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
IX
CENTRAL BANKING: REMOVING THE LIMITS
Free banking, then, will inevitably be a regime of hard money and virtually no inflation. In contrast, the essential purpose of central banking is to use government privilege to remove the limitations placed by free banking on monetary and bank credit inflation. The Central Bank is either government-owned and operated, or else especially privileged by the central government. In any case, the Central Bank receives from the government the monopoly privilege for issuing bank notes or cash, while other, privately-owned commercial banks are only permitted to issue demand liabilities in the form of checking deposits. In some cases, the government treasury itself continues to issue paper money as well, but classically the Central Bank is given the sole privilege of issuing paper money in the form of bank notes—Bank of England notes, Federal Reserve Notes, and so forth. If the client of a commercial bank wants to cash in his deposits for
paper money, he cannot then obtain notes from his own bank, for that bank is not permitted to issue them. His bank would have to obtain the paper money from the Central Bank. The bank could only obtain such Central Bank cash by buying it, that is, either by selling the Central Bank various assets it agrees to buy, or by drawing down its own checking account with the Central Bank.
For we have to realize that the Central Bank is a bankers’ bank. Just as the public keeps checking accounts with commercial banks, so all or at least most of them keep checking accounts with the Central Bank. These checking accounts, or “demand deposits at the Central Bank,” are drawn down to buy cash when the banks’ own depositors demand redemption in cash.
To see how this process works, let us take a commercial bank, the Martin Bank, which has an account at the Central Bank (Figure 9.1).
FIGURE 9.1 — CENTRAL BANKING
We are ignoring Central Bank notes kept for daily transactions in the Martin Bank’s vault, which will be a small fraction of its account with the Central Bank. Also, we see that the Martin Bank holds little or no gold. A vital feature of classical central banking is that even when the banking system remains on the gold standard, virtually all bank holdings of gold are centralized into the Central Bank.
In Figure 9.1, the Martin Bank is practicing fractional reserve banking. It has pyramided $5 million of warehouse receipts on top of $1 million of reserves. Its reserves consist of its checking account with the Central Bank, which are its own warehouse receipts for cash. Its fractional reserve is 1/5, so that it has pyramided 5:1 on top of its reserves.
Now suppose that depositors at the Martin Bank wish to redeem $500,000 of their demand deposits into cash. The only cash (assuming that they don’t insist on gold) they can obtain is Central Bank notes. But to obtain them, the Martin Bank has to go to the Central Bank and draw down its account by $500,000. In that case, the transactions are as follows (Figure 9.2).
FIGURE 9.2 — DRAWING DOWN RESERVES
In a regime of free banking, the more frequently that bank clients desire to shift from deposits to notes need not cause any change in the total money supply. If the customers of the Martin Bank were simply willing to shift $500,000 of demand liabilities from deposits to notes (or vice versa), only the form of the bank’s liabilities would change. But in this case, the need to go to the Central Bank to purchase notes means that Martin Bank reserves are drawn down by the same amount as its liabilities, which means that its fraction of reserves/deposits is lowered considerably. For now its reserves are $500,000 and its demand deposits $4.5 million, the fraction having fallen from 1/5 to 1/9. From the point of view of the Central Bank itself, however, nothing has changed except the form of its liabilities. It has $500,000 less owed to the Martin Bank in its demand deposits, and instead it has printed $500,000 of new Central Bank notes, which are now redeemable in gold to members of the public, who can cash them in through their banks or perhaps at the offices of the Central Bank itself.
If nothing has changed for the Central Bank itself, neither has the total money supply changed. For in the country as a whole, there are now $500,000 less of Martin Bank deposits as part of the money supply, compensated by $500,000 more in Central Bank notes. Only the form, not the total amount, of money has changed.
But this is only the immediate effect of the cashing in of bank deposits. For, as we have noted, the Martin Bank’s fraction of reserves/deposits has been sharply lowered. Generally, under central banking, a bank will maintain a certain fraction of reserves/deposits, either because it is legally forced to do so, as it is in the United States, or because that is the custom based on market experience. (Such a custom will also prevail—at significantly far higher fractions—under free banking.) If the Martin Bank wishes to or must remain at a fraction of 1/5, it will meet this situation by sharply contracting its loans and selling its assets until the 1/5 fraction is restored. But if its reserves are now down to $500,000 from $1,000,000, it will then wish to contract its demand deposits outstanding from $4.5 million to $2.5 million. It will do so by failing to renew its loans, by rediscounting its IOUs to other financial institutions, and by selling its bonds and other assets on the market. In this way, by contracting its holding of IOUs and deposits, it will contract down to $2.5 million. The upshot is shown in Figure 9.3.
But this means that the Martin Bank has contracted its contribution to the total money supply of the country by $2.5 million.
