I was reading this article and came across this passage regarding expansion of credit not backed by savings:
In a free-market economy, intermediaries such as banks will have difficulty expanding unbacked credit. For instance, Farmer Joe sells his saved 1 kilogram of seeds for $100. He then deposits this $100 with Bank A. Note that the $100 is fully backed up by the saved 1 kilogram of seeds. Also, observe that Joe is exercising his demand for money by holding cash in the demand deposits of the Bank A. (Joe could have also exercised his demand for money by holding the money at home in a jar or keeping it under the mattress.)
Let us say that Bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional real savings back up these $50. What we have here is $150 that is backed by $100.
Now, Joe demands money not to hold it as such but to use it as a medium of exchange. So let us say that Joe decides to use $100 to buy goods from Sam who banks with Bank B. Let us also assume that Bob, who borrowed $50 from Bank A, uses them to also buy goods from Sam. (Both Joe and Bob pay Sam with checks.) All this, however, will pose a problem to Bank A. On the following day Bank B will ask Bank A to honor the checks for $150. Bank A will have difficulty honoring the checks since he has only $100 in cash. In short, Bank A is “caught” here, so to speak.
In a free market, then, if a particular bank engages in an unbacked expansion of credit this bank runs the risk of being “caught.” Consequently, the threat of bankruptcy is likely to deter banks from pursuing the expansion of unbacked credit. We can thus conclude that there is no inherent tendency in the capitalistic economy to generate unbacked credit that destabilizes the economy.
The article goes on then to explain how, with a central bank, it is possible to expand credit without savings and thus begin an inflationary bubble. However, the article goes on to explain that to eliminate credit expansion, it would be advisable to dispose of a central bank.
This got me thinking, if in a free banking environment what would stop bank A just creating the additional $50, to honor the check, “out of thin air”? Couldn’t private banks (assume with their own currency) just print the money if they practise fractional reserve banking? What market forces mitigate credit expansion (assuming no legal tender laws)?