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Chapter VIII

Free Banking and the Limits on Bank Credit Inflation

Let us assume now that banks are not required to act as genuine money warehouses, and are

unfortunately allowed to act as debtors to their depositors and noteholders rather than as bailees retaining

someone else’s property for safekeeping. Let us also define a system of free banking as one where banks are

treated like any other business on the free market. Hence, they are not subjected to any government control or

regulation, and entry into the banking business is completely free. There is one and only one government

“regulation”: that they, like any other business, must pay their debts promptly or else be declared insolvent and

be put out of business.1 In short, under free banking, banks are totally free, even to engage in fractional reserve

[p. 112] banking, but they must redeem their notes or demand deposits on demand, promptly and without

cavil, or otherwise be forced to close their doors and liquidate their assets.

Propagandists for central banking have managed to convince most people that free banking would be

banking out of control, subject to wild inflationary bursts in which the supply of money would soar almost to

infinity. Let us examine whether there are any strong checks, under free banking, on inflationary credit

expansion.

In fact, there are several strict and important limits on inflationary credit expansion under free banking.

One we have already alluded to. If I set up a new Rothbard Bank and start printing bank notes and issuing

bank deposits out of thin air, why should anyone accept these notes or deposits? Why should anyone trust a

new and fledgling Rothbard Bank? Any bank would have to build up trust over the years, with a record of

prompt redemption of its debts to depositors and noteholders before customers and others on the market will

take the new bank seriously. The buildup of trust is a prerequisite for any bank to be able to function, and it

takes a long record of prompt payment and therefore of noninflationary banking, for that trust to develop.

There are other severe limits, moreover, upon inflationary monetary expansion under free banking.

One is the extent to which people are willing to use bank notes and deposits. If creditors and vendors insist on

selling their goods or making loans in gold or government paper and refuse to use banks, the extent of bank

credit will be extremely limited. If people in general have the wise and prudent attitudes of many “primitive”

tribesmen and refuse to accept anything but hard gold coin in exchange, bank money will not get under way or

wreak inflationary havoc on the economy.

But the extent of banking is a general background restraint that does precious little good once banks

have become established. A more pertinent and magnificently powerful weapon against the banks is the dread

bank run—a weapon that has [p. 113] brought many thousands of banks to their knees. A bank run occurs

when the clients of a bank—its depositors or noteholders—lose confidence in their bank, and begin to fear

that the bank does not really have the ability to redeem their money on demand. Then, depositors and

noteholders begin to rush to their bank to cash in their receipts, other clients find out about it, the run intensifies

and, of course, since a fractional reserve bank is indeed inherently bankrupt—a run will close a bank’s door quickly and efficiently.2

Various movies of the early 1930s have depicted a bank run in action. Rumors spread throughout a

town that the bank is really insolvent—that it doesn’t have the money to redeem its deposits. Depositors form

lines at 6:00 A.M. waiting to take their money out of the bank. Hearing of the rumors and seeing the lines,

more depositors rush to “take their money out of the bank” (money, of course, which is not really there). The

suave and authoritative bank manager tries to assure the depositors that the rumors are all nonsense and that

the excited and deluded people should return quietly to their homes. But the bank clients cannot be mollified.

And then, since of course the hysterical and deluded folk are really quite right and the money is of course not

there to cover their demands, the bank in fact does go bankrupt, and is out of business in a few hours.

The bank run is a marvelously effective weapon because (a) it is irresistible, since once it gets going it

cannot be stopped, and (b) it serves as a dramatic device for calling everyone’s attention to the inherent

unsoundness and insolvency of fractional reserve banking. Hence, bank runs feed on one another, and can

induce other bank runs to follow. Bank runs instruct the public in the essential fraudulence of fractional reserve

banking, in its essence as a giant Ponzi scheme in which a few people can redeem their deposits only because

most depositors do not follow suit.

When a bank run will occur cannot be determined, since, at least in theory, clients can lose confidence

in their banks at any time. In practice, of course, loss of confidence does not come [p. 114] out of thin air. It

will happen, say, after an inflationary boom has been underway for some time, and the fraction of

reserves/demand liabilities has been lowered through credit expansion. A rash of bank runs will bring the

insolvency of many banks and deflationary contraction of credit and the money supply.

