Yesterday we posted the introduction to the chapter in which Dr. Harold G. Moulton demolished the Keynesian money multiplier, which ironically, despite the fact that it is based on an easily disproved fallacy, forms the basis of the monetary and fiscal policy of virtually every government on Earth.
|Medieval (Deposit) Banking|
Understanding Moulton’s explanation relies on understanding the nature of money itself, as well as the function of the three different types of banks. We have gone over money many times on this blog, so we need to focus on what a bank is and does.
As we said, there are three basic types of banks, each filling a particular social and financial need. Very briefly, these are:
I. Banks of Deposit. This is what most people think of as a “bank.” A bank of deposit is defined as a financial institution that takes deposits and makes loans out of those deposits and its capitalization. A bank of deposit does not create money.
II. Banks of Issue/Circulation. For all practical purposes, banks of issue and banks of circulation are the same thing. They are defined as financial institutions that take deposits, make loans, and issue promissory notes that circulate as “current money,” i.e., “currency.” A bank of issue/circulation does not, strictly speaking, create money, either, but functions to change one form of money into another form of money more easily used to carry out financial transactions.
III. Banks of Discount. A bank of discount is the only type of bank that actually creates money. It does this by accepting bills of exchange/commercial paper at a discount from the face value, and issuing a promissory note to “buy” the bill or paper. This promissory note is negotiable, and could be used as currency . . . except the denomination is usually far too large to be useful for daily circulation, e.g., you cannot buy lunch with a $100,000 promissory note (traditionally the minimum denomination for commercial paper), even though it is money the same as the one cent piece in your pocket.
|Medieval Merchant/Mercantile/Commercial Banking|
Now, this is where a little confusion creeps in. A modern commercial, merchant, or mercantile bank (different names for the same thing) is a combination of all three types of bank. It takes deposits and makes loans out of those deposits, thus acting as a bank of deposit. It also changes one form of money — accepted bills of exchange and commercial paper — into a form more convenient for transacting business, almost always these days by issuing a promissory note used to back a new demand deposit. It also accepts the bills of exchange and commercial paper, "buying" (accepting) them by issuing a promissory note that it uses to back new demand deposits.
Paradoxically, although many people think that commercial banks create money out of thin air by creating demand deposits, it is easily seen that when a commercial bank accepts a bill of exchange or commercial paper that it is really creating asset-backed money. In contrast, when the government emits “bills of credit” and the central bank “buys’ the bills of credit (misleadingly usually called government bonds these days) by creating a demand deposit or printing currency for the government, it really is creating money out of thin air — or (more accurately) future taxes that might never be collected.
So today we begin looking at —
HOW THE COMMERCIAL BANKING SYSTEM MANUFACTURES CREDIT
|Harold G. Moulton|
It is the operation of the commercial banking system, taken as a whole, that results in the creation of credit currency and thereby adds to the total volume of circulating media. In order to make the process of credit creation clear, however, it will be necessary first to analyze the operations of an individual commercial bank. For this purpose we shall assume a self‑contained community, that is, one having no financial relations outside its own borders and having as yet no commercial banking institutions. Such an assumption is not unrealistic, for it was under such conditions that the actual development of banking began. We shall then broaden the analysis, in successive steps, to include the several banks which may exist within a given community, and, finally, all of the banks within a nation as a whole.
Let us assume, then, that a group of individuals within an isolated community decides to form a commercial bank with a capital of a million dollars. Ten thousand shares of stock are issued at $100 per share. This stock is set down as a liability of the bank, inasmuch as it represents the obligation of the banking corporation to the shareholders. After an outlay of $100,000 for a bank building and the necessary furniture and fixtures, the preliminary financial statement of such a bank would stand as follows:
Two types of operations may be expected to begin almost immediately. First, certain individuals — stockholders, and others — will deposit with the bank cash which has hitherto been held in their own strong boxes. If, in the course of a few months, deposits in the amount of $100,000 are made and there are no withdrawals, the balance sheet will show, in addition to the foregoing items, new assets in the form of cash of $100,000, and new liabilities in the form of deposits (owing to depositors) of $100,000. Such deposits would be identical in character with those which individuals would make at a savings bank.
It is the second type of operation, however, which constitutes the essential characteristic of the commercial bank. The bank, when it opens its doors, states not only that it solicits deposits of cash but that it is in a position to make loans to merchants, manufacturers, and others. These loans, as we shall see, result in new deposits against which checks may be drawn in the same way as they are drawn against deposits of actual cash.
It is how the commercial bank creates money that we will start to look at next Tuesday.