The Mystery of Banking

Central Bank
Assets
Equity & Liabilities
Demand deposits
of Martin Bank
+$500,000
Central Bank notes 
– $500,000
F
IGURE
9.7 — D
EPOSITING
C
ASH
: T
HE
C
ENTRAL
B
ANK
Thus, as a result of $500,000 of cash being deposited in the
banks by the public, the Martin Bank has created $2.5 million in
new bank deposits, the Central Bank has decreased its notes out-
standing by $500,000, and the net result is a $2 million 
increase
in the money supply. Again, paradoxically, a drop in paper money
outstanding has led to a multiple 
expansion
in the supply of
money (paper money + bank demand deposits) in the country. 
We should note, by the way, that the total money supply only
includes money held by the public (demand deposits + Central
Bank notes). It does 
not
include demand deposits of the banks at
the Central Bank or vault cash held by the banks, for this money
is simply held in reserve against outstanding (and greater) compo-
nents of the money supply. To include 
intra
bank cash or deposits
as part of the money supply would be double counting, just as it
would have been double counting to include 
both
gold in the
Central Banking: Removing the Limits
131
Chapter Nine.qxp 8/4/2008 11:38 AM Page 131

---

banks 
and
warehouse receipts for gold as part of the money sup-
ply. Warehouse receipts are surrogates for reserves, even when
they are pyramided on top of them, so that reserves cannot 
also
be included in an account of the supply of money. 
Under central banking, then, the total supply of money, M,
equals cash in the hands of the public plus demand deposits
owned by the public. Cash, in turn, consists of gold coin or bul-
lion among the public, plus Central Bank notes. Or, putting this
in equation form, 
M = gold in public + Central Bank notes in public + 
Demand deposits of the commercial banks 
When a nation is taken off the gold standard, gold dollars or
francs are no longer part of the money supply, and so the money
supply equation becomes (as it is in the United States and all other
countries now): 
M = Central Bank notes + Demand deposits 
It is clear that, even under central banking, if the public is or
becomes unwilling to hold any money in bank deposits or notes
and insists on using only gold, the inflationary potential of the
banking system will be severely limited. Even if the public insists
on holding bank notes rather than deposits, fractional reserve
bank expansion will be highly limited. The more the public is
willing to hold checking accounts rather than cash, the greater the
inflationary potential of the central banking system. 
But what of the other limits on bank inflation that existed
under free banking? True, the Central Bank—at least under the
gold standard—can still go bankrupt if the public insists on cash-
ing in their deposits 
and
Central Bank paper for gold. But, given
the prestige of the Central Bank conferred by government, and
with government using the Central Bank for its own deposits and
conferring the monopoly privilege of note issue, such bankruptcy
will be most unlikely. Certainly the parameters of bank inflation
132
The Mystery of Banking
Chapter Nine.qxp 8/4/2008 11:38 AM Page 132

---

have been greatly widened. Furthermore, in most cases govern-
ment has conferred another crucial privilege on the Central Bank:
making its notes legal tender for all debts in money. Then, if A has
contracted with B for a debt of $10,000 in money, B 
has
to accept
payment in Central Bank notes; he cannot insist, for example, on
gold. All this is important in propping up the Central Bank and
its associated commercial banks. 
What of the dread bank run? Cannot a bank still be subjected
to drastic loss of confidence by its clients, and hence demands for
redemption, either in gold or in Central Bank notes? Yes, it can,
under the gold standard, and bank runs often swept through the
American banking system until 1933. But under central banking
as contrasted to free banking, the Central Bank stands ready at all
times to lend its vast prestige and resources—to be, as the Eng-
lishman Walter Bagehot called it in the mid-nineteenth century—