1. A Critical Analysis of the Banking School

In this section we will examine the theoretical arguments advocates of fractional-reserve banking have constructed to justify such a system. Although these arguments have traditionally been considered a product of the Banking and Currency School controversy which arose in England during the first half of the nineteenth century, the earliest arguments on fractional-reserve banking and the two opposing sides (the banking view versus the currency view) can actually be traced back to contributions made by the theorists of the School of Salamanca in the sixteenth and seventeenth centuries.

THE BANKING AND CURRENCY VIEWS AND THE SCHOOL OF SALAMANCA

The theorists of the School of Salamanca made important contributions in the monetary field which have been studied in detail.²

The first Spanish scholastic to produce a treatise on money was Diego de Covarrubias y Leyva, who published Veterum collatio numismatum (“Compilation on old moneys”) in 1550. In this work the famous Segovian bishop examines the history of the devaluation of the Castilian maravedi and compiles a large quantity of statistics on the evolution of prices. Although the essential elements of the quantity theory of money are already implicit in Covarrubias's treatise, he still lacks an explicit monetary theory.³ It was not until 1556, several years later, that Martín de Azpilcueta unequivocally declared the increase in prices, or decrease in the purchasing power of money, to be the result of a rise in the money supply, an increase triggered in Castile by the massive influx of precious metals from America.

Indeed Martín de Azpilcueta's description of the relationship between the quantity of money and prices is faultless:

In the lands where there is a serious shortage of money, all other saleable items and even the labor of men are given for less money than where money is abundant; for example, experience shows that in France, where there is less money than in Spain, bread, wine, cloth and labor cost much less; and even when there was less money in Spain, saleable items and the labor of men were given for much less than after the Indies were discovered and covered Spain with gold and silver. The reason is that money is worth more when and where it is scarce, than when and where it is abundant.⁴

In comparison with the profound and detailed studies which have been conducted on the monetary theory of the School of Salamanca, up to this point very little effort has been made to analyze and evaluate the position of the scholastics on banking.⁵ Nevertheless the theorists of the School of Salamanca carried out a penetrating analysis of banking practices, and by and large, they were forerunners of the different theoretical positions which more than two centuries later reappeared in the debate between members of the “Banking School” and those of the “Currency School.”

As a matter of fact, in chapter 2 we mentioned the severe criticism of fractional-reserve banking voiced by Doctor Saravia de la Calle in the final chapters of his book, Instrucción de mercaderes. In a similar vein, though not as strongly critical as Saravia de la Calle, Martín de Azpilcueta, and Tomás de Mercado undertake a rigorous analysis of banking which includes a catalog of the requirements for a fair and lawful monetary bank deposit. These early authors could be viewed as members of an incipient “Currency School,” which had long been developing at the very heart of the School of Salamanca. These scholars typically adopt a consistent, firm stance on the legal requirements for bank-deposit contracts, as well as a generally critical, wary attitude toward banking.

A distinct second group of theorists is led by Luis de Molina and includes Juan de Lugo and, to a lesser extent, Leonardo de Lesio and Domingo de Soto. As stated in chapter 2, these authors follow Molina's example and, like him, they demand only a weak legal basis for the monetary bank-deposit contract and accept fractional-reserve practices, arguing that such a contract is more a “precarious” loan or mutuum than a deposit. We will not repeat here all arguments against Molina's position on the bank-deposit contract. Suffice it to say that underlying his position is a widespread misconception which dates back to the medieval glossators and their comments on the institution of the depositum confessatum. What concerns us now is the fact that this second group of scholastics was much more lenient in their criticism of bankers and went as far as to justify fractional-reserve banking. It is not, then, altogether far-fetched to consider this group an early “Banking School” within the School of Salamanca. As their English and Continental heirs would do several centuries later, members of this school of thought not only justified fractional-reserve banking, in clear violation of traditional legal principles, but also believed it exerted a highly beneficial effect on the economy.

