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

Central and Free Banking Theory 683largely creates its own demand. In other words, modern freebankingtheory contains the Old Banking School’s fundamentalerror, which, as Mises adeptly revealed, lies in a failureto reflect that public demand for credit depends preciselyon banks’ inclination to lend. Thus those bankers who, in thebeginning, are not overly concerned about their future solvencyare in a position to expand credit and place new fiduciarymedia in the market simply by reducing the interestrate they ask for the new money they create and easing theirnormal credit terms. 121 Therefore, in contrast with theassumptions of Selgin and the other theorists of his school,bankers can initiate credit expansion in a free-banking systemif for some reason they disregard their own solvency, whetheror not a prior variation in the demand for fiduciary media hasoccurred.Another factor explains why, during a prolonged period,the increase in the quantity of deposits (from credit expansion)actually tends to stimulate demand for fiduciary media. In fact alleconomic agents who are unaware that an inflationaryprocess of expansion has begun, and that this process willultimately cause a relative decrease in the purchasing powerof money and a subsequent recession, will notice that certaingoods and services begin to rise in price faster than othersand will wait in vain for such prices to return to their “normal”level. Meanwhile they will most likely decide toincrease their demand for fiduciary media. To again citeMises:121 The Banking School failed entirely in dealing with these problems.It was confused by a spurious idea according to whichthe requirements of business rigidly limit the maximumamount of convertible banknotes that a bank can issue. Theydid not see that the demand of the public for credit is a magnitudedependent on the banks’ readiness to lend, and thatbanks which do not bother about their own solvency are in aposition to expand circulation credit by lowering the rate ofinterest below the market rate. (Mises, Human Action, pp.439–40)Moreover let us remember that the process spreads and feeds uponitself as debtors borrow more newly-created deposits to repay earlierloans.