In Monetary Nationalism, Nobel Prize winner Friedrich Hayek denounces two kinds of monetary systems: those based on fiat money and those based on what he calls “national reserve” banking. A “national reserve” banking system places the vast majority of its liquid reserve assets inside the vaults of the national central bank, leaving the right to issue claims against that limited and small amount of gold to national commercial banks. The problem with national reserve banking is that foreign interbank indebtedness is cleared through payments in specie coming from the reserves of the central bank, so that the excessive liabilities of some commercial banks diminishes the reserve at hand for the rest. In other words, imprudent credit expansion by some financial institutions affects the ultimate liquidity reserve of all, forcing a general and random credit contraction in the whole economy.
It is obvious that no rational design lies behind these arrangements. On the contrary, they are the natural result of restricting the role of the lender of last resort to some financial institutions, arbitrarily defined and empowered by national Governments, thus ignoring all the branches and foreign interrelations of national commercial banks. Hayek’s solution is to replace this politically mixed system by one of these two extreme alternatives: either a complete centralization of reserves in a truly international central bank or a total decentralization of those reserves in so many local and provincial banks as may exist. In Hayek’s words:
It is important here first to distinguish between the need for some ‘lender of last resort’ and the organization of banking on the ‘national reserve’ principle. … It is far less obvious why all the banking institutions in a particular area or country should rely on a single national reserve. This is certainly not a system which anybody would have deliberately devised on rational grounds and it grew up as an accidental by-product of a policy concerned with different problems. The rational choice would seem to lie between either a system of ‘free banking’, which not only gives all banks the right of note issue and at the same time makes it necessary for them to rely on their own reserves, but also leaves them free to choose their field of operation and their correspondents without regard to national boundaries, and on the other hand, an international central bank. I need not add that both of these ideals seem utterly impracticable in the world as we know it. But I am not certain whether the compromise we have chosen, that of national central banks which have no direct power over the bulk of the national circulation but which hold as the sole ultimate reserve a comparatively small amount of gold, is not one of the most unstable arrangements imaginable (Hayek 1937).
Complete centralization has the advantages of preserving the lender of last resort function and not atomizing the system reserves in many different banks, but its shortcoming is an excessive concentration of power in a single international bureaucracy which could promote a coordinated worldwide credit expansion not based on true savings (Hayek 1931). On the other hand, total decentralization has the advantage of leaving the liquidity management at the discretion of every single bank, but it has the drawback of lacking a lender of last resort which could solve transitory liquidity shortfalls.
|International central bank||Financial integration of reserves in an international lender of last resort||Risk of a coordinated worldwide artificial credit expansion|
|Free banking with decentralized reserves||Micromanagement of liquidity||Lack of a lender of last resort|
Hayek’s trade-off seems to suggest that we cannot enjoy the advantages of both systems without avoiding their shortcomings. The purpose of this paper is to show that this dual characterization of a banking system is unrealistic: a free banking system with decentralized gold reserves would tend to evolve into an international system where reserves are more or less centralized in a few private banks acting as worldwide clearinghouses and lenders of last resort (i.e., as private and competing central banks).
In this system, each commercial bank would micromanage its liquidity by choosing, among many other variables, which percentage of gold reserves it stores in its own vaults and which is used to acquire and hold short-term claims against private central banks. Thanks to this, a high proportion of the whole monetary base would be kept in very few international financial institutions, which would in turn allow them to provide Bagehotian financing against good collateral. Furthermore, worldwide artificial credit expansion would be rather restricted by the continuous convertibility in gold of all bank claims and its consequent strong incentives for both individual banks and private central banks to micromanage responsibly their liquidity.