Though Luis de Molina's arguments concerning the bank contract rest on a very shaky theoretical foundation and in a sense constitute a regression with respect to other attitudes held by members of the School of Salamanca, it should be noted that Molina was the first in the “Banking School” tradition to realize that checks and other documents which authorize the payment, on demand, of certain quantities against deposits fulfill exactly the same function as cash. Therefore it is not true, though it is widely believed, that the nineteenth-century theorists of the English Banking School were the first to discover that demand deposits in banks form part of the money supply in their entirety, and thus affect the economy in the same way as bank bills. Luis de Molina had already clearly illustrated this fact over two centuries earlier in Disputation 409 of his work, Tratado sobre los cambios [“Treatise on exchanges”]. In fact, Molina states:

People pay bankers in two ways: both in cash, by giving them the coins; and with bills of exchange or any other type of draft, by virtue of which the one who must pay the draft becomes the bank's debtor for the amount which the draft indicates will be paid into the account of the person who deposits the draft in the bank.⁶

Specifically, Molina is referring to certain documents which he calls chirographis pecuniarum (“written money”), and which were used as payment in many market transactions. Thus:

Though many transactions are conducted in cash, most are carried out using documents which attest either that the bank owes money to someone or that someone agrees to pay, and the money stays in the bank.

Moreover Molina indicates that these checks are considered “on demand”: “The term ‘demand’ is generally used to describe these payments, because the money must be paid the moment the draft is presented and read.”⁷

Most importantly, long before Thornton in 1797 and Pennington in 1826, Molina expressed the essential idea that the total volume of monetary transactions conducted at a market could not be carried out with the amount of cash which changes hands at the market, were it not for the money banks create with their deposit entries, and depositors’ issuance of checks against these deposits. Hence banks’ financial activities result in the ex nihilo creation of a new sum of money (in the form of deposits) which is used in transactions. Indeed Molina expressly tells us:

Most of the transactions made in advance [are concluded] using signed documents, since there is not enough money to permit the huge number of goods for sale at the market to be paid for in cash, if they must be paid for in cash, or to make so many business deals possible.⁸

Finally, Molina distinguishes sharply between those operations which do involve the granting of a loan, since the payment of a debt is temporarily postponed, from those carried out in cash via check or bank deposit. He concludes:

We must warn that an item cannot be considered purchased on credit if the price is withdrawn from a bank account, even if an immediate cash payment is not made; for the banker will pay the amount owed in cash when the market is over, if not sooner.⁹

Juan de Lugo, for his part, strictly adheres to Molina's doctrine and views the monetary bank deposit as a “precarious” loan or mutuum which the banker may use in his private business dealings as long as the depositor does not claim it.¹⁰

Molina and Lugo are so confused as to the legal basis of the bank deposit contract that they actually claim it can have a distinct legal nature for each of the parties involved (i.e., that it can simultaneously be a deposit to the depositor and a loan to the banker). These two theorists apparently see no contradiction in this position, and with respect to bankers’ activities, content themselves with cautioning bankers to act “prudently,” so that, in keeping with the law of large numbers, their liquidity will always be sufficient to allow them to satisfy “customary” requests for deposit returns. They fail to realize that their standard of prudence is not an objective criterion adequate to direct the actions of bankers. It certainly does not coincide with bankers’ ability to return all deposits in their keeping at any time, and Molina and Lugo themselves are careful to point out that bankers commit “mortal sin” when they use their depositors’ funds speculatively and imprudently, even if such actions end well and they are able to return their depositors’ money in time.¹¹ Moreover the standard of prudence is not a sufficient condition: a banker may be very prudent yet not very perceptive, or he may even have bad luck in business, so that when the time comes to pay he lacks ample liquidity and cannot return deposits.¹² What, then, is an acceptable standard of prudence? This question clearly has no objective answer capable of serving as a guide in banking. Furthermore as we saw in earlier chapters, the law of large numbers is inapplicable to fractional-reserve banking, since the credit expansion involved in such banking practices leads to recurrent cycles of boom and recession which invariably cause difficulties for bankers. Indeed the banking business itself creates the liquidity crises and thus, the widespread insolvency of banks. At any rate, when the crisis hits it is highly likely that the bank will be unable to pay, i.e., that it will suspend payments, and even if in the end all its creditors are lucky enough to receive their money, in the best of circumstances this only happens after a long liquidation process in which the depositors’ role is altered. They lose immediate availability of their money and become forced lenders with no choice but to postpone withdrawal of their deposits until the liquidation is over.

