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pro-64 FREE TO CHOOSE: A Personal Statementbasic problem, an excess of hand-loom weavers, worse—preciselywhat happened in India.. Economic Freedom An essential part of economic freedom i

The Tyranny of Controls 59

Britain British rule left it with a highly skilled and trained civilservice, modern factories, and an excellent railroad system None

of these existed in Japan in 1867 India was technologically

back-ward compared to the West, but the differential was less than thatbetween Japan in 1867 and the advanced countries of that day.India's physical resources, too, were far superior to Japan's.About the only physical advantage Japan had was the sea, whichoffered easy transportation and a plentiful supply of fish For therest, India is nearly nine times as large as Japan, and a muchlarger percentage of its area consists of relatively level and ac-cessible land Japan is mostly mountainous It has only a narrowfringe of habitable and arable land along the seacoasts

Finally, Japan was on its own No foreign capital was invested

in Japan; no foreign governments or foreign foundations in talist countries formed consortiums to make grants or offer low-interest loans to Japan It had to depend on itself for capital tofinance its economic development It did have one lucky break

capi-In the early years after the Meiji Restoration, the European silk

crops experienced a disastrous failure that enabled Japan to earnmore foreign exchange by silk exports than she otherwise couldhave Aside from that, there were no important fortuitous or or-ganized sources of capital

India fared far better Since it achieved independence in 1947,

it has received an enormous volume of resources from the rest ofthe world, mostly as gifts The flow continues today

Despite the similar circumstances of Japan in 1867 and India

in 1947, the outcome was vastly different Japan dismantled itsfeudal structure and extended social and economic opportunity

to all its citizens The lot of the ordinary man improved rapidly,even though population exploded Japan became a power to bereckoned with on the international political scene It did notachieve full individual human and political freedom, but it madegreat progress in that direction

India paid lip service to the elimination of caste barriers yetmade little progress in practice Differences in income and wealthbetween the few and the many grew wider, not narrower Popula-tion exploded, as it did in Japan eight decades earlier, but eco-nomic output per capita did not It remained nearly stationary

60 FREE TO CHOOSE: A Personal Statement

Indeed, the standard of life of the poorest third of the populationhas probably declined In the aftermath of British rule, Indiaprided itself on being the largest democracy in the world, but

it lapsed for a time into a dictatorship that restricted freedom

of speech and press It is in danger of doing so again

What explains the difference in results? Many observers point

to different social institutions and human characteristics gious taboos, the caste system, a fatalistic philosophy—all theseare said to imprison the inhabitants of India in a straitjacket oftradition The Indians are said to be unenterprising and slothful

Reli-By contrast, the Japanese are lauded as hardworking, energetic,eager to respond to influences from abroad, and incredibly in-genious at adapting what they learn from outside to their ownneeds

This description of the Japanese may be accurate today It wasnot in 1867 An early foreign resident in Japan wrote: "Wealthy

we do not think it [Japan] will ever become The advantagesconferred by Nature, with exception of the climate, and the love

of indolence and pleasure of the people themselves forbid it.The Japanese are a happy race, and being content with little arenot likely to achieve much." Wrote another: "In this part of theworld, principles, established and recognized in the West, appear

to lose whatever virtue and vitality they originally possessed and

to tend fatally toward weediness and corruption."

Similarly, the description of the Indians may be accurate todayfor some Indians in India, even perhaps for most, but it certainly

is not accurate for Indians who have migrated elsewhere Inmany African countries, in Malaya, Hong Kong, the Fiji Islands,Panama, and, most recently, Great Britain, Indians are successfulentrepreneurs, sometimes constituting the mainstay of the entre-preneurial class They have often been the dynamo initiatingand promoting economic progress Within India itself, enclaves

of enterprise, drive, and initiative exist wherever it has been sible to escape the deadening hand of government control

pos-In any event, economic and social progress do not depend

on the attributes or behavior of the masses In every country atiny minority sets the pace, determines the course of events Inthe countries that have developed most rapidly and successfully,

The Tyranny of Controls 61

a minority of enterprising and risk-taking individuals have forgedahead, created opportunities for imitators to follow, have enabledthe majority to increase their productivity

