Wednesday, July 25, 2012

Lies, Damned Lies, and Definitions, XXI: The Economics of Banking

In his Essay on the Restoration of Property (1936), Hilaire Belloc observed that the "small" man, that is, someone who is not rich, is not as "interesting" (read "profitable") to bankers as the "large" man. This makes sense. A bank is in business to make a profit. It is much easier to service one large account than a hundred smaller accounts that total the same amount loaned. The gross revenue generated by many small accounts is greater than that realized from a large account for the same amount, but so are the costs and the time and trouble.

The real problem, however, is not the added costs of servicing many small accounts. The loan process can be streamlined without sacrificing proper scrutiny, especially with modern communications. With the proper system and oversight, a commercial bank could make at least as much servicing a large number of small accounts, rather than a small number of large accounts.

The real problem is the way commercial banking has usually operated. There is a "double standard" when it comes to how loans are made, and has been at least since the British Bank Charter Act of 1844 and its clone, the National Banking Act of 1863, as amended 1864. This is because loans for the "small" man most often come out of existing accumulations of savings, whereas loans for the "large" man typically involve creating new money by accepting bills of exchange.

In theory, of course, a bill of exchange offered for discounting or rediscounting at a commercial bank can be in any amount. In practice, the minimum denomination of the promissory note — "commercial paper" — that is issued by a bank on acceptance of a bill is $100,000, with million-dollar multiples being more usual. A commercial bank with excess reserves — existing savings — may lend them directly to "small" men, and reserve its money creation power to "large" men, if only because it is easier for the bank to rediscount large denomination commercial paper and make an immediate profit, than wait to redeem the paper on maturity.

This was the case in the United States following the Civil War. The National Banking Act of 1863 imposed an inelastic paper currency backed with government debt on the country — the National Bank Notes. This was to replace the inflated United States Notes (the "Greenbacks") with which the federal government had financed the war. The idea was to deflate the Greenback currency to restore parity with gold, resume convertibility of the Greenbacks into gold once the faith and credit of the federal government was restored, then meet the needs of daily commerce with the National Bank Notes (also convertible into gold), supplemented with gold and token silver.

The problem was that standard banking practice limited the "small" men to existing pools of savings. During this period the policy of deflation (at first official, then unofficial) to restore parity of the paper currency with gold drained existing savings out of the economy.


Primarily this was to meet loan payments for debts incurred when prices were high, and that now had to be repaid when prices were low.  As William Jennings Bryan put it, farmers had taken out loans when wheat was (for example) $2 per bushel, and now had to pay back the loans when wheat was 50¢ per bushel.  A farmer thus had to pay back four times what he had borrowed, plus the interest on the loan.

Consequently, the homesteaders and small businessmen were unable to get sufficient credit to develop their holdings properly. They generally relied on mortgages rather than traditional commercial loans, paying the interest and refinancing when the balloon payment came due. This destroyed many farms during the Great Depression of the 1930s when banks stopped renewing mortgages that had in some cases been outstanding for sixty or seventy years or more.

At the same time, the "large" men were able to get all the credit they needed (and then some) by drawing bills of exchange and either using them directly as money, or discounting them at commercial banks. Their access to credit was limited only by the financial feasibility of the capital projects in which they invested, not by the amount by which consumption had been decreased in the past.

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