Fed officials, however, lacking feedback from an unhampered market, cannot know the right quantity of money to supply or the right level of interest rates to try to achieve, no matter how conscientious they might be. Furthermore, the Fed’s legal authority to control the lifeblood of the economy, money, gives special interest groups, including notably Congress and the President, a strong, unhealthy incentive to try to capture the money-creation process, pressuring the Fed to act in their particular interest at the expense of others. Almost always this pressure is to produce more money in order to keep interest rates artificially low.
In a truly free market there could be no over-issuance of money (for more than short periods), no artificially low interest rates, and hence no booms driven by artificially created credit. Let us see why.
In a free market, there would be no government-created central bank. Instead, entirely private banks would be free to issue their own distinctive currencies (hand-to-hand folding money) just as they issue their own distinctive checking-account money today. (Probably not all banks would choose to issue their own paper notes, and possibly the public would choose to accept and use only a few major brands.) All would be denominated in dollars, because dollars are familiar. Very important, all money would be redeemable in—“backed by”—the base money, some commodity, presumably gold or silver. Paper dollars, redeemable in something of independent value, is distinguished from fiat money, money by government decree, or “by fiat.” (In our time, lamentably, all the world’s monies are fiat currencies.)
In such a “free banking” system, as we’ll describe below, the public’s willingness to accept and hold onto money in their wallets and checking accounts would determine the amount of money in circulation. Banks would get prompt and clear profit-and-loss guidance from the market as to how much money they should issue. Their contractual obligation to redeem their notes and checks in gold or silver (or whatever other commodity might emerge as the base money) would prevent them from issuing more than the “right” amount.
The next two sections investigate how free market forces would tend to produce the right amount of money, and how central banking with fiat money tends to produce the wrong amount. The discussion is necessarily somewhat technical, but I hope, dear reader, that you will stick with me through it, because the way freedom works in banking is such a beautiful case of spontaneous order, and because getting the money supply right is so important to our standard of living.
The Right Amount of Money
There is, in principle, a right amount of money. That is the amount the public wishes to hold at the going price level. When the amount of money in the system is exactly that amount, the system is in the ideal condition we call “monetary equilibrium.”
A word on what is meant by the amount of money people wish to hold: Of course we all would like our incomes to be as large as possible, but we don’t hold onto all of our income, nor keep all of our wealth in money. Most of our incomes we spend promptly on food, rent or the mortgage, electricity, transportation, communication, and other necessities. When we make these payments, the money becomes income for the grocery store, electric company, and other businesses; and these businesses in turn spend the money promptly on their employees’ wages and salaries, inventory, supplies, equipment, maintenance, and other expenses.
Though each person or company spends the majority of her income pretty much as soon as she receives it, each of us also holds a certain amount of money in cash, checking, or savings accounts so that we have buying power immediately available when some need or opportunity arises. Different people and businesses choose to hold different amounts of money depending on their particular situations; but each has some approximate quantity that he or she would like to have on hand. (Of course the actual amount typically varies over payment cycles, from larger right after payday to smaller right before payday.)
When we find ourselves holding more money than we wish to—imagine a lovely fat balance in your checking account, perhaps due to unexpected income or lower-than-expected costs—we spend or invest the extra—we don’t want that much on hand. When we find ourselves holding less money than we’d like, we build the amount back up by cutting back on our expenditures or cashing in an investment.
At any point, as myriad payments are made among all the different individuals and businesses in the economy, all the money in the system is held, at every moment, by someone. The right quantity of money for the banking system to supply, in cash and checkable deposits, is the total amount of money that all the different individuals and enterprises wish to hold at that time, prices being what they are. The reason prices matter is that ultimately people want to hold a certain amount of buying power, and at higher prices a given quantity of money has less buying power. Again, we call this match-up condition “monetary equilibrium.”
It is important to the health of any economy that monetary equilibrium be maintained as closely as possible. The reason is that when the banking system chronically supplies more or less money than the public wants to hold (at prevailing prices), inflation or deflation respectively result. Either one, when it results from the wrong supply of money, causes a host of problems. Most important, inflation and deflation hamper the ability of prices to do their crucial job of coordination, in accordance with the Price Coordination Principle discussed in Chapter 1. When price changes are caused by decisions of entrepreneurs and consumers that reflect their changing local knowledge—as when, for example, computer makers lower computer prices to reflect extraordinary advances in building computers at lower costs—these price changes help coordinate the actions of all. When price changes are caused by artificial increases or decreases in the money supply, however, they send false signals and impede coordination.
To illustrate, suppose you are a business owner with rising profits: The price buyers are willing to pay for your product is rising while your labor costs and materials prices stay constant. What is that profit signal telling you? Does it mean the public’s demand for your product has increased? If so, if these prices are “telling the truth,” then you could profitably invest in new equipment, hire more people, and expand your operations. But if the higher price of your product is just the consequence of inflation spreading through the economy—inflation that will soon push up your workers’ pay rates and materials prices and eliminate the profits you are temporarily enjoying—then expansion would be a waste of valuable resources. The increasing price of your product would have fooled you into making an investment that can’t pay off; you’ll just have to lay off the new hires and sell the new equipment, if you can, once prices start to “tell the truth” again.
