Foldvary, Fred

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San Jose State University SJSU ScholarWorks Faculty Publications Economics April 2011 Central Banking Beats Free Banking? It Just Ain’t So! Fred Foldvary Santa Clara University Follow this and additional works at: https://scholarworks.sjsu.edu/econ_pub  Part of the Macroeconomics Commons Recommended Citation Fred Foldvary. "Central Banking Beats Free Banking? It Just Ain’t So!" The Freeman (2011): 6-7. This Article is brought to you for free and open access by the Economics at SJSU ScholarWorks. It has been accepted for inclusion in Faculty Publications by an authorized administrator of SJSU ScholarWorks. For more information, please contact scholarworks@sjsu.edu. In “More Bits on Whether We Need a Fed,” aNovember 21 Marginal Revolution blog post(www.tinyurl.com/3y2gsbx), George Mason Uni-versity economics professor Tyler Cowen questions“why free banking would offer an advantage over post-WWII central banking (combined with FDIC andpaper money).” He adds, “That’s long been the weakspot of the anti-Fed case.”Free banking is better than central banking becauseonly in a free market can the optimal prices and quan-tities of goods be determined. Thosegoods include the money supply, andprices include the rate of interest.There is no scientific way to knowin advance the right price of goods.With ever-changing populations,technology, and preferences, marketsare turbulent, and fluctuating humandesires and costs cannot be accuratelypredicted.The quantity of money in theeconomy is like that of other goods.The optimal amount can only be dis-covered by the dynamics of supply and demand. Theimpact of money on prices depends not just on theamount of money but also on its velocity—that is, howfast the money turns over.The Fed cannot control thissince it cannot control the amount people want tohold, or the demand.Also, even if the Fed could deter-mine the best amount of money for today, the impactof its moves take months to play out, so the centralbankers would need to be able to accurately predict thestate of the economy months into the future.The Fed also fails because of political pressure.Although the Fed is supposed to be independent, inpractice, when the economy is depressed, there is strongpolitical pressure to “do something,” specifically to “stim-ulate” by expanding the money supply. Since Congresscreated the Fed and can alter it, it is impossible for theFed to be purely independent of politics.The Federal Reserve was set up to provide pricestability, yet the United States suffered high inflationduring the 1970s and continuous inflation since WorldWar II.The Fed was also supposed to provide economicstability, but since World War II there have been severe recessions in 1973, 1980, 1990, and2007–2009.The Fed was supposed toensure stability in the financial system,but it failed to prevent the Crash of2008 and the Great Recession thatfollowed. But the challenge is toexplain why free banking would bebetter.Suppose gold once again became aglobal currency. It would be the realmoney, and the U.S. dollar would bedefined as a particular weight of gold.A $20 gold coin had about an ounceof gold before 1933.Under free banking most transactions would notoccur with gold, but rather with more convenientmoney substitutes. Banks would issue paper bank notesinscribed with their bank names.Anyone holding banknotes could exchange them for gold. For example, if$1,000 was equivalent to an ounce of gold, then anyonecould go to a bank and convert $1,000 in paper bills toone ounce of gold coins. Likewise one could withdraw$1,000 of deposits in gold coins.Central Banking Beats Free Banking?It Just Ain’t So!6T H E  F R E E M A N :  w w w. t h e f r e e m a n o n l i n e . o r gB Y  F R E D  F O L D VA R YFred Foldvary (fred@foldvary.net) is a lecturer in economics at Santa ClaraUniversity.The optimal quantityof money in theeconomy, like anyother good, can onlybe discovered bymarkets, notpredicted by the Fed.7 A P R I L  2 0 1 1Competition among banks, as well as convertibilityinto gold, would result in price stability, since the bankswould only be able to issue as many bank notes as thepublic was willing to hold. If there were more banknotes than that, they would come back to the bank tobe exchanged for gold. But the money supply wouldalso be flexible, since if there were a greater demand tohold money, the amount of bank notes or bank depositswould increase.The Structure of Capital GoodsFree banking mitigates the boom-bust cycle.There isa structure to capital goods similarto a stack of pancakes. At the bottomof the stack are rapidly circulatingcapital goods such as inventory closeto the consumer-goods level. As wego up the stack, the capital goods turnover more slowly.At the top are long-duration investments such as real-estate development. Goods becomemore sensitive to interest rates as youmove up the stack. Lower interestrates make the stack steeper, as there is more investment in long-terminvestments.In a free market the “natural rate”of interest depends on the preferencefor goods sooner rather than later,or “time preference.” Interest is the premium paid toshift purchases from the future, for which one wouldhave to save enough to pay cash, to the present day byborrowing.The Fed lowers the rate of interest by creating fiatmoney out of nothing. As a result, businesspeople bor-row more for capital goods high on the stack, such asreal estate. Prices rise fastest and soonest where themoney is being injected into the economy with loans.Thus real-estate prices escalate, creating a bubble likethose that occurred before 1973, 1980, 1990, and 2007;indeed a similar bubble occurred during the 1920sbefore the Great Depression.Every boom preceding a bust has been fueled byartificially cheap credit. With free banking the interestrate would not be manipulated down.The natural rateof interest would raise the carrying cost of borrowedfunds, reducing if not preventing the financial fever.Further ReformsFree banking is not a panacea: There need to beother reforms to achieve sustainable economicgrowth. Punitive taxes, subsidies, and arbitrary restric-tions all distort the economy, stifle enterprise, and cre-ate turbulence. But even without such other reforms,the case for replacing central banking with free bankingis strong, resting on three facts:1. The optimal money supplyand interest rates are unknowable inadvance, and can only be discoveredby market dynamics.2. Political pressure makes theFed expand the money supply andreduce interest rates when the econ-omy is depressed, and this fuels anunsustainable boom that results in thenext bust.3. Government insurance, guar-antees, the expectation of bailouts,and other subsidies induce excessiverisk-taking, making financial crashesworse.Cowen states that if the Fed wereto shut down, the new base money would be Treasurybills. (Base money currently consists of money in cir-culation, bank vault cash, and commercial bankreserves on account at the Fed.) But folks don’t buygroceries with Treasury bills. The best transition basemoney would be the current amount of FederalReserve notes, whose supply would be frozen, as sug-gested by Professor George Selgin. Then new-moneyexpansion would be the money substitutes issued bythe banks, convertible into base money. Eventually,with the abolition of legal-tender laws, world financialmarkets would converge on a common global cur-rency, gold.The case for free banking is similar to the case forhealthy living. It is better to prevent economic illnessthan to have to treat it.C e n t r a l  B a n k i n g  B e a t s  F r e e  B a n k i n g ?  I T  J U S T  A I N ’ T  S O !Free banking is not apanacea. Governmentstill distorts theeconomy in manyways. But evenwithout furtherreforms, the case forreplacing centralbanking is strong.

Central Banking Beats Free Banking? It Just Ain’t So!

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