Human Action: A Treatise on Economics

by Ludwig Von Mises

  The catallactically most important problems of the issuance of fiduciary media on the part of a single bank, or of banks acting in concert, the clientele of which comprehends all individuals, are not those of the limitations drawn to the amount of their issuance. We will deal with them in Chapter XX, devoted to the relations between the quantity of money and the rate of interest.

  At this point of our investigations we have to scrutinize the problem of the coexistence of a multiplicity of independent banks. Independence means that every bank in issuing fiduciary media follows its own course and does not act in concert with other banks. Coexistence means that every bank has a clientele which does not include all members of the market system. For the sake of simplicity we will assume that no individual or firm is a client of more than one bank. It would not affect the result of our demonstration if we were to assume that there are also people who are clients of more than one bank and people who are not clients of any bank.

  The question to be raised is not whether or not there are limits to the issuance of fiduciary media on the part of such independently coexisting banks. As there are even limits to the issuance of fiduciary media on the part of a unique bank the clientele of which comprises all people, it is obvious that there are such limits for a multiplicity of independently coexisting banks too. What we want to show is that for such a multiplicity of independently coexisting banks the limits are narrower than those drawn for a single bank with an unlimited clientele.

  We assume that within a market system several independent banks have been established in the past. While previously only money was in use, these banks have introduced the use of money-substitutes a part of which are fiduciary media. Each bank has a clientele and has issued a certain quantity of fiduciary media which are kept as moneysubstitutes in the cash holdings of various clients. The total quantity of the fiduciary media as issued by the banks and absorbed by the cash holdings of their clients has altered the structure of prices and the monetary unit's purchasing power. But these effects have already been consummated and at present the market is no longer stirred by any movements generated from this past credit expansion.

  But now, we assume further, one bank alone embarks upon an additional issue of fiduciary media while the other banks do not follow suit. The clients of the expanding bank—whether its old clients or new ones acquired on account of the expansion—receive additional credits, they expand their business activities, they appear on the market with an additional demand for goods and services, they bid up prices. Those people who are not clients of the expanding bank are not in a position to afford these higher prices; they are forced to restrict their purchases. Thus there prevails on the market a shifting of goods from the nonclients to the clients of the expanding bank. The clients buy more from the nonclients than they sell to them; they have more to pay to the nonclients than they receive from them. But money-substitutes issued by the expanding bank are not suitable for payments to nonclients, as these people do not assign to them the character of money-substitutes. In order to settle the payments due to nonclients, the clients must first exchange the money-substitutes issued by their own—viz., the expanding bank—against money. The expanding bank must redeem its banknotes and pay out its deposits. Its reserve—we suppose that only a part of the money-substitutes it had issued had the character of fiduciary media—dwindles. The instant approaches in which the bank will—after the exhaustion of its money reserve—no longer be in a position to redeem the moneysubstitutes still current. In order to avoid insolvency it must as soon as possible return to a policy of strengthening its money reserve. It must abandon its expansionist methods.

  This reaction of the market to a credit expansion on the part of a bank with a limited clientele has been brilliantly described by the Currency School. The special case dealt with by the Currency School referred to the coincidence of credit expansion on the part of one country's privileged central bank or of all banks of one country and of a nonexpansionist policy on the part of the banks of other countries. Our demonstration covers the more general case of the coexistence of a multiplicity of banks with different clientele as well as the most general case of the existence of one bank with a limited clientele in a system in which the rest of the people do not patronize any bank and do not consider any claims as money-substitutes. It does not matter, of course, whether one assumes that the clients of a bank live neatly separated from those of the other banks in a definite district or country or whether they live together with those of the other banks. These are merely differences in the data not affecting the catallactic problems involved.

  A bank can never issue more money-substitutes than its clients can keep in their cash holdings. The individual client can never keep a larger portion of his total cash holding in money-substitutes than that corresponding to the proportion of his turnover with other clients of his bank to his total turnover. For considerations of convenience he will, as a rule, remain far below this maximum proportion. Thus a limit is drawn to the issue of fiduciary media. We may admit that everybody is ready to accept in his current transactions indiscriminately banknotes issued by any bank and checks drawn upon any bank. But he deposits without delay with his own bank not only the checks but also the banknotes of banks of which he is not himself a client. In the further course his bank settles its accounts with the bank engaged. Thus the process described above comes into motion.

