Why Rothbard Thought the Fed Eliminated Market Safeguards Against Bank Inflation

Summary

• Central Banking Critique: The podcast discusses Murray Rothbard's view that central banks, contrary to their claims, undermine market safeguards against bank inflation by enabling unchecked credit expansion.
• Free Banking System: Rothbard argues that in a free banking system, market forces naturally limit bank credit expansion, as banks must maintain sufficient reserves to meet customer demands and interbank obligations.
• Role of Central Banks: Central banks are critiqued for acting as lenders of last resort, which removes the natural market checks on banks, allowing them to expand credit without immediate consequences.
• Cartelization of Banks: The podcast highlights how central banks facilitate the cartelization of private banks, preventing new entrants and competition, which would otherwise keep inflation in check.
• 100% Reserve Banking: Rothbard's advocacy for 100% reserve banking is discussed, emphasizing that it would prevent banks from creating money through fractional reserves, thus stabilizing the economy.
• Historical Context: The podcast references historical arguments for central banking, such as the need for an elastic currency and a lender of last resort, and contrasts these with the Austrian School's perspective.
• Market Dynamics: Emphasizes that in a free market, banks would be naturally restrained from excessive credit creation due to competition and the need to maintain customer trust and solvency.
• Investment Implications: The discussion implies that understanding these dynamics is crucial for investors, as central bank policies significantly impact economic cycles and inflation.

Transcript

This is the Human Action podcast where we debunk the economic, political, and even cultural myths of the days. Here's your host, Dr. Bob Murphy. Hey everybody, welcome back to Human Action Podcast. Today, I'm going solo again and we're going to do another deep dive into the issue of central banking. But what I'm going to do for this episode is read to you an excerpt from Murray Rothbart's The Mystery of Banking. And then I'm going to just explain to you his framework because I'm realizing just in seeing discussions on social media, there's even a lot of self-described Austrian school fans who I don't think quite understand just how insidious the central bank is, right? And I realize that's a strong statement since lots of people really can't stand the central bank. But what I mean is what we're going to cover in this particular episode is I'm going to show that in the Rothbartian framework, what the central bank claims to be doing on behalf of the general public visa v a private unregulated banking sector is the exact opposite of what it actually does. Okay? And I don't and I'm not even talking about the purchasing power of the currency, right? Like a lot of people are understand that it's crazy when Fed chairs get up there in front of the cameras and talk about, hey, we're going to do our best to fight inflation here and we're on your side and we're taking all these measures that when they're the ones who are creating the money that's causing prices to go up, right? That's ridiculous, but that's not what I'm talking about. It's something more uh fundamental in terms of the inherent market checks on commercial bank credit expansion. All right, so this all ties in the stuff that I've been talking about lately, ever since Richard Verer was on Tucker Carlson's show. Before we get into the meat of this episode, though, let me make an announcement. The Mises Institute has another book giveaway, and this time it is a collection. It's called Hayek for the 21st century, and it's a collection of some of his most famous essays or excerpts from, you know, his longer works. And I think they did a really good job grabbing various uh samples of Hayek's work just to give you a good sampler if you will of his overall worldview. So there's things there uh like an excerpt from the road to surfom called why the worst get on top that for a lot of people that's really what they took away from that book. Um there's also one of Hayek's most important economic you know peer-reviewed journal articles called the use of knowledge in society. Just a little anecdote that particular essay when I was a grad student at NYU every week we would have the what was called the Austrian colloquium and you know so we're all people in my cohort going through NYU are getting our PhDs in economics and it's a very technical program and then I'm doing this thing every Monday going to this Austrian colloquium and some of my you know classmates were asking me what what is that and so I for some of them I I said well if you really want to know and I had them read the the single selection that I picked for other trained economists to get them to understand what the heck is this Austrian school about. In this case, it I chose high the use of knowledge in society. For what it's worth, it was the two Japanese students asked me and I gave it to them and they came back and they said understand it. It may have been partly a language barrier because their uh English was not great. It their English was way better than my Japanese. I always reassure them. But in any event, my point being that to those who are familiar with Austrian economics, some of the stuff Hayek writes in that particular journal article, it's like you think it's obvious or whatever, but it's I can't express to you just what a fresh perspective that was for the mainstream economics profession and that he was, you know, getting that in a in a good journal u just kind of showed his academic pedigree. So, as I say, this new book from the Mises Institute, Hayek for the 21st century, has a collection of various items just covering the broad um body of work that he produced and it's free. All right, so if you go to mises.org/hayek21, right? So, Hayek and then 21, you can just fill out your information. If you're in the United States, not only is the book free, but they'll even cover the shipping. If you're foreign, they won't charge you for the book, but they will charge you for the shipping. And also, let me just mention, it's not just your personal copy. If you can put in the form how many copies you want and, you know, fill out in the explanation what you're going to use it for. And if you, you know, are part of a homeschooling group and they cover economics or even basically any kind of thing touching on society really and you think that book would be appropriate, you can go ahead and request copies for the kids, uh, you can give it to your local whatever chamber of commerce meeting, just whatever you want. Give it to your church. Go ahead, knock yourself out. Just go ahead and go to mises.org/hayek21. org/hayek21 and fill in your information and they will get that out to you within one to two weeks. Okay. So again, what we're talking about tonight is Murray Rothbard's view of central banking. And here I'm drawing on his magisterial work, the mystery of banking. So, if you're watching the video version of this, we'll be flashing up some screenshots here. And in particular, well, let me just mention as they explain in the preface, or maybe it's the forward, I always get those mixed up to this particular volume that the Mises Institute put out. This was in some sense a neglected classic from Rothbard that there were various hiccups in the publication when it first came out and it it just a lot of people overlooked it. But then when you go and look at it, it's amazing and and so they put it out um right around the financial crisis you to reissue it to make sure that this in PDF form for sure could get into the hands of the people who needed to see it. and Rothbart just in his characteristic fashion just goes through and step by step, you know, he first lays out kind of like the theory of money and banking and then does a history lesson focusing on the United States and the origin of the Federal Reserve and so forth. And one of the things that I know I I