The U.S. Experience
1837 was, however, also the year in which increased public dissatisfaction with the charter or spoils system of bank establishment led to the adoption of “free banking” laws in Michigan and New York. These laws, later adopted in other states as well, brought banking into the domain of general incorporation procedures, so that a special charter no longer had to be secured in order for a new bank to open. This was an important step toward truly free banking, but it stopped well short of it. State governments, having relied for years on financial assistance they had received from privileged banks, sought to retain such assistance while still allowing free entry into the banking business.
To accomplish this they included “bond-deposit” provisions in their free-banking laws. These provisions required banks to secure their note issues with government bonds, including bonds of the state in which they were incorporated. Typically, a bank desiring to issue 90 dollars in notes would first have to purchase 100 dollars (face value) of specified state bonds, which could then be deposited with the state comptroller in exchange for certified currency.
Though bond-deposit requirements were ostensibly aimed at providing security to note holders, they only served this function if the required bond collateral was more liquid and secure in value than other assets that banks might profitably invest in. In reality, the opposite was often true, particularly in free banking states in the west and midwest. In these places, “banks” emerged whose sole business was to speculate in junk bonds — especially heavily discounted government bonds.
Bond-collateral, purchased on credit, was duly deposited with state officials in exchange for bank notes equal to the better part of the face value of the bonds. The notes were then used to finance further rounds of bond speculation, with any increase in the market value of purchased bonds (which remained the property of their buyers) representing, along with interest earnings, a clear gain to the bankers. The infamous “wildcat” banks were mainly of this species, most of their issues being used to monetize state and local government debt. 
Even the more responsible examples of bond-deposit banking had a critical flaw: they linked the potential growth of the currency component of the money stock to the value of government debt. This flaw became evident when, with the onset of the Civil War and the tremendous financial burden brought by it, Treasury Secretary Chase decided to employ bond-deposit finance on a national scale. Thus arose the National Banking System, in which the supply of currency varied with conditions in the market for federal bonds. The new system first revealed its incompatibility with monetary stability in the years after 1865, when state bank notes were taxed out of existence.
After 1882, when surpluses began to be used to contract the federal debt, the system’s shortcomings were magnified: as the supply of federal securities declined, their market values increased. The national banks found it increasingly difficult and costly to acquire the collateral needed for note issue. This precluded secular growth of the currency supply.  It also meant that cyclical increases in the demand for currency relative to total money demand could not be met, except by paying out limited reserves of high-powered money which caused the money supply as a whole to contract by a multiple of the lost reserves.
These conditions set the stage for the great money panics of 1873, 1884, 1893, and 1907. Each of these crises came at the height of the harvest season, in October, when it was usual for large amounts of currency to be withdrawn from interior banks to finance the movement of crops. The crises provided the principal motive for creating the Federal Reserve System, which ended the era of plural note issue. Yet the crises would never have occurred (or would have been less severe) had it not been for government regulations that restricted banks’ powers of note issue in the first place. 
States monopolized their coinage early in history. But this does not mean that they were the best makers of coin or that coinage is a natural monopoly.  Rather, state coinage monopolies were established by force. Once rulers had set up their own mints they prohibited private issues, making their coins both a symbol of their rule and a source of profits from shaving, clipping, and seignorage. By the end of the 7th century such motives had caused coinage to become a state function throughout the Greek world (Burns 1927b, chaps. 3 and 4; and 1927a, 308).
In Ruritania, however, since state interference is absent, coinage is entirely private. It includes various competing brands, with less reliable, more “diluted” coins first circulating at discount and eventually forced out of circulation entirely. This appears to contradict Gresham’s Law, which states that “bad money drives good money out of circulation.” Yet, properly understood, Gresham’s Law applies only where legal tender laws force the par acceptance of inferior coins.  In contrast, Ruritania’s free market promotes the emergence of coins of standard weights and fineness, valued according to their bullion content plus a premium equal to the marginal cost of mintage.
Benefits of Fiduciary Substitution
Aside from its immediate benefits to Ruritania’s bankers and their customers, the use of inside money has wider, social consequences. Obviously it reduces the demand for coin in circulation, while generating a much smaller increase in the demand for coin in bank reserves. The net fall in demand creates a surplus of coin and bullion, which Ruritania may export or employ in some nonmonetary use. The result is an increased fulfillment of Ruritania’s nonmonetary desires with no sacrifice of its monetary needs. This causes a fall in the value of money, which in turn “acts as a brake” on the production of commodity money and directs factors of production to more urgent purposes (Wicksell 1935, 124).
Ruritanian consumers trust notes of local banks more than those of distant banks because they know more about the likelihood of local banks honoring their notes and also because they are more familiar with the appearance of these notes (and hence less prone to accept forgeries). 
Those holding the inside money of a local bank, but wishing to do business in distant towns, must either redeem some of their holdings for gold (and suffer the inconvenience of transporting coin), or suffer a loss in the value of their notes by taking them where they are accepted only at a discount, if at all. 
In general, every brand of inside money is at first used only for local transactions, with coin remaining in circulation alongside notes of like denomination. The continued use of coin for non-local exchange also forces banks to hold commodity-money reserves greater than those required by the transfer of inside money. This is because the withdrawal of commodity money for spending generates more volatile reserve outflows than does the spending of notes and deposits.
With the growth of interlocal trade, note brokers with specialized knowledge of distant banks can make a business, just as retail foreign currency brokers do today, of buying discounted non-local notes and transporting them to their par-circulation areas (or reselling them to travelers bound for those areas). Competition eventually reduces note discounts to the value of transaction and transportation costs, plus an amount reflecting redemption risk. In accepting the notes of unfamiliar banks at minimal commission rates, brokers unintentionally increase the general acceptability of all notes, promoting their use in place of commodity money.
