Last Thursday we looked at Dr. Harold Moulton’s statement about the two functions of a commercial bank, or — more specifically — how such a bank makes loans . . . which is how commercial banks create money, regardless what the Keynesians tried to tell you in all those textbooks.
|Money doesn't have to be coin or bills (although that helps).|
As a reminder, “money” is anything that can be accepted in settlement of a debt: “all things transferred in commerce.” It all comes from Adam Smith’s first principle of economics: “Consumption is the sole end and purpose of all production.”
Not counting charity, gift, theft, or inheritance (we think that covers everything), there is only one way to be able to consume, and that is to produce. (The other ways enable someone to consume without producing.)
Consequently, you must either produce for your own consumption, or to trade to others for what they have produced that you want to consume. “Money” is what we call the contract between two or more people exchanging things of value that have been produced and, presumably, are meant for consumption.
As you can see, “money” can take any form convenient to the parties to a transaction. It doesn’t have to be some kind of official certificate as long as both parties are satisfied.
|Standards are helpful when more people come in.|
The problem comes in when a transaction goes beyond parties who know and trust each other. You need some generally recognized form of money that people can trust, even if they are completely unacquainted with the original parties to a transaction.
That is where a commercial bank comes in. A commercial bank is in the business of creating general promises (“money”) that people in the community will recognize out of individual promises made by borrowers from the bank.
And how does a bank do that? By making loans. But doesn’t making loans increase the money supply by depositing the proceeds, and then loaning them out again?
No. All that happens is that the original amount of new money gets passed around from hand to hand. No new money can be created by making deposits, only by making loans. According to Harold Moulton,
|Dr. Harold G. Moulton|
Let us assume that business men, in response to this invitation, come to the bank for loans with which to conduct their business operations. Mr. A is given a loan of $100,000 for four months, the interest at 6 percent being deducted in advance. He has the option of withdrawing $98,000 in actual cash from the bank or of having it credited as a deposit account against which he may draw checks. Since drawing checks is a safer and more convenient means of making payments, A elects to take a deposit account covering the entire $98,000. Inasmuch as we wish to focus attention upon this particular transaction, we shall omit from the balance sheet the $100,000 of new deposits which we assumed had been made in the form of cash. The balance sheet would then stand as follows:
Suppose now that Mr. A writes a check for $98.000 in favor of Mr. B. Suppose also that B desires to be a customer of this bank, and upon receipt of the check presents it at the bank and asks that an account be opened in his name and that the $98,000 check be deposited to this account. It is evident that the result of this operation, so far as deposits are concerned, is merely to deduct $98,000 from A's account and add $98,000 to B's account. The total deposits owed by the bank remain unchanged. While B's deposit account comes over the counter in the form of a check presented to the bank, it is obvious that it is still indirectly the result of the loan that was made to A.
Since it is more convenient for B to meet his obligations by means of checks rather than in the form of actual cash, we may assume that he will write checks to those to whom he is indebted. Let us assume that he writes four checks of $24,500 each; and that Messrs. C, D, E, and F, desiring to do business with this bank, in turn present these checks for deposit. The net result still is to leave the total of deposits unchanged; though instead of being credited to A or B the deposits are now credited to the accounts of other individuals. In their turn C, D, E, and F may write checks against their deposit accounts for varying amounts and to the order of sundry persons. If all the people receiving such checks in turn present them to this bank for deposit to their respective accounts, it is obvious that, while there would be an ever-shifting personnel among depositors, the total deposits would remain at $98,000.
It is obvious, then, from this description, that the Keynesian money multiplier simply does not create money. Money is only created by making new loans, not by re-depositing existing deposits.