Central Banking, Free B a n k i n g ,

and F i n a n c i a l Crises
Roger W. Garrison

A growing literature explores the concept of free banking on

both a theoretical and an historical basis. George Selgin
, (1988) sets out the theory of free banking and makes a compel-
ling case that, despite the uniqueness of money, the forces of supply
and demand are more conducive to monetary stability, correctly under-
stood, than are the edicts of a central bank. Larry White (1984), focus-
ing on the free-banking episode in nineteenth-century Scotland, and
Kevin Dowd (1994), collecting studies of experience with free banking
in many countries and time periods, have shown that this alternative
to central banking has a respectable history.
The aim of this paper is to get a fix on the possible and currently
relevant sources of macroeconomic instabilities in the economy and to
identify the most promising banking arrangements for dealing with
those instabilities. Possible maladies and remedies can be considered
in the context of competing schools of macroeconomic and monetary
thought. Attention is directed to the issue of whether the perceived
problem and/or its solution is inherent in the market economy or lies
outside the market process. This formulation immediately gives rise
to a two-by-two matrix with maladies and remedies represented in one
dimension, market forces and extramarket forces represented in the
other. The fruitfulness of this approach is demonstrated by its ability
to sort out competing schools of thought, put current debate in perspec-
tive, and assess the prospects for a stable macroeconomy--with the
Federal Reserve as currently constituted and with the alternative in-
stitution of free banking.
This exercise in comparative-institutions analysis does not deal with
the dynamics of the macroeconomy in transition between one set of
monetary institutions and another or with the political issues of just
how such a transition might be brought about. Nor does it deal directly

*Roger Garrison is professor of economicsat Auburn University.

The Review of Austrian EconomicsVol. 9, No. 2 (1996): 109-27
ISSN 0889-3047
109
110 The Review of Austrian Economics Vol. 9, No. 2

with the ultimate nature of the monetary standard. There is a strong

presumption, however, that only a central bank can preempt a com-
modity s t a n d a r d with its own fiat money and that banknotes issued by
competing banks in a free-banking system would have to be redeem-
able in some real commodity, such as gold, to make them acceptable in
a m a r k e t where banknote holders can easily express their preferences
among issuers. There is broad agreement among Austrian-oriented
writers that a banking system characterized by (1) central direction
and (2) fractional reserve is not conducive to economic stability. How-
ever, there is some disagreement among the Austrians as to which of
the two mentioned characteristics is f u n d a m e n t a l l y responsible for
the instability. The argument in this paper follows Ludwig von Mises,
as portrayed by White (1992), and takes the centralization of the cur-
rent banking system to be the most fundamental issue and the most
appropriate focus for prescribing reform.

The E q u a t i o n of E x c h a n g e

Underlying all theories of money and b a n k i n g - - a s well as all prescrip-

tions of policy and recommendations tbr reform--is the familiar equa-
tion of exchange: MV = PQ. For the economy as a whole, buying must
equal selling, where buying is represented by the total supply M of
money times the frequency (the circulation velocity V) with which each
monetary unit on average is spent and where selling is represented by
the average price P of goods times the total q u a n t i t y Q of goods sold.
Although true by construction, the e q u a t i o n of exchange helps us to
keep in view the i n t e r d e p e n d e n c i e s t h a t characterize the macroe-
conomy. It is impossible, for instance, to conceive of a change in only
one of the four magnitudes represented in the equation of exchange.
Any one change implies some offsetting change or changes on one side
or the other of the equation--or possibly on both sides. For instance,
a decrease in money's circulation velocity, which simply reflects an in-
crease in the demand for money, must be accompanied by (1) an in-
crease in the money supply, (2) a decrease in prices, or (3) a decrease
in real output sold (or by some combination thereof).
The equation also facilitates the comparison of competing schools
of thought. C o n s i d e r i n g in s e q u e n c e K e y n e s i a n i s m and E a r l y a n d
L a t e M o n e t a r i s m can provide a basis for s e t t i n g out the distinctive
p e r s p e c t i v e t h a t emerges from the theory of free banking. 1 The case

1The comparison of schools facilitated by the equation of exchange is wholly

independent of the unique qualities of Austrian macroeconomics, which t~atures the
intertemporal allocation (and possible misallocation) of resources and requires theoriz-
ing at a lower level of aggregation.
Garrison: Central Banking, Free Banking, and Financial Crises 111

against central banking and in favor of free banking, then, is preceded

by some history of thought--possibly more than some may think jus-
tified. The comparison of schools of thought is included for two rea-
sons. First, some writers have recently gotten it wrong, presenting
monetarist ideas under the Keynesian label. Second, the case for free
banking contains arguments that are sufficiently close to Keynes's
own that they need to be distinguished explicitly from his.
Keynes believed that the economy is chronically unstable because
of instabilities associated with both Q and V. Goods, in the Keynesian
construction, are decomposed into consumption goods C and invest-
ment goods I, the latter being inherently unstable in view of the
pervasive uncertainty faced by the business community--the "dark
forces of time and ignorance that envelop our future" (Keynes, 1936,
p. 155). The strength of the i n v e s t m e n t sector, according to Keynes,
is highly d e p e n d e n t on psychological f a c t o r s - - " a n i m a l spirits"
(pp. 161-62) t h a t motivate each (and, t h r o u g h contagion, all) of
the economy's investors. The occasional waxing and waning of the
animal spirits affect I - - a n d affect C as decisions in the business
community govern incomes and hence spending. Both directly and
derivatively, then, the uncertainty of the future translates into fluc-
tuations in the economy's output magnitude Q.
The equation of exchange reminds us that changes in Q cannot be
the whole story. If prices and wages are sticky and the money supply
is wholly determined by the monetary authority, the rest of the story
must center on money's circulation velocity V. What Keynes called the
"fetish of liquidity" is, in this view, nothing but another perspective on
the waning of "animal spirits." Would-be investors abstain from com-
mitting themselves to investment projects, whose profitability is un-
certain, and instead hold their wealth liquid°
The economy, according to Keynes, is prone to periodic collapse.
Pervasive uncertainty inherent in investment activity and prospects
of economic disaster occasionally overwhelm the business community.
Entrepreneurs cease their individual attempts to outguess one an-
other and begin collectively to guess against the economy. In droves,
they forego real assets in favor of liquidity. Q falls, and along with it,
V. Liquidity, or money (Keynes used the terms synonymously), consti-
tutes something of a "time out" for the entrepreneur/specula-
t o r - s o m e w h a t analogous to rest areas along an interstate highway.
Fog on the highway or the wearing effects of traffic congestion can
make the rest areas increasingly attractive,
The origin and essence of the problem, in the Keynesian view, is to
be found on the righthand side of the equation of exchange (a de-
creased Q). Keynes works on both sides of the equation, however, in
112 The Review of Austrian Economics Vol. 9, No. 2

