Free banking is better than central banking because only in a free market can the optimal prices and quantities of goods be determined. Those goods include the money supply, and prices include the rate of interest.

There is no scientific way to know in advance the right price of goods. With ever-changing populations, technology, and preferences, markets are turbulent, and fluctuating human desires and costs cannot be accurately predicted.

The quantity of money in the economy is like that of other goods. The optimal amount can only be discovered by the dynamics of supply and demand. The impact of money on prices depends not just on the amount of money but also on its velocity—that is, how fast the money turns over. The Fed cannot control this since it cannot control the amount people want to hold, or the demand. Also, even if the Fed could determine the best amount of money for today, the impact of its moves takes months to play out, so the central bankers would need to be able to accurately predict the state of the economy months into the future.

The Fed also fails because of political pressure. Although the Fed is supposed to be independent, in practice, when the economy is depressed, there is strong political pressure to “do something,” specifically to “stimulate” by expanding the money supply. Since Congress created the Fed and can alter it, it is impossible for the Fed to be purely independent of politics.

The Federal Reserve was set up to provide price stability, yet the United States suffered high inflation during the 1970s and continuous inflation since World War II. The Fed was also supposed to provide economic stability, but since World War II there have been severe recessions in 1973, 1980, 1990, and 2007–2009. The Fed was supposed to ensure stability in the financial system, but it failed to prevent the Crash of 2008 and the Great Recession that followed. But the challenge is to explain why free banking would be better.

Suppose gold once again became a global currency. It would be the real money, and the U.S. dollar would be defined as a particular weight of gold. A $20 gold coin had about an ounce of gold before 1933.

Under free banking most transactions would not occur with gold, but rather with more convenient money substitutes. Banks would issue paper bank notes inscribed with their bank names. Anyone holding bank notes could exchange them for gold. For example, if $1,000 was equivalent to an ounce of gold, then anyone could go to a bank and convert $1,000 in paper bills to one ounce of gold coins. Likewise one could withdraw $1,000 of deposits in gold coins.

Competition among banks, as well as convertibility into gold, would result in price stability, since the banks would only be able to issue as many bank notes as the public was willing to hold. If there were more bank notes than that, they would come back to the bank to be exchanged for gold. But the money supply would also be flexible, since if there were a greater demand to hold money, the amount of bank notes or bank deposits would increase.

The Structure of Capital Goods

Free banking mitigates the boom-bust cycle. There is a structure to capital goods similar to a stack of pancakes. At the bottom of the stack are rapidly circulating capital goods such as inventory close to the consumer-goods level. As we go up the stack, the capital goods turn over more slowly. At the top are long-duration investments such as real-estate development. Goods become more sensitive to interest rates as you move up the stack. Lower interest rates make the stack steeper, as there is more investment in long-term investments.

In a free market the “natural rate” of interest depends on the preference for goods sooner rather than later, or “time preference.” Interest is the premium paid to shift purchases from the future, for which one would have to save enough to pay cash, to the present day by borrowing.

The Fed lowers the rate of interest by creating fiat money out of nothing. As a result, businesspeople borrow more for capital goods high on the stack, such as real estate. Prices rise fastest and soonest where the money is being injected into the economy with loans. Thus real-estate prices escalate, creating a bubble like those that occurred before 1973, 1980, 1990, and 2007; indeed a similar bubble occurred during the 1920s before the Great Depression.

Every boom preceding a bust has been fueled by artificially cheap credit. With free banking the interest rate would not be manipulated down. The natural rate of interest would raise the carrying cost of borrowed funds, reducing if not preventing the financial fever.

Further Reforms

Free banking is not a panacea: There need to be other reforms to achieve sustainable economic growth. Punitive taxes, subsidies, and arbitrary restrictions all distort the economy, stifle enterprise, and create turbulence. But even without such other reforms, the case for replacing central banking with free banking is strong, resting on three facts:

1. The optimal money supply and interest rates are unknowable in advance, and can only be discovered by market dynamics.

2. Political pressure makes the Fed expand the money supply and reduce interest rates when the economy is depressed, and this fuels an unsustainable boom that results in the next bust.

3. Government insurance, guarantees, the expectation of bailouts, and other subsidies induce excessive risk-taking, making financial crashes worse.

Cowen states that if the Fed were to shut down, the new base money would be Treasury bills. (Base money currently consists of money in circulation, bank vault cash, and commercial bank reserves on account at the Fed.) But folks don’t buy groceries with Treasury bills. The best transition base money would be the current amount of Federal Reserve notes, whose supply would be frozen, as suggested by Professor George Selgin. Then new-money expansion would be the money substitutes issued by the banks, convertible into base money. Eventually, with the abolition of legal-tender laws, world financial markets would converge on a common global currency, gold.

The case for free banking is similar to the case for healthy living. It is better to prevent economic illness than to have to treat it.

The report card comes in the form of a working paper from the Cato Institute: “Has the Fed Been a Failure?” by George A. Selgin, William D. Lastrapes, and Lawrence H. White.

The authors state in their abstract:

As the one-hundredth anniversary of the 1913 Federal Reserve Act approaches, we assess whether the nation’s experiment with the Federal Reserve has been a success or a failure. Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

In light of the Fed’s defined mission—monetary support for economic growth, stable prices, maximum employment—the authors use the following criteria to assess its record: “the relative extent of pre- and post-Federal Reserve Act price level changes, pre- and post-Federal Reserve Act output fluctuations and business recessions, and pre- and post-Federal Reserve Act financial crises.” The Fed has done poorly on every count. No one familiar with the Mises-Hayek critique of central planning will be surprised. Central banking is not equivalent to comprehensive planning of the economy, but money is the most pervasive good and monetary engineers suffer the same insurmountable ignorance as any central planner.

I can only hit the paper’s highlights here.

Inflation

Selgin et al. pronounce the Fed a dismal failure in controlling inflation. “[F]ar from achieving long-run price stability, it has allowed the purchasing power of the U.S. dollar, which was hardly different on the eve of the Fed’s creation from what it had been at the time of the dollar’s establishment as the official U.S. monetary unit, to fall dramatically.”

The value of the dollar was essentially stable from the late eighteenth century to the second decade of the twentieth century! “A consumer basket selling for $100 in 1790,” they write, “cost only slightly more, at $108, than its (admittedly very rough) equivalent in 1913.”

