The Mystery Of Banking

by Murray N. Rothbard

  FIGURE 17.1 — THE STATE OF THE COMMERCIAL BANKS: BEFORE THE PLAN

  We are proposing, then, that the federal government disgorge its gold at a level of 100 percent to total dollars, and that the Fed, in the process of its liquidation, give the gold pro rata to the individual banks, thereby raising their equity by the same amount. Thus, in the hypothetical situation for all commercial banks starting in Figure 17.1, the new plan would lead to the following balance sheet (Figure 17.2):

  FIGURE 17.2 — THE STATE OF THE COMMERCIAL BANKS: AFTER THE PLAN

  In short, what has happened is that the Treasury and the Fed have turned over $270 billion in gold to the banking system. The banks have written up their equity accordingly, and now have 100 percent gold reserves to demand liabilities. Their loan and deposit operations are now separated.

  The most cogent criticism of this plan is simply this: Why should the banks receive a gift, even a gift in the process of privatizing the nationalized hoard of gold? The banks, as fractional reserve institutions are and have been responsible for inflation and unsound banking.

  Since on the free market every firm should rest on its own bottom, the banks should get no gifts at all. Let the nation return to gold at 100 percent of its Federal Reserve notes only, runs this criticism, and then let the banks take their chances like everyone else. In that case, the new gold price would only have to be high enough to redeem outfight the existing $131.91 billion in Federal Reserve notes. The new gold price would then be, not $1,690, but $500 an ounce.

  There is admittedly a great deal of charm to this position. Why shouldn’t the banks be open to the winds of a harsh but rigorous justice? Why shouldn’t they at last receive their due? But against this rigor, we have the advantage of starting from Point Zero, of letting bygones be bygones, and of insuring against a wracking deflation that would lead to a severe recession and numerous bankruptcies. For the logic of returning at $500 would require a deflation of the money supply down to the level of existing bank reserves. This would be a massive deflationary wringer indeed, and one wonders whether a policy, equally sound and free market oriented, which can avoid such a virtual if short-lived economic holocaust might not be a more sensible solution.

  Our plan differs markedly from other gold standard plans that have been put forward in recent years. Among other flaws, many of them, such as those of Arthur Laffer and Lewis Lehrman, retain the Federal Reserve System as a monopoly central bank. Others, such as that of F.A. Hayek, doyen of the Austrian School of Economics, abandon the gold standard altogether and attempt to urge private banks to issue their own currencies, with their own particular names, which the government would allow to compete with its own money.9 But such proposals ignore the fact that the public is now irrevocably used to such currency names as the dollar, franc, mark, and so on, and are not likely to abandon the use of such names as their money units. It is vital, then, not only to denationalize the issuing of money as well as the stock of gold, but also to denationalize the dollar, to remove the good old American dollar from the hands of government and tie it firmly once again to a unit of weight of gold. Only such a plan as ours will return, or rather advance, the economy to a truly free market and noninflationary money, where the monetary unit is solidly tied to the weight of a commodity produced on the free market. Only such a plan will totally separate money from the pernicious and inflationary domination of the State.

  APPENDIX:

  THE MYTH OF FREE

  BANKING IN SCOTLAND

  “FREE BANKING” IN SCOTLAND

  Professor White’s Free Banking in Britain has already had a substantial impact on the economics profession. The main influence has been exerted by one of the book’s major themes: the “wonderful” results of the system of free banking in Scotland, a system that allegedly prevailed from 1716 (or 1727) until suppressed by the Peel Act in 1845.1 White’s Scottish free-banking thesis consists of two crucial propositions. The first is that Scottish banking, in contrast to English, was free during this era; that while the English banking system was dominated by the Bank of England, pyramiding their notes and deposits on top of the liabilities of that central bank, the Scottish system, in stark contrast, was free of the Bank of England. In White’s words, Scotland “rather maintained a system of ’each tub on its own bottom.’ Each bank held onto its own specie reserves.”2

  The second part of the syllogism is that this free system in some way worked much better than the English. Hence, the triumphant conclusion: that free banking in Scotland was far superior to centrally controlled banking in England. White claims that the salutary effects of free banking in Scotland have been long forgotten, and he raises the hope that current public policy will heed this lesson.