devising possible solutions to the problem. For instance, much of

Keynes's discussion of m o n e t a r y reform, which included support in
principle for Silvio Gesell's stamped money as well as for taxing trans-
actions in securities markets, was aimed at making the time-out op-
t i o n - t h e option of getting or staying liquid--more costly. Keynes fa-
vored all attempts to deprive money of its liquidity value only to la-
ment that investors would find other assets (e.g., gems and precious
metals) that could provid refuge from the uncertain future (Keynes
1936, pp. 353-58).
Reforms in this direction are analogous to installing toll gates at
the rest a r e a s - - o r possibly eliminating rest areas altogether. Travel-
ers would make better time between New Orleans and Atlanta if there
were no possibility of stopping along the way. Keynes did not consider
that some would-be travelers might not depart New Orleans in the di-
rection of Atlanta under such conditions; he did lament that closing or
charging for rest areas might cause travelers to find other places to
stop along the highway.
In lieu of prevention in the form of making liquidity less attractive
or more costly, Keynes recommended monetary policy to accommodate
the demand for liquidity--satiating that demand if necessary to keep
money from competing with real investments in the collective mind of
the business community. To the extent that money-demand entails a
large psychological element, the rest-area analogy holds. A road sign
that reads "LASTREST AREAFORNEXT 100 MILES" m a y attract m a n y cus-
tomers, whereas the travelers m a y stop very infrequently if there were
rest areas all along the way.
While increasing the supply of money to neutralize the effects of
a fetishistic demand for liquidity m a y be a necessary component of pol-
icy prescription, it will not be sufficient, according to Keynes, to re-
store conditions of prosperity. This is only to say t h a t a d e c r e a s e d V
is a s y m p t o m r a t h e r t h a n t h e essence of the problem. The solution
m u s t involve t h e s u b s t i t u t i o n of g o v e r n m e n t spending for p r i v a t e
i n v e s t m e n t s p e n d i n g - - a c c o m m o d a t e d , of course, b y m o n e y crea-
tion. Fiscal s t i m u l a t i o n prods the reluctant travelers along the eco-
nomic highway. Keynes viewed fiscal policy as primary; m o n e t a r y pol-
icy as secondary.
In the Keynesian view, then, the malady is inherent in the market;
the r e m e d y entails e x t r a m a r k e t forces. It is in the very n a t u r e of
things that our weary travelers will, on occasion, follow one another into
the increasingly overcrowded rest areas, where each traveler is reluctant
to resume the journey alone. Restoring and maintaining stability re-
quires intervening forces in a double-barreled way; the interveners
must work simultaneously on both sides of the equation of exchange.
Garrison: Central Banking, Free Banking, and Financial Crises 113

Monetary reform and fiscal stimulation are intended to keep the trav-
elers out of the rest areas and to keep them moving along smartly. Cen-
tral banking is essential for the task. But ultimately, Keynes (1936, p.
378) called for a wholesale replacement of our current system with a
system of public transportation: A comprehensive socialization of in-
v e s t m e n t is offered as the only solution to the problem of unemploy-
ment.
Early monetarism, as exposited by Clark Warburton (1966) in the
1940s and 1950s and as revived in recent y e a r s by Leland Yeager
(1986), has a kinship to the equation-of-exchange perspective on the
Keynesian view. Both schools perceive a possible malady and remedy
that fit into the two-by-two matrix in the same way: M a r k e t malady;
e x t r a m a r k e t remedy. They differ radically, however, in terms of the
specific n a t u r e of the problem and the implied j u d g m e n t about the ef-
ficacy of the m a r k e t economy. Market participants m a y opt for more
money in preference to more real o u t p u t - - w h e r e the relevant alterna-
tives to holding money are both investment goods and consumption
goods. The demand for money is not fetishistic, and changes in it are
not necessarily contagious, but money demand can and does change.
The velocity of money is not constant in the same w a y that Planck's
constant and Avogadro's n u m b e r are. 2
With a given money supply, increases in the demand for money put
d o w n w a r d pressure on prices, a Except in the fanciful case in which
prices adjust fully and instantaneously to this monetary disturbance,
the a d j u s t m e n t process involves quantities as well as prices. Our high-
way travelers are trying to stop and rest even in the absence of ade-
quate rest areas. The unintended consequence is a general slowdown
of traffic. A decreased V impinges on Q as well as on P - - e v e n if the
ultimate, or long-run consequence is a proportionate decrease in P. In
principle, a monetary policy that succeeds in relieving downward pres-
sure on prices by meeting every increased demand for money with an
increased supply will result in greater stability for the economy as a
whole. A constant P becomes, in this view, the essence of monetary sta-
bility. The problem (decreased V) and solution (increase M) are set out in
precisely this way by Paul Krugman (1993, p. 26-28 and passim )--but

