Yesterday we saw that all money is a contract, just as (in a sense) all contracts are money. All contracts consist of offer, acceptance, and consideration. Contracts that are used to create money (as opposed to changing the form of money, i.e., future v. past savings) are called bills of exchange.
Anyone competent to enter into a contract can offer a bill of exchange. It does not become “money,” however, until and unless someone accepts it — and it is only accepted if the issuer is deemed “creditworthy.” This is why bills that are used in commerce directly between individuals and businesses are called “merchants” or “trade acceptances.” If a bill is offered to and accepted by a commercial bank, it is known as a “bankers acceptance.”
A bill is accepted at the present value of the consideration. Usually this is less than the face value of the instrument. Acceptance, then, is almost always at a discount. This is why when a note is accepted, it is called “discounting” for the first offer and acceptance, and “rediscounting” for all subsequent offers and acceptances.
When an issuer of a bill is known and trusted in the community, his or her bills can be used as circulating media to facilitate transactions in the community until the instrument reaches maturity and is presented by the bearer for redemption by the issuer. “Scrooge signed it: and Scrooge's name was good upon ’Change, for anything he chose to put his hand to.”
When the issuer of a bill is not known, he or she cannot, of course, be trusted, and his or her bills will not be accepted. Commercial banks (banks of issue or banks of circulation) were invented as intermediaries between “borrowers” who issue bills, and “lenders” who accept bills. Instead of trusting an unknown issuer, anyone who accepts a bank’s promissory note, by means of which a bank discounts a bill, only needs to trust the bank, not the original borrower.
A bank can issue promissory notes directly for use as money. In that case the promissory notes are called “banknotes.” More commonly today, a bank issues a promissory note and uses it to create a demand deposit, i.e., a checking account, on which a borrower draws in lieu of using banknotes. Banks of issue have been around in one form or another since the dawn of history, as the vast bulk of documents surviving from the ancient world attest.
A “bank of deposit” — what most people think of as a bank — is actually a fairly recent invention. It dates from about the same time as the invention of coined money, cir. 750 B.C. At that time money in the form of coin became not only more durable and easier to manage, but sufficiently “fungible” to be able to serve as “current money” (currency) without having to be indorsed in every transaction. It was thus more easily deposited, loaned, and circulated.
Where a bank of issue is defined as a financial institution that takes deposits, makes loans, and issues promissory notes, a bank of deposit is defined as a financial institution that takes deposits and makes loans. A bank of deposit, of which the most common types are credit unions, savings and loans, and investment banks, cannot accept bills or issue promissory notes to serve as money directly or to back demand deposits.
Technically, then, a bank of deposit deals only with “past savings,” that is, instruments representing the excess of production over consumption in the past: “mortgages.” A bank of issue technically deals only with “future savings,” that is, the present value of future production of marketable goods and services: “bills of exchange.”
Obviously, for the sake of expedience or for political reasons, the functions of banks of issue and banks of deposit are often combined. We don’t have to get into that now, however. All we have to know is that, to generalize very broadly, the “currency principle” is based on past savings, while the “banking principle” is based on future savings.