The Rationale of Central Banking and the Free Banking Alternative

“Free banking”
*49 denotes a
régime where note-issuing banks are allowed to set up in the same way as any other type of business enterprise, so long as they comply with the general company law. The requirement for their establishment is not special conditional authorisation from a Government authority, but the ability to raise sufficient capital, and public confidence, to gain acceptance for their notes and ensure the profitability of the undertaking. Under such a system all banks would not only be allowed the same rights, but would also be subjected to the same responsibilities as other business enterprises. If they failed to meet their obligations they would be declared bankrupt and put into liquidation, and their assets used to meet the claims of their creditors, in which case the shareholders would lose the whole or part of their capital, and the penalty for failure would be paid, at least for the most part, by those responsible for the policy of the bank. Notes issued under this system would be “promises to pay,” and such obligations must be met on demand in the generally accepted medium which we will assume to be gold. No bank would have the right to call on the Government or on any other institution for special help in time of need. No bank would be able to give its notes forced currency by declaring them to be legal tender for all payments, and it is unlikely that the public would accept inconvertible notes of any such bank except at a discount varying with the prospect of their again becoming convertible. A general abandonment of the gold standard is inconceivable under these conditions, and with a strict interpretation of the bankruptcy laws any bank suspending payments would at once be put into the hands of a receiver.

A central bank, on the other hand, being founded with the aid either direct or indirect of the Government, is able to fall back on the Government for protection from the disagreeable consequences of its acts. The central bank, which cannot meet its obligations, is allowed to suspend payment and to go off the gold standard, while its notes are given forced currency. The history of central banks is full of such legalised bankruptcies.
*50

In the natural development of a free-banking system there is no apparent reason why a single bank should acquire a position of hegemony in which the bulk of the gold and cash reserves of the banking community were concentrated in its hands. The dictum of Bagehot, that a centralised reserve system is entirely unnatural and that the natural system would be one where each bank kept its own reserves in its own vaults, has been challenged by reference to the position of New York as a reserve centre prior to 1913. We cannot doubt the tendencies to a concentration of balances on a considerable scale in financial centres, and under a unit banking system the out-of-town banks will carry deposits with the banks in such a centre. The extent of this holding of balances by some banks for the account of others would be much smaller, however, were banks allowed to have their own branches where they chose. The balances that a bank finds it convenient to keep in the financial centre, would then generally be held by the bank’s own branch in that city, where they would remain under its own control and management.

In a multiple system each bank must determine the volume of its note issue, or of its total demand liabilities, with a close watch on its reserve position, and it is to be expected that the total volume of credit a bank could safely leave outstanding would be very sensitive to changes in its reserve position. The central bank can, on the other hand, allow its reserve proportion to undergo large changes partly on account of the concentration of reserves and partly on the expectation that it will be released from its obligations, if it finds itself in difficulties.
*51

We can now turn to the analysis of the major points at issue between those who attacked free banking and those who defended it. Historically the free-banking case was connected predominantly with those theories of currency and credit which were sponsored by the banking school, and the central banking case was likewise, but perhaps a little less closely, linked up with the theories of the currency school. It was not true in all instances that a member of the free-banking school supported the one and a member of the central banking school the other, but because this was true in the majority of cases, the success of the currency school was claimed as a victory for the central banking school as well. Actually the second controversy could be judged independently of the first and should be regarded as distinct. We shall not deal here in detail with the contents of the rival theses in the banking versus currency controversy, which are fairly familiar ground. It will suffice to remark how far the link with the banking
versus currency controversy weighted the evidence in the free banking
versus central banking controversy.

The circumstance that the free-banking school, especially in France, placed so much emphasis on that part of their argument which sprang from the theories of the banking school, tended, it is true, to cast suspicion on the free-banking case. A not inconsiderable number of the free bankers denied the quantity theory of money, and promoted ideas that were of an obtrusively inflationary character. It may be recalled that according to this school no such thing as an over-issue of bank-notes can take place so long as they are only issued in response to the “needs of trade” and continuous convertibility is maintained. It was their contention that so long as notes are issued on short-term loan (or so long as the assets of note-issuing banks are ”
bankmässige“) they cannot be issued in excess. The demand for loans, and therefore for notes, will be confined to limits imposed by the profitability of borrowing. Should the issue be found to be in excess of the needs of trade, notes will come back to the bank in repayment of loans falling due and for which there will be no demand for renewal; they will consequently be automatically withdrawn from the circulation. It was also a prevalent idea that since there is no restriction on the creation of credit by way of bills of exchange in ordinary commercial dealings, it is inconsistent to place a limit on that particular mode of lending which takes place via the note issue. If the banks issue notes with which they discount bills of exchange, they are merely changing the form of the lending. Since the bills would have existed in any case, the banks made no net addition to the total volume of credit.

