In the previous two postings in this series we examined how the idea of money changed from an individual exercise of the natural rights of private property and freedom of association (liberty), to something considered "peculiarly a creation of the State." (John Maynard Keynes, A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 4.) That is, money became a means of controlling people and the economy by exercising effective property in the general wealth of the community — socialism . . . the theory of which was summed up by Karl Marx in The Communist Manifesto (1848) as "the abolition of private property."
This is consistent with political thought through the ages. Money is a derivative of property, just as currency is a derivative of money. Power follows property. "Give me control over money and credit," Mayer Anselm Rothschild is alleged to have said, "and I care not who makes the laws." State control over the creation of money (as opposed to regulation, which is legitimate) effectively abolishes private property. Property being a right, it can be abolished by breaking the necessary links between ownership, control, and disposal — as the State does by making promises that it does not have the capacity to keep except by taking what belongs to others.
So much for our "brief" introduction to the Mysteries of Central Banking. We now move forward into the past of the 17th century. As we noted in our first posting in this series, trade was reviving after a long hiatus, and the financial system beginning to (re)develop. Banks of deposit became more widespread, and commercial/mercantile banking — issue banking — was reintroduced, especially in Italy and England. This, however, created a problem.
A commercial bank is in the business of discounting and rediscounting bills of exchange — large denomination money issued ("drawn" or created by) private individuals and companies in conformity with Say's Law of Markets and its application in the real bills doctrine. A commercial bank breaks these large denomination contracts down into more convenient sizes called promissory notes (banknotes), or demand deposits backed by promissory notes. (A promissory note may or may not bear interest.) A commercial bank thus "repackages" money, as it were, much as a retailer buys large quantities of goods and puts them into smaller packages for sale to individual consumers.
In a "pure" system, a commercial bank would redeem its matured promissory notes (banknotes) and checks drawn on its demand deposits with new, un-matured promissory notes or checks. A holder in due course of a bank's note or a check drawn on a demand deposit held by the bank and backed up with the bank's note doesn't want more of the same, however. He or she wants somebody else's note or the value of the banknotes he or she is holding, or he or she would simply have hung on to the note that came to him or her in the course of trade and used it in a transaction.
Naturally, the bank can't deliver the asset(s) that back the banknote to someone who is not a party to the original transaction. That would violate the terms of the contract between the original borrower and the bank. The bank therefore needs to have some assets on hand that it can deliver to a holder in due course of the bank's notes to satisfy his or her legal claim and ensure public confidence in the bank's promises.
These assets are called "reserves." Historically, reserves have been in the form of gold and silver. Each banknote and demand deposit was thus backed 100% by the value of the bill of exchange that it was created to purchase, and by whatever reserve requirement was mandated by the bank's charter or law. A 20% reserve requirement would mean that each £5 banknote (the lowest denomination permitted after reforms in the mid-18th century) was backed by £6 in assets — £5 worth of bills of exchange (actually a portion of a bill of exchange), and £1 of gold or silver.
Banks didn't need to maintain 100% reserves because the vast bulk of banknotes presented to the bank were in payment of loans, or offset against notes of other banks collected in the course of business and presented for payment through a clearinghouse. The banknotes and an equal portion of the debt would thereby both be cancelled, with no payout of gold or silver needed. Barring a "dirty trick" described by some 18th century writers, only a relatively small portion of a bank's outstanding banknotes were ever presented by holders in due course who demanded specie (gold or silver).
(The dirty trick was a manufactured or induced "run" on a rival bank. A larger bank or consortium would collect another bank's notes and hold them back from redemption until the amount exceeded the targeted bank's reserves. The notes would then all be presented for payment on the same day. This usually forced the issuing bank into bankruptcy. The invention of clearinghouses in the mid-18th century largely eliminated this stunt, although J. P. Morgan, who controlled the clearinghouses, employed a similar technique to drive the Knickerbocker Bank and Trust out of business in the early 20th century, causing the Panic of 1907.)
If everything operated perfectly in a perfect world, the banknotes of every commercial bank would always be backed by the present value of solid private sector assets, and all borrowers would repay their loans in full when due. The world, however — if you weren't aware of it already — is far from perfect. A bank's notes might be backed by assets of questionable value — not intentionally (at least on the part of the bank), but not every investment in existing inventory or new capital is as good as it sounds on paper, and things happen. Even when adequately collateralized, in the event of a default, collateral seized and sold at a sacrifice by a bank frequently brings less than the full amount of the debt.
Consequently, banks might be hesitant to create money even for the soundest of projects — as is the case today. Further, even if the bank was willing, and even if the project was sound without a doubt, the bank might already have lent out the maximum allowed, given its reserves, and competitors might not want to lend the bank additional reserves. Finally, the public's confidence in the bank's notes might not be high, and a £5 note of that bank might circulate for, say, £3 or so — a heavy discount. (Of course, public confidence might also be very high, and a £5 note might circulate at a premium, or an amount over the face value.)
The answer to these problems was the central bank — a bank for banks.