Question on Rothbard's treatise on money.

[Prateek_Sanjay]

Text is lifted from What Has Government Done To Our Money?

If fraud is to be proscribed in a free society, then fractional reserve banking would have to meet the same fate. Suppose, however, that fraud and fractional reserve banking are permitted, with the banks only required to fulfill their obligations to redeem in gold on demand. Any failure to do so would mean instant bankruptcy. Such a system has come to be known as “free banking.” Would there then be a heavy fraudulent issue of money substitutes, with resulting artificial creation of new money? Many people have assumed so, and believed that “wildcat banking” would then simply inflate the money supply astronomically. But, on the contrary, “free banking” would lead to a far “harder” monetary system than we have today.

The banks would be checked by the same three limits that we noted above, and checked rather rigorously. In the first place, each bank’s expansion will be limited by a loss of gold to another bank. For a bank can only expand money within the limits of its own clientele. Suppose, for example, that Bank A, with 10,000 ounces of gold deposited, now issues 2,000 ounces of false warehouse receipts to gold, and lends them to various enterprises, or invests them in securities.

The borrower, or former holder of securities, will spend the new money on various goods and services. Eventually, the money going the rounds will reach an owner who is a client of another bank, B. At that point, Bank B will call upon Bank A to redeem its receipt in gold, so that the gold can be transferred to Bank B’s vaults.

But if bank A and bank B are already having frequent clients between each other, then if $200,000 goes from A to B, and $250,000 goes from B to A, then only $50,000 or some significantly smaller amount need be redeemed by one of the banks. That could easily be way below the fractional reserves being kept by the bank. And it may well be the most that the bank may ever be called for in redemption.

Somehow I am not convinced that the increase in money supply caused by loaning of funds can easily be checked by the three parameters Rothbard described, and his hypothetical belief that the few educated people who understand the monetary expansionism of banks can stop it is hurt by the fact that in real life, even the few educated people who understand insolvency of public services or other schemes have failed to convince the common man against them. Is there any real life case of free society stopping monetary expansion of money substitutes?