took away from this when I first read it was understanding the sense in which the the notion of a central bank. So not just being skeptical of the particulars of like how the Federal Reserve was formed and looking at oh wow they went down to Jackal Islands the I mean yes that's all important and it's fascinating story and so forth. You could tell that around the campfire and scare the little kids. But what Rothbird does in this book is really isolate and lays out step by step how once you understand the operation of a free market in banking and we'll talk more in this episode about what that what that means, what's sometimes referred to as free banking. Then when you see the mechanisms at play and how standard competition and you know volunteerism that characterize everyday market transactions, how that protects the public from uh shady behavior on the part of the bankers, how the very concept of a central bank. So even when a central bank works quote as it's supposed to, it actually tears down those protections for the public. Right? So that's what I want to just get across to you folks in this particular episode. All right? And what's interesting here, we'll flash up for those watching the video version of this. If you see on the screen there, this is the table of contents from the mystery of banking or you know a portion of it. And you can see that section eight is called free banking and the limits on bank credit inflation. And then the next chapter nine is central banking colon removing the limits. All right. So there just in terms of the titles he's laying out what the argument is. Right? So logically speaking, first we have to explain what are the limits of bank credit expansion or inflation in a free banking regime. And then you'll it'll be obvious once once you understand the mechanisms by which the public is protected from rampant credit expansion or inflation of the money stock via the private banks in a regime of free banking where contracts are enforced and there's no special privileges. Then you know once you understand that as the baseline then you see how oh now throwing a central bank into the mix and again not a corrupt central bank not a central bank that goes too far but no a central bank that does what its backers say it's going to do what its ostensible purpose is. You can see how oh that systematically weakens all of these checks on private bank credit inflation that Rothbart just explained in the prior chapter. Right? So that's what I really want you to see to fully appreciate why especially among you know Rothbardians we really are not fans of the central bank and why you know chance of end the Fed spontaneously erupted when Ron Paul went to the podium at his recent uh 90th birthday party right like it's not just some kind of quirky thing that no there's a there's a reason that Rothbardians really do not like central banking Okay. So, I think maybe before I spell out how the regime of free banking works, let me clarify something because this every time you see people arguing about so-called 100% reserve banking versus fractional reserve banking on social media, people will matterof factly say, "Oh, well, if guys like Murray Rothbart had their way, banking would literally be impossible." or at the very least the credit intermediary function of banks by which banks are sort of the middlemen that channel savings from households into the you know the hands of various borrowers that that's one of the functions that you think the banking system provides and they will say that's literally impossible if if we were foolish enough to follow Murray Rothbird's advice and insist on 100% reserve banking and that kind of a model they Okay, all banks would do is just be a place to store your money and that's all it would be like just you you put your your currency or your gold coins if it's a an economy that uses gold as the money on deposit at the bank and then you can go around and write checks on or whatever but that's it like like nobody's able to borrow money from the bank because oh we got to keep 100% reserve and no that is unequivocally wrong okay and I'll I'll spell out in a minute why it's wrong but let me back up what I'm saying here by an appeal to authority. I know that's a logical fallacy, but here what I'm trying to do is convince you, the listener, that this isn't it's it's not possible that that allegation is correct because it's not just Murray Rothbart and his rag tag bag of band of followers in the corners of academia who advanced this theory, right? Go to Wikipedia and look up the Chicago plan. Right. And that refers to in the 1930s seeing what happened with the Great Depression and all the bank runs and everything and how that made the money supply shrink. Irving Fiser and other Chicago school economists said we should consider a plan of 100% reserve banking to stop you know this this source of systemic crisis in our financial system. All right. More recently after the 2008 crisis, it again became popular for some economists to think about this stuff. It under this uh in this iteration sometimes they would refer to it as narrow banking, okay, and say, hey, you know, there should be a thing where if if depositors really want to know that they just their money's going to be there, they don't need to earn interest on their checking account. They just got to know it's going to be there. It's going to be liquid. the bank's not going to go take the money and invest it in other stuff that the money's just going to be there. Why don't we have that? They call that narrow banking. And John Cochran is one of the big proponents of that. I don't want to put words in his mouth. I'm not necessarily saying he's 100% for it, no pun intended, for it. But he's saying, why aren't we considering this? Right? Like let's let's resurrect this. And then I think he even went through the pedigree and showed how over the decades various economists had advanced versions of this. At one point in his career, Friedri Hayek advanced this as well. Now it's more contentious. Did Lud van Mises advocate for it? it. The reason I say it's it's um it's not as crystal clear is because I think for sure what happened is Mises said anything less than 100% reserve banking spawns the business cycle. But then in other portions of his writing he does have nice things to say about certain beneficial consequences from banks issuing what he called fiduciary media. for example, that um prices quoted in gold ounces didn't have to fall as rapidly as they otherwise would have as more people wanted to use gold as the money. Okay. So, my point is over the decades various prominent economists have advocated some version of what we now could call 100% reserve banking. So this isn't some crankish Rothbardian view that only you know the people associate the Mises and Sudnau hold up that no this is a very respectable proposal whether you think it's right or wrong and so specifically say oh so all these economists over the decade just thought banks should stop being credit intermediaries. No they didn't. That's not what the proposal is. That's not what it means when you say I'm in favor of 100% reserve banking. People who say that what they mean is for a specific type of account, namely a demand deposit or in colloquial terms a checking account. So if you're if in your mind what you're doing is putting your money with the bank for safekeeping purposes and for convenience so that they can hold on to it while you decide when to spend it and where as opposed to you having to keep it in your wallet or in a safe at your house. That's one type of operation. And so the proposal is for that type of account where the person thinks that money is available upon demand at any moment I can go ahead and take my money out of the bank and I expect that it will be there for me. Then for those types of accounts the bank should keep that money in the vault. All right. I mean obviously if it's a multi-branch bank it could be in a central place and they can move it around or whatever. restock the ATMs. But you get the