The Mystery of Banking

Free Banking and the Limits on Bank Credit Inflation
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Rothbard Bank Boonville Bank
Assets
Equity & Liabilities Assets Equity & Liabilities
Gold $50,000
Demand 
Demand 
IOU from 
deposits to
deposit to
Smith $80,000
Boonville $80,000
Jones + $80,000
to Others $50,000
Total Assets
Total demand Due from
deposits
Rothbard Bank
$130,000 $130,000
+ $80,000
F
IGURE
8.2 — R
EDEMPTION BY
A
NOTHER
B
ANK
Why should the Boonville Bank call upon the Rothbard Bank
for redemption? Why should it do anything else? The banks are
competitors, not allies. The banks either pay no interest on their
demand deposits—the usual situation—or else the interest will be
far lower than the interest they themselves can earn on their
loans. The longer the Boonville Bank holds off on redemption the
more money it loses. Furthermore, as soon as it obtains the gold,
it can try to pyramid bank credit on top of it. Banks therefore
have everything to lose and nothing to gain by holding up on
redeeming notes or demand deposits from other banks. 
It should be clear that the sooner the borrowers from an
expanding bank spend money on products of clients of 
other
banks—in short, as soon as the new money ripples out to 
other
banks—the issuing bank is in big trouble. For the sooner and the
more intensely clients of 
other
banks come into the picture, the
sooner will severe redemption pressure, even unto bankruptcy, hit
the expanding bank. Thus, from the point of view of checking
inflation, the more banks there are in a country, and therefore 
the
smaller the clientele of each bank,
the better. If each bank has only
a few customers, any expanded warehouse receipts will pass over
to nonclients very quickly, with devastating effect and rapid
bankruptcy. On the other hand, if there are only a few banks in
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a country, and the clientele of each is extensive, then the expan-
sionary process could go on a long time, with clients shuffling
notes and deposits to one another within the same bank, and the
inflationary process continuing at great length. The more banks,
and the fewer the clientele of each, then, the less room there will
be for fractional reserve inflation under free banking. If there are
a myriad of banks, there may be no room at all to inflate; if there
are a considerable but not great number, there will be more room
for inflation, but followed fairly quickly by severe redemption
pressure and enforced contraction of loans and bank credit in
order to save the banks. The wider the number of clients, the
more time it will take for the money to ripple out to other banks;
on the other hand, the greater the degree of inflationary credit
expansion, the faster the rippling out and hence the swifter the
inevitable redemption, monetary contraction, and bank failures. 
Thus, we may consider a spectrum of possibilities, depending
on how many competing banks there are in a country. At one
admittedly absurd pole, we may think of each bank as having only
one client; in that case, of course, there would be no room what-
ever for any fractional reserve credit. For the borrowing client
would immediately spend the money on somebody who would by
definition be a client of another bank. Relaxing the limits a bit to
provide a myriad of banks with only a few clients each would
scarcely allow much more room for bank inflation. But then, as
we assume fewer and fewer banks, each with a more and more
extensive clientele, there will be increasing room for credit
expansion until a rippling out process enforces contraction, defla-
tion, and bank failures. Then, if there are only a few banks in a
country, the limits on inflation will be increasingly relaxed, and
there will be more room for inflation, and for a subsequent busi-
ness cycle of contraction, deflation, and bank failures following
an inflationary boom. 
Finally, we come to the case of one bank, in which we assume
that for some reason, everyone in the country is the client of a sin-
gle bank, say the “Bank of the United States.” In that case, our
limit disappears altogether, for then all payments by check or