We also looked briefly at banks of deposit, and how they do not have the power to create money. A bank of deposit can only lend out what savers have deposited. A bank of deposit cannot create money through the issue of promissory notes as commercial banks are designed to do. Unfortunately, the major schools of economic thought — Keynesian, Monetarist, and Austrian — all make a fundamental and incorrect assumption, that banks of deposit are the only kind of bank; that no bank can (or, at least, should) create money without interaction with other banks.
We did not, however, look at a third type of bank: the central bank. A central bank is, in practice, a hybrid institution. It is intended to serve as a bank of issue for commercial banks, and by default or through expedience usually serves as a bank of deposit for the State. In theory, a central bank need have no connection with the State at all, other than whatever charter is needed to assign the central bank the State's responsibility to regulate the currency and maintain ultimate State oversight of the task to ensure that contracts are kept and a level playing field is maintained. Again, in theory, a central bank can serve exclusively as a bank of issue for commercial banks, ensuring a uniform and stable currency and an adequate supply of money for the private sector, with the potential of allowing commercial banks to have 100% cash reserves behind all demand deposits and promissory notes.
Many people, notably Keynesians, Monetarists, and Austrians — anyone, in short, trapped within the paradigm of the British Currency School — confuse the distinction between a bank of deposit and a bank of issue. They therefore almost inevitably misunderstand the function of a central bank as a bank of issue for banks of issue. Properly run, a central bank should never create money except to purchase qualified loan paper from commercial banks in conformity with the real bills doctrine, thereby ensuring that the economy always has an adequate supply of money without inflation or deflation, the currency is uniform and always passes at par, and that the currency has a stable value.
Reserve requirements and how they function are another area of confusion for many people. To begin with, a commercial bank's notes and demand deposits are backed not by its cash reserves, but by the liens on the assets that the loans themselves financed. Reserves are there only to give added security, and to ensure that the bank's currency and demand deposits pass at par — that is, have the same value without a discount or premium — with all other currencies in the region.
In a perfect world, the only checks presented for payment at a commercial bank would be in payment of an outstanding loan. That, of course, is unrealistic. In the real world, vendors receiving checks and holders in due course, such as other commercial banks, expect to be able to exchange those checks for cash. Naturally, they cannot use their checks to redeem the loan obligations of the commercial bank, for they were not parties to the original transaction.
This requires that the commercial bank keep a certain percentage of assets on hand in the form of cash in order to redeem these checks. Ordinarily, not all of the checks drawn on the bank are presented at one time, any more than the full amount of demand deposits are expended at one time. Further, a significant proportion of the obligations of a commercial bank can be exchanged for those of other banks that the original bank collects in the course of business, while other obligations will be redeemed in the course of paying off loans. The demand for cash redemption for the obligations of a commercial bank are, consequently, relatively low compared to the total amount of obligations outstanding.
That being the case, a commercial bank only needs to hold a certain fraction of its assets in the form of cash or cash equivalents, for not all of the bank's obligations will be redeemed in cash at any one time. Instead, the commercial bank will redeem most of its own obligations by exchanging its own obligations for those of other commercial banks, or accept those obligations in payment of loans extended by the bank. This is the rationale of "fractional reserve banking."
Obviously, one danger of fractional reserve banking is that a commercial bank might be required to redeem a greater amount of its obligations than it has cash on hand. A commercial bank's assets are primarily in the form of loans it has made, and it cannot ordinarily hand those loans over to redeem one of its own promissory notes presented for redemption. Instead, a commercial bank that needs additional reserves can sell some of its loans to other commercial banks that have excess reserves, thereby keeping the bank liquid.
A central bank can serve as a clearinghouse for commercial banks buying and selling loans among themselves. This serves as a check against a "dirty trick" that Adam Smith relates in The Wealth of Nations, where a larger bank or a consortium would drive a competitor out of business either by refusing to purchase any of its loans, or (worse) by accumulating the competitor's promissory notes ("hold them back") and, when they had enough to exceed the competitor's stated reserves, present them all at one time for payment, forcing the competitor into bankruptcy.
A central bank has a far more important function than offering commercial banks limited clearinghouse services, however. A central bank, like the commercial bank, has the power to create money to purchase loans — but not from the public, only from commercial banks. (Again, this is the "pure theory." In practice, most central banks do have one customer other than commercial banks for which they can create money directly: the State. We'll see presently why this is a bad idea.)
If the demand for cash becomes too great for a commercial bank to handle with its existing reserves, the commercial bank can immediately discount (sell) some of its loans to the central bank, thereby securing whatever amount of reserves are required to prevent a run on the bank. In fractional reserve banking, a commercial bank doesn't have to turn all of its loans into cash immediately. It just has to have the ability to do so at need. Also (in theory) a commercial bank does not have to be bound by the artificial constraints of fractional reserve banking. If more reserves are needed, then the commercial bank need merely sell more of its loans to the central bank.
Thus, the idea of reserves is not to ensure that a commercial bank's promissory notes are backed by cash or government debt. The promissory notes are backed by liens on the assets financed by the loans made by the commercial bank. Reserves assure the holder in due course that he or she can use the promissory note to 1) redeem a loan obligation held by the issuing bank, 2) exchange the promissory note at face value within the community in trade, or 3) demand an equal amount of the official legal tender currency in exchange which necessarily passes at par with the commercial bank's promissory notes. A central bank is supposed to ensure that there will always be adequate reserves, and that those reserves are in the form of an asset-backed currency.
