Book Review: The Theory of Free Banking: Money Supply Under Competitive Note Issue by George A. Selgin

Rowman & Littlefield, 81 Adams Drive, Totowa. New Jersey 07512 • 1988 • 218 pages • $33.50 cloth

Banks are in trouble. But an even greater crisis lurks beneath the political surface, on the university blackboards, and in the principles texts and academic journals. Consider the following argument, made recently by David Warsh in the May-June 1988 issue of the Harvard Business Review: “Money is funny stuff. Like language, it has meaning only insofar as people agree to share it. Unlike language, however, it requires supervision.”

Here we have the “conventional wisdom,” accepted by virtually every politician and the vast majority of professional economists. Money is different. Money cannot manage itself. End of story.

Enter, or should I say “re-enter,” the Austrians. Standing firmly on the intellectual shoulders of Carl Menger, Ludwig von Mises, and F. A. Hayek, George Selgin has boldly challenged the status quo in monetary theory. In his recently published book, The Theory of Free Banking, Professor Selgin argues that money will, and must, manage itself.

Ever since Menger, the founder of the Austrian school, wrote his Principles in 1871, Austrian economists have been highly critical of government involvement in the business of money and banking. In Menger’s view, money cannot be arbitrarily created by legislative fiat precisely because it came into being as the unintended consequence of individuals seeking to better satisfy their wants. Money, to be accepted widely, must be the product of voluntary exchange.

Ludwig von Mises refined and extended Menger’s monetary theory in The Theory of Money and Credit, published in 1912. Employing his famous “regression theorem,” Mises demonstrated that the value of money also evolves through a historical process of human interaction. According to Mises, the value of money today is linked to the “price” of money yesterday, and the expected value of money tomorrow will be based on the “price” of money today. When left alone by government, the value of money is both dynamic (responsive to ever-changing economic conditions) and stable (linked with the remembered past and an imagined future).

Because of its historical continuity, money provides a reliable “unit” for economic calculation, the means by which the millions of individuals within a society are able to coordinate their activities. This theoretical understanding of the nature of money provided the Austrians with a devastating critique of planning in general and of central banking in particular.

Unfortunately, this rich tradition in monetary theory was all but forgotten in the turmoil of the Keynesian revolution. Divorced from the plans and purposes of individuals, monetary theory was pushed deeper and deeper into the mystical world of Keynesian “macro-economics.” The intentions of individuals were replaced with functional relationships between imaginary aggregates—equations to be manipulated by government officials to serve government ends.

The appearance of The Theory of Free Banking signals a well-written, well-organized shift in intellectual currents. Professor Selgin’s book will shock some. I am delighted.

Soon after opening the book, the reader will notice the quick precision of Selgin’s prose. After a brief overview of a number of historical episodes of free banking, Selgin moves directly into a theoretical discussion of the evolution of money and banking. Here, Menger’s influence is strong and obvious.

The second part of the book develops the notion of “monetary equilibrium,” borrowed from economists such as J. G. Koopmans, Gottfried Haberler, Fritz Machlup, and Dennis Robertson. This is the idea that there is both a demand for and a supply of bank notes which must continually adjust toward a coordinated equilibrium.

Selgin fuses the theory of monetary equilibrium with the Austrian critique of central banking as developed by Mises and Hayek. Central banking, they argued, is neither responsive nor stable. Besides the obvious political incentives which discourage sound money management within a central banking system, central bankers simply cannot obtain the relevant knowledge required to match the supply of money with money demand.

Only market competition and competitive note issue, Selgin concludes, provide both the incentives and information necessary to maintain monetary equilibrium. Free banking is the only monetary system that can properly adjust to changes in the market demand for bank notes without flooding the market with unneeded, un- backed paper currency. Selgin reminds us that fractional banking, when disciplined by free competition, provides an altogether superior alternative to centralized control and supervision. While Mises might have objected to the use of such a mechanical metaphor, the insight of “monetary equilibrium” is clearly consistent with the Austrian understanding of money—even more so than Selgin is willing to admit. In The Theory of Money and Credit, Mises defined inflation as “an increase in the quantity of money . . . that is not offset by a corresponding increase in the need for money . . . .” Furthermore, “deflation . . . signifies a diminution of the quantity of money . . . which is not offset by a corresponding diminution of the demand for money . . . .”

The difference between Selgin and Mises appears to be one of emphasis. We can quibble over the proper interpretation of Mises on this point, but the fact remains that the real-world problem confronting Mises during the years he wrote was the rampant inflation generated by the central banks of both Europe and the United States. Naturally, Mises emphasized the distortive effects of an over-supply of money. But he also saw the solution, arguing in 1949 in Human Action that “free banking is the only method available for the prevention of the dangers inherent in credit expansion.” According to Mises, there was “no reason whatever to abandon the principle of free enterprise in the field of banking.”

Either way, the importance of Selgin’s contribution should not be underrated. Mises did, in fact, tend to neglect the importance of “the demand side” of money. With the publication of The Theory of Free Banking, Selgin joins a small but growing number of economists who seek to revive and extend the forgotten Austrian tradition of free banking. I am thinking also of F. A. Hayek (Denationalization of Money), Hans Sennholz (Money and Freedom), and Lawrence White (Free Banking in Britain). With books such as Selgin’s, there is hope for the future of ideas and our banking system.

(Matthew Kibbe is a doctoral student in economics at George Mason University and a fellow at the Center for the Study of Market Processes.)