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Central Banking Beats Free Banking?

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Central Banking Beats Free Banking?
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Sunanda K. Chavan
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Central Banking Beats Free Banking? - August 3rd, 2011

Free banking is better than central banking because only in a free market can the optimal prices and quantities of goods be determined. Those goods include the money supply, and prices include the rate of interest.

There is no scientific way to know in advance the right price of goods. With ever-changing populations, technology, and preferences, markets are turbulent, and fluctuating human desires and costs cannot be accurately predicted.

The quantity of money in the economy is like that of other goods. The optimal amount can only be discovered by the dynamics of supply and demand. The impact of money on prices depends not just on the amount of money but also on its velocity—that is, how fast the money turns over. The Fed cannot control this since it cannot control the amount people want to hold, or the demand. Also, even if the Fed could determine the best amount of money for today, the impact of its moves takes months to play out, so the central bankers would need to be able to accurately predict the state of the economy months into the future.

The Fed also fails because of political pressure. Although the Fed is supposed to be independent, in practice, when the economy is depressed, there is strong political pressure to “do something,” specifically to “stimulate” by expanding the money supply. Since Congress created the Fed and can alter it, it is impossible for the Fed to be purely independent of politics.

The Federal Reserve was set up to provide price stability, yet the United States suffered high inflation during the 1970s and continuous inflation since World War II. The Fed was also supposed to provide economic stability, but since World War II there have been severe recessions in 1973, 1980, 1990, and 2007–2009. The Fed was supposed to ensure stability in the financial system, but it failed to prevent the Crash of 2008 and the Great Recession that followed. But the challenge is to explain why free banking would be better.

Suppose gold once again became a global currency. It would be the real money, and the U.S. dollar would be defined as a particular weight of gold. A $20 gold coin had about an ounce of gold before 1933.

Under free banking most transactions would not occur with gold, but rather with more convenient money substitutes. Banks would issue paper bank notes inscribed with their bank names. Anyone holding bank notes could exchange them for gold. For example, if $1,000 was equivalent to an ounce of gold, then anyone could go to a bank and convert $1,000 in paper bills to one ounce of gold coins. Likewise one could withdraw $1,000 of deposits in gold coins.

Competition among banks, as well as convertibility into gold, would result in price stability, since the banks would only be able to issue as many bank notes as the public was willing to hold. If there were more bank notes than that, they would come back to the bank to be exchanged for gold. But the money supply would also be flexible, since if there were a greater demand to hold money, the amount of bank notes or bank deposits would increase.
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