Front Page Titles (by Subject) 3: Credit Expansion with Constant Money Demand - The Theory of Free Banking: Money Supply under Competitive Note Issue
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3: Credit Expansion with Constant Money Demand - George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue 
The Theory of Free Banking: Money Supply under Competitive Note Issue (Lanham, MD.: Rowman & Littlefield, 1988).
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Credit Expansion with Constant Money Demand
The previous chapter ended with a description of long-run equilibrium in a free banking industry. It assumed that note issue and deposit granting under free banking involve increasing marginal costs, especially liquidity costs. This chapter attempts to justify this assumption, showing that it applies only to free banking. Throughout the chapter it is assumed that the public’s total demand for inside-money balances, and the division of this demand between the two forms of inside money (currency and demand deposits) are constant. The effects of changes in the demand for inside money balances will be examined later, in chapter 5; those of changes in the public’s desired currency-deposit mixture will be the subject of chapter 8.
The Rule of Excess Reserves
A well-known principle of money and banking is that, in a system with monopolized currency supply, an individual bank cannot increase its loans and investments unless it has reserves in excess of what it needs to meet currency demands of its customers as well as clearing balances it owes to other banks.1 If a bank has reserves in excess of its liquidity needs and there are no statutory reserve requirements it can expand credit by the amount of the excess, but no more. This “rule of excess reserves” assumes that bank borrowers generally secure loans from banks only when they have purchases to make, implying that the demand for inside money balances does not increase. When a bank makes a loan to a client, the client writes checks against the new balance made out to people who are mainly clients of other banks. The checks are soon deposited, and the banks that acquire the checks waste no time returning them for payment to the bank on which they were drawn. Consequently, the bank that expands credit suffers a clearing drain practically equal to the amount of new credit it grants: its reserves are reduced “just as effectively as if each individual borrower had elected to take cash in the first place” (Rodkey 1928, 41). If the bank lacks excess reserves at least equal to this drain, it has to borrow emergency reserves. Otherwise it has to liquidate some of its investments or contract its loans to restore its reserve/liability ratio to a sustainable level.
The rule of excess reserves is usually applied to the circumstance of a small bank with many, equally small competitors. Nonetheless the rule also applies to a small group of banks so long as the demand for inside money is stationary. Consider a system of five banks, each with an equal amount of fully employed reserves and having equal shares of the market for deposit balances. Suppose Bank A grants a loan of $50,000, a net increase in its outstanding liabilities, to John Smith. On average, four-fifths of the checks drawn by Smith on the new balance will be paid to persons having deposits at Banks B through E. This causes Bank A to suffer an immediate clearing drain of $40,000. The other checks end up with persons who are depositors at Bank A, so that the bank is temporarily spared from a further reserve drain of $10,000. However, the persons who temporarily add $10,000 to their accounts at Bank A also, by assumption, do not intend to increase their average money holdings. Therefore, in the next round of spending they write checks for $10,000 (beyond what they would usually spend) to keep their balances at their original levels. Once again Bank A suffers an immediate clearing drain equal to four-fifths of the amount withdrawn, or $8,000, and so on. The schedule of clearing losses would therefore be as follows:
After five rounds of spending Bank A suffers clearing drains equal to all save $16 of its initial expansion. Assuming that each round of spending and clearing takes five days, this loss is suffered during a twenty-five day period, which is almost certainly less than the time required for the maturation of the loan on which the credit was issued. In any event, the greater part of any reserve drain occurs in the first few spending rounds and hence well before an expanding bank can expect to recover any part of its latest loans or investments.2
The rule of excess reserves also assumes that banks face a determinate demand schedule for their deposit balances (a schedule of quantity demanded for various deposit rates of interest), so that they cannot profit from expansionary policies that increase their loans while simultaneously increasing the public’s demand to hold deposit liabilities. The assumption is justified because, although an expanding bank might offset its reserve losses by attracting an equal sum of new deposits, it can only do so (other things being equal) by raising its marginal deposit rate of interest. On the other hand, the bank can only expand credit by marginally lowering the interest rates it charges to borrowers (or by buying assets with lower risk-adjusted interest yields). It follows that, in its attempts to generate deposit demand sufficient to cover reserve drains from its new loans, an expanding bank, operating in a competitive environment, would incur interest and operating expenses in excess of what the new loans would themselves bring in. Then, although the bank does not lose reserves to its rivals, it still suffers a reduction of net revenues, so that its expansion is unprofitable.3
