The Uneasy Case for Fractional-Reserve Free Banking

van den Hauwe, Ludwig (2006): The Uneasy Case for Fractional-Reserve Free Banking. Forthcoming in: Procesos de Mercado Revista Europea de Economía Política , Vol. III, No. 2 (December 2006)

Abstract

Since a few decades several sub-disciplines within economics have witnessed a reorientation towards institutional analysis. This development has in particular also affected the fields of macroeconomics and monetary theory where it has led to several proposals for far-reaching financial and monetary reform. One of the more successful of these proposals advocates a fractional-reserve free banking system, that is, a system with no central bank, but with permission for the banks to operate with a fractional reserve. This article exposes several conceptual flaws in this proposal. In particular several claims of the fractional-reserve free bankers with respect to the purported working characteristics of this system are criticized from the perspective of economic theory. In particular, the claim that a fractional-reserve free banking system would lead to the disappearance of the business cycle is recognized as false. Furthermore an invisible-hand analysis is performed, reinforcing the conclusion that fractional-reserve free banking is incompatible with the ethical and juridical principles underlying a free society.

• Item Type: MPRA Paper
• Language: English
• Keywords: monetary and banking regimes; comparative institutional analysis; central banking versus free banking controversy; fractional-reserve free banking; Law and Economics of money and banking
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E50 - General; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E42 - Monetary Systems ; Standards ; Regimes ; Government and the Monetary System ; Payment Systems; B - History of Economic Thought, Methodology, and Heterodox Approaches > B5 - Current Heterodox Approaches > B53 - Austrian; K - Law and Economics > K3 - Other Substantive Areas of Law > K39 - Other; G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation; P - Economic Systems > P3 - Socialist Institutions and Their Transitions > P34 - Financial Economics; H - Public Economics > H1 - Structure and Scope of Government > H11 - Structure, Scope, and Performance of Government

