The Mystery of Banking

deficit in the
balance of payments
. This deficit is embodied in an outflow of
gold, since gold, as we have seen, is needed to pay for the rising
imports. Specifically, gold pays for the increased gap between ris-
ing imports and falling exports, since ordinarily exports provide
sufficient foreign currency to pay for imports. 
Thus for all these reasons, inflationary bank credit expansion
in one country causes prices to rise in that country, as well as an
outflow of gold and a deficit in the balance of payments to other
countries. Eventually, the outflow of gold and increasing demands
on the French bank for redemption force the bank to contract
credit and deflate the money supply, with a resulting fall in French
prices. In this 
recession
or bust period, gold flows back in again,
for two interconnected reasons. One, the contraction of credit
means that there are fewer francs available to purchase domestic
or foreign products. Hence imports will fall. Second, the fall of
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prices at home stimulates foreigners to buy more French goods,
and Frenchmen to shift their purchase from foreign to domestic
products. Hence, French exports will rise and imports fall, and
gold will flow back in, strengthening the position of the Bank of
France. 
We have of course been describing the essence of the famous
Hume-Ricardo “specie flow price mechanism,” which explains
how international trade and money payments work on the “clas-
sical gold standard.” In particular, it explains the mechanism that
places at least some limit on inflation, through price and money
changes and flows of gold, and that tends to keep international
prices and the balance of payments of each country in long-run
equilibrium. This is a famous textbook analysis. But there are two
vitally important aspects of this analysis that have gone unno-
ticed, except by Ludwig von Mises. First, we have here not only
a theory of international money flows but also a rudimentary the-
ory of the business cycle as a phenomenon sparked by inflation
and contraction of money and credit by the fractional reserve
banking system. 
Second, we should now be able to see that the Ricardian
specie flow price process is one and the same mechanism by
which 
one
bank is unable to inflate much if at all in a free bank-
ing system. For note what happens when, say, the Rothbard Bank
expands its credit and demand liabilities. If there is any room for
expansion at all, money and prices among Rothbard Bank clients
rise; this brings about increased demands for redemption among
clients of other banks who receive the increased money. Gold out-
flows to other banks from their pressure for redemption forces
the Rothbard Bank to contract and deflate in order to try to save
its own solvency. 
The Ricardian specie flow price mechanism, therefore, is sim-
ply a special case of a general phenomenon: When one or more
banks expand their credit and demand liabilities, they will lose
gold (or, in the case of banks 
within
a country, government paper)
to other banks, thereby cutting short the inflationary process and
leading to deflation and credit contraction. The Ricardian analysis
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is simply the polar case where all banks within a country can
expand together (if there is only one monopoly bank in the coun-
try), and so the redemption constraint on inflation only comes,
relatively weakly, from the banks of other countries. 
But couldn’t the banks within a country form a cartel, where
each could support the others in holding checks or notes on other
banks without redeeming them? In that way, if banks could agree
not to redeem each other’s liabilities, all banks could inflate
together, and act as 
if
only one bank existed in a country. Wouldn’t
a system of free banking give rise to unlimited bank inflation
through the formation of voluntary bank cartels? 
Such bank cartels could be formed legally under free banking,
but there would be every economic incentive working against
their success. No cartels in other industries have ever been able to
succeed for any length of time on the free market; they have only
succeeded—in raising prices and restricting production—when
government has stepped in to enforce their decrees and restrict
entry into the field. Similarly in banking. Banks, after all, are
competing with each other, and the tendency on the market will
be for inflating banks to lose gold to sounder, noninflating banks,
with the former going out of business. The economic incentives
would cut against any cartel, for without it, the sounder, less
inflated banks could break their inflated competitors. A cartel
would yoke these sounder banks to the fate of their shakier, more
inflated colleagues. Furthermore, as bank credit inflation pro-
ceeds, incentives would increase for the sound banks to break out
of the cartel and call for the redemption of the plethora of ware-
house receipts pouring into their vaults. Why should the sounder
banks wait and go down with an eventually sinking ship, as frac-
tional reserves become lower and lower? Second, an inflationary
bank cartel would induce new, sound, near-100 percent reserve
banks to enter the industry, advertising to one and all their non-
inflationary operations, and happily earning money and breaking
their competitors by calling on them to redeem their inflated
notes and deposits. So that, while a bank cartel is logically possi-
ble under free banking, it is in fact highly unlikely to succeed.