The Mystery
of Banking
MURRAY N. ROTHBARD
SECOND EDITION
Copyright © 2008 by the Ludwig von Mises Institute
All rights reserved. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of reprints in the context of reviews.
For information write the Ludwig von Mises Institute, 518 West Magnolia Avenue, Auburn, Alabama 36832. Mises.org.
ISBN: 978-1-933550-28-2
To Thomas Jefferson,
Charles Holt Campbell,
Ludwig von Mises
Champions of Hard Money
The Ludwig von Mises Institute thanks Mr. Douglas E. French and Ms. Deanna Forbush for their magnificent sponsorship of the publication of this book.
CONTENTS
Preface by Douglas E. French
Foreword by Joseph T. Salerno
I. Money: Its Importance and Origins
1. The Importance of Money
2. How Money Begins
3. The Proper Qualities of Money
4. The Money Unit
II. What Determines Prices: Supply and Demand
III. Money and Overall Prices
1. The Supply and Demand for Money and Overall Prices
2. Why Overall Prices Change
IV. The Supply of Money
1. What Should the Supply of Money Be?
2. The Supply of Gold and the Counterfeiting Process
3. Government Paper Money
4. The Origins of Government Paper Money
V. The Demand for Money
1. The Supply of Goods and Services
2. Frequency of Payment
3. Clearing Systems
4. Confidence in the Money
5. Inflationary or Deflationary Expectations
VI. Loan Banking
VII. Deposit Banking
1. Warehouse Receipts
2. Deposit Banking and Embezzlement
3. Fractional Reserve Banking
4. Bank Notes and Deposits
VIII. Free Banking and the Limits on Bank Credit Inflation
IX. Central Banking: Removing the Limits
X. Central Banking: Determining Total Reserves
1. The Demand for Cash
2. The Demand for Gold
3. Loans to the Banks
4. Open Market Operations
XI. Central Banking: The Process of Bank Credit Expansion
1. Expansion from Bank to Bank
2. The Central Bank and the Treasury
XII. The Origins of Central Banking
1. The Bank of England
2. Free Banking in Scotland
3. The Peelite Crackdown, 1844–1845
XIII. Central Banking in the United States I: The Origins
1. The Bank of North America and the First Bank of the United States
2. The Second Bank of the United States
XIV. Central Banking in the United States II: The 1820s to the Civil War
1. The Jacksonian Movement and the Bank War
2. Decentralized Banking from the 1830s to the Civil War
XV. Central Banking in the United States III: The National Banking System
1. The Civil War and the National Banking System
2. The National Banking Era and the Origins of the Federal Reserve System
XVI. Central Banking in the United States IV: The Federal Reserve System
1. The Inflationary Structure of the Fed
2. The Inflationary Policies of the Fed
XVII. Conclusion: The Present Banking Situation and What to Do About It
1. The Road to the Present
2. The Present Money Supply
3. How to Return to Sound Money
Appendix: The Myth of Free Banking in Scotland
Index
PREFACE
Although first published 25 years ago, Murray Rothbard’s The Mystery of Banking continues to be the only book that clearly and concisely explains the modern fractional reserve banking system, its origins, and its devastating effects on the lives of every man, woman, and child. It is especially appropriate in a year that will see; a surge in bank failures, central banks around the globe bailing out failed commercial and investment banks, double-digit inflation rates in many parts of the world and hyperinflation completely destroying Zimbabwe’s economy, that a new edition of Rothbard’s classic work be republished and made available through the efforts of Lew Rockwell and the staff at the Ludwig von Mises Institute at an obtainable price for students and laymen interested in the vagaries of banking and how inflation and business cycles are created.
In the absence of central-bank intervention, the current financial meltdown could be a healthy check on the inflation of the banking system as Rothbard points out in his scathing review of Lawrence H. White’s Free Banking in Britain: Theory, Experience, and Debate, 1800-1845 that first appeared in The Review of Austrian Economics and is included as a part of this new edition to correct Rothbard’s initial support of White’s work in the first edition. There have been virtually no bank failures in the United States since the early 1990s and as Rothbard surmised during that period where there was “an absence of failure” that “inflation of money and credit [was] all the more rampant.” Indeed, from January 1990 to April 2008, the United States M-2 money supply more than doubled from $3.2 trillion to $7.7 trillion. Bankers were living it up, “at the expense of society and the economy faring worse” (Rothbard’s emphasis).
Although ostensibly it is dodgy real estate loans that are bringing the banks down this year, in the seminal book that you hold, Rothbard shows that it is really the fraudulent nature of fractionalized banking that is the real culprit for the bankers’ demise.
But central bankers will never learn. “We should not have a system that’s this fragile, that causes this much risk to the economy,” New York Federal Reserve President Tim Geithner said after engineering J.P. Morgan’s bailout of the failed Bear Stearns investment bank in the first quarter of 2008 with the help of the central bank. Of course the thought of dismantling his employer, the government leaving the counterfeiting business, and a return to using the market’s money—gold—didn’t occur to him. More government regulation in which “the basic rules of the game establish stronger incentives for building more robust shock absorbers,” is what he prescribed.
