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Wednesday, September 1, 2010

Say's Law of Markets, Part V: A Short History of Commercial Banking

As we saw in the first posting in this series, the trigger event that led to the triumph of the Currency School of finance — the basic tenet of which is the belief that only existing accumulations of savings can be used to finance new capital formation — was the "Last Invasion of England" in 1797. That is not to say, however, that the abortive raid into Wales by an undersized and untrained force of remarkably expendable French soldiers was the cause of the crisis. That honor is reserved for the widespread misunderstanding of money and credit that continues to pervade the world.

"Commercial Banking" Existed Before Banks

This misunderstanding is all the more remarkable in that what became basic banking theory antedates even the idea of banking, per se. Bills of exchange representing private property stakes in the present value of existing and future marketable goods and services functioned as money for millennia before coinage was even thought of. The question now is how we can get back on track. That, in turn, requires that we know how we got here in the first place.

We're not really interested in the history of Banks of Deposit for the purposes of this series. Banks of Deposit are institutions based on existing accumulations of savings. While not absolutely essential in an economy, like coined money and its substitutes Banks of Deposit make transactions infinitely more convenient and provide valuable intermediation services between savers and borrowers. A Bank of Deposit is legally defined as a financial institution that takes deposits and makes loans.

Our area of interest is the Bank of Issue, a financial institution that takes deposits, makes loans, and fills one invaluable, even irreplaceable role in any economy, regardless how primitive or sophisticated: it issues promissory notes. A promissory note is a written promise to pay a certain sum of money, at a future time, unconditionally. It can circulate in an economy on the strength of the credit of the maker, or can be a "negotiable" promissory note, requiring an indorsement every time it is transferred to a holder in due course.

A promissory note, which in broad terms is another form of bill of exchange, is therefore "money." If the community accepts the promissory notes of that maker as representing the value of the agreed-upon unit of value in the community, the promissory notes pass as current money or "currency."

Anyone with good credit can issue a promissory note, and value it in terms of anything that the community accepts as a unit of value. In many ancient economies, the unit of value was the cow. Even our terms "pecuniary" and "capital" come, respectively, from pecus, an archaic Latin word for cattle, and caput, referring to the head of a cow. Other societies have used other units of value, such as elephants in Ceylon, cocoa beans in Mexico, symbolic knives in China, and even human skulls in Borneo.

The promissory notes don't have to be cattle or human skulls, nor do they have to be convertible on demand into elephants or cocoa beans, any more than dollars have to be the quantity of gold or silver that the regulator of the currency has decided defines the value thereof. The only thing that is necessary for a promissory note to circulate as currency or, more restrictively, as money, is that the maker deliver something equal in value to the face value of the note, that is, the same value as the property right conveyed by the note, on demand or at the agreed-upon maturity date. What is delivered does not have to be the standard of value. It just has to have the same value.

The Evolution of Trade

Reduced to the simplest possible terms, commercial banks were established 1) to facilitate (intermediate) transactions involving bills of exchange between merchants, thereby adding a degree of confidence to the transaction by substituting the bank's creditworthiness for that of the original issuer of the bills, and 2) convert high denomination bills of exchange into low denomination bills of exchange (usually in the form of banknotes, a type of non-interest bearing promissory note), thereby providing the economy with a currency backed by the bank's creditworthiness suitable for day-to-day transactions.

Dealing in bills of exchange never completely ceased, although the practice was partially eclipsed by the invention of coined money and the spread of gold and silver as the usual standard of value. It wasn't until the late Middle Ages and the rise of the great trade fairs in Europe that bills of exchange once again began to come into their own. Somewhat ironically, although bills of exchange preceded coined money and were far more important than coined money as the medium of exchange once trade began to expand beyond local markets, bills tended to be denominated in units of coined money, although rarely redeemable in coined money.

For example, a bill of exchange might be drawn (issued) to be redeemed by the maker in ninety days from the date of issue "in woolen cloth to the value of twenty pounds of silver, weight of Troyes." "Troy weight" was commonly used, as the trade fair of Troyes in France was the largest of the four great trade fairs of Champagne considered responsible for reviving France economically in the Middle Ages. (If it weren't for the fact that sparkling wines weren't considered desirable until the 17th century, we'd be tempted to think that champagne wine became associated with celebrations because of the good business deals struck and the benefits that accrued to society.)

The bill would be presented to the maker, but neither the maker nor the holder in due course would expect to pay out or receive £20 of silver, Troy weight or otherwise, but the specified woolens — to the value of £20. The silver didn't even have to exist in that amount, or at all. What had to exist was woolen cloth to the value of £20 at the date of redemption — the value of an ounce of silver at Troyes was simply a convenient, commonly accepted (standard) way of measuring the value of a transaction. Consistent with Say's Law, the parties to the transaction weren't trading in silver, but in woolen cloth, and whatever the holder in due course of the bill had produced and delivered to the one who had discounted the bill with him or her. Silver was just the standard of value.