Unfortunately, what should be the case and what actually is the case are different things entirely. What often happens in more instances than not is that the State realizes it can force a central bank into creating money to cover the State's deficits. This gives the illusion that the State and the central bank can somehow create wealth out of nothing. It is a highly feasible political move as well, because when the State can print money at will, it does not need to impose direct taxation to raise funds, letting the hidden tax of inflation handle the unpleasant task of tax collection, with private sector merchants instead of the central government taking the blame for the rising price level. The currency — and, of course, all cash and cash equivalent reserves — gradually (or quickly, depending on the greed or incompetence of the politicians) becomes backed by government debt instead of hard, private sector assets.
Reserves, however, must be in a form in which the public has full confidence. Traditionally this has been specie — gold and silver. Since the First World War, however, reserves have usually been in the form of promissory notes issued by a central bank and backed by government debt ("cash"), or government debt itself ("government securities"). As long as the issuing government is stable and has the power to collect taxes in the future to make good on its debt, the public will have confidence in the legal tender promissory notes and the government debt. As soon as people no longer have confidence in the government (such as when the government issues more promissory notes than the tax base can support), the currency — and the government — usually collapses.
The State must then take steps to reestablish a sound currency. Usually this is a two-step process: 1) restore reserves in the form of hard assets of some kind (again, gold and silver are usually preferred because most people are convinced they have a stable value), and 2) guarantee convertibility at par (face value) of the State's official legal tender promissory notes with the reserve currency. The reserve currency does not, however, need to be in the form of gold or silver. It is only necessary that the reserve currency represent hard assets with a value determined by the present value of existing and future production, not government debt.
Obviously, fractional cash reserves are, in a sense, a form of insurance. As such, there does not need to be 100% coverage, for there is rarely, if ever, a 100% demand to convert a commercial bank's promissory notes into the official legal tender currency. The problem of fractional reserve requirements, however, is that is puts an artificial and rather arbitrary (politically determined) limit on how many loans a commercial bank can make — regardless of the number of feasible projects that might be brought to the bank for financing. In a fractional reserve system, a commercial bank cannot make loans in excess of the reserve requirement.
Still, reserve requirements are a good idea — and one of the main reasons for having a central banking system or, if you prefer the more descriptive name of the institution in the United States, a reserve system to provide, if necessary, any amount of cash reserves at need. As the Federal Reserve System was designed to operate in the United States, a commercial bank had to keep a reasonable amount of reserves on hand in the form of cash or government securities. A commercial bank in need of additional reserves could either "rent" excess reserves on deposit at the Federal Reserve, or discount some of its loans directly to the Federal Reserve and increase its reserves that way.
There is an almost inevitable political problem, however, with establishing a central bank. It is virtually impossible for a central bank to obtain a charter unless it agrees to serve as the State's primary or sole banking facility. This can be beneficial, for such a provision usually means that the promissory notes and demand deposits issued by the central bank are backed by the full faith and credit of the State, and it becomes in the State's best interest not to debauch the currency or borrow beyond its immediate ability to repay within the current period.
More often, however, using the central bank as the State's exclusive or primary banking facility is the fast track to economic and financial perdition. Giving the State the keys to a money machine — or what the powers-that-be have the tendency to think is a money machine — is almost invariably a disaster. As Henry C. Adams pointed out in Public Debts: An Essay in the Science of Finance (1898),
As self-government was secured through a struggle for mastery over the public purse, so must it be maintained through the exercise by the people of complete control over public expenditure. Money is the vital principle of the body politic; the public treasury is the heart of the state; control over public supplies means control over public affairs. Any method of procedure, therefore, by which a public servant can veil the true meaning of his acts, or which allows the government to enter upon any great enterprise without bringing the fact fairly to the knowledge of the public, must work against the realization of the constitutional idea. This is exactly the state of affairs introduced by a free use of public credit. Under ordinary circumstances, popular attention can not be drawn to public acts, except they touch the pocket of the voters through an increase in taxes; and it follows that a government whose expenditures are met by resort to loans may, for a time, administer affairs independently of those who must finally settle the account. (Public Debts, An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 22-23.)This is why including government securities in the definition of reserves causes serious problems. It opens up a back door by means of which the State can, to all intents and purposes, print money at will. This is because in order to regulate reserve requirements of commercial banks, the central bank has to be able to buy and sell secondary government securities, that is, government securities that were sold by the treasury of the country to the public.
Thus, even if the central bank is strictly prohibited from dealing in primary government securities — that is, securities sold by the treasury of the country directly to the central bank — a government can circumvent this prohibition by passing the securities through the hands of intermediaries for a microsecond, creating an extremely lucrative "triangle trade" in government debt for a few chosen individuals instead of monetizing deficits directly, transforming primary securities into secondary securities by sleight-of-hand.
The ease with which governments can hijack the purpose of a central bank and divert it to its own purposes argues a serious need for fundamental systemic reform. That is, the situation is ripe for acts of social justice directed at reforming the institution to conform more closely to the demands of the common good. Like the State itself, a central bank is a tool. If it is used in a manner contrary to the common good of all humanity, that is, the central bank works to inhibit or prevent the acquisition and development of virtue by the great mass of people, it must be reformed so that it serves its original purpose.