Finally, the rule of excess reserves requires that, although one or a few banks may try to expand credit beyond their customers’ willingness to hold deposit credits, other banks are not induced by this to engage in sympathetic overexpansion: if all banks expand in unison their behavior will not be checked by individual banks’ suffering net clearing debits. It is easily shown, though, that profit-maximizing banks are not likely to overexpand in sympathy with their overexpanding rivals. If overexpansion by one bank or group of banks has any effect at all on conditions influencing other banks it is the reduction of the rate of interest on new loans, which makes further lending by them seem less desirable.4
The rule of excess reserves demonstrates clearly that, if all deposit banks in a system are fully loaned up, aggregate credit expansion can only take place if the banks get additional reserves from outside their own ranks:
It is evident that such increased reserves must come from outside the system since otherwise as one bank succeeded in increasing its reserves such increase would be at the expense of some other bank whose reserves were being correspondingly diminished. The expansion of loans by the bank with the increasing reserves would be offset by the contraction necessary in the bank whose reserves were being drawn away, with no net change in the volume of loans for the system as a whole [Rodkey 1928, 185].
If new reserves are added to the system each bank is able to expand, in the first instance, by the amount of new reserves it receives. Loan expansion for the system as a whole, however, will be several times greater than the combined first-round expansion of the first banks to receive the new reserves. “The new reserve, split into small fragments, becomes dispersed among the banks of the system. Through the process of dispersion it comes to constitute the basis of a manifold loan expansion” (Phillips 1920, 40). Expansion continues until all of the new reserve media is absorbed in the economically required balances of the banks (see below, chapter 6).5
The Principle of Adverse Clearings
There is nothing controversial about the rule of excess reserves, applied to a conventional system of deposit banks. What is controversial is whether a similar rule restricts the granting of credit in the form of competitively-issued bank notes. The generalization of the rule of excess reserves involved here will be referred to as the “principle of adverse clearings.” Early upholders of this principle include Sir Henry Parnell (1827), Lord Peter King (1804), and G. Poulett Scrope (1832). More recently, Ludwig von Mises has stated the principle as follows:
If several banks of issue, each enjoying equal rights, existed side by side, and if some of them sought to expand the volume of circulation credit while others did not alter their conduct, then at every bank clearing, demand balances would regularly appear in favor of the conservative enterprise. As a result of the presentation of notes for redemption and withdrawal of their cash balances, the expanding banks would very quickly be compelled to limit the scale of their emissions.6
Still more recent is Hayek’s allusion to the principle in his Denationalisation of Money (1978, 59):
There will of course always be a strong temptation for any bank to try and expand the circulation of its currency by lending cheaper than competing banks; but it would soon discover that, insofar as the additional lending is not based on a corresponding increase of saving, such attempts would inevitably rebound and hurt the bank that over-issued.
According to Alex N. McLeod (1984, 202), adverse clearings “not only limit the total note issue” in a system of competing banks of issue but also “limit the share [of circulation] accruing to each individual bank. A disproportionate expansion of one bank’s issues will deplete its reserves just as surely as if its competitors returned them directly, though perhaps somewhat more sluggishly.”
To prove that the principle of adverse clearings is valid, one must demonstrate that the rule of excess reserves applies to lending and investment of competitively issued notes. The rule assumes that banks extend credit in the shape of checkable deposits. It also assumes that there is a determinate demand for deposit balances, that checks are drawn against unwanted balances, and that these checks rapidly find their way to other banks and thence to their issuers for collection, either directly or through a clearinghouse. The principle of adverse clearings rests on similar assumptions. These are (a) that the total demand for bank notes is determinate, and that surplus notes are parted with; (b) that most of these surplus notes end up in possession of banks other than their own issuers; (c) that banks return their rivals’ notes for redemption; and (d) that a preponderance of the notes that enter the clearing mechanism following overexpansion by any bank will be notes of the overexpanding bank. This implies that the division of the public’s demand for note balances among the issues of various banks is also determinate.
