Mises's distinction between commodity credit and circulation credit is crucial for understanding how banks create inflation and trigger business cycles. When banks hold 100% reserves, they're merely warehousing money and can't inflate. But fractional reserve banking allows banks to issue more receipts (notes and deposits) than they have in reserves. This is fraud—issuing multiple claims to the same money. When government protects this fraud rather than prosecuting it, banks can systematically expand circulation credit, causing inflation and boom-bust cycles. The solution is not central bank management of fractional reserves, but abolition of fractional reserve banking itself, requiring 100% reserves for demand deposits.

The key insight is that circulation credit expansion drives the business cycle by distorting the interest rate signal. The market interest rate should reflect real time preferences—society's willingness to defer consumption. When banks expand circulation credit, they lower the market rate below this natural rate, misleading entrepreneurs into thinking more savings are available than actually exist. This triggers malinvestment in longer production processes that cannot be sustained. The problem is not fractional reserves per se, but the government-sponsored credit expansion that central banking facilitates. Competitive free banking would constrain credit expansion through market discipline, preventing the systematic overexpansion that government-privileged banking encourages.

Rothbard's claim that fractional reserve banking is fraudulent misunderstands the nature of bank contracts. Banks don't promise that every deposit can be redeemed simultaneously—an obvious impossibility. They promise to redeem on demand under normal conditions, while making clear that they invest the funds. This is not fraud if both parties understand the terms. Under free banking without government privileges, the market would determine the optimal reserve ratio. Banks that held insufficient reserves would face redemption demands; those that held excessive reserves would earn lower returns. The competitive process would yield stable reserve ratios without requiring 100% reserves or suffering the economic waste that would entail.

The natural rate concept is somewhat problematic because it suggests a single, identifiable rate, when in reality there are multiple rates for different time periods, risks, and projects. But the fundamental point stands: market interest rates should reflect real time preferences and productivity expectations, not central bank manipulation. When central banks suppress interest rates through monetary expansion, they distort the entire structure of production. The longer the artificially low rates persist, the more malinvestment accumulates, and the more painful the eventual correction. This is why Keynesian policies of perpetual monetary stimulus are so destructive—they prevent necessary corrections while causing ever-larger distortions.

This divergence between money rate and natural rate is the core of Austrian business cycle theory. When credit expansion lowers the money rate below the natural rate, it creates a distorted structure of production. Resources flow into capital goods industries and long-term projects that appear profitable at the artificially low rate. But this structure is unsustainable—it doesn't match consumer time preferences. When the credit expansion slows or stops, interest rates rise, revealing that many investments were malinvestments. The economy must undergo a painful restructuring, redirecting resources from the capital goods sector back toward consumer goods. This is the inevitable bust following the artificial boom.

Under free banking, the money rate would track the natural rate automatically without requiring any authority to 'target' it. When banks expand credit, their notes flow out to other banks and return for redemption, draining reserves and forcing contraction. This clearing-based discipline prevents systematic overexpansion. The money rate might deviate temporarily from the natural rate due to local information advantages or judgment errors, but competitive pressures would limit such deviations. The business cycle as Mises describes it requires sustained, systematic overexpansion—possible under central banking with government support, but unlikely under competitive free banking subject to market constraints.

This theory definitively explains the boom-bust cycle that puzzles mainstream economists. The cycle is not caused by 'animal spirits,' insufficient aggregate demand, or any inherent instability of capitalism. It's caused by government-sponsored monetary expansion through the central bank and fractional reserve banking system. The boom is the problem, not the depression. The boom represents systematic malinvestment driven by false price signals. The depression is the market's attempt to correct these errors and reallocate resources to sustainable uses. Government intervention to 'fight' the depression through fiscal stimulus or further monetary expansion only delays adjustment and makes the ultimate correction more painful.

The genius of Mises's theory is recognizing that the problem lies in the structure of production, not just in aggregate magnitudes. It's not that there's too much investment in the aggregate during the boom—it's that investment is distorted toward wrong projects, typically longer-term ventures that seem profitable only at artificially low interest rates. The heterogeneity of capital is crucial here. The capital goods created during the boom may be worthless because they don't fit together with actual consumer preferences and available complementary factors. This is why crude Keynesian reflation doesn't work—it can't undo the structural distortions caused by the initial expansion.

While Mises's theory correctly explains cycles under central banking, it's important to note that free banking systems have historically shown much greater stability. Episodes like the Scottish free banking era (1716-1845) or pre-Civil War New England saw very mild cycles compared to central banking periods. The reason is that free banking constrains credit expansion through competitive redemption. Banks cannot systematically lower interest rates below natural rates because aggressive expansion leads to reserve losses. The dramatic cycles of the 20th century coincided with central banking, not with free banking, suggesting that the institutional framework of money and banking matters more than the mere existence of fractional reserves.

The only sound credit policy is no credit policy—free banking without government intervention. Central banks cannot 'fine-tune' the economy because the knowledge required doesn't exist in centralized form. The attempt to manage interest rates and money supply inevitably leads to manipulation, inflation, and cycles. We need to separate money and state entirely, just as we separate religion and state. Let private banks issue competing currencies, subject to fraud laws that would effectively require 100% reserves for demand deposits. This would eliminate both inflation and the business cycle, while allowing genuine market-driven credit to fund productive investments based on real saving.

The policy implication is clear but politically unpalatable: the boom must be prevented, and once it occurs, the bust must be allowed to proceed. Attempts to smooth out the cycle through countercyclical policy merely perpetuate the distortions. This is the fundamental flaw in Keynesian economics—it treats the symptoms (recession) rather than the cause (previous monetary expansion), and its treatments (deficit spending, monetary stimulus) worsen the underlying problem. The political economy of this is depressing: voters blame the recession on market failure and demand intervention, not understanding that intervention caused the problem and that more intervention will make it worse. This is why we're trapped in a cycle of expanding government control.

Free banking provides the sound credit policy Mises calls for. Under free banking, banks can expand credit to meet seasonal demands and economic growth without causing cycles, because the expansion is constrained by competitive redemption. When Bank A expands, its notes flow to customers of Bank B, which presents them for redemption, draining A's reserves. This automatic adjustment prevents the systematic, sustained overexpansion that causes cycles. Central banks break this mechanism by providing unlimited reserves to the system and by imposing uniform policy regardless of divergent conditions in different sectors and regions. Decentral banking isn't just more stable—it's more flexible and responsive to actual economic conditions.