  A lot of nonsense has been written about a perverse predilection of the public for banknotes issued by dubious banks. The truth is that, except for small groups of businessmen who were able to distinguish between good and bad banks, banknotes were always looked upon with distrust. It was the special charters which the governments granted to privileged banks that slowly made these suspicions disappear. The often advanced argument that small banknotes come into the hands of poor and ignorant people who cannot distinguish between good and bad notes cannot be taken seriously. The poorer the recipient of a banknote is and the less familiar he is with bank a/fairs, the more quickly will he spend the note and the more quickly will it return, by way of retail and wholesale trade, to the issuing bank or to people conversant with banking conditions.

  It is very easy for a bank to increase the number of people who are ready to accept loans granted by credit expansion and paid out in an amount of money-substitutes. But it is very difficult for any bank to enlarge its clientele, that is, the number of people who are ready to consider these claims as money-substitutes and to keep them as such in their cash-holdings. To enlarge this clientele is a troublesome and slow process, as is the acquisition of any kind of good will. On the other hand, a bank can lose its clientele very quickly. If it wants to preserve it, it must never permit any doubt about its ability and readiness to discharge all its liabilities in due compliance with the terms of the contract. A reserve must be kept large enough to redeem all banknotes which a holder may submit for redemption. Therefore no bank can content itself with issuing fiduciary media only; it must keep a reserve against the total amount of money-substitutes issued and thus combine issuing fiduciary media and money-certificates.

  It was a serious blunder to believe that the reserve's task is to provide the means for the redemption of those banknotes the holders of which have lost confidence in the bank. The confidence which a bank and the money-substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence, the rest of them lose it too. No bank issuing fiduciary media and granting circulation credit can fulfill the obligations which it has taken over in issuing money-substitutes if all clients are losing confidence and want to have their banknotes redeemed and their deposits paid back. This is an essential feature or weakness of the business of issuing fiduciary media and granting circulation credit. No system of reserve policy and no reserve requirements as enforced by the laws can remedy it. All that a reserve can do is to make it possible for the bank to withdraw from the market an excessive amount of fiduciary
media issued. If the bank has issued more banknotes than its clients can use in doing business with other clients, it must redeem such an excess.

  The laws which compelled the banks to keep a reserve in a definite ratio of the total amount of deposits and of banknotes issued were effective in so far as they restricted the increase in the amount of fiduciary media and of circulation credit. They were futile as far as they aimed at safeguarding, in the event of a loss of confidence, the prompt redemption of the banknotes and the prompt payment of deposits.

  The Banking School failed entirely in dealing with these problems. It was confused by a spurious idea according to which the requirements of business rigidly limit the maximum amount of convertible banknotes that a bank can issue. They did not see that the demand of the public for credit is a magnitude dependent on the banks' readiness to lend, and that banks which do not bother about their own solvency are in a position to expand circulation credit by lowering the rate of interest below the market rate. It is not true that the maximum amount which a bank can lend if it limits its lending to discounting short-term bills of exchange resulting from the sale and purchase of raw materials and half-manufactured goods, is a quantity uniquelydetermined by the state of business and independent of the bank's policies. This quantity expands or shrinks with the lowering or raising of the rate of discount. Lowering the rate of interest is tantamount to increasing the quantity of what is mistakenly considered as the fair and normal requirements of business.

  The Currency School gave a quite correct explanation of the recurring crises as they upset English business conditions in the 'thirties and 'forties of the nineteenth century. There was credit expansion on the part of the Bank of England and the other British banks and bankers, while there was no credit expansion, or at least not to the same degree, in the countries with which Great Britain traded. The external drain occurred as the necessary consequence of this state of affairs. Everything that the Banking School advanced in order to refute this theory was vain. Unfortunately, the Currency School erred in two respects. It never realized that the remedy it suggested, namely strict legal limitation of the amount of banknotes issued beyond the specie reserve, was not the only one. It never gave a thought to the idea of free banking. The second fault of the Currency School was that it failed to recognize that deposits subject to check are money-substitutes and, as far as their amount exceeds the reserve kept, fiduciary media, and consequently no less a vehicle of credit expansion than are banknotes. It was the only merit of the Banking School that it recognized that what is called deposit currency is a moneysubstitute no less than banknotes. But except for this point, all the doctrines of the Banking School were spurious. It was guided by contradictory ideas concerning money's neutrality; it tried to refute the quantity theory of money by referring to a deus ex machina, the much talked about hoards, and it misconstrued entirely the problems of the rate of interest.

  It must be emphasized that the problem of legal restrictions upon the issue of fiduciary media could emerge only because governments had granted special privileges to one or several banks and had thus prevented the free evolution of banking. If the governments had never interfered for the benefit of special banks, if they had never released some banks from the obligation, incumbent upon all individuals and firms in the market economy, to settle their liabilities in full compliance with the terms of the contract, no bank problem would have come into being. The limits which are drawn to credit expansion would have worked effectively. Considerations of its own solvency would have forced every bank to cautious restraint in issuing fiduciary media. Those banks which would not have observed these indispensable rules would have gone bankrupt, and the public, warned through damage, would have become doubly suspicious and reserved.