idea, all right? That the bank can't use those reserves to back up loans to other parties or to make other investments, right? That that money has to be there because that's what function economically it is serving is people are storing their money at the bank for purposes of safety andor convenience. Okay. Now, if you want to earn interest with money that you hand over to the bank and you're willing to wait, you can still do that under a proposal of 100% reserve banking. It's just that what you would do it through is what's called a time deposit or think of it as a genuine savings account. Okay? So now a day and especially since 2020, the distinction between checking and savings accounts has been obliterated. But it used to be like when I was a kid, which wasn't that long ago, even though it was longer than for some of you, um, when you, you know, I, you really had a difference in checking and savings at the bank. And yeah, you could move money from one to the other, but the idea was supposed to be the money you put in your savings account, you would just kind of forget about it and it would be there and you know, you'd put it there for long-term storage, whereas your checking was Yeah. like when I get my paycheck, I put it in there because I know I'm going to need to use it over the next two weeks to pay for groceries and to pay the electric bill and you know, that's just again, that's kind of the the stockpile where you're storing your money as you get ready to spend it in the near future. Right? That's what the checking account is for. Whereas the saving account was, as the name suggests, that's where you're saving your money and you're putting it away for the distant future or at least the medium-term future. Okay? And then far more rigorously, you could say banks can still operate as credit intermediaries. They can still be middle men and women in between the household savers and the people buying mortg or you know needing a mortgage or a business that needs a loan and so forth. Somebody's going to go buy a boat. Somebody wants to buy a car and they they want financing. The bank can still be the in between entity that pulls all of the savings of the households and the community. you know, businesses that have a surplus and they want to lend some of those funds out that they can give it to the bank. The bank can pull those funds, pays interest to the lenders, and then the bank's personnel are the ones who evaluate the creditworthiness of the various applicants for loans, and then dole out the loanable funds that way, charging interest rates accordingly. And yes, some loans are going to default, but if the bank does a good job of assessing credit risk and so forth, then you know there's enough aggregate interest earned on the loans portfolio of the bank to be able to pay the people who lent the bank money. All right? A lot of people would call them depositors, but I'm deliberately not calling them depositors because I'm trying to get you to stop thinking like that, right? Okay. So, banks can still do that. And in particular, they can sell CDs, certificates of deposit, that's got the word deposit built into it, right? So if the bank, you know, you you give $950 to the bank and it gives you this legal legally binding document that says in one year's time, you present this to the bank and it owes you $1,000. So that's how you get your built-in interest return. and then they take your 950 and they go lend it to somebody else right there. That's not fractional reserve banking. You can't go to the store and buy groceries with a bank CD. The way you can go to the store and buy groceries with the bank's liability as expressed in your checking account balance. All right. So, that's I touched on a lot. We didn't touch on it. I walk through very laboriously the accounting of all this in a prior episode here of the human action podcast. So I'll link to that in case you haven't seen that episode where I really go through step by step what the bank's balance sheet looks like at each stage if you really want to understand and and put your finger on what is so special about private banks, the way our system works right now and how is it that by granting loans they can quote create money, right? And so to be clear, that's only possible because of what a Rothbardian would describe as fractional reserve banking. Richard Veriner when he was on Tucker Carlson, he he said the fractional reserve model was obsolete or, you know, was never true, but now has been demonstrated to be false. And he advanced what he called a credit creation theory. I I think we're somewhat arguing over semantics that I don't disagree with what he's looking at. we, you know, the proponents of the modern fractional reserve banking theory are just worried about other considerations that I think his approach ignores. But either way, both camps agree that there is a sense in which banks right now, private banks, not just not just the Fed, not just the ECB or the Bank of Japan, but regular commercial banks, when they grant somebody a loan, there's a sense in which they're creating money. And Verer calls that fraud. Rothbart calls it fraud. And it's destabilizing too, I would argue. Right? It's not just that it's wrong, but it also leads to bad consequences. Um, so that that's what the 100% reserveists are opposed to. So again, just let me say one last time and then I'll move on to the main topic for today. But I really want to stress this to make sure people get it cuz again every time I see this argued on social media at some point someone will make this allegation that well gez if we follow the 100% reserveist then banks can't work. And again that's not true. Banks can pull savings from the savers. You know households that live below their means. People get incomes of a certain amount. They only consume a lower amount. So they're frugal. They save some of their income and then they don't want to be directly granting mortgages to people. That's too risky. So instead, they give their savings to the bank which then lends it out to others. That's all fine. It's just you can't do it via checking accounts. And so long as you don't do it through checking accounts, so long as you do it like through CDs or other instruments where the savers that are handing over their savings to the bankers genuinely renounce command of that money for a certain time period, then there's no money being created by what the banks do when they lend that out. It's just a pass through. All right? If you give $950 in currency to the bank, Bank of America, and they give you a CD, a certificate of deposit, this is a one-year time. You present this and we'll give you $1,000 in currency. You have transferred $950 to them and they can go lend that out to somebody, right? The money supply did not go up by $950. You again, you have an asset. You could say right now at the moment of the of the sale, the market value of your CD is $950. But that's not the same thing as saying you have $950 in money. You don't you you used your money to acquire a different type of financial asset, right? You can't go buy stuff with your Bank of America CD. In contrast, if you take $950 in green pieces of paper, go to a bank teller, hand it over, and say, "I want to deposit this in my checking account." And they give you the receipt. And you see your checking account balance just went up by 950. And then the bank now, because it has more reserves, feels comfortable granting more loans. Well, those new loans they granted that increased the money supply because you still think you have that $950 available to spend, right? So, that's the fundamental difference here. And so, again, that is what the 100% reserves are saying should not be allowed. And also, Rothbart would argue in a genuine free market, you know, with a libertarian court system, it wouldn't be allowed. It It's just like that. it's um and market forces would would drive that practice to oblivion or at least to really minimize it. All right. So, it's it's not uh that all Rothbartians are saying, "Oh, we want the