Central and Free-Banking Theory

Chapter 8 of my book Money, Bank Credit and Economic Cycles is devoted to an analysis of the theory of central banking and free banking. There is a long tradition behind banking theory, though it was not until the first third of the nineteenth century was drawing to a close that economists began to grasp what happens in the cycle—an understanding which has culminated only one century later. In any event, we have already seen that the theorists of the School of Salamanca carried out quite a relevant analysis of how banks operate and the effects of fractional-reserve banking. They made important contributions three centuries earlier which unfortunately were forgotten. For example, they realized that deposits form part of the money supply just as paper money does. Luis de Molina used the term chirographis pecuniarum—the “written money” banks generate as a mere entry in their accounting books. I say it was unfortunate, because when the debate broke out in England between the Banking School and the Currency School at the beginning of the nineteenth century, with the arrival of the Industrial Revolution following the Napoleonic Wars, Currency School theorists were correct in their analysis, in which they attributed financial crises to fractional-reserve banking. At the time, banks’ main business activity was the issuance of unbacked paper currency. On July 19, 1844, Sir Robert Peel (the Younger) successfully enacted a law requiring a 100-percent reserve ratio on the issuance of paper money. However, due to an oversight, the same requirement was not set for the issuance of deposits, and therefore, the law was basically inoperative. Bankers simply redirected their business and stopped issuing unbacked paper money, but they began to issue unbacked deposits, and successive stages of boom and financial crisis and recession continued to recur.