If a bank redeems notes it acquires sooner than other banks redeem the first bank’s notes issued in place of theirs, it can, in the interim, purchase and hold interest-earning assets. The resulting profit from “float” can be continually renewed. In other words, a bank’s earnings from replacing other notes with its own may be due, not just to profits from arbitrage, but also to enhanced loans and investments.
In both New England and Scotland established banks that were accepting each other’s notes at par sometimes refused to take the notes of newly entering banks. But they soon had to change their policies, because new banks that accepted their notes were draining their reserves, whereas the established banks were not offsetting this by engaging in the same practice in reverse.
In the long run, banks that accept other banks’ notes at par improve the market both for their own notes and, unintentionally, for the notes that they accept.
In Scotland par acceptance without regular note exchange was present before 1771. During that period, banks’ sought to bankrupt their rivals by “note dueling” — aggressively buying large amounts of their rival’s notes and presenting them for redemption all at once.  For a bank to stay solvent during such raids it has to keep substantial reserves, so that its contribution to the process of fiduciary substitution is small. Charles Munn reports that one Scottish provincial bank at one point kept reserves equal to 61.2 percent of its inside-money liabilities to protect itself against raids by its rivals.
One of the more common tasks the clearinghouses take on is to serve as a credit information bureaus for their members. By pooling their records, Ruritania’s banks can discover whether people have had bad debts in the past or are presently overextended to other banks. This allows them to take appropriate precautions (Cannon 1900, 135).  Through a clearinghouse banks can also share information concerning forgeries, bounced checks, and the like. Clearinghouses may also conduct independent audits of member banks to assure each member bank that the others are worthy clearing partners. For example, beginning in 1884 the New York Clearinghouse carried out comprehensive audits to determine its members’ financial condition (ibid.). Others, such as the Suffolk Bank and the Edinburgh clearinghouse, took their bearings mainly from the trends of members’ clearing balances and the traditional canons of sound banking practice. Those two clearinghouses enjoyed such high repute that to be taken off their lists of members in good standing was a black mark for the offending bank (Trivoli 1979, 20; Graham 1911, 59).
The Rule of Excess Reserves
[3.] Banks might also try to attract more depositors by offering them higher rates while earning the interest through riskier loans and investments. This of course is just a definition of bad banking: the high-risk loans reduce bank revenues in the long run, as default occurs. But the bank may grow inordinately in the short run. Such banking has been behind many of the growing number of bank failures in recent times. It would not, however, be common in unregulated circumstances, where bank owners bear the full costs of failure. Its frequency today must be blamed on regulatory arrangements, including Federal deposit insurance, bank bailouts, and the promise of Federal Reserve support, that subsidize excessive risk-taking and artificially limit losses to bank stockholders.
Thus the absence of note-brand loyalty would make it especially profitable for “undersized” banks to overissue, while forcing larger than average banks to suffer the consequences. Notice, however, that this circumstance would not encourage any general overexpansion, since larger banks would not have any profitable opportunities to expand, much less to overexpand; their best strategy would be to stand pat while their smaller rivals whittle away their circulation. The assumption of note-brand indiscrimination is, in other words, equivalent to an assumption of diseconomies of scale in note issue.
In Scottish, Canadian, and Swedish experience there was considerable diversity of market shares of circulation of various banks, with no evidence that banks with larger shares were at a disadvantage.  Indeed, in the various historical cases of free banking there seems to have been nothing at all that corresponds to the sequence of events one would expect were consumers indiscriminate among note brands.
The Scottish, Canadian, Swedish, and Suffolk systems were all remarkably stable; prudent banks did not appear to suffer at all from overexpansion of their rivals, including smaller ones. During the months leading up to the failure of the Ayr Bank, for instance, the larger Scottish banks did not experience abnormal reserve drains. In fact, their reserves increased because they consistently enjoyed favorable net clearing balances with the Ayr Bank thanks to the latter’s overissue.
Monopolized Note Issue
This bank is the sole source of currency, apart from commodity money, for the entire system. When holders of deposit accounts want to convert parts of their balances into a form useful in hand-to-hand payments where checks are less acceptable, they will demand conversion of their deposits into the notes of the monopoly issuer (or, perhaps, into commodity money). If public confidence in the notes of the monopoly issuer is high, its notes will be preferred to commodity money, which is more cumbersome.
For their part the deposit banks, stripped of the ability to issue their own notes to supply their depositors with currency, rely upon notes of the monopoly bank of issue, or upon deposit credits at the monopoly bank (which they can convert into its notes). As all deposit banks share a common motive for holding liabilities of the monopoly bank of issue, a general demand for these liabilities develops.
Commodity money, instead of being held by the deposit banks, may (to a large extent) be deposited with the bank of issue, possibly at interest, in exchange for liabilities of that bank which, besides being useful in settling clearing balances, are at least as useful as commodity money for supplying the public’s currency needs. 
Thus as a consequence (perhaps unintended) of monopolized note issue, the liabilities of the privileged bank acquire a special status in the banking system; they become a kind of reserve media, supplementing and even superseding reserves of commodity money. Unlike deposit liabilities of non-note-issuing banks and unlike any of the bank liabilities in a system with competing note-issuers, the liabilities of a monopoly bank of issue are a form of high-powered money. Issues of such liabilities add to the base money of the system. This means, in effect, that a monopoly bank of issue is, in the short run at least, exempt from the principle of adverse clearings.
The liabilities it issues not employed as currency in circulation become lodged in the reserves of deposit banks, where they cause a multiplicative expansion of credit. In general (assuming a closed economy) these liabilities will not be returned to their issuer for redemption even though their issue, and the multiplicative expansion of credit caused by it, is not justified by any prior excess demand for inside money.
