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

Central and Free Banking Theory 669The above analysis extends to a large group of bankswhich operate in a free-banking system and maintain a fractionalreserve. The analysis shows that under such circumstances,even if interbank clearing mechanisms limit isolatedexpansionary schemes, these spontaneous mechanisms actuallyencourage implicit or explicit agreements between themajority of banks to jointly initiate the process of expansion.Thus in a fractional-reserve free-banking system, banks tendto merge, bankers tend to arrive at implicit and explicit agreementsamong themselves, and ultimately, a central bank tendsto emerge. Central banks generally appear as a result ofrequests from private bankers themselves, who wish to institutionalizejoint credit expansion via a government agency(as when a prudent and honest bank refuses to cooperate, or an irresponsibleone wants to be the first one to expand). The reasoning behindour application of the “tragedy of the commons” to the fractionalreservefree-banking system parallels the argument originally offered byLongfield, though he attempts, without much justification, to apply hiscase even to isolated instances of expansion by a few banks, while in ouranalysis such instances are limited by the interbank clearing mechanism,a factor Longfield fails to consider. The tragedy of the commonsalso accounts for the forces which motivate banks in a fractional-reservefree-banking system to merge and to request the creation of a centralbank, with the aim of establishing general, common policies of creditexpansion. The first time we explained this typical “tragedy of the commons”process in this context was at the regional meeting of the MontPèlerin Society which took place in Rio de Janeiro September 5–8, 1993.At this meeting, Anna J. Schwartz also pointed out that modern fractional-reservefree-banking theorists cannot seem to grasp that the interbankclearing mechanism they refer to does not curb credit expansion ifall banks decide to simultaneously expand their credit to one degree oranother. See her article, “The Theory of Free Banking,” presented at theabove meeting, esp. p. 5. At any rate, the process of expansion obviouslystems from a privilege which conflicts with property rights, and eachbank clearly reserves for itself all the benefits of its credit expansion andallows the costs to be shared by the entire system. Moreover if mostbankers implicitly or explicitly agree to “optimistically” join in the creationand granting of loans, the interbank clearing mechanism does noteffectively curtail abuses. See also footnote 130.