Money is integral to the successful and efficient operation of a market economy. It facilitates different business undertakings by providing a standard medium of exchange. Governments make use of monetary systems to manage the money supply in their countries. The present system makes use of a central bank, which is characterized by a single controlling bank that has an absolute monopoly on monetary supply in a country. However, there is major dissatisfaction with this system and the free banking system has been presented as a feasible alternative. This paper will highlight the merits and demerits of both systems and explain why the free banking system is superior.
Merits of Central Banking and Free Banking
Central banking provides government control of the economy’s money supply in a naturally unstable market environment. Through the central bank, the government is able to regulate the economy and bring about stability. Policy makers have discretionary powers to adjust the interest rates and control the money supply in a manner that promotes economic stability (Vera 56).
The central bank also serves as a safety net since it is able to act as a lender of last resort to commercial banks in times of financial crisis therefore preventing the economy from falling into catastrophic failure. Vera notes that as “lender of last resort”, central banks come to the rescue of ordinary banks that are experiencing shortage of reserve funds therefore promoting financial stability (6).
Central banking provides the government with the tools necessary to implement policies to promote economic growth. There is a relationship between the supply of money and the economic performance of a country. Rohac state that when there is an increased supply of money, “entrepreneurs are able to engage in investment projects which they would have otherwise not undertaken” (37). The government is also able to adjust the inflation to the most beneficial level. The government is able to engage in easy financing and orchestrate inflationary policies that are beneficial to the public. As such, central banking makes it possible for the government to stimulate economic activity.
In free banking, no single bank holds a monopoly on the issue of money and instead market forces determine the money supply and interest rates. Without a monopoly, free banking eliminates discretion in monetary policy by relegating adjustments in the money supply to markets. Money supply is therefore dictated by current market realities instead of the discretionary policies of policy-makers at the central bank. Vera identifies the best mechanism for issuing notes as one where competition prevails (11). Such a mechanism is possible through free banking in which many issuers of notes are free to act according to their discretion.
Free banking would promote financial and currency stability since the banks would have a monetary incentive to ensure stability. In the free banking system, banks would be granted the right to issue banknotes and engage in other types of banking operations without any special regulations. The level of profit depends on the ability of the free banks to produce a stable currency. Shirley notes that if a bank issues excessively, its notes would depreciate against other currencies (210). Each bank would therefore endeavor to produce an optimal amount of banknotes, which depends on the demand for money.
Demerits of Central Banking and Free Banking
Activity by central banking might induce macroeconomic instability in the country. The policies adopted by the central Bank are at times made out of political considerations. Vera declares that the central bank is not a spontaneous result of the market process but rather a political creation that do not always follow sound economic principles (17).
This statement is supported by Garrison who notes that the Central bank is required to deal with problems that have little to do with maintaining macroeconomic stability (119). The Federal Reserve might be required to weaken the strength of the currency in reaction to chances in exchange rates or trade flows. It might also be expected to lower interest rates when the housing market is on a decline. Such actions, aimed at manipulating employment rates, interest rates, and exchange rates, can induce macroeconomic instability.
Central banking makes it possible for a government to monetize Treasury debt leading to fiscal imbalance. Governments are in the habit of monetizing their debts once they rise beyond a certain point. Garrison notes that the government has control over monetary policy in the country and is able to rely on an accommodating central bank to monetize debts (125). This contributes to excessive federal debts and deficits as fiscally irresponsible government treasuries are able to continue operations since they can monetize their debt for additional money.
Free banking might promote misconduct by financial institutions as they try to make higher profits. A defining characterizing of free banking systems is that they are far less regulated than central banking systems. Vera admits that a desirable feature of a free system is reduced regulations from the government (20). In the free banking mechanism, no bank has supervisory powers over the others. Each bank exercises its own discretion when managing its money supply. This introduces the risk of reckless or fraudulent behavior by commercial banks in their attempt to increase their profitability.
Free banking exposes the economy to the risks of failure due to the inherent instability of the system. Customer confidence in the banking system is crucial to stability. In the free banking system, banks do not have a safety net and they are exposed to the market forces. Arnon observes that public confidence in the banking system, especially when some banks fail, is decreased (143).
The risk of some banks failing is real since many banks are likely to hold inadequate reserves to meet redemption demands by the customers. In the event where a large number of customers withdraw from a bank that has overextended credit, the bank will become insolvent. If this happens to a large number of banks, due to system-wide panics, there will be a catastrophic failure since there is no lender of last resort to rescue the banks. Collapse of banks has a damaging effect on the economy of a nation.
As can be seen from this paper, both central banking and free banking have their relative merits and demerits. However, free banking is the superior form of banking. The free-banking arrangement provides a means for dealing with macroeconomic instabilities in the economy. The competitive forces force each bank to behave in a responsible manner when issuing money since individuals and companies are free to switch to a different currency once a particular currency becomes too inflationary.
In addition to this, the free banking mechanism eliminates government intervention in the money market creating economic stability. The free banking system frees the market from the distortions that are created when the central bank engages in activities such as interest rate manipulation and inflation or deflation of currency. This system is therefore superior and should be adopted as the preferred alternative to central banking.
Arnon, Arie. Monetary Theory and Policy from Hume and Smith to Wicksell: Money, Credit, and the Economy. Cambridge: Cambridge University Press, 2010. Print.
Garrison, Roger. “Central Banking, Free Banking, and Financial Crises.” The Review of Australian Economics 9.2 (1996): 109-27. Web.
Rohac, Dalibor. “Towards Sound Monetary institutions.” Economic Affairs 31.3 (2011): 36-40. Print.
Shirley, Gedeon. “The Modern Free Banking School: A Review.” Journal of Economic Issues 41.1 (2007): 209-223. Web.
Vera, Smith. The Rationale of Central Banking and the Free Banking Alternative. Indianapolis: Liberty Press Pub., 1990. Print.