The Demand for Money
When an excess supply of money exists, people will spend their surplus holdings. Money payments will increase, and so will the flow of money income. If the nominal supply of money and the extent of real output do not independently change, the increased spending will cause prices to rise in the long run. This will reduce the real value of the existing money stock, bringing it in line with the real demand for money balances. If the nominal supply of money is deficient the opposite adjustments occur.
Therefore, although long-run changes in the value of money equate the demand for money with its supply, when considering the short run it is entirely valid to speak of an excess demand for or an excess supply of money. Moreover, since changes in the value of money fully eliminate excess supply or demand only in the long run (because it takes time for changes in spending to influence prices in a general way), short-run corrections in the real money supply require changes in the nominal quantity of money.
The Market for Inside Money and the Market for Loanable Funds
Are adjustments in the supply of loanable funds, meant to preserve monetary equilibrium, also consistent with the equality of voluntary savings and investment? The answer is yes, they are. The aggregate demand to hold balances of inside money is a reflection of the public’s willingness to supply loanable funds through the banks whose liabilities are held. To hold inside money is to engage in voluntary saving. As George Clayton notes, whoever elects to hold bank liabilities received in exchange for goods or services “is abstaining from the consumption of goods and services to which he is entitled. Such saving by holding money embraces not merely the hoarding of money for fairly long periods by particular individuals but also the collective effect of the holding of money for quite short periods by a succession of individuals.” 
Increased Money Demand
Now suppose that some of the bank’s depositor customers write fewer checks on their balances (without increasing the average size of their checks), or that more individuals who come into possession of the bank’s notes hold on to them instead of spending them. The result will be a reduced flow of the bank’s liabilities into the clearing mechanism — a reduction in adverse clearings against it — much like the reduction that would occur if borrower customers elected to increase the portion of their borrowings represented by compensating balances.
Now consider the consequences of an increased general demand for inside money, one that confronts all banks at once. No bank in this case witnesses any improvement in its circumstance relative to other banks, that is, any positive net average clearings. Nevertheless each bank will have fewer gross clearings than before, insofar as the banks considered as a group do not respond to the increased demand, and this will reduce each bank’s need for (precautionary) reserves relative to its actual reserve supply. Thus the banks will find it profitable to expand until their total gross clearings are such as to again raise the demand for reserves to the level of available supply.
To summarize, a general increase in the demand for inside money is equivalent to a general decline in the rate of turnover of inside money. Bank notes change hands less frequently, and holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of inside money in a manner that accommodates the growth in demand for it.
Determinants of Reserve Demand
A free bank’s economic reserve demand for any planning period can be thought of as having two components. These are, first, a component equal to what the bank, because of the structure of its assets and liabilities, anticipates will be the difference between its total clearing debits and its total clearing credits for the period — its “average net reserve demand” — and, second, a component to cover the bank against any adverse clearings it may face during the planning period that (singly or cumulatively) exceed its average net reserve demand. The latter component is the bank’s “precautionary reserve demand.”  It protects the bank, not from such adverse clearings as might be predicted given a determinate structure of the demand for the bank’s liabilities, but from temporary, random fluctuations in these adverse clearings above their expected value. A bank that fails to hold precautionary reserves might, on average, have credit clearings equal to its debit clearings, so that its average net reserve demand would be zero. Yet the bank would stand a great risk (one chance in two in fact) of being unable to redeem all its debits at the clearinghouse during any particular clearing session if it held zero reserves. It follows that banks have to hold positive precautionary reserves so long as the exact incidence of clearing debits is unknowable or uncertain,  and even though they may have no reason to doubt that their clearing debits and credits will be equal in the long run. 
… Thus, to take the limiting case, additional liabilities with zero turnover would not add to an expanding bank’s reserve demand, and contraction of zero turnover liabilities by a bank would not add to its excess reserves. On the other hand, a bank’s reserve demand may increase even though it has not expanded its liabilities, because turnover of its liabilities has increased. Finally, a bank’s reserve needs may fall although its liabilities are unchanged because the average period the public holds its liabilities has increased.
… a bank that expects to acquire more reserves than it expects to lose during a planning period (because the demand to hold its liabilities has increased) will expand its loans and investments to make up the difference; one that expects to lose more than it gains (because the demand to hold its liabilities has fallen) will contract. …
Does extending this conclusion to the banking system and hence to adjustments in aggregate liabilities involve a fallacy of composition? It does not, because expansion by any one bank in response to reduced clearing debits against it does not, in the case of an increased demand for (reduced turnover of) its liabilities, involve any reduction of the reserves or lending power of rival banks. Indeed, such expansion actually prevents the redistribution of reserves that would occur if the supply of inside money were not adjusted in response to demand. The same holds for credit contractions by individual banks when these contractions serve to maintain an equilibrium of supply and demand for their liabilities.
Uniform Changes in Money Demand
For example, if there is a general fall in the demand for inside money that uniformly raises the gross clearings of all banks no single bank will suffer a deficiency of average net reserves. Each will have its debit and credit clearings increase in equal amounts, with no change in adverse clearings. Similarly, if all banks witness equal increases in the demand for their issues, none will feel a need to expand in so far as the only motivation to do so is to prevent excess reserves (due to positive clearings) from accumulating.
… A fall in the total volume of clearings will likewise lead to a fall in the demand for precautionary reserves.
