The British Banking School
The roots of the Banking School go back millennia, to the beginning of the idea of money. The most basic principle of the Banking School is the definition of money: that money is anything that can be used in settlement of a debt. That is, someone has something of value that he or she wishes to exchange for something else of value that another has. For an exchange to be legitimate, of course, both parties have to own that which they offer in exchange.
"Money" is thus, in a sense, a right of private property: the right of disposal. An owner may do as he or she wishes with what he or she owns, as long as no individual (including the owner), group, or the common good as a whole is harmed. The "right of disposal" includes making a promise to deliver existing or future marketable goods or services and allowing that promise to be circulated as "money" throughout the community as long as the maker of the promise hands over what was promised when the promise is presented for redemption.
Ordinarily, we only offer in exchange what we do not reserve for our own use, our surplus — at least of that good or service. When society is limited to very small, single family groups, everyone contributes according to his or her means, and receives according to his or her needs. That is because the basis of justice within domestic society — the family — is different from that of civil society.
The purpose of domestic society (not to be confused with the meaning of domestic society) is the procreation and rearing of children. This requires that children (and by extension, adults in a dependency status analogous to that of children, such as criminals and slaves) receive as their just due whatever is needed as part of their training to enter civil society as independent, adult "others." Withholding food, clothing, shelter or education within domestic society deprives the child or dependent of his or her just due because it is contrary to the purpose for which domestic society has been established, and is thus a violation of justice.
This is not the case in the larger society outside the family. The presumption of civil society is that full participants — citizens — have been fully trained as "independent others" by their parents or guardians and are competent to function as participants in civil society. All that civil society owes the citizen in justice is the opportunity to participate fully in the institutions of the common good.
The demand of justice shifts from the distribution on the basis of what is needed to rear children or rehabilitate slaves and criminals, to equality of opportunity, a "level playing field." This is so that the adult "independent other" can exercise his or her rights and thereby develop more fully as a human being by acquiring and developing virtue. Thus, in domestic society, someone receives according to his or her needs, while in civil society, someone receives according to his or her inputs — as long as the Four Pillars of an Economically Just Society are functioning and no emergency comes up that renders it expedient in the short term to distribute on the basis of need.
As society advances beyond single family units, then, people tend to specialize in what they do best. This allows people to contribute to the overall common good in the best way they know how, and for society to reward them according to the relative value of their contribution. The hunter concentrates on hunting, the gatherer on gathering, the spear maker on making spears, and so on. This is called "comparative advantage," and, given a free market and full participation in the economy through ownership of both labor and capital, results in wealth maximization and efficient allocation of resources. As Aristotle explained,
The technique of exchange was obviously not a practice of the earliest form of association, the household; it only came in with the large forms. Members of a single household shared all the belongings of that house, but members of different households shared many of the belongings of other houses also. Mutual need of the different goods made it essential to contribute one's share, and it is on this basis that many of the non-Greek peoples still proceed, i.e., by exchange: they exchange one class of useful goods for another — for example they take and give wine for corn and so on. (The Politics, I.ix.)Thus, even though there may be one individual in a group who is good at everything, even to the point of being better at all jobs than everyone else, it is better for that individual to concentrate on doing what he or she does best of all, and letting others specialize in the other areas — even if their best is not as good as the exemplary individual's worst.
This is because one, a single individual cannot do everything and meet all the needs of the community single-handed, and two, if a single individual produces everything for the group, the others either have nothing to offer that individual in exchange, or become dependents of that individual, thereby failing to develop more fully as persons. Under ordinary circumstances and for the good of the social unit, then — the common good of society — each person concentrates on producing what he or she does best.
This brings up what seemed to Aristotle something of a paradox: the production of goods and services that are not put to their proper use by the producer, but are used by the producer to exchange for what others produce. Each party to the transaction gains something that he or she puts to its "proper" use, while at the same time getting rid of "surplus" production resulting from specialization. As Aristotle explained,
Every piece of property has a double use; both uses are uses of the thing itself, but they are not similar uses; for one is the proper use of the article in question, the other is not. For example a shoe may be used either to put on your foot or to offer in exchange. Both are uses of the shoe; for even he that gives a shoe to someone who requires a shoe, and receives in exchange coins or food, is making use of the shoe as a shoe, but not the use proper to it, for a shoe is not expressly made for purposes of exchange. The same is the case with other pieces of property; the technique of exchange can be applied to all of them, and its origin in a state of affairs often to be found in nature, namely, men having too much of this and not enough of that. It was essential that the exchange should be carried on far enough to satisfy the needs of the parties. So clearly trade is not a natural way of getting goods. (The Politics, I.ix.)We disagree with Aristotle that trade — exchange — is not a natural or proper way of getting goods. He may have been blinded by his enculturated contempt for productive work as opposed to leisure work, the work of civilization. As far as Aristotle was concerned, labor performed for productive purposes, that is, to provide for one's material needs, was base and suitable only for slaves. The idea that productive work could be ennobling and be a means of acquiring and developing virtue was at that time limited to Jews and, later, Christians.
