“Fractional reserve banking and central banking as sources of economic instability: the sound money alternative”.
Fractional reserve and central banking are often seen as a panacea
for the economysource of easy credit and new purchasing power to quicken
trade. But, as recognized by Mises and Hayek, fractional reserve banking
supported by a central bank is the major source of financial and
economic instability. Growth generated by money creation is
unsustainable and will end in a bust often accompanied by a financial
crisis. The 2000 dot.com bust and the 2007-09 Great Recession were
policy induced boom-busts. Elimination of this source of instability
requires monetary reform; a denationalization of money as suggested by
Keywords: fractional reserve banking, central banking, sound money,
commodity standard, denationalization of money
Jel Codes: E42, E52, and E58
Fractional reserve banking has historically been viewed by some
economists and most monetary cranks as a panacea for the economy–a
source of easy credit and new purchasing power to quicken trade. Better
economists, however, recognized fractional reserve banking with its
ability to create credit, Mises’s [1971, 268-69] circulation credit
or Rothbard’s  deposit banking, as a major source of
financial and economic instability. The establishment of a central bank
was often, when not driven by fiscal priorities of government, an
attempt to achieve the first while mitigating or eliminating the second.
For the United States, in particular, the effort was perhaps misguided.
Per Vera Smith [1990 , 166]:
A retrospective consideration of the background and circumstances of the foundations of the Federal Reserve System would seem to suggest that many, perhaps most, of the defects of American banking could, in principle, have been more naturally remedied otherwise than by the establishment of a central bank; that it was not the absence of a central bank per se that was at the root of the evil, ... there remained [even with a central bank] certain fundamental defects which could not be entirely, or in any great measure, overcome by the Federal Reserve System.
Rothbard  covers the history of money and banking in the U.
S. and amply documents periods of instability generated by banking
panics associated with fractional reserve banking sans an explicit
central bank. However, compared to this earlier era, fractional reserve
banking supported by ‘scientific’ management of the currency
by a central bank has failed to provide the promised stability. Besides
the continuing instability, the Fed has guided a significant [massive]
decline in the purchasing power of the dollar. The dollar currently has
a purchasing power less than 5% of a 1913 dollar. Selgin, Lastrapes, and
White , “Has the Fed Been a Failure?” summarize:
Drawing on a wide range of recent empirical research, we find the following:  The Fed's full history [1914 to present] has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed's establishment.  While the Fed's performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I.  Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.
During a period known as the Great Moderation, roughly 1983-2000,
the U. S. economy experienced a period of apparent relative stability
and prosperity. The U. S. economy was then buffeted by two boom-bust
cycles tied directly to credit expansion and low interest rates driven
by fractional reserve banking supported by central bank activity
[Garrison 2012 and 2009; Salerno 2012; Ravier and Lewin 2012; and
Cochran 2011]. The most recent recession and slow recovery rivals or
exceeds the instability of 1970s and early 1980s in severity and is
arguably the most significant crisis since the 1930s. While much of the
discussion following the recent crisis has focused on why the recovery
has been so slow, a lesson that should have been learned is that the
economic growth driven by money and credit creation is short term only;
an artificial boom cannot last. Ultimately credit creation is a major
destructive power that misdirects production, falsifies calculation,
even in a period of relatively stable prices, and destroys wealth
[Salerno 2012, 32-36]. An economy with a complex financial system like
the present banking system, which in turn depends on a government
monopoly of the supply of money, is prone to cycles and crisis even with
the best of either discretionary or rule-based management. Under our
current system of interest rate targeting “Policy-induced booms
tend to piggyback on whatever economic development is underway”
[Garrison 2009]. This would be true whether the central bank followed a
single, rather than the current dual mandate, such as a policy goal of
price stability or adopted nominal GDP targeting [Garrison 2012,435-36].
