution of its assets between immediately realisable and less immediately realisable, so as to ensure what it thinks is the necessary degree of liquidity, regards what it holds on deposit at the Bank of England as “as good as cash,” so that according to the calculations of the commercial banks their cash reserves should amount, in addition to the sums of actual cash they keep in their tills, to the whole of that sum which appears on the Bank of England’s books as bankers’ deposits. But what the Bank of England has at any time available in cash, that is, notes in the Banking Department, is always very much less than this—it is only half or even a third of its deposit liabilities—because the Bank relends part of the reserves of the commercial banks. The virtual pooling of the reserves of all the separate banks means that in normal times the Bank of England can count on withdrawals by one bank being counterbalanced by additional depositing by others. The difficulty arises in times of pressure all round, when all banks are likely to be requiring cash at the same time, and it is then that the disadvantages of the single reserve system become apparent. The actual reserve held by the Bank is smaller than the sum of the amounts calculated by all the separate banks to ensure safety and which would really exist in reserve under a decentralised system. The spare cash of the money market is thus reduced to a smaller amount than under the alternative multiple reserve system. MacCulloch had supposed that banking reserves would be larger under a unitary than under a plural system; Bagehot showed that they were smaller.
The second weakness of a central banking system is its tendency to create points in the system at which distress support is given. The existence of such refuges becomes part of the data on which the banks base their policy. It destroys some responsibilities and creates others. It is bound to happen that a central banking system being created by State aid is more likely than a natural system to require State help, and what it knows it can depend on, it will not hesitate to utilise. This circumstance in turn leads the public to demand extra services from the central bank in times of extremity and expects that it should help the smaller establishments, and “it is,” says Bagehot, �”a serious difficulty that the same bank which keeps the ultimate reserve should also have the duty of lending in the last resort. The two functions are, in practice, inconsistent—one prescribes keeping money and the other prescribes parting with money.”
It is this part of the central bank’s activities—acting as “lender of last resort”—that has been singled out by Hawtrey
*23 as constituting the primary function of a central bank. In what Bagehot called “the natural system,” no bank would have any special claim on any other.
In spite of the, in his opinion, manifested disadvantages of a central banking system, Bagehot saw no chance of giving it up and going over to a many reserve system: such an idea he admitted was childish, because it would take decades to build up another system of credit to replace the trust that had now come to be placed in the Bank of England as the pivot of the whole structure. Instead, therefore, of advocating the adoption of the alternative system, he tried only to elucidate canons of policy which would facilitate the less imperfect working of the one we now had.
It had been Bagehot’s aim to make the Bank Directors realise the
double strain placed on the Bank’s cash resources in times of stress by the dual nature of its position, on the one side as holder of the banker’s reserves, and on the other as lender of last resort. Firstly, it must be prepared to provide cash to the banks in respect of what was in all respects their own (viz., Bank of England deposits held as reserve), and secondly, it must provide cash by way of loan to help such institutions as find their own cash resources insufficient.
*24 This led him up to his final conclusion that the Bank must adopt a more cautious policy and that a banking reserve of one-third in normal times was too low.
Bagehot’s influence on the shaping of central bank policy must have been more considerable than that of any other single writer either here or on the Continent. It was mainly as a result of his continued emphasis that it came to be commonly admitted that the correct policy for the central bank in the crisis was to lend freely at a high rate of interest. He did a great deal to secure the recognition of the nature of the special responsibilities of a central bank. His accepted thesis was a rebuttal of what was considered at the time to be one of the cardinal principles of the 1844 Act, namely, that the Bank of England should be released from any obligation to pay attention to the public interest in framing its policy and should be at liberty to act for the benefit of its shareholders, the principles of management by the Banking Department being the same as those regulating any other large deposit bank. J. S. Mill had supposed this principle to have been already rejected by 1857.
*25 But it was not easy to obtain general agreement among the Bank Directors. Immediately after the crisis of 1866 the Governor of the Bank made a public announcement before the proprietors that the Bank had conceived a duty to have been imposed on it of supporting the banking community and had accordingly lent unflinchingly during the crisis at a cost of a great reduction in its reserves.
*26 Bagehot took this as an acknowledgment by the Bank that it kept not merely the currency reserve (gold) of the Country, but also the banking reserve, and that it should use the funds of which it was thus given command to help the banking community in time of a crisis.
*27 One of the Bank Directors and a former Governor, Thomson Hankey, denied vehemently that any such responsibility had been admlitted.
*28 He regarded it as a most pernicious doctrine to expect the Bank to do what was quite inconsistent with the ordinary workings of a deposit bank, namely, to make advances when the public demanded them to an almost unlimited extent, and maintained that the banking community must be taught not to rely on the Bank coming to their aid when they had rendered their own assets unavailable. In these circumstances a banking reserve of one-third against deposits was ample. Hankey’s views were defended also by G. W. Norman.
Bagehot replied that whether the Bank Directors approved in principle or not, the Bank had, in fact, established a guiding precedent by lending freely in previous panics (as in both 1857 and 1866), and such action had become the legitimate expectation of the money market. If the Bank Directorate wanted to repudiate this obligation, it should make an official and unequivocal announcement to that effect.
Bagehot’s “Lombard Street” really concluded controversial discussion on the relative merits of free banking and central banking. Its theme was that we find ourselves in possession of an anomalous banking system. It is not the most perfect if we were able to choose from the beginning, but now that we have it we must make the best of it by clearly recognising its weaknesses, accepting the responsibilities it creates, and keeping adequate funds on hand to meet them.
We find Goschen re-echoing Bagehot’s warnings respecting the inadequateness of reserves about twenty years later in connection with the Baring crisis of 1890.
We show below the chief disputants in the free-banking controversy cross-grouped with their standpoint towards the banking and currency controversy:
|G. W. Norman|
|R. H. Mills|
Weltwirtschaftliches Archiv., October, 1930.
Westminster Review, 1858, and later included in Vol. III. of “Essays Scientific, Political and Speculative.”
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.
Edinburgh Review, January, 1865; republished in his “Essays and Addresses on Economic Questions.”
The Economist, February 11th, 1865, p. 158.
The Economist, September 1st, 1866.
The Economist, September 22nd, 1866.
The Economist, December 22nd, 1866, p. 1488.