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Friday, August 31, 2012

Money and the Banking System

But even paper money, abstract and ephemeral though it be, cannot be considered as the final stage of that “aenemia” which has characterized the development of money. Paper money is, after all, “cash”; it is a visible concrete currency. Now it is commonly known that most business transactions in the economically most developed countries are consummated not by the use of actual cash but by the transfer of bank deposits. The participants in such transactions maintain bank accounts against which they write checks. In disposing of their bank deposits in this way, they make use of a variety of money which is designated as credit money (bank money, check money, or demand deposits). In this, the dominant medium of exchange today, money has found its most abstract expression. Even the simple counter, as it were, has disappeared from the gaming tables of finance—people simply “keep track of the score.” If, under the general heading of “the banking system” we include both banks of issue and banks which handle demand deposits (commercial banks), it is evident that in the economically advanced countries the monetary system is intimately connected with the banking system. Thenceforth, money and credit constitute an inseparable entity.

We find, too, that the same sequence of credit expansion which is associated with the issuance of bank notes occurred in the case of demand deposits. Thus, to the extent to which demand deposits circulated as money, the banks felt themselves freed of the obligation of maintaining a 100 per cent cash reserve behind these deposits, despite the fact that they are debts of the bank subject to payment on demand (hence the name “demand deposit”). To provide the necessary minimum liquidity (the ability to meet expected demands for cash) it was deemed sufficient to maintain a supply of ready money equal to, let us say, 10 per cent of the total demand deposits oustanding. The banks could loan out the remaining 90 per cent and earn enough in the process to administer the deposits without charge or even to pay a small amount of interest on them. Hence-forth, the whole art of bank management consisted in effecting a daily compromise between the two opposed principles of liquidity and profitability, with the over-all goal being the maintenance of minimum liquidity and maximum profitability. Small errors of calculation could be corrected by recourse to the so-called “money market.” Thus, the whole system is truly “minutely adjusted to reflect the smallest increment in weight which it can just support.” We can now observe what an important bearing banking has on the entire monetary system. Prior to the development described above, only cash money circulated. Thenceforth, demand deposits circulated simultaneously with the greater part of the cash which gave rise to these same deposits. The circulation of demand deposits or check money was equivalent in short to the “creation” of an additional supply of money.

There is yet another angle from which we can observe how the modern banking system affects the
supply of money. A businessman, for instance, may establish a demand deposit (checking account) not only by depositing hard cash in the bank, but by getting the bank to extend him a loan for this purpose. Thus, by adhering to a proportion of 1 : 10 between cash reserves and outstanding demand deposits, with 90 per cent of the actual currency paid in being loaned out, the bank can, by granting cerdits, create new checking accounts (demand deposits) to an amount nine times greater than that which has been paid into it. It is clear in this case that the bank, following the same procedure as a bank of issue, grants credits not out of preceding savings, but from additional resources obtained by the creation of credit. To what extent is a bank capable of creating credit? This depends upon the bank’s liquidity requirements, that is, upon the amount of the reserve which the bank must maintain to meet the demands for the conversion of check money into actual cash. This preoccupation with the maintenance of liquidity, which no bank can safely ignore, more or less effectively limits the bank’s power to create credit. The liquidity requirements of banks fluctuate with the degree of confidence placed in banks, with the amount of the payments made to those who are outside the circle of the bank’s regular clients (payrolls, small payments to retail merchants, farmers, etc.), and with the turnover of individual bank accounts. But more significantly, the fluctuations to which bank liquidity is subject—and pro tanto the fluctuations to which the total supply of credit is subject—coincide to a very large extent with the cyclical fluctuations of prosperity and depression. In a period of expansion the economy’s supply of credit increases, while the banks’ liquidity is proportionately lowered (credit expansion); in a period of depression the banks seek greater liquidity and are forced, in the process, to contract credit (deflation).

It is of great importance that we thoroughly understand the above relationships, for without such understanding we cannot adequately comprehend the perils and the problems which currently beset our economic system. Hence, no effort should be spared in getting to the bottom of these relationships.8 One way of doing this is to imagine an economy where all payments are effected without the use of actual currency. Evidently, in such case, there would no longer be any limit to the power of the banks to create credit. The more widely extended is the system of transactions effected without cash, the greater becomes the power of the banks to “manufacture” credit. Yet again, we may compare a bank with the cloakroom of a theatre. In both cases we deposit something: in the bank, currency and in the cloakroom, our hats; in both cases in exchange for a receipt which authorizes us to reclaim what we have deposited. But while the cloakroom employees cannot count on the theatre-goer’s not presenting his receipt because he regards it as just as good as his headgear, the bank may safely assume that its clients will in fact consider their receipts (i.e., their right to claim their deposits) to be equally as good as their deposits. A bank is in consequence an institution which, finding it possible to hold less cash than it promises to pay and living on the difference, regularly promises more than it could actually pay should the worse come to the worst. Indeed, it is one of the essential features of a modern bank that alone it is unable to meet a simultaneous presentation for payment of all the debts owed by it (“run on the bank”).