The characteristics of the Indians that so many outside servers deplore reflect rather than cause the lack of progress.Sloth and lack of enterprise flourish when hard work and thetaking of risks are not rewarded A fatalistic philosophy is anaccommodation to stagnation India has no shortage of peoplewith the qualities that could spark and fuel the same kind ofeconomic development that Japan experienced after 1867, oreven that Germany and Japan did after World War II Indeed,the real tragedy of India is that it remains a subcontinent teemingwith desperately poor people when it could, we believe, be aflourishing, vigorous, increasingly prosperous and free society

ob-We recently came across a fascinating example of how an nomic system can affect the qualities of people Chinese refugeeswho streamed into Hong Kong after the communists gainedpower sparked its remarkable economic development and gained

eco-a deserved reputeco-ation for initieco-ative, enterprise, thrift, eco-and heco-ardwork The recent liberalization of emigration from Red Chinahas produced a new stream of immigrants—from the same racialstock, with the same fundamental cultural traditions, but raisedand formed by thirty years of communist rule We hear fromseveral firms that hired some of these refugees that they are verydifferent from the earlier Chinese entrants into Hong Kong Thenew immigrants show little initiative and want to be told preciselywhat to do They are indolent and uncooperative No doubt a fewyears in Hong Kong's free market will change all that

What then accounts for the different experiences of Japan from

1867 to 1897 and of India from 1947 to date? We believe thatthe explanation is the same as for the difference between Westand East Germany, Israel and Egypt, Taiwan and Red China.Japan relied primarily on voluntary cooperation and free mar-kets—on the model of the Britain of its time India relied oncentral economic planning—on the model of the Britain of itstime

The Meiji government did intervene in many ways and played

a key role in the process of development It sent many Japanese

62 FREE TO CHOOSE: A Personal Statement

abroad for technical training It imported foreign experts Itestablished pilot plants in many industries and gave numeroussubsidies to others But at no time did it try to control the totalamount or direction of investment or the structure of output Thestate maintained a large interest only in shipbuilding and ironand steel industries that it thought necessary for military power Itretained these industries because they were not attractive toprivate enterprise and required heavy government subsidies.These subsidies were a drain on Japanese resources They im-peded rather than stimulated Japanese economic progress Finally,

an international treaty prohibited Japan during the first threedecades after the Meiji Restoration from imposing tariffs higherthan 5 percent This restriction proved an unmitigated boon toJapan, though it was resented at the time, and tariffs were raisedafter the treaty prohibitions expired

India is following a very different policy Its leaders regardcapitalism as synonymous with imperialism, to be avoided at allcosts They embarked on a series of Russian-type five-year plansthat outlined detailed programs of investment Some areas of pro-duction are reserved to government; in others private firms arepermitted to operate, but only in conformity with The Plan.Tariffs and quotas control imports, subsidies control exports Self-sufficiency is the ideal Needless to say, these measures produceshortages of foreign exchange These are met by detailed andextensive foreign exchange control—a major source both of in-efficiency and of special privilege Wages and prices are controlled

A government permit is required to build a factory or to make anyother investment Taxes are ubiquitous, highly graduated onpaper, evaded in practice Smuggling, black markets, illegal trans-actions of all kinds are every bit as ubiquitous as taxes, under-mining all respect for law, yet performing a valuable social service

by offsetting to some extent the rigidity of central planning andmaking it possible for urgent needs to be satisfied

Reliance on the market in Japan released hidden and pected resources of energy and ingenuity It prevented vestedinterests from blocking change It forced development to conform

unsus-to the harsh test of efficiency Reliance on government controls

in India frustrates initiative or diverts it into wasteful channels

The Tyranny of Controls 63

It protects vested interests from the forces of change It substitutesbureaucratic approval for market efficiency as the criterion ofsurvival

The experience in the two countries with homemade and tory-made textiles serves to illustrate the difference in policy.Both Japan in 1867 and India in 1947 had extensive production

fac-of textiles in the home In Japan foreign competition did not havemuch effect on the home production of silk, perhaps because ofJapan's advantage in raw silk reinforced by the failure of theEuropean crop, but it all but wiped out the home spinning ofcotton and later the hand-loom weaving of cotton cloth A Japa-nese factory textile industry developed At first, it manufacturedonly the coarsest and lowest-grade fabrics, but then moved tohigher and higher grades and ultimately became a major exportindustry

In India hand-loom weaving was subsidized and guaranteed amarket, allegedly to ease the transition to factory production.Factory production is growing gradually but has been deliberatelyheld back to protect the hand-loom industry Protection has meantexpansion The number of hand looms roughly doubled from

