In yesterday’s posting we saw how commercial and mercantile banks create money. They do it the same way anybody can create money: by accepting mortgages and bills of exchange, trading their promissory notes for the contract, thereby creating asset-backed money. So why should we have a central bank, if commercial banks, even people by themselves without banks, can do the trick?
|All money is a contract, and all contracts are, in a sense, money.|
Well, suppose we want to make sure all the money created in this way, whether by individuals, groups, or commercial and mercantile banks all has the same unit value everywhere, regardless which bank created the demand deposit, or individuals or groups who entered into a contract. To make the question easier, we’ll deal just with commercial banks from this point on.
The unit values of all demand deposits in a single bank are, of course, the same. A $5 check drawn by Customer A on Bank X has exactly the same value of a $5 check drawn by Customer B on Bank X. No problem.
What happens, however, when Customer A of Bank X wants to pay a $5 debt he owes to Bank Z with a $5 check drawn on Bank X, or even just cash or deposit a check since he is also a customer of Bank Z? Any number of problems can crop up:
· Bank Z has no agreement with Bank X to accept Bank X’s obligations in settlement of debts owed to Bank Z.
· Bank Z has no agreement with Bank X to exchange each other’s obligations.
· A dollar created by Bank X doesn’t have the same value as a dollar created by Bank Z.
· Bank Z doesn’t have enough reserve currency on hand to pay out on any obligations other than its own, nor is it required to do so.
· Bank Z doesn’t have reserves, period. It can’t pay even its own obligations; everything is loaned out.
And a lot of other problems, too.
|Currency should be "fungible," i.e., all units legally the same.|
What’s the answer? A “bank for banks,” or “central bank.” Central banks were invented to solve all the problems noted, and more besides. By requiring all commercial (promissory note issuing) banks to be “customers” of the central bank, the commercial banks become, in a sense, autonomous branches of the central bank so that the units of currency in the area served by the central bank all have exactly the same value.
The unit values of all demand deposits of all member banks of the central bank are exactly the same because they are, ultimately, obligations of the central bank, regardless which commercial bank created the demand deposit. A $5 check drawn on Bank X thus has exactly the same value as a $5 check drawn on Bank Z.
|A properly run banking system can't run out of reserves.|
What about running out of reserves to cash checks? Bank Z can’t run out of reserves because all it has to do is take some or all of the loans it has made and transfer the obligation to the central bank, receiving in return enough reserve currency or its equivalent to satisfy 100% of its obligations. This used to take a little time if somebody presented a large check or banknote for redemption, but with electronic communications, it can be virtually instantaneous.
Does Bank Z have to cash a check drawn on Bank X if presented by a customer of Bank Z? It sure does, at least if they are both member banks of the central bank. Whether the check is good (i.e., the issuer has enough money on deposit at Bank X to cover it) is another matter, and why Bank Z will “hold” the funds until the check clears and is made good by Bank X, but the working assumption of Bank Z in accepting a check drawn on Bank X is that it is good. Of course, Bank Z has no obligation to accept a check drawn on Bank X if presented by a non-customer of Bank Z. Bank Z is responsible only for its own obligations, not those of other banks.
In this way a central bank ties the financial system together, ensuring uniformity, stability, adequate liquidity (accommodation), and making things less risky — or, at least, it would do so if used properly instead of being hijacked to finance government and manipulate the economy for political ends.
So how do we get the Federal Reserve and other central banks throughout the world back on the right track? Tune in tomorrow.