And since that time? “[T]hereafter the price soared, reaching $2,422 in 2008. . . . [M]ost of the decline in the dollar’s purchasing power has taken place since 1970, when the gold standard no longer placed any limits on the Fed’s powers of monetary control.”

The dollar has lost 95 percent of its value since the Fed came into existence.

Deflation

The authors say that since the Great Depression the Fed has rid the economy of deflation (defined as falling prices), which was a feature of the late nineteenth-century economic landscape. Economists, including Fed chairman Ben Bernanke, generally deem deflation as something to be avoided at almost all costs, so they would give the Fed kudos in this respect. But Selgin et al. point out (as have others, such as Steven Horwitz, in the January/February 2010 Freeman) that what matters is not deflation per se but the kind of deflation:

Harmful deflation—the sort that goes hand-in-hand with depression—results from a contraction in overall spending or aggregate demand for goods in a world of sticky prices. As people try to rebuild their money balances they spend less of their income on goods. Slack demand gives rise to unsold inventories, discouraging production as it depresses equilibrium prices. Benign deflation, by contrast, is driven by improvements in aggregate supply—that is, by general reductions in unit production costs—which allow more goods to be produced from any given quantity of factor and which are therefore much more likely to be quickly and fully reflected in corresponding adjustments to actual (and not just equilibrium) prices.

Historically, benign deflation has been the far more common type.

During roughly the last quarter of the nineteenth century, prices in the United States declined 37 percent—1.2 percent a year on average. That’s what the Fed has saved us from, thank you very much.

Frequency and Duration of Recessions

Again, the pre-Fed record is better than the Fed’s performance. Drawing on the latest research, the authors conclude:

[A]lthough contractions were indeed somewhat more frequent before the Fed’s establishment than after World War II (though not, it bears noting, more frequent than in the full Federal Reserve sample period), they were also almost three months shorter on average, and no more severe. Recoveries were also faster, with an average time from trough to previous peak of 7.7 months, as compared to 10.6 months. Allowing for the recent, 18-month-long contraction further strengthens these conclusions.

Moreover, the Fed has violated traditional standards by bailing out insolvent banks. Selgin et al. reject the “too big to fail” doctrine, arguing that the fear-mongering about “systemic risk” is unsubstantiated. Bailing out the creditors of insolvent institutions, as the Fed did during the current financial crisis, has increased the future exposure of the public by reinforcing moral hazard—encouraging excessively risky behavior by creating the expectation of government rescue. In the process the Fed has gone from lender of last resort to allocator of capital—an ominous move toward central planning.

The authors do not endorse the pre-Fed system, which was heavily regulated by the national and state governments. Indeed, for most of American history interstate and intrastate branch banking was illegal, producing an industry of uncompetitive and undiversified banks.

Nor do they explore the free-banking alternative, though Selgin and White are well-known advocates of it. Instead they confine their analysis to various rules that would take away the Fed’s discretionary power over the money supply. These would be improvements but a far distant second to free banking.

The authors leave no doubt that “the Fed’s poor record calls for seriously contemplating a genuine change of regime.”

The report card comes in the form of a working paper from the Cato Institute: “Has the Fed Been a Failure?” by George A. Selgin, William D. Lastrapes, and Lawrence H. White. (White, of course, is a Freeman contributing editor and regular lecturer at FEE’s Advanced Austrian Economics Seminar. Click here for a C-SPAN video of White summarizing the paper [at 46 minutes in], and click here for a podcast of an interview with Selgin.)

The authors state in their abstract:

As the one-hundredth anniversary of the 1913 Federal Reserve Act approaches, we assess whether the nation’s experiment with the Federal Reserve has been a success or a failure. Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

In light of the Fed’s defined mission — monetary support for economic growth, stable prices, maximum employment — the authors use the following criteria to assess its record: “the relative extent of pre- and post-Federal Reserve Act price level changes, pre- and post-Federal Reserve Act output fluctuations and business recessions, and pre-and post-Federal Reserve Act financial crises.” The Fed has done poorly on every count. No one familiar with the Mises-Hayek critique of central planning will be surprised. Central banking is not equivalent to comprehensive planning of the economy, but money is the most pervasive good and monetary engineers suffer the same insurmountable ignorance as any central planner.

I can only hit the paper’s highlights here.

Inflation

Selgin et al. pronounce the Fed a dismal failure in controlling inflation. “[F]ar from achieving long-run price stability, it has allowed the purchasing power of the U.S. dollar, which was hardly different on the eve of the Fed‘s creation from what it had been at the time of the dollar‘s establishment as the official U.S. monetary unit, to fall dramatically.”

This is truly astounding. The value of the dollar was essentially stable from the late eighteenth century to the second decade of the twentieth century! “A consumer basket selling for $100 in 1790,” they write, “cost only slightly more, at $108, than its (admittedly very rough) equivalent in 1913.” (Of course that extra $8 bought far better products.)

And since that time? “[T]hereafter the price soared, reaching $2422 in 2008…. [M]ost of the decline in the dollar‘s purchasing power has taken place since 1970, when the gold standard no longer placed any limits on the Fed’s powers of monetary control.”

The dollar has lost 95 percent of its value since the Fed came into existence.

Deflation

The authors say that since the Great Depression the Fed has rid the economy of deflation (defined as falling prices), which was a feature of the late nineteenth-century economic landscape. Economists, including Fed chairman Ben Bernanke, generally deem deflation as something to be avoided at almost all costs, so they would give the Fed kudos in this respect. But Selgin et al. point out (as have others, such as Steven Horwitz) that what matters is not deflation per se but the kind of deflation.

Harmful deflation — the sort that goes hand-in-hand with depression — results from a contraction in overall spending or aggregate demand for goods in a world of sticky prices. As people try to rebuild their money balances they spend less of their income on goods. Slack demand gives rise to unsold inventories, discouraging production as it depresses equilibrium prices. Benign deflation, by contrast, is driven by improvements in aggregate supply — that is, by general reductions in unit production costs — which allow more goods to be produced from any given quantity of factor and which are therefore much more likely to be quickly and fully reflected in corresponding adjustments to actual (and not just equilibrium) prices.

Historically, benign deflation has been the far more common type.