Notes issued on short-term loan, the argument continues, become only temporarily part of the circulation, and this was held to constitute a vital distinction between bank-notes which had an automatic reflux and “pure paper money” which, instead of being paid out by way of short-term loan, was permanently released in payment for goods and services. Real paper money made a permanent addition to the amount of the circulation, and neither was its quantity controlled by the needs of trade. It therefore exerted a marked and lasting influence on prices. In the case of bank-notes, the flowback after the expiry of the term of the loan served also a second purpose by providing safeguards for the maintenance of continuous convertibility, since at the time of such repayments either the note issue was decreased or the gold reserves were increased.

It has been pointed out, in criticism of this doctrine, that it failed to perceive that borrowing on bills of exchange or on any other security will not be a given quantity fixed independently of bank policy, but will be a function of the rate of interest charged, and can be expanded indefinitely, provided the banks offer a low enough rate. Secondly, if the banking school argued that the principle of ”
bankmässige Deckung” provided against all dangerous contingencies, such as a threat to reserves and therefore to convertibility, simply because notes were always only temporarily issued and could be withdrawn at short notice, they ignored the truth that an over-issue even for so short a period as the normal
échéance of bills of exchange cannot (if it is general to a majority of banks in the case of a free-banking system, and without qualification in a unitary banking system) be suddenly rectified without causing all those effects characteristic of a credit contraction which are to be regarded as the evil aftermath of any over-issue. A net reduction of loans cannot take place without causing disturbances both in the financial and in the industrial structure. One bank can only make heavy reductions without causing widespread liquidations and losses in the system if another bank will lend to fill the gap. It is a matter of shifting, and the whole system cannot shift at the same time. The mere fact that the banks’ loans are on short term does not mean that a credit contraction can take place in the nick of time without causing just those disturbances which the currency school aimed at preventing.

There remains, however, one point connected with the principle of ”
bankmässige Deckung” and the automatic reflux of notes which might have a certain validity in a free-banking system which it could not have in a centralised system of note issue. This point relates to the possibility of the mutual control between banks operating as a check on over-issue. In a multiple system of issue the notes of any individual bank will be continually flowing into other banks and cleared. Now the shorter the period for which loans are made, the more frequent will be the repayment of outstanding loans; and the larger the proportion of total loans outstanding that are coming forward for repayment each day, the larger will be the proportion of the outstanding note issue coming into the banks on any day. If we suppose that one bank starts to expand while other banks maintain only the same issues as before, the flow of adverse claims required to be met in gold by the former through the clearings will be affected by the shorter or longer length of the term for which loans are made. How far this mechanism can be effective as a break on over-issues we shall discuss in a later section of this chapter.
*52

The currency school intended to make the total circulation vary with outflows and inflows of gold in the supposed manner of purely metallic currency. They thought that this end could be accomplished by fixing the fiduciary note issue. Their error was to have ignored the fundamental similarity of deposit credits to the issue of notes. This error would not have been crucial in so far as it concerned only the deposit credit creating facilities of the commercial banks.
*53 In so far as these banks keep fairly constant ratios between their cash reserves and their deposit liabilities, the total volume of credit can be made to move in response to gold movements (its changes will be a fairly constant multiple of such movements),
provided the reserves of these banks are made to move in the same way as gold. But this would require the fixing, not of the fiduciary note issue of the Bank of England but of the quantity not covered by gold, of its notes in circulation plus its deposit liabilities. As it is, the Bank of England can vary its lending and so alter the volume of deposits on its books to the credit of the commercial banks, and therefore the cash reserves of those banks, independently of gold movements, merely allowing the operation to affect its own reserve “proportion.” It can do this within limits that are of course widened by the willingness of the Government to abrogate the Bank Act in case of emergency.

There were mistakes and omissions in the doctrines of both schools, and as they worked out in practice there seems not to be such a great deal of difference between the actual results secured by those who insisted that it was essential to impose some such rule as a fixed limitation on the amount of the fiduciary note issue, and those who believed that the only necessary regulation was that notes should be convertible into specie.

