Observations on the Discussions Concerning Free Banking
The Banking School taught that an overissuance of banknotes is impossible if the bank limits its business to the granting of short-term loans. When the loan is paid back at maturity, the banknotes return to the bank and thus disappear from the market. However, this happens only if the bank restricts the amount of credits granted. (But even then it would not undo the effects of its previous credit expansion. It would merely add to it the effects of a later credit contraction.) The regular course of affairs is that the bank replaces the bills expired and paid back by discounting new bills of exchange. Then to the amount of banknotes withdrawn from the market by the repayment of the earlier loan there corresponds an amount of newly issued banknotes.
The concatenation which sets a limit to credit expansion under a system of free banking works in a different way. It has no reference whatever to the process which this so-called Principle of Fullarton has in mind. It is brought about by the fact that credit expansion in itself does not expand a bank’s clientele, viz., the number of people who assign to the demand-claims against this bank the character of money-substitutes. Since the overissuance of fiduciary media on the part of one bank, as has been shown above, increases the amount to be paid by the expanding bank’s clients to other people, it increases concomitantly the demand for the redemption of its money-substitutes. It thus forces the expanding bank back to a restraint.
This fact was never questioned with regard to demand deposits subject to check. It is obvious that an expanding bank would very soon find itself in a difficult position in clearing with the other banks. However, people sometimes maintained that things are different as far as banknotes are concerned.
In dealing with the problems of money-substitutes, catallactics maintains that the claims in question are dealt with by a number of people like money, that they are, like money, given away and received in transactions and kept in cash holdings. Everything that catallactics asserts with regard to money-substitutes presupposes this state of affairs. But it would be preposterous to believe that every banknote issued by any bank really becomes a money-substitute. What makes a banknote a money-substitute is the special kind of good will of the issuing bank. The slightest doubt concerning the bank’s ability or willingness to redeem every banknote without any delay at any time and with no expense to the bearer impairs this special good will and removes the banknotes’ character as a money-substitute. We may assume that everybody not only is prepared to get such questionable banknotes as a loan but also prefers to receive them as payment instead of waiting longer. But if any doubts exist concerning their prime character, people will hurry to get rid of them as soon as possible. They will keep in their cash holdings money and such money-substitutes as they consider perfectly safe and will dispose of the suspect banknotes. These banknotes will be traded at a discount, and this fact will carry them back to the issuing bank which alone is bound to redeem them at their full face value.