Chapter 1 INTRODUCTION

It is no longer possible to deny that there exist widespread academic concern for and dissatisfaction with the American financial system. In particular, various regulatory agencies have been singled out for criticism. The FDIC, the now-defunct FSLIC, and the Federal Reserve have all come under fire in the recent past.

It has been demonstrated that the FDIC and FSLIC have contributed to the banking and savings and loan (S&L) crises by virtue of their role as sources of “moral hazard.”¹ Moral hazard is the idea that any entity that is insured against risk—especially when it does not bear the full costs of the risk—tends to indulge in riskier behavior. The principal problem with FDIC insurance is that the premiums paid by financial institutions are not adjusted for the riskiness of the asset portfolios held by those institutions. As a predictable result, many institutions have acquired assets, for example, made loans that promised high potential rates of return but also were subject to significant risk. At the first sign of an economic downturn, many such assets experience rapid declines in their market value. This may leave the institution insolvent. Thus, deposit insurance has contributed to the large number of failures of both S&Ls and banks during the past decade.

Less thoroughly explored and less commonly discussed has been the instability brought about by the very existence of the American central bank, the Federal Reserve. Nevertheless, a growing number of economists have begun to perceive the Federal Reserve (the “Fed”) as an agency more concerned with its own authority than with the “general welfare” and as an ineffectual, even counterproductive, monetary authority. The following observations by three Nobel laureates perhaps convey the depth and breadth of such concerns.

Milton Friedman has stated that “in my opinion, no major institution in the United States has so poor a record of performance over so long a period . . . as the Federal Reserve” (1985, 5). He goes on to recommend that we “abolish the money-creating powers of the Federal Reserve, freeze the quantity of high powered money, and deregulate the financial system” (1985, 12).² Friedrich Hayek has argued that “I do not think it an exaggeration to say that it is wholly impossible for a central bank subject to political control, or even exposed to serious political pressure, to regulate the quantity of money in a way conducive to a smoothly functioning market order” (1978, 113). James Buchanan, finding the existing operating structure wholly inadequate, proposes that the salaries of Fed officials be inversely related to the rate of inflation as a means of promoting monetary stability. He goes on to suggest that “if no incentive-motivational structure is deemed to be institutionally and politically feasible . . . the argument for more basic regime shift in the direction of an automatic or self-correcting system based on some commodity base is substantially strengthened” (1986, 148).

The question remains: Is the problem one of specific policies undertaken by the Fed (which, presumably, could be curbed by changing the motivational constraints on the Fed), or is the problem the fact that the United States has a central bank? In short, are central banks inherently inconsistent with monetary stability? The overwhelming majority of economists are very reluctant to answer the latter question in the affirmative. Despite the rapidly growing body of scholarly work on free banking, most still scoff at the idea that money can be safely and sanely provided in an unfettered market context. This is evidenced, for example, by the fact that free banking is rarely discussed sympathetically in textbooks, if it is mentioned at all.³

The position taken by advocates of free banking is that no amount of tinkering with the present system will suffice. They insist that only a fundamental change in the banking structure can solve the monetary problems faced by the United States or any nation. The purpose of this work is to explore the characteristics of the most radical of alternative regimes: free banking.

DEFINITIONS OF CENTRAL BANKING AND FREE BANKING

Before discussing free banking in any detail, one must first of all define the term—as well as its opposite, central banking. Central banking is a nonmarket, centralized approach to monetary matters. A central bank is granted certain legal powers and privileges that are the means by which it attempts to manipulate selected macroeconomic measures. These measures most often are the rate of inflation, the rate of unemployment, various market interest rates, and Gross National Product (GNP). The specific tools by use of which a central bank may affect the foregoing usually include (as in the case of the Federal Reserve) the buying and selling of government securities, changes in the rate of interest charged by the central bank on loans to private depository institutions,⁴ and changes in the reserve requirements imposed on these institutions.

It is crucial to understand that the central bank’s roles as a holder of commercial bank reserves and as a supplier of credit both are derivative. Both depend largely on the fact that central banks typically are granted a legal monopoly on the issue of banknotes (Smith 1990, 168). That is, central banking and legal tender laws go hand-in-hand. Moreover, “a central bank is not a natural product of banking development. It is imposed from outside or comes into being as the result of Government favours” (Smith 1990, 169).

