White contra Mises on Fiduciary Media
Several recent blog posts indicate that the modern supporters of "free banking" continue to misconstrue the fundamental theoretical challenge posed by their critics. The main question is not about the ethical-legal issue of whether or not fractional-reserve banking is "fraud" under all circumstances. Nor, ultimately, is it even about fractional-reserve banking versus 100-percent reserve banking. It is about whether the creation of fiduciary media, fraudulent or not, produces the sequence of phenomena we recognize as the business cycle.
Thus, the deep and serious debate over "free banking" is not a new debate carried on within a narrow circle of "free marketeers" or "libertarians" or "Austrians" or whatever you want to call them; it is a very old one between two divergent movements in monetary theory whose views have never been reconciled. The one movement may be called the neo–Currency School (NCS) and the other, the neo–Banking School (NBS). Their forerunners, the Currency School and Banking School respectively, squared off in a titanic debate in the mid-19th century that was never finally resolved.
The main proponents of the neo–Currency School were Ludwig von Mises and Murray Rothbard. Both held firmly to the doctrine that the creation of fiduciary media by the banking system, whether "free" or governed by a central bank, inevitably generates business cycles. Mises initially believed that unregulated or "free banking" based on a gold standard was superior to the legal imposition of a 100-percent gold reserve requirement as a means for suppressing the issue of additional fiduciary media. In one of his later works, Mises did propose a plan for legally requiring a 100-percent reserve requirement for new currency and checking deposits.
Rothbard ranked the effectiveness of the means for abolishing fiduciary media in reverse order than Mises, although in his last work addressing the question Rothbard proposed gold-based free banking as a temporary "second-best" solution for the problem. Thus, Mises and Rothbard were united in their analysis of the disruptive effects of the creation of fiduciary media on the market economy. Their differences concerned only their evaluations of the alternative techniques available for achieving their shared goal of abolishing the ability of banks to issue new fiduciary media.
The founders of NBS are Lawrence H. White and his student George Selgin. They contend that the creation of fiduciary media by banks is not only benign, but a necessary prerequisite to prevent the market economy from plunging into depression in circumstances where households and businesses increase their demand to hold cash, effectively reducing total spending in the economy. In contrast to Mises and Rothbard, White and Selgin argue that the natural evolution of a free banking system would result in the progressive replacement of gold ("outside money") in people's cash holdings by currency and demand deposits ("inside money") issued by freely competing banks.
Thus, under a system of free competitive banking, bank notes and deposits would eventually become money, and gold would be relegated to the role of an interbank clearing asset. Harking back to the older Banking School's "law of reflux," White and Selgin argue that a free banking system would automatically and finely adjust the supply of money to changes in its demand, thus always maintaining "monetary equilibrium," operationally defined as stability of a macro aggregate called "total spending."
So it seems that the lines of the controversy are clearly drawn. But the White-Selgin NBS does not see it this way. This is evident in recent blog posts in which the NBS adherents adamantly declare, "Mises was a free banker." One even queries incredulously, "Why is there even a debate about this?" Well, to answer this rhetorical question — there is not and there never was any debate about this. With respect to Mises, the debate has always been about his views on fiduciary media and their effects on the market economy. Now lest my friends of the NBS respond that I am making arbitrary and unsupported claims and changing the terms of the debate here, there is reprinted below a slightly revised excerpt from an article that I published in 1993.
In his essay, Lawrence H. White characterizes Mises as the prototype of the modern free banker, who opposes any ban on competing private banks issuing fiduciary media redeemable in gold on demand on the grounds that "such a ban (1) would make the economy more vulnerable to money demand shocks, and (2) would needlessly increase the cost of supplying the economy with media of exchange" (White, p. 528).
As White notes, this interpretation of Mises's rationale for free banking clashes sharply with Murray Rothbard's argument that Mises favored free banking as a preferred means of suppressing the issuance of fiduciary media because it circumvents the dangers associated with ceding virtual control over the banking system to government, a result that Mises believed might be entailed by an outright legal prohibition of fractional reserves.
