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D. The Limits of Credit Expansion
Having investigated the consequences of credit expansion, we must discuss the important question: If fractional-reserve banking is legal, are there any natural limits to credit expansion by the banks? The one basic limit, of course, is the necessity of the banks to redeem their money-substitutes on demand. Under a gold or silver standard, they must redeem in specie; under a government fiat paper standard (see below), the banks have to redeem in government paper. In any case, they must redeem in standard money or its virtual equivalent. Therefore, every fractional reserve bank depends for its very existence on persuading the public—specifically its clients—that all is well and that it will be able to redeem its notes or deposits whenever the clients demand. Since this is palpably not the case, the continuance of confidence in the banks is something of a psychological marvel.117 It is certain, at any rate, that a wider knowledge of praxeology among the public would greatly weaken confidence in the banking system. For the banks are in an inherently weak position. Let just a few of their clients lose confidence and begin to call on the banks for redemption, and this will precipitate a scramble by other clients to make sure that they get their money while the banks’ doors are still open. The obvious—and justifiable—panic of the banks should any sort of “run” develop encourages other clients to do the same and aggravates the run still further. At any rate, runs on banks can wreak havoc, and, of course, if pursued consistently, could close every bank in the country in a few days.118
Runs, therefore, and the constant underlying threat of their occurrence, are one of the prime limits to credit expansion. Runs often develop during a business cycle crisis, when debts are being defaulted and failures become manifest. Runs and the fear of runs help to precipitate deflationary credit contraction.
Runs may be an ever-present threat, but, as effective limitations, they are not generally active. When they do occur, they usually wreck the banks. The fact that a bank is in existence at all signifies that a run has not developed. A more active, everyday limitation is the relatively narrow range of a bank's clientele. The clientele of a bank consists of those people willing to hold its deposits or notes (its money-substitutes) in lieu of money proper. It is an empirical fact, in almost all cases, that one bank does not have the patronage of all people in the market society or even of all those who prefer to use bank money rather than specie. It is obvious that the more banks exist, the more restricted will be the clientele of any one bank. People decide which bank to use on many grounds; reputation for integrity, friendliness of service, price of service, and convenience of location may all play a part.
How does the narrow range of a bank's clientele limit its potentiality for credit expansion? The newly issued money-substitutes are, of course, loaned to a bank's clients. The client then spends the new money on goods and services. The new money begins to be diffused throughout the society. Eventually—usually very quickly—it is spent on the goods or services of people who use a different bank. Suppose that the Star Bank has expanded credit; the newly issued Star Bank's notes or deposits find their way into the hands of Mr. Jones, who uses the City Bank. Two alternatives may occur, either of which has the same economic effect: (a) Jones accepts the Star Bank's notes or deposits, and deposits them in the City Bank, which calls on the Star Bank for redemption; or (b) Jones refuses to accept the Star Bank's notes and insists that the Star client—say Mr. Smith—who bought something from Jones, redeem the note himself and pay Jones in acceptable standard money.
Thus, while gold or silver is acceptable throughout the market, a bank's money-substitutes are acceptable only to its own clientele. Clearly, a single bank's credit expansion is limited, and this limitation is stronger (a) the narrower the range of its clientele, and (b) the greater its issue of money-substitutes in relation to that of competing banks. In illustration of the first point, let us assume that each bank has only one client. Then it is obvious that there will be very little room for credit expansion. At the opposite extreme, if one bank is used by everybody in the economy, there will be no demands for redemption resulting from its clients’ purchasing from nonclients. It is obvious that, ceteris paribus, a numerically smaller clientele is more restrictive of credit expansion.
As regards the second point, the greater the degree of relative credit expansion by any one bank, the sooner will the day of redemption—and potential bankruptcy—be at hand. Suppose that the Star Bank expands credit, while none of the competing banks do. This means that the Star Bank's clientele have added considerably to their cash balances; as a result the marginal utility to them of each unit of money to hold declines, and they are impelled to spend a great proportion of the new money. Some of this increased spending will be on one another's goods and services, but it is clear that the greater the credit expansion, the greater will be the tendency for their spending to “spill over” onto the goods and services of nonclients. This tendency to spill over, or “drain,” is greatly enhanced when increased spending by clients on the goods and services of other clients raises their prices. In the meanwhile, the prices of the goods sold by non-clients remain the same. As a consequence, clients are impelled to buy more from nonclients and less from one another; while nonclients buy less from clients and more from one another. The result is an “unfavorable” balance of trade from clients to nonclients.119 It is clear that this tendency of money to seek a uniform level of exchange value throughout the entire market is an example of the process by which new money (in this case, new money-substitutes) is diffused through the market. The greater the relative credit expansion by the bank, then, the greater and more rapid will be the drain and consequent pressure on an expanding bank for redemption.
