Between Wicksell and Hayek: Mises' theory of money and credit revisited - Special Invited Issue: Money, Trust, Speculation and Social Justice - Part 2: Trust and Money

American Journal of Economics and Sociology, The, Oct, 1998 by Riccardo Bellofiore

II

The Money Supply: The Role Of Fiduciary Media

Let us then look at Mises more closely. The growth of money in the broad sense,(3) what Mises thinks is the only apt theoretical meaning of the word inflation(4), is caused by an increase of fiduciary media, that is, of banknotes and of bank credit in excess of reserves of money proper.(5)

When the banks do not restrict themselves to the intermediary role of lending third parties' money, and therefore also release "circulation credit," newly created purchasing power does not correspond to any sacrifice neither by the bank nor by the depositors. The latter do not give up any purchasing power and can withdraw their deposits on demand; in any case, sure and readily exchangeable claims to money proper are a perfect substitute for it. Their functional equivalence to money in the narrower sense causes the money-substitutes to circulate more widely and allows more of them to be issued than there are reserves. Setting aside the very low technical costs of the issue of banknotes and of credit creation, the banker is able to give credit almost free. The only warning that it has to heed is that of ensuring "his ability to satisfy promptly that proportion of the claims that is actually enforced against him" (Mises, 1971, p. 267). Mises then asks: is there some upper limit to credit creation by the banking system?

Mises' claim, defended forcefully in the Theory and present also in his later writings, is exactly that, from the point of view of the strictly monetary mechanism, there is no force stopping the banking system as a whole from expanding its loans at will.(6) He starts his argument from the simplest case of the single bank, working out Wicksell's insights in great detail.(7) Payments are supposed to be made only by bookkeeping transfers or by means of the issue of notes. Cash payments are considered too small to be of interest, and are disregarded. On these hypotheses, there are no constraints to the issue of money-substitutes. Given that there are, by definition, no leakages out of circulation, the single bank can never find itself in trouble. It, therefore, does not need to keep reserves of money in the narrower sense. The same holds true if there are a number of banks acting with the same intentions as to granting loans and issuing banknotes.(8)

Mises recognizes that no bank can put more money substitutes into circulation than are actually requested by its customers' business with each other, where the bank's clientele include everyone who accepts the money-substitutes.(9) Despite the difficulty of giving a practical definition of this ceiling,(10) if it were not respected, then outflows to the customers of other banks would exceed inflows, and the issuing bank would have to find some way of dealing with the debts toward them. In the two cases considered so far, this risk is absent. This is obvious for the case of a single bank. But it holds true when banks merge, given that no individual bank has to face a negative balance at the clearinghouse. It is in the banks' interest to extend their loans as far as they can because they earn interest on the free credit creation. In any case, an expansion that goes ahead paripassu does not undermine either the reputation or the liquidity of the banks. On these grounds, the case of the banks tandem movement is not merely of theoretical interest, but it approximates well to the behavior of the banks in the institutional context that Mises saw shaping up at the end of the nineteenth century.