[From "More
Than Quibbles: Problems with the Theory and History of Fractional Reserve
Free Banking" in the spring 2019 issue of The Quarterly Journal
of Austrian Economics.]
Setting aside the potential legal and conceptual problems with fractional
reserve banking in order to focus on the economics, one of the key areas of
dispute is whether FRB necessarily leads to an unsustainable boom as
described first by Mises ([1912] 2009) and elaborated by his disciple Hayek
(e.g. [1931] 1967). It is significant that both of these developers of what
is sometimes called “the Mises-Hayek theory of the business cycle” thought
that FRB was a central element of the story. To be sure, Mises and Hayek may
have been mistaken, but it is worth documenting their position
because in the debate over FRB, one often hears (especially in informal
venues) casual claims that only dogmatic Rothbardians could find fault with
fractional reserve banking per se.
We find an unambiguous statement of Mises’s position in Human Action.
Mises defines “fiduciary media” as bank-issued claims to money, payable upon
demand, that are not covered by base money in the vault, and then
declares:
The notion of “normal” credit expansion is absurd. Issuance of
additional fiduciary media, no matter what its quantity may be, always sets
in motion those changes in the price structure the description of which is
the task of the theory of the trade cycle . Of course, if the
additional amount issued is not large, neither are the inevitable effects of
the expansion. (Mises [1949] 1998, 439, n. 17; bold added.)
Regarding Hayek, even the FRFB writers admit that his understanding of
commercial bank behavior is inconsistent with their claims. For example,
Larry White (1999, 761) writes that Hayek ([1925] 1984, 29) “suggested in one
of his earliest writings a radical solution to the problem of swings in the
volume of commercial bank credit: impose a 100 percent marginal reserve
requirement on all bank liabilities….”
Mises too at some points in his career called for an explicit prohibition
on additional issuance of fiduciary media, though he also wrote (for example in Human
Action) in favor of “free banking” as the best practical way to
restrain the issuance of fiduciary media . (Salerno 2012, 96–97) Readers
should therefore not misinterpret Mises’s praise for laissez-faire in banking
as an endorsement of the modern “free banking” claim that fractional reserve
banking, at least under certain conditions, promotes economic stability.
To appreciate the specific problem of fiduciary media in the eyes of
Mises, it is very instructive to consider where he placed the
business cycle discussion in Human Action. One might have classified
the periodic boom-bust cycles plaguing market economies as a result of
political intervention, which would mean placing the discussion (as Rothbard
did in Man, Economy, and State ) in the same section of the book that
handled minimum wage laws and taxation. Yet Mises rejects this plausible
approach, and his explanation illuminates his broader views on fractional
reserve banking:
It is beyond doubt that credit expansion is one of the primary issues of
interventionism. Nevertheless the right place for the analysis of the
problems involved is not in the theory of interventionism but in that of the
pure market economy. For the problem we have to deal with is
essentially the relation between the supply of money and the rate of
interest, a problem of which the consequences of credit expansion are only a
particular instance .
Everything that has been asserted with regard to credit expansion is
equally valid with regard to the effects of any increase in the supply of
money proper as far as this additional supply reaches the loan market at an
early stage of its inflow into the market system . If the additional
quantity of money increases the quantity of money offered for loans at a time
when commodity prices and wage rates have not yet been completely adjusted to
the change in the money relation, the effects are no different from those of
a credit expansion. In analyzing the problem of credit expansion,
catallactics completes the structure of the theory of money and of interest….
What differentiates credit expansion from an increase in the
supply of money as it can appear in an economy employing only commodity money
and no fiduciary media at all is conditioned by divergences in the quantity
of the increase and in the temporal sequence of its effects on the various
parts of the market . Even a rapid increase in the production of the
precious metals can never have the range which credit expansion can attain.
The gold standard was an efficacious check upon credit expansion, as it forced
the banks not to exceed certain limits in their expansionist ventures. The
gold standard’s own inflationary potentialities were kept within limits by
the vicissitudes of gold mining. Moreover, only a part of the
additional gold immediately increased the supply offered on the loan market.
The greater part acted first upon commodity prices and wage rates and
affected the loan market only at a later stage of the inflationary process .
(Mises [1949] 1998, 571–72; bold added.)
The above excerpt from Mises is extraordinarily important in understanding
what role he thought the commercial banks played in a typical
boom-bust cycle. Yet to correctly parse it, we should first remind ourselves
what Mises means precisely by the phrase “credit expansion” (since he is contrasting
it with “an increase in the supply of money proper”). Earlier in the book,
Mises does not yet explain the trade cycle but defines the terminology that
he will later need. He explains:
The term credit expansion has often been misinterpreted. It is
important to realize that commodity credit cannot be expanded. The only
vehicle of credit expansion is circulation credit. But the granting of
circulation credit does not always mean credit expansion. If the amount of
fiduciary media previously issued has consummated all its effects upon the
market, if prices, wage rates, and interest rates have been adjusted to the
total supply of money proper plus fiduciary media (supply of money in the
broader sense), granting of circulation credit without a further increase in
the quantity of fiduciary media is no longer credit expansion. Credit
expansion is present only if credit is granted by the issue of an additional
amount of fiduciary media, not if banks lend anew fiduciary media paid back
to them by the old debtors . (Mises [1949] 1998, 431; italics in
original, bold added.)
Putting together all three of the block quotations from Human Action
that we have provided above, we can summarize Mises’s position as follows:
The unsustainable boom occurs when a newly created (or mined) quantity of
money enters the loan market and distorts interest rates, before other prices
in the economy have had time to adjust. In principle, this process could
occur even in the case of commodity money with 100 percent reserve banking.
However, in practice Mises believes such a theoretical
possibility can be safely neglected, because (a) the quantity of new gold (or
other commodity money) entering the economy will likely be relatively small
over any short period and (b) whatever the stock of new commodity
money entering the economy as a whole, typically only a small fraction of it
would be channeled into the loan market upfront.
Thus, even though in principle Mises’s theory of the boom-bust cycle is
fundamentally about new quantities of money hitting the loan market early on,
in practice the explanation revolves around newly-created fiduciary media
being lent into the market. That is why Mises described his explanation as
the “circulation credit theory of the trade cycle.” When we understand how
Mises thought (in principle) newly mined gold could conceivably set in motion
the boom-bust cycle, it becomes crystal clear that he thought any amount
of newly-issued fiduciary media—i.e., a credit expansion—would do the same.
(Remember, our earlier quotation shows Mises claiming that “[i]ssuance of
additional fiduciary media, no matter what its quantity may be,
always sets in motion” the processes that cause the unsustainable boom.) Thus
there are no caveats or other conditions to consider, on this narrow
question. Mises thought fractional reserve banking per se would set in motion
the business cycle.
