Back in 2001, supermiddleweight boxer James Butler was heavily fined and barred from the sport for sucker-punching his opponent instead of congratulating him after being bested in a match.

Alas, there are no similar penalties for late sucker punches delivered after economics debates, or else the BBC-sponsored Hayek versus Keynes debate held at the LSE last month might have been Lord Skidelsky’s last. For yesterday his noble lordship delivered a most ignoble below-the-belt blow to his late opponents in the shape of a Project Syndicate column titled “The Keynes-Hayek Rematch.”

Here, among other things. Lord Skidelsky suggests that Keynes “savaged him [Hayek] while he was still alive,” and that Hayekian ideas have only succeeded in gaining popularity since thanks to Hayek’s having long outlived Keynes–as if Hayek’s growing popularity wasn’t itself mainly posthumous, and as if Keynesian ideas have lacked huge battalions of defenders, both in and out of the academy, since his death. He writes as well that only “Hayekian fanatics” could possibly not believe that the “global stimulus of 2009 stopped the slide into another Great Depression”–a statement that, besides dismissing as “fanatics” a large number of persons, including some pretty good macroeconomists who are no more Hayekian than Lord Skidelsky himself, seems rather brash. He repeats the slur, which I took pains to expose as such during the debate, that Hayek favored doing nothing to combat a post-boom collapse of spending, likening Hayek’s stand to one of “denying blankets and stimulus to a drunk who has fallen into an icy pond, on the grounds that his original trouble was overheating.” He also repeats the claim, refuted in my last post, “that public-sector austerity at a time of weak private-sector spending guarantees years of stagnation, if not further collapse.” Finally, Lord Skidelsky declares that “Hayekians have nothing sensible to contribute” (my emphasis) to the debate concerning the extent to which “strengthening the tools of macroeconomic management”–meaning (presumably) further expanding government spending and indebtedness as well as further strengthening central banks’ powers–is likely to prove beneficial and prudent.

To the last assertion, an astute commentator offers a most appropriate reply. “It’s hard to believe,” he observes, that the observation in question, among others noted,

was written by the same man who, half a dozen years ago, said of Hayek, “The particular threats to liberty that he identified may be on the wane—his book has done its work well—but there are other threats, and the victory of liberty is never secure. Hayek’s key message for us today is surely this: every new restriction or regulation should be judged by its effect not just on the problem that it is designed to solve or the danger that it is designed to avert but by its effect on the system of liberty as a whole. If we are blind to this, we will be left with a damaged system of liberty long after the particular problem or danger has passed away.”

“That, however,” the commentator continues, “was upon receiving the Manhattan Institute’s $50K ‘Hayek Prize.’ Perhaps they ought to have spread out the payments!”

It turns out that, when Lord Skidelsky was given it back in 2005, the Hayek Prize was worth only $10 thousand. I leave it to readers to decide whether to wish it had been more, or that it had been less.

As I pointed out in a previous post, in the course the BBC/LSE “Hayek versus Keynes” debate the Keynesian side made some claims to which I had no opportunity to respond. My earlier post addressed some of them, but left another alone. This was Lord Skidelsky’s claim, aimed at Great Britain’s current riot-provoking austerity campaign, that no government has ever achieved a speedy recovery from a recession by clamping down on its spending or reducing its indebtedness.

But there is at least one instance of economic recovery–and hardly a trivial one–that contradicts, or at least very much appears to contradict, Lord Skidelsky’s claim. This is the United States’ rapid recovery from the deep recession into which it sank in the last half of 1920.

In many respects the boom-bust cycle that started in April 1919 was typically “Hayekian”: during the boom year ending in April 1920 the Fed held its rediscount rate at 4 percent despite rising money market rates. Commercial banks took advantage of the low rate–as they’d actually been encouraged to do by the Fed–by borrowing from the Fed in order to re-lend at a profit, causing bank loans and investments to increase by just over 25 percent. General prices, and prices of commodities and land and other factors of production especially, in turn rose more rapidly than they had since the Civil War, exacerbating a gold drain that had begun with the armistice. Under the circumstances a reversal was only a matter of time.

