Roger Garrison - Central Banking, Free Banking, And Financial Crises

8/12/2019 Roger Garrison - Central Banking, Free Banking, And Financial Crises

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Central Banking Free Bankingand Financial CrisesRoger W. Garr isonA growing literature explores the concept of free banking onboth a theoretical and a n historical basis. George Selgin1988) sets out the theory of free banking and makes a compel-ling case that, despite the uniqueness of money, the forces of supplyand demand are more conducive to monetary stability, correctly under-stood, than are the edicts of a central bank. Larry White 1984), focus-ing on the free-banking episode in nineteenth-century Scotland, andKevin Dowd 1994), collecting studies of experience with free bankingin many countries and time periods, have shown that this alternativeto central banking has a respectable history.

The aim of this paper is to get a fix on the possible and currentlyrelevant sources of macroeconomic instabilities in the economy and toidentify the most promising banking arrangements for dealing withthose instabilities. Possible maladies and remedies can be consideredin the context of competing schools of macroeconomic and monetarythought. Attention is directed to the issue of whether the perceivedproblem andlor its solution is inherent in the market economy or liesoutside the market process. This formulation immediately gives riseto a two-by-two.matrix with maladies and remedies represented in onedimension, market forces and extramarket forces represented in theother. The fruitfulness of this approach is demonstrated by i ts abilityto sort out competing schools ofthought, put current debate in perspec-tive, and assess the prospects for a stable macroeconomy-with theFederal Reserve as currently constituted and with the alternative in-sti tution of free banking.

This exercise in comparative-institutions analysis does not deal withthe dynamics of the macroeconomy in transition between one set ofmonetary institutions and another or with the political issues of justhow such a transit ion might be brought about. Nor does i t deal directly

Roger Garr iso n is professor of economics a t Auburn Universi ty .The Review of Au strian Economics Vol 9,No. 2 (1996): 109-27SSN 0889-3047


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with the ultimate nature of the monetary standard. There is a strongpresumption, however, that only a central bank can preempt a com-modity standard with its own fiat money and that banknotes issued bycompeting banks in a free-banking system would have to be redeem-able in some real commodity, such as gold, to make them acceptable ina market where banknote holders can easily express their preferencesamong issuers. There is broad agreement among Austrian-orientedwriters t hat a banking system characterized by 1 central directionand 2) fractional reserve is not conducive to economic stability. How-ever, there is some disagreement among the Austrians as to which ofthe two mentioned characteristics is fundamentally responsible forthe instability. The argument in this paper follows Ludwig von Mises,as portrayed by White (1992), and takes the centralization of the cur-rent banking system to be the most fundamental issue and the mostappropriate focus for prescribing reform.The quation of xchangeUnderlying all theories of money and banking-as well as all prescrip-tions of policy and recommendations for reform-is the familiar equa-tion of exchange: MV PQ. For the economy as a whole, buying mustequal selling, where buying is represented by the total supply M ofmoney times the frequency (the circulation velocity V) with which eachmonetary unit on average is spent and where selling is represented bythe average price P of goods times the tota l quantity Q of goods sold.Although t rue by construction, th e equation of exchange helps us tokeep in view the interdependencies that characterize the macroe-conomy. It is impossible, for instance, to conceive of a change in onlyone of the four magnitudes represented in the equation of exchange.Any one change implies some offsetting change or changes on one sideor the other of the equation-or possibly on both sides. For instance,a decrease in money s circulation velocity, which simply reflects a n in-crease in the demand for money, must be accompanied by 1 an in-crease in the money supply, (2) a decrease in prices, or 3 ) a decreasein real ou tput sold (or by some combination thereof).

The equation also facilitates the comparison of competing schoolsof thought. Considering in sequence Keynesianism and Early andLa te Monetarism can provide a basi s for setting out the distinctiveperspective th a t emerges from the theory of free banking. The case


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against central banking and in favor of free banking, then, is precededby some history of thought-possibly more than some may th ink jus-tified. The comparison of schools of thought is included for two rea-sons. First, some writers have recently gotten it wrong, presentingmonetarist ideas under the Keynesian label. Second, the case for freebanking contains arguments that are sufficiently close to Keynes'sown that they need to be distinguished explicitly from his.

