policy was in the ‘right’ direction in 155 months, in the ‘wrong’ direction in 226 months; so actual policy was ‘better’ than the [constant 4% rate of money growth] rule in 41% of the months.” Nor is the objection that the pre-Keynesian era biased his study a good one, since, “For the period after World War II alone, the results were only slightly more favorable to actual policy according to this criterion: policy was in the ‘right’ direction in 71 months, in the ‘wrong’ directio in 79 months, so actual policy was better than the rule in 47% of the months.”19But that is not all, Friedman quickly adds. Even if the Fed had a batting average of 50-50, it would not show itself to be just as good as a constant growth rule. There would be a tie in the contest to preserve monetary equilibrium. But the variance of the discretionary policies would inject instability and uncertainty into the market, whereas the rule, being changeless, would never be an independent worry to market participants. Friedman concludes that any alternative to his growth rule must succeed far more than 50% of the time to warrant serious consideration.One of the best ways to parry a metaphor is with another metaphor. Keynesians have a host of metaphors in their rhetorical arsenal; one frequently voiced is that a wise government should “lean against the wind” when choosing policy. Friedman counters: “We seldom know which way the economic wind is blowing until several months after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, itself a variable date that may be a half year or a year or two from now. Leaning today against next year’s wind is hardly an easy task in the present state of meteorology.”20Friedman’s remarks, as even his strong critics admit, are mighty and strike at the heart of any activist “stabilization” policy. By meeting Keynesians on their own theoretical turf and scrutinizing their practice, Friedman manages to produce objections that both Keynesians and non-Keynesians must take seriously. The Argument Against Activism from Conflict of InterestEarly Keynesians focused more on fiscal policy than monetary policy. Specifically, they attacked the so-called “responsible” annual balanced budget. “What’s so important about the year?” they asked. Why not balance the budget over the cycle, with surpluses in boom years and deficits in bad years?One could apply the same logic to Keynesian monetary policy. Why not adjust the position of the money supply, increasing it during hard times and decreasing it during booms? There is nothing in the insufficient aggregate demand interpretation of unemployment to suggest money should have a positive rate of change. Strangely, Keynesians leap from aggregate supply and demand curves that relate output and the position of prices to output and the rate of change of prices.Despite this, under Keynesian management there has been some tendency toward systematic budget deficits and a strong tendency toward continuous increase in the money supply. This is true of many countries, but I will limit these brief comments to America.First, during the post-Keynesian era, the public debt in America has stayed positive and at a high level compared to pre-Keynesian peacetime years.21 Moreover, there have been high deficits during boom years with continuous deficits since 1970. Second, the money supply has increased continuously since 1940 – though inflation rates have, of course, varied, drifting upwards until the early 80’s, dropping sharply, and then slowly climbing again.All this is old hat. Sophisticated Keynesianism can easily explain these facts. Why bother to bring it up? Many of the peacetime deficits occurred after fiscal policy was no longer used for short-term stabilization. And of course, when people expect positive inflation, it is movements in the rate of change of prices, not the position of prices, that matter.The reason to bring this up is: according to Keynesian theory – even state-of-the-art Keynesianism – there is no reason why the budget would not be balanced over the cycle, and why there should be persistent inflation. But Keynesian practice has never achieved these goals, nor even loudly called for aiming at them. Some critics of Keynesianism solve this paradox by pointing an accusing finger at the free scope that Keynesian theory grants to policymakers, unrestrained by strict and objective rules. James Buchanan and Richard Wagner, in their Democracy in Deficit, give a concise statement of this public choice critique of Keynesianism. Active policy gives wide powers to monetary and fiscal authorities, limited only by their ability to show that, in some way, their methods are consonant with their overall goal. But authorities can act in a way which, though not blatantly opposed to their announced purpose, really aims at some other end – an end that the voting public would not endorse if it understood the situation. In short, if we assume that the government is properly a servant of the public’s wishes, active policy creates a principal-agent problem. As Buchanan and Wagner put it, “The economy is not controlled by the sages+,but by politicians engaged in a controlling competition for office+Political decisions in the United States are made by elected politicians, who respond to the desires of voters and the ensconced bureaucracy.”21Buchanan and Wagner think that an overlooked aspect of the Keynesian revolution was its destruction of the implicit “fiscal constitution” in America. Classical