When it came, the reversal was both sudden and sharp. Commodity prices tumbled from an index value of 248 in May 1920 to one of just 141 the following August, while consumer prices witnessed their greatest rate of deflation ever. Businesses were unable to pay their bills, industrial production fell by an unheard of 30 percent, and almost 5 millions workers lost their jobs, bringing the unemployment rate, which had been less than 2 percent, to just below 12 percent. Yet by August 1921 recovery was well underway. What’s more, it was so swift that by the spring of 1923 unemployment had given way to a pronounced labor shortage, while industrial production reached a new peak.

Did the U.S. government hasten the recovery by means of deficit spending and other “stimulus” programs? Not in the least. instead, it stuck to conducting business as usual which, in those naive days before Keynes revealed that prudence and thrift were shopworn Victorian shibboleths, meant reverting to its prewar budget and retiring its wartime debt. In other words, it followed what would today be called an “austerity” policy, and did so to a degree that makes recent austerity measures in Great Britain and the U.S. seem downright profligate. Instead of spending more than it had been, the Harding administration steadily cut expenditures, exclusive of debt retirement, from just over $6.4 billion in fiscal 1920 to just under $3.3 billion in fiscal 1923–a whopping 45 percent! As a percentage of GNP, Randy Holcombe shows, Federal outlays fell from just over 7 percent to well under 4 percent.* And although its revenues also declined over the same period, from about $6.7 billion to about $4 billion, the government nevertheless devoted a large share–almost $1 billion–to reducing its indebtedness. As Benjamin Anderson, who was at the time an economist employed by Chase National Bank, observes in Economics and the Public Welfare (1949),

The idea that an unbalanced budget with vast pump-priming government expenditure is a necessary means of getting out of a depression received no consideration at all. It was not regarded as the function of the government to provide money to make business activity. It was rather the business of the United States Treasury to look after the solvency of the government, and the most important relief that the government felt that it could afford to business was to reduce as much as possible the amount of government expenditure, which had risen to great heights during the war; to reduce taxes–but not much; and to reduce public debt.*

Turning to monetary policy, although easy money did contribute somewhat to the recovery, the contribution was minor and largely unintended. Thus while the Fed banks gradually lowered their discount rate from 7 to 4 percent between 1921 and 1922, 4 percent was not especially low in light of the rapid deflation then in progress. And despite the rate lowering commercial bank rediscounts declined, as banks preferred reducing their indebtedness to the Fed to taking advantage (as they regretted having done earlier) of opportunities to re-lend borrowed funds at a profit. The Fed also made what was at the time an unusually large open-market purchase of government securities. But this only served to further reduce commercial bank rediscounts, and was moreover done, not with any intent of stimulating recovery, but solely so that the Fed could earn enough revenue to cover its expenses and pay promised dividends to its commercial-bank shareholders.

Proponents of Keynesian pump-priming often berate the Hoover administration for its “liquidationist” strategy for dealing with the outbreak of the Great Depression–forgetting that it was Hoover himself who caricatured Andrew Mellon, his Secretary of the Treasury, as someone who wished to “liquidate” the stock market, farmers, real estate, and so forth, and who took pride in not having followed his advice. But Mellon was also Harding’s Secretary of the Treasury; and Harding, unlike Hoover, trusted him. It is one of the greater ironies of economic history that “liquidationist” policies, including government austerity, are blamed for prolonging a depression for which those policies were set aside, while being denied credit for perhaps helping to end one in which they really were put into practice.

*Sentences added 8/20/2011
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Addendum

On very rare occasions, when it regards a broadcast as having been particularly well-received, BBC Radio 4 rebroadcasts the same program for a third time. I’m very pleased to say that it has chosen the Hayek versus Keynes debate for this honor, and will therefore air it again, for the sake of regular listeners who missed it (and can’t be bothered with podcasts) on August 24th. Yo Hayek!

This morning over breakfast at the neighborhood bakery, I read a very nice article in the New York Times concerning the “unconventional” views of Kansas City Fed President Thomas Hoenig–views that have made Hoenig my own favorite Fed insider for some years now. Hoenig’s beliefs, as summarized there, struck me as being virtually the same a those I’d put forward in London in what I considered to be a defense of Hayek’s thinking about business cycles. Consider:

“The central bank has to be, in a way, a neutral player, and yet we find ourselves trying to stimulate, and the effect is further leveraging,” he said. “If I thought zero rates would bring jobs, I’d want it forever. But it distorts the economy.”