References

Alonso, M. A. 2004. « La macroeconomía del capital en el siglo XXI », Análisis Económico, Núm. 40, vol. XIX, 23- 47. Barro, R.J. and D.B. Gordon 1983a. "A positive theory of monetary policy in a natural rate model”, Journal of PoliticalEconomy, 91 (4), 589-610. Barro, R.J. and D.B. Gordon 1983b. “Rules, discretion and reputation in a model of monetary policy”, Journal of Monetary Economics, 12, 101-21. Block, W. 1988. “Fractional Reserve Banking: An Interdisciplinary Perspective,” Chapter 3 in Man, Economy, and Liberty: Essays in Honor of Murray N. Rothbard, W. Block and L. H. Rockwell, Jr., eds., Auburn: Ludwig von Mises Institute, pp. 24-32. Checkland, S. G. 1975. Scottish Banking – A History, 1695-1973, London: Collins. Daugherty, M. R. 1942. “The currency-banking controversy Part 1”, Southern economic journal, vol. 9, Oct., 140-55. Daugherty, M. R. 1943. “The currency-banking controversy: II”, Southern economic journal, vol. 9, Jan., 241-51. Diamond, D. W. and P. H. Dybvig 1983. “Bank runs, deposit insurance, and liquidity”, Journal of Political Economy, 91 (June), 401-19. Dowd, K. 1993. Laissez-faire banking, London: Routledge. Dowd, K. 1996. Competition and Finance – A Reinterpretation of Financial and Monetary Economics, London: MacMillan Press. 60 Edgeworth, F. Y. 1888. “The Mathematical Theory of Banking”, Journal of the Royal Statistical Society, 51, 113-127. Fetter, F. W. 1965. Development of British Monetary Orthodoxy 1797-1875, Cambridge: Harvard University Press. Garrison, R. W. 1996. “Central Banking, Free Banking, and Financial Crises”, The Review of Austrian Economics, vol. 9, no. 2, 109-27. Garrison, R. W. 2001. Time and Money – The Macroeconomics of Capital Structure, London: Routledge. Goodhart, C. 1988. The Evolution of Central Banks, Cambridge: The MIT Press. Hayek, F. A. 1941. The Pure Theory of Capital, London: Routledge & Kegan Paul. Hayek, F. A. 1973. Rules and Order, London: Routledge. Hayek, F. A. 1991. Denationalisation of Money – the Argument Refined, reprinted as Ch. 2 in: Economic freedom, Institute of Economic Affairs, 125-235. Hoppe, H.-H. 1994. “How is Fiat Money Possible?-or, The Devolution of Money and Credit”, The Review of Austrian Economics, vol. 7, no. 2, 49-74. Hoppe, H.-H., Hülsmann J. G. and W. Block. 1998. “Against Fiduciary Media”, The Quarterly Journal of Austrian Economics, vol. 1, no. 1, 19-50. 61 Hoppe, H.-H. 2006. The Economics and Ethics of Private Property, Auburn: Ludwig von Mises Institute. Horwitz, S. 1992. Monetary Evolution, Free Banking, and Economic Order, Oxford: Westview Press. Horwitz, S. 2000. Microfoundations and Macroeconomics, London: Routledge. Huerta de Soto, J. 1994. “Banque Centrale ou Banque Libre: Le Débat Théorique sue les Réserves Fractionnaires”, Journal des Économistes et des Études Humaines, vol. 5, no. 2/3, 379-391. Huerta de Soto, J. 1995. “A Critical Analysis of Central Banks and Fractional-Reserve Free Banking from the Austrian School Perspective”, Review of Austrian Economics, vol. 8, no. 2, 25-38. Huerta de Soto, J. 1998. “A Critical Note on Fractional- Reserve Free Banking”, The Quarterly Journal of Austrian Economics, vol. 1, no. 4, 25-49. Huerta de Soto, J. 1998. Dinero, Crédito Bancario y Ciclos Económicos, Madrid: Unión Editorial. Huerta de Soto, J. 2006. Money, Bank Credit, and Economic Cycles, Auburn: Ludwig von Mises Institute. Hülsmann, J. G. 1996. “Free Banking and the Free Bankers”, The Review of Austrian Economics, vol. 9, no. 1, 3-53. 62 Keynes, J. M. 1997. The General Theory of Employment, Interest, and Money, Amherst: Prometheus Books. Klein, B. 1974. « The Competitive Supply of Money », Journal of Money, Credit, and Banking, vol. 6 (Nov.), 423-453. Kydland, F.E. and Prescott, E.C. (1977), ‘Rules Rather Than Discretion: The Inconsistency of Optimal Plans’, Journal of Political Economy, 85 (June), 473-91. Laidler, D. 1992. “Free banking: theory”, The New Palgrave Dictionary of Money and Finance, 196-7. Menger, C. 1892 [1994]. On the Origin of Money, in: Kirzner I. M. 1994. Classics in Austrian Economics, Vol. I, The Founding Era, London: William Pickering, 91-106. Menger, C. 1994. Principles of Economics, Grove City: Libertarian Press. Mises, L. von. 1998. Human Action (Scholar´s Edition), Auburn: Ludwig von Mises Institute. Mises, L. von. 1978. On the Manipulation of Money and Credit, New York: Free Market Books. Mises, L. von. 1981. The Theory of Money and Credit, Indianapolis: LibertyClassics. Mises, R. von. 1957 [1981]. Probability, Statistics and Truth, New York : Dover Publications. 