  The influence of White’s thesis is remarkable considering the paucity of his research and the thinness of his discussion. In a brief book of less than 200 pages, only 26 are devoted to the Scottish question, and White admits that he relies for facts of Scottish banking almost solely on a few secondary sources.3 And yet, White’s thesis on Scottish banking has been hastily and uncritically accepted by many diverse scholars, including the present writer.4 This has been particularly unfortunate because, as I shall demonstrate, both parts of Professor White’s syllogism are wrong. That is, the Scottish banks were (1) not free—indeed, they too pyramided upon the Bank of England—and (2) not surprisingly, they worked no better than the English banks.

  Let me take the second part of Professor White’s syllogism first. What is his basis for the conclusion that the Scottish banks worked significantly better than the English banks? Remarkably, there is not a word that they were significantly less inflationary; indeed, there is no attempt to present any data on the money supply, the extent of bank credit, or prices in England and Scotland during this period. White does say that the Scottish banks were marked by greater “cyclical stability,” but it turns out that he does not mean that they generated less inflation in booms or less contraction during recessions. By cyclical stability, White means solely that the extent of Scottish bank failures was less than in England. Indeed, this is Professor White’s sole evidence that Scottish banking worked better than English.

  But why should lack of bank failure be a sign of superiority? on the contrary, a dearth of bank failure should rather be treated with suspicion, as witness the drop of bank failures in the United States since the advent of the FDIC. It might indeed mean that the banks are doing better, but at the expense of society and the economy faring worse. Bank failures are a healthy weapon by which the market keeps bank credit inflation in check; an absence of failure might well mean that that check is doing poorly and that inflation of money and credit is all the more rampant. In any case, a lower rate of bank failure can scarcely be accepted as any sort of evidence for the superiority of a banking system.

  In fact, in a book that Professor White acknowledges to be the definitive history of Scottish banking, Professor Sydney Check-land points out that Scottish banks expanded and contracted credit in a lengthy series of boom-bust cycles, in particular in the years surrounding the crises of the 1760s, 1772, 1778, 1793, 1797, 1802–03, 1809–10, 1810–11, 1818–19, 1825–26, 1836–37, 1839, and 1845–47.5 Apparently, the Scottish banks escaped none of the destabilizing, cycle-generating behavior of their English cousins.

  Even if free, then, the Scottish banking system worked no better than central-bank-dominated English banking. But I turn now to Professor White’s central thesis on Scottish banking: that it, in contrast to English banking, was free and independent, with each bank resting on its own specie bottom. For Scottish banking to be “free,” its banks would have to be independent of central banking, with each redeeming its notes and deposits on demand in its own reserves of gold.

  From the beginning, there is one embarrassing and evident fact that Professor White has to cope with: that “free” Scottish banks suspended specie payment when England did, in 1797, and, like England, maintained that suspension until 1821. Free banks are not supposed
to be able to, or want to, suspend specie payment, thereby violating the property rights of their depositors and noteholders, while they themselves are permitted to continue in business and force payment upon their debtors.

  White professes to be puzzled at this strange action of the Scottish banks. Why, he asks, did they not “remain tied to specie and let their currency float against the Bank of England note?” His puzzlement would vanish if he acknowledged an evident answer: that Scottish banks were not free, that they were in no position to pay in specie, and that they pyramided credit on top of the Bank of England.6 Indeed, the Scottish banks’ eagerness for suspension of their contractual obligations to pay in specie might be related to the fact, acknowledged by White, that specie reserves held by the Scottish banks had averaged from 10 to 20 percent in the second half of the eighteenth century, but then had dropped sharply to a range of less than 1 to 3 percent in the first half of the nineteenth. Instead of attributing this scandalous drop to “lower costs of obtaining specie on short notice” or “lower risk of substantial specie outflows,” White might realize that suspension meant that the banks would not have to worry very much about specie at all.7

  Professor Checkland, indeed, presents a far more complete and very different account of the suspension crisis. It began, not in 1797, but four years earlier, in the banking panic that struck on the advent of the war with France. Representatives of two leading Scottish banks immediately went to London, pleading for government intervention to bail them out. The British government promptly complied, issuing Treasury bills to “basically sound” banks, of which £400,000 went to Scotland. This bailout, added to the knowledge that the government stood ready to do more, allayed the banking panic.