As the Philosopher himself pointed out, however, the acquisition and development of virtue — "the good life" — requires the exercise of the rights of private property. (The Politics, I.iv.) One of the rights of private property is the right of disposal, of which exchange is as legitimate a choice as anything else, especially if the goal is to obtain whatever else is necessary to free one from material wants and needs in order to pursue the acquisition and development of virtue. Consistent with Aristotle's belief that different people have expertise in different areas, specialization allows society to benefit to the maximum through the functioning of comparative advantage — which requires exchange as a socially "natural" means of getting goods.
The Idea of Money
Nevertheless, Aristotle did not view exchange per se as contrary to nature. He viewed simple barter as a means of re-establishing nature's own equilibrium of self-sufficiency. (The Politics, I.ix.) It was only an exchange involving money that Aristotle considered as contrary to nature. He evidently failed to realize that, understanding money as anything that can be used in settlement of a debt, even barter involves "money"; money as a symbol of the present value of existing and future marketable goods and services is simply a more convenient way of exchanging those same goods — barter "writ large," as it were. Understood properly, all exchanges are barter. Aristotle, unfortunately, restricted his definition of money to currency, i.e., "coined money," obscuring what was actually happening in an exchange:
It was out of it [i.e., barter] that money-making arose, predictably enough — for as soon as the import of necessities and the export of surplus goods began to facilitate the satisfaction of needs beyond national frontiers, men inevitably resorted to the use of coined money. Not all the things that we naturally need are easily carried; and so for purposes of exchange men entered into an agreement to give to each other and accept from each other some commodity, itself useful for the business of living and also easily handled, such as iron, silver, and the like. The amounts were at first determined by size and weight, but eventually the pieces of metal were stamped. This did away with the necessity of measuring since the stamp was put on as an indication of the amount. (The Politics, I.ix.)This is, more or less, how numismatic historians believe coinage developed. Aristotle's error — to recur almost continually in later centuries until finally congealed into a dogma in the tenets of the British Currency School — was to limit the idea of money to currency.
This was somewhat excusable, as coined money by Aristotle's day had been around for three or four centuries, and had largely displaced earlier forms of money such as bills of exchange and other negotiable instruments. The very convenience of coin and its ability to circulate as general purchasing power made it much more inconvenient to draw bills on the present value of existing and future marketable goods and services and use the bills as money.
Reliance on coined money also led to the illusion that all money has to be based on existing accumulations of savings. Coins can only be struck once the precious metal out of which they are made has been mined and refined. Supplies of metal — savings — have to be accumulated before money can be used either for consumption or investment — if we limit "money" to coin. If the coinage is debased, that is, less metal is put into a coin than is stated on the face, all that means is that existing accumulations of savings are being divided into increasingly smaller portions. The price level rises accordingly and each piece of money purchases less value of goods and services than before.
Viewing coined money or other State-authorized or issued currency as somehow substantially different from all other forms of money was thus, in effect, a great leap backwards. One, as we noted, it led to the idea that State authorization is essential to something being regarded as "money"; that nothing else can possibly be money. This is a change in the substantial nature of what takes place in an exchange, from being based necessarily on someone's private property in what is being exchanged, to a redistribution by the State of what ostensibly belongs to private individuals. Private property is, in effect, abolished. As John Locke pointed out, "For what property have I in that which another may by right take, when he pleases to himself?" (John Locke, Second Treatise of Government, § 140.)
Two, viewing coined money and other State-authorized or issued currency as the only true money led to the disastrous and erroneous belief that new capital formation can only be financed by cutting consumption, accumulating, and then forming the capital. To all intents and purposes this restricts ownership of all new capital to those who had the ability to accumulate: the rich. It doesn't matter that any first year accounting student could point out the basic fallacy of this belief — retained earnings (savings) are not charged for capital investment — it became accepted economic and financial dogma. This was despite the fact that there was no evidence that finance was actually carried out in this manner once society advanced beyond reliance on human labor and simple technology as the predominant factors of production. (Vide Harold G. Moulton, The Formation of Capital. Arlington, Virginia: Economic Justice Media, 2010.)
Finally, and perhaps most fatally, the belief that only coined money or its State-authorized substitutes can be money ignores reality. It may seem a small thing today, when so many basic institutions of society are destroyed or redefined seemingly on a whim, but the claim that reality can be so changed is a profound shift in our perception of reality, and thus what it means to be human.