public finance theory endorsed a balanced budget during peacetime. This set firm and clear limits upon government spending. Why are limits beyond simple voting necessary? The classical reason pointed to the public good characteristics of fiscal restraint. No one wants their programs cut, because the costs come out of general tax revenues rather than the pockets of the direct beneficiaries. And in the case of deficit finance – which involves intertemporal substitution of tax payments – the consumers of the government goods and services may never be taxed for them, and the people who will be taxed for them may never consume them.But why is the principal-agent problem too severe to solve with voting? Won’t political competition work to deliver what the voters desire? Buchanan and Wagner don’t think so. There are serious differences between competition in markets and competition in politics. Market competition is continuous, while political competition is intermittent. Market competition allows the simultaneous survival of many competitors, while political competition is typically an all-or-nothing affair. On the market the consumer usually knows the attributes of the good in advance, and may have quality guarantees, while the “political consumer” votes for a good with indeterminate attributes. He receives no actionable assurances. (Imagine a “truth-in-advertising” law for elections!) Last, market transactions require unanimous consent, while political ones merely need a majority.23 Each of these facts makes opportunistic behavior less costly to authorities.Keynesians have on occasion scoffed at the alleged “rationality” of market participants. Buchanan and Wagner are analogously skeptical of the rationality of political participants. Voters do not merely make errors; they suffer from “illusion,” that is, they have systematic misconceptions. The government that they live under can take advantage of this ignorance. Buchanan and Wagner explain that this is hardly beyond our common experience: “complex and indirect payment structures create a fiscal illusion that will systematically produce higher levels of public outlay than those that would be observed under single-payments structures. Budgets will be related directly to the complexity and indirectness of tax systems. The costs of public services, as generally perceived, will be lower under indirect than under direct taxation, and will be lower under a multiplicity of tax sources than under a system that relies heavily on a single source.”24Buchanan and Wagner examine two major sources of fiscal illusion. Rejecting Barro-Ricardo equivalence, they argue that the freedom of the government to run budget deficits artificially makes government goods seem less costly vis-a-vis market goods. “The allocative bias stems from the proposition that, if individuals are allowed to finance publicly provided goods and services through borrowing rather than taxation, they will tend to ‘purchase’ more publicly provided goods and services than standard efficiency criterion would dictate.”25 Another way of thinking of this is that tax increases reduce consumption of private goods, while budget cuts reduce consumption of public goods. But deficits let individuals have greater current consumption with only a vague possibility that one day they will have to enjoy less as a consequence. Different people may be paying the bills at the later date. In a sense, then, unrestrained deficit finance is a species of negative externality.Another point implicit in Buchanan and Wagner’s analysis is that each instance of government spending gives highly concentrated benefits to a minority, while the costs are thinly spread out over the tax-payers as a whole. Thus, the lobbyists who work to maintain and expand each program will have a lot at stake, while each member of the public bears only a tiny part of the burden. The norm of the balanced budget was one method of checking this problem. Because Keynesianism gave economic justifications for deficits, this norm is no more. Buchanan and Wagner explain it this way: “The removal of the balanced-budget principle or constitutional rule generated an asymmetry in the conduct of budgetary policy in competitive democracy. Deficits will be created, but to a greater extent than justified by Keynesian principles; surplus will sometimes result, but they will result less frequently than required by the strict Keynesian prescriptions.”26The other important hidden tax is the so-called “inflation tax,” which, more than budget deficits, has increased because of the Keynesian revolution. Keynes himself argued that inflation works in a way that “not one man in a million is able to diagnose.” Buchanan and Wagner agree. To analyze inflation as a species of tax requires a degree of economic literacy that only a small minority of voters have. When governments use inflationary finance, the government receives the benefits of seigniorage, lower real interest rates, and real debt erosion, but businesses and unions take the blame. “As it appears to them [the voters], their real income declines not because the government collects more real taxes but because private firms charge higher prices for their products.”27Unlike a true tax, the inflation “tax” is not likely to deter the demand for public goods, since most people do not perceive it as the price paid for government services. On top of this, since stronger government is the usual answer to perceived private sector