Tomás de Mercado was undoubtedly motivated by the above considerations when he emphasized that Molina and Lugo's principles of prudence were an objective no bank fulfilled in practice. It seems as if Tomás de Mercado was aware that such principles do not constitute a practical guide to guaranteeing the solvency of banks. Moreover if these principles are ineffectual in consistently achieving the goal of solvency and liquidity, the fractional-reserve banking system will not be capable of honoring its commitments in all situations.

Two Jesuit economists recently examined the doctrine of the scholastics on banking; one did so from the perspective of the Banking School, and the other from that of the Currency School. The first is the Spanish Jesuit Francisco Belda, the author of an interesting paper entitled, “Ética de la creación de créditos según la doctrina de Molina, Lesio y Lugo” [“The ethics of the creation of loans, according to the doctrine of Molina, Lesio and Lugo”].¹³ Indeed Father Belda considers it obvious that:

It can be gathered from Molina's description that in the case of bankers there is a true creation of loans. The intervention of banks has lead to the creation of new purchasing power previously nonexistent. The same money is simultaneously used twice; the bank uses it in its business dealings, and the depositor uses it as well. The overall result is that the media of exchange in circulation are several times greater in quantity than the real amount of cash at their origin, and the bank benefits from all these operations.

Furthermore according to Belda, Molina believes

banks can reasonably do business with the deposits of their clients, as long as they do so prudently and do not risk being unable to honor their own obligations on time.¹⁴

In addition, Belda states that Juan de Lugo offers

a thorough description of the practices of money changers and bankers. Here we do find explicit approval of credit creation, though not with the formal appearance of created credit. Banks do business with the deposits of their clients, who at the same time do not give up the use of their own money. Banks expand the means of payment through loans, trade-bill discounting and other economic activities they carry out with the money of third parties. The final result is that the purchasing power in the market is pushed far beyond that represented by the cash deposits at its origin.¹⁵

Belda obviously concludes correctly that of all the scholastics’ doctrines, those of Molina and Lugo are the most favorable to banking. Nevertheless we must criticize Father Belda for not explaining the positions of the other members of the School of Salamanca, for example Tomás de Mercado, and especially Martín de Azpilcueta and Saravia de la Calle, who as we know, are much harsher and more critical judges of the institution of banking. Furthermore Belda bases his analysis of the contributions of Molina and Lugo on a Keynesian view of economics, a perspective which not only ignores all the damaging effects credit expansion exerts on the productive structure, but also presents such practices as highly beneficial because they increase “effective demand” and national income. Therefore Belda adopts the Keynesian and Banking-School view and only analyzes the contributions of those members of the School of Salamanca who are the least strict concerning the legal justification for the monetary bank deposit and, thus, the most inclined to defend fractional-reserve banking.

Nonetheless another prominent Jesuit, Father Bernard W. Dempsey, is the author of an economic treatise, entitled Interest and Usury,¹⁶ in which he also examines the position of the members of the School of Salamanca on the banking business. Father Dempsey's theoretical knowledge of money, capital and cycles serves as the foundation of his study and represents a much sounder basis than the one Father Belda builds upon.¹⁷

Strangely, Dempsey does not develop his thesis with an analysis of the views of those members most against banking (Saravia de la Calle, Martín de Azpilcueta, and Tomás de Mercado), but instead focuses on the writings of those most favorable to the banking business (Luis de Molina, Juan de Lugo and Lesio). Dempsey carries out an exegesis on the works of these authors and concludes that fractional-reserve banking would not be legitimate even from the standpoint of their own doctrines. These Salamancan authors defend certain traditional principles concerning usury, and Dempsey supports his conclusion by applying such principles to banking and its economic consequences, which, though unknown in the age of these scholastics, had been revealed in the theories of Mises and Hayek before Dempsey produced his treatise. Indeed though we must acknowledge Molina and Lugo's more favorable treatment of banking, Dempsey expressly states that the loans banks generate ex nihilo in the course of their operation with a fractional-reserve entail the creation of buying power backed by no prior voluntary saving or sacrifice. As a result, considerable harm is done to a vast number of third parties, who see the purchasing power of their monetary units fall owing to the inflationary expansion of banks.¹⁸ According to Dempsey, this ex nihilo generation of buying power, which implies no previous loss of purchasing power to other people, violates the essential legal principles Molina and Lugo themselves lay down and in this sense is reprehensible. Specifically, Dempsey asserts:

