Monday, January 6, 2014

A Brief Course in Banking Theory, IIa: Banks of Issue

In the previous posting in this short series we covered what money is, and how a bank of deposit operates.  As we promised, here’s a brief explanation of how a “bank of issue” operates.  Believe it or not, although “bank of deposit” is what most people think of as a bank, “banks of issue” (also called “banks of circulation”) are thousands of years older.

To understand issue banking, we start where we started with deposit banking: what is money?  Since we covered that the last time, we’ll just repeat: money is anything that can be accepted in settlement of a debt.  As it says in Black’s Law Dictionary, money consists of everything that can be transferred in commerce.

The problem is that often the thing you have to offer in exchange (transfer) might not be what the person who has what you want, wants.  He has a pig, and you have chickens that you want to trade for the pig you want, but he doesn’t want chickens for his pig.  He wants wheat.

You could go around until you find someone with wheat to trade who wants chickens, trade your chickens for his wheat, and then hoof it back to the pig guy and trade him the wheat for his pig.  That’s a lot of trouble, though.

What you could do instead is draw up a contract consisting of a promise to deliver 25 chickens to the holder in due course of the contract, and offer it to the pig guy.  If he accepts it, he gives you the pig, and offers the contract to the wheat guy.  If the wheat guy accepts it, the former pig guy gets the wheat he wants, and the former wheat guy gets a contract good for 25 chickens.

The former wheat guy takes the “chattel mortgage” of 25 chickens and presents it to you for redemption.  You cancel the contract (“settle the debt”) by delivering 25 chickens.  The contract is called a “chattel mortgage,” by the way, because one, the goods exist at the time the contract was issued, and, two, chickens are not land, but chattels.

Let’s take it one step further.  Suppose you want a pig, and the pig guy wants chickens, but you don’t have chickens.  You do, however, know a guy who has laying hens that he will give you in exchange for a pig.  The chickens are good layers and produce 75 chicks that grow to maturity in 90 days.  (If there are any actual chicken raisers reading this, please don’t say anything.  I’m making this all up for the sake of the example.)

You therefore offer the pig guy a contract to deliver 50 chickens in 90 days in exchange for two of his pigs.  He accepts your contract, and gives you two pigs.  You keep one pig and trade the other for the chicken guy’s chickens.

This time the contract is called a “bill of exchange” instead of a “mortgage” because you do not — yet — have the goods on hand to redeem the bill when it is presented for redemption.  A bill of exchange is based not on what you have when you issue the bill, but on what you expect to have when the bill is presented for payment; bills of exchange are based on the issuer’s “creditworthiness,” i.e., the expectation that the issuer will keep his promise.

At the end of 90 days, you have 75 new chickens plus the old ones, and redeem the contract you gave the pig guy with 50 of your new chickens.  From nothing, you ended up with one pig, 25 new chickens, and a flock of hens that are still producing new chickens at the rate of 75 every 90 days.

Obviously, we can keep refining this with new scenarios and extending the network of transactions, until we have the situation where everybody involved starts with nothing, and ends up with what they want, all based on promises they make and pass back and forth, and then set to work producing something of value to make good their promises.

A system like this, however, relies on everybody in the network knowing everybody else, and trusting them to keep the promises that they make.  What happens when you have a network of transactions in which everybody doesn’t know and trust everybody else?

That is where the “bank of issue” comes in.


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