He continued, “In 2003, when we lowered rates and kept them there because unemployment was 6.5 percent — look at the consequences.” Those consequences included the nation’s mortgage feast, followed by its current economic famine.

Returning home, I read this comment from Bill Woolsey on David Beckworth’s blog:

I am a bit of an ABCT skeptic, but I am more and more concerned that using a commitment to keep interest rates low in the future is the most likely way to generate malinvestment. In my view, the way to avoid malinvestment despite errors in monetary policy is for people to understand that future short term rates will reflect future conditions. An investment project that is only profitable if short term rates are maintained into the future, is an error. And, by the way, having the Fed purchase long term bonds to directly lower long term rates has a similar problem.

Although I don’t call myself an Austrian economist, and am more than happy find fault with arguments by self-styled “Austrians” that I think unsound, I can’t help feeling that Hayek deserves a lot more credit than he’s getting for having put forward a theory which, whatever its general merits may be, seems to fit the recent boom-bust experience so well. So far as I’m aware, Mr. Hoenig never mentions Hayek, and may not even be aware of the overlap between his own thinking and Hayek’s theory. Bill Woolsey, on the other hand, knows about the ABCT, sees the fit to recent experience, but remains a “skeptic.” I wonder whether he is merely indicating his disagreement with those more fervent proponents of the theory who seem to insist that it is the only valid theory of cycles.

In any event it seems to me that anyone who believes that the recent bust is to some important extent a consequence of past malinvestment that was sponsored by easy monetary policy ought to acknowledge the fact that F.A. Hayek spent much of his early career warning against this very possibility, and later won a Nobel prize for the work in question. That something akin to his theory, if not the very thing itself, is now subscribed to by many non-Austrians, either with no mention of Hayek’s contribution or with somewhat grudging acknowledgment of it only, seems to me both strange and unfair.

(Both parts of this article originally appeared, under the title “Fractional Reserves and Economic Development,” on the short-lived Free Market News Network.)

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When Adam Smith first drew attention to the benefits of fractional-reserve banking, those benefits were but a glimmer of far more impressive gains to come. In 1776, the year of the appearance of Smith’s Wealth of Nations, Scotland had only 10 note-issuing banks, the two oldest of which, the Bank of Scotland and the Royal Bank of Scotland, were but 81 and 49 years old, respectively. The note-exchange and settlement system was still in its infancy, so metallic reserves still accounted for about a fifth of issuing banks’ liabilities. By the time of the passage of the Scottish Bank Act of 1845, which placed restrictions on further Scottish note issues, Scotland had almost twice as many note-issuing banks, with coin reserves often amounting to less than two percent of their liabilities. Scottish banks’ had thus achieved a substantial improvement in their ability to invest Scotland’s money holdings productively, and had done so without engendering the least loss of public confidence in their notes.

Although Scotland offers an especially impressive example of the gains to be had from fractional-reserve banking, such banking has also played a crucial role in worldwide economic development. Persuasive evidence of this can be found in two collections of studies, Banking in the Early Stages of Industrialization (1967) and Banking and Economic Development (1972), both edited by economic historian Rondo Cameron. Surveying the findings of the first volume, Cameron concludes that banks, through their “substitution of various forms of bank-created money for commodity money,” played an essential part in fostering industrial development, and that they were most effective in so doing in places, like Scotland in the early 19th century, where they were least hampered by government regulations, including regulations limiting banks’ right to issue circulating notes.

More recent research has reinforced Cameron’s conclusions by showing how “repressive” financial regulations—meaning regulations that prevent banks from functioning as efficient savings-investment intermediaries, such as statutory minimum reserve requirements—have impeded economic growth in less-developed countries. Oppressive banking regulations are especially harmful to poor countries, where money holdings represent are large portion of available savings. Of such oppressive regulations the monopolization of paper currency by central banks is perhaps the most oppressive of all, for it means that a substantial part of the public’s monetary savings is diverted from the private sector, which might employ those savings productively, to the government, which tends to squanders them instead.

