In case you were thinking all these brilliant ideas in the last half dozen or so postings came from us (which means you probably missed the significance of all those big pictures of Dr. Harold G. Moulton and the quotes in boldface type), no, we’re just quoting from Moulton’s 1935 refutation of the monetary and banking theories underpinning the Keynesian New Deal, The Formation of Capital.
|"Don't worry. I don't know what I'm talking about."|
Yesterday, we started to look at the role reserves play in commercial banking. To summarize, contrary to popular (Keynesian) belief, commercial banks are not supposed to make loans out of reserves. (What they've actually been doing to take advantage of the massive funny money creation by the federal government is another issue. . . .) That’s not what reserves are for. Rather, reserves are there to exchange other forms of money for the reserve currency, just in case there is anything left over when the bank offsets its liabilities against those of its borrowers.
Thus, two banks are continually trading their obligations back and forth, cancelling out most of them, with only a little bit, the balance, that needs to be settled in cash using the reserve currency. But what if there are more than two banks involved? Don’t worry, Moulton covered that, too:
|Dr. Harold G. Moulton|
The situation may be complicated still further by assuming that eventually a considerable number of banks are organized in this community and that each is daily making loans and creating deposit accounts against which checks are drawn and deposited in one bank or another. This approaches the actual situation that exists in large financial centers. Under these circumstances each individual bank finds that claims are presented against it by all the other banks and that it, in turn, has counter‑claims against all the other banks in the community. By means of a clearing‑house association a single balance may be struck for each bank with all the other banks — which balance, only, need be paid in cash.
The situation may now be complicated yet another degree by articulating the activities of this community, which we have thus far assumed to be self‑contained, with the business and financial activities of other communities in which commercial banks have also been developed. Some of the checks drawn against deposit accounts in the community in question will be sent to individuals in other communities and these checks will be deposited in banks outside the community in which they originate. Will it not now be necessary, when these checks are presented for payment, for the second community to draw funds away from the first? The answer once more is that cash will move only to settle net balances which cannot be offset by counter‑claims.
|A bill of exchange.|
There tends to develop a network of interrelations between the banks of different communities and, as a result, cash moves only as a last resort — to settle balances that cannot be otherwise offset. Since the establishment of the Federal Reserve system the movement of cash between communities has been almost entirely eliminated, the obligations being adjusted by debits or credits against balances held by the member banks with Federal Reserve banks.
It should also be pointed out at this place that the commercial banking and credit system which we are describing operates more or less on a world plane. Checks — or rather, in this instance, bills of exchange — drawn against American banks are deposited in the banks of other countries; and in turn bills of exchange on the banks of other countries are presented for payment at banks in this country. Thanks to the mechanism of the foreign exchange market these counter‑claims are in the main offset, not only as between the United States and a single country such as Great Britain, but between the United States and all other countries; and also, for that matter, between Great Britain or any other country and the rest of the world as a whole. That is to say, each country settles its financial operations with the outside world in the main without any substantial movements of cash.
|"And Scrooge's name was good upon change for anything."|
In all the foregoing discussion we have been referring to a normal situation in which the commercial banking credit system and the exchanges are functioning smoothly. At times a particular bank may be subjected to a very heavy pressure for funds; and, if its cash is insufficient to meet the demands and if it cannot sell some of its assets or borrow from other banks, it will have to close its doors. Similarly, the banks of a whole community or of the whole nation may, as a result of a loss of confidence on the part of depositors, be subjected to demands for funds beyond their capacity to meet. In case of a panic of this kind all the banks naturally have to suspend payments in specie, and the commercial credit structure and the international exchange system break down. We are not, however, concerned at this place with the causes of panics, or with the control devices which might possibly be established for the prevention of credit debacles.
In summary, the evolution of the commercial banking system has served to create a vast quantity of circulating media equivalent, under ordinary circumstances, to money.* This credit currency was gradually created through the process of making loans, which gave rise to deposits in the banking system as a whole. In the absence of this phenomenon, deposits would have been limited to the metallic and government paper money actually placed with the banks; and such deposits would have been but a fraction of those arising out of our credit mechanism. Some idea of the extent to which this credit system has expanded the supply of funds available for business uses is indicated in the following section.
*Moulton meant, of course, currency, or “current money.” Broadly, money is everything transferred in commerce, regardless of its specific form.
That concludes our series of extracts from Moulton’s The Formation of Capital (1935). If you want to get the bigger picture, you might want to read Moulton’s book, and follow it up with Kelso and Adler’s The New Capitalists (available for free from the website of the Center for Economic and Social Justice (CESJ). The subtitle of the Kelso-Adler book says why: “A Proposal to Free Economic Growth from the Slavery of Savings.”