federal regulators to come down and impose 100% reserves or else throw people in jail." That's not really I mean maybe some think that but no that that's that's not entailed by the position. What Rothbart is arguing is that in a free market just standard principles of contract enforcement and that how the market would work the forces of competition would greatly restrict the ability of any given private bank from being able to lower its reserve ratio without getting spanked by market forces. Okay. Um just like that silly analogy just you understand that what I'm trying to get across here you could say oh in a free market I would never expect that um restaurants would slap customers when they walked in the door and then when they sit down would come and dump hot soup on them and then would uh you know, swear at them and so forth. You would list all kinds of stuff. And he said, "Oh, because you're saying in a free market like the libertarian judges would know that that those are all crimes and the restaurants can't behave in that way." And he's like, "Well, maybe, you know, depending on the hot soup, like did it leave a secondderee burn or something, maybe that would be actually something that, you know, an actionable offense, but that you could seek, you know, restitution in the courts with or over. But putting all that aside, that's kind of a moot point is, you know, yeah, any restaurant that operated like that would go out of business and like so the problem would be quickly taken care of that way at the very least you regardless of the legality of those actions or that behavior, right, by the restaurant staff. So again, likewise when it comes to 100% reserve banking, Rothbart thinks that once you understand how a genuinely free market in banking would operate, a system of true free banking, then he thinks, yeah, this this notion of very low reserve ratios is crazy. Okay, so let me go ahead now that I kind of sketched the outline of what it is I'm trying to get across, let me just walk you through some of the particulars. Just making a note to make sure I fulfill my promise to put links in the show notes page for some of those earlier discussions about the the uh bookkeeping and such. Okay. So what Rothbart lays out in that first chapter specifically uh chapter 8 free banking and the limits on bank credit inflation is he says that I think maybe it's easiest to imagine you're an original equilibrium let's say there's like 10 major commercial banks in the community or or the economy if you want to think of it that All right. And each bank has some market share by which I mean some of the public, you know, they bank primarily at a particular bank. You know, people could have multiple checking accounts at different banks, but in general, most people bank at one particular bank, right? And even businesses that might have large accounts, unless you're a gigantic corporation, even you know, midsize and smaller businesses, they probably just have their business checking account at one bank, right? So, let's just assume for the sake of argument that each bank has 10% market share. Okay? Nothing's going to be affected in the argument if you disagree with, you know, if we change the scenario, but just to keep things simple, right? Right? So each bank has 10% of the market share and let's suppose originally all the banks practice 100% reserve banking you know on their checking accounts. Further just for for me I think it's just easier to keep things distinct if we do it this way. Again the argument doesn't depend on this but when you're first hearing these ideas spelled out for what it's worth I I just think it's easier to keep stuff straight. assume the the underlying money of the economy in this community are gold coins, right? That that's what you might call the base money, the the the primitive, the bedrock foundation. So prices are quoted in let's say there's ounces, right? So the standard money is a gold coin that's 1 ounce and and you it's you can either have it be private sector created or the government can create it. It doesn't really affect the argument in terms of the banking, right? That private banks historic or sorry, private mints historically existed. People would go get find gold, you know, raw gold. People gold rushes, miners would go out and find it. People would be prospecting, get it. You would bring raw chunks of yellow metal in and people at the private mints and they would stamp them into coins. Okay. So that's that's a possibility just to keep in mind. You don't need the government involved even in money production. Okay. Um but it doesn't really affect the argument whether it's the private mints or if you think the government isn't, you know, it has the job of taking the gold and stamping it into 1 gold coins and puts, you know, official legal tender on it, whatever. Okay. So that's the base money. Stores quote prices in terms of ounces of gold. That's how people get paid wages and so on. Now in that world 100% reserve banks could function and banks you know people could take their gold coins into a bank a private commercial bank give the gold coins over and then the banker could somehow let the person leave with some type of mechanism by which he could tell the community this is how much I have on deposit. with that bank and I have the ability to easily transfer my claim on the bank to you. Okay. So, one way to do that that we're familiar with is, you know, electronic checking account where like you have a plastic card that you can swipe and that gives the relevant information particularly then if you know what your PIN is to validate it just, you know, to minimize the chance that someone just pickpocketed you when they stole your bank card. And then that what's what's happening under the hood there is you know you've went to Bank of America. You gave them 100 gold coins. So now you're walking around town. I have a 100 ounces of gold on deposit with Bank of America. I take my card. I want to buy something that's 8 ounces of gold. I take my card and I swipe it through your machine. And then ultimately it's the bank's computers are talking to the merchants computers and Bank of America says all right we you know yes this person has 8 ounces of gold on deposit with us. He has more but yep he can he can cover that. So we'll go ahead and we will deduct 8 ounces of gold from his balance with us and we owe you 8 ounces of gold now. So if the merchant already is a customer of Bank of America that's really straightforward. Bank of America just adds eight ounces of gold to that store's checking account balance and subtracts eight from the customers, right? So, Bank of America on its end is just changing the numbers on its books internally. Okay, so that's pretty straightforward. It's but now what happens if the merchant is not a Bank of America customer? Right? So remember we said originally imagine there's 10 banks that each have 10% of the market share. So you know the one guy the customer is one of the 10% of the community that banks with Bank of America but this merchant banks with Wells Fargo. Okay. And so what happens there again perfectly straightforward. There's not a hitch. It's not that oh gez in a system of private banking you can only shop at places where the merchants in your network. No, that's not that wouldn't be convenient. The banks all have agreements with each other to facilitate transactions amongst their customers because that makes it uh more useful to be a customer of a bank that's part of a network like that, right? If if you signed up and had a checking account with a bank that didn't have arrangements both, you know, like contractually like economically, but also in terms of just the hardware and the ability for merchants who are plugged into some rival banks systems to be able to accept payment from customers of a different bank. Like then you wouldn't want to open your check account with that bank, right? you would tend to prefer other things equal banks that had relationships with their peers even though they were competitors, but