Let us examine these assumptions one by one. The first is straightforward. A note-issuing bank faces a market where the total demand for the combined note balances of issuing banks is given in the short run. This means that any note issue not in response to an increased demand for note balances causes an aggregate excess supply of notes. That surplus notes when spent eventually find their way into possession of rival banks (assumption b) is less obvious because, unlike checks, notes are not necessarily cashed or deposited immediately upon their receipt. They might be used to make additional purchases and so remain in circulation for an extended period. Still the assumption is justified. Consider the typical fate of a bank note not wanted in anyone’s average holdings. If the note is not immediately deposited at some bank, it will probably be used to purchase goods from a retail merchant.7 Merchants receive much more money in the form of notes in the course of a typical business day or week than they require for making change. They bring the excess notes to their banks in exchange for checkable deposits, a form of inside money more useful than notes for paying rent and insurance and making wholesale purchases, and one that can earn interest as well. Thus the majority of notes received by retail merchants is deposited: the deposit accounts of merchants act as “note filtering” devices, helping surplus notes find their way rapidly into banks that are (for the same reason as in the case of checks) mainly not the banks that created the note surplus to begin with. The farther a note travels up the ladder of production (from retail tradesmen to distributors to manufacturers of higher-order goods), the greater its chances of being exchanged for a deposit credit, and the greater its chances of entering the clearing system.
Assumption (c) is also not difficult to defend. Notes received by banks other than those responsible for their issue are immediately sent for redemption directly or through a clearinghouse. This is the strategy most consistent with the maximum profits and safety of the recipient banks. Some reasons for this were given in the previous chapter. By returning its rivals’ notes a bank gives up only assets (notes of other banks) that do not earn interest, in return for which it receives either its own notes held by other banks (which reduces its outstanding liabilities that could be employed to drain off its reserves) or, alternatively, more liquid and risk-free commodity money.
Hence, if, starting in a situation where no excess demand for bank-note balances exists, some bank adds $100,000 of notes to the total quantity of notes in circulation, the result would be an excess supply of notes of $100,000, which amount (if not redeemed or deposited directly) would be added to the stream of expenditure and income. As a consequence $100,000 of surplus notes would eventually enter the clearing mechanism, to be sent to their issuers for redemption. This brings us to assumption (d). Is it reasonable to assume that, of the $100,000 of notes returned for redemption, a preponderance will belong to the bank that caused the note surplus to begin with? If the banks initially had (on average) zero net clearing balances with one another, how would net balances due be altered by the additional $100,000 of clearing debits and credits? Would the expanding bank suffer adverse clearings after creating a note surplus, or would it emerge unscathed, even victorious, because other banks are forced to share the burden of a note reflux?
The answer depends on which notes are spent off when consumers first find themselves holding more notes than they want, and this in turn depends on how strong the note-brand preferences of consumers are. If consumers practice 100 percent note-brand discrimination—that is, if besides knowing the total quantity of notes they desire they have strict preferences about what brands or mixture of brands they will hold—then any bank that causes an aggregate note surplus in the face of unchanged preferences cannot expect consumers to substitute its notes for notes of other banks in their holdings. Such being the case, the expanding bank would bear the full burden of clearing debits caused by the note surplus it creates, just as if it had created a surplus of checkable deposits.
On the other hand, if consumers do not at all discriminate among note brands they are not likely to select for spending the notes of a bank that causes an excess aggregate supply of notes. Then the principle of adverse clearings would not be valid and note issue, from the perspective of the individual bank, would not be subject to increasing marginal liquidity costs. This means that there might be a tendency for banks to try to out-issue their competitors. Such “predatory overexpansion” could continually push the system as a whole beyond sustainable limits of expansion as determined by the supply of reserves. (On the demand for precautionary reserves as an ultimate check on expansion see below, chapter 6.)
Notice that there is no reason to doubt that consumers are discriminating when it comes to checkable deposit accounts. Were this not so, someone who receives a check written on any bank would be as likely to deposit it into that bank as into any other. If his total accounts became excessive, he might withdraw some part of each (or withdraw from one account chosen at random). The result would be that people would on average have accounts at scores of banks. Obviously such is not the case.