We may conclude from this that a Scholastic of the seventeenth century viewing the modern monetary problems would readily favor a 100-percent reserve plan, or a time limit on the validity of money. A fixed money supply, or a supply altered only in accord with objective and calculated criteria, is a necessary condition to a meaningful just price of money.¹⁹

Dempsey insists that bank credit expansion drives down the purchasing power of money, and that therefore banks tend to return deposits in monetary units of increasingly reduced purchasing power. This leads him to conclude that if members of the School of Salamanca had possessed a detailed, theoretical understanding of the functioning and implications of the economic process which fractional-reserve banking triggers, then even Molina, Lesio, and Lugo would have condemned it as a vast, harmful, and illegitimate process of institutional usury.

Now that we have analyzed the main postures members of the School of Salamanca adopted on banking, we will see how their ideas were collected and developed in later centuries by both continental European and Anglo-Saxon thinkers.

THE RESPONSE OF THE ENGLISH-SPEAKING WORLD TO THESE IDEAS ON BANK MONEY

Although a comprehensive analysis of the evolution of monetary thought from the scholastics to the English Classical School would exceed the scope of this book,²⁰ it is fitting that we should comment briefly on the evolution of ideas concerning fractional-reserve banking up to the time the controversy between the Banking and Currency Schools officially arose, in nineteenth-century Britain.

The seminal monetary ideas conceived by members of the School of Salamanca later won the support of Italians Bernardo Davanzati²¹ and Geminiano Montanari, whose book, La moneta, was published in 1683.²² In their treatises these theorists take the contributions of the School of Salamanca as a starting point and go on to develop the quantity theory of money as presented by Azpilcueta and other scholastics. Although the influence of this monetary trend soon spread to England, basically through the works of Sir William Petty (1623–1687),²³ John Locke (1632–1704),²⁴ and others, it was not until John Law, Richard Cantillon, and David Hume had made their contributions that we find express reference to the problems posed by fractional-reserve banking with respect to both monetary issues and the real economic framework.

We have already referred to John Law (1671–1729) elsewhere in this book: in chapter 2 we pointed out his unusual personality, as well as his utopian, inflationist monetary proposals. Although he made some valuable original contributions, such as his opposition to Locke's nominalist, conventional theory on the origin of money,²⁵ John Law also made the first attempt to give a veneer of theoretical respectability to the fallacious and popular idea that growth in the quantity of money in circulation always stimulates economic activity. In fact, from the correct initial premise that money as a widely-accepted medium of exchange boosts commerce and encourages the division of labor, Law arrives at the erroneous conclusion that the greater the amount of money in circulation, the larger the number of transactions and the higher the level of economic activity. What follows would constitute another fatal error in his doctrine, namely the belief that the money supply must at all times match the “demand” for it, specifically the number of inhabitants and the level of economic activity. This implies that unless the amount of money in circulation keeps pace with economic activity, the latter will decline and unemployment will rise.²⁶ This theory of Law's, later discredited by Hume and Austrian School monetary theorists, has in one form or another survived up to the present, not only through the work of nineteenth-century Banking-School theorists, but also through many modern-day monetarists and Keynesians. In short, Law attributes Scotland's poor level of economic activity in his time to the “reduced” money supply and thus carries the ideas of the Mercantilist School to their logical conclusion. For this reason, Law claims the primary objective of any economic policy must be to increase the amount of money in circulation, an aim he attempted to accomplish in 1705 by introducing paper money backed by what then was the most important real asset: land.²⁷ Law later changed his mind and centered all his economic-policy efforts on the establishment of a fractional-reserve banking system which, through the issuance of paper money redeemable in specie, was expected to increase the money supply as needed in any given situation to sustain and foster economic activity. We will not dwell here on the details of the inflationary boom Law's proposals generated in eighteenth-century France, nor on the collapse of his entire system, which brought great social and economic harm to that nation.