Keynes believed t hat the economy is chronically unstable becauseof instabilities associated with both and I?Goods, in the Keynesianconstruction, are decomposed into consumption goods C and invest-ment goods I, the latter being inherently unstable in view of thepervasive uncertainty faced by the business community-the darkforces of time and ignorance th at envelop our future (Keynes, 1936,p. 155 The strength of the inves tment sector, according to Keynes,is highly dependent on psychological factors- animal spi rit s(pp. 161-62) t h a t motivate each (and, through contagion, al l) ofthe economy's investors . The occasional waxing and waning of theanimal spir its affect I-and affect C as decisions in the businesscommunity govern incomes and hence spending. Both directly andderivatively, then, the uncertainty of the future translates into fluc-tuat ions in the economy's output magnitude Q.

The equation of exchange reminds us that changes in cannot bethe whole story. If prices and wages are sticky and the money supplyis wholly determined by the monetary authority, the rest of the storymust center on money's circulation velocity V What Keynes called thefetish of liquidity is, in this view, nothing bu t another perspective on

the waning of animal spirits. Would-be investors abstain from com-mitting themselves to investment projects, whose profitability is un-certain, and instead hold their wealth liquid.

The economy, according to Keynes, is prone to periodic collapse.Pervasive uncertainty inherent in investment activity and prospectsof economic disaster occasionally overwhelm the business community.Entrepreneurs cease their individual attempts to outguess one an-other and begin collectively to guess against the economy. In droves,they forego real assets in favor of liquidity. Q falls, and along with it,V Liquidity, or money (Keynes used the terms synonymously), consti-tu te s something of a time out for th e entrepreneurlspecula-tor-somewhat analogous to rest areas along an interstate highway.Fog on the highway or the wearing effects of traffic congestion canmake the rest areas increasingly attractive.


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devising possible solutions to the problem. For instance, much ofKeynes s discussion of monetary reform, which included support inprinciple for Silvio Gesell s stamped money as well as for taxing trans-actions in securities markets, was aimed a t making the time-out op-tion-the option of getting or staying liquid-more costly. Keynes fa-vored all at tempts to deprive money of its liquidity value only to la-ment that investors would find other assets (e.g., gems and preciousmetals) that could provid refuge from the uncertain future (Keynes1936, pp. 353-58).

Reforms in this direction are analogous to installing toll gates a tthe rest areas-or possibly eliminating rest areas altogether. Travel-ers would make better t ime between New Orleans and Atlanta if therewere no possibility of stopping along the way. Keynes did not considerthat some would-be travelers might not depart New Orleans in the di-rection of Atlanta under such conditions; he did lament that closing orcharging for rest areas might cause travelers to find other places tostop along the highway.

In lieu of prevention in the form of making liquidity less attractiveor more costly, Keynes recommended monetary policy to accommodatethe demand for liquidity-satiating that demand if necessary to keepmoney from competing with real investments in the collective mind ofthe business community. To the extent that money-demand entails alarge psychological element, the rest-area analogy holds. A road signtha t reads LAST R ES T AREA FOR NEXT 1 MILES may attract many cus-tomers, whereas the travelers may stop very infrequently if there wererest areas all along th e way.

While increasing the supply of money to neutralize the effects ofa fetishistic demand for liquidity may be a necessary component of pol-icy prescription, it will not be sufficient, according to Keynes, to re-store conditions of prosperity. This is only to say t ha t a decreasedis a symptom ra ther t han th e essence of th e problem. The solutionmust involve the substitution of government spending for privateinvestment spending-accommodated, of course, by money crea-tion. Fiscal s timulation prods th e reluctant travelers along the eco-nomic highway. Keynes viewed fiscal policy as primary; monetary pol-icy as secondary.

In the Keynesian view, then, the malady is inherent in the market;the remedy entails extramarket forces. It is in the very nature ofthings that our weary travelers will, on occasion, follow one another intothe increasingly overcrowded rest areas, where each traveler is reluctant


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Monetary reform and fiscal stimulation are intended to keep the trav-elers out of the rest areas and to keep them moving along smartly. Cen-tral banking is essential for the task. But ultimately, Keynes (1936, p.378) called for a wholesale replacement of our current system with asystem of public transportation: A comprehensive socialization of in-vestment is offered as the only solution to the problem of unemploy-ment.

Early monetarism, as exposited by Clark Warburton (1966) in the1940s and 1950s and a s revived in recent years by Leland Yeager(19861, has a kinship to the equation-of-exchange perspective on theKeynesian view. Both schools perceive a possible malady and remedythat fit into the two-by-two matrix in the same way: Market malady;extramarket remedy. They differ radically, however, in terms of thespecific na tu re of the problem and the implied judgment about th e ef-ficacy of the market economy. Market participants may opt for moremoney in preference to more real output-where the relevant alterna-tives to holding money are both investment goods and consumptiongoods. The demand for money is not fetishistic, and changes in i t arenot necessarily contagious, bu t money demand can and does change.The velocity of money i s not constant in the same way that Planck'sconstant and Avogadro's number are.'