they would all agree, yeah, this is better for all of us if we have a network like this where where our customers can do transactions with each other and then we the banks just all communicate with each other to stay square, right? So, let me just walk you through what does that process look like. Okay. So again, the scenario is the Bank of America customer originally put a 100 ounces of gold, you the actual metal coins on deposit with Bank of America. They went and put those coins in the vault. They credited his account with 100 ounces. He's walking around town. He goes to the store. That merchant who owns that store happens to be a customer of Wells Fargo. He swipes his card. He wants to buy something that's 8 ounces of gold, right? So the store's computers are talking to each other or talking to the bank's computer. They interface with Wells Fargo. And so ultimately the way that transaction gets recorded is Bank of America's Bank of America's, you know, it on its books it's saying its liability to their customer went from 100 ounces of gold down to 92. But its liability to Wells Fargo went up by eight. You know, I don't know what it was before this transaction, but whatever it was, it went up by eight. Say, "Oh, now we owe Wells Fargo an extra 8 ounces of gold compared to what we owed them 2 minutes ago." But Bank of America is still the same, right, in terms of its liabilities because now it owes that customer 8 ounces less. Okay? So, it's still 100 ounce of liability. just looking at, you know, narrowly this customer and his original deposit and now it just transfers the aid, you know, away from the customer and over to Wells Fargo. And then Wells Fargo for its part, what happens on its books, it has that increase. Oh, Bank of America, whatever they owed us two minutes ago, we have like a running total that we're keeping track of now because of this transaction that just got booked. Bank of America owes us eight ounces of gold more than they did two minutes ago. So you may say, "Oh, so Wells Fargo just had a windfall, right?" No, because the other leg of that transaction is Wells Fargo now on its book says that that merchant, whatever his balance was or his business, if it's a business checking account balance with Wells Fargo was 2 minutes ago, well, now they just added 8 ounces of gold to that, too. So, Bank of America and Wells Fargo, their overall financial position didn't change. It's just they changed some of the components of their assets and liabilities, right? They were offsetting. The people whose financial position changed were the c the the Bank of America customer and the Wells Fargo customer. The Bank of America customer, his financial position just went down 8 ounces of gold and the other guys went up. Okay. And you know there was a transfer of merchandise, right? So there's that. But in terms of the the money. Okay. So I'm just walking you through the mechanics of that so you can see how it would work. And again, it would be in the interest of Bank of America and Wells Fargo to have agreements with each other to facilitate that and to allow for um temporary movements in net liabilities between the two banks, right? It would be okay. like you know so that happens if if for whatever reason on a given day a lot of Bank of America's customers let's say a lot of them just for geographical reasons maybe they all work at a particular um place you know particular employer and they all get paid at the same time you know on the same day and then that their spending habits are similar and just just for reasons like that just there's patterns in spending of the people in community such that you know for few days of the month it typically happens that Bank of America's customers spend a lot more buying things from Wells Fargo customers than vice versa. And so over the course of that 48 hour stretch, there's a lot of incoming transactions where money is being electronically spent that Bank of America owes Wells Fargo more and more money like so that that balance just keeps going up and up and then you know the Wells Fargo people their checking account balances with Wells Fargo keeps going up too because they're the ones selling all this stuff to the Bank of America customers and they're drawing down you know their checking accounts waiting for the next payday to come. Okay, so that's fine and Wells Fargo would be okay with that. But the point is they wouldn't just let that balance do just grow indefinitely and just have it be that Bank of America just continually every week in week out has its customers spending more on Wells Fargo customers than vice versa. such that Bank of America just over time keeps owing more and more to Wells Fargo, among other things. Wells Fargo couldn't just let that roll indefinitely because it owes more and more to its own clients, right? the people who bank at Wells Fargo who are as a group in the aggregate the net beneficiaries or recipients of all this spending from the Bank of America clientele, they think that their checking account balances keep going higher and higher, right? And so if they want to go and withdraw some of that and you know say, "Hey, it says right here I've got 220 ounces of gold on deposit with you in my Wells Fargo checking account. I'd actually like to draw out 20 of those ounces in the form of gold coins." You know, Wells Fargo has to comply with that. That's what that's what the deal is. That's what it means to have a checking account with them. They say we can you can show up at any time and we'll be prepared to redeem your electronic deposits with us in gold coin upon demand. So, they have to have that in the vault and be ready to or they have to have enough in the vault such that for what they expect the requests for redemption might be on any given day that they're going to be fine. and they're going to, you know, want a margin above that, too, cuz their business is ruined. If there's ever a time when somebody shows up who's a Wells Fargo customer and says, "Yes, I would like to withdraw gold coins as I'm supposed to be able to do," and Wells Fargo says to them, "You know what? Sorry, vault's running a little a little tight this last week. So, can you come back next week?" Once word in the community spreads that that happened, nobody's want gonna keep their money at Wells Fargo and then they're done. Wells Fargo goes out of business because everybody shows up and says, "Give us our money." Okay. Even if Wells Fargo's loan portfolio was great, that no, we did a good job assessing creditworthiness that we charged enough in the interest like for the particularly risky borrowers, we charged enough in the interest rate that we charged them such that, you know, on average that pool of risky loans is still, you know, paying an overall average rate of return comparable to our other lines and so forth. Even if they're doing that, fine. The loan officers did a great job and everything. If they just kept letting Bank of America's customers spend way more week in and week out visav the Wells Fargo customers than eventually the Wells Fargo customers, you know, might drain Wells Fargo's vault. Okay? So that's why Wells Fargo can't just sit back and let that happen. They need to at some point tell Bank of America, hey, you know, over the last few weeks just on net, you keep owing us more and more. And so we're going to need to call that, right? Because because that's what it means, right? That's part of the agreement that the banks all entered into on the front end when they joined and formed this network is they agreed yes we will honor for all of us who are in this network we will ar honor each other's transactions at par that if for example if a Wells Fargo customer I just want to explain to you what does it mean to say you know honor their transactions apart a Wells Fargo customer who is a merchant. A Bank of America customer client, I should say, just to keep things distinct so you're not getting confused. A Bank of America client is the customer at this merchant store. The Bank of America client walks in, he wants to buy something that's 8 ounces of gold. Like that's what the sticker price says. So he could just take out eight gold coins, slap them on the counter, and the merchant could go ahead and sell him the merchandise and say, "Oh, there's the 8 ounces of gold." It's a expensive piece of merchandise. Don't get me wrong, I'm working through these examples. 