THE Global Justice Movement Website

THE Global Justice Movement Website
This is the "Global Justice Movement" (dot org) we refer to in the title of this blog.

Wednesday, May 26, 2010

Out of the Depths, Part I: An Introduction to Money and Banking

No one in his day understood the principles of sound paper currency, credit, and banking better than he — and no one managed to cause more trouble through the misapplication of those same principles. Truth be told, however, much of the opprobrium or praise heaped upon John Law depends on our understanding of money itself. (The basic outline of John Law's career is taken from Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds. New York: Farrar, Straus and Giroux, 1932, a fairly objective account of the events surrounding the "Mississippi Bubble.")

What is "Money"?

Despite all the mystery piled onto the concept of money, it is a very simple thing to understand. "Money" is anything that can be used in settlement of a debt. ("Money," Black's Law Dictionary.) It can consist of coin, paper currency, bills of exchange, commercial paper — or anything else people will accept as a medium of exchange. That's it. The problem seems to be that money is so simple a thing that people just naturally have to make it more complicated.

Consequently, there is a wide variety of views on money, especially paper money, that wander rather aimlessly between two extremes. At one end of the spectrum are people who hold that all paper money, credit cards, checks, and so on, are bad, in and of themselves. The only real and lawful money is gold, silver, and (sometimes) copper and bronze, refined, weighed, and stamped by the government into coin of the realm.

At the other end of the spectrum we find the people who are of the opinion that official State-issued paper currency is the only lawful money. People who hold this position claim that the best way to supply the nation with money is to have the government print and spend it into circulation, backed by the general wealth of the country. This is a particularly easy method, by the way, of transferring wealth from current owners, to issuers and holders of the newly issued currency.

Anyone familiar with basic principles of sovereignty that underpin western civilization will instantly see the problem. Backing the currency — often erroneously construed as the whole of the money supply — with the general wealth of the economy assumes as a given that the State has some kind of claim on that wealth. That is, the State is the ultimate owner of everything that exists. This is because money is a derivative of wealth, a symbol, a means of conveying a property right. (Irving Fisher, The Purchasing Power of Money. New York: Macmillan, 1931, 4.) The issuer must, therefore, have ownership of whatever it is that backs the money he, she, or it issues. To issue money that is not backed by anything owned directly by the issuer is theft.

Thus, defining "money" as limited to that which is issued or authorized by the State, and backed only by the State's promise to pay is the same as saying that the State is the universal owner of everything. This is the claim made by Thomas Hobbes in Leviathan. That is, a subject only holds what he or she owns against other subjects. Against the ruler, the subject is absolutely helpless. (Leviathan, II.29.) This is a basic tenet of the divine right of kings as well as socialism. It is the antithesis of democracy, to say nothing of abolishing private property to all intents and purposes. (Vide Karl Marx and Friedrich Engels, The Communist Manifesto. London: Penguin Books, 1967, 96.)

True Principles of Money and Credit

Principles of sound money and credit lie beyond these extremes. It isn't necessary, for instance, as the "gold bugs" maintain, for a currency to be the actual asset that it represents or in terms of which it is valued or measured. Nor is it a good idea to issue inconvertible currency with no direct tie to specific assets, as the populist position often advocates. That would destroy the institution of private property as effectively as direct confiscation by the State. As long as the present value of existing or future marketable goods and services stands behind a paper or token currency, however, it will generally be sound.

Thus, a gold or silver currency or paper backed 100% with gold or silver is perfectly acceptable as long as any increase or decrease in the gold and silver supply matches the present value of existing and future marketable goods and services in the economy. The Spanish discovered the falsity of the illusion that gold and silver are automatically sound money when the flood of precious metals came in from the New World after the discovery of America. The abundance of specie (gold and silver) caused a 400% inflation rate in the 16th and 17th centuries. (Sir Archibald Alison, cited by Norman Angell, The Story of Money. New York: Frederick A. Stokes Company, 1929, 131. NB: Angell cited Alison to disparage the idea that the quantity of gold had any effect on the price level, and to dismiss the possibility that the simultaneous increase in gold and silver, and the quadrupling of the price level were in any way connected.)