We may conclude that logically, in so far as the disagreement between the two parties free banking and central banking was based solely on the positions they took up with regard to the banking
versus currency controversy, there is no definite ground for presumption in favour of either one or the other. It is, furthermore, true that, given the independent arguments in the free-banking case which we are about to examine, it was perfectly consistent for the currency school, in so far as their aim was to find a system in which there were checks on fluctuations in the volume of credit, to sponsor the free-banking case. Both Michaelis and Mises are in this position.

The decisive arguments, and those, therefore, on which the case can be exclusively discussed, are the arguments introduced by either side additional to, and independent of, the points at issue between the banking and currency schools. We shall, therefore, turn our attention to the major arguments of the free banking
versus central banking controversy proper. The points that have been raised in defence of the one system or in condemnation of the other can be dealt with under five heads.

The first of these is an argument against free banking, which runs in the following terms. It is always to be expected under a multiple banking system that even if the general stability of the whole system is assured, there will be failures of individual banks from time to time, just as there occur bankruptcies among the firms in other industries. The notes of any bank do not stay in the hands of those people who are enabled to borrow from that bank and therefore directly benefit from its note issue. They are paid away into the hands of third parties who have no immediate connection with the bank concerned. Those people who happen to be in possession of the notes of the failed bank at the time of its failure will suffer loss. A large proportion of such notes is likely to be in the hands of those who are either too ignorant, or by reason of their subordinate position, unable, to refuse to accept the notes of a bank which a more informed or better-placed person would reject because of suspicion attaching to the affairs of that bank. In other words, there is placed on the community the burden of discriminating between good and bad notes, and it falls especially hard on those sections of the community who are least able to bear it. It is, therefore, concluded that the Government should intervene and protect the note-holder by introducing some uniformity into the note issue. In the last analysis this is an argument for spreading the risk evenly among all note-holders. Whether or not we accept it is not dependent on economic analysis, and it is a question which we cannot decide on scientific grounds. We can but call attention to the suggestion of the free bankers that the spreading of the risk could only be done at the expense of increasing the losses all round.

The second point and the one to which most attention has usually been devoted is the question of the relative probability of inflations of the currency leading up to the phenomena of crises and depressions. The central banking school supposed that under a free-banking system fluctuations in the volume of money and therefore in economic activity in general would be much more violent than in a system where there was a single note issuer. In a free-banking system competition among the banks would provoke a constant tendency to the lowering of discount rates and increases in the volume of credit. It would be followed eventually by an external drain of gold, but this was a check which operated too late, because by the time the drain began to affect the banks’ reserves the seeds of the depression had already been sown, and the crisis would only be made more intense by the sudden contraction of lending forced on the banks by the urge to protect their reserves.

It was further argued that any tendency to expansion would become cumulative, because it was useless for some banks, who might be more acutely conscious of the difficulties that would arise in the event of an expansion and the resulting pressure on reserves, to hold off from expanding. They could not hope for escape from the strain by pursuing a conservative policy while others were inflating. The reasoning on which this conclusion was based is the following. When the public starts to demand gold for export, they will not select the notes of the guilty banks and present these for payment. They will send in any notes that come into their hands, and the proportions in which the notes of the different banks will be returned will roughly correspond to the proportions the note issues of the individual banks bear to the total circulation. Hence the non-expanding banks have to bear part of the pressure resulting from the expansion of a rival bank. Should a non-expanding bank insist on retaining its former reserve ratio, it will be compelled as a result of the encroachment on its reserves to decrease its lending. If this happens, the expanding bank (or group of banks) can go on expanding and taking business away from its rivals until the latter are finally driven out of business and the former obtains a de facto monopoly. So whether the banks with the more conservative tendencies expanded or not, they could not help losing reserves, and if they did not expand, they would lose business. Consequently, the argument runs, they will, in the interests of self-preservation, be induced to join in the inflation.

The flaw in this argument is its failure to observe that as a result of continuous expansion by one group and continuous contraction by the other the proportion of the gold outflow falling on the expanding group must increase
pari passu, and that the reserves of this group will be exhausted entirely before the conservative group has been driven out of business.

