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.
In the present century centralised banking systems have come to be regarded as the usual concomitant, if not one of the conditions of the attainment of an advanced stage of economic development. The belief in the desirability of central bank organisation is universal. Recently also there have been attempts to widen the unit of control in the movement towards international banking institutions and international co-operation between the already existing central banks of the separate countries. There is, however, a noticeable lack of any systematic examination of the bases of the alleged superiority of centralised banking over its alternative.
Practically all the discussion on the relative merits of a centralised monopolistic banking system and a system of competitive banks all possessing equal rights to trade, took place in a period of some forty to fifty years in the nineteenth century, since when it has never been reopened. In that period, however, the subject was one of the most keenly debated of its time. This is especially true of France, and indeed the period of about twenty years during which French thinkers occupied themselves with this problem is perhaps the most productive of any in French economic literature, both from the point of view of Output and from the standpoint of its quality in comparison with that of other countries in the same years.
In the twentieth century most countries have finally decided in favour of a central banking system, but in the nineteenth century (at least up to 1875), again, most especially on the Continent and in the United States—in England the system as it stood after the passage of the Bank Act of 1844 was not seriously challenged after that date—it was still a matter of dispute as to what sort of form the banking system should take. It is notable that when
laisser-faire theories and politics were at their height so far as other industries were concerned, banking was already regarded as in another category. Even the most doctrinaire free-traders, with the possible exception of Courcelle-Seneuil in France, were unwilling to apply their principles to the business of banking. It was widely contended that banking must be the subject of some special regulations, although what precise form these regulations should take remained an open question for several decades.
Very little attention has been paid in modern economic literature to the consideration of the rationale of the particular system of banking that we have succeeded in evolving, in the light of the progress that has been made in economic science since the time when the problem was in the forefront of discussion.
*3 The actual discussion which did take place is, moreover, one of the controversies among our forefathers with which this generation, more especially in England, is surprisingly unfamiliar. Neither do we find that the authorities responsible for introducing central banks into countries previously without them have any clear idea of the benefits to be obtained therefrom.
It is the purpose of this essay to investigate the motives that have in the past led to the establishment of central banks and to discover the theoretical foundations underlying such motives. An examination of the reasons for the eventual decision in favour of a central banking as opposed to a free banking system reveals in most countries a combination of political motives and historical accident which played a much more important part than any well-considered economic principle.
The exact significance to be attached to the terms “free banking” and “central banking” will become clear in the course of the argument, but for the present we shall summarise the problem in the following questions: Is it preferable that the note issue should be in the hands of one single bank, or at any rate a definitely limited number of banks specially authorised to undertake it, and among which one bank holds a position of sufficient predominance over the rest as to be able to exercise some control over them,
or is it preferable that there should be as many banks of issue as find it profitable to enter the note-issuing business? Further, if this latter alternative is affirmed and plurality is allowed, is it necessary to impose special requirements, such as a prior lien on assets or the deposit of bonds, to protect note-holders from the consequences of bank failures? Secondly, even if the issue of notes is restricted to a single bank, should there not be freedom for the foundation of banks of deposit exercising no rights of issue? The question may be put still more generally: Is it necessary in the interests of sound banking and a stable currency to impose special restrictions, other than those imposed on all business corporations under the company law, firstly, on banks issuing notes, and, secondly, even providing the answer to this is in the affirmative, on banks of deposit which issue no notes?
This was the historical approach to the question as it presented itself to the writers of last century. The place of primary importance was given to the first problem of the note issue, and it is to this that we shall devote most attention. Our plan will be first to sketch the decisive events, relevant to our main topic, in the history of banking and credit in the leading countries, and then to examine the arguments of both sides in the theoretical controversy.
So far as English banking is concerned, the broad outlines were quite clearly drawn at a comparatively early date, and the system, once established, was never very seriously threatened. Scotland is of particular interest, because the Scotch system was quoted by practically every member of the free-banking school as the conclusive example of the remarkably successful functioning of the system they advocated. The United States of America were likewise cited by the protagonists of the central banking school as the clearest
disproof of the practicability of any such system. France was rather later than England in finally and irrevocably adopting a centralised banking system. Germany went through a series of moves and countermoves before at last deciding in favour of the same plan in 1875, but here it rather distorts the discussion to consider Germany as a whole, and it is more appropriate to consider the separate States, since Germany did not form a unit till 1871. The theoretical discussion of the subject was practically closed by 1875, by which time the question of the standard had come to assume a far greater importance, but in America several points of interest were raised some years later in the debates preliminary to the establishment of the Federal Reserve System.
In our study of the chronological development of the banking systems of England, Scotland, France, the United States and Germany, our main emphasis will be concentrated on those facts, firstly, which mark the choice at various stages between monopoly and Competition, and, secondly, which refer to other aspects of Government management and interference in banking in general.
The chief interest of any theoretical treatment of the place of the banking system in the general economy lies in the part it may be assumed to play in the causation of the phenomena of booms and depressions. We shall have occasion to consider some of the theories of trade cycle causation evolved by the disputants in the Free Banking
versus Central Banking controversy. Both sides produced evidence to show that financial and industrial crises were not the fault of the particular system they advocated. The most satisfactory theory yet offered in explanation of booms and depressions, however, is one which at that time was undeveloped and which finds the perpetually disequilibrating force in monetary disturbances expressing themselves in a divergence between the “natural” and market rates of interest and between voluntary savings and real investment. This divergence is in some way connected with bank policy, and the question then arises: How can banks continually act as disequilibrating forces? It might be supposed that if banks made mistakes as a result of which they sooner or later found themselves in difficulties, they would in future act differently on the basis of their revised estimates of their opportunities. Such we should expect to be the consequences, provided the banks had to submit to the full effects of their acts. One of the questions which must be put is whether this responsibility condition is not too often shelved by certain features of the particular system of banking organisation which has been favoured by the modern world. While recognising that the maladjustments may be due, not to the specific form of the banking system, but rather to at present unresolved technical difficulties, common to any system, in maintaining equilibrium between savings and investment, or in stabilising the effective quantity of circulating media, it seems not improbable that the tendencies to misdirection are magnified by the form of the system, in particular that part of it which entrusts the determination of the volume of credit to a single authority, between which and the Government there exist reciprocal incentives to paternalism. It is not unlikely that the bolstering up of banking systems by their Governments is a factor which makes for instability.