At the other extreme, Germany's currency at the beginning of World War I was backed by gold, and commercial, industrial and agricultural paper rediscounted by commercial banks at the Reichsbank and convertible on demand to gold. Germany's currency was considered the soundest in Europe, and the financial system of the Second Reich, copied throughout Europe, provided the model for the United States Federal Reserve System. (Moulton, Financial Organization and the Economic System. New York: McGraw Hill Book Company, 1938, 343-344.) When Germany's domestic war debt came due after the war and reparation payments were made, however, the gold and productive-asset backing were removed and replaced with the government's mere promise to pay. This precipitated the disastrous hyperinflation of the 1920s.

With these examples in mind, the principles become clear. A sound currency requires backing by a private property claim on the present value of actual, existing assets or the present value of productive assets to be brought into existence with any newly created money. A stable currency requires that the financial institutions of an economy be structured in a way that allows proper management of the money supply. Anything that circulates as money — coin, paper currency, bills and notes (whatever is used to carry out transactions and settle debts) — must increase or decrease to match the present value of the assets that back the currency. Money is clearly a derivative of the present value of existing and future production of marketable goods and services.

Money, Currency, and Banks

"Money," however, is not simply currency. In fact, coin and currency typically make up the smaller part of the money supply. In Jacksonian America, Congressman George Tucker demonstrated that the bulk of the money supply in his day, possibly as much as 90% or more, was not in the form of coin or banknotes at all. (George Tucker, The Theory of Money and Banks Investigated. Boston, Massachusetts: Charles C. Little and James Brown, 1839.) Most money was in the form of bills of exchange and other credit instruments — "mercantile paper." By the first decade of the 21st century, this "non-currency" money, or money issued directly by individuals and businesses in the private sector, still accounted for approximately 60% of the money supply in the United States, even with the growing intrusion of the State into the economy. Most money does not "look" like what most people think of as money. The greater part of the money supply never sees the inside of a bank, or even goes near Wall Street.

Such "private sector money" generally requires that the two parties to a transaction have some basis for trusting each other, or the money will not be accepted. If the individual or institution that issues the pledge is trusted ("and Scrooge's name was good upon 'Change, for anything he chose to put his hand to" — Charles Dickens, A Christmas Carol, "Stave I."), no bank or State need ever get involved. A derivative issued by someone with good credit — a "real bill" — circulates as money as readily as the official currency.

If the parties to a transaction don't know or trust each other, however, or if one of the parties wants "cash money" right away, they can use the services of a commercial bank. A commercial bank is a type of "bank of issue." A bank of issue operates in accordance with the "real bills doctrine." The real bills doctrine is that the money supply can be increased or decreased without inflation or deflation as long as the increase or decrease in the money supply matches the increase or decrease of the present value of existing and future marketable goods and services in the economy. Instead of dealing directly, the parties use the bank to intermediate the transaction, substituting the established faith and credit of the bank for that of the two parties. For providing this service the bank takes a fee, or "discounts" the paper. A bill can generally be rediscounted any number of times before the due date, at which time it must be presented to the issuer for redemption.

Sometimes these private promises circulate even more readily than official currency, if the State's credit is bad. This was the case during the hyperinflation in Germany, Austria, and Hungary following the First World War. Unofficial privately issued tokens called Kriegsgeld and Notgeld took over much of the burden from the grossly inflated official currency for daily transactions (Courtney L. Coffing, A Guide and Checklist of World Notgeld, 1914-1947, and Other Local Issue Emergency Monies. Iola, Wisconsin: Krause Publications, 1988), while real bills denominated in quantities of goods or foreign currencies instead of the national currency were used between individuals, businesses, and internationally for larger transactions.

Having a recognized and presumably secure value, such pledges can be transferred from individual to individual, or from institution to institution (discounted and rediscounted), until they mature and can be redeemed for the marketable goods or services that backed them. As we saw, to provide ready cash for someone's or something's daily transactions demand for cash, an individual or a business can take such a pledge to a financial institution and discount (sell) it to a financial institution. This is the function of a commercial bank. "Currency" is thus a derivative of money, which is itself a derivative of the present value of existing or future marketable goods and services.

