[From "More Than Quibbles: Problems with the Theory and History of Fractional Reserve Free Banking" in the spring 2019 issue of The Quarterly Journal of Austrian Economics.]

Setting aside the potential legal and conceptual problems with fractional reserve banking in order to focus on the economics, one of the key areas of dispute is whether FRB necessarily leads to an unsustainable boom as described first by Mises ([1912] 2009) and elaborated by his disciple Hayek (e.g. [1931] 1967). It is significant that both of these developers of what is sometimes called “the Mises-Hayek theory of the business cycle” thought that FRB was a central element of the story. To be sure, Mises and Hayek may have been mistaken, but it is worth documenting their position because in the debate over FRB, one often hears (especially in informal venues) casual claims that only dogmatic Rothbardians could find fault with fractional reserve banking per se.

We find an unambiguous statement of Mises’s position in Human Action. Mises defines “fiduciary media” as bank-issued claims to money, payable upon demand, that are not covered by base money in the vault, and then declares:

The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle . Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion. (Mises [1949] 1998, 439, n. 17; bold added.)

Regarding Hayek, even the FRFB writers admit that his understanding of commercial bank behavior is inconsistent with their claims. For example, Larry White (1999, 761) writes that Hayek ([1925] 1984, 29) “suggested in one of his earliest writings a radical solution to the problem of swings in the volume of commercial bank credit: impose a 100 percent marginal reserve requirement on all bank liabilities….”

Mises too at some points in his career called for an explicit prohibition on additional issuance of fiduciary media, though he also wrote (for example in Human Action) in favor of “free banking” as the best practical way to restrain the issuance of fiduciary media . (Salerno 2012, 96–97) Readers should therefore not misinterpret Mises’s praise for laissez-faire in banking as an endorsement of the modern “free banking” claim that fractional reserve banking, at least under certain conditions, promotes economic stability.

To appreciate the specific problem of fiduciary media in the eyes of Mises, it is very instructive to consider where he placed the business cycle discussion in Human Action. One might have classified the periodic boom-bust cycles plaguing market economies as a result of political intervention, which would mean placing the discussion (as Rothbard did in Man, Economy, and State ) in the same section of the book that handled minimum wage laws and taxation. Yet Mises rejects this plausible approach, and his explanation illuminates his broader views on fractional reserve banking:

It is beyond doubt that credit expansion is one of the primary issues of interventionism. Nevertheless the right place for the analysis of the problems involved is not in the theory of interventionism but in that of the pure market economy. For the problem we have to deal with is essentially the relation between the supply of money and the rate of interest, a problem of which the consequences of credit expansion are only a particular instance .

Everything that has been asserted with regard to credit expansion is equally valid with regard to the effects of any increase in the supply of money proper as far as this additional supply reaches the loan market at an early stage of its inflow into the market system . If the additional quantity of money increases the quantity of money offered for loans at a time when commodity prices and wage rates have not yet been completely adjusted to the change in the money relation, the effects are no different from those of a credit expansion. In analyzing the problem of credit expansion, catallactics completes the structure of the theory of money and of interest….

What differentiates credit expansion from an increase in the supply of money as it can appear in an economy employing only commodity money and no fiduciary media at all is conditioned by divergences in the quantity of the increase and in the temporal sequence of its effects on the various parts of the market . Even a rapid increase in the production of the precious metals can never have the range which credit expansion can attain. The gold standard was an efficacious check upon credit expansion, as it forced the banks not to exceed certain limits in their expansionist ventures. The gold standard’s own inflationary potentialities were kept within limits by the vicissitudes of gold mining. Moreover, only a part of the additional gold immediately increased the supply offered on the loan market. The greater part acted first upon commodity prices and wage rates and affected the loan market only at a later stage of the inflationary process . (Mises [1949] 1998, 571–72; bold added.)

The above excerpt from Mises is extraordinarily important in understanding what role he thought the commercial banks played in a typical boom-bust cycle. Yet to correctly parse it, we should first remind ourselves what Mises means precisely by the phrase “credit expansion” (since he is contrasting it with “an increase in the supply of money proper”). Earlier in the book, Mises does not yet explain the trade cycle but defines the terminology that he will later need. He explains:

The term credit expansion has often been misinterpreted. It is important to realize that commodity credit cannot be expanded. The only vehicle of credit expansion is circulation credit. But the granting of circulation credit does not always mean credit expansion. If the amount of fiduciary media previously issued has consummated all its effects upon the market, if prices, wage rates, and interest rates have been adjusted to the total supply of money proper plus fiduciary media (supply of money in the broader sense), granting of circulation credit without a further increase in the quantity of fiduciary media is no longer credit expansion. Credit expansion is present only if credit is granted by the issue of an additional amount of fiduciary media, not if banks lend anew fiduciary media paid back to them by the old debtors . (Mises [1949] 1998, 431; italics in original, bold added.)

Putting together all three of the block quotations from Human Action that we have provided above, we can summarize Mises’s position as follows: The unsustainable boom occurs when a newly created (or mined) quantity of money enters the loan market and distorts interest rates, before other prices in the economy have had time to adjust. In principle, this process could occur even in the case of commodity money with 100 percent reserve banking.

However, in practice Mises believes such a theoretical possibility can be safely neglected, because (a) the quantity of new gold (or other commodity money) entering the economy will likely be relatively small over any short period and (b) whatever the stock of new commodity money entering the economy as a whole, typically only a small fraction of it would be channeled into the loan market upfront.

Thus, even though in principle Mises’s theory of the boom-bust cycle is fundamentally about new quantities of money hitting the loan market early on, in practice the explanation revolves around newly-created fiduciary media being lent into the market. That is why Mises described his explanation as the “circulation credit theory of the trade cycle.” When we understand how Mises thought (in principle) newly mined gold could conceivably set in motion the boom-bust cycle, it becomes crystal clear that he thought any amount of newly-issued fiduciary media—i.e., a credit expansion—would do the same. (Remember, our earlier quotation shows Mises claiming that “[i]ssuance of additional fiduciary media, no matter what its quantity may be, always sets in motion” the processes that cause the unsustainable boom.) Thus there are no caveats or other conditions to consider, on this narrow question. Mises thought fractional reserve banking per se would set in motion the business cycle.