2It shoald be noted, however, that even before the impact of Milton Friedman's
empirical work was fully felt, the Early Monetarists held that the typical and most
significant reductions in MV were attributable to reductions in M and not in V~
3Here and throughout the paper, the phrases "increase in the demand for money'
and "decrease in the velocity of money" are used interchangeably. Although this usage
is not unconventional, some monetary theorists take money demand to be defined by
the equation of exchange itself. That is, Md = (1/V)PQ, in which case any change on the
righthand side of the money-demand equation would constitute a change in the demand
for money.
114 The Review of Austrian Economics Vol. 9, No. 2

with this view offered as Keynes's understanding of the nature of busi-

ness cycles! Early Monetarism is wrongly attributed to Keynes. 4
Early and Late Monetarists share an analytical framework as well
as a basic judgment about the central bank's capacity to do good and
to do harm. It was Milton Friedman, of course, who shifted the focus
of attention away from problems of monetary disequilibrium to the
general relationship between M and P that endures over space and
time. Empirical studies using data from many different economies and
many different time periods lent support to the proposition t h a t
changes in the lefthand side of the equation of exchange are over-
whelmingly attributable to changes in the quantity of money. Study
after study demonstrating the stability of money demand (a near-con-
stant V) had the effect of focusing attention on the money supply M as a
basis for accounting for both inflation and deflation. Changes in the
money supply are much more likely to be a problem than to be a solution
to a problem. Empirical and theoretical considerations, as welt as con-
siderations from political economy, underlay this summary judgment.
Under typical conditions, in which money demand remains relatively
constant, there is a "long and variable lag" that separates changes in
the money supply and the subsequent changes in the price level. This
empirical fact, coupled with the lack of any timely and unambiguous
indicator of actual changes in the demand for money, weighs against
the prospects for even well-intentioned money-supply management
having a stabilizing effect on the macroeconomy. Dimming the pros-
pects still further, of course, is the fact that the central bank may in-
tend to do more than act as a stabilizing agent and that some of its
intentions, such as dealing narrowly in alternating episodes with the
problems of inflation and unemployment and with problems associ-
ated with the strength or weakness of the dollar in international mar-
kets, are antithetical to the idea of a central bank as macroeconomic
stabilizer.

4Even worse, the school of thought whose sails have most recently caught the
academic wind calls itself New Keynesianism--seriously missing the mark with both
parts of its name. Gregory Mankiw and others (Ball, et al., 1988) remain largely
agnostic about the specific source of change on the lef~hand side of the equation of
exchange. Their theorizing holds up whether it is M or V that decreases. The Keynesian
label is adopted simply on the basis of their recognition that prices do not change
i n s t a n t l y - - a basis t h a t actually distinguishes their (and many other) arguments only
from extreme versions of New Classicism. The "New" is added in recognition that the
assumption of sticky prices is replaced with "sophisticated" reasons for prices not
adjusting instantaneously. But Early Monetarism as initially set out and in modern
expositions does not fail to include reasons tbr the behavior of those who set prices. New
Keynesianism is Early Monetarism offered with the aid of now fashionable modeling
techniques, which involve mathematically t r a c t a b l e - - i f largely implausible--con-
straints on price- and wage-adjustments.
Garrison: Central Banking, Free Banking, and Financial Crises 115

We can locate Monetarism in our two-by-two matrix by noting that

both malady and remedy are in the extramarket category. In fact,
Monetarisra consists, by and large, of (1) the recognition that the cen-
tral bank is a destabilizing force and (2) the recommendation that it
not be a destabilizing force. Adherence to a monetary rule according to
which the money supply is increased at a slow, steady, and prean-
nounced rate is likely to engender more macroeconomic stability than
central bank activism can achieve--no matter how well-intentioned
and expertly conceived. Actual experience both befbre and after the
heyday of Monetarism suggests that the same understanding that
gives rise to Monetarists'view of the central bank also accounts for the
central bank's inability and unwillingness actually to adopt and abide
by a monetary rule. The so-called Monetarist experiment begun in Oc-
tober of 1979 under the chairmanship of Paul Volcker, for instance,
was Monetarist only in a limited and perverse sense. The Federal Re-
serve did shift its attention from interest rates to monetary aggre-
gates, a move that would be preliminary to actually adopting a rule for
monetary growth. But its policies following this shift made for even
greater variation in the money supply (and in the rate of interest) cre-
ating significantly greater macroeconomic instability than had been
experienced before. Ultimately, a monetary rule, however widely and
forcefully recommended, is at odds with the even more widely per-
ceived view that the Federal Reserve Chairman is the second most
powerful individual in the country.

Free Banking
The basic case for free banking is the general case for decentralization
of economic activity. The uniqueness of money does not immunize it
against the forces of supply and demand and does not make the invis-
ible hand of the marketplace any less beneficial to society. Quite to the
contrary, our rest-area analogy suggests that market forces have spe-
cial advantages in adjusting money supply to money demand. While
the market cannot respond on a daily basis, supplying rest areas any-
where along the highway that they happen to be demanded by today's
travelers, free banking can and automatically would supply liquidity
along the economic highway anytime and anywhere it is demanded.
The case for decentralization is strengthened by comparing free-bank-
ing dynamics to central-bank policies that we have actually experi-
enced and even to the policies of an idealized non-politicized central
bank whose sole objective is that of maintaining macroeconomic sta-
bility. A comparison favoring free banking follows from two proposi-
tions. First, the failure in fact of the central bank to adopt a monetary
rule (and the unlikelihood of its adopting such a rule in the future)
116 The Review of Austrian Economics Vol. 9, No. 2