In fact, White's interpretation of Mises's views on fractional reserves and free banking is based on his unwarranted homogenization of Mises with Adam Smith, the forerunner of the Banking School, on the question of the criteria for an ideal monetary system. White falls into error because he overlooks important passages in the very works of Mises that he cites, and because he ignores significant developments in Mises's theory of money that occurred between the publication of the first German edition of The Theory of Money and Credit in 1912 and the publication of Nationalökomie (the German language forerunner of Human Action) in 1940. In his memoirs, Mises tells us that it was in Nationalökomie that his "monetary theory achieve[d] completion," with the merger of "the theory of indirect exchange with that of direct exchange into a coherent system of human action." These developments resulted in an important modification of Mises's earlier assessment of the relative benefits and costs of fiduciary media that is not acknowledged by White.
As White correctly points out, in The Theory of Money and Credit, Mises identified three significant benefits of the creation of fiduciary media. The first benefit involves the prevention of "convulsions" in economic activity that would have occurred in the absence of an expansion of the money supply as a result of "an enormous extension of the demand for money" and the consequent increase in its purchasing power that was brought about by the historical extension of the money economy. The second benefit is the familiar one enunciated by Adam Smith of reducing the "cost of the monetary apparatus." And the final benefit of fiduciary media is that their issuance sufficiently enhanced the profitability of the credit activities of the banking system early in its history to permit its survival and growth.
The only disadvantage of fiduciary media that Mises recognized in this book, according to White, is a relatively minor one: the risk of default by the issuing bank due to mismanagement or bank runs. Thus White concludes that Mises "viewed fractional-reserve banking as a natural and desirable development in a free society."
White's conclusion is mistaken, however. And this mistake is attributable to his failure to fully come to terms with one of Mises's most famous contributions to economic theory: his demonstration of the causal link between the creation of fiduciary media and the business cycle. White evidently holds that, according to Mises, business cycles are generated by the overexpansion of fiduciary media by central banks unrestrained by competitive market forces. However, Mises's chapter on the business cycle, following directly upon the chapter enumerating the benefits of fiduciary media that White cites in support of his own interpretation, makes it clear that the necessary and sufficient cause of the cycle is the unsustainable divergence between the "loan" and "natural" rates of interest caused by the creation of fiduciary media.
For Mises, then, cyclical discoordination of the economy is indeed a disadvantage to be counted against fiduciary media per se. Accordingly, it is only after fully discussing both the advantages and disadvantages of fiduciary media, that Mises, in a section comprising the concluding five pages of the book — which is ignored by White — addressed the "basic questions of future currency policy." Here, Mises reprinted the conclusion of the first German edition (the English edition is a translation of the second German edition published in 1924), in which he emphatically urged the suppression of all further creation of fiduciary media, if not the outright banning of fractional-reserve banking. Contrary to White's assertion, Mises was evidently convinced that the disadvantages of issuing fiduciary media, now including their cycle-generating property, far outweighed their three advantages, which he enumerated earlier in the book.
[Fiduciary media] should logically be subjected to the same principles that have been established with regard to money proper; the same attempts should be made in their case as well to eliminate as far as possible human influence on the exchange ratio between money and other economic goods. The possibility of causing temporary fluctuations in the exchange ratios between goods of higher and of lower orders by the issue of fiduciary media, and the pernicious consequences connected with a divergence between the natural and money rates of interest, are circumstances leading to the same conclusion. Now it is obvious that the only way of eliminating human influence on the credit system is to suppress all further issue of fiduciary media. The basic conception of Peel's Act ought to be restated and more completely implemented than it was in the England of his time by including the issue of credit in the form of bank balances within the legislative prohibition.…
It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of fiduciary media must necessarily lead to its breakdown.… It will be a task for the future to erect safeguards against the inflationary misuse of the monetary system by the government and against the extension of the circulation of fiduciary media by the banks.
The only reasonable conclusion to be drawn from the passages that I have emphasized in the foregoing quotation is that Mises looked with great disfavor upon the creation of fiduciary media by banks, whether "free" or not, and strongly urged its elimination. And it should be reiterated that this was a position that he maintained from the very beginning of his career as a monetary theorist in 1912.
White cites a part of a paragraph from a later work, originally published in 1928, in which Mises reiterated the point that a suppression of the issue of fiduciary media would have given rise to historical situations in which the emergence of an excess demand for money resulted in an increase in the purchasing power of money that was temporarily disadvantageous to the economy. However, for some reason, White does not cite the last sentence of this same paragraph, which identifies an important benefit that would have followed from the prohibition of further emission of fiduciary media: "the economy surely would not then have experienced the stormy upswings followed by dramatic reversals of the upswings into crises and declines."
