Obscuring Unpopular Truth
Why Macleod's theories remain obscure to this day is easy to understand — and it has nothing to do with the validity of his theories. He was a Scot, writing about economics and finance in a United Kingdom dominated by the Currency School and its crowning achievement, Sir Robert Peel's Bank Charter Act of 1844. He was also not the most facile writer. His books are probably unnecessary verbose, getting into the thousands of pages for ideas that probably could have been handled in much less space. As an adherent of the British Banking School (below), the public was not conditioned to accept his ideas, despite the inherently more egalitarian orientation of the Banking School than that which characterized the Currency School.
Consequently, using a tactic that was later employed against the Binary Economics of Louis Kelso and Mortimer Adler with indifferent success, the economics establishment was able to dismiss Macleod without actually having to do anything to disprove his ideas. As Joseph Schumpeter described the situation,
Many economists of the seventeenth and eighteenth centuries had had clear, if sometimes exaggerated, ideas about credit creation and its importance for industrial development. And these ideas had not entirely vanished. Nevertheless, the first — though not wholly successful — attempt at working out a systematic theory that fits the facts of bank credit adequately, which was made by Macleod, attracted little attention, still less favorable attention. (Joseph A. Schumpeter, History of Economic Analysis. New York: Oxford University Press, 1954, 1115.)As Schumpeter footnoted the above comment, "Henry Dunning Macleod (1821-1902) was an economist of many merits who somehow failed to achieve recognition, or even to be taken quite seriously, owing to his inability to put his many good ideas in a professionally acceptable form. Northing can be done in this book to make amends to him, beyond mentioning the three publications by which he laid the foundations of the modern theory of the subject under discussion, though what he really succeeded in doing was to discredit this theory for quite a time: The Theory and Practice of Banking, 1855, Lectures on Credit and Banking, 1882; The Theory of Credit, 1889-91."
Evidently the spite exhibited by academic economists is not a recent phenomenon. (In this context the refusal of both Milton Friedman and Paul Samuelson to give serious consideration to the theories of Kelso and Adler are worthy — if that is the word we want — of note.) Macleod's revolutionary theory was that the idea of money developed out of credit, not the other way around. As we saw in the discussion on the real bills doctrine, this is obviously based on an application of Say's Law of Markets. (Say, Letters to Malthus, loc. cit.)
The Origin of Money
Not surprisingly, once we accept the possibility that "money" developed out of credit instead of vice versa, a great many otherwise difficult questions become easy to solve. Two questions head the list. One, there is the problem of matching the money supply to the quantity of goods and services offered in the market. Two, the problem of ensuring that the promise retains its value, that is, the value of the promise remains stable and sound.
Credit is simply the capacity to make and keep promises to deliver something of value — convey a property right — on demand or at some specified time. If what we promise to deliver — a marketable good or service — is backed by the ability to deliver that which we promised, then our credit is good. If anyone who produces a marketable good or service has the power to promise to deliver that which he or she produces, then there will always be sufficient credit to take care of all transactions and the credit will have a stable value.
Coined money, that is, lumps of gold and silver stamped by an authority that people trust, fills the need for a convenient form of credit that serves the needs of a limited economy more or less adequately. That is, specie (gold and silver) fills this role adequately, or at least as long as economic growth and the supply of gold and silver expand and contract more or less together. Usually this describes an economy in the primitive stages of development in which human labor is the predominant factor of production.
Coined money, however, although it appeared at roughly the same time in the west and the east, was a relative latecomer on the scene. Once we know what to look for — credit instruments — we find that money in the form of negotiable instruments was a regular feature of civilization centuries before the appearance of the first coin. Dating from before the days of the construction of the pyramids until well into Roman times, for example, a huge amount of papyri — written records — from Egypt involve agreements that can loosely be categorized as bills of exchange. A bill of exchange is a contract conveying a property right in the present value of a marketable good or service, broadly, a promissory obligation for the payment of money. ("Bill," Black's Law Dictionary. St. Paul, Minnesota: West Publishing Company, 1951.)
These documents are so numerous, in fact, that some Egyptologists who are unaware of the wealth of detail such documents convey about everyday life have been known to complain about the volume of material. Yet, "Literary papyri, whether representing lost or extant works, of course form but a fraction of what has been found." (Vide A. S. Hunt and C. C. Edgar, translators, Select Papyri in Three Volumes, I: Non-Literary Papyri, Private Affairs. Cambridge, Massachusetts: Harvard University Press, 1988, x-xiii.)