During roughly the last quarter of the nineteenth century, prices in the United States declined 37 percent – 1.2 percent a year on average. That’s what the Fed has saved us from, thank you very much.

Frequency and Duration of Recessions

Again, the pre-Fed record is better than the Fed’s performance. Drawing on the latest research the authors conclude:

[A]lthough contractions were indeed somewhat more frequent before the Fed‘s establishment than after World War II (though not, it bears noting, more frequent than in the full Federal Reserve sample period), they were also almost three months shorter on average, and no more severe. Recoveries were also faster, with an average time from trough to previous peak of 7.7 months, as compared to 10.6 months. Allowing for the recent, 18-month-long contraction further strengthens these conclusions.

So the central bank has given us longer recessions and slower recoveries. Nice.

This provocative paper also addresses the Fed’s record regarding volatility in output and employment, banking panics, the “Great Moderation” of the Greenspan years, and its role as “lender of last resort.” This last topic is especially interesting. Under the classical doctrine, the lender of last resort was to make loans only to solvent (though illiquid) banks at higher-than-market interest rates. The Fed has trashed that doctrine by bailing out insolvent institutions and accepting toxic “assets” as collateral.

Selgin et al. reject the “too big to fail” doctrine, arguing that the fear-mongering about “systemic risk” is unsubstantiated. Bailing out the creditors of insolvent institutions, as the Fed did during the current financial crisis, has increased the future exposure of the public by reinforcing moral hazard — encouraging excessively risky behavior by creating the expectation of government rescue. In the process the Fed has gone from lender of last resort to allocator of capital – an ominous move toward central planning.

The authors do not endorse the pre-Fed system, which (as discussed last week) was heavily regulated by the national and state governments. Indeed, for most of American history interstate and intrastate branch banking was illegal, producing an industry of uncompetitive and undiversified banks.

Nor do they explore the free-banking alternative, though Selgin and White are well-known advocates of it. Instead they confine their analysis to various rules that would take away the Fed’s discretionary power over the money supply. These would be improvements but a far distant second to free banking.

The authors leave no doubt that “the Fed‘s poor record calls for seriously contemplating a genuine change of regime.”

This issue came up briefly in a recent installment of the excellent podcast series “EconTalk,” when George Mason University professor Russ Roberts interviewed Australian economist John Quiggin, author of Zombie Economics: How Dead Ideas Still Walk among Us. Quiggin, a social democrat, thinks free-market ideas should be seen as a casualty of the late financial crisis, yet those ideas continue to stalk the world: Hence, they constitute “zombie economics.” He favors vigorous government regulation of the financial industry because he assumes bailouts of big integrated financial companies are inevitable. The price of this safety net, he says, should be close oversight by the State. (Quiggin commits the Nirvana Fallacy — comparing “imperfect” real-world markets to idealized  but impossible regulatory regimes.)

Admirably, Roberts protested that since the federal government and the Federal Reserve have stood ready to bail out the influential creditors of financial companies at least since 1984, it can’t be that the free market has been tried and found wanting. After all, if there were no prospect of a bailout, creditors would monitor risk and act as a brake on reckless financial activity – they don’t want to lose their money. But if creditors can count on being rescued by the government or its central bank, they will not perform that watchdog role, as least not as vigilantly as they would in a free market. (See Roberts’s paper “Gambling with Other People’s Money.”)

So, Roberts asked Quiggin, “Why wouldn’t you simply be in favor of no bailouts? …We’ve never tried market liberalism, so why do you think we should go in a different direction?”

To which Quiggin responded: “Of course, we’ve never had a pure system of market liberalism but equally of course my remaining communist friends tell me we’ve never had pure communism. At some point you have to say this is as close as we are likely to get, and the contradictions only get worse.”

Glibberish

This is a glib answer, which Quiggin should be called on. One hears it often, and frankly it makes little sense. Right off the top, so what if communists say — defensively and incorrectly — that pure communism hasn’t been tried? That in no way undermines the proposition that the free market — particularly free banking — has not been allowed to exist in this century, and was not allowed in the last or the one before that either, and therefore that none of the depressions and other economic debacles that occurred in that time can be attributed to it.

For the record, communism – in the sense of a State-planned economy with the market essentially suppressed — was tried, certainly in Cambodia and North Korea, if not elsewhere. The results were disastrous. It was also tried during the postrevolutionary Soviet period known as War Communism. The result? “The country, and the government, were at the very edge of the abyss,” Trotsky said. So Lenin enacted his New Economic Policy, reintroducing money (a gold ruble) and allowing some independent entrepreneurship (by the NEPmen). (See my article “War Communism to NEP: The Road from Serfdom” [pdf]. For the full story, see Peter Boettke’s first book, The Political Economy of Soviet Socialism.)

As for a free market in banking, I see no reason to join Quiggin in saying, we are as “close as we are likely to get.” First, we have never been very close. Between the state and national governments, banking has always been substantially regulated in the United States. From the start it was one of the commanding heights of America’s “Merchant-state,” to use Albert Jay Nock’s term. Intrastate branch banking was long illegal, interstate banking was forbidden until 1994, and governments almost always had the power to cap interest rates and regulate the currency, even when gold played a role. Alexander Hamilton, James Madison, and Abraham Lincoln gave us national banks. Then came the Federal Reserve, followed 15 years later by the 1929 crash, which raised the curtain on the Great Depression and more regulation.

To say the latest financial debacle has roots in the free market is simply to confuse the competitive market economy with the corporate state, the competition-inhibiting partnership between influential businesses and government officials. Implicit taxpayer-backed guarantees to creditors, government-sponsored enterprises such as Fannie Mae and Freddie Mac, deposit insurance that anesthetizes depositor wariness, Fed-organized bank cartelization — none of this has anything to do with the free market.

Moreover, Quiggin is in no position to say that we’re as close as we’re going to get to the free market. How could he possibly know this? The government-sponsored banking cartel is a key party to an impending economic crisis that just might wake people up to the need to remove government from this realm in favor of market competition without privilege. Criticism of the Fed at the grassroots has never been harsher.

Finally, Quiggin did not say what contradictions he had in mind, but the theory and history of free banking, in the few places it has been given a chance, justify confidence that banking without government – that is, freedom — is not only possible but also practical and efficient – not to mention just. (For details see various works by Steven Horwitz, Lawrence H. White, and George Selgin.)