8 ounces of gold is is a pretty I was going to say a pretty penny. It's a lot more than that. Okay, so that's one way to do the transaction. And then the merchant would just, you know, at the end of the day or certainly at the end of the week, would take the accumulated gold coins, maybe in an armored vehicle, and go down to the bank and put them into his checking account. So, that's one way of doing it. But what if instead the Bank of America client pulls out his debit card, that's a Bank of America debit card, and says, "No, let me just swipe this because I don't I'm not walking around with 8 ounces 8 oz gold coins on me. That's crazy." Okay. And so in order for the merchant to say, "Oh yeah, whether you pay me in yellow discs or you pull out a plastic card and swipe it in my little computer thing here, either way, I'm this merchandise that I'm selling to you, I'm just going to charge you 8 ounces of gold. Either way, that's what it means for the merchant to be accepting those two forms of payment at par." And so for the merchant to be willing to do that, it's got to be the case that his bank in this story Wells Fargo treats those deposits as equivalent also. Right? Right. So the in other words, the merchant is only willing to pass that equivalence through to his own customers if he knows that, oh yeah, when I want to get deposits into my business checking account balance at Wells Fargo, whether I go up to their counter with 8 ounces of gold and lay it on the counter and say, "Put this into my business checking account," or my computer talked to their computer when the customer swiped his plastic card and said, "Oh, yes. We have an incoming transaction that we validated with the PIT and everything and we you know we have reason to believe this person really is the the lawful owner controller of this account at Bank of America and Bank of America confirms that he has at least 8 ounces of gold on deposit with them and so they're trying to transfer it to you. should we go ahead and go through with this transaction? And that Wells Fargo will say, "Yes, we will also credit our client's account by 8 ounces just as if he had walked in here with eight metal discs because we trust Bank of America. We have an arrangement with them." All right. So because Wells Fargo is willing to treat Bank of America's liabilities or IUS if you want to call it that as equivalent to gold coins then so too would the merchant be. All right. So the banks again, you you realize the convenience that that that's their that's their model, their business model, right? To get people to use their checking accounts, they need to convince the community that, hey, this has all the advantages of gold coins and none of the downside, right? It's just it's a it's a more convenient way for you to use your gold coins is give them to us and then we will give you the ability to transfer effective ownership over these gold coins that sit safely in the vault here with us. Okay? So they need that willingness of most of the community to accept claims on Bank of America as being equivalent to the actual gold coins. All right. So again, why would Wells Fargo agree to that on the front end? It's only because Bank of America would agree yes at any time if you've got claims on us that are piling up. You can ask for those to be, you know, for us to to settle with you to get square and that if you know the end of the week, if we owe you 618 ounces of gold on net because our customers spent that much more visav your customers than vice versa, then we will get an armored car, load up 16 618 ounces of gold and ship it to you. then you can put it in your vault, right? Okay. So, you know, whether it's every week or every month or if it's every day, you know, those are kind of irrelevant details, but the the concept is there that for this kind of a system to work, clearly the banks who are in competition with each other are going to insist on some ability through clearing house operations to settle up with each other. Okay. So, now that I've kind of walked you through that, it's real straightforward to see how does that type of system, so long as there's just standard contract enforcement and there's as long as there's open entry, right, that anybody can open up a new bank and set whatever policies they want. How does that type of system contain the ability of any individual bank from inflating? Right? So, somebody goes in, he puts 100 gold ounces on deposit. The bank puts it in the vault. He's walking around town thinking he's got 100 ounces. What's to stop that bank from making a loan to somebody else of 90 ounces, right? They don't have to like take it out of the vault. They can just go ahead and write it up electronically, right? Somebody else walks in and says signs a contract saying I am borrowing 90 ounces of gold from Bank of America at a 6% interest rate and they go ahead and credit it. And now I walk out of there with 90 ounces of gold electronically in my Bank of America account because I just borrowed that from them. And so in that case, Bank of America now is practicing only 10% reserve, you know, ratio or obeying a 10% reserve ratio. All right. So um the problem with that or the danger is that now look at what just happened. bank, the Bank of America's clientele now just got an extra shot of 90 ounces of gold without the amount in the vault being increased, the amount of gold coins. And so now Bank of America's customers are able to spend more in the community visa v the clients of the other banks. Okay? So the idea is in a free banking system, if any individual bank lowers its reserve ratio below what the other banks are practicing, it has a short-term advantage of that, right? It can advance more loans and earn more interest income on those loans and that doesn't affect their other clients, right? that no, for the same amount of gold that was sitting in the vault, if on the margin the bank just quote magically out of thin air grants credit to some borrower and now that borrower has to pay interest so long as the borrower doesn't default but pays the loan back plus the interest, then Bank of America just wins free and clear, right? The other customers are still doing their thing. They still got gold coins in the vault that, you know, maybe getting drawn down or whatever. But as long as that customer can take the loan, go do his thing and come back and pay the loan off plus the interest. As long as Bank of America can get through that and not go under, they benefited from that operation. They earned that interest income free and clear. And now they can do whatever they want with that. Okay. But the so you see the benefit to Bank of American larger stockpile of checking account balances that are backed up by the same number of coins sitting in the vault. Right? So every loan that they grant Bank of America is lowering its reserve ratio. So you see what the incentive for doing that is what they gain. they gain extra interest income. But the downside is if they push it too aggressively and in particular if they're doing that more aggressively than their competitors are who they share the market with then other things equal as they keep pushing that their customers have more and more money at their disposal. And so that means statistically their clients when they interact with other members of the community are going to eventually be interfacing with people who are not Bank of America customers. Okay? So maybe this is a way of seeing the point. If everybody banked at Bank of America, right, if Bank of America had virtually the entire market, it wouldn't matter. there'd be no checks on his credit expansion because granting a loan quote out of thin air to some