In the previous posting in this mercifully brief series, we described how, simply by making promises to deliver marketable goods and services in the future, people can start with absolutely nothing and end up with something they want. The system we described, however, relies on everybody in the system knowing and trusting everybody else. What happens when the system gets too big for everyone to know and trust everyone else?
That is the question some genius asked possibly as early as 10,000 years ago. The answer is to find somebody that everybody trusts, and have him accept other people’s promises (mortgages and bills of exchange), and issue his own promises (promissory notes) for them to use in carrying out exchanges.
Problem solved. Instead of everybody having to know and trust everybody else, everybody only has to trust the guy making the promises that people use in carrying out exchanges. In fact, if you’re convinced that the promise itself is good, you don’t have to trust or even know the person you’re making the exchange with, just the person who issued the promise you’re using in exchange.
This is called “issue banking.” Since the promissory notes circulate in the community as money, the institutions that do it used to be called “banks of circulation” as well as “banks of issue.”
So the basic difference between a bank of deposit and a bank of issue is that a bank of deposit can only lend out money it has, while a bank of issue can “create money.” This is in the form of promissory notes if a borrower brings a mortgage or a bill of exchange to the bank of issue and the borrower trades his promise that nobody knows or trusts, for the bank’s promise that everybody knows and trusts.
It is, of course, a lot more complicated than that in practice. All we want here is the basic theory, however. Even a very simplified explanation of how a bank of issue works in practice gets complicated:
· A borrower brings a mortgage or bill of exchange to a bank of issue.
· After deciding that the borrower is good for it, the bank issues a promissory note and “accepts” the mortgage or bill of exchange.
· The bank uses the promissory note to back a new “demand deposit” (i.e., “checking account”).
· The bank gives the borrower a checkbook to be able to draw on the demand deposit (which is why it’s called a “demand deposit”: it’s available “on demand”).
· The borrower repays the loan (buys back his mortgage or bill of exchange), which cancels both the bank’s promissory note, and the borrower’s mortgage or bill of exchange.
We didn’t mention it, but if the borrower is smart, he will only use the new money the bank created for him to finance new capital formation, which he will then put to use producing marketable goods and services that can be sold at a profit. The borrower takes some of the profits and uses them to repay the loan.
Assuming that everyone keeps his word and things work out as planned, the money supply in the community is always exactly what is needed, either to finance new capital formation using bills of exchange, or to clear inventories of existing goods using mortgages.
What happens, however, if things don’t go as expected or planned, and people, even with all the good will in the world, don’t keep their promises? What if one bank has a high level of trust, while the bank down the street is only so-so? What if banks decide to play tricks on each other to try and drive the competition out of business? What if some banks won’t accept mortgages, bills, and promissory notes of other banks?
That’s where central banking comes in, and something we’ll look at tomorrow.