Money, Bank Credit, and Economic Cycles - The Ludwig von Mises ...

254 Money, Bank Credit, and Economic Cycles8THE CREDIT TIGHTENING PROCESSOne of the central problems posed by the process ofcredit expansion and ex nihilo deposit creation, and thus bythe bank deposit contract involving a fractional reserve, isthat just as this process inevitably unleashes forces thatreverse the effects of credit expansion on the real economy, italso looses forces which lead to a parallel process of credittightening or contraction. Ceteris paribus, any of the followingThe Economist, 1847), p. 282; see also Vera C. Smith’s comments in herbook, The Rationale of Central Banking and the Free Banking Alternative, p.89. Smith makes a most perceptive observation when referring to Wilsonand to the grave error of the Currency School, which was incapableof recognizing the economic parallels between bills and deposits. Shestates:The reason the currency school usually gave for this distinctionwas that bank notes increased the circulation anddeposits did not. Such an argument was not, of course,acceptable to Wilson as a member of the banking school ofthought which both denied that the issue of notes could beincreased to any undesirable extent so long as convertibilitywas strictly maintained, and pointed out that the differenceclaimed between notes and deposit liabilities was invalid. Butit was still denied in many quarters that demand depositsformed part of the circulation, and it was probably by nomeans generally admitted right up to the time of MacLeod.(p. 89)Wilson was completely justified in pointing out this contradiction;given the economic equivalence of banknotes and deposits, the argumentsin favor of regulating the issuance of one unbacked form aredirectly applicable, mutatis mutandis, to the other. Moreover this is thesame inconsistency manifested nearly a century later by defenders ofthe contract of irregular deposit of securities in which the bank isallowed to make use of deposits. This controversy arose at the beginningof the twentieth century with respect to banking practices inBarcelona, and at that time the use of a fractional reserve in connectionwith irregular deposits of securities was called into question andharshly condemned. As defenders of this contract correctly argued atthe time, the reasons put forward against this practice should also beapplied to monetary bank deposits with a fractional reserve (see relatedobservations in chapter 3).