That consumers would discriminate among note brands is not so obvious, though. The inconvenience of holding an everchanging mixture of bank notes is not so apparent as is the inconvenience of holding deposit accounts at numerous, continually changing, banks. If all note brands are equally acceptable to merchants and to banks, why should consumers care which brand they use?
The answer is that, although many note brands may be equally receivable, people may still prefer to hold on to particular brands. Banks, like manufacturers of light bulbs, razor blades, and gasoline, have every reason to establish brandname reputations for their products so that individuals do not, at least in their holding behavior, treat all brands as equals.8 A bank profits if note holders discriminate in favor of its issues since their holdings of its notes constitute an interest-free loan to it. Since, however, some may doubt that this is so, the reasonableness of assuming note-brand discrimination can be more decisively demonstrated by showing the counterfactual implications of nondiscrimination among bank notes. Under nondiscrimination, consumers return excess notes in proportion to the banks’ shares of total circulation after the excess is created.9 This would be tantamount to consumers shedding excess notes while blindfolded. Thus, for example, suppose there are two banks, A and B, each with a starting note circulation of $1 million and commodity-money reserves of $100,000. Their combined circulation of $2 million is just what consumers want to hold. Suppose A decides to issue an additional $100,000, which consumers do not want to hold. The consumers shed the excess by depositing it in the proportion $11 of A’s notes for every $10 of B’s notes, or $52,381 of A’s notes and $47,619 of B’s notes.10 Taking into account assumption b (discussed above), that all returned notes fall into the hands of banks other than their issuer, A loses $4,762 of reserves to B at their next clearing. This is much less than the entire amount of A’s overissue. Although A would be deterred from overissuing if it lacked excess reserves, if A did have excess reserves it could expand credit (in the form of notes) in amounts greater than the excess, suffering only a partial reserve drain.
For an expanding bank, expansion is more costly the greater the number of other banks in the system, assuming the bank overissues by the same amount and that all banks begin with equal shares of the original ($2 million) circulation. Thus, if there are four banks beginning with $500,000 circulation each, and one overexpands $100,000, it will lose approximately $5,720 of reserves to one or several of the other banks, instead of losing $4,762 as in the previous example.11 Furthermore, if an expanding bank begins with a greater than average share of total circulation, this also causes it to suffer greater clearing debits relative to the total note surplus, other things being equal. Even so, the principle of adverse clearings does not apply with full force.
Even more troublesome is a situation where there are few banks and the expanding bank is smaller than the rest. Suppose there are three banks, where Bank A has $1 million of notes in circulation and $100,000 of commodity-money reserves, Bank B has $2 million of circulation and $200,000 of reserves, and Bank C has $3 million of circulation and $300,000 of reserves. If Bank A overissues $100,000 of notes again, consumers return $11 of A’s notes for every $20 of B’s notes and every $30 of C’s notes, or $18,033 of A’s notes, $32,787 of B’s notes, and $49,180 of C’s notes. Bank A does not lose any reserves at all; instead, Banks B and C, which did not overissue, lose reserves to it; furthermore, Bank C loses reserves to Bank B! Since the proportions in which consumers return the notes of one bank to the other banks makes a difference in the amounts of the net clearing balances, let us assume in accordance with the previous example that consumers return the notes of each bank to its rivals in proportion to the rivals’ relative shares of total circulation.12 They return the $18,033 of A’s notes in the proportion of $20 to Bank B for every $30 to Bank C, or $7,213 to B and $10,820 to C. They return the $32,787 of B’s notes in the proportion $11 to A for every $30 to C, or $8,797 to A and $23,990 to C. They return the $49,180 of C’s notes in the proportion $11 to A for every $20 to B, or $17,429 to A and $31,729 to B. The net clearing balances are:
Bank C suffers a net reserve loss of $14,348, whereas banks A and B gain $8,193 and $6,155 of reserves, respectively. These results are summarized in Table 3.1 below. They imply that Bank A can continue to engage in predatory overexpansion without losing any reserves until its circulation is as big as Bank B’s; Bank C will continue to lose reserves to Banks A and B until Bank A’s circulation is as big as its own.