As nations become wealthier, the relative importance of fractional-reserve banks diminishes, because the public becomes increasingly able to afford financial assets other than money, including stocks and bonds. Industry can then rely, to some extent at least, on funds acquired by selling securities, instead of having to borrow from banks. Yet bank loans remain a major source of business funding, and of small-business funding especially, even in wealthy nations with well-developed securities markets. In the United States, for instance, businesses today get more than twice as much credit from banks as they get by issuing their own bonds, and many times as many funds as they get by selling shares. In Germany and Japan bank loans account for a still larger share of business funding. And although commercial banknotes have been legally suppressed in most countries, demandable bank IOUs, in the form of demand deposits, remain banks’ own principal source of funds. Without fractionally-backed bank money, in other words, most businesses would have to go begging for credit—as they were forced to do, temporarily, during the banking crisis of the 1930s.

I realize that claims concerning how fractional-reserve banks promote prosperity will carry little weight among those who insist that such banking necessarily entails fraud. It would be tragic indeed if they were right, for then we would confront a stark choice between condoning fraud on one hand and enjoying economic prosperity on the other. Fortunately, though, we face no such dilemma: as I hope to make clear in a later essay, the claim that fractional-reserve banking involves fraud is just as untenable as the claim that it has contributed nothing to the wealth of nations.

Last week’s debate has naturally generated some response from defenders of Keynes who have found fault with my and Jamie Whyte’s characterization of Keynes’s views, or who have simply found fault with our…personalities!

Over at Tax Research UK, for instance, Richard Murphy and some of his friends observe that, besides being humorless, Jamie and I must also lack the basic human ability to “empathize” with others (which is, when you get down to brass tacks, just a tiny step away from coming right out and calling us a couple of sadists), for how could we otherwise be opposed to unbridled government spending and bailouts? Concerning the last, Mr. Murphy takes for granted that in suggesting that insolvent banks ought to have been allowed to fail I meant that they ought to have been left to collapse, leaving depositors out in the cold. Murphy’s implicit view that collapse is the only alternative to bailouts is of course one that insolvent bankers themselves are happy to see promulgated. Nevertheless it is perfectly unfounded, as I indicate in my contributions to the blog in question, where I refer to what some have styled the “Swedish” alternative.

At Social Democracy a post-Keynesian blogger who styles himself “Lord Keynes” similarly misinterpreted my “liquidationist” stand, inviting what became a long exchange with me there that was interesting in part because by engaging in it I learned that trying to argue with a dreaded Post-Keynesian can after all be a lot more rewarding, as well as a lot more pleasant, than trying to argue with many Rothbardians!

Finally, at Prime another post-Keynesian, Victoria Chick (who I reckon one of my favorite “Keynesian” economists, for what it’s worth) accuses Jamie Whyte and me of committing eight serious “fallacies” in our part of the debate. As I only just finished replying to her post, and my answers–one for each of the supposed “fallacies”–still await moderation, I reproduce the latter here (you must consult the original blog for the accusations themselves):

1. Hayek as “an opponent of financial excess”

The suggestion that deregulation was responsible for the sub-prime excess is unfounded. The Glass-Steagall “repeal” of 1999 merely allowed investment banks to have commercial bank subsidiaries; since it was the investment banks themselves rather than their (smallish) commercial bank subsidiaries that got in hot water, the reform made no difference except by making it easier to rescue tottering stand-alone investment banks through bank mergers. As for deregulation in the ’80s, the supposed link to the sub prime boom here is too obviously tenuous to be worthy of comment.

2. Keynesian policy as “promoting the big state”

It’s true that Keynes himself was what today would be considered a (long-run) fiscal conservative. This is a point I myself made in an excised portion of the debate. However it is also true that the Keynesian suggestion that expansionary policies are generally capable (see below) of combating non-trivial levels of unemployment has been seized upon by politicians as justifying government profligacy.

