Economists debate whether Ludwig von Mises advocated free banking or 100 percent reserve banking. This debate is significant. Mises states, “the institution of credit expansion … may be called the most important economic problem of our age.”1 Given this statement, he must have viewed the solution to the problem as an extremely serious matter. Free bankers insist that Mises’s solution was free banking. In reality, Mises advocated 100 percent reserve banking.
On June 14, 1912, Mises published his seminal work The Theory of Money and Credit. In that book, Mises shows that fractional reserve banking has four fundamental economic consequences:
1. Fractional reserve banking causes price inflation.
2. Fractional reserve banking causes wealth redistribution.
3. Fractional reserve banking is the cause of systemic banking panics.
4. Fractional reserve banking is the cause of the business cycle.
Mises advocates the legal prohibition of fractional reserve banking in The Theory of Money and Credit. Specifically, he recommends legislation that extends Peel’s Act of 1844 to bank deposits. This “legislative prohibition” would establish a rigid 100 percent reserve for all future notes and deposits.
Fiduciary media are scarcely different in nature from money … Hence, they should logically be subjected to the same principles that have been established with regard to money proper; the same attempts should be made in their case as well to eliminate as far as possible human influence on the exchange ratio between money and other economic goods…. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel’s Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition.2
In 1913, Mises published a paper called The General Rise in Prices in the Light of Economic Theory. This was his first major paper on money and banking after The Theory of Money and Credit. He concludes,
As I have explained [in The Theory of Money and Credit], there is a serious danger for the future of the individualistic organization of the economy in the development of fiduciary media; if the legislature does not put some obstacle in the way of its expansion, an unrestrained inflation could easily come about, the destructive effects of which cannot really be imagined. Even if we ignore this, as yet, not immediate threat, there is sufficient risk from the very nature of the system of fiduciary media…. it would be desirable to put an end to the artificial expansion of fiduciary media. It would not only slow down the rate of devaluation [price inflation], but it would also be the best way of preventing economic crises.3
Mises makes three significant points in this neglected passage. First, Mises considered fractional reserve banking a serious danger to capitalism. This was a constant theme in all his writings on money and banking for five decades. Second, Mises thought the “legislature” should “put an end” to fractional reserve banking. In other words, he wanted limitations on fractional reserve banking to be enshrined in law. Third, he notes that putting an end to fractional reserve banking will prevent the business cycle.
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Germany and Austria experienced hyperinflation after the First World War. In 1923, Mises was invited to write an expert report on monetary stabilization. His report was titled Stabilization of the Monetary Unit – From the Viewpoint of Theory. Following The Theory of Money and Credit, his proposal was based on Peel’s Act.
The bedrock and cornerstone of the provisional new monetary system must be the absolute prohibition of the issue of any additional notes not completely covered by gold…. There must be absolutely no expansion above this maximum under any circumstances…. As may be seen, this constitutes acceptance of the leading principle of Peel’s Bank Act.4
In 1928, Mises wrote a long piece called Monetary Stabilization and Cyclical Policy. Like The Theory of Money and Credit, this paper recommends the legal prohibition of fractional reserves by extending Peel’s Act to bank deposits. Moreover, he argues that eliminating the business cycle is essential, and 100 percent banking alone will eradicate destructive booms and busts.
The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market. That means a return to the theory of the Currency school, which sought to suppress all future expansion of circulation credit and thus all further creation of fiduciary media .… it means the introduction of a new program based on the old Currency school theory, but expanded in the light of the present state of knowledge to include fiduciary media issued in the form of bank deposits…. That would mean a complete reorganization of central bank legislation. The banks of issue would have to return to the principles of Peel’s Bank Act, but with the provisions expanded to cover also bank balances subject to check…. By this act alone, cyclical policy would be directed in earnest toward the elimination of crises.5
The Chicago school of economics emerged during the early 1930s with the Chicago Plan.6 The Chicago Plan was produced by a group of economists at the University of Chicago: Henry C. Simons, Frank Knight, Lloyd Mints, Aaron Director, Henry Schultz, Paul H. Douglas, Garfield V. Cox, and Albert G. Hart. The Chicago Plan aimed at reforming the American banking system by legally requiring 100 percent reserves. It proposed “the outright abolition of deposit banking on the fractional-reserve principle.”7 Irving Fisher was the most zealous proponent and developer of the 100 percent reserve Chicago Plan, and over 230 other American economists eventually supported the proposal.8 In short, the Chicago school of economics has its origins in the 100 percent reserve banking movement.9
Albert G. Hart helped produce the Chicago Plan, and he wrote a 1935 paper called The “Chicago Plan” of Banking Reform. In a footnote on the first page, Hart references Mises’s Monetary Stabilization and Cyclical Policy, and he acknowledges that Mises advocated 100 percent reserves.10 Moreover, Hart credits this insight to Friedrich Hayek, meaning Hayek considered Mises a 100 percent reserve banker. Finally, in his book 100% Money, Fisher includes an appendix listing other works related to 100 percent banking. Fisher refers to The Theory of Money and Credit and Monetary Stabilization and Cyclical Policy.11 All this shows that, in the 1930s, economists in the 100 percent reserve banking movement recognized that Mises endorsed 100 reserves.