Thus the absence of note-brand loyalty would make it especially profitable for “undersized” banks to overissue, while forcing larger than average banks to suffer the consequences. Notice, however, that this circumstance would not encourage any general overexpansion, since larger banks would not have any profitable opportunities to expand, much less to overexpand; their best strategy would be to stand pat while their smaller rivals whittle away their circulation. The assumption of note-brand indiscrimination is, in other words, equivalent to an assumption of diseconomies of scale in note issue.
Here, then, is the rub, for the assumption of diseconomies of scale in competitive note issue has empirical implications which are clearly counterfactual, namely, that a banking system with competitive note issue should tend toward large numbers (if not an infinite number) of banks each having a minuscule share of total note circulation. Nothing of the kind appears to have been the case anywhere where competitive note issue took place. In Scottish, Canadian, and Swedish experience there was considerable diversity of market shares of circulation of various banks, with no evidence that banks with larger shares were at a disadvantage.13 Indeed, in the various historical cases of free banking there seems to have been nothing at all that corresponds to the sequence of events one would expect were consumers indiscriminate among note brands. The Scottish, Canadian, Swedish, and Suffolk systems were all remarkably stable; prudent banks did not appear to suffer at all from overexpansion of their rivals, including smaller ones. During the months leading up to the failure of the Ayr Bank, for instance, the larger Scottish banks did not experience abnormal reserve drains. In fact, their reserves increased because they consistently enjoyed favorable net clearing balances with the Ayr Bank thanks to the latter’s overissue. So historical experience confirms that consumers do discriminate between note brands and, hence, that competitive note issue, like deposit creation, is subject to increasing marginal costs.
To reject the hypothesis of note-brand indiscrimination is, however, not to say that all persons have rigid note-brand preferences (as the 100 percent note-brand discrimination hypothesis would suggest). What can be said is that a significant number of money holders do exhibit brand loyalty. It is these people’s choices that determine the relative market shares of the various note issuers. Ultimately, the presence of a stratum of nondiscriminating individuals, if it has any influence whatsoever, merely increases the amount of precautionary reserves each bank has to hold relative to its total outstanding note liabilities. Banks may find that they do not always suffer reserve drains equal to the full amount of the expansion of their note liabilities. But this temporary reprieve will be offset at other times when the lack of note-brand discrimination works in favor of other banks. On the whole, fluctuations in the flow of clearing balances are random, so that no systematic opportunities for overexpansion result from the presence of nondiscriminating note holders. In other words, as long as note-brand discrimination is not rare, the principle of adverse clearings can be assumed to govern credit expansion in a system with competing banks of issue. It follows that there is no reason to expect competitively issued note liabilities to be more prone to overexpansion than competitively issued checkable deposit liabilities.
This result has other important implications. It means that a solitary bank in a free banking system cannot pursue an independent loan-pricing policy. A “cheap-money” policy in particular would only cause it to lose reserves to rival banks. Also, no bank would be able, by overissuing, to influence the level of prices or nominal income to any significant degree, since the clearing mechanism rapidly absorbs issues in excess of aggregate demand, punishing the responsible bank. Consequently, the structure of nominal prices would not be indeterminate. Assuming stationary conditions of production, free banks face a determinate schedule of nominal money demand which strictly limits the extent of their issues.
These conclusions are precisely opposite those reached by John G. Gurley and Edward S. Shaw in Money in a Theory of Finance (1960, 253ff). Gurley and Shaw claim that a laissez-faire banking system will lead to an indeterminate price level, with the nominal supply of money “subject to no rational rule and . . . free of guidance by any hand, visible or invisible” (ibid., 256). A (minimal) solution to this problem of price-level indeterminacy, according to these authors, requires the presence of a central bank able to create nominal private-bank reserve balances in the form of claims on itself (ibid., 257). The central bank must limit its issues of such reserves while also paying a fixed rate of interest on them:
Nominal money and the price level are determined when the Central Bank sets nominal reserves and the reserve-balance rate, given a reserve-demand function (liquidity-preference function) that defines the optimal portfolio between reserves and primary securities at alternative combinations of bond rate, reserve-balance rate, deposit rate, and real stock of money [ibid., 266-67].