It is the failed doctrines of statism that constitute the zombies that still stalk us.

I don’t want to rehearse the whole debate in this column, but I do want to address a claim made by opponents of FRB.  They often say something like: “If I deposit $1,000 in my bank and it has to hold only 10 percent reserves, it can create $10,000 in new money.”  This claim is ambiguous at best and downright wrong at worst. As stated it betrays a lack of understanding how fractional reserve banks (whether under free or central banking) actually work.

First of all, this claim is ambiguous about where the deposit comes from and what it consists of.  For example, if I deposit a $1,000 check in my bank that you’ve written on your bank, what happens?  It’s true that my bank gets $1,000 in new reserves, but it cannot create $10,000 in new loans with the money.  Why not?  Imagine it credited $10,000 to the borrowers’ accounts.  What would they then do?  They would spend it because that’s why people borrow money!  And what happens when it’s spent?  The banks in which the funds are eventually deposited ask the original bank for $10,000 in reserves.

The problem is that if the bank was at its 10 percent requirement before the $1,000 deposit came in, it cannot lose $10,000 in reserves without falling below its minimum requirement (or its desired level, in a free-banking system with no such requirement, which would be unacceptably risky without deposit insurance).  What can the original bank afford to lose?  Well, it has my new deposit of $1,000 against which it has to keep 10 percent, or $100.  Therefore it has $900 to loan out.  And that’s all.  Banking rule #1: No individual bank can lend more than its excess reserves, in this case $900.

Now you say, “Yes, but that $900 will be spent and deposited at another bank, which will keep $90 and lend out $810, and so on.”  And you are quite right, which indicates banking rule #2:  The banking system can expand by a multiple of those original excess reserves.  Assuming 1) all banks face a 10 percent requirement, 2) no one takes out cash, and 3) no banks hold excess reserves, the system will create $10,000 based on that original $1,000 deposit.  So perhaps the problem with the original statement is that it focused on one bank only rather than the banking system as a whole.

What’s Unseen

But that’s not it — and we need the help of Monsieur Bastiat to see the unseen.  If the $1,000 I deposited came from your bank, it loses the $1,000 in reserves transferred to my bank.  That forces your bank to call in loans to make up the lost reserves, which leads to reserves being lost by other banks, which then have to do the same thing.  The result is that the $10,000 created by my bank’s gain in reserves is canceled by the $10,000 destroyed by your bank losing those reserves.  When you write a check to me and I deposit it, there is no bank multiplier on net (assuming the three conditions above hold). Thus we see the reverse of rule #2, as the system simultaneously contracts by a multiplied amount of the original deposit/withdrawal.

So how does new money ever get created and multiplied on net?  By injections of new reserves.  Only one entity can create new reserves in a fiat money system with a central bank:  the central bank.  When the Fed conducts open-market operations it adds new net reserves to the system, which enables the money-multiplier process with no offsetting loss in reserves elsewhere.  The central bank and only the central bank can do this.

A clever fellow might now say, “Well, what if I deposit currency into my bank?  There’s no offset then, right?”  That is indeed true.  But where did the currency come from?  At some point, you or someone else had to withdraw it from the banking system, which caused a multiplied contraction in the total money supply because currency counts as reserves.  The two halves of the process are separated in time, unlike with the deposits, but the net effect in the long run is still zero.

New currency can cause the money multiplier, but guess what is the only thing that can create new currency in a system with a monopoly central bank?  You got it:  the central bank. If you want to know whom to blame for setting off the money-multiplier process, you need only look there.

The moral of the story?  There’s nothing wrong with fractional reserve banking that getting rid of central banking and its various interventions can’t cure.

Along similar lines other scholars over the years have discovered countless historical examples of the successful private provision of public goods. Sometimes it is achieved by firms seeking monetary profit, while other times it is achieved by people cooperating for gains that are real but not monetized or exchanged in conventional markets.

The discovery of any such instance always surprises the typical economist, whose thinking is stymied by too many wrongheaded models of economic interaction.

Perhaps the most surprising of these discoveries is the issue of private currencies (or “free banking”). F. A. Hayek, George Selgin, and my George Mason University colleague Larry White led the way in showing not only that sound money can be supplied privately but that it has been supplied privately—most notably in Scotland from 1716 until 1844.

What about roads?

Limited-access highways are no problem. Private highway builders can erect tollbooths at entrances and exits and charge for use of their roads. No free riders will thwart builders’ efforts to collect payment from willing customers.

Local city streets are different. Having tolls at each intersection seems awfully inconvenient.

One way of solving the problem of privately supplying local city streets was seen in St. Louis. As reported by historian David Beito:

In 1867, property on Benton Place, the first private street in St. Louis, went on the market. The street had been subdivided a year earlier by Montgomery Blair, who had been Postmaster General under Abraham Lincoln. Blair entrusted design of the street to Julius Pitzman. By the 1870s, at least four other private streets ringed Lafayette Park. Pitzman laid a park median on the street, a feature emulated by later private places. Every lot extended to the center of the median. Following the pattern of Lucas Place [a St. Louis street with some private characteristics], each deed carried restrictions, including a setback from the street of twenty-five feet. Business use and multifamily housing were not prohibited, however. The restrictions provided for the annual election of three commissioners by the lot owners. The commissioners had authority to maintain the street, street lighting, the park median, sewers, and the alley by levying an annual assessment of fifty cents per front foot on each property. Armed with private-street ownership, Benton Place’s residents enjoyed a range of powers not possessed [by residents of nonprivate streets]. The commissioners, exercising their proprietary rights, erected a gate at one end of the street and a retaining wall at the other. They could deny access to the alley or park median to residents delinquent in their assessments to the street association.

Note that the private payments for this private street were simultaneously also payments for several other public goods that people value: sewerage, a park, and street-cleaning services, among others. By bundling these public amenities into a single package—namely, title to property on Benton Place—the developer was paid for providing this range of public goods. Persons who didn’t buy property on Benton Place and live up to their express agreement to pay annual assessments got no residential rights to live there.

Note, too, that Beito does not call the assessments “taxes.” He’s right not to do so. Everyone who bought property on Benton Place expressly agreed to pay the assessments according to the contractual agreements they signed with the developer. These payments, therefore, were made voluntarily.