A contemporary of John Law was fellow banker Richard Cantillon (c. 1680–1734), whose life and adventures we have already covered. Cantillon, also a speculator and banker, was endowed with great insight for theoretical analysis. He produced a highly significant study of the influence an increase in the quantity of money in circulation exerts on prices, an influence which first becomes evident in the prices of certain goods and services and gradually spreads throughout the entire economic system. Therefore Cantillon argued, as Hume later would, that variations in the quantity of money mainly affect the relative price structure, rather than the general price level. Cantillon, a banker first and foremost, justified fractional-reserve banking and his self-interested use of any money or securities his customers entrusted to him as an irregular deposit of fungible goods indistinguishable from one another. In fact chapter 6 (“Des Banques, et de leur credit”) of part 3 of his notable work, Essai sur la nature du commerce en général, contains the first theoretical analysis of fractional-reserve banking, in which Cantillon not only justifies the institution but also draws the conclusion that banks, under normal conditions, can smoothly conduct business with a 10-percent cash reserve. Cantillon states:

If an individual has to pay a thousand ounces to another, he will pay him with a banker's note for that sum. Possibly this other person will not claim the money from the banker, but will keep the note and, when the occasion requires it, hand it over to a third person as payment. Thus the note in question may be exchanged many times to make large payments, without anyone's thinking of demanding the money from the banker for a long time. There will hardly be anyone who, due to a lack of complete trust or to a need to make small payments, will demand the sum. In this first case, a banker's cash does not represent as much as 10 percent of his business. (Italics added)²⁸

After Cantillon, and aside from some interesting monetary analysis by Turgot, Montesquieu, and Galiani,²⁹ no important references to banking appear until Hume makes his essential contributions.

David Hume's (1711–1776) treatment of monetary matters is contained in three brief but comprehensive and illuminating essays entitled “Of Money,” “Of Interest” and “Of the Balance of Trade.”³⁰ Hume deserves special recognition for having successfully refuted John Law's mercantilist fallacies by proving that the quantity of money in circulation is irrelevant to economic activity. Indeed Hume argues that the volume of money in circulation is unimportant and ultimately influences only the trend in nominal prices, as stated by the quantity theory of money. To quote Hume: “The greater or less plenty of money is of no consequence; since the prices of commodities are always proportioned to the plenty of money.”³¹ Nevertheless Hume's unqualified acknowledgment that the volume of money is inconsequential does not prevent him from correctly recognizing that rises and falls in the amount of money in circulation do have a profound effect on real economic activity, since these changes always influence primarily the structure of relative prices, rather than the “general” price level. Indeed certain businessmen are always the first to receive the new money (or to experience a slump in their sales as a result of a decrease in the money supply), and thus begins an artificial process of boom (or recession) with far-reaching consequences for economic activity. Hume maintains:

In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry.³²

Although Hume lacks a theory of capital to show him how artificial rises in the quantity of money damage the productive structure and trigger a recession, the inevitable reversal of the initial expansionary effects of such rises, he correctly intuits the process and doubts that increases in credit expansion and in the issuance of paper money offer any long-term economic advantage: “This has made me entertain a doubt concerning the benefit of banks and paper-credit, which are so generally esteemed advantageous to every nation.”³³ For this reason Hume condemns credit expansion in general and fractional-reserve banking in particular and advocates a strict 100-percent reserve requirement in banking, as we saw in chapter 2. Hume concludes:

[T]o endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant and manufacturer. And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received [this is the case with the Bank of AMSTERDAM], and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.³⁴

Equally valuable is Hume's essay, “Of Interest,” devoted entirely to criticizing the mercantilist (now Keynesian) notion that a connection exists between the quantity of money and the interest rate. Hume's reasoning follows:

For suppose, that, by miracle, every man in GREAT BRITAIN should have five pounds slipt into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, not for some time, be any more lenders, nor any variation in the interest.³⁵

According to Hume, the influence of money on the interest rate is only temporary (i.e., short-term) when money is increased through credit expansion and a process is initiated which, once completed, causes interest to revert to the previous rate:

The encrease of lenders above the borrowers sinks the interest; and so much the faster, if those, who have acquired those large sums, find no industry or commerce in the state, and no method of employing their money but by lending it at interest. But after this new mass of gold and silver has been digested, and has circulated through the whole state, affairs will soon return to their former situation; while the landlords and new money-holders, living idly, squander above their income; and the former daily contract debt, and the latter encroach on their stock till its final extinction. The whole money may still be in the state, and make itself felt by the encrease of prices: But not being now collected into any large masses or stocks, the disproportion between the borrowers and lenders is the same as formerly, and consequently the high interest returns.³⁶

