The only slavery with which we are concerned in this series of postings, however, is the slavery of savings. We are not, of course, hostile to savings, any more than we are excusing human chattel slavery. Savings are absolutely essential to the financing of capital formation. What we object to (and to which, if you insist, we are irrevocably "hostile") are the fixed and erroneous beliefs that 1) "saving" can only be understood as "reducing current consumption," and 2) existing accumulations of savings are the sole source of financing for new capital formation, that is, the sole means of acquiring and possessing private property in the means of production.
Both of these beliefs are based on the wrong definition of money, a definition promulgated by the British Currency School and accepted as absolute dogma ever since, even by people who reject all other absolutes, and others who elevate it to the status of religious revelation. While it would probably be a much clearer presentation to refute one or the other of these erroneous beliefs individually, they are so intertwined that we are going to have to take them both on at once — and we can only do that by coming to a correct understanding of money.
John Maynard Keynes presented the most widespread — and incorrect — understanding of money in his Treatise on Money (1930). As he declared (without bothering to present any evidence to support his assertions),
It is a peculiar characteristic of money contracts that it is the State or Community not only which enforces delivery, but also which decides what it is that must be delivered as a lawful or customary discharge of a contract which has been concluded in terms of the money-of-account. The State, therefore, comes in first of all as the authority of law which enforces the payment of the thing which corresponds to the name or description in the contract. But it comes in doubly when, in addition, it claims the right to determine and declare what thing corresponds to the name, and to vary its declaration from time to time — when, that is to say, it claims the right to re-edit the dictionary. This right is claimed by all modern States and has been so claimed for some four thousand years at least. It is when this stage in the evolution of Money has been reached that Knapp's Chartalism — the doctrine that money is peculiarly a creation of the State — is fully realized. (John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 4.)We can reject this understanding of money without too much trouble. It is an unwarranted intrusion on freedom of association as well as the rights to and of private property to claim that people may not engage in contracts for any lawful or moral purpose without the explicit sanction of the State. Worse, there is no connection whatsoever between money and production in Keynes's analysis, much less the essential direct private property link between money and production. Keynes's explanation is directly contrary to the natural moral law and constitutes a direct attack on human dignity.
The correct understanding of money is at once easier to grasp and much more useful.
Money is anything that can be used in settlement of a debt. Anything. If two people agree, of their own free will, to enter into a contract to exchange items or claims on those items to which they attach value, why should the State have anything at all to say about the matter? As long as the matter is lawful, all parties to the contract are satisfied, and there has been no deception or fraud of any kind, there is no need for the State to be concerned.
This, of course, assumes that the parties to the contract have a direct private property stake in whatever good or service they choose to exchange — that is, they have the private property right to dispose of the good or service as they will. As we have already seen, the State's role is to keep order and maintain (though not necessarily provide) a "level playing field" so that everyone's rights are equally respected. As long as parties to a contract keep the peace and do not infringe on anyone's rights, the matter ends there without the State becoming involved.
The conveyance of value or a claim on the present value of production (the property right) is the essence of money. The understanding of money employed by the Currency School confuses the vehicle, the form of the thing, with the substantial nature of the thing. The definition of the Currency School embodies a triumph of form over substance, serving only to disconnect money from production. If this were an anthropological discussion of myth and belief, we would point out that the Currency School has fallen victim to "magical thinking," that is, mistaking appearance (form) for substance (the "law of similarity"), and believing that knowing something's "true name" allows you to manipulate that thing and control it absolutely (positivism). Thus, if the all-powerful, absolutist State declares that a thing is "money," than nothing else can be money . . . right?
Wrong. We've mentioned the work of Jean-Baptiste Say in previous postings, usually in reference to his "Law of Markets," which is that supply generates its own demand, and demand its own supply, and his theoretical support for the real bills doctrine. The real bills doctrine is the basis for Dr. Harold Moulton's claim that capital formation can be financed without recourse to existing accumulations of savings. It is Say's explanation of the real bills doctrine that concerns us at this point, although the real bills doctrine is also an integral part of his Law of Markets.