Modern Examples

Columbia, Maryland, and Reston, Virginia, provide more recent examples of cities whose infrastructures were built and supplied privately. In both cases, private developers—James Rouse in Columbia and Robert Simon in Reston—planned and constructed the streets, sewer lines, and parks. They then sold real estate that included a prorated portion of the infrastructure’s cost.

Obviously these developers also had incentives to provide high-quality infrastructure. Were the streets too few, the park too small, the sewer lines too narrow, the maximum prices that buyers would pay for homes in these towns would have been lower.

Interestingly, not only was physical infrastructure provided privately in Reston and Columbia, so, too, was perhaps the most important public good of all: law. By buying real estate in Reston or Columbia, a buyer also expressly agreed to abide by the town’s bylaws, which serve as constitutions. They specify limits on property use (for example, no old cars on cinder blocks in front yards) as well as procedures for making future collective decisions that affect all residents. Unlike constitutions and statutes chosen by majoritarian voting, these rules have the actual unanimous consent of the people they govern.

In our 2002 paper, “Contractual Governments in Theory and Practice,” Randy Holcombe and I called the rule-making procedures and agencies formed by such constitutions “contractual governments.” We explained:

A single owner who intends to subdivide property and sell individual parcels forms the typical contractual government. The owner’s motivation is to increase the value of the parcels. As such, the creator of the contractual government has an incentive to create constitutional rules with the highest value. . . . The entrepreneur who forms a contractual government is a residual claimant whose income depends on the production of efficient constitutional rules. In municipal government, in contrast, there is no residual claimant. Mayors, city managers, and town-council members may have some incentive for making efficient decisions, but not the direct incentive that they would have if they were able to capture the profit from efficient decisions directly, as is the case with contractual governments. Thus, a direct incentive exists to produce efficient constitutional rules under which a contractual government will operate, unlike the situation that exists with municipal governments.

Sounds like a pretty good system.

More than 175 prominent economists are warning that “the independence of U.S. monetary policy is at risk” because of attacks on the Fed. They are urging Congress and the president to “avoid compromising [the U.S. central bank's] ability to manage monetary policy as it sees fit” and to refrain from politicizing its decisions on emergency loans to financial institutions.The move to publicly defend the Fed’s role reflects growing unease among academic economists, former Fed officials and some investors that the vehemence of the criticism from Congress of the Fed’s handling of the financial crisis suggests a readiness in Congress to weaken the freedom the Fed has to move interest rates as it see fits.

Why don’t we just abolish the Fed and stop worrying about it?

When Austrian-school theorists have examined the dynamics of market exchange, they have stressed the importance not only of the larger political context within which such exchanges take place, but also the ways in which politics influences and molds the shape and character of those exchanges. Indeed, with regard to financial institutions in particular, they have placed the state at the center of their economic theories on money and credit.

Throughout the modern history of the system that most people call “capitalism,” banking institutions have had such a profoundly intimate relationship to the state that one can only refer to it as a “state-banking nexus.” As I point out in Total Freedom: Toward a Dialectical Libertarianism:

A nexus is, by definition, a dialectical unity of mutual implication. Aristotle . . . stresses that “the nexus must be reciprocal . . . [T]he necessary occurrence of this involves the necessary occurrence of something prior; and conversely . . . given the prior, it is also necessary for the posterior to come-to-be.” For Aristotle, this constitutes a symbiotic “circular movement.” As such, the benefits that are absorbed by the state-banking nexus are mutually reinforcing. Each institution becomes both a precondition and effect of the other.

The current state and the current banking sector require each other. They are so reciprocally intertwined that each is an extension of the other.

Remember this the next time somebody tells you, as New York Times columnist Bob Herbert did, that “free market madmen” caused the current financial crisis that is threatening to undermine the global economy. There is no free market. There is no “laissez-faire capitalism.” The government has been deeply involved in setting the parameters for market relations for eons; in fact, genuine “laissez-faire capitalism” has never existed. Yes, trade may have been less regulated in the nineteenth century, but not even the so-called Gilded Age featured “unfettered” markets.

One reason I have come to dislike the term “capitalism” is that, historically, it has never manifested fully its so-called “unknown ideals.” Real, actual, historically specific “capitalism” has always entailed the intervention of the state. And that intervention has always had a class character; that is, the actions of the state have always benefited and must always benefit some groups at the expense of others.

No Neutral Government Action

Mises understood this when he constructed his theory of money and credit. For Mises, there is no such thing as a “neutral” government action, just as surely as there is no such thing as “neutral” money. As he pointed out in The Theory of Money and Credit and other works, “Changes in the quantity of money and in the demand for money . . . never occur for all individuals at the same time and to the same degree and they therefore never affect their judgments of value to the same extent and at the same time.” He traced how, with the erosion of a gold standard, an inflation of the money supply would diffuse slowly throughout the economy, benefiting those, such as banks and certain capital-intensive industries, who were among the early recipients of the new money.

One reason the gold standard was abandoned is its incompatibility with a structural policy of inflation and with a system heavily dependent on government intervention. (It should be pointed out that a free-banking system need not necessarily entail a 100 percent reserve gold standard, but I leave this discussion for another day.) The profiteers of systematic inflation are not difficult to pinpoint. Taking their lead from Mises, Hayek, and Rothbard and such New Left revisionist historians as Gabriel Kolko and James Weistein, Walter Grinder and John Hagel III point out:

Historically, state intervention in the banking system has been one of the earliest forms of intervention in the market system. In the U.S., this intervention initially involved sporadic measures, both at the federal and state level, which generated inflationary distortion in the monetary supply and cyclical disruptions of economic activity. The disruptions which accompanied the business cycle were a major factor in the transformation of the dominant ideology in the U.S. from a general adherence to laissez-faire doctrines to an ideology of political capitalism which viewed the state as a necessary instrument for the rationalization and stabilization of an inherently unstable economic order. This transformation in ideology paved the way for the full-scale cartellization [sic] of the banking sector through the Federal Reserve System. The pressure for systematic state intervention in the banking sector originated both among the banks themselves and from certain industries which, because of capital intensive production processes and long lead-times, sought the stability necessary for the long-term planning of their investment strategies. The historical evidence confirms that the Federal Reserve legislation and other forms of state intervention in the banking sector during the first decades of the twentieth century received active support from influential banking and industrial interests. . . . [“Toward a Theory of State Capitalism: Ultimate Decision-Making and Class Structure,” Journal of Libertarian Studies, 1977.]