1948 to 1978 Today, in thousands of villages throughout India,the sound of hand looms can be heard from early morning to late

at night There is nothing wrong with a hand-loom industry, vided it can compete on even terms with other industries InJapan a prosperous, though extremely small, hand-loom industrystill exists It weaves luxury silk and other fabrics In India thehand-loom industry prospers because it is subsidized by the gov-ernment Taxes are, in effect, imposed on people who are nobetter off than the ones who operate the looms in order to paythem a higher income than they could earn in a free market.Early in the nineteenth century Great Britain faced preciselythe same problem that Japan did a few decades later and Indiadid more than a century later The power loom threatened todestroy a prosperous hand-loom weaving industry A royal com-mission was appointed to investigate the industry It consideredexplicitly the policy followed by India: subsidizing hand-loomweaving and guaranteeing the industry a market It rejected thatpolicy out of hand on the ground that it would only make the

pro-64 FREE TO CHOOSE: A Personal Statement

basic problem, an excess of hand-loom weavers, worse—preciselywhat happened in India Britain adopted the same solution asJapan—the temporarily harsh but ultimately beneficent policy ofletting market forces work.'

The contrasting experiences of India and Japan are interestingbecause they bring out so clearly not only the different results ofthe two methods of organization but also the lack of relationbetween objectives pursued and policies adopted The objectives

of the new Meiji rulers—who were dedicated to strengthening thepower and glory of their country and who attached little value toindividual freedom—were more in tune with the Indian policiesthan with those they themselves adopted The objectives of thenew Indian leaders—who were ardently devoted to individualfreedom—were more in tune with the Japanese policies than withthose they themselves adopted

CONTROLS AND FREEDOMThough the United States has not adopted central economic plan-ning, we have gone very far in the past fifty years in expandingthe role of government in the economy That intervention hasbeen costly in economic terms The limitations imposed on oureconomic freedom threaten to bring two centuries of economicprogress to an end Intervention has also been costly in politicalterms It has greatly limited our human freedom

The United States remains a predominantly free country—one

of the freest major countries in the world However, in the words

of Abraham Lincoln's famous "House Divided" speech, "A housedivided against itself cannot stand I do not expect thehouse to fall, but I do expect it will cease to be divided It willbecome all one thing or all the other." He was talking abouthuman slavery His prophetic words apply equally to governmentintervention into the economy Were it to go much further, ourdivided house would fall on the collectivist side Fortunately, evi-dence grows that the public is recognizing the danger and isdetermined to stop and reverse the trend toward ever biggergovernment

All of us are affected by the status quo We tend to take for

The Tyranny of Controls 65

granted the situation as it is, to regard it as the natural state ofaffairs, especially when it has been shaped by a series of smallgradual changes It is hard to appreciate how great the cumulativeeffect has been It takes an effort of the imagination to get outsidethe existing situation and view it with fresh eyes The effort iswell worth making The result is likely to come as a surprise, not

to say a shock

Economic Freedom

An essential part of economic freedom is freedom to choose how

to use our income: how much to spend on ourselves and on whatitems; how much to save and in what form; how much to giveaway and to whom Currently, more than 40 percent of our in-come is disposed of on our behalf by government at federal, state,and local levels combined One of us once suggested a new na-tional holiday, "Personal Independence Day—that day in theyear when we stop working to pay the expenses of government and start working to pay for the items we severally and indi-vidually choose in light of our own needs and desires." In 1929

that holiday would have come on Abraham Lincoln's birthday,February 12; today it would come about May 30; if present trendswere to continue, it would coincide with the other IndependenceDay, July 4, around 1988

Of course, we have something to say about how much of ourincome is spent on our behalf by government We participate inthe political process that has resulted in government's spending

an amount equal to more than 40 percent of our income Majorityrule is a necessary and desirable expedient It is, however, verydifferent from the kind of freedom you have when you shop at asupermarket When you enter the voting booth once a year, youalmost always vote for a package rather than for specific items

If you are in the majority, you will at best get both the items youfavored and the ones you opposed but regarded as on balanceless important Generally, you end up with something differentfrom what you thought you voted for If you are in the minority,you must conform to the majority vote and wait for your turn tocome When you vote daily in the supermarket, you get precisely