borrower and now he's got just funds that were magically added to his Bank of America checking account and he goes and spends it somewhere. If that person he spends it on is also a Bank of America client, Bank of America, you know, there's no drain on its gold reserves in the vault. It just moves numbers around in terms of client balances, right? that the real check in a free banking model on the credit expansion of anyone bank is not from the public like reading statistics about reserve ratios and going, "Oh geez, Bank of America's getting a little too risky for my blood. I'm going to go pull close down my checking account." It I mean that could happen, but that it doesn't need to. That the system does not rely on the public's vigilance in order to keep the bankers honest. No, it's the banks themselves competing with each other that keep each other honest in that sense, right? Because again, and and it's not some policy should. It's not that the other banks need to have intelligence agents who are monitoring what the other banks are doing and sneaking in at night and trying to get a look into their vault to see, oh wow, how many gold coins they got in there. They don't need to do any of that. It's all automatic. that just if one bank is expanding the stock of money held by its clients by just granting more and more loans gratuitously to use a phrase, you know, in other words, without more gold coins being put in the vault, but just no, they're just granting more credit X Neilo. They nothing's stopping them in the moment from doing that. But then that automatically sets up processes where eventually that bank that's expanding more rapidly than its peers is going to keep racking up higher and higher net deficits with its peers, its its competitors. And so again, maybe the competitors are content to let that roll for a bit, but eventually they're going to say, "Yeah, you got to start paying down what you owe us here." Okay. And then that starts draining the gold reserves. So really the only time that the public would be involved is if if somebody goes to the bank that's been very rapid with its expansion and says, "Yeah, I you know I'm I'm going out of town and I'm going to a country where they might not accept me swiping my debit card with you. So I actually I want to load up on some physical gold coins for that trip." And then they say, "Oh yeah, sorry. We don't have it." Like that's when the public starts to get alarmed and could be a problem. But again, before that point, well before that point, the actual check is that if one bank expands rapidly relative to its peers, it's going to suffer a drain of its reserves from the vault into the vaults of its peers. Okay. So having walked through all that now Rothbber does anticipate an obvious objection is to say okay so really there you haven't shown that banks as a whole can't expand in a free banking system. All you've shown is that one bank can't expand too rapidly relative to its peers. But what if the banks I mean after all you admitted Murphy the banks are all like in this network right that they all communicate with each other and coordinate in that sense like they have to have it so that their hardware can talk to each other and whatnot. So if they're already that coordinated in that respect, is it so difficult to imagine that they're going to form a cartel and say, "Look at guys, we all benefit from more interest income if we lower our reserve ratios. So let's just all inflate in unison." Okay? And so the and what Rothberg points out is for one thing even on its own terms that might be difficult to pull off because the banks aren't all going to be identical in terms of the uh acumen of their credit officers or their loan excuse me their loan officers and so forth. Right? So, some of the banks are going to be more conservative and savvier than the other ones, and so they're not going to want to all just throw in their lot in one common pot, as it were. Um, but even if they did, still, if it's just a genuine free market and banking is a business just like opening up a pizza shop, all right, where it's not, you know, you fill out some standard paperwork or whatever and boom, you go. It's just a matter of enforcing your contracts. Well, then if the banks all lowered their reserve ratios to 2% and they all inflated a lot and they're making tons of interest income and it's great and there's no net drain because they all did it in unison. Well, some upstart could open up a new bank and have a reserve ratio of 50%. And then you know his clients his clientele would be small in the beginning but proportionally they would um over time you know be getting more receipts from other bank clients than vice versa. And so that new bank would be slowly at first draining the gold reserves of all of the established cartel banks. Okay? and you you know they could make a deal and try to bring that bank into the cartel but you know there's nothing stopping that from happening over and over again in a free banking system. Okay. So that's the sense in which you know Rothbart is going to say regardless of whether legally 100% reserves is enforced just as a matter of juristprudence that oh yeah that's what it means when you have a checking account that it's a bailman contract if you're familiar with that kind of terminology. Putting all that aside, you can just say through standard market forces that reserve ratios there's mechanisms in place that would keep them trending towards 100%. Okay, maybe not literally 100% but you can see that there are forces in place that would push that towards 100% limiting the ability of the banks to engage in credit expansion. Okay. So, let me again just go reread now that I've walked you through that. In chapter nine, the opening Rothbart says, remember chapter 9's title is central banking removing the limits. And it says free banking then will inevitably be a regime of hard money and virtually no inflation. Okay. So now that what I just walked you through in this episode, I'm hoping you understand why he's saying that, what he means. 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. Okay. So now that we've so painstakingly walked through the limits on bank credit expansion that exist under regime of free banking, it's pretty easy for me to explain how does a central bank knock that down. Okay, so first and foremost, most obviously, what is the original rationale of a central bank? What function was it supposed to serve? You might think, oh, is it supposed to uh promote high employment and stable prices? I think that's what the Fed that so-called dual mandate for the Fed is what they told it to do when they revised the authorizing legislation in the 1970s after Nixon went off the gold standard. No, originally if you go read like the op-eds and things that the the bankers would write in the popular press trying to agitate and and drum up public support for a central bank in the years leading up to the 1913 passage of the Federal Reserve Act. No, the the central claim was that you needed the central bank to have an elastic currency and to act as a quote lender of last resort. And so the idea was like, oh, in the 1907 financial panic when a bunch of financial institutions, including private banks, got into trouble and had a liquidity crunch. They all had to go hatinand to guys like JP Morgan and ask for short-term financing. And then he got to pick winners and losers and decide who went under and who stayed afloat. And we don't want that kind of power in the hands of some man. Let's put that in the hands of public-minded officials that, you know, there's democratic governance and blah blah blah, right? And so, the central bank is going to be a lender of last resort that when your the private sources of financing and temporary liquidity aren't there, you go to the central bank. Okay? So, that sounds great, right? But think of what type of entity the central bank is going to be a lender of last resort to. Well, it's a private bank that's experiencing a drain on its reserves even though its loan portfolio might