In contrast, one finds free banking, a term that denotes a market-oriented, decentralized approach to money. Free banking’s most obvious features are (1) the absence of any central monetary authority and (2) the issuance of notes as well as deposit accounts by individual private banks. More generally, under a free-banking structure, “banks are free to pursue whatever policies they find advantageous in the issuing of liabilities and the holding of asset portfolios, subject only to the general legal prohibition against fraud or breach of contract” (White 1985, 117). Furthermore, “entry into a free banking system is unrestricted” (Selgin 1988b, 621), and “loans and securities would not be subjected to interest controls, nor would investment in any particular industry be mandated or forbidden . . . banks could even acquire equity positions in other firms” (Wells and Scruggs 1986b, 262). Also, such banks “would be free to open and close branches wherever they wanted” (Wells and Scruggs 1986b, 263). Finally, government deposit insurance would be neither necessary nor desirable, since market forces would encourage consumers to “find ways to protect their funds” privately (England 1988, 772). Thus, a “pure” free-banking system (which has never existed⁵) would be one in which there were (1) no governmental restrictions on entry or exit by firms into or out of banking, (2) no restrictions (other than the enforcement of valid contracts) on the issuing of notes as well as deposit accounts by financial institutions, (3) no central bank that acts as an ex ante lender of last resort, (4) no governmental deposit insurance, (5) no statutory reserve requirements, (6) no minimum capital requirements, (7) no restrictions on branching, (8) no restrictions regarding the kinds of activities in which a bank might engage, such as the underwriting of corporate stock or bond issues, and (9) no interest rate controls. In short, free banking means the total deregulation of the banking industry. It is the thorough application of the principles of laissez faire to the one realm of economic activity where even most “free market” economists have assumed such principles cannot be applied: money and banking.

One ambiguity must be addressed before progressing. What has just been described might be called “true” or “pure” free banking, or simply “laissez-faire banking.” Historically, however, what has been called “free banking”—particularly in the United States—has often not been laissez-faire banking (Smith 1990, 169fn). That is, as will be discussed in Chapters 5 and 6, these historical episodes exhibited significant departures from the free-banking model. On the other hand, they all did share the one essential feature of free banking: multiple private issuers of banknotes. In short, the convention has arisen of classifying historical periods as being (rough) examples of free banking as long as the issuance of banknotes had not been monopolized during the period in question. This is not necessarily an error. However, it does raise a potentially troublesome question. When an episode of historical free banking possesses some of the theoretical characteristics but lacks others, does one ascribe its success to the presence of some or to the absence of the others? Based on these mixed examples from history, are clear-cut tests of the free-banking model possible?

SPONTANEOUS EVOLUTION OF FREE BANKING

Having established in theory what free banking is, one is driven to inquire next how such a system might come into being. Perhaps the first work to address this issue was that by George A. Selgin and Lawrence H. White (1987). What follows is a summary of their lucid analysis.

First of all, Selgin and White point out that although there had been a few articles in recent years dealing with various aspects of unregulated monetary systems, none (at the time of their writing) had provided a logical evolutionary explanation of how such a system might develop. They do not suggest that their approach is the only valid method of explaining the rise of free market monetary institutions; indeed they explicitly acknowledge the value of optimization models that incorporate transaction costs and/or informational asymmetries. They merely note that theirs is a method that had not been utilized previously (Selgin and White 1987, 439).

The authors argue that, following the emergence of a standardized commodity money, the evolution of a free-banking regime proceeds through three stages: (1) “the development of basic money-transfer services which substitute for the physical transportation of specie,” (2) the “emergence of easily assignable and negotiable bank demand liabilities” (often referred to as “inside money”), and (3) the appearance of “arrangements for the routine exchange (“clearing”) of inside monies among rival banks” (Selgin and White 1987, 440). Each stage is allegedly a Smithian “invisible hand” outgrowth of the previous stage, that is, each new institutional arrangement is the unconscious product of the actors’ conscious concern with promoting their own self-interest.

Their explanation of the origin of money follows closely along that outlined by Carl Menger (1892). This simply recognizes that money arises in barter societies because of the inefficiency referred to by W. S. Jevons as the “double coincidence of wants.” Durable, highly divisible goods that were consistently in high demand for their use-value as commodities (gold, silver) came to be seen as a means of facilitating exchange by reducing search costs. These became money because of their high marketability. Private mints began to produce coins of standard weights of these metals as a means of reducing the costs of continual reassessment.