Surely Murray is somewhere laughing.
My introduction to The Mystery of Banking came in 1992 as I was finishing my thesis at UNLV under Murray’s direction. I found the book in the university library and couldn’t put it down. The book was long out of print by that time and being prior to the start of Amazon.com and other online used book searches, I was unable to find a copy of the book for purchase. Thus, I fed dimes into the library copier one Saturday afternoon and made myself a copy. When the online searches became available I waited patiently and bought two copies when they surfaced, paying many times the original $19.95 retail price (as I write this AbeBooks.com has three copies for sale ranging from $199 to $225, and Bauman Rare Books recently sold a signed first edition for $650).
When I discovered Rothbard’s great work I had been a banker for six years, but like most people working in banking, I had no clear understanding of the industry. It is not knowledge that is taught on the job. Murray may have referred to me as “the efficient banker,” but he was the one who knew the evil implications of the modern fractionalized banking system: “the pernicious and inflationary domination of the State.”
DOUGLAS E. FRENCH
LAS VEGAS, NEVADA
JUNE 2008
FOREWORD
Long out of print, The Mystery of Banking is perhaps the least appreciat
ed work among Murray Rothbard’s prodigious body of output. This is a shame because it is a model of how to apply sound economic theory, dispassionately and objectively, to the origins and development of real-world institutions and to assess their consequences. It is “institutional economics” at its best. In this book, the institution under scrutiny is central banking as historically embodied in the Federal Reserve System—the “Fed” for short—the central bank of the United States.
The Fed has long been taken for granted in American life and, since the mid-1980s until very recently, had even come to be venerated. Economists, financial experts, corporate CEOs, Wall Street bankers, media pundits, and even the small business owners and investors on Main Street began to speak or write about the Fed in awed and reverential terms. Fed Chairmen Paul Volcker and especially his successor Alan Greenspan achieved mythic stature during this period and were the subjects of a blizzard of fawning media stories and biographies. With the bursting of the high-tech bubble in the late 1990s, the image of the Fed as the deft and all-seeing helmsman of the economy began to tarnish. But it was the completely unforeseen eruption of the wave of sub-prime mortgage defaults in the middle of this decade, followed by the Fed’s panicky bailout of major financial institutions and the onset of incipient stagflation, that has profoundly shaken the widespread confidence in the wisdom and competence of the Fed. Never was the time more propitious for the radical and penetrating critique of the Fed and fractional-reserve banking that Roth-bard offers in this volume.
Before taking a closer look at the book’s contents and contributions, a brief account of its ill-fated publication history is in order. It was originally published in 1983 by a short-lived and eclectic publishing house, Richardson & Snyder, which also published around the same time God’s Broker, the controversial book on the life of Pope John Paul II by Antoni Gronowicz. The latter book was soon withdrawn, which led to the dissolution of the company. A little later, the successor company, Richardson & Steirman, published the highly touted A Time for Peace by Mikhail Gorbachev, then premier of the U.S.S.R. This publishing coup, however, did not prevent this firm from also winding up its affairs in short order, as it seems to have disappeared after 1988.
In addition to its untimely status as an orphan book, there were a number of other factors that stunted the circulation of The Mystery of Banking. First, several reviewers of the original edition pointedly noted the lax, or nonexistent, copy editing and inferior production standards that disfigured its appearance. Second, in an important sense, the book was published “before its time.” In 1983, its year of publication, the efforts of the Volcker Fed to rein in the double-digit price inflation of the late 1970s had just begun to show success. Price inflation was to remain at or below 5 percent for the rest of the decade. During the 1990s, inflation, as measured by the Consumer Price Index, declined even further and hovered between 2 and 3 percent. This led the Greenspan Fed and most professional monetary economists to triumphantly declare victory over the inflation foe and even to raise the possibility of a return of the deflation bogey.
Despite the adverse circumstances surrounding its publication, however, The Mystery of Banking has gone on to become a true underground classic. At the time of this writing, four used copies are for sale on Amazon.com for between $124.50 and $256.47. These prices are many times higher than the pennies asked for standard money-and-banking textbooks published in the 1980s and even exceed the wildly inflated prices of the latest editions of these textbooks that are extracted from captive audiences of college students. Such price discrepancies are a good indication that Rothbard’s book is very different—in content, style, and organization—from standard treatments of the subject.
Rothbard’s book is targeted at a readership actively interested in learning about the subject and not at indifferent students slouching in the 500-seat amphitheatres of our “research” universities. While it is therefore written in Rothbard’s characteristically sparkling prose it does not shy away from a rigorous presentation of the basic theoretical principles that govern the operation of the monetary system. Indeed the book is peppered with diagrams, charts, and tables aplenty—and even a simple equation or two. But before you run for the hills, you should know that it is not a “textbook” in the conventional sense.
