Most people, when they think of what a bank is, imagine a giant metal vault, something on the order of Uncle Scrooge McDuck’s Money Bin, where people with money deposit cash and the bank lends it out to other people. Well, it turns out that banking is substantially different from the image it has in the popular mind.
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| When you mix politics and finance. |
First, there is the idea that banks are in a giant conspiracy against humanity by usurping the sovereign power of the State to create money out of nothing. Do only governments have the right to create money? More to the point, does anybody have the right to create money out of nothing?
Well . . . no. To be legitimate, money must be backed by something of definable value that is owned by the issuer or creator of the money. Of course, governments have the unilateral power to issue what amounts to counterfeit money by backing it with its own debt, but that doesn’t make it right. Government debt is owned by future taxes . . . which the government doesn’t own and may never own if the taxpayers don’t vote the required taxes. Taxation, as John Locke and other political philosophers have pointed out, is not the exercise of property by the State, but a grant from the people.
It comes as a surprise to many that ordinary people create money every day, as do businesses and other organizations. Money is created and often cancelled every single time there is an economic exchange. This is because “money” is the medium of exchange. It isn’t only coin, currency or checking accounts and credit cards, which is what most people think of when you say the M-word. Money is “all things transferred in commerce,” whatever its appearance or form.
In most economies today there are three kinds of money, although many forms. Two of these are legitimate, one is illegitimate. The illegitimate kind is that backed by something that has no value, insufficient value, or that the issuer doesn’t own. We can call this “no savings money,” as there is nothing of value or “saved” behind it. This is what governments and counterfeiters issue.
The two legitimate forms of money are backed by savings, and therein lies a tale. To understand banking, it is essential to understand the “first principle of finance.” That is to know the difference between a mortgage and a bill of exchange.
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| If you own an orchard it does . . . |
A “mortgage” is a financial instrument backed by an existing thing of value in the possession of the issuer. In other words, a mortgage is backed by past or existing savings (however you want to put it), and we can call this type of money “past savings money.”
A “bill of exchange” is a financial instrument backed by the present value of a thing of value that the issuer reasonably expects to have in his or her possession when the bill of exchange matures and falls due. In other words, a bill of exchange is backed by future savings, so we can call this type of money “future savings money.”
Both past and future saving can be used in commerce interchangeably. All that matters is that money be backed with actual value, not whether the thing of value is past or future savings.
The three types of banks correspond loosely to the two types of money and one form. These are:
· Banks of Deposit,
· Banks of Issue or of Circulation, and
· Banks of Discount.
A “Bank of Deposit” is defined as a financial institution that takes deposits and makes loans. It is what most people think of a bank but is actually a relative latecomer on the scene. CA bank of deposit cannot create money but can only loan out of its capitalization and deposits. Types of deposit banks are credit unions. Investment banks, savings and loans, and industrial banks (which are savings banks for the “industrial classes,” not for industry). Banks of deposit deal exclusively in currency and “currency substitutes,” such as checks and electronic transfers.
A “Bank of Issue”
(which used to be known as a “Bank of Circulation”) is defined as a financial
institution that takes deposits, makes loans, and issues promissory notes. A bank of issue can create money by accepting
a mortgage (not a home mortgage, which is handled by a bank of deposit
as it is a consumer good) and issuing a promissory note backed by the accepted
mortgage. The promissory note can then be
used to back a new demand deposit (“checking account”) or — almost unheard-of
these days — new or reissued banknotes. Pawn
shops and the famous cheese banks of Parma are examples of banks of issue.
A “Bank of Discount” is also defined as a financial institution that takes deposits, makes loans, and issues promissory notes. A bank of discount can create money by accepting a bill of exchange and issuing a promissory note backed by the accepted bill. As with a bank of issue, the promissory note can then be used to back a new demand deposit (“checking account”) or new or reissued banknotes. The difference between a bank of issue and a bank of discount is that a bank of issue deals in existing or past savings, while a bank of discount deals in future savings.
As far as we know, there are no pure discount banks left in the world. Instead, commercial or mercantile banks and central banks combine issue and discount banking. In theory this allows economies to be provided with adequate liquidity to carry out commerce, industry, and agriculture. In reality, with the advent of Keynesian economics, the global financial system has been largely diverted into a de facto branch of government serving political instead of economic ends, with the result that the world is burdened with immense amounts of debt issued to finance government growth instead of the needs of people.
Correcting this situation is not impossible, but it will require passage of the Economic Democracy Act at the earliest possible date.
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