This was perhaps illustrated most graphically in the 17th and 18th century when, bankrupt from the wars of Gustavus Adolphus and drained of silver, Sweden issued gigantic "coins" containing the full value of pure copper denominated in silver. Large amounts of this "plate money" were exported as a commodity, but much served as the medium of exchange. Later, Sweden realized that the coin didn't have to contain copper to the value of the denomination in silver (any more than it had to contain the full value of silver), and issued copper tokens carrying the legend, "1 Daler S.M." or "One Daler (Dollar) Silver Money." If a holder in due course presented one of these tokens for redemption at a bank or at the Swedish mint, he or she would not receive a Daler in silver, but a warehouse receipt entitling the bearer to a pound or so of copper, a Daler per pound being about the price of copper in the late 17th and early 18th centuries. He or she couldn't get silver, because there wasn't any silver — but Sweden's currency for centuries had been silver, and it was the accepted standard of value.

People today have trouble accepting the fact that until the late 19th century coin and currency weren't particularly common. Credit instruments other than coin and currency were the primary media of exchange. A typical merchant might see coin or currency very rarely, especially away from a city. Customers would charge purchases, and settle up at harvest time or quarter day with goods that the merchant would either hold for resale, or factor to other merchants . . . for credit, that is, bills of exchange. Congressman George Tucker estimated that in the 1830s before Andrew Jackson's "Specie Circular" forbade the federal government to sell lands or accept payment of duties and taxes in anything other than gold or silver coin (and thereby threw the economy into a depression, "Hard Times"), bankers' acceptances exceeded the amount of gold and silver in the economy by a factor of 20 to one.

Nor did this include merchant's acceptances, or the smaller scale transactions carried out between merchants and consumers on the basis of credit and which were, essentially, small denomination bills of exchange. (Vide George Tucker, The Theory of Money and Banks Investigated. Boston, Massachusetts: Charles C. Little and James Brown, 1839.) Transactions might be valued in terms of gold or silver coin, but no one really expected actually to be able to convert his or her credit balances at the local store into gold or silver coin — which didn't exist for the most part in any event. Authorities estimate that from 1830 to 1857 there was less than one coin per person struck by the United States mint. Prior to the late 19th century there simply wasn't enough coin available in many cases to supply the needs of daily commerce.

Supplying the Nation with Money

Bills of exchange had always served to facilitate large transactions, and thus constituted the bulk of the money supply. Coin and currency were the medium of exchange for the much smaller, day-to-day transactions. It is the small, day-to-day transactions, however, that really drive an economy. Given, as Adam Smith pointed out, that the purpose of production is consumption, if ordinary consumers aren't buying, the economy eventually goes into a downturn, more or less rapidly as consumers lose purchasing power, whether through loss of jobs, confiscation of income through taxation, or induced inflation.

One source of loss of purchasing power is, ironically, a shortage of the medium of exchange. Within a system that applies Say's Law of Markets consistently in the real bills doctrine, this would be incomprehensible. If a merchant or a farmer has goods to sell, but is not selling them because there is a shortage of money, he or she can draw a bill on the present value of those goods and take the bill to a commercial bank for discounting. In Scotland, where there was a perennial shortage of gold and silver, the commercial banking system had rapidly developed into an extremely sophisticated social tool. Small denomination banknotes backed by discounted bills of exchange were very common.

According to conventional accounts, the most notable event in recent financial history was the establishment of the Bank of England in 1694. Originally the Bank was supposed to be nothing more than another privately owned commercial bank. While a typical commercial bank would discount bills of exchange from individual merchants, they generally would not offer accommodation to their competition: other commercial banks. The idea of the Bank of England, however, was a commercial bank that would discount and rediscount bills of exchange of other commercial banks as well as individual merchants — a bank for banks. Because it was intended to accommodate both banks and individual merchants, the Bank's capitalization was, in its day, enormous: £1.2 million in gold and silver.

A commercial bank gets its name from the fact that most of the bills of exchanged that were (and continue to be) discounted were "commercial paper," usually with a maturity date of 90 days — a quarter of a Julian year — from the date of issue. A commercial bank, of course, is not and never was restricted exclusively to commercial paper. Through its discounting power, a commercial bank can discount paper representing the present value of any sound and financially feasible capital project. It's just that the original commercial banks were established to offer accommodation to the short-term needs of commerce, and the name stuck.