Under fractional reserve banking supported by a central bank the
interest rate brake which would normally stop such events before they
turn into bubbles or booms is effectively neutered [Hayek 1975 ,
406-10]. Because of this neutering, booms and busts remain a significant
threat in a “learning by doing” policy framework [Garrison
Without a foundation of sound money, a market determined money;
cycles are inevitable and destructive not only of short-term economic
well-being, but potentially destructive of long-term freedom and
prosperity. It is urgent than that policy makers take seriously
Hayek’s  proposal, developed during the economic crisis of
the 1970s, for drastic monetary reform, for a “denationalization of
money.” This call is echoed by Garrison [2012,436] who argues
future prospects for “achieving long run sustainable growth can
only rest on the prospects for decentralizing the business of
After the decline of former socialist countries and under the
influence of the apparent prosperity in most market economies during the
Great Moderation,most economists recognized the importance of markets
and private property for long-term economic prosperity. As Shleifer
 summarized, “Between 1980 and 2005, as the world embraced
free market policies, living standards rose sharply, while life
expectancy, educational attainment, and democracy improved and absolute
poverty declined.” But markets and private property generate
prosperity because only in such an order can monetary calculation
facilitate rational economic planning. But for monetary calculation to
operate in a way most consistent with consumer sovereignty, calculation
and prices must be embedded is a sound monetary system. As expressed by
Salerno [2010 , 468]:
While there is now a basic recognition by economists that rational allocation of resources necessitates institutional reforms that return resources to private hands and restore genuine markets for productive inputs, there is no such comprehension of the importance of sound money to the processes of economic calculation.
Salerno  continues “Sound money, then is simply one which
does not lead to systematic falsification of or nullificationof economic
calculation.” Economic calculation requires money prices, but for
calculation to most adequately achieve the goal of solving the economic
problem, the money prices used for calculation must reflect the
valuations of producers/consumers that are based on their individually
unique preferences, knowledge, and resources.
Sound money then is money whose purchasing power and quantity are
determined by consumers’ and producers’ valuations;
preferences, knowledge, and resources–that is, a market-determined
commodity money absent government intervention. As expressed by Mises
[1998 , 225],
Economic calculation does not require monetary stability in the sense in which this term is used by champions of the stabilization movement. The fact that rigidity in the monetary unit's purchasing power is unthinkable and unrealizable does not impair the methods of economic calculation. What economic calculation requires is a monetary system whose functioning is not sabotaged by government interference. The endeavors to expand the quantity of money in circulation either in order to increase the government's capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation.
FRACTIONAL RESERVE BANKING AND CYCLES
The Austrian business cycle theory (ABCT) is a blend of monetary
and capitaltheory and highlights coordination problems connected to
“time and money.” In the framework developed by Ludwig von
Mises, banks create money by creating credit. This created credit
finances investment in excess of savings, distorts the structure of
production, and sets the stage for the boom-bust cycle.
But what is created credit and when and how do banks create credit?
Different answers to this question yield different implications for
businesscycle theory and monetary policy, as well as different monetary
reform proposals. In ABCT banks and central banking provide the link
between capital markets, money, and economic instability.
Fractional reserve banks developed from two separate, apparently
legitimate, business activities: banks of deposit or warehouse banking
offering transactions services for a fee, and banks of circulation or
financial intermediaries. Economists, early on, recognized that
circulation banking, often in the form of term financial intermediation,
reduces transactions costs and enhances the efficiency of the capital
markets; leading to more savings, investment, and economic growth.
However, for a counter-argument on the beneficial aspects of term
intermediation see Barnett and Block [2009a, 2009b, and 2011].
Fractional-reserve banking combined these two types of banking
institutions into one institution–a single institution offering both
transaction services and intermediation services. Selgin [1988, chap. 2]
argues that fractional-reserve banking develops naturally in a free
economy as “a result of individuals finding new ways to promote
their self-interest.” Banks are pure intermediaries [Selgin 1996,
120]. Other Austrians have argued that fractional-reserve banks are
hybrid institutions that could only develop as the result of special
privileges granted to banks by government. The activities of these
hybrids are not pure intermediation. The critical economic issue is: Is
credit issued by a fractional reserve bank financial intermediation or
credit creation [Mises 197111912], 268-77 and Cochran and Call 1998,
33-35]? With the development of a fractional reserve banking system,
money creation, either through note issue or deposit expansion, and
credit creation became institutionally linked.
