The Free-Banking vs. Central-Banking Debate

Ah, what a lovely way to start the day. A glorious morning, cool and fresh. A meeting of aged soccer players on a lush and muddy turf. No broken bones. No pulled hamstrings. I even scored a goal. Oh, the joy.

And now back home to read over my fan mail. You know…I had no idea that Americans were so passionate. I think that
American-style passion frightens us little Canadians. I suspect that this is what makes Canada so dull. And it’s probably the reason I left too. Welcome to the jungle, Mr. Andolfatto.

As many of you can imagine, I’ve been the recipient of hundreds of rather nasty emails lately. I don’t know any other way to describe it except as “awesome.” Oh, I don’t especially like being called names and being insulted, but it’s no big deal (academics need pretty thick skins to survive). The awesome part is how people are so eager to express their views. It is, I think, a part of what makes America great.

Now for a little story–some background, I guess. Long ago, a remarkable debate took place about the optimal way to organize an economy’s money and banking system. The proponents of free-banking eventually lost out to those who favored some form of central bank regime. The nature of these debates are nicely summarized by Vera Smith in her book, The Rationale of Central Banking.

Then for a long time, it seemed that very few people were interested in this debate anymore. Oh, a few academics would talk about it here and there. But if one was interested in practical monetary policy issues, well, one simply had to take the existence of a central bank as given.

That attitude always struck me as wrong-headed. As a young academic, I was interested in the theoretical foundations for monetary exchange. And I became fascinated in the experiments with money and banking regimes that were tried in the past. I made a point of teaching this to my students. And, in particular, I emphasized the free-banking alternative.

And now I find myself employed at a central bank (I still retain affiliation with my university). Well, I’m at a regional branch of a central bank (there are 12 regional Feds). And because of my present employment, many people evidently believe that I am a hard-nosed central bank type whose sole purpose is to defend the institution and its policies. As if an academic could or would want to ignore 20 years of scholarly research on the subject just like that. No, that’s now how it works–and it’s not the reason I was hired by the St. Louis Fed (if it was, I would not have come).

I love the research division here in St. Louis. My colleagues are great and the intellectual atmosphere is vibrant. The debates we have among ourselves often get lively. And yes, we sometimes talk about the merits of gold standards, free-banking, etc. I have even invited George Selgin, an ardent and articulate proponent of free-banking, to visit us in St. Louis and give us a lecture on the topic (which he has agreed to do some time in the future).

As an academic who has devoted a considerable amount of time on the subject, I cannot say that I presently fall strongly on either side of the debate. I can see merits (and defects) in both points of view. And I think it is great that Ron Paul has brought the subject back into the spotlight. As an academic interested in the subject, it is no less than thrilling. I think I can speak for most of us economists working at the St. Louis Fed in saying that we welcome a healthy debate. (And do not make the mistake of thinking that all Fed economists necessarily fall on one side of the issue).

To make a solid case one way or the other, it is important to keep the facts straight. (Yes, I realize that I am setting myself up for more abuse but please, spare yourself the trouble.) Moreover, it is also important, I think, not to present data in a misleading light. Now, I do not think everything Ron Paul says is wrong. In fact, as I said in my original post, I appreciate the libertarian philosophy. But if one wants to promote libertarianism based on sound intellectual foundations, it does the cause no good to make and promote misguided statements about money, prices, and the role of central banks. History is replete with bad government policies well before the existence of central banks. In my view, it is wrong to convey the impression that something close to economic nirvana will dawn in the absence of a central bank.

In my original post, I wanted to attack one particular idea promoted by Ron Paul. (I did not mean to attack the man personally, and I regret adjective I used to describe what I thought of his idea). I want to be clear that the post was not meant to critique all or even most of the Congressman’s ideas–nor was the post meant to serve as a defense for the Fed.