Individual banks and liquidity management
Banks are financial intermediaries whose core business consists in issuing debt of different maturities and levels of risk in order to lend proceeds of different maturities and levels of risk. Prudently managed banks should try to match the maturity and the level of risk of their assets with the maturity and the level of risk of their liabilities (Mises 1912). If their assets mature much later than when their debts come due, banks will face a liquidity problem: they will have to either liquidate part of their long-term assets or refinance their maturing liabilities. Something similar would happen if bad investments are made and, consequently, part of their assets has to be written off: in case the equity buffer is not large enough to absorb those losses, banks will have to look for new capital contributions to avoid bankruptcy. Consequently, every single bank must continually manage its liquidity in order to assure the short and long-term fulfillment of their liabilities.
However, at first sight it seems to be a collective action problem with liquidity management. On one hand, becoming illiquid can be a very profitable business for banks: issuing short-term debt is cheaper than issuing long-term debt; longer-term and riskier investments provide a higher yield than the safer shorter-term alternatives; and leverage has a multiplier effect on companies’ return on equity. On the other hand, when only a few banks have liquidity problems, they are more or less easily solved: assets can be sold at good prices; refinancing can be obtained at moderate interest rates; and equity can be increased without excessive dilution of current shareholders’ ownership. But none of these strategies can be successful when illiquidity affects the whole banking system: asset prices plunge abruptly on generalized fire sales; interest rates skyrocket as a result of massive credit demand; and not much equity can be obtained through widespread public offerings. Therefore, rewards for eroding one’s liquidity are individually reaped while damages are collectively absorbed.
Nonetheless, precisely because liquidity is more valuable when it is harder to obtain in the market, banks should be pressed by evolution to behave more prudently. I.e., they will learn not to be absurdly confident that, under any stressed condition, they will be able to advance income by selling long-term assets at good prices, to postpone payments by obtaining cheap refinance and to compensate losses with new overabundant equity (Palyi 1936). This is chiefly true when banks’ creditors are not protected by deposit insurance schemes and, consequently, they learn over time that risky financial strategies (such as maturity mismatching) entail a very high probability of losing large sums of their savings (so they continually keep an eye on banks to preemptively recover their gold reserves). The threat of a sudden bank-run in the absence of a monopolistic and irresponsible lender of last resort and of governmental deposit insurances is the most disciplinary element of the banking system.
In a sense, one could even foresee scenarios where the vast majority of banks held too much liquidity in relation to its longest term and riskiest investments because they assumed no liquidity whatsoever would be available in the market under pressing conditions. Those excesses, however, would be useful to offset the illiquidity of those other less experienced banks which fall victims to the euphoria of cheap credit bubbles.
The crucial point in the previous reasoning is that social institutions developed by trial-and-error processes –such as private prudential norms in the financial industry– can solve the collective action problem of banking illiquidity, but just as long as those trial-and-error processes are not interrupted or falsified by State interventionism. For instance, the creation of a monopolistic and privileged lender of last resort which provides unlimited refinancing to private banks whatever the quality of their discountable assets is, allows private banks to hugely mismatch the maturity and risks of their assets and liabilities without suffering any penalty from the market. Extraordinary profits coming from lending long and borrowing short are privatized while extraordinary losses resulting in price inflation, asset bubbles and general misallocation of resources are socialized (Fekete 1984): banks have no incentive to end their malpractices and the citizenry is strongly tempted to ask the State for more useless regulations to avoid economic consequences which do not come as a result of too much freedom but from too many financial privileges.
The economic necessity of a central bank
In the absence of State intervention, it seems pretty plausible that financial companies would individually manage their assets and liabilities in order to avoid systemic illiquidity. This macroprudential micromanagement could be thought of as consisting of decentralized banking reserves, i.e., where each bank hoards its own cash. However, the truth is that the same economic incentives that drive individuals to purchase demand deposits in exchange for their own cash also keeps banks from hoarding all cash in their own vaults.