In an Austrian analysis of money and credit, injection effects
matter. The way money enters the economic system–that is the
injection–affects the dynamic adjustment process. The spending of those
who are initially affected by the monetary disturbance change before the
spending plans of those who receive additional money balances only as
the effects of the monetary change spread through the economy. In an
economy with a developed banking system, monetary changes most often
enter the economy as changes in the availability of credit. This
analysis, which is the foundation of Austrian business cycle theory,
combines the theoretical proposition that injection effects matter with
the empirical observation that these effects take place as the banking
system extends credit.
Monetary changes that originate through the banking system alter
not just bank credit but total credit available in the economy and thus
put downward pressure on interest rates. It is not the change in the
rate of interest per se that is important, but the change in the rate
relative to the natural rate or equilibrium rate. The term “natural
rate” is controversial. Following Mises [1971 , 359 and 1978,
120-30], the term will be used to distinguish between an equilibrium
rate and a rate that has been altered by credit manipulation.
An equilibrium rate reflects the “ratio of the value assigned
to want-satisfaction in the immediate future and the value assigned to
want-satisfaction in remoter periods of the future. It manifests itself
in the market economy as the discount of future goods as against present
goods” [Mises 1998 [1949, 523]. Ordinarily, Mises [1998 ,
534] argues, “The loan market does not determine the rate of
interest. It adjusts the rate of interest on loans to the rate of
originary interest as manifested in the discount of future goods.”
Credit creation temporarily suspends this adjustment process. Credit
creation alters the money rate of interest relative to the equilibrium
rate and disrupts the balance between the “supply and demand”
Mises developed an argument clearly explaining why and how credit
creation takes place. Mises [1978, 119] cautioned:
One must be careful not to speak simply of the effects of credit in general on prices, but to specify clearly the effects of "increased credit" or "credit expansion." A sharp distinction must be made between (1) credit which a bank grants by lending its own funds or funds placed at its disposal by depositors, which we call "commodity credit" and (2) that which is granted by the creation of fiduciary media, i.e., notes and deposits not covered by money which we call "circulation credit."
Circulation credit is created credit because “[c]irculation
credit is granted out of funds especially created for this purpose by
banks. In order to grant a loan, the bank prints banknotes or credits
the debtor on deposit account. It is creation of credit out of
nothing” [Mises 1978, 218]. Others in the Austrian tradition have
who attempted to define credit creation include Machlup and Selgin.
Machlup [1940, 224n] explicitly calls Mises’s circulation credit
I use the term transfer credit if the purchasing power accruing to the borrower is counterbalanced by purchasing foregone by somebody else, such as a voluntary saver or a disinvesting producer. My term "transfer credit" corresponds to Mises's "commodity credit." For Mises's term "circulation credit," I have substituted the term "created credit," which clearly conveys the meaning that the purchasing power accruing to the borrower is not counterbalanced by any purchasing foregone by anybody else.
Selgin [1988, 66] defines created credit as “credit granted
independently of any voluntary abstinence from spending by holders of
The Misesian model of credit creation sees modern
fractional-reserve banks as hybrid institutions. Some transactions by
these banks are financial intermediation, and as such enhance the
efficiency of the saving and investment process. Other transactions by
these same institutions create credit. Mises [1971 , 261]describes
these two distinct roles as “the negotiation of credit through the
loan of other people’s money and the granting of credit through the
issue of fiduciary media, i.e., notes and bank balances that are not
covered by money.” Transactions in which both a depositor and a
borrower retain, temporarily, current claims to money may not be
intermediation, but credit creation. According to Mises[1971 ,
It is usual to reckon the acceptance of a deposit which can be drawn upon at any time by means of notes or checks as a type of credit transaction and juristically this view is, of course, justified; but economically, the case is not one of a credit transaction  ... but this is not a credit transaction, because the essential element, the exchange of present goods for future goods, is absent. 
The transaction is different in nature from a true credit
transaction. In a true credit transaction the lender temporally
surrenders “money or goods, disposal over which is a source of
satisfaction and renunciation of which is a source of
dissatisfaction” [Mises 1971 , 264].