3. The inflation of the 1970s as “the fault of Keynesian policies”

I don’t recall myself blaming “Keynesianism” for the inflation of the 70s. On the contrary: in part of the debate that was edited I specifically observed that Keynes had been a consistent advocate of price-level stabilization. As for the 70s, in the U.S. inflation started creeping up in the 60s, partly because of the Vietnam war but also at the urging of prominent self-styled Keynesians who insisted that higher inflation would bring lower unemployment, as had appeared to be the case earlier in the decade. The so-called stable “Phillips Curve” is not something critics of Keynesianism invented: it was the brainchild of self-styled Keynesians themselves, and it did certainly play its part in the Vietnam-era escalation of U.S. inflation rates.

4. Keynes as “advocate of deficit spending”

and

5. Keynes as “a supporter of wasteful expenditures”

Whether he intended the consequence or not, Keynes’s “pyramid building” rhetoric licensed wasteful government spending. It’s a shame that he isn’t around to assail those who have abused his arguments so. But even a smallish dose of public-choice theory should have sufficed to predict what politicians would make out of the suggestion that any sort of spending is capable of combating depression and, indeed (if Lord Skidelsky is to be taken at his word) capable of promoting long-run economic growth!

6. Roosevelt’s New Deal as “trivial in scale and impact”

Romer wasn’t “compromised” by her earlier writings on the New Deal: she was simply embarrassed by them once she found herself leading the economic team of an administration committed to fiscal stimulus. The evidence and argument contained in her key writings on the 30s remain as solid as ever. Moreover, she is far from alone in having argued that major components of the New Deal, and the NRA especially, were either ineffective or actually counterproductive in ending the depression.

Indeed, Keynes himself believed that the NRA would impede rather than hasten recovery, and said so in a letter to Roosevelt written after the act’s passage. The letter reads in part,

“I am not clear, looking back over the last nine months, that the order of
urgency between measures of Recovery and measures of Reform has been duly
observed, or that the latter has not sometimes been mistaken for the former. In
particular, I cannot detect any material aid to recovery in N.I.R.A., though its
social gains have been large. The driving force which has been put behind the
vast administrative task set by this Act has seemed to represent a wrong choice
in the order of urgencies. The Act is on the Statute Book; a considerable amount
has been done towards implementing it; but it might be better for the present to
allow experience to accumulate before trying to force through all its details. That
is my first reflection–that N.I.R.A., which is essentially Reform and probably
impedes Recovery, has been put across too hastily, in the false guise of being
part of the technique of Recovery.”

(Interested readers can read the whole letter here.)

7. The 2008–9 financial rescue as “‘Keynesian”

Well, here is Keynesian support for bank bailouts. Q.E.D.

By the way, it has been suggested by some (not here) that in opposing such I in effect favored simply letting banks collapse. But the suggestion that collapse is the only alternative to bailouts ignores what some term the “Swedish approach”, which was the alternative I had in mind.

8. The failure of stimulus as “a failure of Keynesian policy”

Sorry, but it’s back to pyramids again: the Keynesian argument is that the problem is solely one of inadequate demand, so that, much as public works and such might be preferred, any sort of fiscal [stimulus] should help; and it was on such grounds that U.S. proponents of fiscal stimulus didn’t trouble themselves over just where stimulus money would go in arriving at their (ultimately very wrong) estimates of the “multiplier” effects we could all look forward to. If more orthodox Keynesians think that all this was a mistake, I am glad to hear it. But they still need to explain how to reconcile their ideal stimulus with the workings of real world (democratic) governments.

Addendum: Soon after this posting Mr. Murphy shut-down comments on his blog entry. Perhaps I’m being too uncharitable in supposing that this had anything to do with the accumulation of negative feedback he was receiving, much of which was evidently from sympathetic, regular readers. Mr. Murphy, in any event, allowed himself the following last words:

“Trouble is – I’ve never known an empathic person who can find a cent of sympathy for Hayek and Hayekians.”

Meaning, I surmise, either (1) that he couldn’t hear all those people shouting “Yo Hayek” in the BBC podcast or (2) that he maintains that every one of them was incapable of empathy.

Methinks the man doth protest too much.

BBC Radio 4 is about to air the debate between myself and Jamie Whyte (defending Hayek) and Lord Skidelsky and Duncan Weldon (defending Keynes),so I thought I might supply a little background on it for the sake of anyone who may be interested in how these things shape up.

