2. Our Proposal for Banking Reform

Logical deduction based on this book's analysis points to a particular program of banking reform: on the one hand, the institutions related to the financial market should be made contingent on traditional legal principles; and on the other, the government agencies which until now have controlled and directed the financial system should be eliminated. We believe that in order to establish a truly stable financial and monetary system for the twenty-first century, a system which protects our economies as far as possible from crises and recessions, the following will be necessary: (1) complete freedom of choice in currency; (2) a system of free banking and the abolition of the central bank; and most importantly, (3) obligatory observance of traditional legal rules and principles by all agents involved in the free-banking system, particularly the important principle according to which no one may enjoy the privilege of loaning something entrusted to him on demand deposit. In short, it is necessary to maintain at all times a banking system which includes a 100-percent reserve requirement. We will now discuss in greater detail each component of our proposal.

TOTAL FREEDOM OF CHOICE IN CURRENCY

We recommend the privatization of currency and an end to state and central-bank intervention with respect to its issuance and control over its value. This goal requires the elimination of legal tender regulations which oblige all citizens, even against their will, to accept the state-issued monetary unit as a liberatory means of payment in all cases. The revocation of legal tender laws is therefore an essential part of any process of deregulation of the financial market. This “denationalization of money,” in Hayek's words, would allow economic agents, who possess far more accurate, first-hand information on their specific circumstances of time and place, to decide in each case what type of monetary unit it would most benefit them to use in their contracts.

It is not possible to theorize a priori about the future evolution of money. Our theoretical analysis must be limited to the observation that money is an institution which emerges spontaneously, like law, language, and other legal and economic institutions which involve an enormous volume of information and appear in an evolutionary manner throughout a very prolonged period of time in which many generations of human beings participate. Moreover, as with language, certain institutions which in the social process of trial and error best fulfill their function tend to predominate. Trial alone, throughout the spontaneous, evolutionary market process, can lead to the predominance of those institutions most conducive to social cooperation, without the possession by any one person or group of the intelligence and information necessary to create these types of institutions ex novo.

These reflections are fully applicable to the emergence and evolution of money,³⁵ and hence in this field we must be particularly suspicious of proposals to create an artificial currency, no matter how many advantages such a plan may at first appear to have.³⁶

Therefore our proposal of free choice in currency is clear. In the transition process which we will examine further on, money in its current form is to be privatized via its replacement by that form of money which, in an evolutionary manner, generation after generation, has prevailed throughout history: gold.³⁷ In fact it is pointless to attempt to abruptly introduce a new, widespread monetary unit in the market while ignoring thousands of years of evolution in which gold has spontaneously predominated as money. According to the monetary regression theorem, such a feat is impossible, since no form of money can be used in society as a generally accepted medium of exchange if it does not rest on a very prolonged historical process which begins with the original industrial or commercial use of the commodity in question (as with gold and silver). Thus our proposal is based on privatizing money in its current form by replacing it with its metallic equivalent in gold and allowing the market to resume its free development from the time of the transition, either by confirming gold as the generally accepted form of money, or by permitting the spontaneous and gradual entrance of other monetary standards.³⁸

A SYSTEM OF COMPLETE BANKING FREEDOM

This second element of our proposal refers to the necessity of revoking banking legislation and eliminating central banks and in general any government agency devoted to controlling and intervening in the financial or banking market. It should be possible to set up any number of private banks with complete freedom, both in terms of corporate purpose and legal form. As the distinguished Laureano Figuerola y Ballester stated in 1869, it is necessary to leave “the choice of banking forms to each individual, who will know how to choose the best ones, according to particular circumstances of time and place.”³⁹ Nevertheless the defense of free banking does not imply permission for banks to operate with a fractional reserve. At this point it should be perfectly clear that banking should be subject to traditional legal principles and that these demand the maintenance at all times of a 100 percent reserve with respect to demand deposits at banks. Hence free banking must not be viewed as a license to infringe this rule, since its infringement not only constitutes a violation of a traditional legal principle, but it also triggers a chain of consequences which are highly damaging to the economy. The legal and economic aspects of such affairs are intimately related, and it is impossible to violate legal and moral principles without causing grave, harmful consequences for the spontaneous process of social cooperation. Thus free banking should have no other limit than that established by the framework of general legal principles. This brings us to the third essential element in our proposal; let us now consider it.⁴⁰

