Say's Law of Markets, Part IV: An Overview of Commercial Banking

As we have seen, banking in a real sense began thousands of years before the invention of what most people think of as "money." The elements of true banking, properly understood, developed early on in ancient Egypt and Mesopotamia. A bank is not simply a financial institution that takes deposits and makes loans — although it can be that, and many types of banks down to the present day operate in this fashion. These "banks of deposit" are known as credit unions, savings and loans, cooperative banks, mutual loan societies, micro-lending, investment banks, and so on.

Capital Formation with Existing Savings

Deposit banking, however, is not an irreplaceable function in an economy. Anyone with an existing accumulation of funds can, assuming he or she is willing to lend those savings, serve as a bank of deposit. The problem is that, when the rate of economic growth is tied exclusively to existing accumulations of savings, it is necessarily slow, and tends to benefit those at the top much more than those at the bottom. As technology advances in a system in which the financing of new capital is tied to existing accumulations of savings, the gap between the haves and the have-nots, absent coercive redistribution through government mandate, inflation or the tax system, tends to widen dramatically.

In order for rapid and sustainable economic development to take place, two critical factors need to be in place in a society. One, there needs to be widespread direct ownership of the means of production. Two, there needs to be a financial system that can turn potential production of marketable goods and services into actual marketable goods and services by providing adequate financing for capital projects.

When we assume as a given that only existing accumulations of savings can be used to finance new capital, both of these factors are dismissed, ignored, or actively opposed. This is understandable. Within a system that admits only existing accumulations of savings can be used to finance new capital formation, then as technology advances, ownership of the means of production must become increasingly concentrated. This is because, in order to finance the increasingly expensive advanced capital, there must be individuals who can afford to refrain from consuming all of their income.

In general, only those who are already wealthy can afford to refrain from consuming all of their income. In fact, when an individual wealth accumulation reaches a certain point, it becomes impossible for a single individual to consume all that his or her capital produces. He or she is forced to save the vast amount of income generated, or give it away.

This presents the "past savings" economist with a dilemma. If the wealthy are taxed in order to redistribute their income, or they give away the bulk of their wealth or income as charity — alms — the economy will not have sufficient savings available to finance new capital formation. This in turn means that no new jobs will be created, and consumption will fall. Existing jobs will start to disappear, which will accelerate the decline in consumption, causing more jobs to disappear, and so on, in a vicious circle.

If, however, the wealthy reinvest all of the income that they are unable to consume, new capital is formed, and new jobs are created. Unfortunately, the fall in consumption that results from diverting income from consumption to investment means that the new jobs will not be sustainable. Without a sufficient level of effective demand in the economy, marketable goods and services will either remain unsold, or will not be produced in the first place. Workers will be laid off, existing consumption power will decline, and the economy start to decline in a vicious circle.

The Keynesian Solution

In order to counteract the negative effects resulting from reliance on existing accumulations as the sole source of financing for new capital formation, John Maynard Keynes advocated State manipulation of money and credit, and (a surprising revelation possibly even to Keynes) effective abolition of the institution of private property in the means of production.

We won't waste too much time proving this latter claim. In brief, as Louis O. Kelso pointed out, "Property in everyday life, is the right of control." (Louis O. Kelso, "Karl Marx: The Almost Capitalist," American Bar Association Journal, March, 1957.) "Control," of course, must be correctly understood when talking about private property. Control means the right to decide what to do with what you own, that is, how to allocate or dispose of your resources. It also means the right to decide what to do with the income generated by what you own: the "fruits of ownership."

Any time the State or anybody or anything else tells you how you must use what you own, or how much income you are permitted to receive from what you own, you cannot really be said to own it. You may hold "official" legal title, but the real owner is who- or whatever controls how you allocate what you own and how much income you are permitted to enjoy.

We must be careful at this point, however, not to confuse the necessary and just limitations society imposes on the exercise of property, with the unjust infringement on the rights of owners through illicit imposition of control. In general, no one may use what he or she owns to harm him- or herself, other individuals, groups, or the common good as a whole.

As for manipulation of money and credit by the State, this is (as Friedrich von Hayek pointed out — unfortunately without realizing the implications of his own reliance on existing savings) as fully collectivist as outright socialism, and as unjust. The Keynesian "fine tuning" of the economy by controlled inflation and setting of interest rates deprives wage earners of the value of their wages, and inhibits new capital formation that creates jobs and presumably replaces the effective demand eroded by inflation.