66 FREE TO CHOOSE: A Personal Statement

what you voted for, and so does everyone else The ballot boxproduces conformity without unanimity; the marketplace, una-nimity without conformity That is why it is desirable to use theballot box, so far as possible, only for those decisions where con-formity is essential

As consumers, we are not even free to choose how to spendthe part of our income that is left after taxes We are not free tobuy cyclamates or laetrile, and soon, perhaps, saccharin Ourphysician is not free to prescribe many drugs for us that he mayregard as the most effective for our ailments, even though thedrugs may be widely available abroad We are not free to buy anautomobile without seat belts, though, for the time being, we arestill free to choose whether or not to buckle up

Another essential part of economic freedom is freedom to usethe resources we possess in accordance with our own values—freedom to enter any occupation, engage in any business enter-prise, buy from and sell to anyone else, so long as we do so on astrictly voluntary basis and do not resort to force in order tocoerce others

Today you are not free to offer your services as a lawyer, aphysician, a dentist, a plumber, a barber, a mortician, or engage

in a host of other occupations, without first getting a permit orlicense from a government official You are not free to work over-time at terms mutually agreeable to you and your employer, unlessthe terms conform to rules and regulations laid down by a govern-ment official

You are not free to set up a bank, go into the taxicab business,

or the business of selling electricity or telephone service, or ning a railroad, busline, or airline, without first receiving permis-sion from a government official

run-You are not free to raise funds on the capital markets unlessyou fill out the numerous pages of forms the SEC requires andunless you satisfy the SEC that the prospectus you propose toissue presents such a bleak picture of your prospects that no in-vestor in his right mind would invest in your project if he tookthe prospectus literally And getting SEC approval may cost up-wards of $100,000-which certainly discourages the small firmsour government professes to help

The Tyranny of Controls 67

Freedom to own property is another essential part of economicfreedom And we do have widespread property ownership Wellover half of us own the homes we live in When it comes tomachines, factories, and similar means of production, the situa-tion is very different We refer to ourselves as a free private enter-prise society, as a capitalist society Yet in terms of the ownership

of corporate enterprise, we are about 46 percent socialist Owning

1 percent of a corporation means that you are entitled to receive 1percent of its profits and must share 1 percent of its losses up tothe full value of your stock The 1979 federal corporate incometax is 46 percent on all income over $100,000 (reduced from 48percent in prior years) The federal government is entitled to 46cents out of every dollar of profit, and it shares 46 cents out ofevery dollar of losses (provided there are some earlier profits tooffset those losses) The federal government owns 46 percent ofevery corporation—though not in a form that entitles it to votedirectly on corporate affairs

It would take a book much longer than this one even to list infull all the restrictions on our economic freedom, let alone describethem in detail These examples are intended simply to suggest howpervasive such restrictions have become

As you know, the real issue more so than the price per thousandcubic feet is the continuation of the First Amendment of the Consti-tution, the guarantee of freedom of speech With increasing regula-tion, as big brother looks closer over our shoulder, we grow timidagainst speaking out for truth and our beliefs against falsehoods andwrong doings Fear of IRS audits, bureaucratic strangulation or gov-ernment harassment is a powerful weapon against freedom of speech

In the October 31 [19771 edition of the U.S. News & World Report,the Washington Whispers section noted that, "Oil industry officialsclaim that they have received this ultimatum from Energy Secretary

68 FREE TO CHOOSE: A Personal Statement

James Schlesinger: `Support the Administration's proposed tax oncrude oil—or else face tougher regulation and a possible drive to break up the oil companies.' "

His judgment is amply confirmed by the public behavior of oil

officials Tongue-lashed by Senator Henry Jackson for earning

"obscene profits," not a single member of a group of oil industryexecutives answered back, or even left the room and refused tosubmit to further personal abuse Oil company executives, who inprivate express strong opposition to the present complex structure

of federal controls under which they operate or to the majorextension of government intervention proposed by PresidentCarter, make bland public statements approving the objectives ofthe controls

Few businessmen regard President Carter's so-called voluntarywage and price controls as a desirable or effective way to combatinflation Yet one businessman after another, one business organi-zation after another, has paid lip service to the program, saidnice things about it, and promised to cooperate Only a few, likeDonald Rumsfeld, former congressman, White House official, andCabinet member, had the courage to denounce it publicly Theywere joined by George Meany, the crusty octogenarian formerhead of the AFL-CIO