In Chapter VII, we saw that fractional reserve banking expands money and credit, but that this can be

reversed on a dime by enforced credit contraction and deflation of the money supply. Now we see one way

this can occur. The banks pyramid notes and deposits on top of a certain amount of cash (gold and

government paper); the ever-lower fractional reserve ratio weakens the confidence of customers in their

banks; the weakened confidence causes demands for redemption culminating in a run on banks; and bank runs

stimulate similar bank runs until a cycle of deflation and bank collapse is underway. Fractional reserve banking

has given rise to a boom and bust business cycle.

But the bank run, too, is a cataclysmic meat axe event that occurs only after a considerable inflation of

bank credit It is true that continuing, never-ending fear of a bank run will provide a healthy check on

inflationary bank operations. But still the bank run allows for a considerable amount of credit expansion and

bank inflation before retribution arrives. It is not a continuing, day-to-day restraint; it happens only as a

one-shot phenomenon, long after inflation has caught hold and taken its toll.

Fortunately, the market does provide a superb, day-to-day grinding type of severe restraint on credit

expansion under free banking. It operates even while confidence in banks by their customers is as buoyant as

ever. It does not depend, therefore, on a psychological loss of faith in the banks. This vital restraint is simply

the limited clientele of each bank. In short, the Rothbard Bank (or the Jones Bank) is constrained, first, by

the fear of a bank run (loss of confidence in the bank by its own customers); but it is also, and even more

effectively, constrained by the very fact that, in the free market, the clientele of the [p. 115] Rothbard Bank is

extremely limited. The day-to-day constraint on banks under free banking is the fact that nonclients will, by definition, call upon the bank for redemption.

Let us see how this process works. Let us hark back to Figures 7.2 and 7.3 where the Rothbard Bank

has had $50,000 of gold coin or government paper deposited in it, and then proceeded to pyramid on top of

that $50,000 by issuing $80,000 more of fake warehouse receipts and lending them out to Smith. The

Rothbard Bank has thereby increased the money supply in its own bailiwick from $50,000 to $130,000, and

its fractional reserve has fallen from 100°/o to 5/13. But the important point to note now is that this process

does not stop there. For what does Smith do with his $80,000 of new money? We have already mentioned

that new money ripples out from its point of injection: Smith clearly does not sit on the money. He spends it on

more equipment or labor or on more consumer goods. In any case, he spends it. But what happens to the

credit status of the money? That depends crucially on whether or not the person Smith spends the money on is

himself a customer of the Rothbard Bank.

Let us assume, as in Figure 8.1, that Smith takes the new receipts and spends them on equipment

made by Jones, and that Jones, too, is a client of the Rothbard Bank. In that case, there is no pressure on the

Rothbard Bank, and the inflationary credit expansion proceeds without difficulty. Figure 8.1 shows what

happens to the Rothbard Bank’s balance sheet {to simplify, let us assume that the loan to Smith was in the

form of demand deposits).

Figure 8.1 A Bank with Many Clients [p. 116]

Thus, total liabilities, or demand deposits, remain what they were after the immediate loan to Smith.

Fifty thousand dollars is owed to the original depositors of gold (and/or to people who sold goods or services

to the original depositors for gold); Smith has written a check for his $80,000 for the purchase of equipment

from Jones, and Jones is now the claimant for the $80,000 of demand deposits. Total demand deposits for the

Rothbard Bank have remained the same. Moreover, all that has happened, from the Rothbard Bank’s point of

view, is that deposits have been shuffled around from one of its clients to another. So long, then, as confidence

is retained by its depositors in the Rothbard Bank, it can continue to expand its operations and its part of the

money supply with impunity.

But—and here is the rub—suppose that Jones is not a client of the Rothbard Bank. After all, when

Smith borrows money from that bank he has no interest in patronizing only fellow clients of his bank. He wants

to invest or spend the money in ways most desirable or profitable to himself. In a freely competitive banking

system, there is no guarantee—indeed not even a likelihood—that Jones, or the person whom Jones will

spend the money on, will himself be a client of the Rothbard Bank.

Suppose, then, that Jones is not a client of the Rothbard Bank. What then? Smith gives a check (or a note) to Jones for the equipment for $80,000. Jones, not being a client of the Rothbard Bank, will therefore

call upon the Rothbard Bank for redemption. But the Rothbard Bank doesn’t have the money; it has only

$50,000; it is $30,000 short, and therefore the Rothbard Bank is now bankrupt, out of business.

