What Mises Said

In his response to my comment, Professor White focuses on two questions pertaining to Mises’s theory of banking:

whether Mises thought there were advantages to the economy as a whole if the demand for monetary gold diminishes due to the development of fractional-reserve banking; and
whether Mises thought that the production of fiduciary media tends to be limited under fractional-reserve banking.

Lawrence White believes my interpretation of Mises to be wrong, at any rate as far as these two points are concerned. Let me therefore address them in turn.

(1) It is correct that the development of fractional-reserve banking tends to diminish the demand for base money under a gold standard. It is correct that Mises, in the second and third parts of The Theory of Money and Credit, highlighted that this tendency implied that more original factors of production could be devoted to the production of other goods. And it is also correct that, in the first edition (1912), Mises considered this tendency to be beneficial from an overall point of view.

However, he thoroughly reconsidered his position in later works, especially in second edition of The Theory of Money and Credit (1924) and again in the fourth part added to the 1953 American edition. More precisely, while he still acknowledged that the development of fractional-reserve banking tends to diminish the production of gold, he no longer held this to be beneficial.

In the concluding chapter of the third part (chap. 20, III, sections 9 and 10) he now stated that the (fractional reserve) gold-exchange standard was pointless because it did not effectively rein in monetary interventionism. The only alternative was either to go the full way to fiduciary media or to return to the actual use of gold in daily exchanges. He clearly opted for the latter alternative. (See Mises 1924, pp. 403f; 1980, pp. 432f.)

He explains his reform plan in more detail in the fourth part added to the 1953 edition. But the objective is the same as in 1924, namely, the establishment of an effective gold-coin circulation. He wrote: “Gold must be in the cash holdings of everybody. Everybody must see gold coins changing hands, must be used to having gold coins in his pockets, to receiving gold coins when he cashes his paycheck, and to spending gold coins when he buys in a store.” (1980, p. 493)

Let us now step back and consider what this means. Mises did not change his analysis of the resource-cost-saving mechanism. The development of fractional-reserve banking tends to diminish the production of gold, and this liberates labor and land resources that can now be devoted to other production projects. But this tendency no longer appears to be beneficial. The “resource-cost-savings” made possible by fractional-reserve banking now appear to be as foolish as the resource-cost-savings of building a car without breaks or shock absorbers.

In other words, Mises had come to the conclusion that the resource costs of gold production were worth the while. In Human Action he recognized that he had once been wrong in endorsing the gold-exchange standard in previous works. (See Mises 1949, chap. 31, section 3, p. 780.) In another chapter he stated: “If one looks at the catastrophic consequences of the great paper money inflations, one must admit that the expensiveness of gold production is the minor evil.” (Mises 1949, chap. 17, section 6, p. 419)

Hence, Lawrence White’s contention that Mises considered the resource-cost-saving induced by fractional-reserve banking to be beneficial from an overall point of view is correct only for the German-language first edition of 1912. In all other editions Mises revised this earlier stance, both in the third part of the Theory of Money and Credit, but also in the fourth part of the same book, as well as in Human Action.

(2) According to Lawrence White, Mises thought that the production of fiduciary media tended to be limited under fractional-reserve banking. Professor White was kind enough to reiterate a lengthy quote from Mises that allegedly substantiates this contention. I shall reciprocate the favor by quoting this passage again, yet with two supplements: First, I shall also quote the few lines that immediately follow the said passage and that conclude section 4 of chapter 17. Second, I shall modify a few sentences of the translation (highlighted), because the English text is here not 100 percent covered by the German collateral:

The circulation of fiduciary media is in fact not elastic in the sense that it automatically accommodates the demand for money to the stock of money without influencing the inner objective exchange value of money, as is erroneously asserted. It is only elastic in the sense that it allows of any sort of extension of the circulation, even completely unlimited extension, just as it allows of any sort of restriction. The quantity of fiduciary media in circulation has no natural limits. If for any reason it is desired that it should be limited, then it must be limited by some sort of deliberate human intervention -- that is by banking policy.Of course, all of this is true only under the assumption that all banks issue fiduciary media according to uniform principles, or that there is only one bank that issues fiduciary media. A single bank carrying on its business in competition with numerous others is not in a position to enter upon an independent discount policy. If regard to the behavior of its competitors prevents it from further reducing the rate of interest in bank-credit transactions, then—apart from an extension of its clientele—it will be able to circulate more fiduciary media only if there is a demand for them even when the rate of interest charged is not lower than that charged by the banks competing with it. Thus we see that, up to a point, the banks pay regard to the periodical fluctuations in the demand for money. They increase and decrease their circulation pari passu with the variations in the demand for money, so far as the lack of a uniform procedure makes it impossible for them to follow an independent interest policy. But in doing so, they make an essential contribution to stabilizing the inner objective exchange value of money. In this regard, therefore, the theory of the elasticity of the circulation of fiduciary media is correct; it has rightly apprehended a tendency manifesting itself on the market, even if it has also completely misapprehended its cause. And precisely because it has employed a false principle for explaining the phenomenon that it has observed, it has also completely closed the way to understanding of a second tendency of the market that emanates from the circulation of fiduciary media. It was possible for it to overlook the fact that so far as the banks proceed uniformly, there must be a continual augmentation of the circulation of fiduciary media, and consequently a fall of the inner objective exchange value of money. [Mises 1912, pp. 360f; cf. Mises 1980, pp. 346f]

The crucial point is this: Mises held that the production of fiduciary media entailed two possible tendencies. If the banks agree on common procedures, the production of fiduciary media is in principle unlimited. If the banks do not agree on common procedures, the further production of fiduciary media is slowed down. He repeats this view in several passages of the third part of his book. (See for example Mises 1912, pp. 340, 420, 425f, 444.)

