Money demand and free banking
by Ingolf Eide
Although it’s unlikely to excite anyone outside the tiny fraternity of monetary “trainspotters”, I can’t not mention Detlev Schlichter’s latest piece at The Cobden Centre. It’s a sweetly crafted (and much needed) response to various lines of argument run by some free bankers.
Put simply, free banking means letting banks run under the same laws as any other business, without special benefits or constraints. No central bank, no lender of last resort, no official deposit insurance, no bank regulators, in fact no government involvement in money or banking whatsoever. Radical, for sure, particularly after a century of central banks, fiat currencies, escalating crises and (lately) visceral disdain for bankers. Mainstream economists, if they think about the idea at all, are appalled at the very notion. It’s definitely the 100 to 1 nag in the banking stakes.
Free bankers believe that under such conditions the market would choose some form of “inelastic, inflexible, apolitical money as the basis of the financial system.” Usually that means gold. They also believe competitive pressures, together with the sobering discipline of operating without a safety net, would produce a surprisingly conservative result. It’s far from an unfounded belief; there’s quite a bit of supportive historical evidence from various countries and times.
Like me, Schlichter sees free banking as the best alternative in this imperfect world, not only in terms of banking but also in the flow on effects to everything else. So his argument isn’t with the principle but with certain claims about its operations and their supposed benefits:
The free bankers are correct to point to real-life frictions in the process of satisfying a changed money demand via an adjustment of nominal prices. The process is neither smooth nor instant, but then almost no market process is in reality. Their explanation that a rise in money demand will lead to a drop in money velocity and that this will, on the margin and under normal conditions, encourage additional FRB [fractional reserve banking]and thus an expansion of bank-produced money also strikes me as correct. Yet, the free bankers fail, in my view, to show convincingly why this process would be faster and smoother than the adjustment of nominal prices, and in particular, why the extra bank credit that also comes into existence through FRB would not generate the problems that the Austrian School under Mises has explained extensively.
For anyone still interested (hello . . . hello??), read on here.
P.S. Cross posted at my other site, Conversations at Stanley Park.