Logically, one next needs to reduce the inconvenience of frequent physical transfers of coins. This was accomplished—for the first time in history—by the money-changers and bill brokers of twelfth-century Genoa who kept ledger accounts for frequent traders (Selgin and White 1987, 442). Notations in account books took the place of specie transfers. Thus deposit banking was born. In this context, Selgin and White point out why fractional reserve banking can develop in a rational and nonfraudulent manner: “(1) money is fungible, which allows a depositor to be repaid in coin and bullion not identical to that he brought in and (2) the law of large numbers with random withdrawals and deposits makes a fractional reserve sufficient to meet actual withdrawal demands with high probability” (1987, 443). This result is reinforced if one allows for the use of “option clauses,” as Selgin and White do.⁶

The desire for more sophisticated means of fund transfer led to the assignability and negotiability of deposited money, that is, to the appearance of fully negotiable banknotes and checkable deposits. To economize on the use of commodity money and to reduce the marginal liquidity costs of maintaining large specie reserves, banks naturally sought some form of regular note-exchange system, which would, by increasing the frequency with which rival banks’ notes were accepted at par, increase the marketability of their own notes. The same result might be accomplished in a very different way. Banks might engage in “note-duelling.” That is, they might begin buying a rival’s notes with the express purpose of presenting them suddenly to the issuer for redemption in specie, thereby hoping to damage the rival’s reputation or even precipitate his insolvency. Still, the likely result is widespread mutual acceptance of banknotes at par (Selgin and White 1987, 446–47). This is a classic example of the fact that the unintended consequences of agents’ acts may prove more significant and/or more durable than the intended consequences (Menger 1963, 130).

From a periodic note-exchange, it is but a small conceptual step to a formal clearinghouse function. The clearinghouse, by supervising the multilateral note and deposit exchange for a group of banks, greatly reduces the time and effort involved in the many pairwise clearing relations that would otherwise be required. Furthermore, the clearinghouse can serve as a credit information bureau, can police individual banks so as to ascertain their soundness, and can provide short-term liquidity to its members in times of financial crisis (Selgin and White 1987, 450).

Selgin and White conclude that all the essential functions of modern banking can be explained by a “spontaneous order” process and that nothing in the institutions that thus freely develop suggests anything about the need for a central bank (1987, 454). The far more common, contrary view will be examined in Chapter 8.

TWO FREE-BANKING MODELS

Monetary economics continues to be dominated by the almost unquestioned assumption that in order to achieve and maintain stability and real growth, all modern industrial nations must have a central bank that both conducts some macromonetary policy and is the sole issuer of legal currency. Nevertheless, in recent years, challenges to that orthodoxy have been mounted by a growing number of theorists.⁷ Perhaps the most influential of these works have been the books by Friedrich Hayek (1978), White (1984a), Selgin (1988a), and Kevin Dowd (1989). There are two distinctly different models of free banking to be found therein. Each will be summarized below. Other approaches to free banking have been proposed by writers such as David Glasner (1989), Robert Greenfield and Leland Yeager (1983), W. William Woolsey and Leland Yeager (1991), Murray Rothbard (1983, 1985), and Ludwig von Mises (1966, 441–48). Such alternative approaches are the subject matter of Chapter 7.

Competing Paper Currencies

Hayek (1978) has proposed a system of competitively issued, inconvertible paper currencies. The incentive for the issuing bank is to be able to gain interest-free funds by inducing consumers to hold its currency. The incentive for the consumer is to gain a currency that possesses stable purchasing power. Such stability of purchasing power is, allegedly, to be guaranteed by the issuer and is to be defined in terms of some market basket of widely traded and homogeneous commodities, such as aluminum, cocoa, coffee, copper, and so forth (Hayek 1978, 56–57). Variations in the purchasing power of an issuer’s currency would be constantly monitored by that issuer via computerized data from currency exchange markets. Appreciations would precipitate increases in supply; depreciations would bring decreases in supply. The definition of the market basket might change over time, however, if either consumer preferences or demand/supply elasticities of the commodities in question were to change (Hayek 1978, 44).