Banking Operations

Formerly, a commercial bank would purchase — "discount" — a bill by creating a demand deposit or printing banknotes — issuing promissory notes. The commercial bank was also known as a "bank of circulation" (which means the same as "bank of issue"), when it issued banknotes instead of being restricted to creating demand deposits. The commercial bank would secure (back) the demand deposit or banknote by taking a lien on the present value of the marketable goods or services that the real bill represented.

Today, commercial banks in the United States and just about everywhere else no longer have the right to issue banknotes, although they are still technically classified as banks of issue. (Vide Charles A. Conant, A History of Modern Banks of Issue. New York: G. P. Putnam's Sons, 1927.) Commercial banks carry out their business through the creation of demand deposits, backed by a lien on the present value of an existing or future marketable good or service and secured by collateral to insure the loan. (Vide John Fullarton, On the Regulation of the Currencies of the Bank of England. London: John Murray, 1845, 29.)

As the system currently operates, a commercial bank cannot extend loans beyond the restrictions imposed by the reserve requirement, regardless how good or how bad the real bill presented for discounting may be. This unnecessarily ties new capital formation to existing accumulations of savings held as reserves. If, for example, the reserve requirement is 20%, the bank must maintain reserves of twenty cents for every dollar in loans. In the United States, these reserves can be in the form of vault cash, demand deposits at the Federal Reserve, or government securities. If a bank needs additional reserves due to the amount of loans it has made, it can either borrow reserves from other commercial banks through the Federal Reserve, or borrow directly from the Federal Reserve itself.

At one time, as provided in the Federal Reserve Act of 1913, a commercial bank in need of reserves could "rediscount" real bills at the regional Federal Reserve Bank. The Federal Reserve Bank would create a demand deposit or issue banknotes to purchase the real bill. This would provide the country with an "elastic" or "flexible" currency that would expand and contract in concert with the present value of marketable goods and services in the economy. (Moulton, Financial Organization and the Economic System, op. cit, 368-374.) If the reserve requirement were 100%, all loans would have to be immediately discounted at the central bank in order to meet the reserve requirement. The quantity of money in the economy would be determined by the level of trade, that is by the actual needs of the economy, not a politician's guess as to how much might be needed artificially to "stimulate" economic growth — or hold it back.

The main difficulty with a managed currency is to structure the financial system in such a way that the money supply is both adequate and stable. In the late 17th century, John Law applied himself to the problem of providing an adequate and stable currency for a country. As a result of his experience in banking and his research, he thought he had discovered a way to provide a permanent, stable currency for a nation and, at the same time, solve the chronic problem of deflation that troubled Europe from the 17th through the 19th centuries. As Conant noted,
Scotland, which gave to the world the founder of the classical school of political economy in Adam Smith, was also the birthplace of Law, the author of "the System" which introduced the use of negotiable securities on a broad scale into France. The name of Law has been synonymous with the most reckless speculation and brazen fraud, but the bank which he founded was at the outset conducted upon conservative principles, and even the system of the "Company of the West" (Compagnie d' Occident), more generally known as the Mississippi Company, was conceived upon broad and not impossible lines before the stock was made the plaything of speculation. (Conant, op. cit., 32-33.)
Scotland and the Development of Issue Banking

Scots coinage under the Stuarts at the end of the 17th and beginning of the 18th century accurately reflected the monetary chaos plaguing most of Europe. Although the same head of State ruled England and Scotland, they had different governments and monetary systems. The currency system in Scotland was a curious amalgam of continental and English denominations. A brief survey reveals Merks (Marks), Pistoles (gold coins that were originally Spanish, but widely adopted in a number of German states), the Dollar and its fractional parts, and Pence and Shillings. (Peter Seaby and P. Frank Purvey, Standard Catalogue of British Coins, Volume 2: Coins of Scotland Ireland & the Islands (Jersey, Guernsey, Man & Lundy). London: Seaby, 1984, 79-90.) This remarkable mixture was probably the result of both cultural and political ties with France ("the Auld Alliance") that were frequently closer than those with England, a traditional enemy. Scots society and institutions would thus tend more toward continental models than English.

Regardless of the variety of denominations, however, Scots coinage was insufficient for the needs of commerce. This was the driving force behind the development of the Scots land bank concept — the need to supply commerce and industry with the tools to carry out economic activity: money and credit. The key to understanding a monetary system is to realize that government, per se, does not "create" money.