weighs in favor of decentralization. What the Federal Reserve lacks

the will and ability to do can be done automatically by the impersonal
forces of supply and demand governing banknote issue. Second, the
difference between the implicit rule that the decentralized banking
system follows and the simple monetary rule of slow and steady
growth of the money supply gives free banking higher marks as a sta-
bilizing force in the economy. In the final analysis, the simplicity of the
monetary rule derives from the judgment that discretionary moves are
more likely to destabilize than to stabilize. The monetary rule is im-
posed, then, in the spirit of the unspoken maxim of yesteryear's medi-
cal profession: "Maintain good bedside manners, and strive to do no
harm."
Free banking automatically discriminates between real distur-
bances and monetary disturbances, reacting only to the latter (Selgin
1988, pp. 64-69). The "automaticity" implies both a timeliness and an
absence of political pressure--features that are forever denied to cen-
tral banking. Under steady-state conditions in which the economy is
experiencing no growth and no changes in the demand for money, the
simple monetary rule and the implicit free-banking rule are the same:
zero growth in the money supply. The consequences are also the same:
a constant price level. Under more typical conditions of some positive
rate of real economic growth and some variability in the demand for
money, the two rules differ. The simple monetary rule is based on a
long-range estimate of secular growth and of secular movement in
money demand. An estimated growth rate of 3 percent and an esti-
mated upward trend in money demand (downward trend in velocity)
of 2 percent translate into a money growth rate of 5 percent. Strict
compliance with the rule would mean that movements in the price
level would exhibit no long-run trend. Actual deviations from trend in
either output or in velocity, however, would result in upward or down-
ward pressure on the general level of prices. Accordingly, the rule itself
might be adjusted to allow for the differential harmfulness of inflation
and deflation. Ingrained notions that prices and wages are stickier
downwards than upwards and that unemployment bites harder into
economic prosperity than does inflation may justify--narrow political
motives aside--a rule of increasing the money supply at some rate
slightly in excess of 5 percent. A mild inflation might be considered
cheap insurance against any actual deflation. 5

5By wholly ignoring discoordinating consequences of deflationary pressures and

factoring in the effect of an anticipated price-level decline on the real value of money
holdings, Friedman (1969, pp. 45-47) argues for a theoretically optimal growth rate for
M that is considerably lower (2% instead of 5%) than that implied by secular changes
in Q and in V.
Garrison: Central Banking, Free Banking, and Financial Crises 117

The implicit rule automatically implemented by free banking is

the old central-bank maxim (usually observed in the breach): "Print
money to hold b u t not money to spend." If the holders of banknotes
issued by a particular bank are willing to hold still more, it is in the
interests of the bank to increase its issue. The fact t h a t the bank's cus-
tomers are holding r a t h e r than spending implies the absence of infla-
tionary pressures. In this context, the bank need not even consider
whether the increased demand for its own notes is a general increase
in the d e m a n d for money or an increase in the d e m a n d for its
banknotes relative to the demand for other banknotes. However, if an
individual bank increases its issue even in the absence of any increase
in d e m a n d to hold its banknotes, then the extra spending of t h e m will
soon impinge on the bank's reserves. The sustainable level of note is-
sue is demand-determined. In a decentralized and competitive environ-
ment, each individual bank can be expected to forego the short-term gains
that overissuing its own banknotes might entail in order to avoid the
long-term losses that the market process would inevitably impose.
In contrast to the simple monetary rule, which is devised to accom-
m o d a t e real economic growth by checking deflationary p r e s s u r e s
w h a t e v e r their source, the implicit free-banking rule involves no
change in the money supply in response to a change in real output.
This difference in the two rules reflects the automatic discrimination,
inherent in free banking, between real and monetary disturbances. An
increase in the demand for money puts downward pressure on product
and factor prices in general. If there were no money-supply response,
a general decline in economic activity would follow, since prices and
wages could not fully and instantaneously adjust themselves to the
new m a r k e t conditions. Goods in general would go unsold; production
would be cut; workers would be laid off. Such quantity effects can be
self aggravating, as the Early Monetarists emphasized. With a less-
than-perfectly flexible price system, general deflationary p r e s s u r e s
can push the economy below its potential during the period in which
prices are adjusting to the higher monetary demand. And the fact that
some prices and some wages are more flexible than others means that
the a d j u s t m e n t period will involve changes in relative prices t h a t re-
flect no changes in relative scarcities. These are precisely the kinds of
problems t h a t are highlighted by modern monetary-disequilibrium
theorists, e.g., Yeager (1986), and that are avoided by free banking's
responsiveness to increases in money demand.
Suppose, however, t h a t with an unchanging d e m a n d for money,
the economy experiences economic growth. Despite the implications of
the familiar neoclassical growth models, the economy's output does not
undergo a general change; there is no disembodied growth that might
118 The Review of Austrian Economics Vol. 9, No. 2

be explained in terms of an economywide technology shock. Rather, the

outputs of various goods increase as a result of an increased availabil-
ity of particular resources used in producing t h e m or the discovery of
a new technique t h a t converts particular inputs into a particular out-
put more efficiently. Downward pressure on the prices of the particular
goods t h a t account for the economy's growth will be felt primarily in
the m a r k e t s for those very goods. Relative prices adjust to reflect the
fact t h a t these goods are now more abundant. The m a r k e t process at
work here is the one t h a t gets emphasis in the sophomore-level eco-
nomics of supply and demand. Perversities t h a t dominate in the con-
text of an increase in money demand get little or no play in the context
of economic growth. The increased Q, which simply reflects a positive
net change in the sum of all the economy's individual qs, is accompa-
nied by a decrease in the corresponding ps. It would be misleading here
to evoke the fears of "deflationary pressures." The individual ps be-
come adjusted to their corresponding qs on a m a r k e t - b y - m a r k e t basis.
The fact t h a t this new constellation of ps average to a lower P t h a n
before has no special claim on our attention. There is no downward
pressure on P over and above the forces of supply and d e m a n d t h a t
operate separately in the affected markets and reflect the underlying
economic realities. There are no perversities i n h e r e n t in this sort of a
relative (and absolute) adjustment.
In terms of the equation of exchange, we can say t h a t free banking
adjusts M so as to offset changes in V; but allows changes in Q to be
accommodated by changes in P. Economic growth does involve price
deflation in a literal sense (the price level falls as output increases) but
does not involve any macroeconomic malady t h a t is commonly associ-
ated with the t e r m "deflationary pressures." In effect, by distinguish-
ing between m a l i g n a n t and benign deflation, free b a n k i n g provides a
much stronger check against inflation t h a n t h a t provided by the sim-
ple m o n e t a r y rule. 6 It would be misleading to classify free banking in
terms of m a l a d y and remedy because the m a l a d y never gets a chance
to show itself. Significantly, though, there are no e x t r a m a r k e t forces
at work here either creating problems or fixing them.
Central Banking and the Debt Bomb
The case for a decentralized banking system, which by and large par-
allels the case for markets and against central planning agents, is a

6Selgin (1991) distinguishes clearly between ,]chat I have called malignant and
benign deflation. It is interesting to note that free banking, which relieves only the
malignant deflationary pressures, may get close to Friedman's theoretical optimum,
which assumes those pressures away.(See footnote5.)
Garrison: Central Banking, Free Banking, and Financial Crises 119

strong one. The central bank cannot outdo free banking or even match its
performance as a macroeconomic stabilizer. It lacks the ability to distin-
guish on a timely basis between movements in V and movements in Q,
it lacks the incentives to act in ways that would promote stability, and as
a key player in a political environment, it actually responds to incentives
in ways that foster instability. None of these characteristics, however, is
at odds with our understanding of the origins of the Federal Reserve
S y s t e m - - e s p e c i a l l y as exposited by Rothbard (1994), whose story does
not place great emphasis on the lofty goal ofmacroeconomic stabiliza-
tion.
It is commonly understood, now, that the Federal Reserve accom-
modates the Treasury by monetizing the government's debt. That is,
it injects credit m a r k e t s with new money so as to relieve the u p w a r d
pressure on interest rates t h a t Treasury borrowing would otherwise
entail. And with telling exceptions, the Federal Reserve m a i n t a i n s an
easy-money policy in the year-and-a-half before each presidential elec-
tion. ~ The so-called political business cycles have now become an inte-
gral part of the macroeconomic landscape. Further, the Federal Re-
serve is called upon to deal with other real or perceived problems hav-
ing little to do with macroeconomic stability. It is expected, for in-
stance, to lower interest rates when the housing m a r k e t is in a slump
and to strengthen or w e a k e n the dollar in response to m o v e m e n t s in
exchange rates or trade flows. All these attempts to manipulate em-
ployment rates, interest rates, and exchange rates interfere with the
Federal Reserve's ability to achieve and maintain macroeconomic sta-
bility or even to refrain from inducing instability. If the simple mone-
tary rule fares poorly in comparison with the implicit rule of free bank-
ing, it fares well in comparison with the actual policies of the Federal
Reserve.
These political factors are well recognized by modern Fedwatch-
ers. Less well recognized are the c u m u l a t i v e effects of decades of defi-
cit a c c o m m o d a t i o n and macroeconomic manipulation. With federal

7The telling exceptions involve Presidents Ford, Carter, and Bush. In 1976 Ford
simply did not play the game. He did not press Federal Reserve C h a i r m a n Arthur
Burns, who had helped Nixon get re-elected four years earlier. With Ford perceived as
a non-starter, Carter boasted that his administration would ~hit the ground running,"
which in terms of monetary policy meant that the expansion was started much too early.
By re-election time (1980), the stimulative effects of the monetary expansion had
receded into history and inflation was upon us. With equally bad timing, but in the
opposite direction, Bush tried to play the game in 1992 but started the expansion too
l a t e - - a f t e r finally realizing that he couldn't ride through the election on his victory in
the Persian Gulf: The monetary stimulant was felt during the first few months of the
Clinton administration. Starting too late, too early, and not at all, these three incum-
bent campaigners had one thing in common: They lost.
120 The Review of Austrian Economics Vet. 9, No. 2

i n d e b t e d n e s s now m e a s u r e d in the trillions of dollars and increasing

annually by hundreds of billions, the need for a stabilizing monetary
system is all the more important. The debt bomb is not ignored by Wall
Street. An explosive ending to this era of fiscal irresponsibility may or
may not be in the making, but the bomb's incessant ticking has its own
effect on the stability of securities markets, s A consideration of the ac-
tions of the Federal Reserve in recent years aimed at dealing with so-
called mini-crashes in the financial sector provides a further basis for
assessing the prospects of centrally produced macroeconomic stability.
From the narrow perspective of the financial sector the issues of mal-
ady and remedy look deceivingly like those identified by Keynes: mar-
ket maladies and e x t r a m a r k e t remedies. An activist central bank is
seemingly justified by its indispensable role in taming an otherwise
wild financial sector. But a fuller understanding of the situation sug-
gests that it is an unbridled Treasury rather than unbridled capitalism
that lies at the root of the economy's current problems. And it is the
Federal Reserve--its very existence--that removed the bridle. On this
understanding, the malady and remedy are both in the e x t r a m a r k e t
category, b u t the diagnosis and prescription are not as simple as the
Monetarists would have us believe.
Increasingly, the significance of the Federal Reserve in the context
of the macroeconomy derives from its ability to monetize government
debt. This is not to say that the actual rate of debt monetization domi-
nates the Federal Reserve's current agenda but rather that the very
potential for debt monetization is taking on increasing significance.
How has the federal government been able to get away with such a
chronically and conspicuously large budgetary i m b a l a n c e - - a n d with
no sign of meaningful fiscal reform--without subjectingitselfto the sub-
stantial penalty imposed automatically by credit markets? Why is there
no default-risk premium on Treasury bills? Excessive debt accumulated
by individuals, corporations, or even municipalities is eventually dealt
with when the borrowers lose their creditworthiness and face prohibitive
rates of interest. This salutary aspect of the market process is short-cir-
cuited in the case of Treasury debt by the very existence of a central

SThere are a n u m b e r of books written in the spirit of Bankruptcy 1995 (1992)

offering calculations of one sort or a n o t h e r about w h e n the debt bomb will blow. Will it
be when i n t e r e s t p a y m e n t s dominate the growth p a t h of t h e debt? Or w h e n i n t e r e s t
p a y m e n t s exceed tax revenues? Calculations based on t h e s e a n d related eventualities
are almost surely irrelevant. In informal discussion, I have designated all such calcu-
lations as e s t a b l i s h i n g w h a t I define to be t h e "Gore Point" t h e point a t which even A1
Gore perceives the debt as a problem, (A colleague h a s suggested a n equally apt n a m e
the "Barro Point, '~in honor of Robert Barro, who persistently downplays all t h e worries
about g o v e r n m e n t indebtedness.) The i m p o r t a n t point here is t h a t financial m a r k e t s
do not a w a i t the education of AI Gore. Much of the instability currently observed on
Wall Street is a t t r i b u t a b l e to the chronically large debt a n d deficit.
Garrison: Central Banking, Free Banking, and Financial Crises 121

bank. The Federal Reserve in its standby capacity as a b u y e r of gov-

e r n m e n t debt keeps the default-risk premium off Treasury bills. The
potential for debt monetization allows federal indebtedness to rise un-
checked to levels that would have been thought fanciful only a few ad-
ministrations back and to remain high and rising into the foreseeable
future.
The potential for debt monetization, critical for maintaining an un-
easy balance between economic and political reality, gives rise to specu-
lation about the timing and extent of actual debt monetization. At issue
here are prospective movements, possibly dramatic ones, in the inflation
rate, interest rates, and exchange rates, which in turn can have dramatic
effects in securities markets. The attractiveness of securities can be dif-
ferentially affected by the inflation that would result from actual debt
monetization or by the movements in exchange rates that reflect the
Treasury's greater or lesser reliance on foreign credit markets or by move-
ments in interest rates brought about by changes in the Treasury's do-
mestic borrowing. At some point, uncertainties about the timing and ex-
tent of debt monetization may dominate securities markets. In this case,
the dense fog that drives our travelers offthe economic highway and into
the rest areas is not inherent in the m a r k e t economy at all b u t r a t h e r
is emitted by the Fed-backed Treasury.
It has become conventional wisdom in recent years that there is
some link (though a poorly defined one) b e t w e e n chronically high
b u d g e t a r y deficits and instability of securities m a r k e t s (Feldstein
1991, p. 8 and p a s s i m ). 9 And it is t a k e n for granted that it is the Fed-
eral Reserve's responsibility to deal with that instability, providing on
a timely basis whatever liquidity is demanded so as to keep the occa-
sional sharp declines of security prices, the mini-crashes, from affect-
ing the performance of the macroeconomy. The implicit objective, here,
seems to be that of building a firewall between the financial sector and
the real economy, allowing both to lead their separate lives. Ironically,
it is largely the existence of the Federal Reserve--its potential for debt
m o n e t i z a t i o n - - t h a t enables the Treasury to borrow almost limitlessly,
thus creating the very instability that is to be kept in check by that
same Federal Reserve.
Short-term success of the Federal Reserve in maintaining the fire-
wall between the financial and real economy depends critically on the wis-
dom and credibility of the Federal Reserve Chairman. Prospects for

9This is not to suggest that deficit-induced instabilities are the only macroeconomi-
cally significant ones. Instabilities emanating directly from the Federal Reserve and
instabilities associated with perverse banking regulations and deposit-insurance pric-
ing also have a claim on our attention. But, arguably, the deficit-induced instabilities
deserve more attention than they have so far received. See Garrison (1993 and 1994).
122 The Review of Austrian Economics Vol. 9, No. 2

longer-term success are problematic d e s p i t e - - o r possibly because

of--a sequence of short-term successes. Considerations of the nature
of the Federal Reserve's role in the context of possibly volatile swings
in the demand for liquidity suggest that continued central manage-
ment of the economy's money supply does not offer the best hope for
macroeconomic stability.
Suppose that the Treasury or the White House urges that the Fed-
eral Reserve become more accommodating and t h a t the Federal Re-
serve Chairman expresses reluctance. Will the urgings get more in-
tense? Will the reluctance fade? Speculation about the ultimate out-
come will likely show up on Wall Street as an increased trading volume
and an increased volatility of security prices. Traders who have little con-
fidence in their own guesses about a possible change in the Federal Re-
serve's policy stance are likely to get out of the market. Securities prices
weaken as these traders begin to liquidate, causing others to follow suit.
Now, even those traders who do have guesses about the Federal Reserve
begin guessing instead about the market's reaction to the uncertainty. The
scramble to get out of the market manifests itself as a liquidity crisis.
Abstracting from the fact that this instability has its origins in extramar-
ket forces, we notice that the nature of this destabilizing speculation
is exactly as described by Keynes (1936, pp. 153-58).
In dealing with the liquidity crisis, the Federal Reserve is imme-
diately pitted against itself. It must expand the money supply to ac-
commodate the increased d e m a n d s for l i q u i d i t y - - a n d by the right
amount in a timely fashion--while maintaining its credibility that it
will not expand the money supply in response to the urgings from the
White House. Fedwatchers are going to need some tea leaves here to
determine j u s t exactly what the Federal Reserve is and is not doing.
Once again, the equation of exchange provides a sound basis for sort-
ing it all out. M is being increased to offset a downward movement in
V. If the increase in M is too little, the net downward movement in MV
will result in the dreaded deflationary pressures which will impinge
only partly on P and hence partly on Q. The Federal Reserve's firewall
is too weak; the liquidity crisis spills over into the real economy. If the
increase in M is too great, then, willy-nilly, the Federal Reserve is suc-
cumbing to the urgings of the executive branch to further accommo-
date the Treasury's borrowing. The extent of the accommodation, as
m e a s u r e d by the net upward movement in MV, will ~n time show up as
inflation, which was one of the prospective eventualities that underlay
the speculation and the liquidity crisis.
As complicated and convoluted as this reckoning is, it constitutes
only half of the story. Removal of the liquidity from the financial m a r k e t
in a timely maturer is as important as its timely injection, The failure
Garrison: Central Banking, Free Banking, and Financial Crises 123

