Basics of Central Banking & Origins of U.S. Central Banking Dr. D. Foster – ECO 473 – Money & Banking

Free Banking & Inflation No government control. No government regulation. Entry and exit is free. Subject only to legal requirement to pay off debts.

What limits excess bank note issue? Trust. Extent to which we use bank notes. Fear of a bank run. If loans are sound, then bank should be able to liquidate without loss to depositors. Once started it is impossible to stop. Limited clientele as a day-to-day restraint. Conclusion: Free banking non-inflationary

Other Free Banking Issues Forces at work to consolidate; weakens restraint. But, forming cartels is quite unlikely. International gold flows would still limit a monopoly bank. Hume/Ricardo “specie flow price mechanism.” Fractional reserve banking as causing boom/bust cycle. Mises: “[F]reedom in the issuance of banknotes [will narrow] down the use of banknotes…”

Central Banking Government privilege or control. Monopoly on note issue. Tend to centralize holding of gold. Can prevent individual bank collapse. Will expand (contract) the MS by expanding (contracting) bank reserve deposits. Assuming banks are “fully loaned up” the MS is: Notes in circulation + (1/rr)*(Bank reserves) Since banks earn their profits by creating new money and lending it out, banks will keep fully loaned up unless highly unusual circumstances prevail. (136)

Free Banking vs. Central Banking With free banking what happens to the MS when depositors cash out some of their DD for banknotes? Nothing. Only the form of the MS changes; from DD to banknotes.

Free Banking vs. Central Banking With central banking what happens to the MS when depositors cash out some of their DD for banknotes? The bank loses liabilities to the CB. To restore reserve balance, loans, DD and MS must fall.

Pyramiding the Money Supply Banks have $1 mill. of gold and rr = 25%. They can issue $4 mill. of loans = notes + demand deposits. Add national banks. They can hold $1 mill. of gold and expand money to $4 million. Other banks can treat $4 mill. as their reserves and expand the MS (by increasing DD) to $16 million. Add the Federal Reserve. They can hold $1 mill. of gold and expand money to $4 million. National banks can treat $4 mill. as their reserves and expand the MS (by increasing DD) to $16 million. Other banks can treat $16 mill. as their reserves and expand the MS to $64 million.

The Origins of U.S. Central Banking 1791–1836 Bank of England The Bank of North America (1781) The First Bank of the United States (1791) The Second Bank of the United States (1816) 1837–1865 The “free-banking” era. The Civil War & greenbacks – a fiat money

1865–1912 The National Banking Act (1863) The Gold Standard (1875). Brief foray into bi-metalism. Panics of 1873, 1893 and 1907 Federal Reserve Act of 1913

Central Banking – The Bank of England Created in 1694 Bought gov’t bonds and issued notes. Held all government debt. Notes were not “legal tender,” but widely accepted. Insolvent in 2 years. Parliament allowed them to suspend specie payment. Brief competition (Nat’l Land Bank; South Seas) 1708: monopoly on bank notes & short term loans. Late 1700s, massive suspension lasted 24 years. 1833: notes made legal tender. Peel Act – limit fractional reserve notes Failed to recognize deposits as money.

Central Banking - The 1st and 2nd BUS Mercantilist movement behind banks. Fed owns 20%, deposits funds here. Banks buy government debt; issue notes. 1791-1796 wholesale prices up 72%. Periodic specie suspension and bank panics. BUS will hold bank notes. 2nd BUS inflates, then deflates in 1819. “The bank was saved, but the people ruined.” Jackson kills the 2nd BUS.

The “Free Banking” Era: 1836-1863 Van Buren sets up Independent Treasury System Came and went and lasted only until Civil War. Fed’l government held only specie, not paper. Decentralized banking 1836-1862 Still heavily regulated. State banks required to hold state gov’t. debt to back their note/dd issue. Notes accepted for taxes. Restricted branching making redemption harder. Private note clearing – Suffolk System Held specie reserve of members. Different bank notes accepted. Insulated banks from panics.

The National Banking System Specie suspension & greenbacks 12/1861. 1861 to 1863, MS doubled. Wholesale prices up 22% per year during war. The National Banking Act of 1863 Created national currency. Taxed non-national bank notes. Bought gov’t debt & issued notes. The rise & fall of Jay Cooke. State banks benefit by holding reserves in nat’l notes. Didn’t stop periodic panics.

Basics of Central Banking & Origins of U.S. Central Banking Dr. D. Foster – ECO 473 – Money & Banking

Appendix – Issues Previously Considered Central Banking & Reserves Central Banking & Inflation Rothbard on the Federal Reserve System Central Banks, Independence & Inflation Review on your own.

Central Banking & Reserves Reserves and desire for cash (public) move in opposite directions. Some factors cash demand: seasonal spending and underground/illegal transactions. Some factors cash demand: credit & debit cards and improvements in the clearing system. The Fed can/does make loans to banks. Although of minor importance, discount rate has been used in way to bias towards inflation. The Fed mostly ∆s reserves by buying stuff (T-bonds). [U]ntil now virtually the only asset the Fed has systematically bought and sold has been U.S. government securities. (157)

Central Banking & Inflation With many banks, an reserves will MS by (1/rr)% If rr=20% and Fed buys $10 billion in bonds from one bank. That bank can increase loans by only $8 billion. But this process continues with all other banks. Net increase in the MS will be $50 billion =(1/.2)*(+$10 b.) Government budget deficit/surplus is “unrelated.” When Fed buys bonds, debt is “monetized” and MS rises. When Fed doesn’t act, gov’t. bonds “crowd out” private sector investment and raise interest rates. WOAPW: Fed buys bonds from bank We get inflation (MS) & tax burden, benefiting of banks. Should Fed buy directly from the Treasury? WOAPW = Worst of all possible worlds

The Federal Reserve System “An engine of inflation.” An addition layer means more money creation. 1914 to 1920, MS doubles member banks DD 250%. non-member banks DD 33%. Reserve deposits on savings falls. Shift from DD to TD. Generally accepted that savings are “payable upon demand.” Ben Strong & the Morgans.

Central Bank Independence, Average Inflation, and Inflation Variability in Major Developed Nations SOURCE: Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” Journal of Money, Credit, and Banking (May 1993): 151–162.