It is entirely appropriate that people should bear a cost—if only

of unpopularity and criticism—for speaking freely However, thecost should be reasonable and not disproportionate There shouldnot be, in the words of a famous Supreme Court decision, "achilling effect" on free speech Yet there is little doubt that cur-rently there is such an effect on business executives

The "chilling effect" is not restricted to business executives Itaffects all of us We know most intimately the academic com-munity Many of our colleagues in economics and the naturalscience departments receive grants from the National ScienceFoundation; in the humanities, from the National Foundation forthe Humanities; all those who teach in state universities get theirsalaries partly from the state legislatures We believe that the Na-tional Science Foundation, the National Foundation for theHumanities, and tax subsidies to higher education are all un-desirable and should be terminated That is undoubtedly a minor-

The Tyranny of Controls 69

ity view in the academic community, but the minority is muchlarger than anyone would gather from public statements to thateffect

The press is highly dependent on government—not only as amajor source of news but in numerous other day-to-day operatingmatters Consider a striking example from Great Britain TheLondon Times, a great newspaper, was prevented from publishingone day several years ago by one of its unions because of a storythat it was planning to publish about the union's attempt to in-fluence the content of the paper Subsequently, labor disputesclosed down the paper entirely The unions in question are able toexercise this power because they have been granted special im-munities by government A national Union of Journalists inBritain is pushing for a closed shop of journalists and threatening

to boycott papers that employ nonmembers of the union All this

in the country that was the source of so many of our liberties.With respect to religious freedom, Amish farmers in the UnitedStates have had their houses and other property seized becausethey refused, on religious grounds, to pay Social Security taxes—and also to accept Social Security benefits Church schools havehad their students cited as truants in violation of compulsoryattendance laws because their teachers did not have the requisiteslips of paper certifying to their having satisfied state requirements.Although these examples only scratch the surface, they illus-trate the fundamental proposition that freedom is one whole, thatanything that reduces freedom in one part of our lives is likely toaffect freedom in the other parts

Freedom cannot be absolute We do live in an interdependentsociety Some restrictions on our freedom are necessary to avoidother, still worse, restrictions However, we have gone far beyondthat point The urgent need today is to eliminate restrictions, notadd to them

in 1933 Total output fell by a third, and unemployment reachedthe unprecedented level of 25 percent of the work force Thedepression was no less a catastrophe for the rest of the world As

it spread to other countries, it brought lower output, higher employment, hunger, and misery everywhere In Germany thedepression helped Adolf Hitler rise to power, paving the way forWorld War II In Japan it strengthened the military clique thatwas dedicated to creating a Greater East Asia coprosperity sphere

un-In China it led to monetary changes that accelerated the final

hyperinflation that sealed the doom of the Chiang Kai-shek regimeand brought the communists to power

In the realm of ideas, the depression persuaded the public thatcapitalism was an unstable system destined to suffer ever moreserious crises The public was converted to views that had alreadygained increasing acceptance among the intellectuals: govern-ment had to play a more active role; it had to intervene to offsetthe instability generated by unregulated private enterprise; it had

to serve as a balance wheel to promote stability and assure rity The change in the public's perception of the proper role ofprivate enterprise on the one hand and of the government on theother proved a major catalyst for the rapid growth of government,and particularly central government, from that day to this.The depression also produced a far-reaching change in pro-fessional economic opinion The economic collapse shattered thelong-held belief, which had been strengthened during the 1920s,that monetary policy was a potent instrument for promotingeconomic stability Opinion shifted almost to the opposite extreme,that "money does not matter." John Maynard Keynes, one of the70

secu-The Anatomy of Crisis 71great economists of the twentieth century, offered an alternativetheory The Keynesian revolution not only captured the economicsprofession, but also provided both an appealing justification and aprescription for extensive government intervention.