The beauty and power of this restraint on the banks is that it does not depend on loss of confidence in

the banks. Smith, Jones, and everyone else can go on being blithely ignorant and trusting of the fractional

reserve banking system. And yet the redemption weapon does its important work. For Jones calls [p. 117] on

the Rothbard Bank for redemption, not because he doesn’t trust the bank or thinks it is going to fail, but

simply because he patronizes another bank and wants to shift his account to his preferred bank. The mere

existence of bank competition will provide a powerful, continuing, day-to-day constraint on frac tional reserve

credit expansion. Free banking, even where fractional reserve banking is legal and not punished as fraud, will

scarcely permit fractional reserve inflation to exist, much less to flourish and proliferate. Free banking, far from

leading to inflationary chaos, will insure almost as hard and noninflationary a money as 100% reserve banking

itself.

In practice, the concrete method by which Jones insists on redemption in order to shift his account

from the Rothbard Bank to his own can take several forms, each of which have the same economic effects.

Jones can refuse to take Smith’s check, insisting on cash, so that Smith becomes the redeemer of his own

deposits. Jones—if the Rothbard Bank could supply him with the gold—could then deposit the gold in his own

bank. Or Jones himself could arrive at the Rothbard Bank and demand redemption. In practice, of course,

Jones would not bother, and would leave these financial affairs to his own bank, which would demand

redemption. In short, Jones would take Smith’s check, made out to him on the account of the Rothbard Bank,

and deposit it in his own bank, getting a demand deposit there for the amount deposited. Jones’s bank would

take the check and demand redemption from the Rothbard Bank. The Rothbard Bank would then have to

confess it could not pay, and would hence go out of business.

Figure 8.2 shows how this process works. We assume that Jones’s account is in the Boonville Bank.

We do not bother showing the complete balance sheet of the Boonville Bank because it is irrelevant to our

concerns, as is the soundness of the bank. [p. 118]

Figure 8.2 Redemption by Another Bank

Thus, we see that dynamically from this transaction, the Boonville Bank finds itself with an increased demand deposit owed to Jones of $80,000, balanced by a check on the Rothbard Bank for $80,000. When it

cashes the check for redemption, it puts such a severe redemption pressure on the Rothbard Bank that the

latter goes bankrupt.

Why should the Boonville Bank call upon the Rothbard Bank for redemption? Why should it do

anything else? The banks are competitors not allies. The banks either pay no interest on their demand

deposits—the usual situation—or else the interest will be far lower than the interest they themselves can earn

on their loans. The longer the Boonville Bank holds off on redemption the more money it loses. Furthermore,

as soon as it obtains the gold, it can try to pyramid bank credit on top of it. Banks therefore have everything to

lose and nothing to gain by holding up on redeeming notes or demand deposits from other banks.

It should be clear that the sooner the borrowers from an expanding bank spend money on products of

clients of other banks—in short, as soon as the new money ripples out to other banks—the issuing bank is in

big trouble. For the sooner and the more intensely clients of other banks come into the picture, the sooner will

severe redemption pressure, even unto bankruptcy, [p. 119] hit the expanding bank. Thus, from the point of

view of checking inflation, the more banks there are in a country, and therefore the smaller the clientele of

each bank, the better. If each bank has only a few customers, any expanded warehouse receipts will pass

over to nonclients very quickly, with devastating effect and rapid bankruptcy. On the other hand, if there are

only a few banks in a country, and the clientele of each is extensive, then the expansionary process could go on

a long time, with clients shuffling notes and deposits to one another within the same bank, and the inflationary

process continuing at great length. The more banks, and the fewer the clientele of each, then, the less room

there will be for fractional reserve inflation under free banking. If there are a myriad of banks, there may be no

room at all to inflate; if there are a considerable but not great number, there will be more room for inflation, but

followed fairly quickly by severe redemption pressure and en forced contraction of loans and bank credit in

order to save the banks. The wider the number of clients, the more time it will take for the money to ripple out

to other banks; on the other hand, the greater the degree of inflationary credit expansion, the faster the rippling

out and hence the swifter the inevitable redemption, monetary contraction, and bank failures.