Gurley and Shaw note that this solution does not depend on a legally-specified, minimum ratio of reserves to private banks’ liabilities.
What Gurley and Shaw overlook in their analysis is that private banks in an unregulated setting already have a well-defined demand for reserves (determinants of which are discussed below, in chapter 6). This demand does not rest on the existence of a central bank capable of augmenting or otherwise influencing the supply of reserve media. Rather, it stems directly from the fact, noted by Gurley and Shaw (ibid., 256) that “the individual bank [in a laissez-faire system] is not permitted to run up an indefinite amount of clearinghouse debt to its competitors.” Thus a market for reserves will exist under laissez faire, where reserves consist of some asset which, though not issued by a central bank, is acceptable to private banks in the settlement of clearinghouse balances. If the reserve asset is an outside commodity-money such as gold, which is costly to produce and which does not bear interest (or, in other words, bears interest at a fixed rate of zero percent), its use satisfies the conditions given by Gurley and Shaw for a determinate price level and nominal money supply. Hence their rejection of laissez-faire banking in favor of central banking is unwarranted. Indeed, as we shall see in the next section, their belief that a central bank is helpful for tying down the price level and nominal supply of money is in a sense the opposite of the truth.
Monopolized Note Issue
Now let us consider a centralized system, based on commodity money, where deposit banking is entirely free but where one bank has sole right of note issue. It has been shown that the rule of excess reserves limits the ability of deposit banks in such a system to expand credit. A monopoly bank of issue is under no similar restraint. This bank is the sole source of currency, apart from commodity money, for the entire system. When holders of deposit accounts want to convert parts of their balances into a form useful in hand-to-hand payments where checks are less acceptable, they will demand conversion of their deposits into the notes of the monopoly issuer (or, perhaps, into commodity money). If public confidence in the notes of the monopoly issuer is high, its notes will be preferred to commodity money, which is more cumbersome. For their part the deposit banks, stripped of the ability to issue their own notes to supply their depositors with currency, rely upon notes of the monopoly bank of issue, or upon deposit credits at the monopoly bank (which they can convert into its notes). As all deposit banks share a common motive for holding liabilities of the monopoly bank of issue, a general demand for these liabilities develops. As Charles Rist notes in his History of Monetary and Credit Theory ( 1966, 208), the liabilities of the monopoly bank of issue come to be treated by the deposit banks much as commodity-money is treated by banks in a system with competitive note issue:
In countries where there is a central bank of issue, which has the exclusive right of issuing bank-notes . . . the deposit banks have come to regard bank-notes, and not coin, as the currency which they must use for payments . . . banks settle their accounts with each other by means of notes or by transfer through the central bank, and their chief concern is to be able at any moment to repay in these notes the deposits entrusted to them.
Commodity money, instead of being held by the deposit banks, may (to a large extent) be deposited with the bank of issue, possibly at interest, in exchange for liabilities of that bank which, besides being useful in settling clearing balances, are at least as useful as commodity money for supplying the public’s currency needs.14
Thus as a consequence (perhaps unintended) of monopolized note issue, the liabilities of the privileged bank acquire a special status in the banking system; they become a kind of reserve media, supplementing and even superseding reserves of commodity money. Unlike deposit liabilities of non-note-issuing banks and unlike any of the bank liabilities in a system with competing note-issuers, the liabilities of a monopoly bank of issue are a form of high-powered money. Issues of such liabilities add to the base money of the system. This means, in effect, that a monopoly bank of issue is, in the short run at least, exempt from the principle of adverse clearings. The liabilities it issues not employed as currency in circulation become lodged in the reserves of deposit banks, where they cause a multiplicative expansion of credit. In general (assuming a closed economy) these liabilities will not be returned to their issuer for redemption even though their issue, and the multiplicative expansion of credit caused by it, is not justified by any prior excess demand for inside money. In other words, in a closed system a monopoly bank of issue can cause an inflationary increase in the money supply—raising the level of nominal income and prices—without suffering any negative consequences.15 Unless some external short-run control is imposed on it, a monopoly bank of issue even when its issues are convertible into commodity money can for some time at least pursue any loan-pricing policy it desires, arbitrarily expanding or contracting the money supply and causing widespread changes in nominal income and prices.