Unfortunately, locked into the assumption that only existing accumulations of savings can be used to finance new capital formation, Keynes recommended that the State take over both allocation of resources and dictate the rate of return owners are permitted to realize from what they own. (John Maynard Keynes, The General Theory of Employment, Interest, and Money (1936), VI.24.iii.) His language was deceptively mild — so much so that one suspects that Keynes didn't really understand the implications of what he said. He may even have believed that the presumed necessity of State control of the economy outweighed all other considerations — that the end justified the means.

Given the assumption that existing accumulations of savings are the only source of financing new capital formation, Keynes was absolutely correct. We even find support for Keynes's position in classic moral philosophy. If there is no possible way for someone to obtain what he or she needs to support him- or herself and his or her dependents in a manner consistent with the demands of human dignity, then justice demands that those with a monopoly on the means to sustain life redistribute an amount sufficient to sustain the life and health of those cut off from the means to take care of themselves and their dependents.

The Just Third Way Solution

The problem with the Keynesian solution, however, is that it is based on a false premise: that Say's Law of Markets does not operate because only existing accumulations of savings can be used to finance new capital formation. If this premise is false — and we will demonstrate in a moment that it is utterly false — then what is presented as "justice" becomes an exercise of raw State power, an act of tyranny of the worst sort.

The fact of the matter is that, given the nature of money as a derivative of the present value of existing and future marketable goods and services, the financing of new capital is not dependent on existing accumulations of savings. As Dr. Harold G. Moulton, president of the Brookings Institution from 1916 to 1952 showed in his 1935 classic, The Formation of Capital, the rate of new capital formation is not tied to the amount of savings currently existing in the system. In point of fact, if existing accumulations are used to finance new capital formation, or even replacement capital to a significant degree, the financial feasibility of the new or replacement capital is seriously impaired.

Further, as Louis Kelso demonstrated time and again, the small ownership that Keynes believed should be eliminated from the economy (General Theory, op. cit., VI.24.ii) is, in fact, absolutely necessary if Say's Law of Markets is to function. The problem of course, is that even if we accept the desirability of widespread direct ownership of the means of production, and even if we admit the possibility that Say's Law is valid, we still don't know how people without ownership can gain ownership.

Actually, that's not entirely correct. We do know how people without ownership of capital can acquire capital. The nature of money and credit tell us how. All we need do is come up with marketable goods and services that have a present value, whether those goods and services exist now, or can be manufactured or provided within a reasonable ("feasible") period of time. We can draw a bill of exchange on the present value of the marketable goods and services we have produced or will produce, and use the bill to carry out transactions.

The Bank of Issue

The problem is that not everyone may know or trust us. What we need is a financial institution that can transform our individual purchasing power, represented by the bill of exchange we have drawn on the present value of the existing or future marketable goods and services that we own, i.e., in which we have a private property right, into general purchasing power that everyone accepts without having to worry whether we will make good on our promise to deliver what we have promised.

Fortunately, such institutions exist. They are custom-made to transform individual purchasing power into general purchasing power. That is, these institutions change one form of money into another form of money. These institutions are called "Banks of Issue," and are most familiar today in the form known as commercial banks.

A commercial bank is designed to operate in this manner. A borrower takes his or her bill of exchange to a commercial bank. A loan officer scrutinizes the bill, investigates the creditworthiness of the borrower, examines what is offered for collateral and, if everything checks out, "discounts" the bill, which then becomes a "banker's acceptance." (When a bill of exchange is used in a transaction between two individuals or companies one of which is not a bank, it is called a "merchant's acceptance.") If the bank (or merchant) uses the bill of exchange in a subsequent transaction, passing the bill on to another holder in due course, the process is called "rediscounting."

This is called discounting or rediscounting because instead of charging interest on the service provided, a bank or holder in due course accepts the bill at a discount from the face value. For example, if a borrower presents a bill of $100,000 to a commercial bank for discounting at 2%, the bank creates a demand deposit (or, formerly, printed banknotes) in the amount of $98,000. When the loan is repaid at the full rate of $100,000, the bank cancels the $98,000 and books $2,000 in revenue. (Obviously, if the bank rediscounts the bill with another holder in due course, it will be at a higher discount, or it will lose money — but the original borrower is still only obligated for the face value of the note.)

Legitimate Use of Past Savings

If that were as far as it went, it would be possible for commercial banks to create money without any need whatsoever for existing accumulations of savings. Two factors, however, intervene that appear to upset this arrangement and inhibit or prevent people without existing ownership or savings from becoming capital owners. One is the need for cash reserves to redeem obligations issued by the bank that are not used to repay loans. The other is the demand for collateral.