To begin, the real bills doctrine is the basic tenet of the British Banking School. In sharp contrast to the Currency School, the Banking School claims that "money" is anything by means of which two or more people convey value or the property right, and thereby settle a debt or obligation. This understanding of money is embodied in the common law of England, as a glance at the definition of money in Black's Law Dictionary will reveal, and as any lawyer who took a course in bills and notes should be able to confirm.
The Banking School is called by that name because it recognizes that commercial banks are designed and intended to create money as needed in order to facilitate transfers of value among people as conveniently and as safely as possible. A commercial bank has the capacity to turn anything that has a present value — a produced good or service — into money, which can then be exchanged among individuals or groups until presented to the issuer for redemption.
To explain further, there are two basic kinds of banks, the bank of deposit, and the bank of issue (also called the "bank of circulation"). Most economists and virtually all policymakers do not understand banks of issue, and frequently assume that all banks are banks of deposit. That is, a "bank" to them is something that takes deposits and makes loans. Period.
Given this definition of "bank" — which is absolutely correct as the definition of the bank of deposit — it is impossible to make any loan for any purpose unless a saver has cut consumption, saved, and deposited his or her savings in the bank. The bank then lends out the savings, taking a fee for the purpose, and turning over the balance to the saver as his or her interest on savings. Common types of banks of deposit are savings and loans, credit unions, and investment banks. These institutions function exclusively as intermediaries between savers and borrowers.
A bank of issue, however, is a different type of institution. A bank of issue also takes deposits and makes loans . . . and issues promissory notes. A bank of issue thereby has the power not only to lend out what a saver has deposited, but also create a promissory note drawn on a "real bill," that is, a bill or note backed by the present value of something, which bill a borrower brings to the bank of issue and temporarily "sells" (pledges) to the bank in return for a general promissory note drawn against the bank's ability to pay.
The borrower exchanges the promissory note for goods and services needed to complete the process of capital formation. Once the new capital becomes profitable, the borrower takes a portion of the profits generated by the capital, and uses it to buy back the lien from the bank, paying back the amount loaned plus a fee to compensate the bank for the use of its good credit. The bank accepts the money, returns the lien, and cancels the amount of money equal to the original amount of the loan. The excess — the fee the bank received (usually called "interest") — is the bank's profit, which it uses to meet its own expenses and pay out dividends.
This is where something called "future savings" comes in. Previously we have been in the habit of using the terms "future" and "forced" savings interchangeably, but "forced savings" has a special meaning in Keynesian, Monetarist, and Austrian economics, so we will try and restrict ourselves to "future savings." (We will not get into the special meaning of "forced savings" here; our goal is to explain how the system should and, to a limited degree, does work, not to waste our time analyzing untenable theories from other economic systems.)
Even with respect to future savings we need only note that the necessary equation of investment and savings is preserved by saving out of future income generated by the investment itself and used to repay the bank loan extended by a commercial bank, not in cutting current consumption, saving, then investing. This is a process that Keynes and others declared was impossible, but which, nevertheless, happens every day.
To counter the theory — fact, rather — of future savings on which the real bills doctrine is based, economic schools of thought based on the tenets of the British Currency School developed the theory of the "multiplier effect." The primary purpose of the multiplier theory is to discredit the real bills doctrine and Say's Law of Markets. It does neither.
The multiplier effect presumably 1) explains away the power of a commercial bank to create money by issuing promissory notes in exchange for a lien on the present value of existing or future production of marketable goods and services, and thereby 2) undermines the real bills doctrine and Say's Law of Markets. Under the real bills doctrine, of course, which ties into Say's Law of Markets, a commercial bank can create any amount of money, as long as the money is backed by the present value of existing or future marketable goods and services. If the agency granting the bank's charter imposes a reserve requirement, the amount of money that can be created is limited by the reserve requirement.
For example, if a bank has $1,000 in reserves, and is subject to a 10% reserve requirement, it can create money by issuing promissory notes up to the amount of $10,000. Most authorities today, however, claim that this is either possible but too dangerous (risky), or simply is not or cannot be done. Instead, the explanation for the potential expansion of the money supply under fractional reserve banking is asserted to be the result of the bank with $1,000 lending out $900, and retaining $100 in reserves, and $900 in cash to back the demand deposits.