… Consider a situation where the volume of gross bank clearings per week is $1 million, consisting of 100,000 checks with an average value of ten dollars. Now suppose that bank customers alter their spending habits by writing only 50,000 checks per week with an average value of twenty dollars. The weekly volume of gross bank clearings is still $1 million, but the smaller number of larger, “lumpier” payments leads to an increased precautionary demand for bank reserves. The tendency (given a fixed volume of reserves) is, therefore, for the supply of inside money to fall. Yet the change in the public’s spending habits reflects, not a smaller, but a greater demand for money balances. So the money supply, rather than adjusting in the same direction as the demand for money (as it does when average payment size is unchanging and the volume of clearings moves inversely with the demand for money) adjusts in the opposite direction.
That this is a potential defect of free banking cannot be denied. But it is unlikely to be of great practical importance. This becomes apparent if one considers that changes in the average size of payments are usually accompanied by changes in frequency in the same direction, in which case their effect is to reinforce demand-accommodating changes in money supply. The exceptional case, where the frequency and average size of payments move in opposite directions, is only likely to occur in response to a change in the general level of prices which is not itself a consequence of monetary disequilibrium. In this case a real balance effect might lead to a change in frequency of payments opposite the change in average payment size. The scope for this kind of price-level change under free banking is rather limited. Suppose though, for the sake of argument, that such a price-level change did occur, causing a disequilibrating change in the supply of inside money. The disequilibrium would be short lived, because its effect would be to reverse the movement in prices that set it in motion to begin with.
Credit Expansion “in Concert”
Once again the difficulty is resolved by considering the determinants of precautionary reserve demand. Under in-concert expansion no member of a system of banks expanding in unison (and in the face of an unchanged demand for money) will experience any increase in its average net reserve demand; the change in expected value of its clearing credits will be exactly equal to the change in expected value of its clearing debits. But the growth in total clearings will bring about a growth (though perhaps less than proportionate) in the variance of clearing debits and credits, which increases the precautionary reserve needs of every bank. Thus, given the quantity of reserve media, the demand for and turnover of inside money, and the desire of banks to protect themselves against all but a very small risk of default at the clearinghouse at any clearing session, there will be a unique equilibrium supply of inside money at any moment. It follows that spontaneous in-concert expansions will be self-correcting even without any “internal drain” of commodity money from bank reserves.
Banks as Pure Intermediaries
A monopoly bank of issue is clearly not a pure intermediary, since the principle of adverse clearings does not apply to it. The position of deposit banks in a system where the supply of currency is monopolized is more complicated. They can respond by a multiplicative expansion to any issues by the monopoly bank that exceed the public’s pre-existing demand for currency. […]
First, insofar as the public wish to save in part by holding greater balances of currency, deposit banks are, beyond a certain point, powerless to accommodate their wants without assistance from the monopoly bank. They can issue currency from the monopoly bank held in their reserves only by sacrificing liquidity. Second, changes in the public’s relative demand for currency (i.e., shifts from deposit holding to currency holding and vice-versa) are disequilibrating: they alter the supply of high-powered money available in deposit-bank reserves, and so affect lending power and the total supply of deposit money even though the overall demand for inside money (though not its division between notes and deposits) is unchanged.
Defects of Monetary Guidelines
Some of the more popular alternatives for central bank monetary policy are:
1. money supply changes aimed at stabilizing some index of prices;
2. money supply changes aimed at pegging some interest or discount rate;
3. money supply changes aimed at achieving “full employment”; and
4. money supply changes aimed at achieving a fixed percent rate of growth of the monetary base or of some monetary aggregate.
… Before a price index can be constructed, three problems must be solved. The first and most obvious is that of choosing goods and services to include in the index. The second concerns choosing a measure of central tendency to collapse the chosen set of prices into a single value. The last is assigning to each price a weight or measure of relative importance. For example, should a change in the price of a bale of cotton influence the index to the same or to a greater or lesser extent than a proportional change in the price of an ounce of gold? Furthermore, assuming that a value can be chosen for each “coefficient of importance,” will it have to be modified regularly according to changes in the relative prominence of particular goods? Would the coefficient of importance of slide rules be the same today as it might have been twenty years ago?
Such practical issues might be of minor importance were it not for the fact that each of the countless ways of resolving them (there is no obvious, right solution) leads to a different index which would, in turn, suggest a different schedule of money supply adjustments. Presumably, if any one schedule is correct for maintaining monetary equilibrium, the others cannot be. Chances are that the correct schedule would not be the one actually adopted. 
[12.] The experiment in price-level stabilization of the 1920s is a good example of how the use of a wrong index of prices may deceive the authorities into believing that theirs is a noninflationary credit policy. Most price indices used at that time did not include prices of stock-certificates and real estate.
… To see that a fall in prices in response to reduced per-unit costs is, not only consistent with, but essential to the maintenance of equilibrium, consider what would happen if the money supply were increased so that a greater output of goods could be purchased without any fall in the general price structure. Then producers would, following the injection of new money, have nominal revenues exceeding their nominal outlays: illusory profit signals would be generated, spurring additional investment. As Haberler notes, “the entrepreneurs would be led on by the double inducement of (1) reduced costs [without reduced revenues] and (2) interest rates falsified by the increase in the volume of money to undertake capital improvements on too large a scale” (1931, 21):
“Suppose, in a particular branch of industry, production is increased as the result of a technical improvement, aggregate costs remaining stationary, by 10 per cent (equivalent to a reduction of average costs of 10 per cent). If the demand increases by exactly the same figure [i.e., is unit elastic with respect to nominal price, holding other prices constant] the price of the product will fall by 10 per cent, and the economic position will otherwise be unchanged. If, however, the effect of this reduction of price on the price-level is compensated by increasing the volume of money . . . new purchasing power will be created which will clearly produce exactly the same results as . . . inflation.”