With a given money supply, increases in the demand for money putdownward pressure on prices.3 Except in the fanciful case in whichprices adjust fully and instantaneously to th is monetary disturbance,the adjustment process involves quantities as well as prices. Our high-way travelers are trying to stop and rest even in the absence of ade-quate rest areas. The unintended consequence is a general slowdownof traffic. decreased V impinges on Q as well as on P-even if theultimate, or long-run consequence is a proportionate decrease in F Inprinciple, a monetary policy that succeeds in relieving downward pres-sure on prices by meeting every increased demand for money with a nincreased supply will result in grea ter stability for the economy as awhole. Aconstant P becomes, in this view, the essence ofmonetary sta-bility. The problem (decreased and solution (increaseM are set out inprecisely this way by Paul Krugman (1993, p. 26-28 and passim)-but

'1t should be noted, however, that even before th e imp act of M ilton Friedman'sempirical work wa s fully felt, the Early M onetarists h eld that the typical and m ostsignifican t reductions in MV were attributable to reductions in M and not in V.3 ~ e r end throughout the paper, the phrases increase in the demand for moneynand decrease in the velocity of money are used interchangeably. Although this usage


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with this view offered a s Keynes's understanding of the nature of busi-ness cycles Early Monetarism is wrongly attributed to Keynes4

Early and Late Monetarists share an analytical framework as wellas a basic judgment about the central bank's capacity to do good andto do harm. I t was Milton Friedman, of course, who shifted the focusof attention away from problems of monetary disequilibrium to thegeneral relationship between and P that endures over space andtime. Empirical studies using da ta from many different economies andmany different time periods lent support to the proposition thatchanges in the lefthand side of th e equation of exchange are over-whelmingly at tributable to changes in the quant ity of money. Studyaf ter study demonstrating the stability of money demand (a near-con-stant V had the effect of focusing attention on the money supply M a s abasis for accounting for both inflation and deflation. Changes i n themoney supply are much more likely to be a problem than to be a solutionto a problem. Empirical and theoretical considerations, as well as con-siderations from political economy, underlay th is summary judgment.Under typical conditions, in which money demand remains relativelyconstant, there is a "long and variable lag" that separates changes inthe money supply and the subsequent changes in the price level. Thisempirical fact, coupled with the lack of any timely and unambiguousindicator of actual changes in the demand for money, weighs againstthe prospects for even well-intentioned money-supply managementhaving a stabilizing effect on the macroeconomy. Dimming the pros-pects still further, of course, is the fact tha t the central bank may in-tend to do more than act as a stabilizing agent and th at some of itsintentions, such as dealing narrowly in a lternating episodes with theproblems of inflation and unemployment and with problems associ-ated with the strength or weakness of the dollar in international mar-kets, are antithetical to the idea of a central bank as macroeconomicstabilizer.

4 ~ v e nworse, the school of thought whose sails have most recently caught theacademic wind calls itself New Keynesianism-seriously missing the mark with bothparts of its name. Gregory Mankiw and others (Ball, et a]., 1988) remain largelyagnostic about the specific source of change on the lefthand side of the equation ofexchange. Their theorizing holds up whether it is M or V that decreases. The Keynesianlabel is adopted simply on the basis of their recognition that prices do not changeinstantly-a basis that actually distinguishes their (and many other) arguments onlyfrom extreme versions of New Classicism. The "New" is added in recopition that theassumption of sticky prices is replaced with "sophisticated" reasons for prices notadjusting instantaneously. But Early Monetarism as initially set out and in modern


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We can locate Monetarism in our two-by-two matrix by noting thatboth malady and remedy are in the extramarket category. In fact,Monetarism consists, by and large, of 1 the recognition that the cen-tral bank is a destabilizing force and 2) the recommendation that itot be a destabilizing force. Adherence to a monetary rule according to