The borrower spends the proceeds of the loan with a check, which is deposited in another bank. This increases the reserves of the second bank by $900. The second bank then loans out $810, retains $90 in reserves, and $810 in cash to back the demand deposits. The $810 is spent in the form of checks and deposited in yet a third bank. This process continues until the original $1,000 plus the $900 plus the $810, and so on, equals $10,000.
While this explanation of the multiplier theory is in all the textbooks, it is completely wrong. It requires counting every unit of currency in the form of checks multiple times, relying essentially on the creation of "fictitious bills." The explanation ignores one glaringly obvious fact: that the $900 in the second bank, the $810 in the third bank, and so on, are not in the form of cash, but checks. Checks do not remain in the bank in which they are deposited, but instead are taken and presented to the bank on which the checks are drawn for payment. The bank on which the checks are drawn does not retain the reserves, but turns over the cash behind the demand deposit. The amount of money in the system does not increase at all, but regardless how many banks it passes through, remains at $1,000. As Dr. Harold Moulton points out, giving the example of an original loan in the amount of $100,000 discounted at 2% (a net of $98,000),
If all the people receiving such checks in turn present them to this bank for deposit to their respective accounts, it is obvious that, while there would be an ever shifting personnel among depositors, the total deposits would remain at $98,000. (The Formation of Capital, op. cit., 80.)Just as obvious from Moulton's full explanation (found in Chapter VI of The Formation of Capital, "Commercial Banks and the Supply of Funds") is that it makes no difference whether one bank is involved in the process, or hundreds, even thousands of banks. The result is the same.
The bottom line is that a bank of issue performs the invaluable service of creating money by allowing a borrower to substitute the bank's presumably good credit, accepted throughout the community, for the borrower's individual credit, which is generally not known or accepted beyond the borrower's limited circle. The bank's promissory notes can take the form of banknotes, demand deposits, commercial paper, or any other vehicle that is readily acceptable in trade and commerce ("bankers' acceptances"). These are, to all intents and purposes, "money," for they all convey a private property right, and can all be used in settlement of a debt. The money is created, used to form capital, and the capital generates the future savings necessary to repay the loan that created the money to finance the capital formation in the first place.
The most common type of bank of issue today is the commercial bank. Few if any banks of issue actually print their own banknotes any more. Instead, they create demand deposits. The end result is the same: an expansion of bank credit.
A recent development is the modern "non-bank bank," or "non-banking financial institution," of which finance companies and consumer credit card companies are the most common examples. While this is not universal (the category is only vaguely defined by government banking regulations) non-bank banks typically do not take deposits, but only create money for consumption purposes, backing the new money not with the present value of existing or future production, but with the borrower's presumed ability to repay the loan out of other income (production) not linked directly or indirectly to the new money. (Again, there are exceptions. A number of non-banking financial institutions such as factoring houses and leasing companies, serve legitimate commercial purposes. These, however, are — relative to the economic impact of consumer finance companies and consumer credit card companies — of minor importance.)
Credit extended by a bank of deposit is therefore sound, or "good credit" in the sense that even if all loans made by the bank go bad and are not repaid, no holder in due course of a check or other obligation drawn on the bank will receive less than the face value of the obligation; all demand deposits are — in theory — backed 100% by cash deposits (or, more accurately, cash and cash-equivalent securities). Credit extended by a bank of deposit has the potential to be "bad credit" in the sense that, in the case of credit unions and savings and loans, the proceeds of the loans are usually for consumption. Loans by banks of deposit are not usually intended to finance capital formation, which capital can then be put into production, thereby generating the income necessary to repay the loan.
Credit extended by a bank of issue is (at least in theory) good credit in both senses. All loans made by a commercial bank (again in theory) are backed 100% by liens on hard assets with a present value, and again with collateral — assets that can be seized to settle the debt if the assets which the loan financed prove to be worthless or otherwise fail to generate sufficient production to repay the loan. If a commercial bank is part of a central banking system, the loan is triply backed by the central bank's power to "discount" — that is, create money and purchase loans from commercial banks, thereby increasing the cash reserves of the commercial bank, preventing "runs" and stabilizing the currency.