As Grinder and Hagel explain, “[C]artellization [sic] of banking activity permits banks to inflate their asset base systematically.” This has the effect of strengthening the “ultimate decision-making authority” of banking institutions over “the activities of industrial corporations,” and, by extension, “the capital market.” These banking institutions serve as a key “intermediary between the leading economic interests and the state.”

Thus one of the major consequences of inflation is a shift of wealth and income toward banks and their beneficiaries. But this financial interventionism also sets off a process that Hayek would have dubbed a “road to serfdom,” for inflation introduces a host of distortions into the delicate structure of investment and production, setting off boom and bust and, in Grinder and Hagel’s words, “a process of retrogression from a relatively free market to a system characterized by an increasingly fascistic set of economic relationships.”

Just as the institution of central banking generates a “process of retrogression” at home, engendering additional domestic interventions that try to “correct” for the very distortions, conflicts, and contradictions it creates, so too does it make possible a structure of foreign interventions. In fact, it can be said that the very institution of central banking was born, as Rothbard argues in The Mystery of Banking, “as a crooked deal between a near bankrupt government and a corrupt clique of financial promoters” in an effort to sustain British colonialism. The reality is not much different today, but it is a bit more complex in terms of the insidious means by which government funds wars, and thereby undermines a productive economy.

So where does this leave us today?

Much has already been said about the most recent financial crisis, viewed from a radical libertarian and Austrian perspective, which helps to clarify its interventionist roots. (See, for example, Steven Horwitz’s “An Open Letter to My Friends on the Left,” and Sheldon Richman’s “Bailing Out Statism“). The seeds for this particular crisis were planted some years ago. The origins of the housing bubble can be traced to the creation of Fannie Mae and Freddie Mac, government-sponsored enterprises that extended risky loans to low-income borrowers in the hopes of expanding the “ownership society.” But the larger crisis must be understood within the wider political-economic context shaped by inflationary government and Federal Reserve policies that fueled a binge of reckless borrowing. Horwitz explains:

All of these interventions into the market created the incentive and the means for banks to profit by originating loans that never would have taken place in a genuinely free market. It is worth noting that these regulations, policies, and interventions were often gladly supported by the private interests involved. Fannie and Freddie made billions while home prices rose, and their CEOs got paid lavishly. The same was true of the various banks and other mortgage market intermediaries who helped spread and price the risk that was in play, including those who developed all kinds of fancy new financial instruments all designed to deal with the heightened risk of default the intervention brought with it. This was a wonderful game they were playing and the financial markets were happy to have Fannie and Freddie as voracious buyers of their risky loans, knowing that US taxpayer dollars were always there if needed. The history of business regulation in the US is the history of firms using regulation for their own purposes, regardless of the public interest patina over the top of them. This is precisely what happened in the housing market. And it’s also why calls for more regulation and more intervention are so misguided: they have failed before and will fail again because those with the profits on the line are the ones who have the resources and access to power to ensure that the game is rigged in their favor.

This is precisely correct; indeed, there are those of a certain political bent who might seek to place blame for the current financial crisis on the recipients of subprime mortgages, particularly those in minority communities. But if elements of the current housing bubble can be traced to Clinton administration attempts to appeal to traditional Democratic voting blocs, it’s not as if the banks were dragged kicking and screaming into lending those mortgages. This is, in a nutshell, the whole problem, the whole history, of government intervention, as Horwitz argues. Even if a case can be made that the road to this particular “housing bubble” hell was paved with the “good intentions” of those who wanted to nourish the “ownership society,” their actions necessarily generated deleterious unintended consequences. When governments have the power to set off such a feeding frenzy, government power becomes the only power worth having, as Hayek observed so long ago.

We heard a lot about “change” during the last presidential campaign, and about the necessity to end the influence of Washington lobbyists on public policy. But that influence exists because Washington has the power to dispense privilege. And privileges will always be dispensed in ways that benefit “ultimate decision-makers.” That’s the way the system is rigged. It is not simply that intervention breeds corruption; it’s that corruption is inherent in the process itself.

It is therefore no surprise that the loudest advocates for the effective nationalization of the finance industry are to be found on Wall Street; at this point, failing financiers welcome any government actions that will socialize their risks. But such actions that socialize losses while keeping profits private are a hallmark of fascist and neofascist economies. They are just another manifestation of “Horwitz’s First Law of Political Economy” (“Capitalists, Capitalism, and the Siren’s Song of Stability”): “No one hates capitalism more than capitalists.”

It is the government’s monetary, fiscal, and global policies that have created insurmountable debt and record budget deficits, speculative booms and bubble bursts. What is needed is genuine structural change. But the primary battle is an intellectual and cultural one. It requires that we question the fundamental basis of the current statist system.

During the Keynesian dark ages persisting through the mid-1970s, no one—except a few monetary cranks and monetarist economists cloistered in their academic ivory towers—believed that the Federal Reserve’s monetary policy even mattered. This was a period when Paul Samuelson, who would go on to win the 1970 Nobel Prize in economics the second time it was awarded, could proclaim in a 1969 Newsweek column that “there is no sight in the world more awful than that of an old-time economist, foam-flecked at the mouth and hell-bent to cure inflation by monetary discipline. God willing, we shan’t soon see his like again.” Today almost everyone—economists, investors, and the general public alike—seems to have swerved to the opposite extreme. The Fed controls not only inflation, they seem to think, but also everything else that happens to the American economy, good or bad. The truth, however, is somewhere in the middle.

We are not arguing that Greenspan’s policies were perfect. Nor should anything that follows be construed as a defense of central banking or of the Federal Reserve. Particularly alarming is the way the lender-of-last-resort function has been expanding the moral-hazard safety net and mispricing risk—trends to which Greenspan no doubt contributed. Our ideal would combine abolition of the Fed and unregulated free banking.