Families and companies choose to hold part of their short-term assets in the form of claims against banks –either notes or deposits– because these claims are assets almost as liquid as money but they enjoy one important advantage over it: both large denomination banknotes and checks have much lower carrying and storage costs than money. This is especially true when all such claims are against one same bank which allows their offset and liquidation without any need of physically moving the stored cash. It can be safely asserted that banknotes and demand deposits are a faster and more efficient medium of exchange than money (Rist 1938), with just one essential drawback: depositors and banknote holders face counterparty risk. Whenever a bank is imprudently managed, creditors may experience much higher losses than the costs associated with dealing with metallic money from the beginning. Hence, individuals must continually compare the advantage of using banks’ liabilities as means of payment with their inherent risk: as soon as individuals perceive that a bank is not managed prudently enough, they will proceed to cash in its liabilities and will thus restrict its lending prodigality.
When families and companies use banks’ liabilities to buy goods and services, it becomes quite normal for sellers to collect liabilities of banks with which they do not usually work. Therefore, those individuals who do not want to hold claims against unknown or untrustworthy banks will bring them to their reliable institution either to cash them or to exchange them for the latter’s liabilities. In any case, after receiving a bundle of a competitor’s liabilities, a bank will generally try to redeem them in gold. However, its competitor will probably also possess claims against it, in which case both groups of liabilities will be offset and the net indebtedness of any of these institutions will be cleared by sending to the other part of their cash reserves.
The high cost of these operations is the reason why, in addition to family and firms, individual banks also have incentives to hold short-term claims against a third party institution which could be properly called a “central bank”. The central bank was not originally a monopoly responsible for issuing legal tender notes, but rather an institution placed in the financial center of an economic system which acted as a bank for all commercial banks (see, for instance, the historical case of the Suffolk Bank [Rothbard 2002]). Central banks, as their name denotes, are useful instruments to centralize reserves, to offset interbank indebtedness and to rearrange the property of clearing reserves so that net balances are liquidated. In this way, a huge proportion of all the gold in an economy remains inside the vaults of the central bank –just as individuals’ cash balances remained inside the vaults of commercial banks in a decentralized financial system– and net interbank liabilities can be liquidated without any physical shift of reserves among commercial banks (Withers 1909).
Furthermore, since a central bank concentrates a large proportion of all the gold circulating in an economy, its liabilities tend to be perceived almost as good as money itself. People may distrust the notes of a particular bank, but, with very few exceptions, will trust the liabilities of the bank which has in its vaults the vast majority of all gold reserves. As a consequence, despite the fact that commercial banks’ own liabilities may still circulate in trustworthy environments, the means of payment par excellence in an economy will be gold coins and central bank liabilities. One more indirect implication, which will be further developed below, is that central banks also become particularly very well fitted to provide liquidity lines for the rest of the financial system in times of stress by issuing their own liabilities against any good collateral in possession of commercial banks (Bagehot 1873), i.e., against any short-term commercial debt backed by present and highly demanded consumption goods (Smith 1776).
Hence, commercial banks will tend to store their gold reserves in the vaults of a central bank, whose liabilities will then be used as a money-economizing means of payment. However, let us remember that commercial banks face counterparty risk while holding central bank’s liabilities in much the same way individuals do while holding commercial banks’ liabilities. In other words, commercial banks will be continually forced to micromanage their liquidity by choosing between gold cash in their own vaults (safer but more costly reserves) and short-term claims against central bank (cheaper but riskier reserves).
Avoiding artificial credit expansions
A financial system with all its reserves concentrated in a single central bank is more likely to fall prey to mismatching the maturity and risk of its assets and liabilities than one with multiple reserves centers. In the latter, those commercial banks issuing short-term liabilities to fund long-term investments will rapidly face adverse interbank clearings unless rival banks do the same (Hayek 1929).