In this system, there would probably be only a handful of large banks that issued their own currencies; the majority of institutions would denominate deposits and loans in terms of one of those currencies. The small number of banks-of-issue would be due to the fact that only a few different currencies would, presumably, be marketable. This follows from Hayek’s apparent belief that the information and transaction costs to consumers of coping with multiple currencies rise significantly as the number of such currencies increases (Hayek 1978, 23–24). Since the banks-of-issue would not want “to repeat the mistakes governments have made” (Hayek 1978, 61), they would not guarantee to bail out nonissuing banks that had outstanding obligations denominated in the currencies of the issuing banks. Thus, the large number of nonissuing banks would be compelled to practice more or less 100 percent reserve banking (Hayek 1978, 61). Such institutions would, therefore, be more like present-day finance companies than commercial banks.⁸

Competing Convertible Banknotes

It must be pointed out that although White (1984a) was the first since Vera C. Smith in 1936 to outline and defend the system described below, it has been Selgin (1988a) who has greatly elaborated upon White’s work. The fundamental aspects of the model—save one—are the same in both versions; the primary contrast is in terms of the much greater detail offered by Selgin. In particular, Selgin provides an insightful analysis of the relationships between free-banking activities and macroeconomic variables, such as national income and the price level. The one aspect that differs is that White assumes a small, open economy, because he is examining the Scottish free-banking period and, thus, assumes that the purchasing power of money is set exogenously by the world price of gold (1984a, 11), whereas Selgin apparently assumes (it is not stated explicitly) that he is dealing with a large, closed economy since he allows for endogenous changes in money’s purchasing power (1988a, 99–102).

In the work of both White and Selgin, banks would, of course, be free to issue their own distinctive notes as well as deposit accounts. The supposed attraction for consumers would be the explicit guarantee by the issuing bank to redeem its notes in gold or silver upon demand of the holder.⁹ Banks would compete for consumers’ patronage by providing branch offices in convenient locations, by remaining open longer hours per day and/or being open more days per year, and by offering higher rates of interest on deposits and lower rates on loans (White 1984a, 7–9). Above all, however, banks would vie with one another in terms of public confidence in the note issue. A bank’s market share would increase as did consumers’ belief that the bank would never fail to convert its notes (or deposit accounts) into specie on demand.

Unlike Hayek’s model, here the supply of a given bank’s notes would not vary according to either the exchange rates between currencies or the value of a particular market basket of commodities. Rather, a bank would regulate its note issue in response to the extent to which it experienced either “reflux” or “adverse clearings,” that is, the return of its notes for redemption, either by individuals or by other banks (White 1984a, 14–18). Assuming each bank had a preferred specie/notes ratio (which White and Selgin take to be less than one; that is, these banks hold fractional reserves), the level of reflux and/or adverse clearings would determine the size of the bank’s note circulation. The preferred, or “optimal,” reserve ratio could change of course, as will be discussed in the next chapter. Indeed, the realization that a free bank’s optimal reserve ratio is positively related to the income velocity of money will be seen to be one of Selgin’s key contributions to the literature, as well as a critically important aspect of the formal model that will be presented.

Comparison of the Models

Under neither model of free banking is money production a natural monopoly, nor is money a public good.¹⁰ Issuers do not face marginal costs that decline throughout the relevant range of output. This follows from the fact that it is not the mere physical production of the banknote that is important; it is maintaining it in circulation that requires public acceptance and incurs rising marginal cost (White 1984a, 5–8). Furthermore, money cannot be a public good, because its benefits are clearly excludable. Person B cannot enjoy the liquidity services provided by a unit of money that is held by Person A (Selgin 1988a, 154). Additionally, in Hayek’s scheme, as well as in the White-Selgin model, the nominal money supply for the society is determined at a microeconomic level. Changes in said money supply certainly have important macroeconomic effects. Nevertheless, and in contrast to central banking, the source of the changes is microeconomic in nature. Both models imply that there is no role for a central bank that conducts monetary policy on a national basis. Many economists infer that chaos would inevitably result from the absence of centralized control. Yet, as Thomas Saving has pointed out, “competition is perfectly compatible with a stable monetary system” (1976, 994). The manner in which such stability might be achieved will be seen later.

The two models differ significantly, however, in regard to one aspect. In Hayek’s system the various currencies (“ducats,” “florins,” “mengers,” etc.) constitute separate units of account, whereas in the White-Selgin system, the competing banknotes, although distinct from one another and not necessarily possessed of equal marketability, nevertheless are assumed to be denominated in a single unit of account. Thus one might argue that Hayek’s banknotes are more highly differentiated than are the White-Selgin notes. This is especially true if, as Hayek suggests, such units were to be trademarks of the issuing bank (1978, 42). All of this means that, in terms of the conventional market structures, Hayek’s proposal may imply less “perfectly competitive” firms than does that of White and Selgin.