It is my belief that Ron Paul promotes a misleading argument concerning the fact that our price-level today is much higher today than it was 100 years ago. His argument implicitly suggests that nominal wages today would be roughly where they are at even in the absence of currency debasement. This is, in my view, just plain wrong.

But for people who believe it (and evidently there are many out there that do), it provokes rage against the Fed. It is as if the Fed has stolen virtually all of their wages and that real material living standards today would be much higher if only the price-level had remained at its 1913 level. This proposition is grossly at odds with the evidence, which shows roughly 2% annual real growth in per capita income and roughly stable income and expenditure shares. There is, of course, considerable discussion about growing income inequality. But almost every paper I read about this phenomenon seems to point either to skill-biased technological change or competition from emerging economies. I’m not sure what Fed policy has to do to with those forces.

I am no defender of inflation. But the US inflation rate has been low and stable for decades now. Seigniorage revenue is small potatoes relative to the appropriations made by Congress via direct taxation. Ending the Fed will do little, in my view, to diminish the level of those appropriations. Tackling that issue will take serious tax reform–a reform that would have to take place whether or not a Fed was in existence.

Now, there may be other reasons for abolishing the institution, but if so, then why not emphasize those? As I said in my original post, there are many legitimate arguments one could level at the Fed as an institution or in the way it conducts its policy. But it does no service to the libertarian cause to attack the Fed with misleading arguments (that are mixed in with other more legitimate ones). It does no good because opponents to the libertarian cause can latch on to the lame arguments and use them to discredit the more worthy ones.

The Fed was established by an act of Congress in 1913. The Fed is operating under the rules established by Congress. If you have a problem with these rules, then I encourage you to lobby your Congressional representatives to change them. Blaming the Fed for following the law as established by Congress  (and other guidelines, such as the dual mandate) seems like a rather strange way to go. But hey–power to the people.

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About David Andolfatto 95 Articles

Affiliation: Simon Fraser University and St. Louis Fed

David Andolfatto is a Vice President in the Research Division of the Federal Reserve Bank of St. Louis. He is also a professor of economics at Simon Fraser University.

Professor Andolfatto earned his Ph.D. in economics from the University of Western Ontario in 1994, M.A. and B.B.A. from Simon Fraser University. He was associate professor at the University of Waterloo before moving to Simon Fraser University in 2000.

His current research is focused on reconciling theories of money and banking. His past research has examined questions relating to the business cycle, contract design, bank-runs, unemployment insurance, monetary policy regimes, endogenous debt constraints, and technology diffusion.

Visit: MacroMania, David Andolfatto's Page

6 Comments on The Free-Banking vs. Central-Banking Debate

  1. Mr. David,

    I’m just a silly little economics undergraduate, only 20 years old ( you’ve been researching this for all my life) but i’ll still take you on!!

    you say that annual real growth in per capita income has been 2% but you do nothing to address the lag between this increase and the increase in prices.

    secondly, what if I’m retired and on fixed income installments? how does this increase help me??

    what if I’ve been saving money for 30 years? i can imagine a person 1000 years ago digging a hole and calling it his savings account.. burying a couple of silver coins everyday and giving this wealth to his grandchildren at the end of his life.. but what will happen to my wealth if i do that today?

    also, we all know an act of congress was what established the federal reserve, but was it on their own initiative? if it was then please take a look at this and explain it to me. ( you’ll have to scroll down just a bit )

    so i wonder why congress couldn’t discuss this system themselves?

    i don’t think you’re delusional, nor an idiot. I think you understand perfectly whats going on here.. but hey humans don’t bite the hand that feeds them!! do yourself a favor stop writing about the subject unless you’re going to be a man, suck it up and admit to your mistakes.

    • I got to agree with you except for one point I do think he is delusional and an idiot. Not for the faulty logic he is putting out but definitely for thinking that any 20 year old kid with any brains would not make Swiss cheese of such a pathetic attempt at a rebuff.
      “stop writing about the subject unless you’re going to be a man” I doubt he is going to listen to this unfortunately.
      At the very least make it a little more challenging pinhead.