Thus, we may consider a spectrum of possibilities, depending on how many competing banks there are

in a country. At one admittedly absurd pole, we may think of each bank as having only one client; in that case,

of course, there would be no room whatever for any fractional reserve credit. For the bor rowing client would

immediately spend the money on somebody who would by definition be a client of another bank. Relaxing the

limits a bit to provide a myriad of banks with only a few clients each would scarcely allow much more room for

bank inflation. But then, as we assume fewer and fewer banks, each with a more and more extensive clientele,

there will be increasing room for credit expansion until a rippling out process enforces contraction, deflation,

and bank failures. Then, if there [p. 120] are only a few banks in a country, the limits on inflation will be

increasingly relaxed, and there will be more room for inflation, and for a subsequent business cycle of

contraction, deflation and bank failures following an inflationary boom.

Finally, we come to the case of one bank, in which we assume that for some reason, everyone in the

country is the client of a single bank, say the “Bank of the United States.” In that case, our limit disappears

altogether, for then all payments by check or bank note take place between clients of the same bank. There is

therefore no day-to-day clientele limit from the existence of other banks, and the only limit to this bank’s

expansion of inflationary credit is a general loss of confidence that it can pay in cash. For it, too, is subject to the overall constraint of fear of a bank run.

Of course we have been abstracting from the existence of other countries. There may be no clientele

limits within a country to its monopoly bank’s expansion of money and credit. But of course there is trade and

flows of money between countries. Since there is international trade and money flows between countries,

attenuated limits on inflationary bank credit still exist.

Let us see what happens when one country, say France, has a monopoly bank and it begins merrily to

expand the number of demand deposits and bank notes in francs. We assume that every country is on the gold

standard, that is, every country defines its currency as some unit of weight of gold. As the number of francs in

circulation increases, and as the French inflationary process continues, francs begin to ripple out abroad. That

is, Frenchmen will purchase more products or invest more in other countries. But this means that claims on the

Bank of France will pile up in the banks of other countries. As the claims pile up, the foreign banks will call

upon the Bank of France to redeem its warehouse receipts in gold, since, in the regular course of events,

German, Swiss or Ceylonese citizens or banks have no interest whatever in piling up claims to [p. 121] francs.

What they want is gold so they can invest or spend on what they like or pyramid on top of their own gold

reserves. But this means that gold will increasingly flow out of France to other countries, and pressure on the

Bank of France will be aggravated. For not only has its fractional reserve already de clined from the

pyramiding of more and more notes and deposits on top of a given amount of gold, but now the fraction is

declining even more alarmingly because gold is unexpectedly and increasingly flowing out of the coffers of the

Bank of France. Note again, that the gold is flowing out not from any loss of confidence in the Bank of France

by Frenchmen or even by foreigners, but simply that in the natural course of trade and in response to the

inflation of francs, gold is flowing out of the French bank and into the banks of other countries.

Eventually, the pressure of the gold outflow will force the Bank of France to contract its loans and

deposits, and deflation of the money supply and of bank credit will hit the French economy.

There is another aspect of this monetary boom-and-bust process. For with only one, or even merely a

few banks in a country, there is ample room for a considerable amount of monetary inflation. This means of

course that during the boom period, the banks expand the money supply and prices increase. In our current

case, prices of French products rise because of the monetary inflation and this will intensify the speed of the

gold outflow. For French prices have risen while prices in other countries have remained the same, since bank

credit expansion has not occurred there. But a rise in French prices means that French products become less

attractive both to Frenchmen and to foreigners. Therefore, foreigners will spend less on French products, so

that exports from France will fall, and French citizens will tend to shift their purchases from dearer domestic

products to relatively cheaper imports. Hence, imports into France will rise. Exports falling and imports rising

means of course a dread deficit in the balance of payments. This [p. 122] deficit is embodied in an outflow

of gold, since gold, as we have seen, is needed to pay for the rising imports. Specifically, gold pays for the

increased gap between rising imports and falling exports, since ordinarily exports provide sufficient foreign

currency to pay for imports.

Thus for all these reasons, inflationary bank credit expansion in one country causes prices to rise in that

country, as well as an outflow of gold and a deficit in the balance of payments to other countries. Eventually,

the outflow of gold and increasing demands on the French bank for redemption force the bank to contract

credit and deflate the money supply, with a resulting fall in French prices. In this recession or bust period, gold flows back in again, for two interconnected reasons. One, the contraction of credit means that there are fewer

francs available to purchase domestic or foreign products. Hence imports will fall. Second, the fall of prices at

home stimulates foreigners to buy more French goods, and Frenchmen to shift their purchase from foreign to

domestic products. Hence, French exports will rise and imports fall, and gold will flow back in, strengthening

the position of the Bank of France.