be sound. Right? In other words, exactly the kind of bank that we just walked through in the last half hour showing, oh, if you had a regime of free banking and one individual bank is being more aggressive than its peers and it lowers its reserve ratio by granting more loans. Well, again, they need the loans, enough of them to pay back, right? So the bankers aren't just handing out money to hairbrained lunatics who have crazy wildeyed schemes. No, they're they're trying to give loans to people that they think will pay back or again like I say that they're charging a high enough interest rate that they think the pool of such loans in the aggregate will give us the same kind of return as you know something that was more tailored to more uh creditw worthy borrowers. Okay. So when a bank gets into trouble in that in that model or that that system, it's not because they made bad investments and that there was like a crash in real estate or something that no, even if the economy is doing fine, if that bank was just too aggressive though and lowered its reserve ratio, then again through what's called like the law of reflux that they start piling up obligations to their rival banks. And so they are perhaps solvent, right? Their assets might be higher than their liabilities in terms of just looking at their balance sheet like, oh yeah, these loans are still performing. It's just in a sense they borrowed short and lent long, right? People put in deposits that were immediately callable, demand deposits. That's what a checking account is, is a demand deposit. and then they went out and granted 30-year mortgages and other long-term investments, funded them. Okay? So, a bank that gets into trouble because it's reserve ratio is too low, it's not that they necessarily made bad investments or that the economy tanked. It's just they're, you know, they have a liquidity crunch. So, the issue is liquidity, not solveny. And so a central bank that's going to be a lender of last resort, what do they do? They come into the rescue. And especially if there's a quote elastic currency and that central bank is able to print notes that are legally equivalent to gold coins, right? Because that's an important thing in the free banking system, a pure one that's just lazair. The bank's obligations, Bank of America's promise that I owe you 100 ounces of gold is not the same thing as a 100 gold coins in the vault. In many cases, it might be treated at par with them, but everyone understands, no, a gold coin is a different thing than Bank of America saying, "We owe you one gold coin when you ask for it." Those are different things. But depending on the legislation, but in the, you know, the theory of central banking proper, the central bank's obligations are the base money, right? Like right now, what's in your wallet? Federal Reserve notes. A $10 bill is a Federal Reserve note. In our system right now, to say the Federal Reserve owes you money is the same thing as saying you have money. That's what the money is. It's a Federal Reserve obligation. Okay. So you see that fundamental shift there. And so my point is if the central bank is acting as a lender of last resort, you can see clearly again not attributing malice to anybody just if it if they're doing what their mandate is. They are rescuing precisely those types of banks that in the free banking regime analysis we showed, oh, there's limits to credit expansion by any one bank because it would find itself in a position where yeah, it may have made sound loans, but the timing is off. There's a there's a maturity mismatch. And so having a lender of last resort means, oh, that doesn't spell our doom. if if our gold reserves are getting too low, we can just go to the central bank and say, "Hey, can we have a short-term loan of gold, please?" And we'll pay it back in three months. And so that's what's going to get them through the crisis. Okay? So there's that element. And then last thing I'll say here and we'll conclude. What's the other main check? Remember we said okay so yeah any one bank expands too rapidly relative to its peers they get spanked in a free banking regime. The other main check was well what if the banks all form a cartel and they expand in unison or they inflate in unison keeping roughly the same reserve requirements visav each other so that the net claims all cancel out and you know there's not gold being moved from one vault to the other. And there we said well the ultimate check is that um well for one thing the banks might have different standards and so they might not all agree with each other and so there's that element that makes form and a cartile difficult but then the other problem is they in a system you know of open entry lazair you can't stop somebody else from just opening up a new bank and they could set a reserve ratio higher than what the cartel had all agreed to and then that bank's going to siphon away weigh your gold reserves over time and they can't stop that. Even if they bring that one in, don't somebody else could start a new one, right? Well, not if the banking sector is highly regulated by the authorities, including the central bank who say, "Oh, no. To open a bank, I mean, you got to that's a long process. You got to put up a bunch of capital. You got to fill out a bunch of paperwork. You got to do this. You got to do that. You It's not like opening up a pizza shop. I mean, this is a bank. This is serious. This is important for our nation's financial integrity." So no, it's hard to open up a new bank. You can't just have anybody opening up a bank. What kind of wildcat crazy lazy fair system would that be? Think of how unstable that would be, right? So that's the idea. And then also imposing all sorts of regulations on the banks to have, you know, uniform standards of capital requirements and reserve ratios and things like that, right? So notice everything that you would think textbook a central bank ought to be doing to serve the public's interest. Each component of that knocks down all the stuff that we just brought up in the prior discussion this episode as to here's how a genuine free banking regime would protect the public from credit expansion. And that's why you wouldn't have these wild boom bust cycles if you really just had private sector banking left to the market. That no, when you bring a central bank in, it knocks down all of those protections and it cartilizes the private commercial banks, keeps out competitors, sets rules so they, you know, they can all say, "All right, nobody's really taking advantage of anyone else. We're all kind of inflating together. and we don't have to worry about some upstart coming in because the central bank, you know, the regulators keep them out. They can't, it's illegal. Can't compete with us. Got to be part of the club. All right. So, I'll stop there. I hope I've gotten my point across that in the Rothbartian system and here he was just elaborating what Mises had had done in his works that the central bank far from oh occasionally overstepping or straying from its mandate and doing things that weren't in the original vision. Even according to the textbook argument of what a central bank is supposed to do for the public, once you understand how a genuinely free market and banking would work, you see that the central bank actually is almost systematically designed to knock out all of those safeguards. And so it shouldn't be any surprise that geez, even after central banks were established around the world, the global financial sector just keeps having these massive boom bust cycles. Not to mention that the currencies all get wrecked in terms of their purchasing power. Not a coincidence. So if you want to learn more, go read Murray Rothbart's The Mystery of Banking, which of course the free PDF is available at mises.org. Thanks for your attention, everybody. See you next time. Check back next week for a new episode of the Human Action podcast. In the meantime, you can find more content like this on mises.org. [Music] [Applause] [Music] [Applause] [Music] [Applause]