Thursday, April 25, 2013

Why a Central Bank?, I: What Do Banks Do?

Tomorrow we join the Coalition for Capital Homesteading at their annual demonstration at the Federal Reserve Board of Governors building in Washington, DC.  If you’re in the neighborhood, you might consider showing up to see the fun . . . and hear a few speeches, including a very brief one by me that might sound suspiciously like this posting (assuming I can condense it into five minutes or less).

The demand to “End the Fed” is a graphic illustration of the fact that we fear that which we do not understand.  And of all the things people don’t understand in this world, money, credit, banking and finance are right up there near the top of the list.

Ironically, it’s not that hard to understand — as long as you first realize that a lot of what you’ve been told is just plain wrong.  It’s actually very simple once you get the very first principle down pat.

The first principle of money is its definition.  Money is anything that can be accepted in settlement of a debt.

Money is not just coin or banknotes, or checks.  Money is a symbol, a means of exchanging what we produce, for what others produce.  That is why money is called the medium of exchange.

As Adam Smith pointed out in The Wealth of Nations, “Consumption is the sole end and purpose of all production.”  If we cannot produce, we cannot consume.  If others produce something we want, we have to offer them something we have produced in exchange.

As Jean-Baptiste Say explained, we don’t really purchase what others produce with money, but with what we produce.  Money is, again, only a symbol of what we produce by means of our labor and capital.  Thus, if we wish to consume, we must first produce.

We obviously cannot consume more than we produce, and because the purpose of production is consumption, we shouldn’t consume less.  If everyone is producing and consuming, then, and if everything else is equal, supply will equal demand, or, as some have a little oversimplified matters, supply generates its own demand, and demand its own supply.  This is “Say’s Law of Markets.”

All money is a contract.  In fact, in a sense we can say that all contracts are money because all contracts involve exchanging what we produce or supply, for what others produce or supply — the quid pro quo, or “consideration,” the inducement to enter into a contract.  Anybody who is competent to enter into a contract can therefore create money.

If you don’t know me or trust me, however, you won’t enter into a contract with me.

That’s where banks come in.  For a small fee, a bank will accept my contract, and issue its own contract called a promissory note.  Assuming that people in the community trust the bank, I can either take the bank’s promissory note and use it as money, or the bank holds on to the promissory note and creates a demand deposit on which I can draw checks.

If other people don’t know or trust the bank, however, they won’t accept the bank’s promissory notes or checks drawn on the bank.

That’s where central banks come in.  Just as an ordinary commercial or mercantile bank ensures that an individual’s or business’s promises are good, a central bank ensures that a commercial or mercantile bank’s promises are good.  This makes certain not only that there is always exactly enough money in the economy, but that all the units of currency have the same value because they are all, ultimately, backed up by the central bank.

Thus, if used properly, a central bank is the “lender of last resort” for the private sector, making certain that every good promise somebody makes can be turned into money as needed.

This is, in fact, what it says in the first paragraph of the original Federal Reserve Act of 1913:

“An Act To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.”


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