The shift in opinion of both the public and the economics fession resulted from a misunderstanding of what had actuallyhappened We now know, as a few knew then, that the depressionwas not produced by a failure of private enterprise, but rather by

pro-a fpro-ailure of government in pro-an pro-arepro-a in which the government hpro-adfrom the first been assigned responsibility—"To coin money, regu-late the Value thereof, and of foreign Coin," in the words of Sec-tion 8, Article 1, of the U.S Constitution Unfortunately, as weshall see in Chapter 9, government failure in managing money isnot merely a historical curiosity but continues to be a present-dayreality

THE ORIGIN OF THE FEDERAL RESERVE SYSTEM

On Monday, October 21, 1907, some five months after the start

of an economic recession, the Knickerbocker Trust Company, thethird largest trust company in New York City, began to experiencefinancial difficulties The next day a "run" on the bank forced it

to close (temporarily, as it turned out; it resumed business inMarch 1908) The closing of the Knickerbocker Trust precipi-tated runs on other trust companies in New York and then inother parts of the country—a banking "panic" was under way of

a kind that had occurred every now and then during the teenth century

nine-Within a week, banks throughout the country reacted to the

"panic" by "restriction of payments," i.e., they announced thatthey would no longer pay out currency on demand to depositorswho wanted to withdraw their deposits In some states the gov-ernor or attorney general took measures that gave legal sanction

to the restriction of payments; in the remaining states the practicewas simply tolerated and banks were permitted to stay open eventhough they were technically violating the state banking laws.The restriction of payments cut short bank failures and endedthe runs But it imposed serious inconvenience on business It led

72 FREE TO CHOOSE: A Personal Statement

to a shortage of coin and currency, as well as to the private culation of wooden nickels and other temporary substitutes forlegal money At the height of the shortage of currency, it took

cir-$104 of deposits to buy $100 of currency Together, the panic andthe restriction, both directly, through their effects on confidenceand on the possibility of conducting business efficiently, and in-directly, by forcing a decline in the quantity of money, turned therecession into one of the most severe that the United States hadexperienced up to that time

However, the severe phase of the recession was short-lived.Banks resumed payments in early 1908 A few months later,economic recovery began The recession lasted only thirteenmonths in all, and its severe phase only about half that long.This dramatic episode was largely responsible for the enact-ment of the Federal Reserve Act in 1913 It made some action

in the monetary and banking area politically essential DuringTheodore Roosevelt's Republican administration a National Mon-etary Commission was established that was headed by a prominentRepublican senator, Nelson W Aldrich During Woodrow Wil-son's Democratic administration, a prominent Democratic con-gressman, later senator, Carter Glass, rewrote and repackaged thecommission's recommendations The resulting Federal ReserveSystem has served as the key monetary authority of the countryever since

What do the terms "run" and "panic" and "restriction of ments" really mean? Why did they have the far-reaching effects

pay-we have attributed to them? And how did the authors of theFederal Reserve Act propose to prevent similar episodes?

A run on a bank is an attempt by many of its depositors to

"withdraw" their deposits in cash, all at the same time The runarises from rumors or facts that lead depositors to fear that thebank is insolvent and will be unable to live up to its obligations

It represents an attempt by everyone to get "his" money outbefore it is all gone

It is easy to see why a run would cause an insolvent bank tofail sooner than it otherwise might But why should a run cause

a responsible and solvent bank trouble? The answer is linked toone of the most misleading words in the English language—the

The Anatomy of Crisis

73

word "deposit," when used to refer to a claim against a bank

If you "deposit" currency in a bank, it is tempting to supposethat the bank takes your greenbacks and "deposits" them in abank vault for safekeeping until you ask for them It does nothing

of the kind If it did, where would the bank get income to payits expenses, let alone to pay interest on deposits? The bank maytake a few of the greenbacks and put them in a vault as a "re-serve." The rest it lends to someone else, charging the borrowerinterest, or uses to buy an interest-bearing security

If, as is typically the case, you deposit not currency but checks

on other banks, your bank does not even have currency in hand

to deposit in a vault It has only a claim on another bank forcurrency, which it typically will not exercise because other bankshave matching claims on it For every $100 of deposits, all thebanks together have only a few dollars of cash in their vaults

We have a "fractional reserve banking system." That system worksvery well, so long as everyone is confident that he can always getcash for his deposits and therefore only tries to get cash when

he really needs it Usually, new deposits of cash roughly equalwithdrawals, so that the small amount in reserve is sufficient tomeet temporary discrepancies However, if everyone tries to getcash at once, the situation is very different—a panic is likely tooccur, just as it does when someone cries "fire" in a crowdedtheater and everyone rushes to get out

