Books / Digital Text

Easing the Limits on Bank Credit Expansion

The institution of Central Banking eased the free-market restrictions on fractional-reserve banking in several ways. In the first place, by the mid-nineteenth century a “tradition” was craftily created that the Central Bank must always act as a “lender of last resort” to bail out the banks should the bulk of them get into trouble. The Central Bank had the might, the law, and the prestige of the State behind it; it was the depository of the State's accounts; and it had the implicit promise that the State regards the Central Bank as “too big to fail.” Even under the gold standard, the Central Bank note tended to be used, at least implicitly, as legal tender, and actual redemption in gold, at least by domestic citizens, was increasingly discouraged though not actually prohibited. Backed by the Central Bank and beyond it by the State itself, then, public confidence in the banking system was artificially bolstered, and runs on the banking system became far less likely.

Even under the gold standard, then, domestic demands for gold became increasingly rare, and there was generally little for the banks to worry about. The major problem for the bankers was international demands for gold, for while the citizens of, say, France, could be conned into not demanding gold for notes or deposits, it was difficult to dissuade British or German citizens holding bank deposits in francs from cashing them in for gold.

The Peel Act system insured that the Central Bank could act as a cartelizing device, and in particular to make sure that the severe free-market limits on the expansion of any one bank could be circumvented. In a free market, as we remember, if a Rothbard Bank expanded notes or deposits by itself, these warehouse receipts would quickly fall into the hands of clients of other banks, and these people or their banks would demand redemption of Rothbard warehouse receipts in gold. And since the whole point of fractional-reserve banking is not to have sufficient money to redeem the receipts, the Rothbard Bank would quickly go under. But if a Central Bank enjoys the monopoly of bank notes, and the commercial banks all pyramid expansion of their demand deposits on top of their “reserves,” or checking accounts at the Central Bank, then all the Bank need do to assure successful cartelization is to expand proportionately throughout the country, so that all competing banks increase their reserves, and can expand together at the same rate. Then, if the Rothbard Bank, for example, prints warehouse receipts far beyond, say triple, its reserves in deposits at the Central Bank, it will not, on net, lose reserves if all the competing banks are expanding their credit at the same rate. In this way, the Central Bank acts as an effective cartelizing agent.

But while the Central Bank can mobilize all the banks within a country and make sure they all expand the money-substitutes they create at the same rate, they once again have a problem with the banks of other countries. While the Central Bank of Ruritania can see to it that all the Ruritanian banks are mobilized and expand their credit and the money-supply together, it has no power over the banks or the currencies of other countries. Its cartelizing potential extends only to the borders of its own country.