Nor was ancient Egypt an isolated case. Possibly as early as three thousand years ago, Assyria had a well-developed system of commercial instruments. These included many of the modern forms, such as promissory notes, bills of exchange, and transfer checks. (Conant, op. cit., 1.) (In a sense, all negotiable instruments are different forms of bills of exchange, including coined money, which presumably carries the commodity being conveyed along with the bill itself.) As this was before coined money, the instruments usually stipulated payment in terms of commodities, but that does not make them any less money: anything that can be used in settlement of a debt.
The Role and Function of Issue Banking
It was only after the invention of coined money c. 700 BC that what most people think of as banks came into being. When wealth was in the form of commodities or livestock, "savings" was, essentially, a meaningless term as there was no difference in the wealth and the form in which it was usually conveyed. "Interest" on someone's "savings" consisted almost exclusively of the natural increase from, say, one's herd of cattle — the most common form of more-or-less portable wealth, and thus currency, before the invention of coinage.
There are two basic types of bank, "banks of deposit" and "banks of issue." We mentioned banks of deposit in passing in Part II of this series. A bank of deposit is what most people think of as a bank. It is a financial institution that takes deposits and makes loans. A bank of deposit cannot make loans in any amount greater than its deposits.
A bank of issue is different. A bank of issue is defined as a financial institution that takes deposits, makes loans — and issues promissory notes. As we mentioned in the previous posting, that means that a bank of issue has the power to create money. More accurately, a bank of issue has the power to "monetize" the present value of existing or future marketable goods and services.
A bank of issue does this by taking a borrower's particular purchasing power based on a bill drawn by the borrower and backed by the borrower's private property stake in that present value. The bank changes this individual purchasing power of the borrower into general purchasing power of the bank. Rather than individual purchasing power backed by a possibly unknown individual, the general purchasing power is backed by the bank's presumably good name and a lien that the bank takes on the present value of existing and future marketable goods and services the borrower brings to the bank for monetization.
The procedure is (relatively) simple. The borrower draws a bill backed by the present value of existing or future marketable goods and services in which the borrower has a private property stake. There are a number of ways to do this. When a private individual draws a bill, he or she does not necessarily need the intermediation of a financial institution, especially if other private individuals or businesses will accept the bill based on the credit worthiness of the private issuer. Despite the fact that this can be done without a bank being involved, such a bill is just as much money as any coin, banknote, or check drawn on a demand deposit. (Fullarton, Regulation of the Currencies of the Bank of England, op. cit., 28-30.) When such a bill circulates among private individuals and businesses, it is called a "merchant's acceptance."
When a bank is involved, such a bill is called a "banker's acceptance." This can get involved, but a borrower can draw a bill and take to a bank for replacement with a bank's promissory note, or the borrower and the bank can collaborate in the bank's issue of a promissory note without first drawing a bill, or any number of other mutually satisfactory arrangements.
Whatever the arrangement, the bank uses the promissory note to back a demand deposit or banknotes. The specific form is irrelevant and depends on whatever is most convenient, efficient, or legal. Both demand deposits and banknotes are equally "money," as all but the most rigid adherents of the Currency School now recognize. The borrower takes the banknotes or checkbook, and spends the money.
Presumably, the money is expended on something that will generate its own repayment in the future. This is the concept called "financial feasibility." Financial feasibility is the essence of Say's Law of Markets and the real bills doctrine. As a side comment, we should note that, in this context, the term "borrower" is not, strictly speaking, accurate. This is because all the "borrower" has done is exchange one form of purchasing power for another, but the term is in general use, and we do not (at present) have a better one.
As the project on which the purchasing power — "money" — has been expended generates a profit — "interest" — the borrower repays the general purchasing power, buying back the lien on the present value of his or her existing or future marketable goods and services. The money — the debt — is canceled as it is repaid, and the borrower regains full possession of the present value of the existing or future marketable goods and services he or she pledged to back the debt.
The Invention of Coined Money
When coined money came into use around 700 BC, there was a moderate leap forward and, ironically, a giant leap backwards. Daily transactions became easier to carry out, and it was easier to accumulate savings in the form of cash. While the first coins were privately issued, it soon became convenient for the State to take over the task of certifying that the lumps of precious metal were all to the same standard of weight and purity. This made it easier to trust the currency. Finally, the use of precious metals as currency made it clear that money as money is not a productive asset (capital), and that charging interest on a loan of money as money is a form of theft — "usury," or taking a profit when no profit has been made.