Nonetheless Alan Greenspan stands out as the most competent—arguably the only competent—helmsman of U.S. monetary policy since creation of the Federal Reserve System. As Milton Friedman observed on Greenspan’s retirement, “For the first 70 years after it opened in 1914, the Fed did far more harm than good, presiding over inflation in two World Wars, converting a moderate recession into the great depression, and then, in the 1970s, producing the most serious peacetime inflation in our nation’s history.” By contrast, Greenspan’s “performance has indeed been remarkable.”

Greenspan oversaw relatively low and stable inflation and ushered in a striking decline in the volatility of real gross domestic product. Although defenders of macroeconomic intervention often suggest that government policies after World War II dampened business cycles, the truly significant change should be dated at 1987, the year Greenspan assumed office. The current fuss about a recession that, according to standard indicators, still is no worse than the minor recessions of 1990 and 2001 testifies to how high his legacy has raised the bar. Until a year or so ago many observers had therefore credited Greenspan with being the best at reading the economic tea leaves. But as we will demonstrate, the source of Greenspan’s apparent success has little to do with monetary discretion.

Freezing Total Reserves

Recently-converted critics are now charging Greenspan with having carried on an excessively expansionary monetary policy, particularly following the recession of 2001 and possibly during the dot-com boom that preceded it. But an objective examination of his record of nearly two decades shows that he did not. Instead, however unintentionally and unwittingly, he came close to freezing the domestic monetary base and deregulated the broader monetary aggregates.

Why do people now believe Greenspan was an “inflationist”? For one main reason: They note how low interest rates were from 2002 through 2004. But interest rates have never proved an adequate gauge of what the Fed is doing—not during the Great Depression, when rates were very low despite a collapsing money stock; not during the Great Inflation of the 1970s, when rates were high despite an expanding money stock; and not under Greenspan. A focus on interest rates ignores the simple fact that interest rates can change as a result of real factors involving supply and demand and are not simply “set” by the Fed.

The market ultimately determines interest rates. While central banks are big enough players in the loan market (and the quintessential noise traders to boot) that they can push short-term rates up or down somewhat, that ability is increasingly diminished—even fora major central bank like the Fed—as globalization integrates world financial markets. In defending his actions, Greenspan is correct in attributing the unusually low interest rates early this decade mainly to a massive flow of savings from emerging Asian economies and elsewhere.

A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base (see chart, p. 36). From 2001 to 2006 the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent. During that same time M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006. When all these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan despite the low interest rates.

The key to what was really going on is the monetary base, which the Federal Reserve controls directly. The base consists of reserves held by the banks and other depositories, either in their accounts at the Fed or as vault cash, plus currency in circulation among the general public. Between December 1986—eight months before Greenspan became Fed chairman—and December 2005, the monetary base rose by a hefty amount, from $248 billion to $802 billion (no figures are seasonally adjusted). True, that doesn’t sound like a freeze. But virtually the whole increase was in currency in circulation. (See the graph of the monetary base and its two components on p. 37.) During that same time total bank reserves grew from $65 billion to $73 billion, for an average annual growth rate of a mere 0.65 percent. (These figures are unadjusted for any changes in reserve requirements and—unlike the somewhat misleading reserve totals reported by the Fed’s Board of Governors—include all vault cash, clearing balances, and float.) In some years aggregate reserves rose; in others they fell, with the major bump surrounding Y2K, when the accumulation of reserves by banks appears to have induced the Fed to accommodate a 40 percent jump followed by a 30 percent drop. Total reserves are also the one monetary measure whose growth rate shows a slight uptick into 2003, when interest rates were down. But that is thin backing for the extravagant accusations that “easy Al” was conducting an exceptionally expansionary monetary policy.

Currency in Circulation

During the same 19 years, currency in circulation exploded faster than the monetary base—at an annual rate of 7.54 percent. Before this explosion currency was less than three-quarters of the total monetary base; by the end of Greenspan’s tenure it was over 90 percent. In a period when debit cards and possibly ATMs were reducing currency demand, analysts were aware that all this new cash was not bulging in the wallets and purses of the average American. It was going abroad as a stable dollar evolved into an international currency. These growing foreign holdings of Federal Reserve notes became an additional factor increasing money demand and keeping U.S. inflation in check during the 1990s.

Ideally we should adjust the monetary base and monetary aggregates downward to account for this drain abroad. Richard G. Anderson of the St. Louis Fed estimates that the proportion of U.S. currency held abroad doubled between 1986 and 2005, from 25 to nearly 50 percent. Although his estimates may be too low, the Fed makes no such adjustment. Doing so would reduce the average annual growth rate of the monetary base between December 1986 and December 2005 from 6.4 to 4.9 percent.

Furthermore, in a fully deregulated monetary system, private banks—not the Fed—would be the institutions issuing currency. Currency would become an additional bank liability like deposits and respond to market forces. In our current system, the public still determines how much of the base becomes currency in circulation by their decisions to withdraw and redeposit cash. The Fed controls only the total base whereas currency passively expands to accommodate people’s preferences. This suggests that a more meaningful approximation of the base would be simply to subtract all currency in circulation, leaving us with only aggregate reserves as our proxy. Thus the virtual freezing of reserves turns out to be the most salient yet ignored feature of Greenspan’s tenure. Interestingly, the late Milton Friedman had recommended in the 1980s something similar to what Greenspan did de facto: freeze the base.

Greenspan also helped deregulate the broader monetary aggregates: M2, MZM, and M3. The Depository Institutions Deregulation and Monetary Control Act of 1980 had begun phasing out interest-rate ceilings on deposits and modified reserve requirements in complex ways. Combined with later administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1—savings deposits, small time deposits, money market deposit accounts, and retail money-market mutual fund shares—utterly free of reserve requirements and allowed banks to reclassify many M1 checking accounts as M2 savings deposits. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.

A result noted by Milton Friedman in 2003 is that fluctuations in the velocity of M2 were offset by fluctuations in the amount of M2. Interestingly, this is similar to what monetary economists George A. Selgin and Lawrence H. White predicted would happen under free banking—or a market-determined monetary system void of government involvement. They argued that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rose, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity fell, signaling a rise in money demand, banks would enlarge the quantity of money. The response of M2 to changes in velocity in the 1990s offers stunning confirmation of this claim. The result was that inflation was held in check.