The amount of capitalization of the Bank of England proved too great a temptation, and the government forced a loan as a condition of granting the Bank its charter. In addition to acquiring "government stock" as reserves for its banknotes, the Bank was granted other privileges, such as issuing banknotes, backed by gold or government debt. The end result was to convince many otherwise intelligent people that government debt (if kept within bounds) was as good as gold or other assets as the backing of the currency. History has demonstrated the falsity of this belief, but this has had virtually no effect on monetary and fiscal policy throughout the world.

The next step in the development of modern commercial banking came soon after. In the early 18th century John Law proposed that England consider alleviating its chronic shortage of currency by setting up a "land bank" to monetize the present value of land and use it as the backing of the currency. The proposal was rejected, but a few years later Law was able to convince the French Regent to permit the establishment of a development bank for Louisiana.

The idea was that the economic development of Louisiana would be financed by issuing banknotes backed by shares of stock in the Mississippi Company, the value of which were based on the presumed present value of the marketable goods and services to be produced in Louisiana. Unfortunately, as related in Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds (1841), the Regent somehow got it into his head that the notes issued by Law's bank were valuable in and of themselves, and he did not need to worry about production as long as he could increase effective demand by printing up vast quantities of banknotes. Naturally the program collapsed, although the Regent was able to blame Law for everything.

Fifty or so years later, Adam Smith explained the principles of Say's Law and its application in the real bills doctrine in the second book of The Wealth of Nations (1776) — being careful to point out where Law's program went wrong. Several improvements came about in the interim, such as the invention of the clearinghouse, which helped secure a reasonably solid foundation for the financial system.

Suspension of Convertibility

Then came the Last Invasion of England, and the suspension of convertibility of Bank of England notes into gold. The financial, commercial, and political establishments began a furious debate over the nature of money and credit and the proper administration of the financial system and the money supply. Two schools of thought on finance evolved that were later termed the British Currency School, and the British Banking School. The Currency School defined money solely as coin and banknotes backed by gold or government debt. The Banking School defined money as anything that could be used to settle a debt. The Banking School based its position on what became known as Say's Law of Markets, especially as applied in the real bills doctrine. For its part, the Currency School based its position on rejecting Say's Law and the real bills doctrine.

Making matters more complicated for today's economists and historians, both the Banking School and the Currency School were divided into the "Bullionists" and the "Anti-Bullionists." Bullionists insisted that banknotes must be convertible into gold on demand, because gold was the standard of value. Anti-Bullionists took the position that, even if the currency was measured in terms of gold, linking the money supply to the quantity of a commodity in fixed supply by maintaining convertibility unnecessarily shackled economic growth and development.

There were thus four major groups in the debate, all of which could agree on certain positions held by the other three groups, but none of which could reach agreement on fundamental principles. To make matters even more confusing for today's commentators, many economists and historians equate the Bullionist position with the Currency School, and the Anti-Bullionist position with the Banking School. This is a misleading half-truth that prevents most people from gaining any real perspective on the situation — there were Banking School adherents who firmly supported convertibility, just as there were Currency School advocates who maintained that reliance on a limited supply of gold inhibited economic growth.

This was the situation when Henry Thornton, a banker who had been elected to parliament in 1782 even after refusing to give the customary bribe to the voters, published An Enquiry into the Nature and Effects of the Paper Credit of Great Britain in 1802. This book is the reason that Thornton is regarded as "the Father of Central Banking," although ironically this is due to the belief, as mistaken as it is widespread, that Thornton "disproved" the real bills doctrine — a belief that appears to have originated in a foreword written by Friedrich von Hayek to a 1939 republication of Thornton's book.

On the contrary, Thornton demonstrated how a sound financial system relies on the operation of Say's Law through the functioning of the real bills doctrine. Thornton took a moderate position on the Bullionist controversy, which probably confused modern commentators even more. With Adam Smith, Thornton explained that it didn't matter whether the amount of gold in the economy matched the present value of existing and future marketable goods and services, the amount of gold plus real bills equaled that amount, or there was no gold at all, just real bills as the backing of the currency, the economy would suffer neither inflation nor deflation.

While a financial system could be run without any gold at all, however (even when the currency is measured in terms of the equivalent value of gold), Thornton as a practical banker realized that people need to have confidence in the currency. That being the case, prudence dictated that a commercial bank should have some of its reserves in the form of gold in order to reassure people that the currency was, in fact, "good as gold." To later authorities, this sounded as if Thornton was advocating the hard-line Bullionist/Currency School position, rather than a moderate semi-Bullionist/Banking School position.

The problem with what otherwise would have ended up being a tempest in a very small teacup is that the economy was changing — and Great Britain was at the very heart of the change. The science of economics was being confronted with the effects of advancing technology and the shift away from a labor-oriented production system, and wasn't keeping pace. Something had to give, and what gave was a sound understanding of money and credit.