The Mystery of Banking

confidence is retained
by its depositors in the Rothbard
Bank, it can continue to expand its operations and its part of the
money supply with impunity. 
But—and here is the rub—suppose that Jones is 
not
a client
of the Rothbard Bank. After all, when Smith borrows money from
that bank he has no interest in patronizing only fellow clients of
his bank. He wants to invest or spend the money in ways most
desirable or profitable to himself. In a freely competitive banking
system, there is no guarantee—indeed not even a likelihood—that
Jones, or the person whom 
Jones
will spend the money on, will
himself be a client of the Rothbard Bank. 
Suppose, then, that Jones is 
not
a client of the Rothbard Bank.
What then? Smith gives a check (or a note) to Jones for the equip-
ment for $80,000. Jones, not being a client of the Rothbard Bank,
will therefore call upon the Rothbard Bank for redemption. But
the Rothbard Bank doesn’t have the money; it has only $50,000;
it is $30,000 short, and therefore the Rothbard Bank is now bank-
rupt, out of business. 
The beauty and power of this restraint on the banks is that it
does not depend on loss of confidence in the banks. Smith, Jones,
and everyone else can go on being blithely ignorant and trusting
of the fractional reserve banking system. And yet the redemption
weapon does its important work. For Jones calls on the Rothbard
Bank for redemption, 
not 
because he doesn’t trust the bank or
thinks it is going to fail, but simply because he patronizes another
bank and wants to shift his account to his preferred bank. The
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mere existence of bank competition will provide a powerful, con-
tinuing, day-to-day constraint on fractional reserve credit expan-
sion. Free banking, even where fractional reserve banking is legal
and not punished as fraud, will scarcely permit fractional reserve
inflation to exist, much less to flourish and proliferate. Free bank-
ing, far from leading to inflationary chaos, will insure almost as
hard and noninflationary a money as 100 percent reserve banking
itself. 
In practice, the concrete method by which Jones insists on
redemption in order to shift his account from the Rothbard Bank
to his own can take several forms, each of which have the same
economic effects. Jones can refuse to take Smith’s check, insisting
on cash, so that Smith becomes the redeemer of his own deposits.
Jones—if the Rothbard Bank could supply him with the gold—
could then deposit the gold in his own bank. Or Jones himself
could arrive at the Rothbard Bank and demand redemption. In
practice, of course, Jones would not bother, and would leave
these financial affairs to his own bank, which would demand
redemption. In short, Jones would take Smith’s check, made out
to him on the account of the Rothbard Bank, and deposit it in his
own bank, getting a demand deposit there for the amount
deposited. Jones’s bank would take the check and demand
redemption from the Rothbard Bank. The Rothbard Bank would
then have to confess it could not pay, and would hence go out of
business. 
Figure 8.2 shows how this process works. We assume that
Jones’s account is in the Boonville Bank. We do not bother show-
ing the complete balance sheet of the Boonville Bank because it is
irrelevant to our concerns, as is the soundness of the bank. 
Thus, we see that dynamically from this transaction, the
Boonville Bank finds itself with an increased demand deposit
owed to Jones of $80,000, balanced by a check on the Rothbard
Bank for $80,000. When it cashes the check for redemption, it
puts such a severe redemption pressure on the Rothbard Bank
that the latter goes bankrupt.