The Idea of Credit
Clearly, the development of coined money was in many respects an important advance. Misused or not properly understood, however, it managed to become a drag on economic and social development. This was, in large measure, the result of viewing coined money, and later forms of money, such as banknotes and demand deposits, as the only "real" money, or a substitute for "real" money, respectively. Consequently, everything except coined money was considered either not real money at all, or a derivative of real money, i.e., coined money.
The problem is that by restricting our understanding of "real" money to coined money, and considering banknotes and demand deposits as derivatives of "real" money, and all forms of credit as similarly derived, is completely backwards. The fact is that "money" and "credit" are two different terms for the same thing. As Henry Dunning Macleod explained, "Money and Credit are essentially of the same nature; Money being only the highest and most general form of Credit." (Henry Dunning Macleod, The Theory of Credit. Longmans, Green and Co., 1894, 82.)
The fact is that what we think of as "credit" preceded coined money by hundreds, if not thousands of years. Bills of exchange and promissory notes — negotiable credit instruments — were common in both ancient Mesopotamia and Egypt, as the vast amount of material in the form of clay and papyrus documentation makes abundantly clear. Such credit instruments are derivatives of the present value of existing and future marketable goods and services.
Credit instruments can take any form to which the parties to a transaction agree and which thereby constitutes a contract. This can be a verbal agreement supported solely by a promise maker's reputation — his or her creditworthiness — a clay tablet specifying the terms of the contract, a sheet of papyrus, parchment, or paper, or a generalized certification stamped on a lump of metal by some recognized authority.
Money as a Derivative of Production
To be legitimate, that is, to constitute a valid contract or promise, the maker of the promise — the issuer of the "money" — has to have the power to make a promise. Because the matter of a contract deals with the deliverability of marketable goods and services, the maker of the promise has to own that which he or she promises to deliver. A contract is therefore a derivative of the present value of existing or future marketable goods or services.
A bill of exchange or a promissory note is thus a derivative of existing or future production of marketable goods and services. Drawing a bill or issuing a promissory note is creating a promise — a debt — while redeeming the bill or making good on the note is settling the debt. Because a bill or a note has a present value, it can itself be used to settle a debt, and circulate as money until presented by the holder in due course for redemption by the issuer.
Early bills of exchange and promissory notes were usually denominated in terms of commodities, e.g., so many head of cattle or so much weight of metal. When Abraham purchased the field of Ephron with its twin caves as a burial ground, he paid not in coin, but in weighed silver, as was the custom before the invention of coinage: "He [Abraham] weighed out the money that Ephron had asked, in the hearing of the children of Heth, four hundred sicles of silver, of common current money." (Genesis 23:16.)
Obviously having to weigh out metal every time someone wished to engage in a transaction was both time consuming and complex. Someone eventually had the brilliant idea that a large weight of metal, e.g., a talent, could be broken up into smaller pieces, e.g., drachma, pre-weighed and stamped with a certification to save time and effort. Similarly, a few thousand years later someone would realize that a bill of exchange or promissory note, instruments usually denominated in very large amounts, could be treated the same way. The smallest denomination of a bill of exchange that would be accepted by the United States Federal Reserve System when it was first established in 1913, for example, was $100,000, the standard denomination at the time for commercial paper, the usual term for short-term bills of exchange.
Obviously, bills of exchange would be too cumbersome for everyday transactions under ordinary circumstances. There have been exceptions, such as the County of Lancashire in England in the late 18th and early 19th century, when bills of exchange in small denominations circulated more readily than banknotes, and during the Great Depression when personal checks, bank drafts, and similar instruments filled in for a dearth of legal tender currency. Ordinarily, however, besides being typically issued in large denominations, bills of exchange have to be indorsed ("endorse" — traditionally, "indorse" is the spelling used for financial instruments, but "endorse" is not incorrect) by each holder in due course until presented to the issuer for redemption.
Commercial banking was invented as a way of "breaking up" commercial paper into smaller pieces called banknotes: small denomination promissory notes backed by the general credit of the issuing bank and secured by the commercial paper, that would be acceptable in daily transactions wherever the bank's credit was trusted. Turning commercial paper or other bills of exchange into banknotes is called "discounting" and "rediscounting," a term also applied when the bill itself is used as money directly.
The term "discount" comes from the practice of using a bill as money or exchanging it for a different form of money (e.g., coin, demand deposits, or banknotes) but at less than the face value of the instrument. For example, commercial paper with a face value of $100,000 may be offered in settlement of a debt of $98,000, meaning that the bill is discounted at 2%. When a holder in due course uses the bill to settle a debt in turn, it may be "rediscounted," say, at 1% and pass at $99,000, depending on how much time is left before maturity.