  When the Scottish banks followed the Bank of England in suspending specie payments in 1797, White correctly notes that the suspension was illegal under Scottish law, adding that it was “curious” that their actions were not challenged in court. Not so curious, if we realize that the suspension obviously had the British government’s tacit consent. Emboldened by the suspension, and by the legality of bank issue of notes under £1 after 1800, a swarm of new banks entered the field in Scotland, and Checkland informs us that the circulation of bank paper in Scotland doubled from 1793 to 1803.

  Before the Scottish banks suspended payment, all Scottish bank offices were crowded with depositors demanding gold and small-note holders demanding silver in payment. They were treated with contempt and loathing by the bankers, who denounced them as the “lowest and most ignorant classes” of society, presumably for the high crime of wanting their money out of the shaky and inherently bankrupt banking system. Not only the bankers, but even elite merchants from Edinburgh and throughout Scotland complained, in 1764, of “obscure people” demanding cash from the banks, which they then had the effrontery to send to London and profit from the rate of exchange.8 Particularly interesting, for more than just the 24 years of the British suspension, was the reason the Scottish banks gave for turning to suspension of specie payments. As Checkland summed up, the Scottish banks were “most gravely threatened, for the inhibitions against demanding gold, so carefully nurtured in the customers of Scottish banks, was rapidly breaking down.”9

  Now I come to the nub: that, as a general rule, and not just during the official suspension period, the Scottish banks redeemed in specie in name only; that, in substance, depositors and note holders generally could not redeem the banks’ liabilities in specie. The reason that the Scottish banks could afford to be outrageously inflationary, i.e. keep their specie reserves at a minimum, is that, in practice, they did not really have to pay.

  Thus, Professor Checkland notes that, long before the official suspension, “requests for specie [from the Scottish banks] met with disapproval and almost with charges of disloyalty.” And again:

  The Scottish system was one of continuous partial suspension of specie payments. No one really expected to be able to enter a Scots bank ... with a large holding of notes and receive the equivalent immediately in gold or silver. They expected, rather, an argument, or even a rebuff. At best they would get a little specie and perhaps bills on London. If they made serious trouble, the matter would be noted and they would find the obtaining of credit more difficult in future.10

  At one point, during the 1750s, a bank war was waged between a cartel of Glasgow banks, which habitually redeemed in London bills rather than specie, and the banks in Edinburgh. The Edinburgh banks set up a private Glasgow banker, Archibald Trotter, with a supply of notes on Glasgow banks, and Trotter demanded that the banks of his city redeem them, as promised, in specie. The Glasgow banks delayed and dragged their feet, until Trotter was forced to file a law suit for damages for “vexatious delay” in honoring his claims. Finally, after four years in court, Trotter won a nominal victory, but could not get the law to force the Glasgow banks to pay up. A fortiori, of course, the banks were not shut down or their assets liquidated to pay their wilfully unpaid debts.

  As we have seen, the Scottish law of 1765, providing for summary execution of unredeemed bank notes, remained largely a dead letter. Professor Checkland concludes that “this legally impermissible limitation of convertibility, though never mentioned to public inquiries, contributed greatly to Scottish banking success.”11 No doubt. Of one thing we can be certain: this condition definitely contributed to the paucity of bank failures in Scotland.

