The Mystery of Banking

does
provide a superb, day-to-day
grinding type of severe restraint on credit expansion under free
banking. It operates 
even
while confidence in banks by their cus-
tomers is as buoyant as ever. It does not depend, therefore, on a
psychological loss of faith in the banks. This vital restraint is sim-
ply the 
limited clientele of each bank
. In short, the Rothbard Bank
(or the Jones Bank) is constrained, first, by the fear of a bank run
(loss of confidence in the bank by its own customers); but it is
also, and even more effectively, constrained by the very fact that,
in the free market, the clientele of the Rothbard Bank is extremely
limited. The day-to-day constraint on banks under free banking is
the fact that nonclients will, by definition, call upon the bank for
redemption. 
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Let us see how this process works. Let us hark back to Figures
7.2 and 7.3 where the Rothbard Bank has had $50,000 of gold
coin or government paper deposited in it, and then proceeded to
pyramid on top of that $50,000 by issuing $80,000 more of fake
warehouse receipts and lending them out to Smith. The Rothbard
Bank has thereby increased the money supply in its own bailiwick
from $50,000 to $130,000, and its fractional reserve has fallen
from 100 percent to 5/13. But the important point to note now is
that this process 
does not stop there
. For what does Smith do with
his $80,000 of new money? We have already mentioned that new
money ripples out from its point of injection: Smith clearly does
not sit on the money. He spends it on more equipment or labor
or on more consumer goods. In any case, he 
spends
it. But what
happens to the credit status of the money? That depends crucially
on whether or not the person Smith spends the money on is 
him-
self
a customer of the Rothbard Bank. 
Let us assume, as in Figure 8.1, that Smith takes the new
receipts and spends them on equipment made by Jones, 
and
that
Jones, too, is a client of the Rothbard Bank. In that case, there is
no pressure on the Rothbard Bank, and the inflationary credit
expansion proceeds without difficulty. Figure 8.1 shows what
happens to the Rothbard Bank’s balance sheet (to simplify, let us
assume that the loan to Smith was in the form of demand
deposits). 
The Rothbard Bank
Assets
Equity & Liabilities
Gold $50,000
Demand 
deposits:
IOU from Smith $80,000
to Smith
$0
to Jones
$80,000
to Others
$50,000
Total Assets
$130,000
Total demand deposits $130,000
F
IGURE
8.1 — A B
ANK WITH
M
ANY
C
LIENTS
Free Banking and the Limits on Bank Credit Inflation
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Thus, total liabilities, or demand deposits, remain what they
were after the immediate loan to Smith. Fifty thousand dollars is
owed to the original depositors of gold (and/or to people who
sold goods or services to the original depositors for gold); Smith
has written a check for his $80,000 for the purchase of equip-
ment from Jones, and Jones is now the claimant for the $80,000
of demand deposits. Total demand deposits for the Rothbard
Bank have remained the same. Moreover, all that has happened,
from the Rothbard Bank’s point of view, is that deposits have
been shuffled around from one of its clients to another. So long,
then, as