The purpose of banks’ keeping any specie reserves in their vaults (assuming no legal reserve requirements) now becomes manifest. It is not to meet bank runs—since no fractional-reserve bank can be equipped to withstand a run. It is to meet the demands for redemption which will inevitably come from nonclients.
Mises has brilliantly shown that a subdivision of this process was discovered by the British Currency School and by the classical “international trade” theorists of the nineteenth century. These older economists assumed that all the banks in a certain region or country expanded credit together. The result was a rise in the prices of goods produced in that country. A further result was an “unfavorable” balance of trade, i.e., an outflow of standard specie to other countries. Since other countries did not patronize the expanding country's banks, the consequence was a “specie drain” from the expanding country and increased pressure for redemption on its banks.
Like all parts of the overstressed and overelaborated theory of “international trade,” this analysis is simply a special subdivision of “general” economic theory. And cataloging it as “international trade” theory, as Mises has shown, underestimates its true significance.120,121
Thus, the more freely competitive and numerous are the banks, the less they will be able to expand fiduciary media, even if they are left free to do so. As we have noted in chapter 11, such a system is known as “free banking.”122 A major objection to this analysis of free banking has been the problem of bank “cartels.” If banks get together and agree to expand their credits simultaneously, the clientele limitation vis-à-vis competing banks will be removed, and the clientele of each bank will, in effect, increase to include all bank users. Mises points out, however, that the sounder banks with higher fractional reserves will not wish to lose the goodwill of their own clients and risk bank runs by entering into collusive agreements with weaker banks.123 This consideration, while placing limits on such agreements, does not rule them out altogether. For, after all, no fractional-reserve banks are really sound, and if the public can be led to believe that, say, an 80-percent-specie reserve is sound, it can believe the same about 60-percent- or even 10-percent-reserve banks. Indeed, the fact that the weaker banks are allowed by the public to exist at all demonstrates that the more conservative banks may not lose much good will by agreeing to expand with them.
As Mises has demonstrated, there is no question that, from the point of view of opponents of inflation and credit expansion, free banking is superior to a central banking system (see below). But, as Amasa Walker stated:
Much has been said, at different times, of the desirableness of free banking. Of the propriety and rightfulness of allowing any person who chooses to carry on banking, as freely as farming or any other branch of business, there can be no doubt. But, while banking, as at present, means the issuing of inconvertible paper, the more it is guarded and restricted the better. But when such issues are entirely forbidden, and only notes equivalent to certificates of so much coin are issued, banking may be as free as brokerage. The only thing to be secured would be that no issues should be made except upon specie in hand.124
- 117. Perhaps one reason for continuing confidence in the banking system is that people generally believe that fraud is prosecuted by the government and that, therefore, any practice not so prosecuted must be sound. Governments, indeed (as we shall see below), always go out of their way to bolster the banking system.
- 118. All this, of course, assumes no further government intervention in banking than permitting fractional-reserve banking. Since the advent of deposit “insurance” during the New Deal, for example, the bank-run limitation has been virtually eliminated by this act of special privilege.
- 119. In the consolidated balance of payments of the clients, money income from sales to nonclients (exports) will decline, and money expenditures on the goods and services of nonclients (imports) will increase. The excess cash balances of the clients are transferred to non-clients.
- 120. Older economists also distinguished an “internal drain” as well as the “external drain,” but included in the former only the drain from bank users to those who insist on standard money.
- 121. See Human Action, pp. 434–35.
- 122. For various views on free and central banking, see Vera C. Smith, The Rationale of Central Banking (London: P.S. King and Son, 1936).
- 123. Mises, Human Action, p. 444.
- 124. Amasa Walker, Science of Wealth, pp. 230–31.