FREE BANKING AND THE LIMITS ON BANK CREDIT INFLATION

et 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.
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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.
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.
112 The Mystery of Banking
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
Free Banking and the Limits on Bank Credit Inflation 113
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.
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.