THE OBLIGATION OF ALL AGENTS IN A FREE-BANKING SYSTEM TO OBSERVE TRADITIONAL LEGAL RULES AND PRINCIPLES, PARTICULARLY A 100-PERCENT RESERVE REQUIREMENT ON DEMAND DEPOSITS

There remains little for us to add here on the recommendation of a 100-percent reserve requirement for banking. We have devoted this book's entire analysis to justifying this third element in our proposal, a point logically and intimately linked to the other two. Indeed the only way to eradicate the state central-planning agency related to money and the financial system (i.e., the central bank) is to permit society to resume the use of that form of private money which in an evolutionary manner has emerged throughout history (gold, and to a lesser extent, silver). Moreover a free market economy can only operate based on the framework provided by the rules of substantive law. When applied to banking, these rules demand the establishment of a completely free banking system, but one in which bankers consistently observe the principle of maintaining a 100 percent reserve on demand-deposit contracts.

Combined, the three above elements comprise the core of a proposal to definitively reform and privatize the modern banking and monetary system, to free it from the obstacles which now disrupt it, especially central-bank intervention and state-granted privileges enjoyed by the most important agents in the financial sector. This reform would permit the development of banking institutions truly appropriate to a market economy, institutions which would facilitate economic development and the accumulation of wisely invested capital, while preventing the maladjustments and crises which the current, rigorously controlled and centralized system causes.

WHAT WOULD THE FINANCIAL AND BANKING SYSTEM OF A TOTALLY FREE SOCIETY BE LIKE?

We agree with Israel M. Kirzner that it is impossible to know today what information and institutions entrepreneurs who participate in the financial and banking system of the future will freely and spontaneously create tomorrow, assuming they suffer no institutional state coercion and are subject merely to the legal framework of substantive rules required by the operation of any market. As we know, the most important of all such rules in banking is the principle of a 100 percent reserve.⁴¹

Despite the above, we can conjecture with F.A. Hayek⁴² that under these circumstances a variety of mutual funds would spontaneously emerge,⁴³ in which people would invest a portion of current “deposits.” These mutual funds would be highly liquid, due to the existence of widespread secondary financial markets. However, as is logical, they would not guarantee their participants the recovery at any time of the nominal value of their investments. As with the value of any other security in the secondary market, this would be subject to changes in the market value of the corresponding shares. Thus a sudden change (albeit improbable) in the social rate of time preference would cause generalized fluctuations in the value of shares. Such oscillations in value would only affect the holders of the corresponding shares and not, as now occurs, all citizens, who, year after year, see a significant drop in the purchasing power of the state-issued monetary units they are obliged to use.

Quite possibly, this widespread system of mutual funds would be accompanied by an entire network of institutions devoted to providing their customers with such services as payments, transfers, bookkeeping, and cashier services in general. These companies would operate in an environment of free competition and would charge the corresponding market prices for their services.

Also conceivable is the appearance of a number of private firms with no connection whatsoever to credit, companies dedicated to the extraction, design, and supply of the different forms of private money. Such firms would also receive a profit (most likely a modest one) for their services. We say “extraction” because we have no doubt that in an environment of complete freedom, the predominant form of money will always be a metallic one with at least those essential characteristics that until now gold alone has offered: immutability, great homogeneity, and above all, scarcity. For the scarcer money is, and the more unlikely significant increases or decreases in its volume within relatively short periods of time are, the better money fulfills its function.⁴⁴