The illusion ends once the excessive money supply has its effects on wage rates and on the prices of other factors of production: an injection of money has the same discoordinating consequences whether it results in absolute inflation (rising prices) or only in relative inflation which, instead of causing prices to rise, merely prevents them from falling in accordance with increased productivity. Relative inflation does not reveal itself in a rising consumer price index, although it does result in an upward movement in the prices of factors of production. 
E. F. M. Durbin, in comparing the consequences of expanding the money supply to offset increased productive efficiency with those from expanding it to meet an increased demand for money balances relative to income, says (1933, 186-87) that the latter “will exert no effect on relative price levels. . . . It will merely maintain the level of money incomes and allow prices to decline in proportion to costs.” The former, on the other hand, will add to the aggregate stream of money payments, thereby interfering with those adjustments that would otherwise guide relative prices to their proper levels.
What if there is a decline in productive efficiency, that is, what if the per-unit cost of production of a number of consumer goods increases? Stabilization of a consumer-goods price index would then cause a reduction of consumers’ aggregate nominal income and expenditure. This would in turn lead to a deficiency of producer revenues relative to outlays, to the disappointment of entrepreneurs’ “expectations of normal profit,”  and to further curtailment of production. The lull in productive activity continues until factor prices, including wages, fall to a level consistent with the restoration of producer profits.
… even if a price index could be constructed that would change only in response to monetary disequilibrium, the index would still be a defective policy guide: any corrections made by the monetary authority would come too late. They would come too late, not just because there is a lag between the actions of the central bank and adjustment of commercial bank deposits and currency in circulation, but, more fundamentally, because price changes recorded in an “ideal” price index are themselves equilibrating adjustments to previous money-supply errors. To the extent that general price adjustments occur in response to monetary disequilibrium, the gap between the nominal demand for money and its nominal supply is reduced. Once such price adjustments are revealed in an altered price index, the excess demand or excess supply of money has already been at least partly eliminated by changes in the purchasing power of money. Changing the quantity of money at this point would simply cause a new disequilibrium change opposite the original disturbance.
… Even before the authorities realize that there has been a discrepancy between the nominal demand for money and its nominal supply at the target price level, the nominal demand for money may already have altered significantly, not only because general price-level changes have altered the real value of money balances, but also because of entirely independent changes in the demand for real balances. …
Another popular central banking policy is interest rate pegging or targeting (pegging within a specified range). 
… While changes in the interest rate may represent a departure of the market rate from an unchanging natural or equilibrium rate due to a disequilibrium money supply, they may also represent changes in the natural or equilibrium rate of interest itself. Whether observed changes in the interest rate are equilibrium changes or not depends on what is happening to the public’s relative preference for present commodities, bonds, and money. The natural or equilibrium rate of interest may rise, even though the demand for money hasn’t changed, because of a shift in demand away from bonds and into commodities. If the monetary authority tried to prevent this kind of increase in the interest rate through monetary expansion (as if a rise in the interest rate always meant an increase in the market rate above the equilibrium rate, due to insufficient growth of the money supply), the result would be an excess supply of money. Likewise, if the interest rate fell due to a shift in preferences from present commodities to bonds (again with no change in the demand for money), any effort to keep the rate from falling by contracting the money supply would be deflationary. Furthermore there may be times when, although the demand for money is changing, an accommodative change in the supply of money will not be the same as a change aimed at pegging the rate of interest.
For example, if the demand for money increases primarily at the expense of the demand for present commodities, the equilibrium rate of interest falls. Finally, if the demand for money increases primarily at the expense of the demand for bonds, there may be no change in the equilibrium rate of interest. The latter case is the only one consistent with a policy of pegging the rate of interest in the face of a changed demand for money.
In short, so long as market rates move in a manner consistent with changes in the (voluntary) supply of and demand for loanable funds, their movement is no indication of excessive or deficient money supply. The achievement of monetary equilibrium by interest rate pegging (or targeting) could only be an incredible, and short lived, stroke of luck. 
A third major guideline of monetary policy in recent years has been full employment. … An excess demand for money may lead to a rise in unemployment, especially if monopolistic elements in the labor market or other causes interfere with downward adjustments in wage rates. Likewise an excess supply of money may sometimes manifest itself in a fall in unemployment, due to delayed upward adjustment of labor-supply schedules (caused perhaps by a temporary bout of “money illusion”). But to assign to monetary policy the goal of guaranteeing “full” employment, when this means fixing a target rate of unemployment … is to assume that all fluctuations of unemployment around the targeted rate are due to maladjustments of the money supply which could be avoided by proper adjustment of the money supply. This is not so. … much of the unemployment observed today must be attributed to imperfect competition in the labor market. Unemployment caused by minimum wage laws is only the most flagrant example of this. The existence of stagflation — the simultaneous occurrence of high unemployment and rising prices — is, in a growing economy, almost certain proof that the unemployment is not due to any deficiency of aggregate demand. Attempts to combat such unemployment by further monetary expansion can only serve to augment an already satisfactory or excessive money supply, furthering the tendency of prices to rise.
A final set of monetary guidelines consists of rules prescribing a fixed rate of growth for the monetary base or for some monetary aggregate.  … a fixed growth rate rule obviously ignores the fact that the demand for money fluctuates on a day-to-day (or at least month-to-month) basis. It would produce the stability in nominal income that its advocates desire only if the demand for money grew steadily at the prescribed money growth rate. 
The Relative Demand for Currency
… acceptance of a check requires a level of trust beyond what is required in the acceptance of currency of equal face value: the acceptor of a check has to have confidence not just in the bank upon which the check is drawn, which may or may not be good for the transferred sum, but also in the drawer of the check himself, who may or may not possess an adequate deposit balance.
