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 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 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 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 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 percent 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

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 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 fractional 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 percent 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.

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.

FIGURE 8.2 — REDEMPTION BY ANOTHER BANK

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, 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 enforced 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 borrowing 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 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 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 declined 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 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 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 redemption 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 inflationary 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 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 percent reserve banks to enter the industry, advertising to one and all their non-inflationary 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

• 1This is not the place to investigate the problem whether bankruptcy laws confer a special privilege on the debtor to weasel out of his debts.
• 2From 1929 to 1933, the last year when runs were permitted to do their work of cleansing the economy of unsound and inflationary banks, 9,200 banks failed in the United States.
• 3Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), p. 443; Human Action, Scholar’s Edition (Auburn, Ala.: Ludwig von Mises Institute, 1998), p. 443.