The argument so far considered refers only to the unreliability of a check on inflation by way of the presentation of notes to the banks for redemption by the public. The freebanking party laid particular stress on another check which they contended worked automatically through the reciprocal claims of the banks upon each other’s reserves.
*54 Any bank will continually be receiving payments from customers either in payment of loans or in the form of cash being paid in on deposit. In a system where all banks are competitors for business, one bank will not be prepared to pay out over its own counter the notes of rival banks, but will return them to their issuers through the clearing process. It is therefore to be supposed that if one bank expands out of step with the rest, the clearing balances will go against it and its rivals will draw on its gold reserves to the extent of its adverse balance. This mechanism would work at a much earlier stage than the external drain of gold and would cause the reserves to feel the effects of expansion almost immediately. It is unlikely that all banks will decide in concert to decrease their reserve ratios, and the bigger the conservative group which is not desirous of so doing, the stronger will be the check of these on the expansion of the other group. A bank which contemplates an expansion has got to take into account not only the direct effect on its reserve ratio, which comes about in the first instance when it increases its issue against the same absolute total reserve as before, but also the indirect effect occasioned by the withdrawal of cash to other banks. The size of the addition it can afford to make to its loans on the basis of a given drop in its reserve ratio will be correspondingly reduced, and its action will react partly to the benefit of the other banks who secure an accretion to their reserves. While admitting that circumstances may occur in which the majority of the banks are willing to allow some reduction in their reserve ratios, it is unlikely that they will ever risk fluctuations of dimensions anything like as great as those which are viewed with comparative equanimity by the central bank.

The free bankers therefore submitted that under their system an over-expansion was not only not any more likely, but even much less likely than under a central banking system. In the latter system all notes are issued by a single bank: this bank receives all payments in, in its own notes, and can always pay its own notes out again; it therefore neither gives nor receives claims on specie reserves so far as inter-bank claims are concerned. The only source of claims is the demand for gold by the public. The effect could be seen in the very much longer average period of circulation (less frequent redemption) of notes under a unit system as compared with a multiple system of note issues.

The central banking school alleges that inter-bank control via the clearing mechanism is largely an illusion, and only functions under very special circumstances. If one bank increases its issues by a given proportion, its business will increase in the same proportion, and therefore the larger amount of loan repayments it will have falling due in any week will give it the same number of claims on rival banks as they have on it, so that no differences arise in the clearings and no claims on reserves.

It was consequently denied that, failing recourse to the situation where the notes of any one bank circulate, not over the whole area, but only over a narrowly circumscribed area, in which case notes passing out of their area of issue would be sent in by the
public for collection
*55 — a case which is analogous to that of international exchanges and which raises objections of its own—there is any automatic check on the expansion of note issues in a multiple banking system.

The argument as stated and the illustrations
*56 given in support of it take no account of a lag occurring between the increase in the circulation of the expanding bank (which we will call A) and the increase in its loan repayments. If we assume such a lag which in practice must occur, there will be a drain in the first instance on A’s reserves, though this will only be a temporary efflux, and at a later period, when A’s loan repayments increase, there will be a return of these reserves to A.
*57 It seems, therefore, that whether or not the clearing mechanism will act as a factor tending to check A’s expansion will depend on whether or not A can stand the reduction in its reserves during this interim period.

It is always assumed that in the case of a deposit credit system, the clearing mechanism will function against a bank which expands out of step with others.
*58 The only differences between the two cases would seem to be that the temporary withdrawals in the lag period will be more rapid in the check case than in the note case. All checks which are drawn on the additional deposit credit, as the borrower spends it, will be paid into the banks for clearance immediately, and those drawn in favour of people banking with other banks will give rise to cash claims on the expanding bank.
None of the checks will remain out in circulation;
all will pass through the clearings. In the case of the note issue, on the other hand, only a small part of the issue will come back from circulation to the banks—viz., those notes that come in via loan repayments or in the form of new deposits. Eventually the expanding bank would get back the reserves it previously lost in the deposit case no less than in the note case, but the clearing mechanism exerts a controlling effect because the bank cannot stand a heavy reduction of reserves in the interim period; it cannot wait until their return at a later date.

