The Mystery of Banking

Free Banking and the Limits on Bank Credit Inflation
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We conclude that, contrary to propaganda and myth, free
banking would lead to hard money and allow very little bank
credit expansion and fractional reserve banking. The hard rigor
of redemption by one bank upon another will keep any one
bank’s expansion severely limited. 
Thus, Mises was highly perceptive when he concluded that 
It is a mistake to associate with the notion of free banking
the image of a state of affairs under which everybody is free
to issue bank notes and to cheat the public 
ad libitum
. Peo-
ple often refer to the dictum of an anonymous American
quoted by (Thomas) Tooke: “free trade in banking is free
trade in swindling.” However, freedom in the issuance of
banknotes would have narrowed down the use of banknotes
considerably if it had not entirely suppressed it. It was this
idea which (Henri) Cernuschi advanced in the hearings of
the French Banking Inquiry on October 24, 1865: “I believe
that what is called freedom of banking would result in a
total suppression of banknotes in France. I want to give
everybody the right to issue banknotes so that nobody
should take any banknotes any longer.”
3
124
The Mystery of Banking
3
Ludwig von Mises,
Human Action
(New Haven, Conn.: Yale Univer-
sity Press, 1949), p. 443; 
Human Action
, Scholar’s Edition (Auburn, Ala.:
Ludwig von Mises Institute, 1998), p. 443.
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IX.
C
ENTRAL
B
ANKING
:
R
EMOVING THE
L
IMITS
F
ree banking, then, will inevitably be a regime of hard money
and virtually no inflation. In contrast, the essential purpose
of central banking is to use government privilege to remove
the limitations placed by free banking on monetary and bank
credit inflation. The Central Bank is either government-owned
and operated, or else especially privileged by the central govern-
ment. In any case, the Central Bank receives from the government
the monopoly privilege for issuing bank notes or cash, while other,
privately-owned commercial banks are only permitted to issue
demand liabilities in the form of checking deposits. In some cases,
the government treasury itself continues to issue paper money as
well, but classically the Central Bank is given the sole privilege of
issuing paper money in the form of bank notes—Bank of England
notes, Federal Reserve Notes, and so forth. If the client of a com-
mercial bank wants to cash in his deposits for paper money, he can-
not then obtain notes from his own bank, for that bank is not per-
mitted to issue them. His bank would have to obtain the paper
money from the Central Bank. The bank could only obtain such
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Central Bank cash by 
buying
it, that is, either by selling the Cen-
tral Bank various assets it agrees to buy, or by drawing down its
own checking account with the Central Bank. 
For we have to realize that the Central Bank is a bankers’
bank. Just as the public keeps checking accounts with commercial
banks, so all or at least most of them keep checking accounts with
the Central Bank. These checking accounts, or “demand deposits
at the Central Bank,” are drawn down to buy cash when the
banks’ own depositors demand redemption in cash. 
To see how this process works, let us take a commercial bank,
the Martin Bank, which has an account at the Central Bank (Fig-
ure 9.1).