You wouldn’t have been able to trip up Ebenezer Scrooge on the subject of today’s posting. He was a banker and worked in the City of London, that is to say, the financial district, sort of the British Wall Street (very sort of). He knew the difference between a mortgage (a past savings financial instrument) and a bill of exchange (a future savings instrument), and it’s doubtful whether you could have persuaded Scrooge to speculate in government debt, especially foreign government debt. He would probably have said “Bah, humbug” to it even after the visits of the three spirits and his completion and reformation.
Scrooge would also have been very well aware of the different types of banks, something about which many of today’s bankers and financial professionals seem to be completely in the dark. This is almost certainly thanks to the British Bank Charter Act of 1844. As we saw in the previous posting on this subject, it was then that the fixed idea entered economics (and thus the minds of virtually all academics and politicians) that everything — both production and consumption — must be financed by cutting consumption and accumulating savings.
That this “past savings assumption” involves a logical absurdity doesn’t seem to occur to the experts. And what is the logical absurdity? More or less simply stated, if the only way to be able to produce, and therefore consume, is to cut consumption and accumulate savings before producing . . . where did the original production come from that someone refrained from consuming in order to be able to produce?
|If production must precede production, where does the first production come from?|
Put another way, if the only source of financing for production is unconsumed production, where did the original production come from in the first place? There is no way that something can be saved out of production if there has been no production to begin with.
|Future savings is the simplest way to save|
Of course, once we understand money — i.e., that it is a promise to deliver something in the future — we realize we don’t have to finance with past production withheld from consumption. Instead, we can finance with a promise to produce something in the future. By realizing we can shift our source of financing from past reductions in consumption, to future increases in production, the presumed limit on economic growth and development imposed by what economists call “the Production Possibilities Curve” becomes meaningless. We need no longer be enslaved to past savings (past reductions in consumption) but liberated by future savings (future increases in production).
|Completely unnecessary with modern banking|
Without the presumed necessity of accumulating savings to finance economic growth and development, the justification for cosmically huge accumulations of wealth in the hands of a very few private individuals or the State completely disappears. We can begin to have a true understanding of what money is and how it functions. Instead of assuming that economic growth and development depend on the amount of savings already accumulated or the total money in the economy, we realize that the total money in the economy (and thus the amount of savings) depends on economic growth and development.
|Financed with bills of credit|
These two ideas were the single biggest bone of contention in the science of political economy in the days when Scrooge was growing up and finding his place in the world — or the world was finding its place in him, as it were. Heavily influenced by the way the British government financed the war effort against Napoléon Buonaparte — emitting bills of credit instead of through taxation or borrowing existing savings — a new “school” of monetary theory developed.
Later named the “British Currency School,” the fundamental tenet of this theory is that the amount of money determines the level of economic activity. This is the “Currency Principle,” and today’s three mainstream schools of economics — the Keynesian, Chicago/Monetarist, and Austrian — all take this as a fundamental assumption, despite the obvious contradictions and paradoxes involved.
|Last Banking Principle Economist Standing|
The older school of monetary theory, later named the “British Banking School,” has as its basic tenet the principle that the level of economic activity determines the amount of money in the economy. This is the “Banking Principle,” and is embodied today only in the binary economics of Louis O. Kelso.
The three types of banks with which Scrooge would have been familiar assume the validity of the Banking Principle. These are banks of deposit, banks of issue or of circulation, and banks of discount. Each is a very specialized type of institution, designed to serve a very specialized social function.
The simplest to understand is actually the newest type, the bank of deposit. Paradoxically, this type is the one most people think of as being the only type of bank. A bank of deposit is defined as a financial institution that takes deposits and makes loans. Period. It cannot create money or turn other assets into money. It can only accept existing money on deposit and lend out that same money. It can also take money that has not been loaned out and invest it on behalf of its depositors and shareholders to gain some return on otherwise “idle” funds.
|There are different kinds of banks|
A more sophisticated type of bank is the oldest type of financial institution, the bank of issue or of circulation. This is defined as a financial institution that takes deposits, makes loans, and issues promissory notes — promissory notes being a form of money that can either be used as money directly, or used to back other forms of money.
The special function of a bank of issue (the term “bank of circulation is considered archaic, although it means the same thing) is to turn existing assets — past savings — into circulating media so that there is enough money in the economy to purchase existing production. Thus, a bank of deposit deals with existing savings in the form of money, while a bank of issue turns existing savings into money.
The third type of bank is the bank of discount. It, too, is defined as a financial institution that takes deposits, makes loans, and issues promissory notes. The difference between a bank of issue and a bank of discount, however, is that where a bank of issue deals with existing or past savings and turns them into money, a bank of discount deals with future savings and turns them into money. Put another way, a bank of issue deals with mortgage type securities (past savings) and turns them into circulating media, while a bank of discount deals with bills of exchange (future savings) and turns them into circulating media.
What baffles people today is that there are few if any pure banks of circulation or of discount left in the world. What we have instead is banks of deposit (credit unions, savings and loans, investment banks, etc.) and commercial or mercantile and central banks. This is the sort of thing with which Scrooge would have been familiar.
|Not quite what we meant by "elastic currency" . . .|
A commercial or mercantile bank is a combination of a bank of issue and a bank of discount. A commercial or mercantile bank thus deals with both past and future savings. Conceptually, a central bank is a commercial bank for commercial banks. In its purest form it should never deal directly with the public or with the government at all, either directly or indirectly.
As we saw previously, the use of a central bank to turn government debt into money is an accident of history and was never intended to be a function of either a central bank or any commercial bank. The purpose of a central bank is to ensure that all the currency issued by its member commercial banks is uniform, elastic (i.e., expands and contracts directly with the needs of the economy), stable, and asset-backed . . . and we don’t mean government debt, but private sector hard assets.
Politics, however, has a way of knocking even the best and soundest theories into a cocked hat. As we will see in the next posting on this subject, what happened to the financial system during and after the Napoleonic Wars was largely determined by politics, not common sense or sound theory, and shaped the modern financial world.