We have of course been describing the essence of the famous Hume-Ricardo “specie flow price

mechanism,” which explains how international trade and money payments work on the “classical gold

standard.” In particular, it explains the mechanism that places at least some limit on inflation, through price and

money changes and flows of gold, and that tends to keep international prices and the balance of payments of

each country in long-run equilibrium. This is a famous textbook analysis. But there are two vitally important

aspects of this analysis that have gone unnoticed, except by Ludwig von Mises. First, we have here not only a

theory of international money flows but also a rudimentary theory of the business cycle as a phenomenon

sparked by inflation and contraction of money and credit by the fractional reserve banking system.

Second, we should now be able to see that the Ricardian specie flow price process is one and the

same mechanism by [p. 123] which one bank is unable to inflate much if at all in a free banking system. For

note what happens when, say, the Rothbard Bank expands its credit and demand liabilities. If there is any

room for expansion at all, money and prices among Rothbard Bank clients rise; this brings about increased

demands for re demption among clients of other banks who receive the increased money. Gold outflows to

other banks from their pressure for redemption forces the Rothbard Bank to contract and deflate in order to

try to save its own solvency.

The Ricardian specie flow price mechanism, therefore, is simply a special case of a general

phenomenon: When one or more banks expand their credit and demand liabilities, they will lose gold (or, in the

case of banks within a country, government paper) to other banks, thereby cutting short the inflation ary

process and leading to deflation and credit contraction. The Ricardian analysis is simply the polar case where

all banks within a country can expand together (if there is only one monopoly bank in the country), and so the

redemption constraint on inflation only comes, relatively weakly, from the banks of other countries.

But couldn’t the banks within a country form a cartel, where each could support the others in holding

checks or notes on other banks without redeeming them? In that way, if banks could agree not to redeem each

other’s liabilities, all banks could inflate together, and act as if only one bank existed in a country. Wouldn’t a

system of free banking give rise to unlimited bank inflation through the formation of voluntary bank cartels?

Such bank cartels could be formed legally under free banking, but there would be every economic

incentive working against their success. No cartels in other industries have ever been able to succeed for any

length of time on the free market; they have only succeeded—in raising prices and restricting

production—when government has stepped in to enforce their decrees and restrict entry into the field. Similarly

in banking. Banks, after all, are competing with each other, and the tendency [p. 124] on the market will be for

inflating banks to lose gold to sounder, noninflating banks, with the former going out of business. The economic

incentives would cut against any cartel, for without it, the sounder, less inflated banks could break their inflated

competitors. A cartel would yoke these sounder banks to the fate of their shakier, more inflated colleagues.

Furthermore, as bank credit inflation proceeds, incentives would increase for the sound banks to break out of

the cartel and call for the redemption of the plethora of warehouse receipts pouring into their vaults. Why should the sounder banks wait and go down with an eventually sinking ship, as fractional reserves become

lower and lower? Second, an inflationary bank cartel would induce new, sound, near-100% reserve banks to

enter the industry, advertising to one and all their noninflationary operations, and happily earning money and

breaking their competitors by calling on them to redeem their inflated notes and deposits. So that, while a bank

cartel is logically possible under free banking, it is in fact highly unlikely to succeed.

We conclude that, contrary to propaganda and myth, free banking would lead to hard money and

allow very little bank credit expansion and fractional reserve banking. The hard rigor of redemption by one

bank upon another will keep any one bank’s expansion severely limited.

Thus, Mises was highly perceptive when he concluded that

It is a mistake to associate with the notion of free banking the image of a state of affairs

under which everybody is free to issue bank notes and to cheat the public ad libitum.

People often refer to the dictum of an anonymous American quoted by (Thomas)

Tooke: “free trade in banking is free trade in swindling.” However, freedom in the

issuance of banknotes would have narrowed down the use of banknotes considerably

if it had not entirely suppressed it. It was this idea which (Henri) Cernuschi advanced

in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that

what is called freedom of banking would result in a total suppression of banknotes in

France. I want to give everybody the right to issue banknotes so that nobody should

take any banknotes any longer.”3 [p. 125] [p. 126] [p. 127]