  The less-than-noble tradition of nonredeemability in Scottish banks continued, unsurprisingly, after Britain resumed specie payments in 1821. As the distinguished economic historian Frank W. Fetter put it, writing about Scotland:

  Even after the resumption of payments in 1821 little coin had circulated; and to a large degree there was a tradition, almost with the force of law, that banks should not be required to redeem their notes in coin. Redemption in London drafts was the usual form of paying noteholders. There was a core of truth in the remark of an anonymous pamphleteer [writing in 1826] “Any southern fool [from south of the Scottish-English border] who had the temerity to ask for a hundred sovereigns, might, if his nerves supported him through the cross examination at the bank counter, think himself in luck to be hunted only to the border.12

  If gold and silver were scarcely important sources of reserves or of grounding for Scottish bank liabilities, what was? Each bank in Scotland stood not on its own bottom, but on the very source of aid and comfort dear to its English cousins—the Bank of England. As Checkland declares: “the principal and ultimate source of liquidity [of the Scottish banks] lay in London, and, in particular, in the Bank of England.”13

  I conclude that the Scottish banks, in the eighteenth and first half of the nineteenth centuries, were neither free nor superior, and that the thesis to the contrary, recently revived by Professor White, is but a snare and a delusion.

  THE FREE-BANKING THEORISTS RECONSIDERED

  The bulk of Free Banking in Britain is taken up, not with a description or analysis of Scottish banking, but with analyzing the free-banking controversies in the famous monetary debates of the two decades leading up to Peel’s Act of 1844. The locus classicus of discussion of free versus central banking in Europe is the excellent work by Vera C. Smith, The Rationale of Central Banking.14 While Professor White makes a contribution by dealing in somewhat more depth with the British controversialists of the era, he unfortunately takes a giant step backward from Miss Smith in his basic interpretation of the debate. Miss Smith realized that the currency school theorists were hard-money men who saw the evils of bank credit inflation and who tried to eliminate them so that the money supply would as far as possible be equivalent to the commodity standard, gold or silver. On the other hand, she saw that the banking school theorists were inflationists who favored bank credit expansion in accordance with the “needs of trade.” More importantly, Miss Smith saw that for both schools of thought, free banking and central banking were contrasting means to arrive at their different goals. As a result, she analyzes her monetary writers according to an illumin
ating 2x2 grid, with “currency school” and “banking school” on one side and “free banking” and “central banking” on the other.

  In Free Banking in Britain, on the other hand, Professor White retreats from this important insight, misconceiving and distorting the entire analysis by separating the theorists and writers into three distinct camps, the currency school, banking school, and free-banking school. By doing so, he lumps together analysis and policy conclusions, and he conflates two very distinct schools of free bankers: (1) those who wanted free banking in order to promote monetary inflation and cheap credit and (2) those who, on the contrary, wanted free banking in order to arrive at hard, near-100 percent specie money. The currency school and banking school are basically lumped by White into one group: the pro-central-banking faction. Of the two, White is particularly critical of the currency school, which supposedly all wanted central banks to levy “arbitrary” restrictions on commercial banks. While White disagrees with the pro-central-banking aspects of the banking school, he is clearly sympathetic with their desire to inflate bank credit to supply the “needs of trade.” In that way, White ignores the substantial minority of currency school theorists who preferred free banking to central bank control as a way of achieving 100 percent specie money. In addition, he misunderstands the nature of the inner struggles to find a correct monetary position by laissez-faire advocates, and he ignores the vital differences between the two wings of free bankers.

  On the currency school, it is true that most currency men believed in 100 percent reserves issued either by a central bank monopoly of note issue or by an outright state bank monopoly. But, as Smith pointed out, the aim of the currency men was to arrive at a money supply equivalent to the genuine free market money of a pure specie commodity (gold or silver). And furthermore, since currency men tended to be laissez-faire advocates distrustful of state action, a substantial minority advocated free banking as a better political alternative for reaching the desired 100 percent gold money than trusting in the benevolence of the state. As Smith notes, Ludwig von Mises was one of those believing that free banking in practice would approximate a 100 percent gold or silver money. Free banking and 100 percent metallic money advocates in the nineteenth century included Henri Cernuschi and Victor Modeste in France, and Otto Hübner in Germany.15 Mises’ approach was very similar to that of Otto Hübner, a leader of the German Free Trade Party. In his multivolume work, Die Banken (1854), Hübner states that his ideal preference would have been a state-run monopoly 100 percent specie reserve bank, along the lines of the old Banks of Amsterdam and Hamburg. But the state cannot be trusted. To quote Vera Smith’s paraphrase of Hübner’s position: