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I almost stopped reading

Michael Woodford of Columbia University is acknowledged as probably the most influential academic monetary economist today. His 2003 book Interest and Prices: Foundations of a Theory of Monetary Policy is his magnum opus. It is not a book for laymen, but it is one of the handful of books over the last 40 years that everyone who participates in academic debate on monetary economics needs to have read.

When introducing his theoretical framework, Woodford writes near the bottom of page 63, "I begin by considering price-level determination in an economy in which both goods markets and financial markets are completely frictionless: markets are pefectly competitive, prices adjust continuously to clear markets, and there exist markets in which state-contingent securities of any kind may be traded."

By page 64, though, a central bank somehow becomes part of this system of perfectly competitive markets. It is a perfect example of how limiting it is to know only the present. Free banking has a history centuries long: the first free banking system began in China apparently about 995, more than 600 years before the first central bank. More than 60 countries have had free banking. And yet, Woodford does not even pause for a page to consider what a banking system would look like without a central bank.

  • Ben F.

    Mr. Schuler, I'm doing research into the views of economists regarding the central banking system for a potential book. What their views were and are, how they developed, and so forth–particularly on the underlying economic logic driving the analysis. Are there any books or articles on this subject that you can recommend to me, or can you think of an expert on this subject who it would benefit me to contact?

    • Kurt Schuler

      Larry White is the man. Vera Smith's book The Rationale of Central Banking (see my latest post for a link) discusses this question as it applied to the 1800s and early 1900s.

  • Cato posted videos from their annual monetary conference which includes talks from 4 contributors to this blog. All the talks were great, especially the closing talk from John Allison, whom I did not know before but gave an excellent talk from his perspective as a bank CEO.

    • Kurt, I was very interested in your call for entrepreneurs to start issuing competitive bank note currency. I have had an idea germinating for a while but I have a question. How do banks which compete in note issue and cooperate in clearing arrangements practically minimize the reserves they need on hand to handle clearing transactions? Basically, what sort of algorithm for how long to hold a competitors notes before redeeming them should a free banker use? Obviously instantaneous clearing would be inefficient since if both sides agree to wait some time they will accumulate each others notes and only have to pay the difference in reserves, but there is a cost to holding competitors notes since you are sacrificing potential seignorage earnings to your competitor.

      • Kurt Schuler

        There is a simple answer to this: it's already being done in the places where multiple issuers of notes still exist, namely Scotland, Northern Ireland, Hong Kong, and Macau. Unfortunately, I don't know the details, but there is somebody I can ask about one case and it would make a good topic for a future post. I do know that historically, there was a tendency towards more and more frequent clearing, as often as twice a day in major financial centers in the early 20th century. My understanding is that notes were exchanged along with checks.

  • Paul Marks

    Very odd.

    Why would someone who was writing a book on economic theory (not political practice) and who formally states he is going to start from a totally free market perspective suddenly slap a Central Bank into things?

    The fact (and I assume it is a fact) that he does not know ancient Chinest history does not seem like a sufficient explination. Although, I suppose, even the Canadaian, which did not have a Central Bank till after 1935, might not seem like the present to someone with the attention span of a Mayfly.

    But the book was about economic theory – not modern political practice.

    Even if all nations had had Central Banks for a thousand years the author should still have gone through the formal process of considering from first principles.

    Otherwise he is not doing the job of writing a book about economic theory (i.e. principles).

    However, on the Chinese point….

    I would guess that China had money lenders long before 995 AD. And in a free market there is no difference (no difference what-so-ever) between a money lender and a bank.

    A money lender may lend out their own money, or money entrusted by others to them (to be lent out), a "bank" is only different to this if it has some government granted immunity from the normal rules of contract (or some other special privilege) – in which case it is not a free market.

    Of course, in a free market, there is nothing (nothing) a "bank" can do that an individual (potentially any individual) can not do.

    An individual may lend out their own money or money entrusted to them (to be lent out), and so may an enterprise called a "bank".

    As for the "creation of money" in a free market an individual may do this also.

    An individual may (for example) mint a gold coin, or collect sea shells (if people use sea shells as money) and so on. And so may an enterprise.

    And an individual may issue a paper document that "represents" a certain amount of a commodity – and so may an enterprise.

    As long as, of course, they actually have the amount of the commodity their paper documents claim they have.

  • I agree that it is a huge flaw in Woodford's book that he does not even consider what a banking system would look like without a central bank. But, as you say, this is a perfect example of how limiting it is to know only the present. I only came across the concept of free banking very recently, and until then I had simply assumed that central banks were an inevitable and indispensable element in any financial system. It was only when I learned about free banking that I suddenly realized how flawed this unexamined assumption was. The embarrassment I felt at my previous failure to examine this assumption was, however, outweighed by the excitement of broadening my intellectual horizons. It is incredibly liberating to question one's unexamined assumptions.

  • Tong Si Man

    I think the global economy will collapse if there is no free banking. Transactions between countries need the help of bank since it involves huge amount of money. Central bank plays an important role in clearing checks and backs up all commercial banks. Free banking encourages investment and business. It brings a lot of convenience to our daily lives. It helps to higher our living standard as more high-quality goods and services are provided by different business company. Free banking is really a great system! This post reminds me how I am benefited from this banking system. It really works well!

  • Paul Marks

    I got a message (which does not seem to have appeared here) about multiple sources of bank notes in Scotland and Northern Island.

    In practice this makes no difference at all (neither good not bad). They are all fiat notes on a 1 for 1 par with the notes the Bank of England issues.

    Although it may mentally prepare people for a different monetary order when this one breaks down (which will not take long – if the Bank of England, and the other Central Banks, carry on with their present antics).

    Also, as what might be considered a silly point – but I do not believe it is silly.

    The Bank of Ireland (not owned by the Irish govenrment) Pound notes are very attractive.

    They bring a little colour into this world. And contain the coats of arms of the counties of Ulster.

    That is reason enough to be glad that the Bank of England does not have a monopoly on note design.

  • Paul Marks

    Tong Si Man.

    The present system, dominated by Central Banks, is NOT "free banking" – under free banking there would be no Central Banks (neither government owned or "private" ones that are givcen powers by governments).

    Central Banking and Free Banking are ALTERNATIVES, they are not part of the same system.

    "The economy would collapse without Central Banks".

    The international economy is going to collapse BECAUSE

  • Paul Marks

    The international economy is going to collapse BECAUSE of Central Banking (and the rest of interventionism).