One bank alone can meet a run by borrowing from otherbanks, or by asking its borrowers to repay their loans The bor-rowers may be able to repay their loans by withdrawing cashfrom other banks But if a bank run spreads widely, all bankstogether cannot meet the run in this way There simply is notenough currency in bank vaults to satisfy the demands of all de-positors Moreover, any attempt to meet a widespread run bydrawing down vault cash—unless it succeeds promptly in re-storing confidence and ends the run so that the cash is redeposited

—enforces a much larger reduction in deposits On the age in 1907, the banks had only $12 of cash for every $100

aver-of deposits Every dollar aver-of deposits converted into cash andtransferred from the vaults of banks to the mattresses of depositorsmade necessary the reduction of deposits by an additional $7 if

74 FREE TO CHOOSE: A Personal Statement

banks were to maintain the prior ratio of reserves to deposits.That is why a run that results in hoarding of cash by the publictends to reduce the total money supply It is also why, if notstopped promptly, it causes such distress Individual banks try

to get cash to meet the demands of their depositors by pressingtheir borrowers to repay loans and by refusing to renew loans or

to extend additional ones Borrowers as a whole have nowhere

to turn, so banks fail and businesses fail

How can a panic be stopped once it is under way, or better yet,how can it be prevented from starting? One way to stop a panic

is the method adopted in 1907: a concerted restriction of ments by the banks Banks stayed open but they agreed with oneanother that they would not pay cash on demand to depositors In-stead, they operated through bookkeeping entries They honoredchecks written by one of their own depositors to another by re-ducing the deposits recorded on their books to the credit of theone and increasing the deposits of the other For checks written

pay-by their depositors to another bank's depositors, or pay-by anotherbank's depositors to their depositors, they operated almost asusual "through the clearinghouse," that is, by offsetting thechecks on other banks received as deposits against the checks ontheir own hank deposited in other banks The one difference wasthat any differences between the amount they owed other banksand the amount other banks owed them was settled by a promise

to pay instead of, as ordinarily, by the transfer of cash Bankspaid out some currency, not on demand, but to regular customerswho needed it for payrolls and similar urgent purposes, and simi-larly, they received some currency from such regular customers.Under this system banks might and did still fail because they were

"unsound" banks They did not fail merely because they couldnot convert perfectly sound assets into cash As time passed,panic subsided, confidence in banks was restored, and the bankscould resume payment of cash on demand without starting a newseries of runs That is a rather drastic way to stop a panic but itworked

Another way to stop a panic is to enable sound banks to vert their assets into cash rapidly, not at the expense of otherbanks but through the availability of additional cash—of an

con-The Anatomy of Crisis 75

emergency printing press, as it were This was the way embodied

in the Federal Reserve Act It was supposed to prevent even thetemporary disruptions produced by the restriction of payments.The twelve regional banks established by the act, operating underthe supervision of a Federal Reserve Board in Washington, weregiven the power to serve as "lenders of last resort" to the com-mercial banks They could make such loans either in the form

of currency—Federal Reserve Notes, which they had the power

to print—or in the form of deposit credits on their books, whichthey had the power to create—the magic of the bookkeeper's pen.They were to serve as bankers' banks, as the U.S counterpart ofthe Bank of England and other central banks

Initially, it was expected that the Federal Reserve Banks wouldoperate mostly by direct loans to banks, on the security of thebanks' own assets, in particular, the promissory notes correspond-ing to loans by banks to businesses In many such loans, thebanks "discounted" the notes—that is, paid out less than the faceamount, the discount representing the interest charged by thebanks The Federal Reserve in turn "rediscounted" the promis-sory notes, thereby charging the banks interest on the loans

As time passed, "open market operations"—the purchase orsale of government bonds—rather than rediscounts became themain way in which the System added to or subtracted from theamount of money When a Federal Reserve Bank buys a govern-ment bond, it pays for it either with Federal Reserve Notes that

it has in its vaults or that it has freshly printed or, more typically,

by adding on its books to the deposits of a commercial bank.The commercial bank may itself be the seller of the bond or itmay be the bank in which the seller of the bond keeps his depositaccount The extra currency and deposits serve as reserves for thecommercial banks, enabling them as a whole to expand their de-posits by a multiple of the additional reserves, which is why cur-rency plus deposits at Federal Reserve Banks are designated

"high-powered money" or the "monetary base." When a FederalReserve Bank sells a bond, the process is reversed Reserves ofcommercial banks decline and they are led to contract Until fairlyrecently the power of the Federal Reserve Banks to create cur-rency and deposits was limited by the amount of gold held by the