I was only asked to take part in the debate about two weeks before it was scheduled to take place, presumably because one or two or half a dozen other persons couldn’t or wouldn’t do it. But as I am actually an admirer of Lord Skidelsky (his biography of Keynes is truly splendid), and the LSE venue was itself classy enough, despite having only recently returned from a long stay in Europe I was glad to accept.

It was only after I did so that I learned that this was to be one of those debates in which each speaker had only a few minutes (originally 3.5, later expanded to 4) to make his case. Boiling down Hayek’s position to what (given my slow manner of talking) amounted to about 500 words was no easy matter; and here I must say the Keynes team had something of an advantage, since Hayek’s is a rather involved boom-bust theory, whilst Keynes’s is only a theory of how spending is what’s needed to end busts.

So I set to work reading and re-reading works by Lord Skidelsky, who had obligingly written several things specifically dealing with Hayek, and thereby formed what turned out to be a very good guess of the arguments he would in fact make. I also contacted Jamie Whyte, who I did not know, to coordinate my efforts with his. We agreed that I would follow Skidelsky and that he would handle the second round against Duncan Weldon.

Just before I was to leave for London, however, the BBC decided that they wanted Jamie to go first, which rather put a wrench in our works. What’s more in London they suggested that terms like “Fannie” and “Freddie” and “cyclical unemployment” that had appeared in my originally prepared remarks, though fine for the LSE crowd, might go over the heads of some of the 1‑million-odd Radio 4 listeners. In fact I’m sure they were worried stiff that I was going to bore everyone to death. So they suggested some changes which, besides not being my own words, added on another 500 words or so! Consequently I spent much of Tuesday morning rewriting my talk from scratch in light of their concerns, getting it down to about 700 words, with a paragraph I could dump if I needed to (which in fact I did).

Despite all the last-minute changes the debate itself seemed to go very well–certainly everyone had a good time, thanks partly to Paul Mason’s excellent mood-setting (and occasional, unintentionally funny bloopers). I hope that shows in the broadcast version. (I certainly hope that I don’t end up boring anyone to death after all.)

There were times, though, when I regretted not having had the chance, or sometimes not having had the wit, to answer or answer more fully some of the arguments made on Keynes’s behalf. I especially regret not having been called upon to answer Duncan Weldon’s claim that Hayekians are like dentists who have nothing to offer someone who is suffering from a rotten tooth. I might then have been tempted to point out, first of all, that it was pretty cheeky for a British proponent of greater government intervention to be bringing up dentistry. But what I really wanted to observe was that it is the Hayekians who, after all, are all for pulling an economy’s “rotten teeth” not only to eventually stop the pain but also to keep them from stinking it up, whereas it’s the Keynesians who say, in effect, “Oh, don’t worry about that tooth…just have some more candy and everything will be all better.”

I wish as well that I’d had more time to address Lord Skidelsky’s suggestion that one had to be far gone to believe that FDR’s New Deal actually delayed U.S. recovery from the Great Depression. He evidently is unaware of the very substantial body of research pointing to the harm done by certain New Deal programs, and especially by the National Recovery Administration, none of which by the way is due to crazy Hayekians. Indeed, some is by scholars generally considered sympathetic to Keynesian ideas.

Finally, neither Jamie nor I managed to make as much hay as we ought to have out of Skidelsky’s assertion that government spending of whatever kind is as good as any other sort for promoting long-run economic growth. Here surely was a chance, had we only the time, to draw attention to the rotten heart of Keynesian economics. For Skidelsky’s argument–that workers will supply factories with orders for things no matter who pays them–illustrates in all its naked crudity the dangers of ignoring the “supply side” of economic activity. After all, it isn’t just what workers would like to have in exchange for their paychecks that determines what they can have. On the contrary: what they can have depends crucially on what they themselves actually produce in exchange for the payments they receive. An army of government workers employed digging and refilling ditches, for instance (and the sweeping nature of Skidelsky’s assertion warrants the reductio) contributes absolutely nothing to either its own or others’ ability to consume, let alone to the maintenance or augmentation of the stock of productive capital. A body of economic doctrine that lends itself to such a serious misapprehension of the basis for economic prosperity can hardly be expected to provide sound advice for nursing a sick economy to health.