Hume's two brief essays constitute as concise and correct an economic analysis as can be found. We may wonder how different economic theory and social reality would have been if Keynes and other such writers had read and understood from the start these important contributions of Hume's, and had thus become immune to the outdated mercantilist ideas which, time and again, reappear and gain new acceptance.³⁷

Compared to Hume's, Adam Smith's contributions must largely be considered an obvious step backward. Not only does Smith express a much more positive opinion of paper money and bank credit, but he also openly supports fractional-reserve banking. In fact Smith claims:

What a bank can with propriety advance to a merchant or undertaker of any kind, is not, either the whole capital with which he trades, or even any considerable part of that capital; but that part of it only, which he would otherwise be obliged to keep by him unemployed, and in ready money for answering occasional demands.³⁸

The only restriction Smith places on the granting of loans against demand deposits is that banks must use deposits “prudently,” for if they abandon caution, they lose the confidence of their customers and fail. As was the case with those Salamancan scholastics (Molina and Lugo) whose views were closest to those of the Banking School, nowhere does Smith define his criterion of “prudence,” nor does he ever comprehend the devastating effects temporary credit expansion (beyond the level of voluntary saving) exerts on the productive structure.³⁹

After Adam Smith, the most important thinkers on banking activities are Henry Thornton and David Ricardo. In 1802 Thornton, a banker, published a noteworthy book on monetary theory entitled An Inquiry into the Nature and Effects of the Paper Credit of Great Britain.⁴⁰ Thornton produced a highly precise analysis of the effects credit expansion exerts on prices in the different stages of the productive structure. He even guesses that whenever banks’ interest rate is lower than the average rate of profit companies derive, an undue increase in the issuance of bills results, triggering inflation and, in the long run, recession. Thornton's intuitions foreshadowed not only Wicksell's theory on the natural rate of interest, but also much of the Austrian theory of the economic cycle.⁴¹

After Thornton's, the most notable work was produced by David Ricardo, whose distrust of banks parallels Hume's. Ricardo may be regarded as the official father of the English Currency School. In fact Ricardo strongly disapproved of the abuses committed by bankers in his day and particularly resented the harm done to the lower and middle classes when banks were unable to honor their commitments. He deemed such phenomena the result of banking offenses, and while he did not anticipate the precise development of the Austrian, or circulation credit theory of the business cycle, he at least understood that artificial processes of expansion and depression stem from certain banking practices, namely the unchecked issuance of paper money unbacked by cash and the injection of this money into the economy via credit expansion.⁴² In the following section we will examine in detail the key principles of the Currency School, started by Ricardo, as well as the main postulates of the Banking School.⁴³

THE CONTROVERSY BETWEEN THE CURRENCY SCHOOL AND THE BANKING SCHOOL

The popular arguments raised by defenders of fractional-reserve banking from the days of the School of Salamanca became more widespread and systematic in England during the first half of the nineteenth century, owing to the efforts of the so-called Banking School.⁴⁴ During that period a sizeable group of theorists (Parnell, Wilson, MacLeod, Tooke, Fullarton, etc.) formed, bringing together and systematizing the three main tenets of the Banking School, namely: (a) that fractional-reserve banking is juridically and doctrinally justified and highly beneficial to the economy; (b) that the ideal monetary system is one which permits the expansion of the money supply as required by the “needs of trade,” and particularly to adjust to population and economic growth (this is the idea John Law initially developed); and (c) that the fractional-reserve banking system, through credit expansion and the issuance of paper bills unbacked by commodity-money, permits increases in the money supply to meet the “needs of trade” without producing inflationary effects or distortions in the productive structure.