One may conceive a scenario of decentralized reserves where all commercial banks increased at the same time and at the same rate their short-term liabilities far in excess of their realizable liquid assets. In such a world, the only restriction on the continuance of artificial credit expansion would come from commercial banks’ non-financial creditors: in the case that even they accepted to hold their liabilities without redeeming them in gold, artificial credit expansion and all its well-known disruptive effects (Huerta de Soto 1998) would endure for a long time (up to the moment when either demand or supply of credit collapses due to the economic plunge). However, it is not very plausible that, without an established and coordinating lender of last resort, all commercial banks decide to issue short-term liabilities at the same time and at the same rate; especially because as soon as one of them chooses to slow down the rate of credit expansion, adverse clearings will appear for the rest, forcing them either to seek an external source for refinancing or to liquidate part of their non-liquid assets.
The risk of eroding one’s liquidity without a permanently available backstop facility is just too great to ignore for long periods. Consequently, central banks appear to be at first sight an essential tool to coordinate and cartelize a banking credit expansion: as they possess the majority of reserves in the system, even when creditor commercial banks do not want to refinance debtor commercial banks, credit expansion can continue through the central bank’s discount window.
That would certainly be true in the case of a monopolistic central bank which issues legal tender non-convertible means of payment, but we should also consider whether the same conclusions remain valid when both central banks and the use of their gold-convertible liabilities as means of payment are opened to competition. In such a scenario, central banks face the threat of a sudden drain of gold derived from a generalized redemption of their circulating banknotes by any of their creditors (commercial banks, families or firms). Once prudent and diligent commercial banks realize that their debtor central bank is giving cheap and excessive financing to their unwise rivals, they will cash gold and deposit it either inside their own vaults or inside the vault of another emerging central bank, which tries to outcompete the incumbent and overly rash one. As a result, by micromanaging their own liquidity in order to guarantee the continuous redeemability of their own liabilities (i.e. by choosing between riskier and cheaper central bank’s claims or safer and costlier gold), those more prudent commercial banks assure the liquidity of the whole system.
Under the threat of losing not only their gold reserves but also their credibility in favor of other better managed financial institutions, central banks know that they must behave diligently and fund just those operations of short-term maturity and backed by good collateral. Of course, a central bank could try to coordinate a cartelized credit expansion, but, as we have so far explained, in that case there would be two mechanisms that would prevent the illiquidity of the system: (1) the tendency by part of commercial banks’ clients to cash their demand liabilities would force these institutions to stop their artificial credit expansion and to withdraw part of their gold reserves from the central bank; (2) as a direct result, the tendency by central banks’ customers (especially commercial banks) to redeem their liabilities at any moment of stress or uncertainty would undermine their liquidity and reputation unless they possessed enough gold reserves or realizable liquid assets to attend all those demands.
The virtue of free money and free banking is not to eliminate all possibilities of artificial credit expansion by rigidly forbidding all financial elasticity, but to put all the forces and incentives of the system at work to discover, end and reverse as soon as possible those distorting excesses of credit.
Avoiding undesired credit contractions
Even without artificial credit expansions, an economic system which employs credit securities as part of its means of payment may suffer at any time from generalized distrust in financial intermediaries. Insofar as the volume of credit in a society depends critically on the trust level among its members and insofar as that trust level may fluctuate reasonably or unreasonably at any moment, the amount of means of payment may also fluctuate sharply, misleading investment and consumption decisions.
If people started thinking that commercial banks are insolvent, banks’ customers would try to redeem immediately their credits against financial institutions, but debtor banks would not be able to fulfill all their promises to pay gold, as there would not be enough pledged metal available. This run on gold would cause not only a widespread bank suspension, but also a contraction of the means of payment in that economy (Thornton 1802). And since the purchasing power in the hands of the public would no longer suffice to clear the market, the structure of prices would have to vary and adjust accordingly. The most obvious risk of this distrust-driven deflation is that not only absolute prices but also relative ones could be altered due to rigidities and slowness in the price adjustment process, which in turn would distort the whole structure of production.