which the money supply is increased a t a slow, steady, and prean-nounced rate is likely to engender more macroeconomic stability thancentral bank activism can achieve-no matt er how well-intentionedand expertly conceived. Actual experience both before and after theheyday of Monetarism suggests that the same understanding thatgives rise to Monetarists view of the central bank also accounts for thecentral bank s inability and unwillingness actually to adopt and abideby a monetary rule. The so-called Monetarist experiment begun in Oc-tober of 1979 under the chairmanship of Paul Volcker, for instance,was Monetarist only in a limited and perverse sense. The Federal Re-serve did shift its attention from interest rates to monetary aggre-gates, a move that would be preliminary to actually adopting a rule formonetary growth. But its policies following this shift made for evengreater variation in the money supply (and in the rate of interest) cre-ating significantly greater macroeconomic instability tha n had beenexperienced before. Ultimately, a monetary rule, however widely andforcefully recommended, is a t odds with the even more widely per-ceived view that the Federal Reserve Chairman is the second mostpowerful individual in the country.Free ankingThe basic case for free banking is the general case for decentralizationof economic activity. The uniqueness of money does not immunize itagainst the forces of supply and demand and does not make the invis-ible hand of the marketplace any less beneficial to society. Quite to thecontrary, our rest-area analogy suggests that market forces have spe-cial advantages in adjusting money supply to money demand. Whilethe market cannot respond on a daily basis, supplying res t areas any-where along the highway th at they happen to be demanded by today stravelers, free banking can and automatically would supply liquidityalong the economic highway anytime and anywhere it is demanded.The case for decentralization is strengthened by comparing free-bank-ing dynamics to central-bank policies that we have actually experi-enced and even to the policies of an idealized non-politicized centralbank whose sole objective is that of maintaining macroeconomic sta-


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weighs in favor of decentralization. What the Federal Reserve lacksthe will and ability to do can be done automatically by the impersonalforces of supply and demand governing banknote issue. Second, thedifference between the implicit rule that the decentralized bankingsystem follows and the simple monetary rule of slow and steadygrowth of the money supply gives free banking higher marks a s a sta-bilizing force in the economy. In the final analysis, the simplicity of themonetary rule derives from the judgment tha t discretionary moves aremore likely to destabilize than to stabilize. The monetary rule is im-posed, then, in the spirit of the unspoken maxim of yesteryear's medi-cal profession: Maintain good bedside manners, and strive to do noharm.

Free banking automatically discriminates between real distur-bances and monetary disturbances, reacting only to the lat te r (Selgin1988, pp. 64-69). The automaticity implies both a timeliness and anabsence of political pressure-features that are forever denied to cen-tral banking. Under steady-state conditions in which the economy isexperiencing no growth and no changes in the demand for money, thesimple monetary rule and the implicit free-banking rule are the same:zero growth in the money supply. The consequences are also the same:a constant price level. Under more typical conditions of some positivera te of real economic growth and some variability in the demand formoney, the two rules differ. The simple monetary rule is based on along-range estimate of secular growth and of secular movement inmoney demand. An estimated growth rate of 3 percent and an esti-mated upward trend in money demand (downward trend in velocity)of 2 percent translate into a money growth rate of 5 percent. Strictcompliance with the rule would mean tha t movements in the pricelevel would exhibit no long-run trend. Actual deviations from trend ineither output or in velocity, however, would result in upward or down-ward pressure on the general level of prices. Accordingly, the rule itselfmight be adjusted to allow for the differential harmfulness of inflationand deflation. Ingrained notions that prices and wages are stickierdownwards than upwards and th at unemployment bites harder intoeconomic prosperity than does inflation may justify-narrow politicalmotives aside-a rule of increasing the money supply a t some ra teslightly in excess of 5 percent. A mild inflation might be consideredcheap insurance against any actual de f l a t i ~ n . ~

5 ~ yholly ignoring discoordinating consequences of deflationary pressures and


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The implicit rule automatically implemented by free banking isthe old central-bank maxim (usually observed in the breach): Printmoney to hold but not money to spend. If the holders of banknotesissued by a particular bank are willing to hold still more, it is in theinterests of the bank to increase it s issue. The fact that the bank's cus-tomers are holding rather than spending implies the absence of infla-tionary pressures. In this context, the bank need not even considerwhether the increased demand for it s own notes is a general increasein the demand for money or an increase in the demand for itsbanknotes relative to the demand for other banknotes. However, if anindividual bank increases its issue even in the absence of any increasein demand to hold its banknotes, then th e extra spending of them willsoon impinge on the bank's reserves. The sustainable level of note is-sue is demand-determined. In a decentralized and competitive environ-ment, each individual bank can be expected to forego the short-term gainsthat overissuing its own banknotes might entail in order to avoid thelong-term losses that the market process would inevitably impose.