failures, inflation may have the additional bonus – from the government’s viewpoint – of making citizens more eager to vote for its services, more willing to smile upon its growth. If one is not yet convinced, Buchanan and Wagner have a clinching argument: “If the effects of money issue, in terms of behaviorial reactions, should be, in fact, equivalent to those of a tax, there would seem to be no point in all such activities of politicians.”28Hence, the solution public choice theorists offer to the inconsistency between Keynesian theory and practice is: Monetary and fiscal authorities – the agents – take advantage of the imperfect information of the voting public – the principals – to have higher deficits and money creation than is necessary for full employment. If authorities strove unswervingly to fulfill the public good, then their free reign might be best. But in the real world such persons are few and difficult to identify. Given this, the only realistic way to solve this problem is to whittle down the sphere of independent decision-making the government holds by binding it with strict and objective rules. Buchanan and Wagner’s derive two proposals from this principle. The first is to constitutionally bind the government to annually balance the budget. Deficits would imply proportional across-the-board cuts; surpluses would retire the national debt. The balanced-budget rule could be suspended during time of emergency with a two-thirds vote from both houses of Congress. Second, they would adopt Friedman’s constant growth rule for the money supply.29Public choice theory, as we have noted, is like Keynesianism in one respect: Both believe that individuals are not perfectly rational Mr. Spock-type creatures. They can make systematic errors. But they diverge in their analysis of which sphere of economic life systematic errors usually occur. Keynesians talk about the money illusion of market participants and the animal spirits of investors. Public choicers, in contrast, see most of the error in the political sphere, and point to fiscal illusion and the public good aspects of democracy. In a like vein, some Keynesians believe that market imperfections explain macroeconomic problems. Public choicers point to the much more extreme cases of political imperfections: the intermittent character of political competition, the all-or-nothing victories that resolve political conflicts, the lack of guarantees, the principal- agent problem, and the substitution of majority rule for unanimous consent.One flaw that I see in public choice theory is that it does not go far enough. The analogy between voters and consumers is very weak. Unlike consumption, which benefits the individual directly, voting is a pure public good. The intelligent citizen gets no benefit for his investment in wise voting. The foolish voter pays nothing for his folly. And the voting act itself involves positive costs of time and effort. Empirical studies of actual voter behavior by political scientists show that voter behavior is virtually the paradigm case of irrational action. Dye and Zeigler, in their Irony of Democracy, define the following necessary conditions for rational voting: “(1) competing candidates would offer clear policy alternatives; (2) voters would be concerned with policy questions; (3) election results would clarify majority preferences on these questions; (4) elected officials would be bound by the positions they assume during their campaigns.”30 From detailed research, they find that none of these hold for the mass of voters; indeed, “large numbers of the electorate are politically uninformed and inarticulate.”31Another interesting area for public choice theorists to investigate would be the effect of government “advertising” on the voting public. Liberals such as John Kenneth Galbraith inveigh against the evils of private advertising. But surely this cannot compare to the powers of persuasion that the government possesses with its virtual monopoly on education and its regulation of television and radio.James Buchanan, Richard Wagner, and their fellow public choice theorists have made an important contribution to the critique of the practical aspects Keynesianism – to the analysis of what they call “institutions.” Interdisciplinary cooperation with empirical political science would, I think, improve the depth and realism of their research.Free Banking’s Attack on Central BankingKeynesian theory states that shifts in aggregate demand cause real economic fluctuations. Keynesians infer that the government should counterbalance random variations with contracyclical policy. At first, this inference seems obvious. But it is not. Another premise must be added to this argument to draw this conclusion: The market cannot provide this valuable service for itself. Put in the economist’s terms, it must be shown that proper adjustment of aggregate demand is a public good. If this premise were wrong, if the market could supply this service, the case for government macromanagement would be sharply hurt.Recently, some economists pointed out these facts, and argued that the market could indeed execute these functions. To be specific, they envisage a system in which the banks become the private suppliers of this so-called “public good.” For this system to work, they believe that many regulations currently imposed upon banks must be eliminated. Hence, the system they favor is called “free banking” and its advocates may be called “free bankers.”We