In this framework, based on Mises, money as the medium of exchange
is the present good par excellence. Mises [1971 , 79-92] argued
that money was neither a consumption good nor a production good, but
when he discussed money and credit, Mises [1971 , 268-77],
classified money as a present good. “The claim he has acquired by
his deposit is also a present good for him. The depositing of the money
in no way means that he has renounced immediate disposal over the
utility that it commands” [Mises 1971 , 268], and “[t]he
note is a present good just as much as the money” [Mises [1971
, 272]. Since the holding of cash balances, whether in the form of
demand deposits or bank notes, does not require the sacrifice of present
goods, changes in cash balances financed from current income are part of
the allocation of income to provide present utility. Households can use
current income for present goods or future goods. If present goods are
preferred, the household may choose specific consumption goods or money
balances. Hence, the proper economic interpretation of a demand deposit
or bank note is that the deposit or bank note is a bailment or warehouse
receipt, not a credit instrument. Rothbard [1978, 148-49] argues that
while bank deposits are considered a short-term loan from a legal
standpoint, then the funds are legally considered the property of the
bank, not the property of the depositor. But the legal structure does
not change the economic impact of the transaction. If such deposits [or
notes] are used as a medium of exchange, they are a readily available
source of current purchasing power. The depositor has not engaged in a
true credit transaction because no sacrifice of present utility has
taken place. Fractional-reserve banking combined with the creation of
circulating credit expands the supply of credit beyond the limits set by
prior saving. Banking institutions can and do push interest rates below
the natural rate, resulting in spending by ultimate investors exceeding
Created credit eventually causes an economic crisis. The normal
operations of the money and banking institutions supported by a central
bank generate business cycles by attempting to keep market rates of
interest too low for too long. The recession phase of the business cycle
is the economic correction of previous monetary excesses and the
resulting malinvestment and overconsumption [Salerno 2012].
ALTERNATIVE VIEWS OF FRACTIONAL RESERVE BBANKING
In a Keynesian framework[Cochran and Call 1998], banks are viewed
as financial intermediaries and money is considered a future, not a
present, good; a store of value. This Keynesian framework is what Selgin
[1996, 119] has labeled the “new view” of money and banking,
where banks “are pure intermediaries: they act as brokers of,
rather than creators of, loanable funds, and are not an independent
cause of investment in excess ofex ante saving.” Banks are
financial intermediaries that issue a liability that the public
willingly uses as a medium of exchange. The problem for such a banking
system may not be boom-bust cycles caused by credit creation and
malinvestment, but secular stagnation. Such an economy would suffer from
chronic unemployment as money and banking institutions operated so that
the market rate of interest would be too high. Saving would exceed
Selgin and White [1996, 101] argue that a consistent application of
the Wicksellian framework would recognize not only that money creation
can lower rates below the natural rate, but that “unanticipated
destruction of money [or a drop in ‘velocity’] can drive the
interest rate in the short run above its natural level, and hereby
artificially curtail warranted investments.” Here again, the
Misesian model leads to a different conclusion. Per Mises [1971 ,
360], “The opposite case, in which the rate of interest charged by
the banks is raised above the natural rate, need not be considered; if
banks acted in this way, they would simply withdraw from the competition
of the loan market, without occasioning any other noteworthy
In this Keynesian view, financial intermediation should facilitate
the flow of funds from savers to investors. Bank liabilities that do not
serve as a medium of exchange are clearly of this type. The owner of the
bank liability has loaned the funds to the bank for future
considerations. Such intermediation is usually viewed as efficiency
enhancing. Just as in a credit transaction without intermediation, the
ultimate lender has a claim on future money and the borrower has
acquired present money. In the new view, deposit banking is also
intermediation. The saver prefers liquidity to return and decides to
invest in money. The depositor loans funds to the bank and receives a
bank I.O.U.–a bank deposit payable on demand. The bank now owns
additional loanable funds. As reserves are loaned out, funds are
transferred from an ultimate lender [the depositor] to an ultimate
investor [the borrower].
Banks, for legal or economic reasons, maintain cash reserves to
back these short-term liabilities (demand deposits or bank notes). As a
result total lending will be less than total saving. A dollar held in a
reserve balance is a dollar saved but not loaned to an ultimate
investor. The supply of credit will be less than available saving and
the market rate of interest will rise above the natural rate. Investment
will be less than saving and the economy may remain below its productive
capacity. Fractional-reserve banks and other intermediaries provide
intermediation services that increase investment relative to a system
without banking, but when these institutions hold significant cash
reserves,the amount of investment may consistently be less than ideal.