Of course, in an open system, an increase in the level of domestic prices (due to monetary overexpansion) eventually reduces exports relative to imports, causing an outflow of commodity-money reserves to foreign banking systems. This belatedly checks overexpansion by the domestic bank of issue. Also, inflation usually involves a decline in the relative price of commodity money, encouraging its withdrawal, for industrial and other nonmonetary uses, from the monopoly bank. This last effect checks overexpansion by a monopoly bank of issue even in a closed economy. Still it is a long-term corrective, which takes place after overexpansion has done the larger part of its damage. (On the effects of short-run monetary disequilibrium see below, chapter 4.) Long-term checks on overissue differ significantly from the short-run adjustments that come into play when the principle of adverse clearings operates.
Because of the special character of its liabilities, a monopoly bank of issue is able to influence the money supply like a central bank. Indeed, it is no coincidence that all central banks—that is, banks responsible for carrying out some government-directed monetary policy—have either a monopoly or a virtual monopoly of currency supply. Such a monopoly “gives them the power to dictate terms to banks which are in need of notes for deposit conversion” (Whitney 1934, 17). By controlling the issue of currency, a central bank also controls deposit expansion by non note-issuing banks:
Deposits must always have at the back of them a sufficient reserve of currency, and therefore the total amount of currency must be a major factor in the determination of the total volume of deposits that can be created through the lending operations of the banks. Thus, if a central banking authority controls the issue of notes, it also controls, though less rigidly, the volume of credit [V. Smith 1936, 7].
From this one may be tempted to conclude that legislators, realizing some of the consequences of monopolized note issue, saw fit to impose it as a means for rational monetary control. In reality, however, monopolized note issue is much older than the idea of centralized, “rational” money management. The Bank of England has had a monopoly or quasi monopoly of the London note issue since its establishment in 1694. Yet the idea that it should be held responsible for preventing undesirable fluctuations in England’s money supply was not adopted as public policy until the latter half of the 19th century. Before this, the Bank of England was essentially a profit-maximizing firm the directors of which vigorously denied any responsibility for fluctuations in the money supply. In English experience, which served as the model for all subsequent central-banking reforms, it was not a demand for rational, centralized monetary control that caused note issue to be monopolized. Rather, it was the existence of a partial note-issue monopoly that inspired demands for more rational, centralized control. When monopolization of note issue awards, to a single bank, the power to “control” the money supply, it also gives that bank power to over- and underexpand credit that it would not possess were it one of a system of competing note issuers.
Illustration: The Post-1910 Australian Inflation
Some of the conclusions reached in this chapter are strikingly illustrated by the experience of Australia in the years surrounding World War I.16 Before 1910 Australia had several note-issuing banks all adhering to a gold standard. The banks settled clearings with one another in specie, since this was the only form of high-powered money in the system at the time. Under this arrangement prices were fairly stable, and the principle of adverse clearings insured that no single bank could step out of line with its competitors. If by chance the entire system went out of line, adjustment would come as a consequence of gold losses abroad.
In 1910 the Australian government passed a law authorizing a limited issue of legal-tender Australian government notes, and a year later the Commonwealth Bank was set up as an agent for issuing these notes. Soon afterwards a prohibitive 10 percent tax was imposed on all private bank note issues, and restrictions on the issue of legal-tender notes were relaxed. This gave the Australian government and its agent, the Commonwealth Bank, a virtual monopoly in note issue. The result was that the Australian notes became a new kind of high-powered money. Almost immediately the government increased its issues, and a general expansion of credit followed. So as to thwart the corrective influence of the international price-specie-flow mechanism, the government declared a gold export embargo. In the space of two or three years what had been an open system with plural note issuers was transformed into a closed system with monopolized note issue.
More consequences, all in accord with the predictions of theory, followed. In September 1914, the private banks formally abandoned their regular procedure of settling clearings in specie, giving priority to acquisition of notes from the monopoly bank of issue. By this time Australian credit expansion was entirely unleashed from normal sources of control. The Treasury and the Commonwealth Bank were free to manipulate the money supply, by altering the supply of high-powered money, in any direction they desired. As it happened, the authorities took advantage of the new arrangement to finance wartime expenditures. As J. R. Butchart notes (1918, 29), monopolization of the Australian currency
opened the door for the Commonwealth Treasurers to create vast deposits by simply printing notes and paying them into the counter at the Commonwealth Bank. These notes created deposits in the books of the Commonwealth Bank. Against the deposits the Government drew its checks [which were] transferred from the Commonwealth Bank all over Australia.