In contrast to the simple monetary rule, which is devised to accom-modate real economic growth by checking deflationary pressureswhatever their source, the implicit free-banking rule involves nochange in the money supply in response to a change in real output.This difference in the two rules reflects the automatic discrimination,inherent in free banking, between real and monetary disturbances. Anincrease in the demand for money puts downward pressure on productand factor prices in general. If there were no money-supply response,a general decline in economic activity would follow, since prices andwages could not fully and instantaneously adjust themselves to thenew market conditions. Goods in general would go unsold; productionwould be cut; workers would be laid off. Such quantity effects can beself aggravating, as the Early Monetarists emphasized. With a less-than-perfectly flexible price system, general deflationary pressurescan push the economy below its potential during the period in whichprices are adjusting to the higher monetary demand. And the fact thatsome prices and some wages are more flexible than others means t ha tthe adjustment period will involve changes in relative prices that re-flect no changes in relative scarcities. These are precisely t he kinds ofproblems that are highlighted by modern monetary-disequilibriumtheorists, e.g., Yeager 1986 ,and th at a re avoided by free banking'sresponsiveness to increases in money demand.

Suppose, however, that with an unchanging demand for money,


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be explained in terms of an economywide technology shock. Rather, theoutputs of various goods increase a s a result of an increased availabil-ity of particular resources used i n producing them or the discovery ofa new technique t hat converts particular inputs into a particular out-put more efficiently. Downward pressure on the prices of the particulargoods that account for the economy's growth will be felt primarily inthe markets for those very goods. Relative prices adjust to reflect thefact th at these goods are now more abundant. The market process a twork here is the one th at gets emphasis in the sophomore-level eco-nomics of supply and demand. Perversities t hat dominate in the con-text of an increase in money demand get li ttle or no play in the contextof economic growth. The increased Q, which simply reflects a positivenet change in the sum of all the economy's individual qs, is accompa-nied by a decrease in the corresponding ps. I t would be misleading hereto evoke the fears of deflationary pressures. The individual ps be-come adjusted to their corresponding qs on a market-by-market basis.The fact that this new constellation of ps average to a lower P thanbefore has no special claim on our attention. There is no downwardpressure on P over and above the forces of supply and demand thatoperate separately in the affected markets and reflect the underlyingeconomic realities. There are no perversities inherent in th is sort of arelative (and absolute) adjustment.

In terms of the equation of exchange, we can say that free bankingadjusts M so as to offset changes in V but allows changes in Q to beaccommodated by changes in P. Economic growth does involve pricedeflation in a literal sense (the price level falls as output increases) butdoes not involve any macroeconomic malady t hat i s commonly associ-ated with th e term deflationary pressures. In effect, by distinguish-ing between malignant and benign deflation, free banking provides amuch stronger check against inflation than that provided by the sim-ple monetary rule.6 I t would be misleading to classify free banking interms of malady and remedy because the malady never gets a chanceto show itself. Significantly, though, there a re no extramarket forcesa t work here either creating problems or fixing them.C e n t r al B a n k in g a n d t h e D e b t B o m bThe case for a decentralized banking system, which by and large par-allels the case for markets and against central planning agents, is a


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strong one. The central bank cannot outdo free banking or even match itsperformance as a macroeconomic stabilizer. It lacks the ability to distin-guish on a timely basis between movements in and movements in Qit lacks the incentives to act in ways that would promote stability, and asa key player in a political environment, it actually responds to incentivesin ways that foster instability. None of these characteristics, however, isat odds with our understanding of the origins of the Federal ReserveSystem--especially as exposited by Rothbard (1994), whose story doesnot place great emphasis on the lofty goal of macroeconomic stabiliza-tion.

I t is commonly understood, now, th at the Federal Reserve accom-modates the Treasury by monetizing the government's debt. That is,it injects credit markets with new money so a s to relieve the upwardpressure on interest ra tes that Treasury borrowing would otherwiseentail. And with telling exceptions, the Federal Reserve maintains aneasy-money policy in the year-and-a-half before each presidential elec-t i ~ n . ~he so-called political business cycles have now become an inte-gral part of the macroeconomic landscape. Further, the Federal Re-serve is called upon to deal with other real or perceived problems hav-ing lit tle to do with macroeconomic stability. It i s expected, for in-stance, to lower interest ra tes when the housing market is in a slumpand to strengthen or weaken the dollar in response to movements inexchange rates or trade flows. All these attempts to manipulate em-ployment rates, interest rates, and exchange rates interfere with theFederal Reserve's ability to achieve and maintain macroeconomic s ta-bility or even to refrain from inducing instability. If the simple mone-tary rule fares poorly in comparison with the implicit rule of free bank-ing, it fares well in comparison with the actual policies of the FederalReserve.