With the most easily recognized form of money being issued and certified by the State, however, many people became convinced that only the State has the right or even the ability to create money. As we have seen, of course, the only way the State can actually be said to create money is when the State owns the assets with the present value that backs the money — socialism.
The rise of coinage also gave birth to the illusion that money and credit were somehow different. Most credit instruments prior to coinage consisted of papyrus, clay, or parchment documents that clearly were different from the assets and the present value in which they conveyed an ownership interest. When precious metals became to be used as the fabric, however, a thing of value was conveyed along with the contract. The gold, silver, or electrum (a naturally occurring alloy of gold and silver) could be used as a medium of exchange and store of value, or melted down and used as precious metal, a valuable commodity in and of itself. This created the illusion that money as money has value instead of the true, derived value it has as a conveyance of the property right.
There was, however, a far more serious problem that rapidly arose. It soon became evident that with a State certification, less than the face value of gold or silver could be put into a coin. In and of itself this need not have been a problem. As with earlier credit instruments made of essentially worthless materials, it doesn't matter of what the fabric of the instrument consists, as long as when the instrument is presented for redemption, the full face value of the instrument at the time of issue is paid out.
Unfortunately, people somehow became convinced that the difference between the cost of the fabric plus the associated costs of manufacture less the face value — seniorage or agio — represents a profit to the issuer. If we stop to think about it for a moment, however, we realize that the difference between the face value of the credit instrument and the cost of producing the credit instrument is not a profit, but a liability on which the issuer must make good or be guilty of theft. The cost of creating the instrument is an expense — no one disagrees about that — but it is not an expense that can be subtracted from the present value conveyed in the instrument. Rather, the cost of drawing the instrument must be added to the present value conveyed.
We see this best in the practice of discounting and rediscounting credit instruments. As we have seen, when a bill is drawn for, say, $100,000, the value conveyed at the time of creation is less a discount to compensate the holder in due course for accepting and holding it. Thus, an instrument with a face or maturity value of $100,000 will be discounted for $98,000, assuming a 2% discount rate. If held to maturity and presented to the issuer for redemption, the $2,000 represents a profit to the holder in due course, not to the issuer. The issuer must make good not the $98,000 of value he or she conveyed at the time the instrument was created, but the full face value of $100,000.
Thus, a State that issues a dollar that costs 98¢ to produce and puts it into circulation at a full dollar does not make 2¢ profit. The State does not redeem dollars for 98¢ — at least not legitimately. By booking the 2¢ as a profit, however, the State might as well have officially depreciated the currency by 2%. This is because taking the agio or seniorage as a profit and spending it means that the State has created unbacked currency of 2¢ for every dollar put into circulation at 98¢, which 2¢ is then "stolen" from all other units of currency, inflating the value.
This of course does not stop States from booking agio as a profit and spending it. Any means by which a politician can evade his or her accountability to the citizens will generally be adopted without a second thought. (Vide Henry C. Adams, Public Debts: An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 22-23.) This is so prevalent, especially under Keynesian economics, that one noted Keynesian — Nobel Laureate Paul Samuelson — is alleged to have called the issuance of unbacked currency by the State "legal counterfeiting." This does not make it any less theft.
The Development of Post-Coinage Banking
As a result of failing to understand coined money as a credit instrument in the same way as any other credit instrument, banking regressed dramatically. For the next several centuries and even down to the present day, to the public at large, "banking" meant deposit banking, not issue banking. Thus, even though Assyria and Babylon had systems of commercial credit, (Conant, op. cit., 1-2.) Greece and Rome were less sophisticated, although subject to more regulation by the State. Banks began dealing almost exclusively with instruments conveying existing accumulations of savings (Ibid., 2-6.), although there was limited dealing in bills of exchange by the Roman "argentarii," or "silver dealers."
The Roman system survived the transformation of the Empire from the classical period to the Middle Ages. The great decrease in commercial activity during the Middle Ages and the consequent diminution of accumulations of portable wealth (i.e., wealth not in the form of land or fixtures) resulted in a narrowing of people's understanding of wealth, and a shift in the idea of "savings." The popular understanding of "savings" moved from equaling all investment to being hoards of coined gold and silver taken out of the channels of commerce and no longer filling their proper and intended role of circulating media (mostly silver, as gold was not a widely-used coinage metal in the west until the 14th century (Karl Helfferich, Money. New York: The Adelphi Company, 1927, 115-146; Conant, op. cit., 6.)
