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Where Did the Free Banking Debate Go?

March 31, 2011

The discussion in monetary institutions is becoming increasingly relevant in economics. How to deal and avoid financial crisis is an important issue. The recent financial crisis showed that economics might not be as suited to foresee and deal with these problems as the theory seems to suggest. This analysis requires a benchmark in the same way the study of market uses a “perfect competition” or “unregulated market” as a guide in the analysis. Unregulated banking, or free banking, is the analogous benchmark for money and banking. The free banking discussion, however, is not new in the discipline.

Some expositions, for example, can be found in Adam Smith’s Wealth of Nations (Book II Chapter II) and in Mises’ The Theory of Money and Credit (1912), as well as in the old debate in the nineteenth century between the Currency School, Banking School and the Free Banking School. However, the free banking alternative may have started to be left aside during the debate between Hayek and Keynes during the 1930s. The free banking alternative was not raised as the debate took place in the context of the Great Depression and was not grounded on purely theoretical considerations, but centered on the specifics of the Great Depression. This debate strongly affected the evolution of economic theory and monetary policy for many years to come. One wouldn’t be too far by stating that while microeconomics is neoclassical based macroeconomics is Keynesian based, that one can do one or the other without paying too much attention to the other. Even though microeconomics could be bridges that are being tried to be constructed between the two worlds, they are still to different structures rather than two faces of the same coin.

In 1950 Hayek moved to the University of Chicago and started to work on other topics, his place as a protagonist in the business cycle debate was filled by Milton Friedman. Friedman, however, employed the Keynesian tools to build his counter-arguments. But in Keynesian tools there is no place for free banking, on the contrary, there is an active role for central banking and fiscal spending. The result was a Keynesian macroeconomics, with Keynesian based economic indicators and no place for free markets in money and banking. One would now ask what is that the central bank should do rather than ask if it should be there in the first place. The result of using Keynesian tools to counter-argue Keynesianism was the casting aside of the free banking alternative.In simple words, the model had no space for such a system.

As long as the problem of monetary institutions is relevant, a comparative analysis including free banking becomes relevant. There are three, rather than two, alternatives in the debate: rules, discretionality or market competition. The study of sound monetary institutions requires us to think outside the box of the model and entertain different alternatives and study their stability and relative benefits and costs to the presence of a centralized monetary authority.

Even though the free banking alternative has been out of scene for a long time, recent work shows that government involvement in banking carries more costs and monetary instability than an unregulated banking can achieve, even though free market is not perfect. The lack of attention on the case of free banking responds more to methodological issues in the monetary debate than to problems in the system. As such, the study of unregulated banking can bring us closer to sound money.

Nicolas Cachanosky is a doctoral student in economics at Suffolk University, as well as a previous Sound Money Essay Contest winner.

Image by nuttakit / FreeDigitalPhotos.net.

3 Comments

  1. MT4 News Indicator November 12, 2014 5:22 AM

    How to deal and avoid a financial crisis is always an important issue, I have to say that we should stay awake and not repeat that disaster which was happening back in the 2008.

  2. Nicolas Cachanosky April 1, 2011 11:01 AM

    Yes. The case of Hayek and Friedman is very interesting. Also, the evolution of Friedman's thoughts on central banking.

    An interesting exposition of Friedman's evolution on this topic is in Selgin, G. (2008). Milton Friedman and the Case Against Currency Monopoly. The Cato Journal, Vol. 28, No. 2.

    I sometimes have the impression that methodological stands have an important effect on the direction and content of the debates. That's what I tried to argue in the post. I think this is another reason why to study methodology is very important.

  3. Adrian Ravier March 31, 2011 11:33 PM

    Very interesting post.

    Milton Friedman and Friedrich Hayek worked together in Chicago, and also have participated in different debates in monetary issues at the Annual Meetings of the Mont Pelerin Society.

    I remember Milton Friedman explaining that there is not another important aspect of economic policy, for which the Liberterians starting from the same fundamental principles get to conclusions so divergent.

    But we should remember also that Friedman, finally, accept to end the Fed. In 2006, in a letter he wrote to Greg Mankiw, he said: "Even better would be to abolish the Fed and mandate the Treasury to keep highpowered money at a constant numerical level."