The difference is a matter of degree rather than of kind. Whether or not the check will operate in the note case will be dependent on the importance of the drain of cash during the lag period. That there must be some lag, whether we take the note case or the deposit case, is indisputable
*59 unless we adopt the unreal assumption that all the additional loans are lent out only “over night.” The existence of the lag presupposes merely that the additional loans do not mature at the next settlement day but only one or more settlements later, or that the shortest period for which the loans may be made cannot make their repayment coincide with the repayment of those old loans which are the next in time to be repaid. It must be supposed that the borrower makes use of the loan proceeds and therefore transfers of funds must have taken place between the time of borrowing and the time of repayment. The borrower must first use the funds to make a purchase and later realise them again by making a sale. The purchases which the new borrowers make will partly provide the funds out of which previous borrowers, whose loans are falling due, make their repayments to the banks. At a later date other borrowers will provide the funds out of which our so-called new borrowers again become liquid and can pay back their loans. The most rapid rate at which such transactions can proceed must allow at least one settlement to take place in which the effect of the increased circulation of the expanding bank becomes apparent in the clearing balances, but has as yet no effect on the volume of loans falling due for repayment.

We can make various assumptions about the term of the old and the new loans. If the term of loans is on the average increased with an increase in their volume, the lag period will be longer than if this is not the case. There seems no reason for assuming that the length of the lag will be any greater under the system of loan by deposit credit than under the system of lending in the form of notes. The only difference is that the size of the temporary drain will be larger in the deposit case than in the note case. Even allowing for the fact that some additional notes will find their way into the banks at an early stage in the form of new deposits by customers as well as by way of current loan repayments, it remains true that this is extremely unlikely to approach anywhere near the extent of the return of checks. It is possible, however, that the drain of cash caused by the reflux of notes to other banks during the lag period may still be sufficient to act as a deterring influence on individual bank expansions. That it can be sufficient would seem to have been borne out in the experiences of such practical examples of competitive note issues as are afforded by the history of the Scotch, Suffolk (Massachusetts) and Canadian systems.
*60 Banks in each of these systems seem to have been definitely conscious of the power of holding other banks in check by the return of notes through the clearings.

What influence will the average period for which bank loans in general are made have on the withdrawals in the lag period? It will affect the
rate of withdrawals. The shorter the average term of all loans outstanding in the banking system the greater will be the withdrawals of cash per week after the expansion, but the shorter will be the lag period, if we assume that the expanding bank has the same average term for its loans as the banking system as a whole. It may be that a sharper pressure on reserves at an early date will act as a more immediate incentive to the expanding bank to hold back, and if this is the case it gives some justification for the principle of ”
bankmässigeDeckung” and automatic reflux of notes on which so much emphasis was laid by the banking and free-banking schools.
*61

Besides questioning the ability of a non-expanding bank to exercise any control over the expanding banks the central banking school has also cast doubt on the realism of the concept of the so-called conservative bank and has submitted that the profit motive may lead all banks to join in an expansion.
*62 The term conservative was intended to imply that the bank for some reason resists the forces causing others to expand credit. If we suppose that there occurs a rise in the demand for capital (a rise in the “natural” rate of interest) it is possible for all banks to get out more credit so long as they keep the market rate of interest at or about its old level, and if the elasticity of demand for credit is greater than unity the gross profits of all banks will be greater if they lend more at the old rates than if they lend the same at a higher rate. If they lend more, of course, they do it at the expense of a reduction in their reserve ratios. If all or a majority of them are unwilling to increase their lending and lower their reserve ratios the market rate of interest will rise towards the “natural” rate, but the fewer are the number of banks who insist on retaining their old reserve ratios the smaller will be the rise in the money rate and the greater the extension in the volume of credit.

A bank which is conservative must be supposed to foresee the events following on the boom, so that it anticipates that the profits it could gain by joining in the boom would be subsequently counterbalanced by the losses of the crisis when credit customers withdraw cash and debtor customers are unable to repay their loans. But it has been suggested that such banks, even though they are fully aware of all the consequences of an expansion, will not have any incentive to hold off from it, because they will find that the profits of the boom more than compensate for the losses of the crisis and depression; and the larger is the number of the banks who want to expand, whether because they do not foresee the crisis and depression or because they compute the gains as greater than the losses, the more unprofitable will it be for any individual bank to stay out, since it has small chance of escaping entirely from the effects of the crisis brought about by the policy of its rivals.
*63 This argument is however still open to the question whether it is likely that the profits would exceed the losses, and therefore whether there would be many banks willing to lower their reserve ratios, if there were no central bank to give external aid during the crisis and the banks were always under the threat of liquidation in the case of a suspension of specie payments. The risk necessary to take in order to make the extra profits in the boom would include the possibility of insolvency.