These political factors are well recognized by modern Fedwatch-ers. Less well recognized are the cumulative effects of decades of defi-cit accommodation and macroeconomic manipulation. With federal

7 ~ h eelling exceptions involve Presidents Ford, Car ter , and Bush. In 1976 Fordsimply did not play the game. He did not press Federal Reserve Chairman ArthurBurns, who had helped Nixon get re-elected four years earlier. With Ford perceived asa non-starter, Carter boasted th at his administration would hit the ground running,which in terms of monetary policy meant that the expansion was started much too early.By re-election time (1980), the stimulative effects of the monetary expansion hadreceded into history and inflation was upon us. With equally bad timing, but in theopposite direction, Bush tried to play the game in 1992 but started the expansion too


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bank. The Federal Reserve in i ts standby capacity as a buyer of gov-ernment debt keeps the default-risk premium off Treasury bills. Thepotential for debt monetization allows federal indebtedness to rise un-checked to levels that would have been thought fanciful only a few ad-ministrations back and to remain high and rising into the foreseeablefuture.

The potential for debt monetization, critical for maintaining an un-easy balance between economic and political reality, gives rise to specu-lation about the timing and extent of actual debt monetization. At issuehere are prospective movements, possibly dramatic ones, in the inflationrate, interest rates, and exchange rates, which in turn can have dramaticeffects in securities markets. The attractiveness of securities can be dif-ferentially affected by the inflation that would result from actual debtmonetization or by the movements in exchange rates tha t reflect theTreasury s greater or lesser reliance on foreign credit markets or by move-ments in interest rates brought about by changes in the Treasury s do-mestic borrowing. At some point, uncertainties about the timing and ex-tent of debt monetization may dominate securities markets. In this case,the dense fog that drives our travelers off the economic highway and intothe res t areas is not inherent in the market economy a t all but ratheris emitted by the Fed-backed Treasury.

I t has become conventional wisdom in recent years that there i ssome link (though a poorly defined one) between chronically highbudgetary deficits and instability of securities markets (Feldstein1991, p. 8 andpassim).g And it is taken for granted tha t i t is the Fed-eral Reserve s responsibility to deal with that instability, providing ona timely basis whatever liquidity is demanded so as to keep the occa-sional sharp declines of security prices, the mini-crashes, from affect-ing the performance of the macroeconomy. The implicit objective, here,seems to be that of building a firewall between the financial sector andthe real economy, allowing both to lead their separate lives. Ironically,i t is largely the existence of the Federal Reserve-its potential for debtmonetization-that enables the Treasury to borrow almost limitlessly,thus creating the very instability t hat is to be kept in check by tha tsame Federal Reserve.

Short-term success of the Federal Reserve in maintaining the fire-wall between the financial and real economy depends critically on the wis-dom and credibility of the Federal Reserve Chairman. Prospects for

is is not to suggest that deficit-induced instabilities are the only macroeconomi-


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longer-term success are problematic despite-or possibly becauseof-a sequence of short-term successes. Considerations of the natureof the Federal Reserve s role in the context of possibly volatile swingsin the demand for liquidity suggest that continued central manage-ment of the economy s money supply does not offer the best hope formacroeconomic stability.

Suppose that the Treasury or the White House urges th at the Fed-eral Reserve become more accommodating and that the Federal Re-serve Chairman expresses reluctance. Will the urgings get more in-tense? Will the reluctance fade? Speculation about the ultimate out-come will likely show up on Wall Street as a n increased trading volumeand an increased volatility of security prices. Traders who have little con-fidence in their own guesses about a possible change in the Federal eserve s policy stance are likely to get out of the market. Securities pricesweaken as these traders begin to liquidate, causing others to follow suit.Now, even those traders who do have guesses about the Federal Reservebegin guessing instead about the market s reaction the uncertainty. Thescramble to get out of the market manifests itself a s a liquidity crisis.Abstracting from the fact that this instability has its origins in extramar-ket forces, we notice that the nature of this destabilizing speculationis exactly as described by Keynes (1936, pp. 153-58).

In dealing with the liquidity crisis, the Federal Reserve is imme-diately pitted against itself. I t must expand the money supply to ac-commodate the increased demands for liquidity-and by the rightamount in a timely fashion-while maintaining its credibility that itwill not expand th e money supply in response to the urgings from theWhite House. Fedwatchers are going to need some tea leaves here todetermine jus t exactly what the Federal Reserve is and is not doing.Once again, th e equation of exchange provides a sound basis for sort-ing it all out. M is being increased to offset a downward movement inV If the increase in M is too little, the ne t downward movement in MVwill result in the dreaded deflationary pressures which will impingeonly partly on P and hence partly on Q The Federal Reserve s firewallis too weak; the liquidity crisis spills over into the real economy. If theincrease inM is too great , then, willy-nilly, the Federal Reserve is suc-cumbing to the urgings of the executive branch to further accommo-date the Treasury s borrowing. The extent of the accommodation, asmeasured by the net upward movement in MV, will i,n time show up asinflation, which was one of the prospective eventualities that underlaythe speculation and the liquidity crisis.


