Lee, a guy who used to comment on here a lot, has a guest post at Lars Christensen's blog. It's definitely worth the read. The beginning goes over the standard story on excess money demand and general gluts, and talks a little about trends in barter and alternative monies.
Then he gets into the alternative of free banking. Now what I still don't understand about free banking is why people think it would solve the problem better than central banking. These discussions always seem to get through the problems with central banking - which I think we all know like the back of our hand by now - and then it moves to free banking as an alternative, but it always seems to wrap up before we really explore free banking! I don't blame Lee for this - he was under no obligation to satisfy my curiosity! But maybe I could get readers here to build my faith in free banking a little.
What you want is a more elastic money supply. I might even go as far as saying that what you want is a perfectly elastic money supply because it's absurd to economize on resource consumption just to get more of the medium of exchange. We should economize on resource consumption because we make tradeoffs with other scarce resources! Why economize on real goods just to make tradeoffs with green pieces of paper that don't earn a return? I'm not sure if that's right - maybe we don't want a perfectly elastic money. But we want a more elastic money supply for all the traditional reasons we've always wanted it: because an excess demand for money is completely pointless and for many people quite painful.
So what I would think free bankers would want to demonstrate to skeptics like me is that free banking offers a more stable and more elastic money supply. Is there any reason to think this?
Why do we demand money? While Lee is right that excess demand for money results in general gluts, it can also be caused by general gluts (yes, you read that right). Remember when people talk about a general equilibrium in the context of a general glut, they're usually thinking of a point in time. But a lot of the sales at that point in time are contingent on expectations about the future. All investment is contingent on expectations. And of course, a lot of consumption is too. We smooth consumption over time, and if we are concerned about our income stream in the future we're going to cut some consumption today. General swings in expectations about the future can result in an excess demand for money (which can of course further generalize the glut, through the more traditional mechanism that Lee outlines).
We know how central banking reacts to this, and the answer is "as well as the central bankers react". The incentives of the central bankers are often OK - particularly here in the U.S. where we have a dual mandate. The biggest problems come from things like knowledge problems, reaction times, etc.
The fact that knowledge problems are a potential issue in central banking is what (understandably) piques many peoples' interest in free banking. But what is a banker's incentive under free banking? If asset values are falling because of a general depression of expectations about future economic performance, it seems to me that banks are not going to be making money readily available, they're going to be worrying about their own solvency. And that's the critical difference: central bankers don't worry about solvency or profits, but free bankers do. For that reason I just can't get my head around why people think free bankers would do better in a crisis situation.
There are a couple pieces of evidence. First is the relative absence of systems of free banking. I get some predictable push-back when I talk about this (to anticipate one form of push-back - yes I know about the good old days in Scotland), and obviously its not proof of anything. But it is indicative, I think. If free banking were really that much better you would think it would be naturally selected into more widespread existence.
But you can also just look at the behavior of banks under central banking. As the Fed discovered in the 1930s, and as they're discovering today, bankers don't always do the socially optimal thing. The money that the Fed actually has control over has been much more responsive than broader monetary aggregates that banks have control over:
Obviously this isn't competing monies exactly, but I'd be interested in someone explaining to me why the same fears and conservatism on the part of banks wouldn't stymie the generation of new money in a system of free banking. That's my concern. It's not - as Boettke and Smith suggest - an idealization of central bankers thats holding me back. It's that I don't understand why free banking would provide more elastic money, and I don't feel like anyone has explained to me why I should expect it to.
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