shall, first, describe exactly what “free banking” is, which regulations – at a minimum – must be repealed for a system to count as “free.” Then, we will explain how free banking would replace government management of the macroeconomy, and show how free banking solves or at least substantially mitigates many of the problems government demand management faces. Last, we shall discuss some of the important objections to free banking, especially the charge that it would inadequately protect the public against bank failures.Here are the crucial ways that free banking differs from current banking. (1) There would be no central bank with a monopoly of note issue or ability to increase the supply of base money. (2) Banks would have no legal reserve requirements. (3) Banks would be free to issue either deposits or banknotes. Banknotes would take the place of currency as it now exists. But, unlike under central banking, banknotes would not be base money. Instead, they would be “inside money” just as fully as deposits. For base money, there are several possibilities – the only necessity is that the base money be commonly accepted as valuable in itself. The most plausible options are either gold or a frozen stock of fiat dollars.The most novel feature of this, of course, is that currency would be privately issued. This is not, however, as strange as it sounds. It has existed historically in most of the world. There is no reason to think that a system of private issue of currency would be anarchic. Economically speaking, notes would be no different than travellers’ checks. They would be a claim upon a bank that is not contingent upon the reliability of the person using it. In other words, banknotes are one step more marketable than personal checks, since checks require that a seller trust both the bearer and the bank, while the acceptability of notes depends solely on the soundness of the bank issuing them.Free bankers argue that freely fluctuating reserve ratios would solve the problem of change in the demand to hold money. To help our understanding, let us examine how reserve ratios would be set when there are no legal requirements. Once we understand this, we will see how changes in demand to hold affect the optimal reserve ratio.The necessary reserves for a bank – free or not – can be conceptually divided into two parts. The first part is its expected net reserves – the amount needed to cover itself against expected net clearings with other banks. The second is its precautionary reserves – the amount needed to cover itself against random fluctuations in net clearings. Banks will hold the precautionary reserves because they do not know their actual net clearings with certainty. They therefore create a protective buffer against illiquidity.It is clear that, in the long run, every bank’s expected net clearings must be zero. As Selgin explains, “A bank cannot continue to suffer a positive average net reserve demand without eventually disappearing, and it cannot have a continuously negative average net reserve demand unless it fails to exploit fully the demand to hold its liabilities and hence its lending power.”32 Given this, it seems at first that, without legal reserve requirements, any ratio would be stable.This impression is incorrect, because it neglects the fact that precautionary reserves must always remain positive, even in the long run. The variance of net clearings makes this a simple rule of prudence. Given an expected gross level of clearings, banks can estimate the expected deviation of clearings from zero and hold precautionary reserves accordingly. In the long run, then, since banks expect zero net clearings, they set their total reserves equal to their desired precautionary reserves – and it is this that determines their typical reserve ratio.If we accept this, it is fairly easy to see how the banking system would respond to either an increase or decrease in the total demand to hold money. Selgin explains that, “Since the precautionary reserves are held against deviations of average net demand from its mean or expected value, it follows that precautionary reserve demand rises by the same factor as the variance of net clearings. Since gross banking clearings increase whenever their is an uncompensated, general decline in the demand for for inside money+and gross clearings fall when there is an uncompensated, general increase in the demand for inside money, it follows that bank reserve needs are affected by changes in the demand for inside money even when these changes affect all banks simultaneously and uniformly.”33 To illustrate this, imagine a case where banks initially have reserve ratios of 2%. Then, the total demand to hold real balances doubles uniformly. All banks find that no one’s expected net clearings change. However, their gross clearings halve, implying that they need only half the precautionary reserves that they did before. It is therefore safe for all banks to simultaneously expand their notes and deposits until the previous ratio of gross clearings to reserves returns. We reach equilibrium when deposits and notes double, and the reserve ratio falls to 1%. Conversely, imagine that demand to hold halved uniformly. Once again, no one’s expected net clearings changes. But their gross clearings double, implying that banks need twice the precautionary reserves they did earlier. Each bank, to protect itself, must contract its notes and deposits until they return to the previous ratio of