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-19th 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
Banking 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 ensured that the central bank could act as a cartilaging 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 banknotes and the commercial bank's all-paramid
expansion of their demand deposits on top of their reserves or checking accounts at
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
It's reserves and 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 Ruritania banks are mobilized and expand their credit and the money supplied 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.