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

Central and Free Banking Theory 625theory might make the inflationist fallacies of this schoolappear somewhat credible. The main error in Fullarton’s lawof reflux lies in its failure to account for the nature of fiduciaryloans. We know that when a bank discounts a bill or grants aloan, it exchanges a present good for a future good. Sincebanks which expand loans create present goods ex nihilo, anatural limit to the volume of fiduciary media the bankingsystem could create would only be conceivable under onecondition: if the quantity of future goods offered in the marketin exchange for bank loans were somehow limited. However,as Mises has eloquently pointed out, this is never the case. 46 Infact banks may expand credit without limit simply by reducingthe interest rate they apply to the corresponding loans. Moreover,given that loan recipients pledge to return a greateramount of monetary units at the end of a certain time period,there is no limit to credit expansion. Indeed borrowers canrepay their loans with new monetary units the banking systemitself creates ex nihilo in the future. As Mises puts it,“Fullarton overlooks the possibility that the debtor may procurethe necessary quantity of fiduciary media for the repaymentby taking up a new loan.” 47Although the monetary theories of the Banking Schoolwere invalid, in one particular respect they were accurate.Banking School theorists were the first to recover a monetarydoctrine of the “banking” sector of the School of Salamanca,namely that bank deposit balances fulfil exactly the same economicfunction as banknotes. As we will later see, throughoutthe debate between the Banking and Currency Schools, inwhich the latter focused solely on the damaging effects ofunbacked paper bills, Banking School defenders correctlyargued that if the recommendations of the Currency Schoolwere sensible (and they were), they should also be applied toall bank deposits, since, as bank money, deposits play a roleidentical to that of unbacked banknotes. Even though this46 Mises, The Theory of Money and Credit, pp. 340–41.47 Ibid., p. 342. For more on Mises’s criticism of the Banking School, seeOn the Manipulation of Money and Credit, pp. 118–19 and Human Action,pp. 429–40.