Another bad consequence of having more money created than the public wishes to hold (we’re coming up on the explanation of why this can be done for an appreciable time by a central bank but not by banks in a free market for banking) is that creation of excess money lowers artificially that all-important price: the interest rate. In a market free of government
How Inflation or Deflation Result from Too Much, or Too Little, Money
The inflation process goes like this: When the banking system has provided more money than people want to hold in total, some people find themselves holding more money than they want, so they spend it away on goods, services, or investments. But each expenditure one person makes becomes another person's income; they can't all spend down their excess money holdings at the same time. The extra spending they are all doing pushes up prices, as their excess money holdings make each one willing to pay a little more.
The consequence is a general increase in prices, or, to put it another way, a general decrease in the purchasing power of money. The process will continue until the purchasing power of people's money holdings has decreased to the point where the amount of money they hold is no longer excessive to them—what used to be an excessive amount (when it could buy more) is now just enough to provide the purchasing power they want (because now it buys less).
For deflation, the p
rocess works in the other direction. People who find themselves with less cash on hand (less purchasing power) than they would like stop spending as much as they normally would, in order to rebuild their money holdings. They can't all do so at the same time, because one person's decision not to make a purchase reduces the income another person earns from selling. Sellers reduce prices in order to attract more purchasers, and the purchasing power of money thereby rises.
interventions in money, a falling interest rate results either from more provision of loanable funds (representing investable resources) by saver/lenders, or less desire for loanable funds (representing investable resources) on the part of borrower/spenders. Either way, a decreasing interest rate tells borrower/spenders that investable resources are relatively abundant, so they may borrow more freely and undertake projects that create a bit less value for customers or take longer to complete.
But when a central bank such as the Fed creates new money, that money does not represent any new savings (no additional investable resources have been made available), so the lower interest rate tells a lie about the amount of investable resources available. It misleads borrower/spenders into thinking that investable resources are more abundant than they actually are. Hence borrower/spenders over-invest, putting resources into time-consuming projects that cannot be completed with the resources available. That is what investors did with housing during the boom. That’s what made it a boom.
To repeat the point of this discussion, maintaining monetary equilibrium is one of the most important things the banking system can do.
A main reason we need to free our market for money is that a free market would naturally tend to maintain monetary equilibrium—keep the quantity of money that banks supply equal to the quantity of money the public wishes to hold—as profit and loss guide banks’ decisions in a spontaneous order. By contrast, in a system of government intervention via central banking, officials tasked with central planning of the money supply cannot possibly know the right amount of money to supply, as we shall see. In the absence of freedom and competition, they lack the profit-and-loss feedback that would help them discover what that amount is, in accordance with the Profit-and-Loss Guidance Principle discussed in Chapter 2.
Free Market Forces Get the Money Supply (Just About) Right
Here we describe how, if we were to free our markets for money and banking, a truly free market would regulate the supply of money and dependably get it very nearly right (just as it gets the supply of pencils very nearly right). The general topic of “free banking” is rich and fascinating in its theory and history. We have space here only to lay out the main elements and processes (readers can pursue the topic by following the references in the chapter notes).
In a truly free market, what is used as money would emerge from the choices of people in the economy. (Of course. That’s what freedom means.) Historically, as civilization deepened and commerce spread, precious metals emerged as the preferred monies, and for most of history most money was either the precious metals themselves, e.g. gold and silver coins, or paper promises to pay the bearer in gold and silver. That is, paper money was redeemable in the underlying commodity (called “base money”). This redeemability of paper money is an essential characteristic of a free market monetary system. Free to choose, the vast majority of people will always insist that their paper money be backed by—exchangeable for—something of independent value. Only within the last century, and only by governmental command, has unbacked paper money—“fiat money”—come to dominate the world economy.
In a truly free market, there would be neither a central bank nor any government role in banking beyond government’s standard task of securing rights by preventing theft and fraud. Anyone would be free (to try) to establish a bank and issue paper money, redeemable in gold or silver, of course. To stay in business and grow its business, a bank would have to earn enough trust so that the public would accept its paper money.
Just as they do today, banks would offer money in the form of checking accounts using that bank’s own checks, printed with its name and logo. In exactly the same way, banks would also offer paper money—their own particular banknotes printed with that bank’s name and logo.
Just as all banks today denominate their checking account money in the unit of account familiar to the people of their own regions (e.g. dollars in the U.S., pounds in England, and yen in Japan), free banks would denominate their notes in the same familiar units of account. The key difference from today’s fiat money system is that “dollar,” “pound,” and “yen” would each mean—would be defined as—some particular weight of gold or silver.