Mises also argued later in the same work that the benefits of fiduciary media fall far short of their costs in terms of cyclical discoordination of economic activity. He therefore called for the implementation of a revised Currency School program in the following terms:
The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market. That means a return to the theory of the Currency school, which sought to suppress all future expansion of circulation credit and thus all further creation of fiduciary media.… [I]t means the introduction of a new program based on the old Currency school theory, but expanded in the light of the present state of knowledge to include fiduciary media issued in the form of bank deposits. (emphasis added)
Far from rejecting the Currency School program, as White would have us believe, it is evident that Mises sought to reformulate it on a sounder theoretical basis in order to strengthen its practical application. Thus, contrary to White, Mises supported a free banking regime precisely because it would eventually result in "extreme restraint in the issue of fiduciary media." Bankers would learn such restraint from their experiences of the crises and bank runs that would inevitably occur during the historical course of development of fiduciary media.
Once these lessons were absorbed by the more astute banking entrepreneurs, policies of extreme caution and restraint would be enforced on the entire banking system as less responsible banks persisting in the further creation of fiduciary media would be immediately confronted by the twin threats of adverse interbank clearings and loss of confidence by a once-or-twice-chastened and now more-sophisticated bank clientele. At this point, the program of the Currency School would be fully and properly implemented, as further extension of "circulation credit" by the banks would be checked and any additional accumulation of bank assets would reflect an increase in commodity credit based on time deposits and equity investments of voluntarily saved funds.
Unlike our modern free bankers, Mises emphatically did not foresee the free-banking system evolving toward a minuscule reserve ratio of gold to demand liabilities and the progressive transformation of gold into a practically demonetized interbank "clearing asset." For Mises, evolution was rather all in the opposite direction, with initial entrepreneurial ignorance precipitating an early splurge in the creation of fiduciary media and the resulting cyclical fluctuations leading slowly back to a system of marginal 100-percent reserves while painfully renewing awareness among the public that bank notes and deposits are not money per se but merely claims to and substitutes for money, i.e., gold.
In his earlier writings, then, Mises did perceive definite advantages associated with the issue of fiduciary media, but he was willing to forego such advantages for the greater advantage of maintaining the integrity of monetary calculation and preventing disruptions of the price-and-interest-rate coordination of the economy. By the time he came to write Human Action, however, his views on entrepreneurship, monetary calculation, and money had evolved to the point where he recognized that the benefits he had once attributed to the creation of fiduciary media were largely illusory. In particular, the later Mises abandoned his earlier belief that an increase in the purchasing power of money is somehow disadvantageous for the market economy.
Regarding a world in which there occurs a persistent "goods-induced" rise in the purchasing power of money resulting from secular growth in the supplies of commodities and services in conjunction with a rigidly fixed nominal money supply, Mises argued in Human Action that such a state of affairs would not disrupt the moment-to-moment price-coordinating function of the market or upset the monetary calculations that lead entrepreneurs to efficiently allocate productive resources in service of anticipated consumer preferences.
Now, modern free bankers would concur with Mises that there is no need for an increase in the money supply in the case of a price deflation caused by economic growth. But, in sharp contrast to the free bankers' dread of "monetary demand shocks," Mises argued that a "money-induced" increase in the purchasing power of money caused by hoarding was no cause for alarm. In particular, Mises denied that an increase in the demand for money at the expense of spending on consumer goods would impede the process of transforming the additional real savings thus generated into an accumulation of new capital goods.
Monetary calculation, taking into account the relative decline in prices of lower-order and consumer products and of the nonspecific factors of production, would faithfully reflect the increase in the availability of capital goods, and the prospect of higher profits would induce entrepreneurs to employ them in the expansion of their operations. As Mises concluded,
the main thing is that the capital goods resulting from additional savings are not destroyed by coincident monetary changes.… Whenever an individual devotes a sum of money to saving instead of spending it for consumption, the process of saving agrees perfectly with the process of capital accumulation and investment. It does not matter whether the individual saver does or does not increase his cash holding.
For Mises and the NCS, then, the coordinative and calculative market process can and will respond with perfect (ex ante) efficiency to any combination of anticipated changes in the set of consumer preferences, including changes in "liquidity" preferences.
This leaves us, finally, with only a single apparent advantage of fiduciary media: the reduction of the resource cost of supplying a medium of exchange. Although, as White notes, Mises was inclined to heavily weight this alleged advantage in his earlier writings, in Human Action, Mises did not allude to it; however, he did refer to "the expensiveness of gold production" as "the minor evil" when compared to the inflationary potential of paper-fiat and credit money.