In this view, there exists no market process that ensures that saving
will equal investment at full employment levels. A “natural”
rate of interest may exist, but it is an equilibrium rate only in the
sense that it preserves a status quo, a status quo that may not be
ideal. A central bank is a necessary addition to the banking system.
Central banks can provide new money and credit, high-powered money, to
offset the general contractionary tendencies due to a fetish for
liquidity which is part of the normal operation of financial markets
[Garrison 2001, chapters on Keynes and Keynesians].
Selgin [1988 and 1996] offers a “qualified defense of the new
view” that can be considered a middle ground between the Misesian
and the new view. While fractional-reserve banking is intermediation,
banks can still create credit. Credit is created when credit is
“granted independently of any voluntary abstinence from spending by
holders of money balances” [Selgin 1988, 60]. Extensive credit
creation requires not just fractional-reserve banking, but central
banking. In this framework, the creation of fiduciary media that is
matched by a willingness to hold the additional fiduciary media is not
credit creation, but financial intermediation. Such transactions
facilitate the flow of saving into investment. In the case where
increased saving [reduced spending on present goods] takes the form of
an increased demand for cash in the form of “inside” money,
consumption is deferred and the funds are loaned to the banks f or
atleast short periods. The extension of bank credit and the creation of
new fiduciary media do not, in this instance, reduce the market rate
below the natural rate, but instead, allow the market rate to follow the
natural rate downward. Investment keeps up with a higher level of saving
rather than exceeding a fixed level of saving. Credit creation can take
place if banks issue fiduciary media and credit in excess of the demand
for fiduciary media. But what mechanism prevents excessive credit
creation? Here Selgin and White [1996, 103] rely on and build on Mises
[1998 , 440] who argues:
Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular--one is tempted to say normal--feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.
The existence of a central bank with the ability to create
high-powered or base money is a necessary prerequisite for excessive
credit creation and the resultant boom-bust cycle. Free banking without
central banking could provide intermediation services that could
mitigate contractionary pressures arising from monetary disequilibrium
while also providing sufficient market discipline to prevent excessive
credit creation. Austrian-type business cycles are thus a phenomenon of
central banking, not of fractional-reserve free banking. This argument
depends on the caveat that free banking means banks operate in an
environment in which banks are subject to the general rules of
commercial and civil law and are not the recipients of special
privileges and protections granted by the state. As expressed by Mises
[1998 , 440], “What is needed to prevent any further credit
expansion is to place the banking business under the general rules of
commercial and civil laws compelling every individual and firm to
fulfill all obligations in full compliance with the terms of the
THE MARKET SYNTHESIS
The differences between the Keynesian-based new view and Mises,
Machlup, and Selgin are significant and lead to different explanations
of macro economic instabilities and policy proposals. In the Keynesian
form of the new view, banks, including a necessary and benevolent
central bank, do not create credit. With a ‘fetish for
liquidity’, an economy absent central bank expansion of credit and
lower interest rates will be subject to economic stagnation as the rate
of interest exceeds the natural rate and investment falls below the
level needed to achieve and sustain full employment. Central banking is
a needed extra-market solution to a market malady [Garrison 2001].
In contrast, Mises [1971 ] developed the argument that
fractional-reserve banking creates credit. Created credit is the source
of the malinvestment of the boom phase of the cycle. But significant
malinvestment in the Misesian cycle depends on central bank action or
government backed special privileges, either explicit or implied. The
central bank either actively provides new base money which banks use to
create credit or the central bank passively makes new base money
available to provide the needed liquidity [reserves] to an overextended
banking system. Machlup [1940, 247-48] argues, “Professor Mises
believes, furthermore, that commercial banks alone without the support
of the central bank can never produce a dangerous credit
inflation.” Mises [1998 , 788] is quite emphatic on this
point, “But today credit expansion is an exclusive prerogative of
government.” Without central bank activity, the credit creation by
fractional reserve banks would be limited in extent. Large misdirection
of production caused by credit creation requires either newly created
base money or the promise to create new base money in the event of a
crisis by a central bank. White [2011, 497] provides a supporting
argument relative to the most recent crisis, “A commodity standard
with free banking, and no central bank to distort the financial system
[emphasis mine], would have avoided such a boom-and-bust credit
Central banks provide the source of the newly created credit or
remove the market barriers to bank initiated created credit. It is the
existence of a lender of last resort who can and will create credit with
newly issued base or high-powered money that leads to a moral hazard
problem that gives fractional-reserve banks an incentive to over-extend
credit, which can show up as either more credit extended at lower rates
of interest or new riskier loans extended at unchanged rates of
Banking freedom can potentially limit the scope of and quickly
correct for or reverse any created credit that originates from
fractional-reserve banking. Extensive and harmful credit creation is the
result of the activity of central banking. The malady is extra-market.