63 Nozick, R. 1974. Anarchy, State, and Utopia, Oxford: Basil Blackwell. Obstfeld, M. and K. Rogoff 2002. Foundations of International Macroeconomics, London: The MIT Press. Popper, K. R. 1983. Realism and the Aim of Science, London: Hutchinson. Reisman, G. 1998. Capitalism, Ottawa: Jameson Books. Rockwell, L. H. (ed.) 1992. The Gold Standard, Auburn: Ludwig von Mises Institute. Rothbard, M. N. 1983. The Mystery of Banking, Richardson & Snyder. Rothbard, M. N. 1988. “The Myth of Free Banking in Scotland”, The Review of Austrian Economics 2, 229-45, now in: Rothbard 1997b, 311-330. Rothbard, M. N. 1991. The Case for a 100 Percent Gold Dollar, Auburn: The Ludwig von Mises Institute. Rothbard, M. N. 1994. The Case Against the Fed, Auburn: Ludwig von Mises Institute. Rothbard, M. N. 1995. Classical Economics, Cheltenham: Edward Elgar. Rothbard, M. N. 1997a. The Logic of Action I, Cheltenham: Edward Elgar. 64 Rothbard, M. N. 1997b. The Logic of Action II, Cheltenham: Edward Elgar. Rothbard, M. N. 1998. The Ethics of Liberty, New York: New York University Press. Rothbard, M. N. 2004. Man, Economy, & State, with Power and Market (Scholar´s Edition), Auburn: Ludwig von Mises Institute. Salin, P. 1998. “Free Banking and Fractional Reserves: A Comment”, Quarterly Journal of Austrian Economics, vol. 1, no. 3, 61-65. Say, J.-B. 2001. A Treatise on Political Economy, London: Transaction Publishers. Schwartz, A. J. 1992. “Banking School, Currency School, Free Banking School”, The New Palgrave Dictionary of Money & Finance 1, 148-152. Sechrest, L. J. 1988. “White´s Free-Banking Thesis: A Case of Mistaken Identity”, Review of Austrian Economics 2, 247-257. Sechrest, L. J. 1993. Free banking – theory, history, and a laissez-faire model, Westport: Quorum Books. Selgin, G. A. 1988. The Theory of Free Banking – Money Supply under Competitive Note Issue, New Jersey: Rowman & Littlefield. 65 Selgin, G. and L. H. White. 1994. “How Would the Invisible Hand Handle Money?”, Journal of Economic Literature, vol. XXXII, no. 4, also in: Selgin, G. 1996, 15-56. Selgin, G. 1994. “On Ensuring the Acceptability of a New Fiat Money”, Journal of Money, Credit, and Banking, vol. 26, no. 4, 808-26. Selgin, G. and L. H. White. 1996. “In Defense of Fiduciary Media-or, We Are Not Devo(lutionists), We Are Misesians!”, The Review of Austrian Economics, vol. 9, no. 2, 83-107. Selgin, G. 1996. Bank Deregulation and Monetary Order, London: Routledge. Shah, P. J. 1997. “The Option Clause in Free-Banking Theory and History: A Reappraisal”, The Review of Austrian Economics, vol. 10, no. 2, 1-25. Skousen, M. 1996. Economics of a Pure Gold Standard, New York: The Foundation for Economic Education. Skousen, M. 1990. The Structure of Production, New York: New York University Press. Smith, A. 1937. An Inquiry into the Nature and Causes of the Wealth of Nations, Edwin Cannan (ed.), New York: The Modern Library. Smith, V. C. 1990. The Rationale of Central Banking and the Free Banking Alternative, Indianapolis: Liberty Press. 66 Walsh, C.E. (2001), Monetary Theory and Policy, Cambridge, MA: The MIT Press. White, L. H. 1989. Competition and Currency-Essays on Free Banking and Money, New York: New York University Press. White, L. H. 1992. “Mises on Free Banking and Fractional Reserves”, in: A Man of Principle – Essays in Honor of Hans F. Sennholz, Grove City College Press, 517-33. White, L. H. 1995. Free Banking in Britain (Second Edition), London: The Institute of Economic Affairs. White, L. H. 1999. The Theory of Monetary Institutions, Oxford: Blackwell. Yeager, L. B. 1993. “Book review of Kevin Dowd´s ‘Laissez-faire banking’”, Manchester School of Economic and Social Studies, University of Manchester: Department of Economics, 321-323.