Consequently, moneychangers took over what was virtually the sole remaining function of banks. Moneychangers became de facto deposit bankers holding and lending existing accumulations of savings for consumption purposes, instead of commercial bankers facilitating investment in new capital formation and mercantile endeavors. This situation was prevalent in the west, in the Byzantine Empire, and throughout the Muslim hegemony and in India. (Conant, op. cit., 6-8.)
China may have retained or been developing some vestiges of commercial banking, but available sources are not clear on this. The issue of paper money seems to have been a way for the State to monetize its deficits, not for people engaged in trade and production to meet the needs of commerce and industry. (Norman Angell, The Story of Money. New York: Frederick A. Stokes Company, 1929, 81; Jack Weatherford, The History of Money. New York: Three Rivers Press, 1997, 125-129; Jonathan Williams, Money: A History. New York: St. Martin's Press, 1997, 149-150, 177.) The Muslim hegemony experimented with paper money on the Chinese model but, again, this appears to have been an attempt to finance State operations with debt, not to provide liquidity for productive activity. (Williams, op. cit., 101.)
In the west, the moneylenders gradually began implementing rudimentary commercial banking through the use of bills of exchange backed by fractional instead of full reserves of coin. This was not true commercial banking, for the bills of exchange were not backed by the present value of existing or future marketable goods and services or capital projects (most such loans being made for consumption or to government), but by the collateral offered by the borrower. (Conant, op. cit., 6-8.)
What we recognize as "banking" preceded the name. The first "bank" so-called was established in the Venetian Republic late in the 12th century to facilitate dealings in bills of exchange, not to make loans. (Hildreth, op. cit., 5.) This, however, was still a bank of deposit, not a commercial bank, strictly speaking. A true commercial bank has the power to create money in the form of bills of exchange and other credit instruments and backed by the present value of existing and future marketable goods and services. A commercial bank does not act as an investment bank (a type of deposit bank) and deal in bills of exchange as a commodity. A commercial bank is properly a type of bank of issue or circulation. This was the case even with the Fuggers, (Richard Ehrenberg, Capital & Finance in the Age of the Renaissance: A Study of the Fuggers and Their Connections. New York: Harcourt, Brace, 1928) the great Renaissance financiering family that virtually ruled non-Jewish banking in the 15th through 17th centuries.
The Fuggers, to stay in the good graces of both Church and State, avoided both creating money and lending at usury except for the tolerated loans to the State. (Summa, IIa IIae, q. 78, a. 1.3. The language of Aquinas makes it abundantly clear that it is expedient, not lawful, to lend money to the State if refusing to lend would cause the State to be unable to carry out its proper role and function as guardian of the common good. Profit itself being a good and not objectively evil, taking a profit in this instance is allowed. This is both in order to permit the State to carry out its function and safeguard the common good (a very great good indeed, for the common good is the network of institutions within which human beings ordinarily acquire and develop virtue, and so fit themselves for their proper end), and to give an incentive to people to lend to the State.
The Bank of Amsterdam, established in the early 17th century, was restricted to dealing in bills of exchange in order to regulate the currency and facilitate trade, not make loans for commerce. (Hildreth, op. cit., 7-11.) The Bank of England, chartered in 1694, is generally considered the first modern bank of issue, as well as the first true central bank. In both capacities the Bank created money by discounting instead of accumulating existing savings and loaning them out. As one authority stated, "The Bank of England, first chartered in 1694, is the prototype and grand exemplar of all our modern banks." (Ibid., 11.)
The Federal Reserve
As we saw in the previous posting, the U.S. Federal Reserve System was established in 1913 for the purpose of providing an "elastic" currency to ensure that there was always enough liquidity in the private sector to meet the needs of industry, agriculture, and commerce. Both the long debates in the House and the Senate (the documentation of which and the testimony was more voluminous than anything since the founding of the United States) and the wording of the Federal Reserve Act of 1913 make it evident that the Federal Reserve was to fill two critical needs.
One (and most immediate), the Panic of 1907 had finally awakened the authorities to the fact that commercial banks in the United States could no longer be expected to function without a central bank that operated as a public institution on which to draw for emergency reserves. The National Bank system established in 1863 was composed of a network of autonomous, privately owned institutions, and could not be required to assist another bank that got into trouble. A central bank on the other hand could, in the public interest, be required to provide emergency reserves.