Mises supported the 100 percent reserve plan as the solution to the monetary problems created by the Second World War. In 1944, he wrote a monograph called A Noninflationary Proposal for Postwar Monetary Reconstruction. He calls for a monetary system with a 100 percent reserve banking system: “reform has to consist of the adoption of a rigid 100 percent reserve plan.”12 Actually, he argues 100 percent banking is the only viable solution: “It is illusory to expect that any method other than the one hundred percent reserve plan could possibly work under postwar conditions.”13
Again, eliminating the business cycle is essential to Mises: “What the 100 percent reserve scheme, as defined above, aims at is the prevention of credit expansion…. What is needed is the elimination of the business cycle. Not stability of prices, but stability of the trend of business is desirable.”14 Mises wanted to abolish the business cycle, and he advocated the 100 percent plan to accomplish this goal.
In Human Action, Mises argues the business cycle cannot occur without fractional reserve banking: “in the absence of such a credit expansion no boom could emerge.”15 He repeats, “the upswing is invariably conditioned by credit expansion…. it could not come into being and continue without credit expansion.” Finally, “If a bank does not expand circulation credit by issuing additional fiduciary media (either in the form of banknotes or in the form of deposit currency), it cannot generate a boom.”16
Free bankers often deny that fractional reserve systems are inherently unstable.17 However, in Human Action, Mises stresses the inherent instability of fractional reserve banking: “th[ere] is an essential feature or weakness of the business of issuing fiduciary media.”18 He says, “One must not forget that every bank issuing fiduciary media is in a rather precarious position.”19 Mises argued that fractional reserve banks are inherently unstable, and this contradicts the free banking position.
Free bankers argue that fractional reserve banking will not cause the business cycle in an economy with free banking.20 Mises disagrees. He argues there will be a business cycle in any economy with fractional reserves: “The notion of ‘normal’ credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle.”21 He explicitly states, “every expansion of credit must bring about the boom.”22
Free bankers assert that the central bank causes the business cycle, not the fractional reserve banks.23 Mises did not hold this view. He declares in a 1951 lecture, “No boom is possible without credit expansion.”24 But his emphasis is expansion by the banks, not the central bank: “To eliminate the depression the preceding boom and credit expansion by the banks must be eliminated.”25 He continues, “the boom which causes the following depression could not occur if the banks did not expand credit. Therefore, one would think the solution would be easy—we have only to prevent the banks from expanding credit.”26 Mises attributes the cycle to fractional reserve banks, not the central bank. Unlike free bankers, Mises argued any fractional reserve banking causes the business cycle, with or without a central bank.
Mises wrote an appendix to The Theory of Money and Credit in 1952. He advocates the same policy he endorsed in 1912. Specifically, Mises wants every bank to hold 100 percent reserves on all future notes and deposits.
No bank must be permitted to expand the total amount of its deposits subject to check or the balance of such deposits of any individual customer, be he a private citizen or the U.S. Treasury, otherwise than by receiving cash deposits in legal-tender banknotes from the public or by receiving a check payable by another domestic bank subject to the same limitations. This means a rigid 100 percent reserve for all future deposits.27
Mises delivered a series of lectures in 1952 called Marxism Unmasked. In these lectures, he describes fractional reserve banking as a “very questionable business.”28 This neglected lecture contains indisputable evidence that Mises was an advocate of 100 percent reserve banking:
for the future there should be no more credit expansion. In the future no additional banknotes should be issued, no additional credit should be entered on a bank account subject to check, unless there is 100 percent coverage in money. This is the 100-percent plan…. no more credit expansion!29
- 1Marxism Unmasked: From Delusion to Destruction (Irvington-on-Hudson, NY: Foundation for Economic Education, [1952] 2006), p. 63.