… In the United States until the 1930s the historical trend was toward less reliance upon currency and greater use of checks and other means for direct transfer of deposit balances. This was due mainly to improvements in deposit banking, which were spurred-on in part by the suppression of competitive note issue. In the last fifty years or so the trend has changed, and the demand for currency relative to total money demand has grown substantially. 
Monopolized Currency Supply
Under monopolized currency supply the ability of non-note-issuing (deposit or commercial) banks to convert deposits into currency is restricted. Deposit banks are not able independently to fulfill currency demands. They have to draw instead on their holdings of notes or fiat currency (or deposits convertible into notes or fiat currency) of the monopoly bank of issue.  In doing so they reduce their reserves of high-powered money. It follows that, unless the monopoly bank of issue adjusts the amount of its credits to the deposit banks to offset their reserve losses due to currency demand,  their lending power decreases. The banks will have to contract their liabilities. A change in the form in which the public wishes to hold money balances causes a disequilibrating change in the total supply of money. 
The same conclusion holds for uncompensated reductions in the relative demand for currency, which in a system with monopolized currency issue results in a return of currency to the deposit banks, who add it to their reserve holdings and use it as a basis for credit expansion. A fall in the relative demand for currency results in monetary overexpansion even though the demand for money has not fallen and even though there is no expansion of credit by the monopoly bank of issue.
… under central banking the public’s use of central bank notes as currency competes with the banks’ use of them as reserves.
Instruments for Reserve Compensation
The first instrument we have to consider, statutory reserve requirements, highlights the significant distributional impact of certain approaches to reserve compensation: although a correct adjustment of statutory requirements preserves monetary equilibrium on the whole, the uneven distribution of changes in liquidity brings welfare losses or gains to particular banks.  Since changes in the relative demand for currency do not affect all banks simultaneously or uniformly, an ideal policy would have to make continual adjustments in statutory reserve requirements, bank by bank. This poses an impossible administrative problem. It requires, moreover, that the central authority know, not just the total extent of the public’s shift into (or out of) currency, but also which banks are affected by the shift. […]
A second vehicle for reserve compensation is open-market operations. … Although it allows direct control of the total amount of base money created or withdrawn, it does not provide any means of ensuring that base money issued goes to banks that are experiencing currency withdrawals or, alternatively, that base money withdrawn is withdrawn from banks experiencing redeposits of currency. […]
To some extent inter-bank lending might reduce these welfare effects from reserve compensation. But this possibility is limited by the fact that banks receiving excess base money will not necessarily lend it to other banks in need of reserve compensation: this may or may not be the most profitable avenue of employment for the surplus funds. Banks suffering reserve losses from currency drains might not offer to pay a high enough interest rate to attract emergency loans, for fear that the currency withdrawals may be permanent ones, which would make it difficult to repay the loans. Or, if banks losing reserves do offer to pay higher rates, other banks may still be reluctant to lend to them because they fear that the rates represent increased risk that the borrowing banks are suffering, not just temporary currency withdrawals, but a permanent loss of business.
A final instrument for reserve compensation is rediscount policy. This seems to offer the advantage of automatically channeling emergency supplies of base money only to banks in need of them, without requiring the monetary authorities to make decisions on a bank-by-bank basis. … A defect of rediscounting, however, is that it relies on deposit banks’ knowing whether currency is being withdrawn from them because of (a) an increase in their clients’ demand for currency or (b) dissaving (a fall in the demand for inside money).  In general it is not possible for banks to know which of these causes is behind some withdrawal of currency by their depositors. Banks may mistakenly borrow base money from the central issuer (by rediscounting) to offset drains of the second type, forestalling the credit contraction needed in such cases to preserve monetary equilibrium. Distributing emergency base money by the rediscount mechanism does not guarantee that it goes to banks suffering from currency drains due solely to changes in the relative demand for currency.
All this assumes that banks, if they knew how, would borrow from the central issuer only the precise amount needed to compensate their losses caused by changes in the relative demand for currency. But the extent of borrowing depends on the rate of rediscount that the central bank charges. A rate below the market rate encourages borrowing, not merely for reserve compensation, but for acquiring excess reserves to relend at a profit. Furthermore, even if banks borrow from the central bank only to offset reserve losses due to currency withdrawals, the return of currency from circulation when the relative demand for it declines may not lead to offsetting repayment of borrowed reserves. If the rediscount rate is too low, the surplus base money will be re-lent instead. Winfield Riefler (1930, 161) cites an example of this in the United States just after World War I. Commercial banks had borrowed heavily from the Federal Reserve during the war to offset reserve losses due to an increased relative demand for currency. At the close of the war, when demand shifted back to deposit balances, returning Federal Reserve notes “were not used to repay member bank borrowings in any corresponding amounts.” Instead, redeposited currency “went in considerable part to build up member bank reserve balances”:
Member banks as a group . . . were content to maintain their indebtedness [to the Federal Reserve banks] at about the level it had previously attained, using funds released from circulation . . . to expand their loans, for which there was an active demand at attractive rates.
In London, for instance, the Bank of England has been the sole supplier of currency since it was established in 1694. Other London banks rely upon their reserves of Bank of England notes to supply depositors’ currency needs. Through most of the first one and a half centuries of its existence the Bank of England felt no obligation to assist other bankers when they found themselves stripped of cash by a shift of demand from deposits to currency. Partly in consequence of this a series of financial crises occurred in 1763, 1772, 1783, 1793, 1797, 1826, 1836, and 1839. Every one was marked by a significant increase in the demand for currency for making payments in and around London: confidence in Bank of England notes was not lacking, and there were few demands to redeem these in specie. Nor was there any evidence of a rush to redeem country bank notes or to exchange them en masse for Bank of England notes. The problem was that country bank notes were not suitable for use in London where their issue and redemption was prohibited. A drop in the acceptability of checks and other noncurrency means of payment therefore translated entirely into greater requests for the notes of London’s sole issuing bank. […]
Another significant financial stringency caused by an uncompensated drain of currency from bank reserves was the “great contraction” in the United States from 1930 to 1932. This involved a large-scale movement from deposits to currency, which was only partly offset by Federal Reserve note issues. The result was a drastic decline in the total money stock followed by a terrible banking collapse. 