John Fullarton (c. 1780–1849) was undoubtedly the most prominent of Banking School representatives. He was among the school's most persuasive authors and in 1844 published a widely-read book entitled On the Regulation of Currencies.⁴⁵ Here Fullarton puts forward what would become a famous doctrine, Fullarton's law of reflux of banknotes and credit. According to Fullarton, credit expansion in the form of bills issued by a fractional-reserve banking system poses no danger of inflation because the bills banks issue are injected into the economic system as loans, rather than direct payment for goods and services. Thus, Fullarton reasons, when the economy “needs” more means of payment it demands more loans, and when it needs less, loans are repaid and flow back to banks, and therefore credit expansion has no negative effects whatsoever on the economy. This doctrine became quite popular, yet it was a clear step backward with respect to advances Hume and other authors had already made in monetary theory. Nevertheless it surprisingly gained the unexpected support of even John Stuart Mill, who eventually, by and large, endorsed Fullarton's theories on the issue.

We have already explained at length why the essential principles of the Banking School are fundamentally unsound. Only ignorance of the simplest basics of monetary and capital theory might make the inflationist fallacies of this school appear somewhat credible. The main error in Fullarton's law of reflux lies in its failure to account for the nature of fiduciary loans. We know that when a bank discounts a bill or grants a loan, it exchanges a present good for a future good. Since banks which expand loans create present goods ex nihilo, a natural limit to the volume of fiduciary media the banking system could create would only be conceivable under one condition: if the quantity of future goods offered in the market in exchange for bank loans were somehow limited. However, as Mises has eloquently pointed out, this is never the case.⁴⁶ In fact banks may expand credit without limit simply by reducing the interest rate they apply to the corresponding loans. Moreover, given that loan recipients pledge to return a greater amount of monetary units at the end of a certain time period, there is no limit to credit expansion. Indeed borrowers can repay their loans with new monetary units the banking system itself creates ex nihilo in the future. As Mises puts it, “Fullarton overlooks the possibility that the debtor may procure the necessary quantity of fiduciary media for the repayment by taking up a new loan.”⁴⁷

Although the monetary theories of the Banking School were invalid, in one particular respect they were accurate. Banking School theorists were the first to recover a monetary doctrine of the “banking” sector of the School of Salamanca, namely that bank deposit balances fulfil exactly the same economic function as banknotes. As we will later see, throughout the debate between the Banking and Currency Schools, in which the latter focused solely on the damaging effects of unbacked paper bills, Banking School defenders correctly argued that if the recommendations of the Currency School were sensible (and they were), they should also be applied to all bank deposits, since, as bank money, deposits play a role identical to that of unbacked banknotes. Even though this doctrine (i.e., that bank deposits are part of the monetary supply) had already been espoused by the Salamancan group most favorable to banking (Luis de Molina, Juan de Lugo, etc.), in nineteenth-century England it had been practically forgotten when Banking School theorists rediscovered it. Perhaps the first to refer to this point was Henry Thornton himself, who, on November 17, 1797, before the Committee on the Restriction of Payments in Cash by the Bank, testified: “The balances in the bank are to be considered in very much the same light with the paper circulation.”⁴⁸ Nonetheless, in 1826 James Pennington made the clearest assertion on this matter:

The book credits of a London banker, and the promissory notes of a country banker are essentially the same thing, that they are different forms of the same kind of credit; and that they are employed to perform the same function... both the one and the other are substitutes for a metallic currency and are susceptible of a considerable increase or diminution, without the corresponding enlargement or contraction of the basis on which they rest. (Italics added)⁴⁹

In the United States, in 1831, Albert Gallatin revealed the economic equivalence of bank bills and deposits and did so more explicitly than even Condy Raguet. Specifically, Gallatin wrote:

The credits in current accounts or deposits of our banks are also in their origin and effect perfectly assimilated to banknotes, and we cannot therefore but consider the aggregate amount of credits payable on demand standing on the books of the several banks as being part of the currency of the United States.⁵⁰

Nevertheless despite this valuable contribution from the Banking School, i.e., the rediscovery that bank deposits and paper money perform exactly the same economic function as specie and cause the same problems, the rest of the Banking School doctrines were, as Mises asserted, seriously faulty. Banking School theorists were unable to coherently defend their contradictory ideas; they tried in vain to refute the quantity theory of money; and they failed in their attempt to develop an articulate interest rate theory.⁵¹