  The attitudes of the European governments and their satellites with regard to banking were from the beginning insincere and mendacious. The pretended solicitude for the nation's welfare, for the public in general, and for the poor ignorant masses in particular was a mere blind. The governments wanted inflation and credit expansion, they wanted booms and easy money. Those Americans who twice succeeded in doing away with a central bank were aware of the dangers of such institutions; it was only too bad that they failed to see that the evils they fought were present in every kind of government interference with banking. Today even the most bigoted étatists cannot deny that all the alleged evils of free banking count little when compared with the disastrous effects of the tremendous inflations which the privileged and government-controlled banks have brought about.

  It is a fable that governments interfered with banking in order to restrict the issue of fiduciary media and to prevent credit expansion. The idea that guided governments was, on the contrary, the lust for inflation and credit expansion. They privileged banks because they wanted to widen the limits drawn to credit expansion by conditions prevailing on the unhampered market or because they were eager to open to the treasury a source of revenue. For the most part both of these considerations motivated the authorities. They were convinced that the fiduciary media are an efficient means of lowering the rate of interest, and asked the banks to expand credit for the benefit of both business and the treasury. Only when the undesired effects of credit expansion became visible, were laws enacted to restrict the issue of banknotes—and sometimes also of deposits—not covered by specie. The establishment of free banking was never seriously considered precisely because it would have been too efficient in restricting credit expansion. For rulers, writers, and the public were unanimous in the belief that business has a fair claim to a “normal” and “necessary” amount of circulation credit and that this amount could not be attained under free banking.17

  Many governments never looked upon the issuance of fiduciary media from a point of view other than that of fiscal concerns. In their eyes the foremost task of the banks was to lend money to the treasury. The money-substitutes were pacemakers for governmentissued paper money. The convertible banknote was merely a first step on the way to the nonredeemable banknote. With the progress of statolatry and the policy of interventionism these ideas have become general and are no longer questioned by anybody. No government is willing today to give any thought to the program of free banking because no government wants to renounce what it considers a handy source of revenue. What is called today financial war preparedness is merely the ability to procure by means of privileged and government-controlled banks all the money a warring nation may need. Radical inflationism, although not admitted explicitly, is an essential feature of the economic ideology of our age.

  But even at the time liberalism enjoyed its highest prestige and governments were more eager to preserve peace and well-being than to foment war, death, destruction, and misery, people were biased in dealing with the problems of banking. Outside of the Anglo-Saxon countries public opinion was convinced that it is one of the main tasks of good government to lower the rate of interest and that credit expansion is the appropriate means for the attainment of this end.

  Great Britain was free from these errors when in 1844 it reformed its bank laws. But the two shortcomings of the Currency School vitiated this famous act. On one hand, the system of government interference with banking was preserved. On the other hand, limits were placed only on the issuance of banknotes not covered by specie. The fiduciary media were suppressed only in the shape of banknotes.

  They could thrive as deposit currency.

  In carrying the idea implied in the Currency Theory to its full logical conclusion, one could suggest that all banks be forced by law to keep against the total amount of money-substitutes (banknotes plus demand deposits) a 100 per cent money reserve. This is the core of Professor Irving Fisher's 100 per cent plan. But Professor Fisher combined his plan with his proposals concerning the adoption of an index-number standard. It has been pointed out already why such a scheme is illusory and tantamount to open approval of the government's power to manipulate purchasing power according to the appetites of powerful pressure gro
ups. But even if the 100 per cent reserve plan were to be adopted on the basis of the unadulterated gold standard, it would not entirely remove the drawbacks inherent in every kind of government interference with banking. What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract. If banks are preserved as privileged establishments subject to special legislative provisions, the tool remains that governments can use for fiscal purposes. Then every restriction imposed upon the issuance of fiduciary media depends upon the government's and the parliament's good intentions. They may limit the issuance for periods which are called normal. The restriction will be withdrawn whenever a government deems that an emergency justifies resorting to extraordinary measures. If an administration and the party backing it want to increase expenditure without jeopardizing their popularity through the imposition of higher taxes, they will always be ready to call their impasse an emergency. Recourse to the printing press and to the obsequiousness of bank managers, willing to oblige the authorities regulating their conduct of affairs, is the foremost means of governments eager to spend money for purposes for which the taxpayers are not ready to pay higher taxes.

  Free banking is the only method available for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular—one is tempted to say normal—feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.