Credit extended by non-bank banks is, as a general rule, bad credit on all counts. (Again, we state this as a general thing, given the overwhelming character of the non-bank bank as focused on consumer credit, and excepting those non-banking financial institutions that fill legitimate industrial, commercial, and agricultural needs, linking their transactions directly to production.) To be good credit, a loan must 1) be extended only for properly vetted productive projects, thereby carrying within itself the capacity to repay the loan out of future production of marketable goods and services, and 2) be directly linked to that production by right of private property.
The bottom line is that a commercial bank is established on the assumption that the real bills doctrine is valid. That is (as the real bills doctrine states), it is possible to issue money in any amount without inflation or deflation — as long as the amount of money so issued is 1) directly linked to the present value of a productive project or existing inventories of marketable goods and services, 2) issued in an amount that does not exceed the present value of a productive project or existing inventories of marketable goods and services, and 3) repaid out of income generated by the capital investment itself — future savings.
The real bills doctrine is based on the nature of money. Jean-Baptiste Say described this best in his exchange with the Reverend Thomas Malthus, who took the view of the Currency School as an absolute dogma. As Say explained the nature of money (and note the essential direct private property link between money and production),
Since the time of Adam Smith, political economists have agreed that we do not in reality buy the objects we consume, with the money or circulating coin which we pay for them. We must in the first place have bought this money itself by the sale of productions of our own. To the proprietor of the mines whence this money is obtained, it is a production with which he purchases such commodities as he may have occasion for: to all those into whose hands this money afterwards passes, it is only the price of the productions which they have themselves created by means of their lands, capital, or industry. In selling these, they exchange first their productions for money; and they afterwards exchange this money for objects of consumption. It is then in strict reality with their productions that they make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands. (Jean-Baptiste Say, Letters to Mr. Malthus on Several Subjects of Political Economy and on the Cause of the Stagnation of Commerce. London: Sherwood, Neely & Jones, 1821, 2.)The key concept in Say's analysis is that "It is then in strict reality with their productions that they make their purchases; it is impossible for them to buy any articles whatever to a greater amount than that which they have produced either by themselves, or by means of their capitals and lands." Money is the vehicle by means of which my productions are exchanged for yours. As Louis Kelso clarified,
Money is not a part of the visible sector of the economy; people do not consume money. Money is not a physical factor of production, but rather a yardstick for measuring economic input, economic outtake and the relative values of the real goods and services of the economic world. Money provides a method of measuring obligations, rights, powers and privileges. It provides a means whereby certain individuals can accumulate claims against others, or against the economy as a whole, or against many economies. It is a system of symbols that many economists substitute for the visible sector and its productive enterprises, goods and services, thereby losing sight of the fact that a monetary system is a part only of the invisible sector of the economy, and that its adequacy can only be measured by its effect upon the visible sector. (Louis O. Kelso, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967, 54.)At this point some people might complain that we have inserted these particular quotes in a singularly large number of our writings. This is true. They then add that they heard us the first time, and there is no need to repeat ourselves. This is not true. People, especially academics and public policymakers, continue to act as if the tenets of the Currency School are absolute dogmas of whatever faith they hold. They seem insistent on the utterly unbelievable idea that consumers and the State can continue creating money backed by debt instead of production, and go on spending forever without having to produce anything. We therefore have no choice but to say the same things over again, try to explain them in new ways, and hope the message finally begins to sink in.
The problem, of course, becomes what to do about this situation. First, of course, we have to reeducate the public, academia, and policymakers to understand and accept a correct understanding of money. We must then implement reforms necessary to change the present debt-backed currency to an asset-backed currency. Finally, we must put money directly at the service of people (not the collectivist "the people," which always means "the State"), instead of maintaining the current arrangement that forces people to be at the service of money.
This requires that we make a close examination of the role of the central bank, the institution charged with regulating the currency in most countries.
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