The Mystery of Banking

Deposit Banking
109
18
We should note, however, that if they wanted to, the holders of
$800,000 of the bank’s demand deposits could cash them in for the notes
of the Jones Bank, as well as for gold or government paper money. In fact,
the notes and deposits of the Jones Bank are interchangeable for each other,
one for one: deposits could, if the owner wished, be exchanged for newly-
printed notes, while notes could be handed in and exchanged for newly-
credited deposits.
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Jones Bank
Assets
Equity & Liabilities
IOUs from 
Demand Liabilities:
borrowers
$2,200,000
Notes
$1,000,000
Cash
$300,000
Deposits
$800,000
Total $1,800,000
Equity
$700,000
Total Assets
$2,500,000
Total Liabilities
$2,500,000
F
IGURE
7.7 — F
RACTIONAL
R
ESERVE IN A
M
IXED
B
ANK
to counterfeiting. But suppose that we don’t have a legal require-
ment for 100 percent banking. How inflationary would be a sys-
tem of free and unrestricted banking, with no government inter-
vention? Is it true, as is generally believed, that a system of free
banking would lead to an orgy of unrestricted money creation
and inflation? 
110
The Mystery of Banking
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VIII.
F
REE
B
ANKING AND THE
L
IMITS
ON
B
ANK
C
REDIT
I
NFLATION
L
et us assume now that banks are not required to act as gen-
uine money warehouses, and are unfortunately allowed to
act as debtors to their depositors and noteholders rather
than as bailees retaining someone else’s property for safekeeping.
Let us also define a system of 
free banking
as one where banks are
treated like any other business on the free market. Hence, they
are not subjected to any government control or regulation, and
entry into the banking business is completely free. There is one
and only one government “regulation”: that they, like any other
business, must pay their debts promptly or else be declared insol-
vent and be put out of business.
1
In short, under free banking,
banks are totally free, even to engage in fractional reserve bank-
ing, but they must redeem their notes or demand deposits on
demand, promptly and without cavil, or otherwise be forced to
close their doors and liquidate their assets. 
111
1
This is not the place to investigate the problem whether bankruptcy
laws confer a special privilege on the debtor to weasel out of his debts.
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Propagandists for central banking have managed to convince
most people that free banking would be banking out of control,
subject to wild inflationary bursts in which the supply of money
would soar almost to infinity. Let us examine whether there are
any strong checks, under free banking, on inflationary credit
expansion. 
In fact, there are several strict and important limits on infla-
tionary credit expansion under free banking. One we have
already alluded to. If I set up a new Rothbard Bank and start
printing bank notes and issuing bank deposits out of thin air, why
should anyone accept these notes or deposits? Why should any-
one trust a new and fledgling Rothbard Bank? Any bank would
have to build up trust over the years, with a record of prompt
redemption of its debts to depositors and noteholders before cus-
tomers and others on the market will take the new bank seriously.
The buildup of trust is a prerequisite for any bank to be able to
function, and it takes a long record of prompt payment and there-
fore of noninflationary banking, for that trust to develop. 
There are other severe limits, moreover, upon inflationary
monetary expansion under free banking. One is the extent to
which people are willing to use bank notes and deposits. If cred-
itors and vendors insist on selling their goods or making loans in
gold or government paper and refuse to use banks, the extent of
bank credit will be extremely limited. If people in general have
the wise and prudent attitudes of many “primitive” tribesmen and
refuse to accept anything but hard gold coin in exchange, bank
money will not get under way or wreak inflationary havoc on the
economy. 
But the extent of banking is a general background restraint
that does precious little good once banks have become estab-
lished. A more pertinent and magnificently powerful weapon
against the banks is the dread