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.
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| 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.
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| 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
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| 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.
#30#