There is, however, an alternative way by which economic agents may obtain enough means of payment to satiate their demands without emptying commercial banks’ gold reserves: to provide them with unlimited quantities of central bank’s liabilities issued against good collateral. As the central bank concentrates the largest part of all gold hoards of a society, its notes and deposits, as we previously suggested, will tend to be accepted as means of payment by almost all economic agents; i.e., central bank’s liabilities are the second most liquid asset in a society, just behind gold coins.
This fundamental property allows commercial banks to manage a liquidity crisis by rediscounting their good assets in the central bank in exchange for its notes or deposits. Since these liabilities are almost as good as gold, commercial banks can redeem their own debts not only in gold but, above all, in the newly obtained central bank’s notes and deposits. Thus, the confidence among commercial banks’ customers can be restored: even though they cannot pay all their maturing obligations in gold, they do have the option to redeem them in trustworthy central banks’ liabilities. As a consequence, sudden and distorting contractions of credit and means of payment may be avoided (Macleod 1889).
However, for this operation to be possible, central banks must maintain their good name. If they usually discount bad quality assets, the liquidity of their liabilities will be called into question by the public: final holders of their notes and deposits will not accept them as trustworthy means of payment and a run on gold which also depletes central banks reserves would start. What is more: as we have explained before, so long as commercial banks foresee that central banks’ liabilities will not pass in the economy as something as good as gold, they would try preemptively to build a large stock of gold in their own vaults (or in the vaults of another emerging and more responsible central bank), so that they would be better positioned than their competitors to react to an unexpected collapse of public confidence.
Precisely, these are the two preventive lines of defense which we spoke about previously and which guarantee the diligent management of liquidity in the whole system: general public, commercial banks and central banks will all watch the liquidity of the system in order to prevent their own illiquidity. This is to say, central banks will be forced by market competition to accept only good collateral for their discounting operations: they will neither expand unsustainably their credit nor favor a devastating contraction of the means of payment. They will limit themselves to act as responsible lenders of last resort and not as promoters of artificial credit expansions.
Although it is impossible to affirm apodictically, it seems quite probable that in a free banking system firms and families would be willing to hold claims against commercial banks and, in turn, commercial banks would be willing to hold claims against a central bank, so that reserve assets such as gold would tend to be brought together in the latter’s vaults. That accumulation of reserves would promote the use of the central bank’s liabilities as the general means of payment, thus reducing the carrying costs of money and enabling this central financial institution to act as a lender of last resort against non-justified panics about the liquidity of the whole banking system. Moreover, convertibility and freedom of entry in the money and financial markets would ensure that banks do not erode their liquidity in order to expand credit and reduce interest rates in an unsustainable way.
There is no radical and strong division, as Hayek seems to imply, between decentralized reserve banking and an international reserve central banking, as long as in a truly free financial system commercial banks’ current assets tend to be composed by both cash in gold and some claims against a central bank. When uncertainty about the liquidity of the central bank is high, commercial banks will tend to increase the proportion of reserves in the form of gold inside their vaults (tightening central bank credit policy); by contrast, when uncertainty is low, commercial banks will tend to prefer holding the large majority of their reserves in the form of central banks’ liabilities, redeemable on demand. Something very similar would happen regarding commercial banks and the general public: when confidence in commercial banks is low, their customers will try to cash their claims against these entities; when confidence is high, they will tend to prefer holding their liabilities. Thus, gold reserves would move throughout the financial system according to its varying perceived level of creditworthiness.
Hence, the true and relevant dichotomy is not between atomistic and internationalist reserve banking, but between free and privileged banking. The former can be either more decentralized or more centralized depending on the particular moment and the surrounding circumstances, but it enjoys all the advantages attributable to both worlds while retaining none of their supposed disadvantages; the latter can be either more nationalist or more internationalist depending on the existing political arrangements, but it is never self-regulated by checks and balances that in a free banking environment help over time to preserve the liquidity of the whole system. This is, in fact, why money must be denationalized (Hayek 1976) from the very beginning.
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