- 2The Theory of Money and Credit (Indianapolis: Liberty Fund, [1912] 1980), pp. 446-47.
- 3“The General Rise in Prices in the Light of Economic Theory,” In Selected Writings of Ludwig von Mises, Vol. 1, 131-55 (Indianapolis: Liberty Fund, 2012), p. 155.
- 4On the Manipulation of Money and Credit (Indianapolis: Liberty Fund, [1978] 2011), pp. 39-40.
- 5On the Manipulation of Money and Credit (Indianapolis: Liberty Fund, [1978] 2011), pp. 148-49.
- 6According to Lloyd Mints, “the Chicago School began formally in November 1933, when several faculty member signed the tract on ‘Banking and Currency Reform.’” Quoted in “In Memoriam: Lloyd W. Mints, 1888-1989: Pioneer Monetary Economist,” R.D. Peterson and R.J. Phillips, The American Economist (vol. 35, no. 1, 1991), p. 80.
- 7“Banking and Currency Reform,” Research in the History of Economic Thought and Methodology , Archival Supplement 4, 31-40 (Greenwich, CT: JAI Press, 1994), p. 32.
- 8A Program for Monetary Reform , I. Fisher (Unpublished, 1939).
- 9Ross B. Emmett writes, “If there was a self-conscious ‘Chicago School’, it began with the publication of the 1932 ‘Chicago Plan.’” The Chicago Tradition in Economics, 1892-1945 (New York: Routledge, 2002), p. ix.
- 10“The Chicago Plan of Banking Reform,” A.G. Hart, The Review of Economic Studies (vol. 2, no. 2, 1935), p. 104n3.
- 11100% Money (New York: Adelphi Company, 1936), p. 221.
- 12“A Noninflationary Proposal for Postwar Monetary Reconstruction,” In Selected Writings of Ludwig von Mises, Vol. 3, 71-118 (Indianapolis: Liberty Fund, 2000), p. 105.
- 13Ibid, p. 108.
- 14Ibid, p. 107.
- 15Human Action (Auburn, AL: Ludwig von Mises Institute, [1949] 1998), p. 552.
- 16Ibid, p. 789n5.
- 17For example, Selgin argues, “fractional-reserve banking systems are not inherently weak or unstable.” Bank Deregulation and Monetary Order (New York: Routledge, 1996), p. 207.
- 18Human Action (Auburn, AL: Ludwig von Mises Institute, [1949] 1998), p. 436.
- 19Ibid, p. 444.
- 20George Selgin and Lawrence White write, “We deny that an increase in fiduciary media matched by an increased demand to hold fiduciary media is disequilibrating or sets into motion the Austrian business cycle.” “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians!” The Review of Austrian Economics (vol. 9, no. 2, 1996), pp. 102-03.
- 21Ibid, p. 439n17.
- 22Ibid, p. 552.
- 23Selgin claims at 30:20 in a debate, “why do we have boom-bust cycles? Well, we have them mostly because of central banks.” He continues at 31:30, “fractional reserve banks aren’t to blame for malinvestment, they play a crucial role in avoiding underinvestment.” Available at: https://reason.com/video/fractional-reserve-banking-murphy-selgin/
- 24The Free Market and Its Enemies: Pseudo-Science, Socialism, and Inflation (Irvington-on-Hudson, N.Y: Foundation for Economic Education, [1951] 2004), p. 76.
- 25Ibid, p. 65.
- 26Ibid, p. 67.
- 27For example, Selgin argues, “fractional-reserve banking systems are not inherently weak or unstable.” Bank Deregulation and Monetary Order (New York: Routledge, 1996), p. 207.
- 28Marxism Unmasked: From Delusion to Destruction (Irvington-on-Hudson, NY: Foundation for Economic Education, [1952] 2006), p. 63.
- 29Ibid, pp. 74-75.