      • Ok, so his pinhead comment was uncalled for, but so are words like delusional and idiot. Let’s call it a draw.

        Are we going to discuss monetary policy or are we going to play this schoolyard name game?

  2. Blah, I too have looked into the mysteries of Jekyl Island. Unfortunately, I can’t in all honesty base the entire Central Banking design flaws on this event. The same story surfaced in the 1970s during the gas squeeze as well as in the 1980s during the credit crunch with S&Ls. Could it be that this urban legend is simply a byproduct of our time? I’m just saying it certainly seems plausible.

    Did these powerful bankers meet for a round of golf? They probably did. Did they devise the inherited centralized system? Perhaps yes – perhaps no, however in legal terms it would all be considered hearsay at this point.

    David has continued to make an excellent point that has yet to be acknowledged – Congressional Spending. As much as the Fed may have exacerbated our economic down turn with some very ill advised policy (QE1, QE2, and soon to be QE3) Congressional spending is equally the culprit. The Fed didn’t force Washington to adopt the foreign policy we have instituted. Additionally, the Fed has not voted to raise the U.S. debt ceiling year after year. We elected our representatives and we bought into the multi-billion dollar campaigns. Thus we got exactly what we voted for under our one party system (it really is just one party, not two – let’s not kid ourselves on that one).

    When Charlie Sheen continues to be the top headline in our news cycle, and events in Libya get a modest second mention there is fundamentally wrong with our human priorities. We allow an adulterous druggy to rule our airwaves because we let him do it – in fact we follow it 24/7 on Twitter. The advertising dollars are aware of this imbalance and cater to it in the name of consumerism. One day, our marginal utility of Charlie Sheen will reach it’s max and there will be another sacrificial celebrity vaulted into pop culture for us to temporarily idolize and eventually destroy by virtue of our “righteousness”.

    The movements in Tunisia, Egypt, Libya, Yemen and a host of other nations are a real reminder of the power of people (both good and bad). We would be wise to watch and support liberty in its infant form and to reject violence & genocide.

    We would also be wise to vote differently. It is said that voting for a “3rd party” is a wasted vote. I must disagree. The real waste of our vote is one that goes to the industrial military complex every 2 to 4 years expecting something that cannot be created – free market prosperity and peace.

    “It does not take a majority to prevail, but rather an irate tireless MINORITY keen on setting brushfires in the minds of men.” – Samuel Adams

  3. brian,

    great points and i agree, it does’t matter and its all hearsay at this point.

    But why doesnt Mr. David reply to my post and explain to me what i do not understand or what i am misinterpreting, after all I’m just 20 years old and just started my second year at uni.. he is a prof, he’s supposed to teach me. But if he can’t then what does this mean?

    I apologize for including words like delusional and idiot in my post, it was very immature. But i just wish for Mr. David to teach me some Economics, tell me why I am wrong, after all I’m just an undergrad kid and he’s a prof!

    Mr David I want to learn from you, please?

  4. The premise of this article is false: it was NOT free-banking versus central banking; free-banking was a step on the way to central banking

    State-chartered banks opposed the central bank, because a central bank curtailed their issue and cut into their business. They got their charters from States, so these banks supported Representatives and Senator who voted against a central bank.

    Free banks got their licence from a legislative act, after which they did not need to “support” politicians…..

    The next step was National banks; they got their licence from a Federal law, so they really didn’t have to pay attention to State politicians. And when the Fed was organized these National banks were invited to join.

    Free-banking started in New York State
    One of the “fathers” of the National Banking Act, Samuel Hooper, 10 years earlier (1852) introduced Free-banking in Massachusetts; in 1862 he was on the Committee of Ways and Means…..

    Please read Mr. Hooper’s speech in the House, in 1862—

    This really is not proper english:
    “I cannot say that I presently fall strongly on either side of the debate”
    ‘presently’ means: in the immediate future

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