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Long out of print, The Mystery of Banking is perhaps the least appreciated work among Murray Rothbard’s prodigious body of output. This is a shame because it is a model of how to apply sound economic theory, dispassionately and objectively, to the origins and development of real-world institutions and to assess their consequences. It is “institutional economics” at its best. In this book, the institution under scrutiny is central banking as historically embodied in the Federal Reserve System—the “Fed” for short—the central bank of the United States.

The Fed has long been taken for granted in American life and, since the mid-1980s until very recently, had even come to be venerated. Economists, financial experts, corporate CEOs, Wall Street bankers, media pundits, and even the small business owners and investors on Main Street began to speak or write about the Fed in awed and reverential terms. Fed Chairmen Paul Volcker and especially his successor Alan Greenspan achieved mythic stature during this period and were the subjects of a blizzard of fawning media stories and biographies. With the bursting of the high-tech bubble in the late 1990s, the image of the Fed as the deft and all-seeing helmsman of the economy began to tarnish. But it was the completely unforeseen eruption of the wave of sub-prime mortgage defaults in the middle of this decade, followed by the Fed’s panicky bailout of major financial institutions and the onset of incipient stagflation, that has profoundly shaken the widespread confidence in the wisdom and competence of the Fed. Never was the time more propitious for the radical and penetrating critique of the Fed and fractional-reserve banking that Roth-bard offers in this volume.

Before taking a closer look at the book’s contents and contributions, a brief account of its ill-fated publication history is in order. It was originally published in 1983 by a short-lived and eclectic publishing house, Richardson & Snyder, which also published around the same time God’s Broker, the controversial book on the life of Pope John Paul II by Antoni Gronowicz. The latter book was soon withdrawn, which led to the dissolution of the company. A little later, the successor company, Richardson & Steirman, published the highly touted A Time for Peace by Mikhail Gorbachev, then premier of the U.S.S.R. This publishing coup, however, did not prevent this firm from also winding up its affairs in short order, as it seems to have disappeared after 1988.

In addition to its untimely status as an orphan book, there were a number of other factors that stunted the circulation of The Mystery of Banking. First, several reviewers of the original edition pointedly noted the lax, or nonexistent, copy editing and inferior production standards that disfigured its appearance. Second, in an important sense, the book was published “before its time.” In 1983, its year of publication, the efforts of the Volcker Fed to rein in the double-digit price inflation of the late 1970s had just begun to show success. Price inflation was to remain at or below 5 percent for the rest of the decade. During the 1990s, inflation, as measured by the Consumer Price Index, declined even further and hovered between 2 and 3 percent. This led the Greenspan Fed and most professional monetary economists to triumphantly declare victory over the inflation foe and even to raise the possibility of a return of the deflation bogey.

Despite the adverse circumstances surrounding its publication, however, The Mystery of Banking has gone on to become a true underground classic. At the time of this writing, four used copies are for sale on for between $124.50 and $256.47. These prices are many times higher than the pennies asked for standard money-and-banking textbooks published in the 1980s and even exceed the wildly inflated prices of the latest editions of these textbooks that are extracted from captive audiences of college students. Such price discrepancies are a good indication that Rothbard’s book is very different—in content, style, and organization—from standard treatments of the subject.

Rothbard’s book is targeted at a readership actively interested in learning about the subject and not at indifferent students slouching in the 500-seat amphitheatres of our “research” universities. While it is therefore written in Rothbard’s characteristically sparkling prose it does not shy away from a rigorous presentation of the basic theoretical principles that govern the operation of the monetary system. Indeed the book is peppered with diagrams, charts, and tables aplenty—and even a simple equation or two. But before you run for the hills, you should know that it is not a “textbook” in the conventional sense.

Conventional money-and-banking textbooks confront the hapless reader with a jumble of dumbed-down mainstream theories and models. Some of these have been discredited and most bear very little systematic relationship to one another or are in actual conflict. The Quantity Theory, in both its “classical” and monetarist versions, Keynes’s liquidity preference theory of interest, the New Keynesian Aggregate Supply curve, the expectations-augmented Phillips curve-one after another, all make their dreary appearance on the scene. Worse yet, this theoretical hodgepodge is generally set out in the last four or five chapters of the textbook and is usually preceded by a bland recitation of random technical details and historical facts about monetary and financial institutions. Unfortunately, the befuddled reader cannot make heads or tails out of these facts without the guidance of a coherent theory. For the privilege of being bewildered, misled, and eventually bored to tears by this indigestible intellectual stew, students get to pay $100 or more for the textbook.

Rothbard will have none of this shabby and disrespectful treatment of his reader and of his science that is meted out by the typical textbook author. In sharp contrast, he begins by first clearly presenting the fundamental principles or “laws” that govern money and monetary institutions. These universal and immutable laws form a fully integrated system of sound monetary theory that has been painstakingly elaborated over the course of centuries by scores of writers and economists extending back at least to the sixteenth-century Spanish Scholastics of the School of Salamanca. As the leading authority in this tradition in the latter half of the twentieth century, Rothbard expounds its core principles in a logical, step-by-step manner, using plain and lucid prose and avoiding extraneous details. He supplements his verbal-logical analysis with graphs and charts to effectively illustrate the operation of these principles in various institutional contexts.