LIKELIHOOD OF THE WHITE-SELGIN MODEL

Assuming the complete deregulation of the financial services sector, which of the two approaches to free banking would be more likely to arise and, moreover, survive and prosper? At one level, of course, that question is unanswerable, since the results would depend on consumer preferences, which cannot be known to an observer a priori. However, there remain several aspects of the question that deserve comment nonetheless.

The principal attraction of the Hayekian currencies is, as was seen earlier, the promise of constant purchasing power. Thus, the critical issues become: (1) could such banks actually maintain such constancy in the purchasing power of money,¹¹ and (2) would it be maintained regardless of circumstances? Hayek himself seems to think that the only safeguard against fluctuations in purchasing power is the continual monitoring of the currency’s value by consumers (1978, 59). But would such monitoring actually be an effective safeguard? There are reasons to doubt it.

First of all, what would be the effect on exchange rates between currencies if all banks-of-issue increased (or decreased) their supplies of notes at the same time and at the same rate? Exchange rates between the currencies would remain as before, and no signal would be sent to consumers to alter their money holdings. As Hayek might point out, however, in his system, such exchange rates are not the ultimate measure of a currency’s value. The ultimate yardstick for consumers is the price of the chosen basket of commodities in terms of the currency in question. Yet it is well known that commodity markets generally adjust to changing conditions more slowly than do financial markets. Would the prices of the relevant commodities change rapidly enough to warn consumers of inappropriate bank policies? It is not at all clear that one can answer that in the affirmative. Furthermore, if the basket of commodities chosen by a bank does not happen at all times to reflect the preferences of a particular consumer, it cannot be claimed that that consumer’s purchasing power is being maintained even if such may be true for other consumers. Finally, one must keep in mind the possibility that not all consumers want constant purchasing power. Do not net debtors prefer inflation and net creditors desire deflation? Hayek does not deny this, but seems to think that those contrary preferences will offset one another in the market as a whole.

Even if Hayekian free banks could keep constant the purchasing power of their currencies—which, from the foregoing, seems problematic—the issue remains of whether (aside from the debtor/creditor issue) such constancy is always desirable. An obvious exception comes to mind. If either the supplies of inputs increase or there occur technological improvements such that marginal production costs pervasively decline, is not the proper economic result a general fall in prices? Indeed, to maintain a constant price level (and constant purchasing power of money) under such circumstances means that goods’ prices are not in line with production costs and, as a result, “false profit signals” are generated (Selgin 1988a, 101). As will be seen in Chapter 2, free banks of the White-Selgin sort act so as to allow a general price decline in the face of falling production costs.

There are several additional reasons why one might expect banks that issue specie-convertible notes and deposit accounts to triumph over Hayekian banks in the free market. For example, it would seem plausible that the information costs to the consumer of constantly monitoring the fluctuating exchange rates among Hayek’s various paper currencies might be significantly greater than those involved with holding notes issued by a bank that explicitly guarantees to redeem its notes in gold on demand. Furthermore, what of transaction costs? Recall that Hayek’s proposed currencies are denominated in different units of account as well as being issued by different banks. This would seem to be significantly less efficient than the White-Selgin model where competitively issued banknotes are denominated in the same units. Also, considering the long Western tradition of specie-backed money, it seems clear that if the United States is fundamentally to reform its monetary system, the direction of that change is more likely to be toward a specie standard than toward inconvertible paper currencies. One may note that the 1981 U.S. Gold Commission appointed by President Ronald Reagan seriously considered a return to gold. Admittedly, this group never really addressed the topic of free banking. Nevertheless, that group’s deliberations can be taken as a barometer of the continuing attractiveness of a specie standard in the minds of many.

Furthermore, it appears to a number of Hayek’s critics, for example, Rothbard (1985, 3–4), that his plan contravenes the evolutionary development of media of exchange so eloquently stated by Carl Menger (1892) and restated by, among others, Ludwig von Mises (1971, 30–33), Selgin (1988a, 16–21), and Karl Warneryd (1989), the latter being in a game-theoretic context. That is to say, how does one progress, in the absence of legal tender laws that impose such a result, from commodity-redeemable currencies to complete fiduciary substitution—the exclusive use of pure paper (irredeemable) currencies? What “invisible hand” could bring this about? It is perhaps significant that Hayek never really comes to grips with this issue. Indeed, in his discussion of monetary developments, Hayek even grants that “it is probably impossible for pieces of paper or other tokens of a material itself of no significant market value to come to be gradually accepted and held as money unless they represent a claim on some valuable object” (1978, 27).

