Thursday, November 10, 2011

It's Academics v. the Politicians . . . v. Economic Reality, Part II: Banking 101

The "in" term right now for bankers is "banksters." The printable term, anyway. This has the advantage of being moderately clever, easy to remember, sets up an immediate association with organized crime, and dehumanizes those who are believed to be beyond redemption.

The problem with this (aside from the obvious one of condemning others on the basis of opinion instead of fact and argument) is that those who are doing the labeling and condemning all banks often aren't too certain of what, exactly, a "bank" is. They know it has to be something evil, or the typical bank wouldn't be so big, would give them money for free instead of charging something called "interest" or making them work for it, and wouldn't make them stand in line for endless minutes while somebody ahead of them argues with the teller over why the customer can't cash a third party check drawn on a bank in the Cayman Islands for more than the bank's vault cash.

The problem is that most economists aren't too clear themselves what a bank is or does. For example, in common with the general public, most economists are completely unaware that there are two kinds of banks! This is due to the fact that your modern major economist tends to be a Keynesian, Monetarist/Chicagoan, Austrian, or some derivative therefrom. Virtually every academic economist — and the politicians who listen to them — thus defines a bank as a financial institution that takes deposits and makes loans.

That is correct as far as it goes. That definition covers things like investment banks, credit unions and savings and loans. It neglects, however, the far more common and important type of bank, defined as a financial institution that takes deposits, makes loans, and issues promissory notes. The most common types of this kind of bank is the commercial or mercantile bank, and central banks. The Big Economic Issue here is that, not understanding what a promissory note is or where it comes from, economists (and politicians) aren't going to understand what "money" is.

Here, then, is your mini course in banking theory. A "bank of issue" issues a promissory note (which is why it's called a "bank of issue . . ."). A bank can't just do that, however. A bank can only issue a promissory note in exchange for . . . a promise! Not only that, the promise actually has to have value, and that value has to be quantified. This is where some accounting comes in handy again, because "the measurement principle" in accounting is that if you can't measure it in terms of money, you can't account for it.

Banks don't create money out of nothing, but out of promises that have something behind them. If the promises aren't good, nobody will accept them, and it's "acceptance" that turns something from an offer into a contract, a promise . . . that is, "money."

On Monday — assuming we last that long, if the economists and politicians don't cause a global economic meltdown in the meantime — we'll get into the mechanics of how banks create money by accepting promises from some people, and exchanging them for promises that can circulate in the economy (which explains why "banks of issue" are also called "banks of circulation").

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