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

Central and Free Banking Theory 681wish to justify a fractional-reserve free-banking system inwhich there may be substantial increases and decreases in themoney supply in the form of fiduciary media, they must independentlylook to the side of demand in the hope of being ableto demonstrate that such modifications in the supply of fiduciarymedia (which are inevitable in a fractional-reserve system)correspond to prior variations in demand which are satisfiedby the reestablishment of a hypothetical, preexistentstate of “monetary equilibrium.”Growth in the money supply in the form of credit expansiondistorts the productive structure and gives rise to an economicboom and subsequent recession, stages during whichsignificant variations in the demand for money and fiduciarymedia take place. Hence the process is not triggered, as theoristsof the modern Free-Banking School suppose, by independent,catalytic changes in the demand for fiduciary media,but by the manipulation of the supply of them. All fractionalreservebanking systems carry out such manipulation to onedegree or another by expanding credit.It is true that in a system composed of a multiplicity of freebanks unsupported by a central bank, credit expansion wouldstop much sooner than in a system in which the central bankorchestrates widespread expansion and uses its liquidity toaid those banks in jeopardy. This is the pro-free-banking argumentParnell originally developed and Mises later identifiedas second-best. 119 However it is one thing to assert that in aBased on historical evidence, the money supply (the stock ofgold) under a pure gold standard would expand [annually]between 1 to 5 percent. And, most importantly, there wouldbe virtually no chance of a monetary deflation under 100 percentgold backing of the currency. (Skousen, The Structure ofProduction, p. 359)119 Selgin himself recognizes thatMises’s support for free banking is based in part on his agreementwith Cernuschi, who (along with Modeste) believedthat freedom of note issue would automatically lead to 100percent reserve banking;and also that Mises “believed that free banking will somehow lead tothe suppression of fractionally-based inside monies.” See Selgin, The