The result was a dramatic rise in Australian prices that continued throughout the course of the war, and for some time thereafter.
[1.] Good statements of the rule of excess reserves are in Chester Arthur Phillips (1920, 33-34), Robert G. Rodkey (1928, 178-85), and Alex N. McLeod (1984, 201).
[2.] See Rodkey (1928, 42). The above argument assumes that, after the first clearing round, Bank A must reduce its loans $40,000 to restore its reserves. The simplest means by which this might be accomplished is if those persons holding the $40,000 of new money balances at Banks B through E use them to buy goods from a debtor of Bank A, who in turn pays back a $40,000 loan. The same sort of transactions can be imagined to occur after each clearing round. By this means one can most readily see that Bank A must soon contract by the full amount of its overexpansion.
[3.] Banks might also try to attract more depositors by offering them higher rates while earning the interest through riskier loans and investments. This of course is just a definition of bad banking: the high-risk loans reduce bank revenues in the long run, as default occurs. But the bank may grow inordinately in the short run. Such banking has been behind many of the growing number of bank failures in recent times. It would not, however, be common in unregulated circumstances, where bank owners bear the full costs of failure. Its frequency today must be blamed on regulatory arrangements, including Federal deposit insurance, bank bailouts, and the promise of Federal Reserve support, that subsidize excessive risk-taking and artificially limit losses to bank stockholders.
[4.] The argument proves only that spontaneous in-concert absolute overexpansion is unlikely; it does not show why, facing a uniform fall in the demand for money, banks as a whole should contract their liabilities, or why a planned in-concert overexpansion would not be sustainable. A more general treatment of the problem of in-concert overexpansion appears in chapter 6.
[5.] If currency is used by the public some of the new reserve media may pass into circulation, lessening the potential expansion. In an open economy reserve media useful in international trade might also be lost to foreign banks. Here we assume that the public’s demand for currency does not increase, and that the economy is a closed one.
[6.] Ludwig von Mises ( 1978, 138). “Circulation credit” is Mises’s term for bank liabilities not backed by commodity-money reserves. Elsewhere Mises uses the term “fiduciary credit” (see chapter 4 below).
[7.] It is reasonable to assume that most non-retail purchases are made using checks rather than notes.
[8.] According to Checkland (1975), the Scottish banks encouraged their customers (depositors and borrowers) to show note brand loyalty by paying in the notes of rival banks, while making their advances to others with their own bank’s notes. Pressure to “push” a bank’s notes was most effectively placed on those in debt to it.
[9.] Such behavior is assumed by Eugene E. Agger (1918, 103).
[10.] This example, as well as one to follow, assumes that new notes are initially issued in a proportional loan to everybody. This assumption is the strongest that can be made in favor of a “predatory overexpansion” scenario. If it is assumed, more realistically, that new issues are first made available to one person or group only, more of them will enter the clearing mechanism, ceteris paribus.
[11.] Compare L. White (1984d, 97fn), who employs somewhat different assumptions and concludes that an overexpanding bank’s reserve losses will fall as the number of its rivals increases.
[12.] We have already seen why it makes little difference if some notes return directly to their issuers.
[13.] For statistics on the note circulation of various banks during the Scottish free banking era, see L. White (1984d) and Munn (1981). For statistics on note issues of Canadian banks in the 19th century, see the Dominion Bureau of Statistics Canada Yearbook. For evidence from the Swedish experience, see Jonung (1985).
[14.] The existence of legal-tender status for the notes of a privileged bank of issue, although it encourages their general acceptance, is not essential to their being held for reissue by deposit banks.
[15.] To recall, we are assuming that there is no public demand to hold coin as a proportion of total money balances. The conclusion also ignores the possible presence of industrial (nonmonetary) demands for the money commodity.
[16.] Except where otherwise noted the facts cited are from Copland (1920).