The Mystery of Banking

Free Banking and the Limits on Bank Credit Inflation
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bank note take place between clients of the 
same
bank. There is
therefore no day-to-day clientele limit from the existence of other
banks, and the only limit to 
this
bank’s expansion of inflationary
credit is a general loss of confidence that it can pay in cash. For
it, too, is subject to the overall constraint of fear of a bank run. 
Of course we have been abstracting from the existence of
other countries. There may be no clientele limits within a coun-
try to its monopoly bank’s expansion of money and credit. But of
course there is trade and flows of money between countries. Since
there is international trade and money flows between countries,
attenuated limits on inflationary bank credit still exist. 
Let us see what happens when one country, say France, has a
monopoly bank and it begins merrily to expand the number of
demand deposits and bank notes in francs. We assume that every
country is on the gold standard, that is, every country defines its
currency as some unit of weight of gold. As the number of francs
in circulation increases, and as the French inflationary process
continues, francs begin to ripple out abroad. That is, Frenchmen
will purchase more products or invest more in other countries.
But this means that claims on the Bank of France will pile up in
the banks of other countries. As the claims pile up, the foreign
banks will call upon the Bank of France to redeem its warehouse
receipts in gold, since, in the regular course of events, German,
Swiss, or Ceylonese citizens or banks have no interest whatever in
piling up claims to francs. What they want is gold so they can
invest or spend on what they like or pyramid on top of their own
gold reserves. But this means that gold will increasingly flow out
of France to other countries, and pressure on the Bank of France
will be aggravated. For not only has its fractional reserve already
declined from the pyramiding of more and more notes and
deposits on top of a given amount of gold, but now the fraction
is declining even more alarmingly because gold is unexpectedly
and increasingly flowing out of the coffers of the Bank of France.
Note again, that the gold is flowing out not from any loss of con-
fidence in the Bank of France by Frenchmen or even by foreign-
ers, but simply that in the natural course of trade and in response
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to the inflation of francs, gold is flowing out of the French bank
and into the banks of other countries. 
Eventually, the pressure of the gold outflow will force the
Bank of France to contract its loans and deposits, and deflation of
the money supply and of bank credit will hit the French economy. 
There is another aspect of this monetary boom-and-bust
process. For with only one, or even merely a few banks in a coun-
try, there is ample room for a considerable amount of monetary
inflation. This means of course that during the boom period, the
banks expand the money supply and prices increase. In our cur-
rent case, prices of French products rise because of the monetary
inflation and this will intensify the speed of the gold outflow. For
French prices have risen while prices in other countries have
remained the same, since bank credit expansion has not occurred
there. But a rise in French prices means that French products
become less attractive both to Frenchmen and to foreigners.
Therefore, foreigners will spend less on French products, so that
exports from France will fall, and French citizens will tend to shift
their purchases from dearer domestic products to relatively
cheaper imports. Hence, imports into France will rise. Exports
falling and imports rising means of course a dread