of the F e d e r a l Reserve to move against an increasing V t h a t charac-

terizes the end of the liquidity crisis accommodates the Treasury and puts
upward pressure on prices. Possibly more critical are the repercussions
of the excess liquidity in international money markets. Overaccommoda-
tion can weaken the dollar. I f this weakness is perceived as the beginning
of a trend, the result may be heavy selling of dollars and dollar-denomi-
nated assets. Thus, a botched attempt to deal with a liquidity crisis can
provoke a currency crisis. The Federal Reserve must somehow defend the
real economy against this double-edged sword. 1°
The F e d e r a l Reserve m a y be allowed some scope for error. The
same difficulties t h a t it faces in knowing j u s t w h a t to do and j u s t when
to do it provide a shroud of uncertainty, even after the fact, about j u s t
w h a t it d i d - - a n d all the more so about w h a t it intended to do. But sev-
eral considerations combine to suggest that, in the long run, the Fed-
eral Reserve is playing against high odds.
First, right or wrong, the financial m a r k e t s will make their moves
ahead of the Federal Reserve. Changes in the d e m a n d for liquidity and
in the s t r e n g t h of the dollar are determined as much if not more by
anticipations about w h a t the Federal Reserve will do r a t h e r t h a n w h a t
it has j u s t done. This consideration is what gives great importance to
the Chairman's credibility. And his credibility reflects more t h a n his
personal integrity and his reputation for reasonableness and consis-
fence: It is affected as well by the economic constraints he faces and
political pressures he feels.
Second, each episode will have characteristics of its own depend-
ing upon all the contemporaneous political and economic factors.
Goals of the Federal Reserve over and above the particular goal of ac-
commodating the Treasury serve as a background against which ex-
pectations are formed. The Federal Reserve may be pursuing a strat-
egy of g r a d u a l m o n e t a r y ease to promote more rapid economic growth
and t h e n subsequently a strategy of gradual m o n e t a r y t i g h t e n i n g to
stave off inflationary pressures. It m a y be possible to m a i n t a i n credi-
bility while increasing the m o n e t a r y aggregates at an accelerated rate
in the first episode but not possible while reversing the direction of
change (relative to trend-line m o n e t a r y growth) in the second episode.
Third, even if the F e d e r a l Reserve generally wins its b a t t l e s
against liquidity crises, it will find t h a t winning streaks are difficult
to m a i n t a i n indefinitely. And perversely, a sequence of wins can create

1°The idea that the Federal Reserve's attempt to deal with a domestic liquidity
crisis may trigger an international currency crisis in this way is drawn from Lawrence
Summers' discussion of the "MacroeconomicConsequences of Financial Crises" in
Feldstein, 1991, pp. 153-56.
124 The Review of Austrian Economics Vol. 9, No. 2

a false sense of confidence on Wall Street t h a t the Federal Reserve is

always willing and able to deal effectively with liquidity crises. Such
confidence might cause investors to maintain a generally lower level
of liquidity in their portfolios than if they had serious doubts about the
s t r e a k continuing. Lower liquidity levels generally can m e a n more
dramatic increases in the demand for liquidity during a crisis. For the
Federal Reserve, the winning streak gets increasingly more difficult
to maintain.
Temporarily and partially offsetting all these reasons for pessi-
mism a b o u t prospects for e n d u r i n g macroeconomic stability is the
widespread belief t h a t the particular individuals that have served as
Federal Reserve Chairman are "geniuses." Dating from the s u m m e r of
1979 Paul Volcker and, after him, Alan Greenspan have risen to the
occasion w h e n e v e r crisis threatened. It m a y indeed be difficult to
n a m e two other individuals who could have done better. "Genius"
might involve overstatement; "seasoned," "savvy," and "nimble," m a y
be more to the point. But there is a greater point to be made here. Any
governmental institution whose success depends critically on the cali-
ber of the individual in charge cannot be considered a lasting source
of stability for the economy. Even geniuses can err. More importantly,
in some episodes where expectations t u r n pessimistic, the m o n e t a r y
ease needed to deal with a liquidity crisis may be more than enough to
trigger a currency crisis. Foreign and domestic traders m a y leave no
room for the Federal Reserve C h a i r m a n to exercise his genius. And
further, geniuses are not necessarily succeeded by geniuses. Volcker
served two four-year terms; G r e e n s p a n has b e g u n his t h i r d t e r m af-
ter an u n s u s p e n s e f u l r e a p p o i n t m e n t in early 1 9 9 6 - - w h i c h h a d the
effect of postponing speculation for a n o t h e r four years. H o w much
confidence will Wall S t r e e t have in Greenspan's t u r n - o f - t h e - c e n t u r y
successor? How m u c h confidence will it have in the F e d e r a l Reserve
in the days or w e e k s before a successor is n a m e d ? Suppose t h a t the
T r e a s u r y is p u t t i n g p r e s s u r e on the F e d e r a l Reserve for g r e a t e r ac-
c o m m o d a t i o n - p o s s i b l y b e c a u s e our t r a d i n g p a r t n e r s are r e l u c t a n t
to extend our g o v e r n m e n t f u r t h e r credit until t h e y k n o w who is re-
placing Greenspan. W h a t would h a p p e n to the d e m a n d for liquid-
ity? And how would the lame-duck F e d e r a l Reserve C h a i r m a n re-
spond so as to m a i n t a i n his own credibility as well as t h a t of his
successor-to-be-named-later? Even mildly cynical or pessimistic an-
swers to these questions m a y suggest that this financial crisis m a y
burn through the firewall. The real economy would t h e n become an
innocent victim as the central bank attempts its e x t r a m a r k e t r e m e d y
to t h e e x t r a m a r k e t m a l a d y in t h e form of a fiscally irresponsible
Treasury.
Garrison: Central Banking, Free Banking, and Financial Crises 125

