Last week we looked at the question of whether the State has the sole right to “create money.” Understanding that money is anything that can be accepted in settlement of a debt, and that it is therefore the medium through which I exchange what I produce for what you produce, we concluded that not only does the State not have the sole right to “create money,” it doesn’t have a legitimate right to “create money” at all. By issuing claims against what other people and organizations produce, the State is, in fact, stealing.
|"Oy, weh! Are you still stuck on that Shylock schtick?"|
Does that mean that “the Jews,” “the banks,” or “the capitalists” are also stealing when they create money? Well, if they are facilitating State money creation (which Irving Fisher called “legal counterfeiting”) . . . yes. That is not, however, what such people and institutions do as a matter of course, or (at least) are not supposed to be doing.
To understand this, we need to know what a “bank” is. That’s not as easy as it might at first seem, even if you actually bother to define your terms before attacking someone or something about which you know virtually nothing.
Types of Banks
There are actually three different types of banks, depending on what social function they provide. These are 1) banks of deposit, 2) banks of issue or circulation, and 3) banks of discount.
The Bank of Deposit. This is what most people think of when they hear the word “bank.” It is defined as a financial institution that takes deposits and makes loans. A deposit bank only deals in currency or currency substitutes that can be accepted for deposit and then loaned out. A bank of deposit is purely a financial intermediary, putting together savers and users of funds. Credit unions, savings and loans, and investment banks are common types of deposit bank.
|The Fuggers: for three centuries bankers to the world.|
The Bank of Issue. A bank of issue in the classic sense is very rare these days. It is defined as a financial institution that takes deposits, makes loans, and issues promissory notes backed by its deposits intended to circulate in the community as currency, hence the older term, “bank of circulation.” Where a deposit bank only deals in currency, a bank of issue deals in all forms of existing money, e.g., currency or currency substitutes, mortgages, and rediscounted bills of exchange. These days the bank of issue is almost always combined with the bank of discount to form a commercial or mercantile bank.
The Bank of Discount. This, too, is very rare these days in the classic sense of a “stand-alone” institution, and is usually combined with the bank of issue to form a commercial or mercantile bank. A bank of discount is defined as a financial institution that accepts (“discounts”) bills and notes, makes loans, and issues promissory notes. A discount bank differs from both the deposit bank and the issue bank by actually creating new money by accepting bills and notes, i.e., entering into a contract. Neither the deposit bank nor the issue bank create new money, but deal with different forms of existing money, i.e., existing contracts.
Applications of the Banking Principle
There are two applications of the Banking Principle that form the backbone of a modern advanced financial system. These are 1) the commercial or mercantile bank, and 2) the central bank.
|Small denomination bill of exchange used as currency.|
The Commercial or Mercantile Bank. A commercial (U.S. term) or mercantile (U.K. term) bank, as we said, combines the function of the bank of issue and the bank of discount. It is intended to provide “accommodation” to people who have financially feasible capital projects and qualify for loans. A commercial bank creates money by accepting a bill of exchange from the borrower with a financially feasible project at a discount and issuing a promissory note. The promissory note is used to back newly issued banknotes (rare these days) or (most common) a new demand deposit. The borrower (issuer of the bill of exchange) uses the banknotes or writes a check to finance new capital formation, puts the new capital into production, and redeems his or her bill of exchange with a portion of the profits, cancelling the bank’s promissory note that backed the banknotes or demand deposit and the bill of exchange at the same time.
|Central banking principles were allegedly worked out in Ptolemaic Egypt.|
Central Bank. Just as people with financially feasible capital projects need commercial or mercantile banks to create money to finance those projects, commercial or mercantile banks need a financial institution that can create a reserve currency to back the loans they make and meet any demands for “cash” by people presenting the obligations of the commercial or mercantile banks for redemption. This is the role of the central bank. Among its other functions, a central bank is supposed to ensure that, just as the banknotes or other currency or currency substitutes issued by individual commercial or mercantile banks are asset-backed and of stable and uniform value, all the banknotes or other currency or currency substitutes of all the banks in the region served by the central bank are asset-backed and of stable and uniform value. In a central banking system, then, the commercial or mercantile banks “surrender” all or part of their money creation powers to the central bank, thereby achieving an asset-backed, stable, and uniform currency throughout the economy.
That’s the idea, anyway. Tomorrow we’ll look at how this ideal state of affairs could be restored and maintained.