As strange as individual banks’ issuing their own notes may sound, it has been common in other times and is still common in other places. When I went to study in Scotland in 1978, I was surprised to find four different kinds of notes circulating: those of the Bank of Scotland, the Royal Bank of Scotland, the Clydesdale Bank, and the Bank of England. All were denominated in pounds, and all businesses accepted them all. (Of course they weren’t redeemable except in other notes also denominated in pounds; sad to say, it is now many years since a British pound note was redeemable in a pound of sterling silver.)
Scotland is also the country that had the longest episode of fairly free banking (to this point in history at least; let us hope for the future). From 1792 to 1847, banking in Scotland was largely free. While it had problems, it had far fewer problems than the neighboring English system, which had a whole variety of restrictions as to who could open banks, where, and so forth. Importantly, only Bank of England notes were allowed to be used in London, the country’s financial center.
In a truly free market, governments would not restrict how much money any bank issues, whether as checking deposits or banknotes. This freedom from government restriction does not mean that banks could legally get away with issuing too much money, however. On the contrary, the banks’ promises to redeem their notes and checks in gold (or silver or whatever other base money were to evolve)—and their court-enforceable legal obligation to keep that promise—would regulate the amount of money any bank dared to issue. That is, market forces would regulate the money supply.
In free banking, competition would (and historically did) force banks to accept routinely the notes and checks of other banks. The reason is that banks must offer their customers convenience. A businessperson who is paid for her goods or services in the notes and checks of various banks wants to be able to deposit all those notes and checks in one stop at her own bank. All banks simply have to provide such a service to attract depositors. Here again, market forces regulate bank behavior for public convenience.
Having accepted the notes and checks of other banks, all banks would wish promptly to return those other banks’ notes and checks for redemption in gold or silver (or whatever is the base money). It would be time-consuming and wasteful for each bank to return notes and checks to every other bank individually. Instead, the banks in a region save expense by establishing a central clearinghouse to which they all send one another’s notes and checks for consolidation and return to one another.
Furthermore, because so many of the payment obligations from bank to bank cancel one another, it makes sense to have the clearinghouse determine the net obligations among the different banks. For example, if in a given day Bank A receives from its customers $50,000 worth of the notes and checks of Bank B, and Bank B receives from its customers $50,000 worth of the notes and checks of Bank A, then the quantities cancel entirely—they clear with no adjustment needed—and no gold or silver need change hands to settle the obligations.
More normally there will be some net obligation to settle. For example, if Bank A receives $40,000 of Bank B’s notes and checks while Bank B receives $50,000 of Bank A’s notes and checks, then at the end of the day Bank A owes Bank B $10,000. When notified of this debt by the clearinghouse, Bank A could pay by taking $10,000 in gold out of the reserves it keeps in its vaults and truck it across town to Bank
B, but banks found it much less costly instead to keep a quantity of reserves of gold (or silver) on deposit at the clearinghouse itself and let the clearinghouse make the transaction. It might literally move $10,000 in gold coins from Bank A’s drawer to Bank B’s drawer, but more likely it would keep all the different banks’ gold coins together in its vault, and move the $10,000 from Bank A’s account to Bank B’s account on its books.
In this way, all the banks of a particular clearinghouse association would settle their varying daily claims on one another at the clearinghouse. On some days, a given bank would see its reserves of gold or silver coins increase as it receives and sends to the clearinghouse a greater dollar amount of other banks’ notes and checks than they return to the clearinghouse of its own. This we call “positive net clearings.” On other days, its net clearings would be negative and the bank would see its reserves decrease. Some days its net clearings would be large, other days small.
Notice that in the kind of mature free banking system we are describing here, gold or silver coins are hardly ever used day to day by the public; paper money and checkable deposits (and subsidiary coins for small transactions) are used instead. Precious metal coins come to be almost exclusively the reserves banks use to settle their mutual claims on one another at the clearinghouse.
With this quick overview of free banking as background, we can now describe the marvelous spontaneous order by which free banking regulates the quantity of money supplied by banks, keeping it very nearly the same as the quantity the public wishes to hold, and thereby staying close to the ideal of monetary equilibrium.
The key incentive that tends to keeps the money supply “right” is each bank’s desire to maintain reserves large enough to cover its redemption obligations at the clearinghouse (or, rarely, at the teller window), but no larger. On the one hand, banks have a strong incentive to keep on deposit at the clearinghouse and in their vaults enough gold (or whatever is the base money) to cover any net obligations to other banks they may have at the end of any day. This coin (also called “specie”) is the banks’ “reserves.” In free banking there would be no legislated reserve requirement; rather, banks would learn from experience how large their largest negative net clearings tend to be in usual periods and in extreme cases, and therefore how much they need to keep in reserve to cover days of unusually large drains on their reserves. Banks want to avoid the embarrassment and damaged reputation that would come from being unable to pay as they promise, and/or the expense of having to borrow reserves at short notice from a competitor.
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