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of th e Federal Reserve to move against an increasing that charac-terizes the end of the liquidity crisis accommodates the Treasury and putsupward pressure on prices. Possibly more critical are the repercussionsof the excess liquidity in international money markets. Overaccommoda-tion can weaken the dollar. If this weakness is perceived as the beginningof a trend, the result may be heavy selling of dollars and dollar-denomi-nated assets. Thus, a botched attempt to deal with a liquidity crisis canprovoke a currency crisis. The Federal Reserve must somehow defend th ereal economy against this double-edged sword.1

The Federal Reserve may be allowed some scope for error. Thesame difficulties th at i t faces in knowing jus t what to do and jus t whento do it provide a shroud of uncertainty, even after the fact, about justwhat it did-and all the more so about what it intended to do. But sev-era l considerations combine to suggest th at , in the long run, the Fed-eral Reserve is playing against high odds.

First, right or wrong, the financial markets will make their movesahead of the Federal Reserve. Changes in the demand for liquidity andin the strength of the dollar are determined a s much if not more byanticipations about what t he Federal Reserve will do ra ther than whatit has just done. This consideration is what gives great importance tothe Chairman s credibility. And his credibility reflects more than hispersonal integrity and his reputation for reasonableness and consis-tency. It is affected as well by the economic constraints he faces andpolitical pressures he feels.

Second, each episode will have characteristics of its own depend-ing upon all the contemporaneous political and economic factors.Goals of the Federal Reserve over and above the particular goal of ac-commodating the Treasury serve as a background against which ex-pectations are formed. The Federal Reserve may be pursuing a s trat -egy of gradual monetary ease to promote more rapid economic growthand then subsequently a strategy of gradual monetary tightening tostave off inflationary pressures. I t may be possible to maintain credi-bility while increasing the monetary aggregates a t an accelerated ratein the first episode but not possible while reversing the direction ofchange (relative to trend-line monetary growth) in the second episode.

Third, even if the Federal Reserve generally wins its battlesagainst liquidity crises, it will find that winning streaks ar e difficultto maintain indefinitely. And perversely, a sequence of wins can create


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a false sense of confidence on Wall Street that the Federal Reserve isalways willing and able to deal effectively with liquidity crises. Suchconfidence might cause investors to maintain a generally lower levelof liquidity in their portfolios than if they had serious doubts about thest reak continuing. Lower liquidity levels generally can mean moredramatic increases in the demand for liquidity during a crisis. For theFederal Reserve, the winning streak gets increasingly more difficultto maintain.

Temporarily and partially offsetting all these reasons for pessi-mism about prospects for enduring macroeconomic stability is thewidespread belief that the part icular individuals that have served asFederal Reserve Chairman are geniuses. Dating from the summer of1979 Paul Volcker and, after him, Alan Greenspan have risen to theoccasion whenever crisis threatened. It may indeed be difficult toname two other individuals who could have done better. Geniusmight involve overstatement; seasoned, savvy, and nimble, maybe more to the point. But there i s a greater point to be made here. Anygovernmental institution whose success depends critically on the cali-ber of the individual in charge cannot be considered a lasting sourceof stability for the economy. Even geniuses can err. More importantly,in some episodes where expectations turn pessimistic, the monetaryease needed to deal with a liquidity crisis may be more than enough totrigger a currency crisis. Foreign and domestic traders may leave noroom for the Federal Reserve Chairman to exercise hi s genius. Andfurther , geniuses a re not necessarily succeeded by geniuses. Volckerserved two four-year terms; Greenspan ha s begun his th ird term af-te r an unsuspenseful reappoin tment in early 1996-which had theeffect of postponing speculation for another four years. How muchconfidence will Wall S tr ee t have in Greenspan's turn-of-the-centurysuccessor? How much confidence will i t have in th e Federal Reservein the days or weeks before a successor is named? Suppose th a t theTreasury is put ting pressure on the Federal Reserve for great er ac-commodation-possibly because our trading pa rtne rs ar e reluctantto extend our government fur ther credit until they know who is re-placing Greenspan. Wha t would happen to the demand for liquid-ity? And how would the lame-duck Federal Reserve Chairman re-spond so as to maintain his own credibility as well a s th a t of hissuccessor-to-be-named-later? Even mildly cynical or pessimistic an-swers to these questions may suggest that this financial crisis mayburn through the firewall. The real economy would th en become an