According to James Boughton and Elmus Wicker (1979, 406), this particular shift from deposits to currency was triggered by the “massive decline in income and interest rates” that began in the fall of 1929.  That meant an increase in the relative frequency of small payments combined with a reduced opportunity cost of holding currency. Also encouraging the shift from deposits to currency were a 2 percent federal tax on checks (enacted in June 1932) and an increase from two to three cents in the postal rate for local letters (from July 1932 to June 1933), which increased the cost of paying local bills by check (ibid., 409). Finally, when state authorities began declaring bank holidays in response to insolvencies caused by currency withdrawals and loan losses, they unwittingly provoked even greater withdrawals of currency by depositors. When banks go on holiday, deposits are immobilized, and checks become practically useless in making payments. Currency can, however, still circulate while banks are temporarily closed. Therefore, any suspicion by the public that their banks will go on holiday will lead to a wholesale flight to currency as consumers rush to protect themselves against the risk of being stuck without any means for making purchases. 
… That greenbacks were sometimes not available in desired, small denominations also added to the inconvenience suffered by the public.
Unanticipated general price movements associated with changes in per-capita output, such as could occur under free banking, do not affect the fortunes of debtors and creditors in the same, unambiguous way as do unanticipated price movements associated with monetary disequilibrium. Where price movements are due to changes in per-capita output, it is not possible to conclude that unanticipated price reductions favor creditors at the expense of debtors. Nor can it be demonstrated that unanticipated price increases favor debtors at the expense of creditors. The standard argument that unanticipated price changes are a cause of injustice is only applicable to price changes caused by unwarranted changes in money supply or by unaccommodated changes in money demand.
This is so because in one of the cases being considered aggregate per-capita output is changing, whereas in the other it is stationary. In both cases a fall in prices increases the value of the monetary unit and increases the overall burden of indebtedness, whereas a rise in prices reduces the overall burden, other things being equal. In the case where per-capita output is stationary (the monetary disequilibrium case), the analysis need go no further, and it is possible to conclude that falling prices injure debtors and help creditors and vice versa. […]
Here (assuming no monetary disequilibrium) reduced prices are a consequence of increased real income, and increased prices are a consequence of reduced real income. Taking the former case, although the real value of long-term debts increases, debtors do not necessarily face a greater real burden of repayment since (on average) their real income has also risen. In nominal terms they are also not affected because, as distinct from the case of falling prices due to a shortage of money, their nominal income is unchanged. Thus debtors need not suffer any overall hardship: the damage done by the unanticipated fall in prices may be compensated by the advantage provided by the unanticipated growth of real income.
Commodity-Money Supply Shocks
In the long run, automatic forces tend to limit cost-related changes in the output of commodity money. Michael Bordo (1984, 201) explains this in reference to gold:
A rapid increase in the output of gold due to gold discoveries or technological improvements in gold mining would raise the prices of all other goods in terms of gold, making them more profitable to produce than gold and thus ultimately leading to a reduction in gold output. Moreover, the initial reduction in the purchasing power of gold would lead to a shift in the demand for gold for nonmonetary use, thus reinforcing the output effects.
The record of gold production in this century is as free of supply shocks as that of the 19th century. The only major accidental discovery of gold was the Amazon River discovery of early 1980. Like the California discovery of 1848, this was a find of alluvial (riverbed) gold. Alluvial gold is much easier to mine than underground gold. … However, as the number of unexplored rivers diminishes, so does the chance of large new discoveries of alluvial gold. […]
By far the most important source of disturbances to gold supply has been, not accidental discoveries, but political interference. The “golden avalanche” of the 1930s (as a contemporary book termed it) and the recent great increase in gold production both resulted from inflation by central banks leading to currency devaluations.
Bank Runs and Panics
There are two kinds of bank runs. One is a run to convert deposits into currency, where currency includes competitively issued bank notes. This can be called a “currency run.” The second is a run to convert deposits or competitively issued notes into high-powered money, meaning commodity money, redeemable notes of a monopoly bank of issue, or centrally issued fiat money. This can be called an “redemption run.” […]
A currency shortage, besides provoking a currency run, may cause a redemption run as well. If by virtue of some restriction a deposit holder seeking currency cannot be accommodated by a further issue of notes, his bank will have no alternative but to satisfy him by drawing on its reserves of high-powered money. Thus a currency run in the face of restrictions on note issue causes banks to suffer a loss of liquidity just as if the run had been for high-powered money in the first place. The loss of liquidity increases the risk that the bank will be unable to redeem its issues. If the precariousness of the bank’s position is discovered, this can in turn cause its liability holders to lose confidence in it and to convert even its notes into high-powered money. […]
Responsibility for these liabilities could be assumed by other banks, as when an insolvent bank is liquidated by a merger with one of its rivals. This was how many Scottish and Canadian free banks, aided by the absence of restrictions on branch banking, wound up their affairs. […]
Private insurance could also protect note and deposit holders against losses due to bank failures.  Government insurance … subsidizes high-risk banks at the expense of low-risk ones, creating a serious moral-hazard problem … In contrast, profit maximizing, competing private insurers would attempt to charge every bank a premium reflecting the riskiness of its particular assets.  While available information would be inadequate to guarantee perfect risk-pricing ex ante, premiums could be continually readjusted ex post, with the help of frequent audits.
