Tuesday, December 12, 2017

That Banking Principle Again

Last week we got another comment on a posting of the kind that we like to get, i.e., that writes another blog posting for us.  This gets more bang for the buck by killing two birds with one stone, as long as we hit the nail on the head.  Which uses up our quota of aphorisms for the day.  So, let’s cut to the chase.  Our commentator said,

What most people think, but it's not correct.
I feel like this banking principle/capital homesteading is the same as a small business loan with the terms defined differently. You talk about someone buying an orchard with the promise of paying part of the harvest for an agreed period of time. The bank acts as an intermediary and pays the seller in silver notes, and the buyer owes the bank the produce. He goes about his business and pays the bank in silver notes from the sale of his apples each year an amount which includes the principle plus interest. That by itself doesn’t create money, but when it’s someone else’s money on deposit, e.g., the orchard seller’s money, being loaned out, then money is created. For every bit of money deposited M1, the money available for circulation M2 is the initial amount M1 divided by the reserve fraction. Do you propose to make the reserve requirement 100%? Or can we just accept that all the money in circulation is M2?
This is a good question, if only because it demonstrates just how hard it is to get across the idea of the Banking Principle versus the Currency Principle.  Essentially, the commentator is mixing apples and oranges.
Dr. Harold Glenn Moulton, President of Brookings
The so-called “multiplier theory” — disproved by Dr. Harold G. Moulton within months of when it was promulgated, which disproof has been completely ignored for over eighty years — is pure Currency Principle.  That’s the belief that banks create money out of nothing by double counting reserves.  By complete coincidence, the mathematical gymnastics involved in the Currency Principle multiplier theory work out to the same answer as the actual Banking Principle operation of a bank bound by a reserve requirement, letting economists who don’t know how a bank operates or basic bookkeeping “prove” their false theory.
But how does a bank create money, if not out of thin air by counting each reserve dollar multiple times?
Under the Banking Principle there are two types of money, past savings money and future savings money.  In technical terms these are mortgages (contracts on existing assets) and bills of exchange (contracts on future assets).  All money is a contract, just as all contracts are, in a legal sense, money.  Any promise consisting of offer, acceptance, and consideration is a contract and thus money.
The role of a commercial bank and a central bank (broadly speaking, a central bank is a commercial bank for commercial banks) is to “accept” money in the form of a personal contract, and issue its own general contract to “buy” it. Strictly speaking, a bank can only “create” money by accepting something of value and issuing a promissory note that obliges the bank to deliver value once the original borrower has redeemed the contract he or she “sold” to the bank. A bank’s promissory notes, whether in the form of banknotes or to back a new demand deposit, are negotiable, and can be used as currency, a general medium of exchange with a uniform and (presumably) stable value.
Jean-Baptiste Say
All the talk of M1 through MWHATEVER are simply ways Currency Principle economists have tried to force their theories to fit reality. The Banking Principle, by defining money as anything that can be accepted in settlement of a debt, avoids this problem. If there was a contract, it counts as money. If there was no contract, there was no money. (That’s simplified, of course, but we’re using the economists’ “ceteris paribus” assumption: keeping everything else the same and assuming that all exchanges of value are commercial transactions.)
If you keep in mind Say’s Law of Markets, founded on Adam Smith’s first principle of economics (“Consumption is the sole end and purpose of all production”), everything falls into place. “Money” is simply the means by which I exchange what I produce, for what you produce, nothing more. Everything else is either ways intended to facilitate this process, or ways that some people have figured out to game the system for their own benefit.
For example, Moulton believed that the reason so many countries went off the gold standard in the 1920s and 1930s was to make it easy for governments to manipulate the currency and impose the hidden tax of inflation, freeing themselves from oversight by the taxpayer, a great benefit to a totalitarian regime.
Now — why does the fractional reserve requirement give the same answer mathematically under both the Banking Principle and the Currency Principle?
Banking Principle: Given a 10% reserve requirement, having reserves of $1 million means the bank can accept contracts totaling $10 million, and issue promissory notes to that amount, thereby expanding the money supply by $10 million.
A theory built on a completely false set of assumptions.
Currency Principle: Given a 10% reserve requirement, having reserves of $1 million means the bank can lend out $900,000, which is deposited in another bank when the borrower issues checks.  In multiplier theory, the $900,000 in checks on deposit is counted as new reserves in addition to the reserves on deposit in the bank on which the checks were drawn.  Multiplier theory assumes that checks are never presented for payment (!), but are kept on deposit, 90% of which are used to back new demand deposits in the second bank in the amount of $810,000.  These in turn are drawn on by the borrower(s) and deposited in a third bank, which creates money in the amount of $729,000, and so on, down to the last nickel.  Keep in mind that the multiplier depends on the assumption that no checks are ever cleared at any time, but remain on deposit as additional reserves . . . which is not only contrary to banking theory and practice, but completely illegal.  The amount by which the money supply allegedly expands in this manner is equal to the reciprocal of the reserve requirement, 1 divided by 10% or 0.1, which equals $10 million.
The bottom line here?
Modern monetary and fiscal policy is based on a principle that is not only completely false, it is so transparently wrong as to be completely insane.
Now, just in case there is any doubt about this, tomorrow we will begin posting Moulton’s refutation of the money multiplier.