Created credit distorts the structure of production causing the
boom-bust cycle and the remedy, really the preventative, is a return to
free markets in money creation. The solution; eliminate the central bank
and restore a free market in money and banking [Herbener, 2012].
Banking freedom would allow market participants to make the
ultimate judgment on what to use as a medium of exchange and where to
draw the line between money as a present good and money as a store of
value. Bankers would make a judgments on the proportion of their
deposits [or notes]that represent saving and the proportion that are
currently serving as present money for the holders of the deposits. Only
funds held as savings may be safely “invested” or loaned.
Consumers of banking services make judgments about the safety and
soundness of the banking institutions with which they deal. Successful
banks will provide the mix of services that meet the needs of their
In an introduction to the most recent issue of the Cato Journal,
“Monetary Reform in the Wake of Crisis” the editor James A.
Dorn  writes:
At no time since the founding of the Federal Reserve nearly a century ago has it been more important to reconsider the role of monetary policy in a free society. In particular, as F. A. Hayek noted, "All those who wish to stop the drift toward increasing government control should concentrate their effort on monetary policy."
Table 1 and Table 2 provide a summary of suggested reforms. Reforms
are listed from a-f in order of ability to generate increased economic
stability, although on this ground reform a, Commodity Standard with
Free Banking and reform b, Commodity Standard with 100% Reserves, are
indistinguishable with perhaps a slight edge to a 100% reserve standard.
By limiting banks ability to use transaction deposits or note issue as a
source of term intermediation a 100% reserve system would most likely
provide greater financial stability. Lipsky  provides commentary
on a recent call for a new gold commission.
Central bank response to the most recent crisis and slow recovery
has moved in the direction of greater, not lesser central bank
involvement in the economy. Recent trends are troubling. Money creation
has been used to finance massive government deficits. Per Taylor [2012b]
the Federal Reserve purchased 77% of the net increase in the debt by the
Federal government in 2011. The Fed has been engaging in
“Mondustrial Policy. The term was used by John B. Taylor at the
2009 American Economic Association meetings to criticize the Fed and
Treasury response to the financial crisis. Taylor, according to
Hilsenrath , used this unflattering term to describe a policy
environment that was “not a monetary framework. It is an
intervention framework fmanced by money creation. This new approach to
monetary policy has not only Austrian economists, but more mainstream
critics recognizing that central banking is financial central planning
[Hummell 2011 and Cochrane 2012].
Cochran describes the Fed reaction:
With this second bust, unlike the first recession of the 21st century, the real economic slowdown was accompanied by a significant financial crisis and if not a public panic, definitely a policy panic. Policy makers feared that the financial crisis would lead to a collapse of the banking and credit system. The fear was deflation. The model was monetary events of 1929 to 1932. The Fed and the federal government responded with an unprecedented bailout of both financial and non-financial firms with the creation and use of new monetary policy tools and Fed-Treasury coordination accompanied by aggressive use of more traditional policy instruments [Duca et a12009]. The result has been a massive expansion of the Fed's balance sheet as well as massive re-structuring of the type assets held by the Fed. The picking of winners and losers has moved the Fed very close to a policy which is even more dangerous to liberty and prosperity than an ordinary fractional reserve banking system supported by a central bank; a mondustrial policy; monetary policy as an agency not only of irresponsible fiscal policy, but of industrial policy as well.