The third argument, advanced in favour of central banking, is that a central banking institution has by reason of the confidence placed in it by the public the power to mollify the difficulties of a crisis. It was explained that in a crisis the banks in a free-banking system would be under pressure from their creditors for payment in cash and would be compelled, in consideration of the safety of their own reserve position, to contract their lending. All banks would be doing the same and borrowers previously accommodated by them would be forced into liquidation. Many of the banks themselves must fail in the process. No bank would be willing to increase its circulation for fear of getting more notes brought back for gold and there would be no other lending agency to ease the situation. If there is a central bank, on the other hand, such a bank can increase its circulation in the crisis without fearing an internal demand for gold, since people are willing to accept its notes without question. The gaps that would otherwise be left by the commercial banks in the credit structure when the crisis constrains them to draw in their loans, can therefore be filled by the central bank acting as the lender of last resort. It can carry out this function of making the market more liquid either by lending direct to the banks or by lending to those who are called on by the banks for repayment.
*64

When the public withdraws large quantities of cash from the banks the lender of last resort lends to fill the deficiencies. This doctrine is one which establishes the practical rule of banking policy, that in time of a crisis the lender of last resort should lend freely on good security at a high rate of interest. Its action implies technically an increase in the total amount of money, but this is held to be harmless at such times and in no way inflationary, because the additional cash merely goes into hoards and is not used to increase the volume of money coming forward in purchase of goods, and so long as the rate of discount is high the amount borrowed is kept well within these limits, while at the same time deposits are attracted back to the banks. The addition made to cash resources by the central bank in time of crisis allays the tendency to a panic and slows up what would otherwise develop into a chronic process of liquidation.

If crises are bound to occur under either system this becomes, according to the one school, in itself adequate reason for preferring a central banking organisation to a free-banking one. The free-banking school has sometimes opposed to this the counter-argument
*65 that if a central or other institution regularly gives aid whenever the money market is in difficulties, the knowledge that this is continually to be relied upon will become part of the
data anticipated by the commercial banks and will itself be a reason why they will expand their lending operations beyond the limits which would give them the margin of safety consistent with a dependence entirely on their own resources, and if distress support ceased to be given and banks were allowed to crash if they were unable to keep going by self-help, the disorders giving rise to a crisis would in future not occur. This counter-argument is weakened if we have to assume that, given the fact that there will be some banks who expand credit unwisely until their solvency becomes suspect, the non-expanding banks cannot escape entirely from the evil impact of the policy followed by their less cautious rivals, and if anything in the nature of a panic starts it is likely to affect all to such an extent that even the prudent banks may not be able to keep above water since no bank can be 100 percent liquid. Unless it can be proved that free banking would entirely eliminate the trade cycle and general runs on the banks, the argument for the lender of last resort remains a very powerful argument in defence of central banking.
*66

Before proceeding to the fourth and fifth arguments in favour of central banking, we may digress here to consider what was the relation of the arguments we have already discussed to two subsidiary problems: the prohibition of small notes and the justification of the exclusion of deposit banking from the strictures applied to the note issue.

The arguments we have so. far examined in connection with the note issue in general were held to apply a
fortiori to the case of notes of low denomination. Small notes were, in the first place, particularly liable to come into the hands of the poorer and more ignorant classes who were most unable to discriminate between the issuers. In the second place they tend to return less frequently to the banks and so are not often put to the test of convertibility, whereas the larger notes not only come back for change but are also mainly in the hands of those who make and receive large payments and are most likely to use them in transactions with the banks. Again, while in normal times small notes are seldom converted, they become particularly dangerous at the least sign of alarm, because it is the poorer and more uneducated people who are the first to “panic.”
*67 We notice that even Wagner, who was in favour of keeping restrictions at a minimum, thought that the prohibition of small notes might be wise in a free-banking system.

Most of the supporters of restrictions on freedom to issue notes conceded that the same strictures did not need to be applied to deposit banking, and many of them fought enthusiastically for freedom in this sphere.

Various reasons were offered at different stages in the development of currency and credit doctrine as to why deposit banking came into another category than that of the issue of notes. The distinction was first supported on the grounds that notes were money and deposits subject to check were not, and therefore they did not have the same effect on prices. Other writers based it on the less fallacious reasoning that the public had less choice in accepting notes than in accepting checks. Later, it was attributed to the circumstance that the creation of deposits is more subject than that of bank-notes to the redemption check via interbank clearings. Finally, it has been justified by reference to the proposition that the control over the creation of bank-notes gives the central bank indirect control over the amount of deposits as well, since central bank money constitutes the cash reserves of the deposit banks.