gross clearings to reserves. This leaves the reserve ratio at 4%.34A second, less serious problem that any monetary system must face is a change in the currency-deposit ratio. Under a system of monopolized note-issue, where currency is also base money, this can involve serious problems – as economic historians such as Friedman and Schwartz note in their Monetary History of the United States. The reason is this: if the central bank fully accomodates a temporary (for example, seasonal) change in the currency-deposit ratio, they create a second problem. Once the public re-asserts its normally preferred mix of currency and deposits by depositing their excess currency, the base money in the banking system will expand, increasing the money supply by a multiplied amount. If the central bank takes the opposite path and refuses to accomodate, the banks may face a serious liquidity crisis. This is not because of any aggregate change, but merely a relative shift in the public’s preferences. But the real consequences may be severe – as numerous 19th and early 20th century panics during crop-moving season (when the public required more currency and less deposits) illustrate.Free bankings’ solution to this problem is so simple it is almost stunning. Under free banking, currency is not base money. It is just as easy for a bank with full freedom of note issue to respond to a change in its clients’ desired ratio of currency to deposits as it is to respond to a change in customers’ desired ratio of yellow checks to white checks. The bank would be decreasing its deposit liabilities by the same amount that it increases its banknote liabilities. The limit on overexpansion of either notes or deposits – as always under free banking – does not come from legislative restrictions, but from loss of base money to other banks if one overexpands. Selgin notes that central banking is a species of central planning; in consequence it suffers from a severe knowledge problem. The problem of central planning is that, when prices are not determined by market forces but are set by the state, there is no automatic way to correct for shortages and surpluses. Compare this to the market, where prices can freely adjust as frequently as demand or supply conditions change. Similarly, when the government is the sole supplier of a good, there is no danger that competitors will take advantage of its incompetance. Even if we assume that the central planner is benevolent and wise, it cannot know that no one could do the job better if it is illegal even to try. (Why a benevolent dictator would want to ban competition is a mystery to me.)Can we apply this generalization to government versus market management of money, to central banking and free banking? Selgin argues that we can. The job of money management is to keep the supply of money equal to the demand for it, so that there is neither inflation nor deflation and demand fluctuations do not affect real variables. If a free bank is doing its job, it tries to avoid both over- or under-expanding its liabilities. If it over-expands, it suffers a loss of base money to other banks. If it under-expands, it loses out on the interest that it could have earned by loaning out more. A bank can see both the direction and approximate magnitude of its errors by simply checking its net clearings. This is very similar to any other market; suppliers have an economic incentive to charge neither too much nor too little, and can swiftly discover their miscalculations by checking for shortages or surpluses at a given price.Since a central bank manages the money supply by adjusting the quantity of base money, it cannot check its performance by examining the direction and magnitude of its net clearings. This, Selgin explains, is why central banks need monetary guidelines in the first place. “When the currency supply is monopolized, as it is under central banking, the clearing mechanism ceases to be an effective guide to changing the money supply in accordance with consumer preferences. Creation of excessive currency and deposit credits by a central bank will not cause a short-run increase in its liquidity costs. This means that other knowledge surrogates (including both means for informing money-supply decisions and means for their timely ex post evaluation) must be found to replace surrogate knowledge naturally present under free banking. That is why there is need for ‘monetary policy’ and money-supply ‘guidelines’ under centralized issue.”35 Just as the central planner must make Five Year Plans after it short-circuits the market’s spontaneous coordination through the price system, the central banker must determine Monetary Policies because it short-circuits the banking system’s spontaneous satisfaction of changes in money demand through the clearing mechanism.Economists know that bureaucratic decisions under central planning are both slow and inaccurate. There are two reasons: imperfect information and lack of incentives. Steven Horwitz, an economist friendly to free banking, describes the information problem aptly: “the goal of a central bank is not just to know what that money supply is but what it ought to be+Rather than having adverse clearings determine optimal money supply decisions in accord with the wants of the public, central bankers must rely on statistical devices for estimating the course of money demand.”36 These statistical devices, like other statistics used by central planners, are often inaccurate initially