Hayek attempts to escape from this conundrum by suggesting that at present consumers will accept private paper currencies (at least those of stable purchasing power) because they have become accustomed to the paper currencies of governments and thus do not find the concept of inconvertibility objectionable (1978, 28). This, however, will just not do. What Hayek must explain is why, when, and if the government’s monopoly on the production of legal currency is abolished, people would continue to prefer inconvertible paper money. In the absence of all legal restrictions on what one may use as “money,” is it not at least as likely that consumers would gravitate toward precisely that form of money that they have so often been denied by the passage of legal tender statutes, namely, commodity-backed currency?

Finally, one must point out that no private system such as Hayek describes has ever existed. On the other hand, rough approximations to the White-Selgin model can be found in the histories of a number of countries—the United States, Scotland, Sweden, Canada, and France, for instance (Selgin 1988a, 7–14). Clearly, this alone does not prove the desirability of one model over the other, but it does seem to lend further credence to the proposition that Hayek has inadequately defended his vision of free banking.

For all the foregoing reasons, this writer believes the approach of White and Selgin to be by far the more plausible. Therefore, their model of free banking will be the primary focus of this work. Furthermore, the work of Selgin and White, taken together, provides a much more detailed look at free banking than that of Hayek. The nature of those details, as well as a formal model of free banking on a specie standard, will be examined shortly.

OUTLINE OF THE BOOK

Chapter 2 derives a mathematical model of a free-banking system based on specie-convertible currency. The explicit equations employed emerge from a detailed discussion of (1) the key characteristics of free banks, (2) the applicability of supply and demand analysis to money, (3) the meanings of “price” and “quantity” in the context of money, and (4) the nature of those factors, changes in which bring about shifts in either the money supply or money demand schedules. Graphical illustrations of those parametric effects are also presented. Chapters 3 and 4 explore related theoretical issues, namely, (1) the role of free banking in understanding and applying Say’s Law and (2) the proposition that central banks are inherently unable to conduct a rational monetary policy. Chapter 5 both summarizes and critiques White’s interpretation of free banking in Scotland. Chapter 6 is devoted to American free banking. A review of recent research is provided, as well as some new evidence on the relative macroeconomic stability of the U.S. free-banking era. Alternative approaches to free banking are discussed in Chapter 7. Some common criticisms of laissez-faire banking are examined in Chapter 8. Chapter 9 concludes the work with suggestions regarding (1) future research, (2) the transition process, and (3) the social, political, and economic necessity of free banking.

NOTES

1. For an excellent analysis of this issue, one should see Edward J. Kane, The Gathering Crisis in Federal Deposit Insurance (Cambridge: MIT Press, 1985).

2. Friedman, along with his long-time collaborator Anna J. Schwartz, repeats this theme in later work (Friedman and Schwartz 1986).

3. An exception is Miller and Pulsinelli (1989). Widely used texts, such as Lawrence Ritter and William Silber (1989) and Frederic Mishkin (1989), either ignore free banking altogether or dismiss it brusquely as chaotic and inflationary.

4. This may be a “discount” rate, as in the United States, or a “penalty” rate, as in Great Britain.

5. For detailed discussions of a number of approximate free-banking episodes, see Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992).

6. The option clause is a device by which a bank may delay the redemption of its notes in exchange for the payment of explicit interest to the noteholder. Option clauses will be discussed in Chapters 5 and 7.

7. Most of the extant articles and books on free banking are listed in the bibliographic section of this book.

8. It is somewhat ironic that Rothbard (1985) bitterly criticizes Hayek’s proposal, since their approaches share one striking feature. In both cases, either most banks (Hayek) or all banks (Rothbard) must make loans out of their own capital rather than out of funds deposited. This follows from the fact that they practice 100 percent reserve banking.

9. Such redemption may or may not be immediate. Both White and Selgin see no problem in permitting banks to issue notes subject to option clauses.

10. One should refer to Chapter 8 for an extended discussion of these points.

11. This one may be taken to be the inverse of the price level. However, there are two possible interpretations of the concept “price level.” The conventional understanding of the term is that the price level is the weighted average of a large number of selected relative prices, as embodied, for example, in the CPI (Timberlake 1987, 88–91). An alternative view is that the price level should be thought of in a more micro-economic way. This approach argues that the price level is nothing more or less than the array of all relative prices, which, supposedly, no index number can represent meaningfully (Rothbard 1988a, 182–83).