The Central Bank has $500,000 more in outstanding bank notes in the hands of the public, for a net decrease in the total money supply of $2 million. In short, under central banking, a demand for cash—and the subsequent issue of new cash—has the paradoxical effect of lowering the money supply, because of the banks’ need to maintain their reserve/deposit ratios. In contrast, the deposit of cash by the public will have the opposite inflationary effect, for the banks’ reserve/deposit ratio will rise, and the banks will be able to expand their loans and issues of new deposits. Figure 9.4 shows how this works. Let us take the original Martin Bank balance sheet of Figure 9.1. People decide to deposit $500,000 of their previously issued Central Bank notes and get the equivalent in checking accounts instead. The Martin Bank’s balance sheet will change as follows (Figure 9.4):
FIGURE 9.3 — ULTIMATE RESULT OF DRAWING DOWN RESERVES
FIGURE 9.4 — DEPOSITING CASH: PHASE I
But then, the Martin Bank will take this bonanza of cash and deposit it at the Central Bank, adding to its cherished account at the Central Bank, as shown in Figure 9.5:
FIGURE 9.5 — DEPOSITING CASH: PHASE II
But now, in Step 3, the banks will undoubtedly try to maintain their preferred 1/5 ratio. After all, excess reserves beyond the legal or customary fraction is burning a hole in the bank’s pocket; banks make money by creating new money and lending it out. After Step 2, the Martin Bank’s fractional reserve ratio is $1.5/$5.5, or a little over 27 percent, as compared to the preferred 20 percent. It will therefore expand its loans and issue new deposits until it is back down to its preferred 1/5 ratio. In short, it will pyramid 5:1 on top of its new total reserves of $1.5 million. The result will be Step 3 (Figure 9.6).
FIGURE 9.6 — DEPOSITING CASH: PHASE III
The Martin Bank has expanded its contribution to the money supply by $2.5 million over its original $5 million. As for the Central Bank, its own notes outstanding have declined by $500,000. This amount was received in cash from the Martin Bank, and the Martin Bank account at the Central Bank is credited by an increased $500,000 in return. The Central Bank notes themselves were simply retired and burned, since these obligations were returned to their issuer. The Central Bank balance sheet has changed as follows (Figure 9.7):
FIGURE 9.7 — DEPOSITING CASH: THE CENTRAL BANK
Thus, as a result of $500,000 of cash being deposited in the banks by the public, the Martin Bank has created $2.5 million in new bank deposits, the Central Bank has decreased its notes outstanding by $500,000, and the net result is a $2 million increase in the money supply. Again, paradoxically, a drop in paper money outstanding has led to a multiple expansion in the supply of money (paper money + bank demand deposits) in the country.
We should note, by the way, that the total money supply only includes money held by the public (demand deposits + Central Bank notes). It does not include demand deposits of the banks at the Central Bank or vault cash held by the banks, for this money is simply held in reserve against outstanding (and greater) components of the money supply. To include intrabank cash or deposits as part of the money supply would be double counting, just as it would have been double counting to include both gold in the banks and warehouse receipts for gold as part of the money supply. Warehouse receipts are surrogates for reserves, even when they are pyramided on top of them, so that reserves cannot also be included in an account of the supply of money.
Under central banking, then, the total supply of money, M, equals cash in the hands of the public plus demand deposits owned by the public. Cash, in turn,
consists of gold coin or bullion among the public, plus Central Bank notes. Or, putting this in equation form,
M = gold in public + Central Bank notes in public + Demand deposits of the commercial banks
When a nation is taken off the gold standard, gold dollars or francs are no longer part of the money supply, and so the money supply equation becomes (as it is in the United States and all other countries now):
M = Central Bank notes + Demand deposits
It is clear that, even under central banking, if the public is or becomes unwilling to hold any money in bank deposits or notes and insists on using only gold, the inflationary potential of the banking system will be severely limited. Even if the public insists on holding bank notes rather than deposits, fractional reserve bank expansion will be highly limited. The more the public is willing to hold checking accounts rather than cash, the greater the inflationary potential of the central banking system.
But what of the other limits on bank inflation that existed under free banking? True, the Central Bank—at least under the gold standard—can still go bankrupt if the public insists on cashing in their deposits and Central Bank paper for gold. But, given the prestige of the Central Bank conferred by government, and with government using the Central Bank for its own deposits and conferring the monopoly privilege of note issue, such bankruptcy will be most unlikely. Certainly the parameters of bank inflation have been greatly widened. Furthermore, in most cases government has conferred another crucial privilege on the Central Bank: making its notes legal tender for all debts in money. Then, if A has contracted with B for a debt of $10,000 in money, B has to accept payment in Central Bank notes; he cannot insist, for example, on gold. All this is important in propping up the Central Bank and its associated commercial banks.
The Mystery Of Banking Page 12