Free Banking as Both Prevention and Cure

The merits of free banking during periods of economic tranquility are
identified on the basis of the theory of competition as applied to the
banking industry and the experience provided by a key episode in nine-
teenth-century Scotland and more recent episodes involving other
countries with partially free banking. Assessing the likely perform-
ance of free banking during twentieth-century financial crises in the
United States necessarily involves some speculative reasoning. It is
worth noting, however, that the most prominent nineteenth-century
defender of free banking argued his case partly on the basis of the abil-
ity of competitive forces to "meet an incipient panic freely and gener-
ously" (Bagehot 1873, p. 104).
Whatever the problems and limitations inherent in free banking
or in market economies generally, competition that characterizes a de-
centralized system wins out over the policy edicts of a central bank
largely because of the absence of key perversities that are inherent in
central control. The advantages of decentralization are partly in the
form of prevention, partly in the form of cure.
One of the major sources of today's macroeconomic instability, the
excessive federal debt and deficits, would be largely absent under tree
banking. Without a central bank to keep the default-risk premium off
Treasury bills, the federal government, like overextended firms and
even fiscally irresponsible municipalities, would have had to deal with
its fiscal imbalance long ago. Free banking, which is free not to monet-
ize Treasury debt, could accomplish what debt-limitation ceilings, the
G r a m m - R u d m a n deficit-reduction plan, or even a balanced-budget
amendment cannot accomplish. Without a chronically high and grow-
ing debt and the attendant speculation about the changing particulars
of deficit accommodation, financial crises are less likely to occur.
If a financial crisis does occur, the provision of supernormal
amounts of liquidity is forthcoming under free banking--but without
the destabilizing speculation about the particular movements in the
money supply. Questions about the "will" or "intent'--or "genius"--of
the banking system as a whole simply do not arise. The supply of li-
quidity automatically follows demand upward during the financial cri-
sis and downward as crisis conditions fade. It is true that some banks
will be more responsive than others at meeting the occasional super-
normal demands for liquidity. One of the beneficial aspects of compe-
tition in any sector of the economy is that those firms who best satisfy
ever-changing demands prosper relative to their competition and are
thus put in charge of greater resources. With free banking, then, suc-
cess breeds success. A sequence of crises gives increased responsibility
to those very banks that are best at dealing with crises.
126 The Review of Austrian Economics Vol. 9, No. 2

To this point the advantages of free banking over central banking

are set out in terms of the likelihood of our needing a firewall between
the financial and real sectors of the economy and the ability of each
b a n k i n g i n s t i t u t i o n actually to provide t h a t firewall. The firewall
metaphor, however, p r e s u m e s t h a t no s y s t e m a t i c a d j u s t m e n t s are
needed in the real economy. But it is entirely possible and even likely
that w h a t e v e r caused the crisis conditions to prevail in the financial
sector also caused non-financial resources to be misallocate& Simul-
taneous financial and real crises, as might be brought about by the
ill-conceived policies of an administration bent on growing the econ-
omy, could not be quelled by a firewall. Quite to the contrary, the real-
location of resources in the economy would require a well-functioning
m a r k e t process, which includes movements in resources t h a t reflect
movements in securities prices. Here, the implicit monetary rule ob-
served by free banking takes on a special significance. Movements on
the lefthand side of the equation of exchange (an increasing V) are ef-
fectively countered; movements on the righthand side (in the ps and
hence in P) are not. If the economy's real sector is out of balance, it
needs help from the financial sector to regain its balance. In such cir-
cumstances, "firewalr' is the wrong metaphor; "penny in the fusebox"
would be more accurate. Only free banking can allow the financial sec-
tor to guide the real sector while preventing the demands for liquidity
from degrading the market's performance.
A Summary View
In the Keynesian view, the central bank is a part of an e x t r a m a r k e t
remedy to a m a r k e t malady. Investment markets are inherently un-
stable; government control of the economy's money supply is an impor-
tant element in macroeconomic stabilization policy. The case against cen-
tral b a n k i n g - - a n d for free banking--reverses the characterization of
both remedy and malady. Free banking is a part of a market remedy to
an extramarket malady. Even this stark reversal understates the case
for free banking. It would remain valid even if we take the dramatic
and chronic fiscal irresponsibility of the Treasury as given. Periodic
crises that will inevitably occur in such a debt-ridden economic envi-
ronment would be more ably countered by the m a r k e t forces of free
banking t h a n by the policy moves of a central bank. But the extent of
the Treasury's fiscal irresponsibility is itself dependent upon w h e t h e r
the Treasury can count on an accommodating central bank. Free bank-
ing limits the scope of this potential source of instability while at the
same time enhancing the market's ability to deal with whatever insta-
bilities that m a y persist.
Garrison: Central Banking, Free Banking, and Financial Crises 127

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