Conventional money-and-banking textbooks confront the hapless reader with a jumble of dumbed-down mainstream theories and models. Some of these have been discredited and most bear very little systematic relationship to one another or are in actual conflict. The Quantity Theory, in both its “classical” and monetarist versions, Keynes’s liquidity preference theory of interest, the New Keynesian Aggregate Supply curve, the expectations-augmented Phillips curve-one after another, all make their dreary appearance on the scene. Worse yet, this theoretical hodgepodge is generally set out in the last four or five chapters of the textbook and is usually preceded by a bland recitation of random technical details and historical facts about monetary and financial institutions. Unfortunately, the befuddled reader cannot make heads or tails out of these facts without the guidance of a coherent theory. For the privilege of being bewildered, misled, and eventually bored to tears by this indigestible intellectual stew, students get to pay $100 or more for the textbook.
Rothbard will have none of this shabby and disrespectful treatment of his reader and of his science that is meted out by the typical textbook author. In sharp contrast, he begins by first clearly presenting the fundamental principles or “laws” that govern money and monetary institutions. These universal and immutable laws form a fully integrated system of sound monetary theory that has been painstakingly elaborated over the course of centuries by scores of writers and economists extending back at least to the sixteenth-century Spanish Scholastics of the School of Salamanca. As the leading authority in this tradition in the latter half of the twentieth century, Rothbard expounds its core principles in a logical, step-by-step manner, using plain and lucid prose and avoiding extraneous details. He supplements his verbal-logical analysis with graphs and charts to effectively illustrate the operation of these principles in various institutional contexts.
It is noteworthy that, despite the fact that this book was written twenty-five years ago, the theory Rothbard presents is up to date. One reason is that the advancement of knowledge in non-experimental or “aprioristic” sciences like economic theory, logic, and mathematics proceeds steadily but slowly. In the case of sound monetary theory, many of its fundamental principles had been firmly established during the nineteenth century. In the German edition of The Theory of Money and Credit published in 1912, Ludwig von Mises, Rothbard’s mentor, integrated these principles with value and price theory to formulate the modern theory of money and prices. Rothbard elaborated upon and advanced Mises’s theoretical system. Thus the second reason that the monetary theory presented in the book remains fresh and relevant is that Rothbard himself was the leading monetary economist in the sound money tradition in the second half of the twentieth century, contributing many of the building blocks to the theoretical structure that he lays out. These include: formulating the proper criteria for calculating the money supply in a fractional-reserve banking system; identifying the various components of the demand for money; refining and consistently applying the supply-and-demand apparatus to analyzing the value of money; drawing a categorical distinction between deposit banking and loan banking; providing the first logical and coherent explanation of how fiat money came into being and displaced commodity money as a result of a series of political interventions. All these innovations and more were products of Rothbard’s creative genius, and many of his theoretical breakthroughs have not yet been adequately recognized by contemporary monetary theorists, even of the Austrian School.
Rothbard’s presentation of the basic principles of money-and-banking theory in the first eleven chapters of the book guides the reader in unraveling the mystery of how the central bank operates to create money through the fractional-reserve banking system and how th
is leads to inflation of the money supply and a rise in overall prices in the economy. But he does not stop there. In the subsequent five chapters he resolves the historical mystery of how an inherently inflationary institution like central banking, which is destructive of the value of money and, in the extreme case of hyperinflation, of money itself, came into being and was accepted as essential to the operation of the market economy.
As in the case of his exposition of the theory, Rothbard’s treatment of the history of the Fed is fundamentally at odds with that found in standard textbooks. In the latter, the history is shallow and episodic. It is taken for granted that the Fed, like all central banks, was originally designed as an institution whose goal was to promote the public interest by operating as a “lender of last resort,” providing “liquidity” to troubled banks during times of financial turbulence to prevent a collapse of the financial system. Later the Fed was given a second mandate, to maintain “stability of the price level,” a policy which was supposed to rid the economy of business cycles and therefore to preclude prolonged periods of recession and unemployment. Thus strewn throughout a typical textbook one will find accounts of how the Fed handled—usually, although not always, in an enlightened manner—various “shocks” to the monetary and financial system. Culpability for such shocks is almost invariably attributed to the unruly propensities or irrational expectations of business investors, consumers, or wage-earners. Even in the exceptional instances, such as the Great Depression, when inept Fed policy is blamed for making matters worse, the Fed’s errors are ascribed to not yet having learned how to properly wield the “tools of monetary policy,” the euphemism used to describe the various techniques the Fed uses in exercising its legal monopoly of counterfeiting money. Each new crisis, however, stimulates the public-spirited policymakers at the Fed by a trial-and-error process to eventually converge on the optimal monetary policy, which was supposedly hit upon in the heyday of the Greenspan Fed during 1990s.
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