(A few years ago I was hired to contribute some articles on free banking and related subjects to an online forum called the Free Market News Network. I wrote several before the checks stopped coming, and then insisted that those already published be taken off the site, which has since ceased to exist.

For a long time I thought the articles were lost for good. But I recently uncovered them on a UGA backup drive, and so have decided to make some of them available again here.)

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Some self-styled friends of the free market think the world would be better off without fractional-reserve banks. They believe, among other things, that fractional reserves are inherently fraudulent and that they promote business cycles. Lawrence White and I have addressed these and related criticisms of fractional reserves both in this forum and elsewhere. Here I wish not to refute claims concerning supposed disadvantages of fractional-reserve banking, but to point to one of its crucial advantages—an advantage its opponents studiously ignore.

This advantage has to do with economic development, and industrial development especially. To state the matter baldly: the most tangible achievements of the free market—the vast improvements in technology and productivity, the industrial plant and infrastructure from which these derive, and the extensive retailing networks that deliver industry’s fruits to consumers—would be far more meager were it not for past and present lending financed by fractionally-backed bank liabilities. To condemn fractional-reserve banking in any form is, in other words, to strike a blow, albeit unwittingly, at one of the supporting pillars modern capitalism.

This claim is hardly unique to modern-day champions of free banking. It has, on the contrary, been widely subscribed to by economists since the very beginnings of industrialization. Although The Wealth of Nations (1776) appeared when Great Britain’s Industrial Revolution was just getting started, that didn’t keep Adam Smith from noticing the substantial contribution fractional reserves had made to British, and especially Scottish, industrial development. Smith’s homage to fractional reserves occurs as part of his refutation of Mercantilism, with its naive identification of a nation’s wealth with its stock of coin and bullion. That stock, Smith says,

makes no part of the revenue of the society to which it belongs; and though the metal pieces of which it is composed, in the course of their annual circulation, distribute to every man the revenue which properly belongs to him, they make themselves no part of that revenue.

Indeed, Smith goes on to say, the real resources devoted to producing a nation’s money—to that “great wheel of commerce” that makes efficient exchange possible—are necessarily diverted from the production of other goods and services. Fractional reserves promote real economic growth by reducing the cost of money—what today’s economists might term money’s “opportunity cost”:

The substitution of paper in the room of gold and silver money, replaces a very expensive instrument of commerce with one much less costly, and sometimes equally convenient. Circulation comes to be carried on by a new wheel, which it costs less both to erect and to maintain than the old one….[T]he circulating notes of banks and bankers are … best adapted for this purpose.

Public confidence in Scottish banknotes was already such in Smith’s time as to allow exchanges in that country to be conducted with only a fifth as much gold and silver as would have been needed had coins alone been used. The savings on metallic money translated into a corresponding increase in Scotland’s working capital. “The operation,” Smith says, “resembles that of the undertaker of some great work, who, in consequence of some improvement in mechanics, takes down his old machinery, and adds the difference between its price and that of the new to his circulating capital, to the fund from which he furnishes materials and wages to his workmen.” Scotland, a relatively backward and poverty-stricken country at the onset of the 18th century, was by Smith’s day rapidly catching up with England, the world’s wealthiest country. That Scotland’s fractional-reserve banks had “contributed a good deal to the increase” in Scotland’s wealth was, according to Smith, a matter that “cannot be doubted.” No wonder Smith favored free banking, or something very close to it. He approved of only two special banking regulations—and approved of them, I should add, on rather faulty grounds. The regulations, which dated from 1765, were the outlawing of notes for less than one pound and of “optional clause” notes giving banks the contractual right temporarily to suspend specie payments. That Smith had nothing good to say about permanently irredeemable, “fiat” money should go without saying.

Economic research since Adam Smith’s day has mainly tended to bolster his favorable views on fractional-reserve banking, both by amassing evidence of its beneficial effects and by delving more deeply into the basis for fractional-reserve banks’ unique ability to harness scarce savings and put them to good use. In the second part of this essay, I will briefly review some of these “post-Smithian” findings.