Central Banking: Removing the Limits

Central banks are operated by governments, and their effect is to remove the limitations placed on banking. Fundamentally, the central bank has unlimited power to issue currency and serves as a safety net, providing currency to banks that do not themselves maintain sufficient reserves to cover their outstanding deposits.

The problem of central banking is that it removes the limitations of free banking (the need for hard currency and safeguards against inflation due to counterfeiting) - the central bank supports commercial banks, and has unlimited license to issue currency.

In this way, banks are free to "pyramid" warehouse receipts (currency) on top of an actual cash reserve that is much smaller (just enough for daily transactions).

The impact of issuing currency on the central bank is nil. Customer banks borrow money, so the central bank accrues receivables, but instead of going to its own reserves, it prints currency (creating currency from thin air).

To protect its interests, the central bank must set a required reserve for its customer banks. Rothbard shows, through a handful of examples, how the amount of currency is increased in inverse proportion to the bank's reserves: if a 1/5 reserve is required, five times as much currency is created. This ratio is called the "Money Multiplier" (MM)

The created currency can be shuffled between real currency (20%) and any mix of credit accounts (such as loans extended to bank customers) and debit accounts (bonds issued by the bank). Regardless of the sophistication of the bank's capital structure, the ratio remains the same.

The imposition of a reserve requirement ensures that no bank creates inflation on its own accord, but that all banks "harmoniously and uniformly" contribute to the inflation rate set by the central bank (for one bank to attempt to hold down inflation or keep a higher reserve of hard currency is at its own detriment - to earn the greatest profit, a bank must keep as much money lent out as possible).