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25arrison: Central Ban king Free Bank ing an d Financial C rises

Free anking as oth Prevention and CureThe merits of free banking during periods of economic tranquil ity areidentified on the basis of the theory of competition as applied to thebanking industry and the experience provided by a key episode in nine-teenth-century Scotland and more recent episodes involving othercountries with partially free banking. Assessing the likely perform-ance of free banking during twentieth-century financial crises in theUnited States necessarily involves some speculative reasoning. It isworth noting, however, that the most prominent nineteenth-centurydefender of free banking argued his case partly on the basis of the abil-ity of competitive forces to meet an incipient panic freely and gener-ously (Bagehot 1873,p. 104).

Whatever the problems and limitations inherent in free bankingor in market economies generally, competition tha t characterizes a de-centralized system wins out over the policy edicts of a central banklargely because of the absence of key perversities tha t are inherent incentral control. The advantages of decentralization a re partly in theform of prevention, partly in the form of cure.

One of the major sources of today's macroeconomic instability, theexcessive federal debt and deficits, would be largely absent under freebanking. Without a central bank to keep the default-risk premium offTreasury bills, the federal government, like overextended firms andeven fiscally irresponsible municipalities, would have had to deal withits fiscal imbalance long ago. Free banking, which is free not to monet-ize Treasury debt, could accomplish what debt-limitation ceilings, theGramm-Rudman deficit-reduction plan, or even a balanced-budgetamendment cannot accomplish. Without a chronically high and grow-ing debt and the at tendant speculation about th e changing particularsof deficit accommodation, financial crises are less likely to occur.

If a financial crisis does occur, the provision of supernormalamounts of liquidity is forthcoming under free banking-but withoutthe destabilizing speculation about th e particular movements in themoney supply. Questions about the will or intent9'-or genius -ofthe banking system a s a whole simply do not arise. The supply of li-quidity automatically follows demand upward during the financial cri-sis and downward as crisis conditions fade. I t i s true that some bankswill be more responsive than others a t meeting the occasional super-normal demands for liquidity. One of the beneficial aspects of compe-tition in any sector of the economy is tha t those firms who best satisfyever-changing demands prosper relative to their competition and ar e


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To this point the advantages of free banking over central bankingare set out in terms of the likelihood of our needing a firewall betweenthe financial and real sectors of the economy and the ability of eachbanking institution actually to provide that firewall. The firewallmetaphor, however, presumes t hat no systematic adjustments areneeded in t he real economy. But i t is entirely possible and even likelythat whatever caused the crisis conditions to prevail in the financialsector also caused non-financial resources to be misallocated. Simul-taneous financial and real crises, as might be brought about by theill-conceived policies of a n administration bent on growing the econ-omy, could not be quelled by a firewall. Quite to th e contrary, the real-location of resources in the economy would require a well-functioningmarket process, which includes movements in resources that reflectmovements in securities prices. Here, the implicit monetary rule ob-served by free banking takes on a special significance. Movements onthe lefthand side of the equation of exchange (an increasing V ar e ef-fectively countered; movements on the righthand side (in the ps andhence in are not. If the economy's real sector is out of balance, i tneeds help from the financial sector to regain its balance. In such cir-cumstances, firewall is the wrong metaphor; penny in th e fuseboxwould be more accurate. Only free banking can allow the financial sec-tor to guide the real sector while preventing the demands for liquidityfrom degrading the market's performance.

ummary ViewIn the Keynesian view, the central bank is a part of a n extramarketremedy to a market malady. Investment markets are inherently un-stable; government control of th e economy's money supply i s an impor-tant element in macroeconomic stabilization policy. The case against cen-tral banking-and for free banking-reverses the characterization ofboth remedy and malady. Free banking is a part of a market remedy toan extramarket malady. Even this stark reversal understates the casefor free banking. It would remain valid even if we take the dramaticand chronic fiscal irresponsibility of the Treasury a s given. Periodiccrises th at will inevitably occur in such a debt-ridden economic envi-ronment would be more ably countered by the market forces of freebanking t han by the policy moves of a central bank. But the extent ofthe Treasury's fiscal irresponsibility is itself dependent upon whetherthe Treasury can count on an accommodating central bank. Free bank-ing limits the scope of this potential source of instability while a t the


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127arr ison: Cen t ral Ban k ing , Free Bank ing , an d Financ ia l Cr i se s

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Roger Garrison - Central Banking, Free Banking, And Financial Crises

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