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

Central and Free Banking Theory 665of a central bank, and therefore abuses and distortions cannotbecome as severe as they often do when a lender of last resortexists and orchestrates the entire expansionary process.Thus it is conceivable that in a free-banking system, isolatedattempts to expand bank credit would be curbed relativelyquickly and spontaneously by customers’ vigilancetoward banks’ operations and solvency, the constant reassessmentof the trust placed in banks, and, more than anything,the effect of interbank clearing houses. In fact any isolatedbank expanding its credit faster than the sector average orissuing notes more rapidly than most would see the volume ofits reserves drop quickly, due to interbank clearing mechanisms,and the banker would be forced to halt expansion toavoid a suspension of payments, and eventually, failure. 92Nonetheless, even though this definite market reactiontends to check the abuses and isolated expansionary schemesof certain banks, there is no doubt that the process only worksa posteriori and cannot prevent the issuance of new fiduciarymedia. As we saw in chapter 2, the emergence of fractionalreservebanking (which in its early days was unaccompaniedby a central bank) marked the beginning of substantial, sustainedgrowth in fiduciary media, first in deposits and loansunbacked by saving, and later, also in banknotes unbacked byreserves of specie. This process has continually distorted theproductive structure and generated cycles of boom and recessionwhich have been historically recorded and studied inmany situations in which private banks have functioned with afractional reserve and without the existence and supervision of acentral bank. Some of the earliest of such studies can be tracedback to the economic and bank crises which hit fourteenthcenturyFlorence. Just as the theory of free banking indicates,the great majority of these expansionary banks did eventuallyfailed, but only after issuing fiduciary media for a varyinglength of time, an activity which never failed to exert crippling92 It is precisely this process that Parnell originally described in 1826 andLudwig von Mises later developed further in chapter 12 of HumanAction: “The Limitation on the Issuance of Fiduciary Media,” pp.434–48.