Of course, in Human Action, Mises still adhered to his previous view concerning the overwhelming disadvantage of the creation of fiduciary media associated with its potential for falsifying interest rates and monetary calculation, introducing inefficiency into the intertemporal allocation of resources, and precipitating the business cycle. This later assessment of the massive imbalance of the disadvantages of fiduciary media over their advantages may have finally caused Mises to overcome his earlier fears of the expansion of political interference with banking, which he had foreseen as a possible consequence of the ultra-hard NCS proposal to legally prohibit all further additions to the outstanding circulation of fiduciary media, including demand deposits as well as notes. Thus, in his 1952 essay on "Monetary Reconstruction," which was included as part four in the second English edition of Theory of Money and Credit, Mises proposed just such a program as the basis for "the United States' return to a sound currency."
I conclude, then, that White's attempt to portray Mises's views on fractional reserves and free banking as prototypical of the modern free-banking school is untenable. To the extent that Mises advocated the unrestricted freedom of banks to issue fiduciary media, he did so only because his analysis led to the conclusion that this policy would result in a money supply strictly regulated according to the currency principle, that is, changing dollar for dollar with the supply of gold money.
Mises's desideratum was thus not a "neutral" money, or even a practical approximation of it; rather, it was the complete elimination of "human influence" on the purchasing power of money. Along with government fiat-money inflation, this included the distortive influence of bank-created fiduciary media on monetary calculation and the dynamic market process. Whether this result was best achieved by "free banking" or a legally mandated marginal 100-percent rule, Mises considered a secondary question of policy technique.
 We define "fiduciary media" as that portion of bank-issued notes and demand deposits that is unbacked by the standard money or "cash," whether it consists of a commodity money like gold or a fiat money like Federal Reserve notes.
 For an account of this controversy see Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, Volume II (Brookfield, VT: Edward Elgar Publishing Company, 1995), pp. 225–74 and the references contained therein.
 The "law of reflux" was originally formulated by the banking-school theorist John Fullarton in 1844. In brief, it states that bank notes and deposits that are convertible into gold or some other commodity money can never be issued to excess and cause price inflation. The reason, according to Fullarton, was that any unneeded notes and deposits would immediately be returned by business borrowers to the banks in repayment of loans.
 Joseph T. Salerno, "Mises and Hayek Dehomogenized," The Review of Austrian Economics, Vol. 6, No. 2 (1993): 113–46.
 Lawrence H. White "Mises on Free Banking and Fractional Reserves," in John W. Robbins and Mark Spangler, eds., A Man of Principle: Essays in Honor of Hans F. Sennholz (Grove City, PA: Grove City College Press) pp. 517–33.
 Ibid., p. 528.
 White, "Mises on Free Banking and Fractional Reserves," pp. 522–24.
 Ibid., p. 522.
 Ibid., pp. 524–25.
 Mises's discussion of the advantages of fiduciary media occurs on pages 298–99 and 323, while his business cycle theory is presented on pages 339–66 in Mises, Theory of Money and Credit.
 Ibid., p. 406.
 Ibid., pp. 407–409.
 White, "Mises on Free Banking and Fractional Reserves," p. 520.
 Ludwig von Mises, "Monetary Stabilization and Cyclical Policy," in idem, On the Manipulation of Money and Credit, trans. Bettina Bien Greaves (Dobbs Ferry, NY: Free Market Books, 1978), p. 145. [Republished by the Mises Institute as Causes of the Economic Crisis (2009)]
 Ibid., pp. 167–68.
 Ibid., pp. 138–40
 Lawrence H. White and George A. Selgin, "The Evolution of a Free Banking System," in Lawrence H. White, Competition and Currency: Essays on Free Banking and Money (New York: New York University Press, 1989), p. 235.
 Ibid., pp. 521–22.
 For a demonstration of this, see Joseph T. Salerno, "Commentary: The Concept of Coordination in Austrian Macroeconomics," in Richard M. Ebeling, ed., Austrian Economics: Perspectives on the Past and Prospects for the Future (Hillsdale, Mich.: Hillsdale College Press, 1991), pp. 335–40.
 Mises, Human Action, p. 422.
 Mises, Theory of Money and Credit, pp. 448–52.