Traditionally, with a specie currency the State purchases precious metal and forms it into coin at full metal value as a public service, sometimes minus a small percentage known as "agio" or "seniorage" to cover the costs of minting. ("Free coinage" does not mean that the State turns bullion into coin free of charge, but that an individual can have as much bullion as he wishes turned into coin, without limit.) As every coin collector and financial historian knows, however, it wasn't long before governments discovered the delightful possibilities inherent in putting substantially less than the full value of precious metal into a coin. This gives the illusion of a profit generated on every coin.

There is no genuine profit, however. What happens is a transfer of value from the erstwhile possessors of currency-denominated wealth (usually the poor and middle class) to the issuer of the currency that always occurs with inflation. Even today governments adhere to the myth that the difference between the face value of a unit of currency and what it costs to produce the currency represents a profit. Not so. Seniorage sets up a liability that should be redeemed for the value represented on the face of the currency at the time it was issued, or there will be an "inflation tax" levied on the citizens of the country and all users of the currency.

Fortunately, the Scottish banks understood this concept, at least with respect to paper money. They did not make the mistake of assuming that they were somehow increasing wealth by the mere fact of printing currency. Otherwise, Scotland and the rest of Europe would have experienced much worse deflationary/inflationary swings than they already had due to a lack of sufficient sound currency.

Issue Banking

The basic theory behind a "Bank of Issue" (or "Bank of Circulation"), as a financial institution that issues promissory notes and emits banknotes is called, is relatively simple. Someone with a financially feasible project comes forward to obtain a loan to float the enterprise. He could, of course, as some people do now with "regional currencies," go around and convince everyone in the community to accept what amounts to his note of hand — his IOUs. That would be difficult, however. The arrangement would have to include whatever laborers he hired, partners, suppliers, customers, and anyone engaged in commercial activity in the area where his notes might circulate. Such a private system falls apart the first time anyone refuses to accept the notes in payment of a debt.

It is much easier for an individual who requires financing to go to a bank of issue, most familiar to us today in the form of a commercial bank. Today's issue banks do not typically print banknotes, however — although two Scottish banks still retain the privilege. Instead, commercial banks issue promissory notes and create demand deposits, which serve the same purpose.

The loan officers of the issue bank presumably subject the loan request to the necessary "due diligence." If all requirements of a sound loan are met, the bank prints the currency and hands it over to the borrower. The bank takes a note as security and backing for the newly printed currency. What happens is that the bank takes the individual purchasing power of the projector (as entrepreneurs used to be called), and "generalizes" it so that it can pass current wherever the bank's promissory notes are accepted in commerce. The bank instead of the individual stands behind the IOU. This presumably makes the promissory note more secure and safer to accept in a transaction.

Any charge on the loan represents the bank's profit for performing this service plus a "risk premium" for the bank's self-insurance for bad loans. Agio is the same principle applied to coinage. As a public institution, of course, a mint should never show a profit as a result of carrying out its primary function of supplying metallic currency. Any such profit is, as noted above, just an inflationary tax on anyone who accepts the coin at face value at the time of issue.

As the loan is repaid, ideally in notes drawn on the issuing bank, the bank receives back its own notes, its "generalized IOUs," and destroys them. Thus, in the best situation, this creates a stable, asset-backed currency that expands and contracts as needed to supply the needs of commerce. (The potential for abuse, however, should be obvious to anyone familiar with the experience of the United States with "wildcat banking" before the National Bank Act of 1864.) The Scottish land banks accepted only land as security for the loans they made and as backing for the currency they printed. They thus linked the issuance of new money to what they perceived to be the most solid and secure productive asset in existence, although a severely limited one. As everyone knows, "they" aren't making any more of it.

Sometimes the returned notes were held in the bank until someone with a financially feasible project requested another loan, eliminating the necessity and expense of printing additional banknotes. Most banknotes, however, were usually canceled. This makes acquisition of specimens of such early paper currency extremely difficult. Evidence of a successful and well-managed paper currency is represented by the fact that few specimens remain. Either they were canceled and destroyed, or worn out in circulation, returned and replaced with new notes, and destroyed. In general, only poorly managed or worthless early paper currency is readily available to students and collectors.

#30#