Then why did he state that “quantity of fiduciary media in circulation has no natural limits”? I think the reason is quite straightforward. Mises believed that the second tendency dominates the first one. Temporarily, it is possible and even likely that fractional-reserve banks do not reach the agreement needed for quick credit expansion. But credit expansion is nevertheless the long-run tendency, for two reasons.

On the one hand, credit expansion does not necessarily have to be fast; it can also occur in a creeping trial-and-error process. Mises wrote (1980, p. 411): “So long as the banks do not come to an agreement among themselves concerning the extension of credit, the circulation of fiduciary media can indeed be increased slowly, but it cannot be increased in a sweeping fashion. Each individual bank can only make a small step forward and must then wait until the others have followed its example.”

On the other hand, the banks may eventually reach an agreement, in which case credit expansion can proceed at a much faster pace. This is actually the scenario that Mises envisioned in developing his business-cycle theory in chapter 19. He wrote:

We know … that all credit-issuing banks endeavor to extend their circulation of fiduciary media as much as possible, and that the only obstacles in their way nowadays are legal prescriptions and business customs concerning the covering of notes and deposits, not any resistance on the part of the public. If there were no artificial restriction of the credit system at all, and if the individual credit-issuing banks could agree to parallel procedure, then the complete cessation of the use of money would only be a question of time.

This passages is intriguing for more than one reason. It not only shows that Mises believed that the “second tendency” – the one toward a continual augmentation of the circulation of fiduciary media – dominated the first tendency. It also highlights the fact that Mises had a different conception of the workings of free fractional-reserve banking, and of the collusion between such banks, than Professor White.

Mises held that all credit-issuing banks try to issue as many fiduciary media as possible. They do not need to be cartelized through government interventions (although that might possibly speed up the process), but have a self-interest in doing so. In spite of political interference, such as legal reserve ratios, however, the long-run tendency was for fractional-reserve banks to cartelize, first on the national level and eventually on a global level. This is what Mises purports to show in chapter 16, where he deals with the “evolution of fiduciary media.” The driving force of this process is the basic and perennial motivation of all banks to increase their issue of fiduciary media. At the time of writing The Theory of Money and Credit, he saw the biggest obstacle to the establishment of a world bank and the full cartelization of all fractional-reserve banks not in the inability of the banks to come to an agreement, but in the reluctance of governments. (See Mises 1912, pp. 339f; 1980, p. 329.)

It is true that, starting from the second edition (1924), Mises underscored the short-run benefits of competition between fractional-reserve banks, and in Human Action he downplayed the strength and even the existence of the “second tendency.” Professor White gives a pertinent quote in which Mises (1949, chap. 17, p. 444) questions the likelihood of the establishment of a banking cartel without government support. However, even then Mises upheld his standard position. Free fractional-reserve banking is the second-best option. The first-best option is to stop any further production of fiduciary media. The very section in Human Action in which Mises rejects the scenario of a banking cartel ends with the following statement:

Government interference with the present state of banking affairs could be justified if its aim were to liquidate the unsatisfactory conditions by preventing or at least seriously restricting any further credit expansion. In fact, the chief objective of present-day government interference is to intensify further credit expansion. This policy is doomed to failure. Sooner or later it must result in a catastrophe. [Mises 1949, p. 445]

These are Mises’s views. Now we can discuss the question whether they are correct. Professor White does not think they are, but he will not be surprised that I think he is wrong. For the sake of brevity, however, I shall conclude with a few cursory statements pertaining to three of his errors.

First, Lawrence White claims that the “issue of fiduciary media is unlimited only in the analytical limiting case (never historically realized) of a single world banking system with a single issuer of fiduciary media,” etc. It is true that such a unified world banking system has never existed, but that does not mean that there is no tendency toward its establishment. I happen to think that such as tendency exists, or is at any rate much more plausible than the model of free fractional-reserve banking cherished in the writings of Professor White. Fractional-reserve banking without collusion not only is an “analytical limiting case (never historically realized),” but there is also not the slightest reason to think that it ever will come to be.

Second, it is not correct that collusion among banks could only aim at restricting industry output. The point of collusion is to increase the revenues of cartel members beyond the level that would be possible under competition. Usually that involves restricting output, but in the case of fractional-reserve banking it implies increasing output.

Third, is there really “no reason to think that banks can successfully collude without government … to enforce the cartels’ prices”? I agree that this is improbable in most circumstances, but then again the fractional-reserve industry is special because it is built on the obfuscation and outright violation of property rights. And then there is also another consideration, highlighted by Professor White himself, who has argued that private central banks can evolve out of clearing house associations. (See White 1999, pp. 70ff.)

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