Two subsidiary arguments in favour of central banks have become prominent, especially in post-war years. The first of these claims that we must have some central monetary authority in order that we may pursue what is called a `�rational� monetary policy.

The policy of the central bank is no longer conceived to be automatic in the manner envisaged by the founders of the currency school. The volume of circulating media does not change in response to specie movements. These may be ignored or offset as the central bank management thinks fit. With the aid of discount rate and open market operations it adopts an active policy of increasing or decreasing the cash reserves of the money market and the total volume of credit. We retain in this country merely a semblance of the principle underlying the Act of 1844. If the deposits the Bank creates cause, in the course of time, a demand for notes which it cannot supply under the fixed fiduciary issue, it can rely on a suspension of Peel’s Act; if they cause an increase in foreign claims and a drain of its gold reserves, it can go off the gold standard.

Out of the realisation of the central bank’s power to determine the volume of credit there arose the notion that it should consciously direct monetary policy along “scientific lines.” The question then arises: What is to be the criterion of this “scientific” management? The criterion which has so far usually been adopted, namely, that of the stability of the general price level, has been suspect in theory and just as unfortunate in practice. Although the contributions of Mises, Hayek, Keynes, Myrdahl
*68 and others have gone far to elucidate the forces at work, we have yet to wait for the formulation of some other criterion in clearly delineated enough terms to allow of its adoption as a rule of monetary policy. Meanwhile, it is the efficacy of central bank control rather than the objective so far followed that is most called into question by monetary reformer, and consequently the demand is raised for the concentration of still more control in the hands of the central monetary authority by extending its direct control to deposits as well as the note issue.

The other argument is of a similar nature. It looks on the central bank as an essential instrument for securing international co-operation in monetary policy. In the past, at least, this has usually meant arriving at understandings in the field of discount policy to obviate the necessity of a deflation in a country which, under the rules of the gold standard, should undergo a decrease in its money incomes. As such it is regarded as an essential link in price stabilisation policy. Thus Mr. Hawtrey
*69 conceives of it as a means of surmounting the difficulties raised by the circumstance that stable exchange rates between countries may not always be compatible with a stable price level within each separate country. If the level in one country A is to be kept stable, it may be necessary to have a rise in country B, or, alternatively, if B’s price level is to be kept stable, there may have to be a fall in country A. He looks to arrangements between central banks to determine how “these departures from the norm” can best be distributed between the countries concerned.

The securing of international co-operation was hinted at as being the most important modern function of central banks both at the Brussels Conference in 1920.
*70 and at the Genoa Conference in 1922.
*71 Central bank leaders see it in the same strong light, and we find Mr. Montagu Norman describing his efforts to bring about co-operation among the central banks of the world as one of his two main tasks during recent years.
*72 That his efforts did not go unrecognised is evidenced by the widespread opinion that the forcing down of discount rates by the Federal Reserve in the latter half of 1927 took place under persuasion from representatives of other central banks.
*73 But more impressive results are evidently envisaged by those who deplore the fact that co-operation has not yet succeeded in going much beyond “an
ad hoc agreement that certain steps may be taken about rates.”
*74 If it were really true that central bank co-operation is directed towards the observation of the rules of the “gold standard game,” as some of its disciples pretend,
*75 there would, even if there were nothing to be said in its favour, be at least nothing to be said against it. In effect, however, the theory underlying it amounts to a complete negation of the principles under which the international gold standard works.

Less objectionable would seem to be that aspect of international co-operation which has had a long history of practical application and which is an extension of the concept of the “lender of last resort” to the international sphere. Where the banking system of any country is faced by a run of foreign depositors, the assistance which can be rendered by the central bank of that country to the deposit banks may not be able to go very far on the basis of its own gold reserves, and it has not infrequently happened in the past that a foreign central bank or group of foreign banks has lent funds to the central bank in difficulties. Mr. Hawtrey looks forward to the time when this function of the international lender of last resort will be assumed by the Bank for International Settlements.
*76

The two arguments last mentioned have become in our time the almost exclusively motivating reasons for the foundations of new central banks. A clear example of this is to be found in the recommendations of the recent Royal Commission on Banking and Currency in Canada.
*77 They are characteristic of the change that has taken place in the theory of central banking. The classical theory of central banking was that it should make monetary movements as far as possible automatic. The modern theory is to substitute “intelligent planning” for automatic rules. To those who would prefer to place their trust in semi-automatic forces rather than in the wits of central bank managers and their advisers, free banking would appear to be by far the lesser evil. Banks which have not the possibility of abrogating their liability to pay their obligations in gold cannot go very far wide of the path following movements in their gold reserves.