It is noteworthy that, despite the fact that this book was written twenty-five years ago, the theory Rothbard presents is up to date. One reason is that the advancement of knowledge in non-experimental or “aprioristic” sciences like economic theory, logic, and mathematics proceeds steadily but slowly. In the case of sound monetary theory, many of its fundamental principles had been firmly established during the nineteenth century. In the German edition of The Theory of Money and Credit published in 1912, Ludwig von Mises, Rothbard’s mentor, integrated these principles with value and price theory to formulate the modern theory of money and prices. Rothbard elaborated upon and advanced Mises’s theoretical system. Thus the second reason that the monetary theory presented in the book remains fresh and relevant is that Rothbard himself was the leading monetary economist in the sound money tradition in the second half of the twentieth century, contributing many of the building blocks to the theoretical structure that he lays out. These include: formulating the proper criteria for calculating the money supply in a fractional-reserve banking system; identifying the various components of the demand for money; refining and consistently applying the supply-and-demand apparatus to analyzing the value of money; drawing a categorical distinction between deposit banking and loan banking; providing the first logical and coherent explanation of how fiat money came into being and displaced commodity money as a result of a series of political interventions. All these innovations and more were products of Rothbard’s creative genius, and many of his theoretical breakthroughs have not yet been adequately recognized by contemporary monetary theorists, even of the Austrian School.

Rothbard’s presentation of the basic principles of money-and-banking theory in the first eleven chapters of the book guides the reader in unraveling the mystery of how the central bank operates to create money through the fractional-reserve banking system and how this leads to inflation of the money supply and a rise in overall prices in the economy. But he does not stop there. In the subsequent five chapters he resolves the historical mystery of how an inherently inflationary institution like central banking, which is destructive of the value of money and, in the extreme case of hyperinflation, of money itself, came into being and was accepted as essential to the operation of the market economy.

As in the case of his exposition of the theory, Rothbard’s treatment of the history of the Fed is fundamentally at odds with that found in standard textbooks. In the latter, the history is shallow and episodic. It is taken for granted that the Fed, like all central banks, was originally designed as an institution whose goal was to promote the public interest by operating as a “lender of last resort,” providing “liquidity” to troubled banks during times of financial turbulence to prevent a collapse of the financial system. Later the Fed was given a second mandate, to maintain “stability of the price level,” a policy which was supposed to rid the economy of business cycles and therefore to preclude prolonged periods of recession and unemployment. Thus strewn throughout a typical textbook one will find accounts of how the Fed handled—usually, although not always, in an enlightened manner—various “shocks” to the monetary and financial system. Culpability for such shocks is almost invariably attributed to the unruly propensities or irrational expectations of business investors, consumers, or wage-earners. Even in the exceptional instances, such as the Great Depression, when inept Fed policy is blamed for making matters worse, the Fed’s errors are ascribed to not yet having learned how to properly wield the “tools of monetary policy,” the euphemism used to describe the various techniques the Fed uses in exercising its legal monopoly of counterfeiting money. Each new crisis, however, stimulates the public-spirited policymakers at the Fed by a trial-and-error process to eventually converge on the optimal monetary policy, which was supposedly hit upon in the heyday of the Greenspan Fed during 1990s.

Rothbard rejects such a superficial and naïve account of the Fed’s origins and bolstering of the banking system development. Instead, he deftly uses sound monetary theory to beam a penetrating light through the thick fog of carefully cultivated myths that surround the operation of the Fed. Rather than recounting the Fed’s response to isolated crises, he blends economic theory with historical insight to reveal the pecuniary and ideological motives of the specific individuals who played key roles in establishing, molding, and operating the Fed. Needless to say, Rothbard does not blithely accept the almost universal view that the Fed is the outcome of a public-spirited response to shocks and failures caused by unruly market forces. Rather he asks, and then answers, the incisive, and always disturbing, question, “Cui bono?” (“To whose benefit?”). In other words, which particular individuals and groups stood to benefit from the Fed’s creation and its specific policies? In answering this question, Rothbard fearlessly names names and delves into the covert motives and goals of those named.

This constitutes yet another, and possibly the most important, reason why Rothbard’s book had been ignored: for it is forbidden to even pose the question of “who benefits” with respect to the Fed and its legal monopoly of the money supply, lest one be smeared and marginalized as a “conspiracy theorist.” Strangely, when a similar question is asked regarding the imposition of tariffs or government regulations of one sort or another, no one seems to bat an eye, and free-market economists even delight in and win plaudits for uncovering such “rent-seekers” in their popular and academic publications. Thus economists of the Chicago and Public Choice Schools have explained the origins and policies of Federal regulatory agencies such as the ICC, CAB, FDA, FTC, FCC, etc., as powerfully shaped by the interests of the industries that they regulated. Yet these same economists squirm in discomfort and seek a quick escape when confronted with the question of why this analysis does not apply to the Fed. Indeed, Rothbard does no more than portray the Fed as a cartelizing device that limits entry into and regulates competition within the lucrative fractional-reserve banking industry and stands ready to bail it out, thus guaranteeing its profits and socializing its losses. Rothbard further demonstrates, that not only bankers, but also incumbent politicians and their favored constituencies and special interest groups benefit from the Fed’s power to create money at will. This power is routinely used in the service of vote-seeking politicians to surreptitiously tax money holders to promote the interests of groups that gain from artificially cheap interest rates and direct government subsidies. These beneficiaries include, among others, Wall Street financial institutions, manufacturing firms that produce capital goods, the military-industrial complex, the construction and auto industries, and labor unions.

With the U.S. housing crisis metamorphosing into a fullblown financial crisis in the U.S. and Europe and the specter of a global stagflation looming larger every day, the Fed’s credibility and reputation is evaporating with the value of the U.S. dollar. The time is finally ripe to publish this new edition of the book that asked the forbidden question about the Fed and fractional-reserve banking when it was first published twenty-five years ago.



JULY 2008

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