When the whole banking system of a country is subject to a run, as in the United States in 1933, it is an event of very grave import. For then the whole ingenious system of immaterial money, founded on convention and on trust, suddenly crashes down and the desire of the public for solid cash erupts with elemental force. What then takes place is a sudden panic collapse of the credit edifice to some anterior stage of monetary evolution. In this headlong retrogression money may fall back past even the paper bank-note stage to full-value coins or, in more drastic cases, to unstamped pieces of the precious metals. In the ’30’s, a number of countries underwent such monetary crises and their effects are still being felt.
The so-called “creation of credit” by commercial banks is possible only because the circulation of short-term credit is equivalent to a circulation of money. To create credit, then, is to create money. This mysterious and seemingly sinister phenomenon may be better understood by once again comparing checks (or demand deposits) with bank notes and by recalling the historic discussion of the problems of bank note issuance. Two important facts emerge from such reflection: (1) bank notes can be printed ad hoc, as the occasion demands; (2) the commercial bank, with its power of creating credit, differs in this respect only in degree and not in kind from the note-issuing bank. No one, certainly, will gainsay the first point. For the truth of our second observation, we have only to recall that the transfer of a demand deposit from one person to another by means of a check, coupled with the confidence of the parties to such a transaction in the solvency of the bank, causes this deposit to circulate exactly as money.
Checking accounts may be regarded as money held on the bank’s books and awaiting withdrawal; checks and drafts drawn on these accounts are, therefore, simply means by which such book money is put into circulation. In the extent to which, in accordance with the law of great numbers, deposits and withdrawals offset each other, and to the extent, furthermore, that the circulation of demand deposits is confined to the banking system’s circle of customers, it is not required to maintain a 100 per cent reserve behind such deposits. On the contrary, a bank can, as we have seen, loan out a part of its deposited funds, even though such funds are callable by the bank’s depositors at any time. Bank notes and demand deposits are thus very similar to each other. Both have this in common, that they are circulating claims which the banks write against themselves and which they can create to an extent equal to some multiple of their cash reserves. The only difference between them is that the acceptability of demand deposits for purposes of general circulation is more limited than that of bank notes, but this is a difference of degree and not of kind.

Few will contest the fact that since bank notes are actual money and can be issued theoretically in unlimited amounts, there should be some kind of legal control over the note-issuing power. This is all the more necessary since in practically all countries bank notes are full legal tender even though they are no longer redeemable in specie. But it is interesting to recall that the power of banks to issue notes at will and thus to increase the supply of money was once just as controversial as is today the corresponding, if more limited power of the commercial banks to create credit.

To be sure, the issuance of bank notes has always been regarded as an undertaking fraught with risk to the community. The history of the note-issuing banks is a long and anguished one, dotted with ruined banks and—what is even more depressing—strewn with the memorials of wrecked monetary systems. “Never,” said the English economist Ricardo 150 years ago, “has a bank which had unlimited power to issue paper money not abused that power.” Thus the conviction grew that the issuing of bank notes should be subject to definite limitation. But where ought the limits to be placed? On this point there was a very heated argument one hundred years ago between two schools—the Currency School and the Banking School. Their differences, even after the lapse of a century, have lost none of their significance.

The opinion of the Banking School with respect to the phenomenon of credit creation may be summarized as follows: bank notes and demand deposits are similar inasmuch as both are phenomena pertaining to banking—hence the name “Banking School”—but neither exert any active influence on the monetary system. In the rigid view of this School, the monetary system will remain shipshape so long as bank notes enter circulation through banking operations alone, that is, through short-term credit transactions. In these circumstances, every legal barrier to the issuance of bank notes would be harmful while, conversely, unrestricted powers of issuance would be absolutely indispensable to maintaining elasticity of the supply of currency, and to adjusting this supply to the fluctuating needs of business. This adjustment would ensue automatically because demands for credit on the note-issuing banks would rise or fall as general economic activity rose or fell. Thus, the position of the note-issuing banks with respect to the increase or decrease of the volume of bank notes would be a completely passive one, since the volume of bank notes would depend on the money and credit needs of the business community and not on the volition of the note-issuing banks. A change in the volume of currency would be not the cause but only the effect of events occurring in the sphere of production, or of changes in the price level, or of cyclical changes, or of variations in the rates of foreign exchange, etc. Every attempt of the banks to alter the volume of currency above or below the requirements of business would fail; if too many notes were issued, the excess would flow back to the banks, while if not enough were issued, business would resort to other circulating instruments.

