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The unresolved problem of gratuitous credit in Austrian banking theory

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Ludwig von Mises called gratuitous credit, the ability banks have to create new credit, the chief problem in a theory of banking. This paper traces how Mises and succeeding generations of Austrian-school economists have grappled with this problem, but have failed to find resolution. The result is that Austrian economists disagree on a variety of issues in banking and business cycle theory, such as whether there is an endogenous business cycle under free banking, or cycles only occur under central banking. Before a resolution can be attempted, current thinking must be clarified. This paper divides Austrian economists into five schools of thought. It points to a possible resolution in the economic development writings of Joseph Schumpeter.

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  1. Such as a 100 % reserve requirement (Rothbard [1970] 2009) or interventions to maintain money supply growth or nominal GDP growth (Hayek, as discussed in White 1999a).

  2. Hayek did not see the central bank as a fundamental cause of gratuitous credit in his earlier writings (see Hayek [1932] 2012), whereas Rothbard was a harsh critic of the central bank as one of two fundamental reasons gratuitous credit led to business cycles. The other reason was fractional reserve banking. Discussed in Sections 3 and 4 below.

  3. The difference between “Mises I″ and “Mises II” will be explained in the next section.

  4. This paper does not focus on the mechanism of the business cycle that Mises pioneered, including the elaborations of that mechanism in Hayek ([1935] 2008) and by later Austrian economists, such as Garrison (1986, 2001). Instead, it focuses on where Austrians address the causal role played by gratuitous credit.

  5. E.g., Mises ([1953] 1971, 144–147). “Banks” and “bankers” refers to a banking system that includes commercial banks and the central bank. See also Haberler (1932), a contemporary of Mises, who uses “banks” to refer to the overall banking system, with no distinction made between private, commercial banks and central banks (Ebeling 1996). In their discussions of banking, both authors, especially Haberler, accept the institutional structure of their day, which included central banks. We will see that this was also true of Hayek ([1932] 2012).

  6. Mises [1953] 1971, 318, 440.

  7. There were exceptions. The Reichsbank and National Bank of Austria were permitted to make direct loans to businesses and governments, which the Bank of England and the later Federal Reserve Bank of the United States were not permitted to do (Mises [1953] 1971). In making such loans, the central bank acted like a private bank. Qua central bank, this argument holds.

  8. This was when the United States abandoned the international convertibility of the dollar into gold.

  9. There are exactly two direct references to free banking in The Theory of Money and Credit (Mises [1953] 1971, 318, 440). The first was written pre-World War II. The second appears in a section added in 1953 for the second English edition in a section entitled “Monetary Reconstruction,” and is part of Mises II thought.

  10. Fiduciary media are money-substitutes, such as banknotes and checks, that are issued in excess of a bank’s reserves of base money, which is gold under a gold standard, or fiat money under a fiat money standard. (Mises [1953] 1971, 133).

  11. Mises views along these lines had undoubtedly begun to shift before the end of World War II, probably with the onset of the major institutional changes and growing power of central banks that began with the onset of the Great Depression in the 1930s. Note that Human Action was largely written prior to the war. Human Action, which appeared in 1949, was largely an English translation of Nationalökonomie, written by Mises from 1934 to 1940 and published in Switzerland in 1940 (Ebeling 2000, xv).

  12. Mises [1953] 1971, 413–455.

  13. See footnote 1.

  14. Chronologically, Hayek’s work appears after Mises I but before Mises II. Monetary Theory and the Trade Cycle ([1932] 2012), his principal work of this period, reads in large part as a direct response to Mises’ writings during the Mises I period.

  15. Prices and Production was written in English and appeared earlier, in 1931, both of which may account for the greater scholarly attention it has received. Also driving its popularity was that it was a collection of prestigious lectures that Hayek presented at the London School of Economics that year. In those lectures, Hayek offers a richer, detailed explanation than Mises of how boom goes to bust, utilizing an intricate model of time-unfolding capital structure. Monetary Theory and the Trade Cycle appeared earlier, in 1929, but in German, and the English translation did not appear until 1932, after Prices and Production. (Caldwell 2004).

  16. Hayek ([1932] 2012,168), quoted below.

  17. This is discussed in Section I of this paper. The central bank, according to Mises, fosters excessive private credit creation by banks via several institutional features that reduce the cost of issuing credit. These include its lender of last resort function, periodic suspensions of convertibility (under the gold standard), open market operations or the buying of debt, and an aggressive discount policy at excessively low interest rates. Mises summarizes all this as the “ideology of inflationism.” Unlike Mises, Hayek sees this as only one of many possible causes of the over-issuance of credit, one that is over-emphasized by Mises.

  18. Of the causes mentioned below, “New inventions or discoveries,” “the opening up of new markets” and “the appearance of entrepreneurs of genius who originate ‘new combinations’” are all causes described in Schumpeter ([1934] 1983).

  19. White provides several examples. In one of these (White 1999a, 763, footnote 13), Hayek endorses central control of the monetary system via an institution such as the Federal Reserve Bank. On page 764, he cites Hayek (1978) where he again argues for a central bank and against a gold standard.

  20. Hayek is quoted in this context in White 1999a, 754: “all money at all times…[is] a kind of loose joint in the otherwise self-steering mechanism of the market.” (Hayek 1960, 25).

  21. Cachanosky (2011) explains that Rothbard’s claim that Mises endorsed a 100 % reserve requirement for private commercial banks under “free banking,” is a mis-reading of Mises, a view I share as evident from the prior section.

  22. He develops the fraud argument in Rothbard ([1970] 2009, 800–804). For a comprehensive rebuttal of the legal argument, see Selgin and White (1996, 86–92).

  23. See Simpson (2014) for a Rothbardian treatment where 100 % reserves are not mandatory. Instead, Simpson hypothesizes that under free banking, the market would naturally evolve toward 100 % reserves. Most banks would operate under 100 % reserves because they would be competitively advantaged over fractional reserve banks, which would be allowed to legally operate. Their hypothesized advantage is that customers would see banks that maintained 100 % reserves as being inherently safer. For a rebuttal of this view, see Selgin (1988).

  24. At this point, I want to emphasize the unique concept of “free banks” held by Rothbard to distinguish it from the conventional historical conception of free banking and the sense used by later Austrian theorists, such as Selgin (1988) and White (1999a, b). Free banking in the latter, standard meaning is a system where banks can freely (i.e., without requiring special governmental charters) establish operations. This also includes the freedom to issue banknotes where the banks maintain partial or fractional reserves for the notes and deposits they issued.

    Rothbard agrees with the part where free banks can operate without special governmental charters, but he holds that they must also adhere to a governmental requirement that they maintain dollar-for-dollar or 100 % reserves for the notes and deposits they issue. Rothbard holds that this requirement is consistent with “free” banking under his legal theory of fraud. This paper will use free banking in the conventional sense unless it is surrounded by quotes. “Free banking” refers to Rothbard’s conception of free banking, where government mandates 100 % reserves.

  25. To distinguish it, Rothbard’s system will be called “100 % reserve free banking.”

  26. Except that Rothbard also required 100 % reserves.

  27. This paper does not explore the role of expectations in detail, which merits a separate treatment. For examples, see Koppl 2002, Cowen 1997, Wagner 2010, Lavoie (1994), Lachmann (1977, 1986), and Lewin (1999, 120–125).


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Niles, R.C. The unresolved problem of gratuitous credit in Austrian banking theory. Rev Austrian Econ 30, 83–105 (2017).

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