Basics of Central Banking & Origins of 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.

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.

Evolution to Central Banking: 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

The National Banking System The National Banking Act of 1863 Created nationally-chartered banks. Created a national currency. Taxed non-national bank notes. Bought gov’t debt & issued notes. The rise & fall of Jay Cooke. State banks still benefit by holding reserves in nat’l notes. Didn’t stop periodic panics.

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.

The Federal Reserve Banking System Purpose: Develop, supervise & control the nation’s money. Serve as a national check-clearing system. Serve as depository for federal gov’t. funds. Board of Governors of the FRS 7 members, equal standing . . . but, includes Secretary of the Treasury and Comptroller of the Currency. Problems: Only using discount window, Each District Bank sets its own policy.

The Federal Reserve Banking System

The Early Fed, 1913–1935 Accommodates the Treasury Dept. during WWI. Buys Treasury bonds to finance G spending (aka “monetizing the debt”). From 1916 to 1918, this increases MS by 70%. Huge risk of inflation. The Great Depression - Failure of the Fed Initially increased liquidity, but pulled back. By 1933, 33% of banks fail, MS fallen 33%.

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