Thus during the dot-com boom of the 90s the velocity of M2 rose as people shifted into stocks. But this was offset by the declining growth rate of M2, which fell to near zero between 1994 and 1996. Assorted Fed watchers reached opposite conclusions depending on which variable they chose to focus on. Some warned that Greenspan’s policies were deflationary. Others looked at the higher growth rates of the base and M1, which remains more closely tied to the base and more distorted by currency going abroad, and predicted higher inflation. Both were wide of the mark, of course, but not because of Greenspan’s miraculous central-bank discretion. The result was a product of the market process, and when the collapse of the dot-com boom burst the M2 velocity bubble it induced a new spike in M2 growth.

Why Any Inflation?

If Greenspan approximately froze total reserves, why was there any inflation at all during his tenure? Rather than averaging 2.5 percent annually, shouldn’t prices have remained constant or actually fallen? Indeed, in a thoughtful critique of an earlier version of this article, Selgin denied that the broader monetary measures were responding to changes in velocity, since productivity growth would have therefore generated just such a gradual deflation. The answer relates to the market’s extraordinary capacity for financial innovation. Until the recent, extraordinary changes in Fed operations, bank reserves in the United States paid no interest, giving banks a strong incentive to economize on their use and maximize lending. They figured out ways to do so even under reserve requirements, as amply illustrated by the origins and growth of the Federal funds market, where banks regularly lend each other excess reserves.

Financial deregulation gave the process an additional boost. From December 1986 to December 2005—the same period during which aggregate reserves remained almost constant—the aggregate de facto reserve ratio of the banking system as a whole backing M2 fell by half, from 2.52 percent to 1.23 percent. So the quantity of M2 deposits grew at a secular rate of 4.6 percent, enough to generate mild, sustained inflation. And the quantity of domestically held currency grew alongside at an accommodating rate.

This steady, long-term decline of reserve ratios cannot easily be halted and confronts government fiat money with a fatal long-run problem. Re-tightening of reserve requirements would only burden banks with an implicit tax not faced by other financial institutions, encouraging the development of new, highly liquid money substitutes that effectively avoid the requirements. Congress has, moreover, moved in the opposite direction, permitting the Fed to eliminate all remaining reserve requirements in 2011, thereby bringing the United States into line with such countries as Australia, New Zealand, Canada, the United Kingdom, and Sweden, which have already done so. True, the Fed has now started paying interest on bank reserves, which has enormously increased demand for them in the short run. Nonetheless banks will still be able to earn greater interest on loans and securities under normal economic circumstances. Moreover, paying interest on reserves in effect transforms that portion of the monetary base into Treasury securities payable in fiat money, rather than genuine fiat money itself.

In short, the ongoing spread of electronic funds transfers and assorted cashless payments is essentially replacing money with a sophisticated network of computerized barter. The demand for fiat money will thus approach zero asymptotically. So long as the money base is built on a fiat foundation with no other source of demand, the price level will slowly but inexorably head toward infinity. Only a commodity base with a nonmonetary demand—say gold, although it could just as well be silver, some combination of the two, or a more complex basket of commodities or financial assets—will anchor the price level over the long haul. Under free banking, the expansion of monetary substitutes would drive down the demand for gold-as-money, but gold’s value can never drop below its commodity value. Gold would continue to provide the unit of account, the common numeraire in nearly all transactions, without ever needing to be used as a medium of exchange.

Greenspan cannot be held responsible for this ultimate unviability of fiat money, although his deregulation accelerated the inflationary bias. A steady, secular contraction of total reserves could in theory have offset the declining reserve ratio, delivering a constant price level or even secular deflation over the last two decades. But the continued fall of base-money demand is itself inevitable as long as developed economies wish to capture the enormous welfare gains of financial innovation and a more efficient allocation of savings.

An Ironic Legacy

So what did cause the current financial crisis? That is similar to asking what caused the minor recessions of 1990 and 2001. Unlike the cause of inflation, the cause of business cycles is not obvious, which is why economists still vigorously debate the question. Minor blips in total reserves under Greenspan may have played some poorly understood role in any of these three events. Because Greenspan only imperfectly implemented Friedman’s rule of freezing the monetary base, without intending to do so, his policy may have ended up slightly too discretionary. But that possibility hardly justifies the “asset bubble” hubris of those economic prognosticators who, only well after the fact, declaim with absolute certainty and scant attention to the monetary measures how the Fed could have pricked or prevented such bubbles.

The misunderstanding of Alan Greenspan’s management of the U.S. money stock has an ironic coda. Before his appointment the Federal Reserve had proved so palpably inept as to all but discredit discretionary monetary policy. Both monetarist rules and free banking were gaining adherents among economists. But today, despite the recent financial turmoil, most interpret Greenspan’s record as showing either that discretionary policy can be done right or that what is needed is some activist pseudo-rule such as that developed by John B. Taylor of Stanford University. Central bankers, after half a century or more of failure, have allegedly learned from their past mistakes. Finally, according to this view, they have the knowledge to plan the money stock properly.

In a review of Greenspan’s memoirs Harvard economist Benjamin Friedman claims that Greenspan was a practitioner par excellence of monetary discretion (despite paying lip service to laissez faire) and that Greenspan’s major failing was that he was not more of a regulator. Friedman is wrong on both counts. Greenspan, like the Wizard of Oz, was a lousy wizard—but he was a good deregulator. And that made all the difference. His success stemmed from weakening Fed discretion with the unintentional approximation of a rigid monetary rule and the very deregulation that Benjamin Friedman deplores. Rather than demonstrating that monetarist rules are obsolete and free banking unnecessary, Greenspan’s policies suggest that the more thoroughly either of those two objectives is implemented, the greater the macroeconomic stability our economy will enjoy.

Money Definitions

• M1: currency in circulation, travelers’ checks, and transaction deposits (accounts that permit unlimited checking).
• M2: M1 plus savings deposits, small time deposits, money-market deposit accounts, and retail money-market mutual fund shares.
• M3 (which the Fed ceased reporting in March 2006): M2 plus bank-issued repurchase agreements, Eurodollar deposits held by U.S. residents in foreign branches of U.S. banks, large certificates of deposit (over $100,000), and institutional money-market mutual fund shares.
• MZM (Money of Zero Maturity and reported only by the St. Louis Fed): M2 minus small time deposits plus institutional money-market mutual fund shares.