Still another private means for giving protection to bank-liability holders would involve banks protecting one another’s liabilities through a system of cross-guarantees.  A failed bank with its liabilities guaranteed by a group of other banks could draw on the capital of those banks to the extent of its insolvency loss. Guarantees could be arranged so that no bank would be both a guarantor of and guaranteed by another bank.
An alternative method for dealing with isolated runs, adopted for a time by the Scottish free banks, is to have an “option clause” on circulating notes.  Such a clause would allow notes to be paid either on demand or within six months following their original presentation for redemption, with interest paid for the length of the delay. This arrangement would permit illiquid banks to suspend payment to their customers for a period up to six months, time enough to liquidate their loans and investments, avoiding the more costly alternative of borrowing emergency funds from rivals.
Note and deposit exchange rates would reflect potentials for capital losses depending on the soundness of underlying bank loans and investments. Chapter 2 showed how note brokerage systematically eliminates note-discounting except when it is based on risk-default generally acknowledged by professional note dealers, including banks themselves. In short, note brokerage produces information on bank-specific risk. […] After confirming through the newspaper that there is no discount on the notes he holds, a bank customer would feel no urge to redeem them in a hurry. Gorton also points out that, even though no distinct secondary (arbitrage) market exists for the risk-pricing of deposit liabilities,  so long as notes and deposits of any one bank are backed by the same asset portfolio (as would be the case under free banking) the existence of a secondary note market provides depositors with all the information required to prevent them from staging a redemption run.
Criticisms from Conventional Wisdom
The gold coins of Templeton Reid of Georgia — which actually had a bullion value slightly above their face value — and the gold Bechtler coins of North Carolina — minted in the 1830s and still in circulation half a century later — competed successfully with coins produced by nearby Federal rivals, and the Bechtler coinage (over three million dollars worth) was for some time the favored money of the mid-Atlantic states.  During the California gold rush at least fifteen private mints struck coins to satisfy a demand that would otherwise have gone unfulfilled due to the absence of any government mint. Some of them produced inferior coin, but those that did so fell rapidly into disrepute and were outcompeted by other firms such as Moffat & Co., Kellogg & Co., and Wass, Molitor & Co. The latter firms enjoyed excellent reputations (in addition to tacit government approval) even though private coinage had become a misdemeanor in California law after April 1850 (Adams 1913, xii).
One of the last American private mints, Clark, Gruber & Co., operated between 1860 and 1862 and produced high-quality gold coins often superior to United States coins of like denomination. In its two years of existence, it produced approximately $3,000,000 of coin and threatened to rob the Federal mints of a substantial part of their market. To guard against this the government bought the mint out in 1863 for $25,000 (Watner 1976, 27-28). Two years later the Federal government passed a law prohibiting all private coinage.
Fraud and Counterfeiting
In any event a bank is likely to have to make a considerable investment in brand-name capital before its notes can travel to persons “far removed in space and acquaintance” who will unhesitatingly accept them. […]
In 1873 (when, due to the influence of the Bank Act, the Scottish system was undergoing substantial consolidation) the average period of circulation for a Scottish bank note was still only 10 or 11 days (Somers 1873, 161). […]
The likelihood of detection of counterfeit notes is inversely related to their average period of circulation. It rises with the frequency with which the notes pass under the specially trained eyes of tellers at the legitimate bank of issue. Counterfeiting should therefore be less lucrative and less tempting under free banking than under monopolized note issue. Experience confirms this. According to Emmanuel Coppieters, during the free-banking era Scottish bank notes, which had a short period of circulation, were rarely forged or counterfeited, whereas Bank of England notes — which circulated for long average periods or even indefinitely — were forged continually. 
[11.] Emmanuel Coppieters (1955, 64-65), cited in L. White (1984d, 40). It is also relevant that the Scottish banks had a policy of accepting counterfeit money at par, in order to encourage its discovery and to assist the capture of its producers. This also eliminated any possibility of losses to note holders arising from this kind of fraud.
The average period of circulation of a Federal Reserve dollar from the time of its issue to the time of its return to a Federal Reserve bank is approximately 17 months.
Money Supply As Natural Monopoly
Although a monopoly in currency supply allows the monopoly bank to escape adverse clearings in the short run, for such a monopoly to be “natural,” that is, for it to represent a stable market equilibrium, it must be able to maintain its notes in circulation more efficiently than rival firms in an environment of free entry where adverse clearings result in demands for its reserves. In other words, the average costs of maintaining notes in circulation, i.e., of building a market for currency holding by the public so that adverse clearings are avoided, must be declining with scale or at least subadditive.  For a single bank to gain a monopoly of note issue it is not sufficient that banking involve substantial fixed costs, with relatively small marginal costs, from issuing additional notes. The bank must also take steps to improve the popularity of its notes relative to commodity money or relative to notes of other banks, or it must suffer the expense of redeeming them soon after their issue. If the costs to the bank of extending the market or of redemption rise rapidly enough at the margin,  its average costs per unit of outstanding currency will rise above the minimum level long before the point at which it would saturate the market for currency. […]
What, then, does the empirical evidence suggest? Simply this: that throughout the experience of both Europe and America the tendency under unrestricted entry has always been toward a plurality of note-issuing banks.  The appearance of monopoly banks of issue in these areas has in every instance been due to legislation restraining rival issuers by limiting their issues, imposing special capitalization or geographical constraints upon them, setting up barriers to new entry, or overtly and directly forcing them out of the issue business altogether. Where such measures were not taken no obvious tendencies toward monopolization were seen.