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
125
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).
Martin Bank
Assets Equity & Liabilities
IOUs $4 million Demand deposits $5 million
Reserves = Demand
deposits at
Central Bank $1 million
Total Assets $5 million
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
126 The Mystery of Banking
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).
Martin Bank
Assets Equity & Liabilities
Demand deposits Demand deposits $500,000
at Central Bank $500,000
Central Bank
Assets Equity & Liabilities
Demand deposits
of Martin Bank -$500,000
Central Bank notes +$500,000
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
Central Banking: Removing the Limits 127
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.
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