Historically, banknotes were money substitutes, that a bank was prepared to exchange free of charge against money proper. With paper money, a banknote is a promise to the same amount of paper money.
A similar kind of substitutes are token coins.
Trust in banknotes
Except for small groups of businessmen who were able to distinguish between good and bad banks, banknotes were always looked upon with distrust. These suspicions slowly disappeared with special charters granted by the governments to privileged banks. The poorer the recipient of a banknote is and the less familiar with bank affairs, the more quickly will it be spent and will return to the issuing bank or to people familiar with banking conditions.
It is very easy for a bank to increase the number of people who are ready to accept loans granted by credit expansion and paid out in an amount of money-substitutes. But it is very difficult for any bank to enlarge the number of people who are ready to consider these claims as money-substitutes and to keep them as such in their cash holdings. Acquiring any kind of good will is hard and takes much time. On the other hand, a bank can lose its clientele very quickly. There must be no doubt about its ability to discharge all its liabilities according to the contract. It must keep a large enough reserve to redeem all banknotes which its holders may submit for redemption.
One way to increase the circulation of banknotes are legal tender laws.
Inflation and Banknotes
If more banknotes are created, the currency does not become heterogeneous (like coins of different quality and metal content) and will avoid resulting deflationary effects. As long as the inflation stays moderate, the banknotes can be exchanged for precious metal. Banks are not in immediate danger, as long as they keep sufficient reserves. At least directly, the incomes of the state are not threatened, international trade and the state's creditors are not harmed - and there is still some competition between banks. The bankers are still motivated to inflate, but need to hold certain reserves. The system is highly inflationary, but there are limits.
The inflationary effects increase and the producer of money can draw resources out of the economy.
- Ludwig von Mises. "11. The Money-Substitutes", Human Action, online version, Chapter XVII. Indirect Exchange, referenced 2009-06-29.
- Jörg Guido Hülsmann. "The Ethics of Money Production", online version, Chapter 12. Paper Money p.162, referenced 2009-06-30.
- Ludwig von Mises. "12. The Limitation on the Issuance of Fiduciary Media", Human Action, online version, Chapter XVII. Indirect Exchange, referenced 2009-06-29.
- Jörg Guido Hülsmann. "The Ethics of Money Production", online version, Chapter 10. Legal-Tender Laws p.125, referenced 2009-07-02.