The Currency School, in contradistinction to the Banking School, considered bank notes to be a money phenomenon and not a credit phenomenon. It reasoned, therefore, that the issuance of bank notes should be just as jealously supervised as the issuance of any other kind of money. In opposition to the Banking School, it argued logically that the sum total of bank credits is not unaffected by the policy of the note-issuing bank which fixes the conditions of credit, particularly the rate of interest. The issuance of bank notes is to be considered like any other creation of money and there is nothing in the nature of the operation of the note-issuing bank which could prevent either an excessive creation of credit (credit inflation) or an insufficiency of credit (credit deflation). Hence, the issuance of bank notes requires strict legal supervision. But this much established, the Currency School forgot that demand deposits can be just as much a source of credit inflation or of credit deflation as bank notes. As a result, the adherents of this school suffered considerable disillusionment when the severe restrictions on the issuance of bank notes embodied in the famous English Bank Act of 1844 failed to solve the problems incident on credit creation; indeed, these restrictions on bank-note issues served to stimulate the growth of the demand deposit (check) system. The more rapid the increase in the last hundred years of the importance of demand deposits in business transactions, the clearer it has become that regulation of the note-issuing banks alone will not suffice to cope with the exceedingly difficult problems attendant on credit creation.
Control of the note-issuing banks must be supplemented by regulation of the demand-deposit system.
Though academic economists are now unanimously of the opinion that commercial banks can and do create credit, there is many a practical man of affairs who is inclined to view such “theories” with skepticism. There are still people in the banking world who hold that their own experience invalidates the creation of credit theory in toto. Such skepticism may be traced, in part, to exaggerated or incomplete descriptions of the process of credit creation. We must guard against overstating our case, for there are, of course, the limits to this process which were noted in an earlier part of this chapter. We also must take into account the optical illusion which causes the individual banker to view the aforementioned process in a radically different way than the economist who surveys the banking system as a whole. Thus the individual bank cannot continue indefinitely to make loans, for the cash reserve it must maintain clearly sets a limit to its loanable funds. If Bank A considers a reserve of 10 per cent adequate, then it can only loan out 90 per cent of its deposited cash. But the process of credit expansion is not therewith concluded because this 90 per cent will ordinarily become a primary deposit in Bank B which again loans out 90 per cent, etc. When the process is continued throughout the entire banking system it will be found that eventually nine times the original amount of cash deposited in the system will have been extended in loans (9/10 + 9/10 • 9/10 + 9/10 • 9/10 • 9/10 . . . . . . . 9/10n). We see that the “enigma of the banking system” (Philipps) consists in a given amount of cash becoming the basis for a towering edifice of credits and deposits, though this is clearly not the case with respect to the individual bank. Hence, by the very nature of the complicated process to which we have just alluded, it becomes impossible to distinguish between genuinely primary cash deposits and those derivative deposits that come into being through the creation of credit. Consequently, we can readily see why an individual banker will so vehemently deny the process of credit creation, a process that to us appears so self-evident. Such denial absolves the individual bank of the “guilt” (or at any rate of the responsibility) of creating additional credit. Now when we said that a bank must pay heed to its cash reserves, we said nothing more than that it must stay liquid. The degree of liquidity desired or required fixes the outer limits to a bank’s powers of credit creation, provided, of course, that actual currency is not completely displaced by demand deposits (check money) centralized in a single bank.

Two conclusions may be drawn from the foregoing analysis. First, that the global sum of a country’s demand deposits does not represent pure saving, but is in large part a consequence of the creation of bank credit. This is something which must never be lost sight of in considering any economic problem. The second conclusion is that money and credit constitute an entity, the complexities of which place a number of formidable difficulties in the path towards economic and monetary stability. A bank is no ordinary commercial enterprise. It is not just a cloakroom where we deposit our monetary property for safekeeping, or a kind of shop where one rents costumes for a masquerade, but an enterprise which exercises a profound influence on the circulation of money and thus on the entire economic process. Consequently, the thought never occurs even to the most intransigent European liberal to abandon the control of such an enterprise to itself. And so we repeat: he who does not understand the role of the banking system is incapable of understanding the operation of the modern economic system.

Economics of the Free Society

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