These Banking School doctrines met with fierce opposition from defenders of the Currency School, who carried on a time-honored tradition which dates back not only to the Salamancan scholastics who were most uncompromising in their views on banking (Saravia de la Calle, Martín Azpilcueta and, to a lesser extent, Tomás de Mercado), but also, as we have seen, to Hume and Ricardo. The leading theorists of the nineteenth-century Currency School were Robert Torrens, S.J. Lloyd (later Lord Overstone), J.R. McCulloch, and George W. Norman.⁵²Currency School theorists provided a valid explanation of the recurring phases of boom and recession which plagued the British economy in the 1830s and 1840s: the booms had their roots in credit expansion which the Bank of England initiated and the other British banks continued. Gold systematically flowed out of the United Kingdom whenever her trading partners either did not engage in credit expansion or did so at a slower pace than Britain, where the fractional-reserve banking system was comparatively more developed. Each of the arguments Banking School theorists devised in their attempt to refute the Currency School's central idea (i.e., that the outflow of gold and cash from Great Britain was the inevitable consequence of domestic credit expansion) failed miserably. However defenders of the Currency School position made three serious mistakes which in the long run proved fatal. First, they failed to realize that bank deposits play exactly the same role as banknotes unbacked by specie. Second, they were unable to combine their sound monetary theory with a complete explanation of the trade cycle. They merely scratched the surface of the problem, and, lacking an adequate theory of capital, were unable to perceive that bank credit expansion exerts a negative influence on the different capital-goods stages in a nation's productive structure. They did not analyze in detail the existing relationship between variations in the money supply and the market rate of interest, and thus they implicitly relied on the naive, mistaken assumption that money could be neutral, an idea today's monetarists have supported. Therefore it was not until 1912, when Ludwig von Mises reformulated Currency School teachings, that monetary theory was finally fully integrated with capital theory, within a general theory of the economic cycle. The third fatal error of the Currency School lay in the notion that, in keeping with Ricardo's suggestions, the best way to curtail the Banking School's inflationary excesses was to grant an official central bank a monopoly on the issuance of bills.⁵³ Currency School theorists failed to realize that in the long run such an institution was bound to be used by Banking School members themselves to speed up credit expansion in the form of bills and deposits in circulation.

These three mistakes of the Currency School proved fatal: they were the reason Sir Robert Peel's famous Bank Charter Act (passed on July 19, 1844), despite the highly honorable intentions of its drafters, failed to ban the creation of fiduciary media (deposits unbacked by metallic money) though it did ban the issuance of unbacked bills. As a result, even though Peel's Act marked the beginning of a central bank monopoly on the issuance of paper currency, and although the central bank theoretically issued only banknotes fully backed by specie (100 percent reserve), private banks were free to expand money by granting new loans and creating the corresponding deposits ex nihilo. Hence expansionary booms and the subsequent stages of crisis and depression continued, and during these periods the Bank of England was obliged time and again to suspend the provisions of the Peel Act and to issue the paper currency necessary to satisfy private banks’ demand for liquidity, thus, when possible, saving them from bankruptcy. Therefore it is ironic that the Currency School supported the creation of a central bank which, gradually and due mainly to political pressures and the negative influence of predominant Banking School theorists, was eventually used to justify and encourage policies of monetary recklessness and financial excesses much worse than those it was originally designed to prevent.⁵⁴

Consequently, even though in terms of theory the Banking School was utterly defeated, in practice it ultimately triumphed. Indeed Peel's Bank Charter Act failed because it did not prohibit the issuance of new loans and deposits in the absence of a 100 percent reserve. As a result, recurrent cycles of boom and recession continued, and the proposals and theories of the Currency School understandably lost a tremendous amount of prestige. Therefore popular demands for inflationary policies which facilitate credit expansion, demands backed by the ever handy mercantilist theories of the Banking School, found a breeding ground in the central-bank-based system, which ultimately became an essential instrument of an interventionist, planned credit and monetary policy invariably aimed at virtually unchecked monetary and credit expansion.

Only Modeste, Cernuschi, Hübner, and Michaelis, followed by Ludwig von Mises and his much more profound analysis, saw that the Currency School's recommendation of central banking was mistaken and that the best, indeed the only, way to uphold the school's principles of sound money was to adopt a free banking system subject to private law (i.e., to a 100-percent reserve requirement) and unbenefited by privileges. However we will study this point in greater detail in the next section, in which we will examine the debate between supporters of free banking and those of central banking.