Two, the Panic of 1893 had made it equally clear that, while the bulk of business involving industry, commerce, and agriculture could and would continue to be carried on by means of privately issued bills of exchange in high denomination, it was neither advisable nor financially feasible to continue using gold coin supplemented with National Bank Notes and a subsidiary silver coinage as the currency for day-to-day transactions. The National Bank Notes were backed by government debt, and — gold being relatively fixed in quantity — the amount of currency in circulation could not be increased at need without increasing unproductive government spending.
Consequently, the Federal Reserve Act was intended to do four things:
• Oversee and regulate clearinghouse operations (i.e., transactions between private financial institutions),The vast bulk of the money supply would continue to be bills of exchange drawn by private sector businesses and discounted either at other businesses or, to a lesser degree, commercial banks. Consistent with Say's Law and the real bills doctrine, this would be money, but not currency, per se. Next would be commercial bank demand deposits at the Federal Reserve and Federal Reserve Notes. This was to be the "elastic" component of the currency, backed by liens on qualified industrial, commercial, and agricultural assets, and would expand and contract with the short-term needs of business. Finally, there would be gold coin and gold certificates, supplemented by the subsidiary silver coinage and silver certificates for daily transactions.
• Provide additional reserves as needed to commercial banks by rediscounting eligible paper directly from member banks and engaging in limited open market operations to rediscount eligible paper from non-member banks and individual businesses,
• Supply the country with an "elastic currency" that would expand and contract with the level of business and so avoid both inflation and deflation by rediscounting eligible paper, and
• Phase out the debt-backed National Bank Notes and replace them with asset-backed Federal Reserve Notes.
For the first time in history, a government had acknowledged the reality of Say's Law of Markets and the real bills doctrine. By the terms of the Federal Reserve Act, the federal government recognized that "money" consists of anything that can be used in settlement of a debt, and is a derivative of the present value of existing and future marketable goods and services. As one authority remarked, "As Professor Beard suggests in 'The Rise of American Civilization' the Federal Reserve Act of 1913 represents the union of 'Jacksonian hopes' with 'financial propriety'." (Angell, The Story of Money, op. cit., 305-306.)
One deviation from "pure" pure credit theory that did not reflect the reality of financing capital formation or the monetization of existing or future marketable goods and services was that the discount rate and the other rates used by the Federal Reserve were to be set by the market. This would, presumably, prevent unfair competition with private savers and venture capitalists, and encourage commercial banks to go first to the private sector before having recourse to the discount powers or open market operations of the regional Federal Reserves, thereby unnecessarily expanding the money supply. The Federal Reserve was intended to be the lender of last resort for the private sector, and avoid monetizing government deficits.
The Federal Reserve Hijacked
Unfortunately, this more or less happy state of affairs did not last long. It turned out that there was an unintended loophole in the design of the system, through which what became the Keynesian past savings dogma could once again insert itself into monetary and fiscal policy. In order to retire the debt-backed National Bank Notes and replace them with Federal Reserve Bank Notes (indistinguishable in appearance from ordinary Federal Reserve Notes), the regional Federal Reserves had to be able to purchase the government securities that the National Banks had on deposit as backing for the National Bank Notes.
The idea was that as the National Bank Notes were retired, they would be replaced with Federal Reserve Bank Notes with which the Federal Reserve would purchase the government bonds held by the National Banks. Because this involved purchasing secondary bonds from the commercial banks instead of directly from the government, the transactions were carried out via open market operations, instead of the prohibited discounting of primary government securities. The Federal Reserve Bank Notes would thus also be debt-backed. The plan, however, was for the federal government to redeem the bonds gradually. By this means Regional Federal Reserve bank operations involving private sector assets would replace the government debt-backed Federal Reserve Bank Notes, with private-sector asset-backed Federal Reserve Notes.
The system operated this way for two years. Then came the need to finance the entry of the United States into the First World War. It being more politically prudent to borrow rather than raise taxes, the First Liberty Loan Drive drained available liquidity out of the economy. During the Second Liberty Loan Drive and the Victory Loan Drive, commercial banks purchased the bonds and then resold them to the Regional Federal Reserves — there was and remains no provision in the law for the direct sale of a bond from the federal government to a Federal Reserve bank in order to prevent the government from monetizing its deficits. The roundabout transactions, while in compliance with the letter of the law, violated the spirit.
Under the influence of Keynesian economics and its rejection of Say's Law and the real bills doctrine, most central banks in the world today do little or no rediscounting of private sector paper, even though this was the reason for the development of central banking. Instead, central banks engage almost exclusively in open market operations in secondary government securities to finance government deficits.
The question becomes how this situation, so opposed to sound money, credit, and banking, came to be regarded as normal.