We ended yesterday’s posting by agreeing with the old saw that you need money to make money. Traditionally, this has meant at least one of two things, usually both. One, that the only way to finance new capital formation is to restrict your (or somebody’s) consumption, accumulate money savings, then use the accumulation to purchase productive capital. Two, somebody else accumulates savings that you borrow in order to purchase productive capital.
|Filled with loan paper, not cash, if the bank is doing its job.|
And don’t you still need an accumulation of wealth that you own to satisfy the bank that it will get its money back even if you don’t repay the loan? And doesn’t the bank have to be able to satisfy its depositors and other people who ended up with the bank’s obligations when they demand cash, i.e., the reserve currency instead of the bank’s obligation?
Let’s reflect on one of these issues for our subject today: reserves.
As we saw yesterday, the U.S. commercial banks got into trouble in 1893 because European investors cashed out and drained gold reserves, that is, the asset-based liquidity of the country, leaving the debt-backed reserve currency, the National Bank Notes. European investors had the right to do so, because they could take their securities, convert them into National Bank Notes, then present the cash for conversion into gold. By taking gold directly, they just cut out several steps.
|National Bank Note debt-backed inelastic reserve currency.|
Unfortunately, the U.S. did not have a central bank to which the commercial banks could go to obtain additional reserves, and the gold supply would have been insufficient, anyway, if the additional reserve currency were to be converted to gold . . . as had happened with the massive issues of United States Notes (“Greenbacks”) at the beginning of the Civil War, which caused the banks to suspend convertibility. In 1893, the commercial banks were holding massive amounts of valuable commercial, industrial, and agricultural assets in the form of mortgages and bills of exchange, but these could not be converted into the hard-asset reserve currency (gold) because the gold had been drained out of the system, and the paper reserve currency, the National Bank Notes, was backed by government debt, the amount of which was set by law.
Both the gold reserves and the paper reserve currency were “inelastic,” that is, more could not be created as needed, even though good, solid, private sector hard assets were there in plenty. What the banks did not have was a reserve currency that could expand and contract directly with the needs of the economy.
|A "Bill of Credit" (above) represents government debt, not private sector assets.|
Had an elastic, asset-backed reserve currency been available through a central banking system, there would have been no problem. When the gold ran out, the commercial banks would still have been able to extend productive credit to U.S. businesses by selling (“rediscounting”) some of their loans to the central bank in exchange for some newly created, asset-backed, paper reserve currency.
The secret is how commercial banks create money by expanding credit.
Commercial banks do not make loans out of reserves. They make loans by turning the present value of future production into money now, and using reserves to redeem the bank’s obligations that non-borrowers present for payment by the bank. This doesn’t usually need to be very much, because obligations that a bank collects that others owe the bank in most cases offset the bank’s own obligations. It’s only when you have a lot of people redeeming the bank’s obligations all at once — as happened in 1893 on a large scale — that the bank gets into trouble, and then only when the bank can’t sell some of its assets for more reserves.
How does a commercial bank create money? It’s actually pretty easy.
Say that someone has the chance to buy some capital that will cost a total of $80,000 and give an annual return of 15% once it is put into operation in one year. These figures are, of course, not realistic. We pulled them out of thin air for ease of calculation. We’re illustrating the concept, not presenting an actual case study.
|Miss O. Oyl, hard-headed business tycoon, off to the bank.|
This someone (call her Olive Oyl) draws up a contract offering to pay someone $10,000 a year for ten years, starting in two years, if they will lend her $80,000 now. Unfortunately, nobody has $80,000 to lend Miss Oyl.
Does that mean the case is closed? By no means. Oyl goes down to the local commercial bank and offers them the same deal. They look it over and think she’s on to something. They decide to accept Oyl’s offer.
In exchange, Oyl signs a promissory note for $100,000, which the bank then uses to back a demand deposit in Oyl’s name in the amount of $80,000. The money supply in the economy has expanded by $80,000.
In due time, Oyl buys the capital she had her eye on, puts it into production, and starts making a profit of $12,000 a year. At the end of Years 2 through 11, Oyl pays the bank $10,000 a year, a total of ten payments adding up to $100,000.
The bank cancels $80,000 — just what it created when it accepted Oyl’s contract — and books revenue of $20,000. Out of that $20,000 the bank meets its own expenses and (we hope) realizes a profit to be able to stay in business to create money to finance other capital projects.
|P. Eye with plenty of green stuff in reserve.|
After paying off the loan, Oyl continues to realize $12,000 each year for the rest of her life. (She wisely uses the cash “generated” by her annual depreciation expense to maintain her capital stake instead of spending it on consumption, thereby maintaining her original productive capacity as the old capital wears out and is replaced with new capital.)
To make this as safe as possible and to ensure that a commercial bank doesn’t run out of reserves when it can’t sell its assets to other banks, we establish a “bank for banks” — a central bank. The primary purpose of a central bank is to ensure that a commercial bank always has somewhere to turn to get additional reserves by converting some of its assets into the reserve currency. (It is also supposed to ensure a uniform and standard currency, as well as oversee clearinghouse operations and a few other things, but adequate liquidity for industry, agriculture, and commerce is the main thing.)
In fact, it is possible to require that all commercial banks immediately sell all their loan paper to the central bank in exchange for currency or demand deposits at the central bank. In this way, there is never any question about having adequate reserves on hand, because all a bank has in that case is reserves — 100% reserves! Having sold its loans to the central bank, the commercial bank already made its profit on the loan, and simply acts as the collection agent for the central bank to repay the loans that are now on the books of the central bank instead of the commercial bank.
So that answers how money can be created as needed to finance new capital formation, thereby getting away from the necessity of a bank holding past savings. What about collateral? We’ll look at that tomorrow.