Hummel  provides, without explicitly mentioning the term, the
intellectual foundations for a “Mondustrial Policy”. Hummel
builds his case by illustrating the significant differences in
“approaches to financial crisis” between the Bernanke approach
and a Friedman approach. In addition to exposing the theoretical
foundation of this misguided and dangerous policy, Hummel provides a
very detailed almost step by step use of this type of policy in response
to the major events of the recent crisis. A must read for anyone
interested in the details of how and why the Fed’s balance sheet
expanded so significantly and how much of what was done did not and does
not show explicitly in regularly reported monetary aggregates, their sub
components, or Fed balance sheet reports.
Hummel argues the differences have been rarely noticed. The impact
as “those differences resulted in another Fed failure-not quite as
serious as the one during the Great depression, to be sure, yet serious
enough–but they have also resulted in a dramatic transformation of the
Fed’s role in the economy. Chairman Bernanke has so expanded the
Fed’s discretionary actions beyond controlling the money stock that
it has become a gigantic, financial central planner.”
It should be clear, that this policy response to the current
situation has set up future monetary conditions that may be very
difficult to unwind without significant inflation and/or a continuing
These trends make a return to sound money which “involves
abolishing central banking and paper fiat money and restoring a
commodity money chosen by and totally subject to the market”
[Salerno 2010 , 474] imperative. There is, however, controversy
over the means. Does sound money require 100 per cent reserve banking or
does it allow banking freedom? Mises [1998, 440] opined, “Only free
banking would have rendered the market economy secure against crises and
depression. [And] [t]here is no reason whatever to abandon the principle
of free enterprise in the field of banking.”
However, Rothbard, Salerno, Herbener, Huerta de Soto, Block, and
Reisman, among others, favor 100 per cent reserves; a clear separation
of deposit banking from loan banking, on the basis of reform proposals
made by Mises [1971 , 448-57, and 1978, 17-21 and 44-47]. In these
proposals, Mises argued for 100 percent backing of any newly issued
notes or checkable deposits. For reform of a monetary system on the
verge of collapse or as a proposal for how we move from our current
system toward a sound money system, such a step may be essential. After
reform though, it is also essential that “the question of banking
freedom must then be discussed again and again, on basic
principles” [Mises 1978, 45].
Three reforms have been introduced in the 112th Congress. The
strongest reform proposal is H.R. 1094 introduced by Ron Paul [Bill Text
H. R. 1094]. H. R. 1094, the “Federal Reserve Board Abolition
Act,” is consistent with reforms a or b listed in Table 1 and is
recommended as preferred, if elimination of the impact of fractional
reserve banking supported by a central bank is the ultimate goal of the
reform. H. R. 4180, introduced by Congressman Brady [Bill Text H. R.
4180] and titled the “Sound Dollar Act of 2012” would be a
strong improvement over current Fed operations. Taylor [2012a], as
summarized in reform e, Table 2, favors this reform. H. R. 245,
introduced by Congressman Pence, would eliminate the current dual
mandate of high employment and stable prices. The resolution would make
price stability the goal of the central bank; per the text,
“Section 2A of the Federal Reserve Act (12 U.S.C. 225a) is amended
by striking ‘maximum employment, stable prices,’ and inserting
‘stable prices'” [H.R. 245]. H. R. 4180 and H. R. 245,
while better than current Fed operations, would leave the economy
subject to boom-bust cycles as monetary policy would still not prevent a
boombust which piggy-backs created credit induced growth on top of
productivity driven growth or, as most recently argued by Garrison
, by supercharging a savings induced growth. A movement in the
right direction would include elimination of all laws restricting
private sector initiatives to develop competing medium of exchanges to
Federal Reserve notes. New competitive currencies could be facilitated
by privatization of all government stocks of precious metals. More
detailed proposals for reform can be found in Rothbard [1991 ,
65-72], Salerno [2010,333-363], White , or Herbener . The
Cato Journal [Spring / Summer 2012, volume 32, number 2] is devoted to
“monetary reform in the wake of crisis.” If or while
significant reform such as H. R. 1094 is politically impossible,
Selgin’s  proposal for a productivity norm, which would
greatly reduce the likelihood of significant credit creation in response
to a productivity shock, should be given strong consideration as an
appropriate guide for improving policy under existing banking
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JOHN P. COCHRAN*
* Emeritus Professor, Economic and Emeritus Dean, School of
Business, Metropolitan State University of Denver, E-mail:
Table 1 Summary of Reforms: No Central Bank a. Commodity Standard with b. Commodity Standard with Free Banking 100% Reserves Mises [1998 , 440]: "Only From Huerta de Soto : free banking would have rendered "[T]heoretical analysis yields the market economy secure against the conclusion that the current crises and depression. [And] monetary and banking system [t]here is no reason whatever to is incompatible with a true abandon the principle of free free-enterprise economy, ... enterprise in the field of and that it is a continual banking." source of financial instability and economic disturbances." Free banking means banks operate Three recommended reforms: in an environment in which banks 1. The reestablishment of a are subject to the general rules 100 per cent reserve of commercial and civil law and requirement as an essential are not the recipients of special principle of private-property privileges and protections granted rights with respect to every by the state; placing "the demand deposit of money and banking business under the general its equivalents; 2. the abolition rules of commercial and civil laws of all central banks [which compelling every individual and become unnecessary as lenders firm to fulfill all obligations in of last resort if reform 1 above full compliance with the terms of is implemented, and which as the contract." true financial central-planning agencies are a constant source of instability] and the revocation of legal-tender laws and the always-changing tangle of government regulations that derive from them; and 3. a return to a classic gold standard, as the only world monetary standard that would provide a money supply that public authorities could not manipulate and that could restrict and discipline the inflationary yearnings of the different economic agents." c. Denationalization of Money Hayek : Elimination of central bank with denationa lization of money and competing currencies. This was Hayek's proposal for drastic monetary reform in response to events in the 1970s. Hayek, as quoted in Pizano [2009, 10] was driven "into proposing the denationalization of money" and "a return to a market-determined money." Table 2 Reforms Retaining Central Banking a. Productivity Norm b. Policy Rules Selgin [1997, 10]: "I submit that Taylor [2012, 2] advocates, a constant price level, even once "However, a more practical in place, would be far from ideal. and effective approach, in my Instead, the price level should be view, is to reform the Federal allowed to vary to reflect changes Reserve and create strong in goods' unit cost of production incentives for rule-like [emphasis mine]. I call ... such a behavior. The starting place rule for individual price changes for such a reform is the a 'productivity norm'. Under a recognition that a clear productivity norm, changes in well-specified goal usually velocity would be prevented results in a consistent and [as under zero inflation] from effective strategy for influencing the price level by achieving that goal." off setting adjustments in the supply of money." A productivity norm is consistent He continues,"In the case of with Hayek of the 1930s. monetary policy, multiple goals enable politicians to lean on the central bank to do their bidding and thereby deviate from a sound money strategy. More than one goal can also cause the Federal Reserve to exceed the normal bounds of monetary policy- moving into fiscal policy or credit allocation policy-as it seeks the additional instruments necessary to achieve multiple goals." Taylor [2012, 4]concludes, "In my view the reforms [H.R. 4180] would enhance the independence of the Fed by adding reassuring accountability appropriate for an independent agency of government and clarifying that its overall responsibility is monetary policy not fiscal policy or credit allocation policy. History and basic economics tells us that such reforms would greatly improve employment and price stability and would help restore America's prosperity." c. Hayek: Price Stabilization or Nominal GDP Targeting Price Stabilization: Hayek [1979, 17]: "Though monetary policy must prevent wide fluctuations in the quantity of money or in the volume of the income stream, the effect on employment must not be a dominating consideration. The primary aim must again become the stability of the value of money [emphasis original]." Hayek [1979, 18] continues that following a bust, then, to prevent a "liquidity crises or panics" there is a need "to ensure convertibility of all kinds of near-money into real money" For this, "the monetary authorities must be given some discretion" Nominal GDP targeting: In a 1975 reply to a question from his old friend Gottfried Haberler in a talk given at the American Enterprise Institute, as quoted by Ransom , argued,"The moment there is any sign that the total income stream may actually shrink [during a post-bust deflationary crash], I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose." Hayek' caveat [1979, 10]: "I do not believe we shall regain a system of international stability without returning to a system of fixed exchange rate[emphasis mine], which impose upon national central banks the restraint essential for successfully resisting pressure of the advocates of inflation in their countries"