Any attempt to make a final evaluation of the relative merits of alternative systems of banking must look primarily to the tendencies they manifest towards instability, or more particularly to the amount of causal influence they exert in cyclical fluctuations. Most modern theories of the trade cycle seek the originating force of booms and depressions in credit expansions and contractions with the banks as the engineering agencies. A more comprehensive view considers that these movements are not features exclusively of the banking system, but that, while liable to be aggravated by the banking system, they will occur under any monetary system.

It was apparently assumed by writers of the currency school
*78 that with a purely metallic currency, and therefore with a strict operation of the currency principle, there would be no disequilibrating monetary factors. In this connection there was some valid point in the classical theory of the hoards. The banking school held that even in a purely metallic currency where there is no creation of bank credit, the effective circulation will still vary with the movements of money in and out of what they called the hoards.
*79 Modern theory essentially generalises this concept to cover all changes in the rate of spending cash balances in general, and comes to the conclusion that it is possible that these fluctuations in the effective circulation which come about as the result of spontaneous action on the part of the public may be sufficient to generate cyclical fluctuations in business activity without the guilt of the banks.

It is difficult to judge how great would be these primary changes in the public’s demand for cash: the movements which have recently made such a marked impression on the financial structure have arisen largely as secondary movements consequent on prior disturbances in the banking system. They were caused either directly or indirectly by credit expansions and contractions. The non-existence of a banking system would eliminate the very large element caused by panic hoarding, but there would remain such factors as integrations and disintegrations in industry, changes in population, alterations in the attitude of the public towards different risk distributions of their assets. If these “natural” accelerations and decelerations in the turnover of balances are likely to reach appreciable dimensions, then it may become part of the object and usefulness of banking to counteract them, and a fiduciary issue (whether in the form of uncovered notes or of check deposits) may, we find, be a necessity, if monetary factors are to be kept neutral.

How to discover a banking system which will not be the cause of catastrophic disturbances, which is least likely itself to introduce oscillations and most likely to make the correct adjustments to counteract changes from the side of the public, is the most acute unsettled economic problem of our day.

There is not much doubt that the present banking system is actively responsible for disturbances. The more difficult task is to determine out of what particular features of the system they arise. But it seems to be an indisputable fact that the major fluctuations come from changes in the amount of cash provided by the central banks. We find that the commercial banks keep relatively stable reserve proportions and that their lending activities follow fairly closely (except in the pit of the depression) movements in central bank money.
*80 These movements are, of course, magnified by the coefficient of expansion, say, ten times, but central bank policy is always conducted with the knowledge of this fact in mind. It is propositions of this kind which seem to lend support to the theory, most recently put forward by Mises,
*81 that fluctuations, while not being entirely eliminated, would be much reduced under free banking. And it is undoubtedly true that such a system is much less capable of monetary manipulation than a system of central control.

But whatever may be our verdict as to the comparative outcome of the two systems in terms of stability it is unlikely that the choice can ever again become a practical one. To the vast majority of people government interference in matters of banking has become so much an integral part of the accepted institutions that to suggest its abandonment is to invite ridicule. One result of this attitude is that insolvency in the sphere of banking has won exception from the rule applied in other lines of business that it must be paid for by liquidation, and it is important also to point out that since the laws of bankruptcy have almost never been strictly applied to banking we should be diffident of drawing the conclusion that actual experiences prove the unworkability of free competition in banking.

Such pleas as are occasionally made in our day for free trade in banking come from sources which do not commend them. They are the product of theories of “money magic.” Their demand for free banking is based on the notion that it would provide practically unlimited supplies of credit and they ascribe all industrial and social evils to deficiencies of banking caused by bank monopoly.
*82 As a matter of practical policy the tendencies are all in the direction of increased centralisation. When the choice was made in the nineteenth century in favour of controlling the note issue, deposit banking was for various reasons left “free.” At the present time there are signs of an approaching extension of the control to deposits. This would secure the final concentration of monetary power in the hands of the central authority and would be the consistent outcome of central bank philosophy and the currency doctrine. There are already strong movements in this direction in both Germany and the United States. In the United States it is as yet only a plan,
*83 in Germany it is an accomplished fact.