When gold and silver circulated and were accepted everywhere as money, bank reserves had to be in gold and silver, or gold and silver equivalents, i.e., certificates redeemable in gold on demand. That is no longer the case, but bank customers may still want "cash money" instead of a check or bank-issued promissory note.

Fortunately, central banks and national banks (the difference need not concern us at this point) were invented to address this problem. Even if specie — gold and silver — does not circulate, the paper certificates issued or demand deposits created by the central bank can be used as reserves by commercial banks. There need never be a shortage of reserves in an economy served by a central bank. Any commercial bank in need of additional reserves should be able to rediscount some or all of its loans at the central bank, thereby giving every commercial bank that has rediscount privileges potentially 100% cash reserves behind its demand deposits.

That leaves the question of collateral. Typically, collateral is in the form of existing inventories of marketable goods and services, or (more common) the general creditworthiness of the borrower backed up by the present value of his or her existing capital assets. When the creditworthiness of a borrower is in question, a bank may demand other forms of collateral, such as marketable securities or a guarantee by a respected and wealthy individual willing to co-sign a loan.

This is actually the real use of existing accumulations of savings in a modern economy. Capital formation is not typically financed out of accumulated savings. Instead, accumulated savings — almost always already invested in productive capital — are pledged as collateral for a loan used to create new money. The new money — not the existing savings — is used to finance new capital formation. If the project proves feasible, the loan is repaid, and the collateral released back to the borrower. If the project does not prove feasible and the loan goes into default, the lender seizes the collateral.

The problem is, again, that if a prospective borrower does not have savings, neither does he or she have investments — savings and investments are, generally speaking, interchangeable as collateral for all practical purposes. People without savings or existing ownership of capital still cannot purchase the capital they need to generate an adequate and secure income even if the banking system has freed itself from the "slavery of savings."

There is, however, an answer, as Kelso pointed out. Collateral is simply a form of insurance. That being the case, the universal demand for collateral can be replaced with capital credit insurance and reinsurance. The usual "risk premium" charged on all loans in any event can, instead, be used as an actual insurance premium. The initial insurance and reinsurance pools would, admittedly, have to be provided out of existing savings or, in a pinch, guaranteed by the government as an expedient until sufficient premiums can be accumulated.

Taking a Wrong Turn

The only question that remains, then, is how, if a financial system based on Say's Law of Markets and its application in the real bills doctrine used to ensure widespread direct ownership of the means of production is so rational, and so obviously beneficial to the economy and the social order as a whole, how did we ever get into the mess we have today? All things considered, all that should have been necessary would be to present the arguments and the proofs for the validity of Say's Law and the clear advantages to be derived from broadened capital ownership, and the problem should solve itself.

This was, in fact, what the Brookings Institution did under the direction of Dr. Moulton in the 1930s. At a time when Say's Law was beginning to fall out of favor and commercial banks and central banks — notably the Federal Reserve System — had, to all intents and purposes, completely abandoned the real bills doctrine, the Brookings Institution published a series of four books presenting an alternative to the New Deal as the framework for economic growth and recovery from the Great Depression. These books, America's Capacity to Produce (1934), America's Capacity to Consume (1934), The Formation of Capital (1935), and Income and Economic Progress (1935) — especially The Formation of Capital — examined the economic and, especially, the financial system in light of the meltdown that followed the Crash of 1929.

Moulton's conclusion as principal author was that reorienting the financial system back to its original purpose — especially the central bank, the Federal Reserve System — would provide a sound foundation on which to rebuild the American economy. In contrast to Keynesian economics, which postulated that lack of effective demand was the problem, and that matters could be put right by devaluing the dollar and inflating the currency to redistribute purchasing power, Moulton stated that neither supply nor demand was the real problem. The United States had the inherent capacity both to produce and to consume — both necessarily go together, a tacit reaffirmation of Say's Law of Markets.

The real problem was connecting supply and demand without harming either the country's capacity to consume or to produce. Saving to accumulate the financing for capital investment causes the capacity to consume to diminish, while using all income for consumption — according to Keynes — dried up the supply of savings required to finance new capital formation. As Moulton pointed out, however, the assumption of the necessity of existing accumulations of savings as the sole source of financing for new capital formation is not only false, but harmful, in that it throws a monkey wrench into the workings of the economy.

Unfortunately, the belief that only existing accumulations of savings can be used to finance new capital formation had been around for over a century by the time the Brookings Institution published Moulton's findings, and it was well entrenched. President Roosevelt and his advisors listened to Keynes, not to Moulton, with the results that we see today.

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