and take so much time to gather that they are outmoded before they can be used as a guide to action.Selgin notes four popular monetary guidelines: price index stabilization, interest rate stabilization, adjustment to achieve full employment, and constant money growth.37 Each of these has been persuasively criticized, one is “too inflationary,” another “ties our hands” and so on. None is perfect. But so long as we must choose between them it is foolish to say, “A plague on all their houses.” We must weigh the pros and cons and choose the least among evils. An important point made by free bankers is that there is another, more radical option: the abolition of any centralized monetary policy in favor of market supply. “A plague on all their houses” may turn out to be wiser than it seems.Earlier in this paper, we discussed two criticisms levelled against Keynesian practice as opposed to Keynesian theory. There was Friedman’s argument from long and variable lags, and Buchanan and Wagner’s argument from conflict of interest. Does free banking do anything to help these problems?Free banking does not completely solve Friedman’s problem. But it does help. The inside lag for free banking would almost certainly be less than a central bank’s, because free banks would be managed by entrepreneurs who respond to current market signals rather than bureaucrats who respond to after-the-fact statistical aggregates. The outside lag would also be shorter because free banks would only adjust the supply of inside money, of notes and deposits. Compare this to a central bank, which injects a given quantity of base money and then waits for the money multiplier to do its work. A central bank cannot safely compensate a change in demand dollar-for-dollar with base money, because the base money ultimately causes a multiplied expansion of the total money supply.It is obvious that public choicers must say that free banking lacks the vulnerabilities inherent in government demand management. Free banks would not be run by politicians, but businessmen. They would be checked, like all businesses on the free market, by competitors. Efficient execution of their duties would be a private good, driven by profit-and-loss. Of course, doing a bad job would not be illegal, but the costs would be borne primarily by the capitalists. Political demand management, as Buchanan and Wagner observed, is a public good. The public bears the brunt of the burden if the authorities mess up. On top of this, the authorities can benefit themselves by deliberately “failing” (from the public’s point of view), due to the principal-agent problem. No such problem exists under free banking, since the interests of the principal are in harmony with those of the agent.Banks can fail, and one of the buffers that prevents failure is a bank’s precautionary reserves. Some critics might reasonably object that it is too dangerous to permit banks to select their own margin of error when a mistake directly harms its customers and indirectly injures everyone who does business with these customers. Especially when the government insures deposits it seems reckless to let each bank select its own reserve ratio.Free bankers are quite aware of this objection, and can, I think, marshall both theory and history to their defense. From the outset, one may point out that bank failures are a public bad only in the loosest sense. If a bank fails, its customers may suffer. They therefore have a direct incentive to protect themselves by selecting only sound and prudent banks. Similarly, those who trade with the customers of a bank that fails may lose out. But once again, this gives them an incentive to only accept the notes and checks of solid banks – just as merchants do today when they guard against bogus checks.Banks depend upon their reputation for prudence just to stay afloat. A bank that helps its customers simultaneously helps itself. Economic theory thus predicts that banks would strive to bolster the security that their customers enjoy. History corroborates this. Countries without branch banking laws, such as Canada, have stoutly resisted bank failures since it is easier to pool risk. There were no bank failures in Canada during the early years Great Depression – while thousands of American banks collapsed.38 In the Scottish and Canadian banking systems (once again unimpeded by branch banking laws), insolvent banks often merged with rivals who would assume the liabilities of the failed bank in full. In exchange, of course, they got their former competitor’s share of the market. Some Scottish banks announced their unlimited liability. Others wrote “option clauses” on their notes, giving the bank the legal right to suspend payment for up to six months. If the bank exercised this option, it paid interest in compensation.The Scottish and Canadian systems were systems of the past. If free banking were reborn in modern times, there are other possible ways to supply banking security. Private, competitively issued insurance is not beyond the bounds of reason. Selgin suggests that current deposit insurance, which charges a flat-rate, subsidizes risk. He plausibly argues that private insurance would set premiums according to portfolio riskiness. Private insurers would have an incentive to monitor their customers that government insurers lack, as the recent S&L bailout brightly illustrates. Competing banks could pool risk through a system of cross-guarantees.39 There is, in sum, a long list o