Topics: Banking System

Banking System

"We have seen that the money supply is generally the dominant force in changing prices, while the demand for money is reactive either to long-term conditions or to changes in supply. We have seen, too, that the cause of our chronic inflation is continuing increases in the supply of money, which eventually generate inflationary expectations that aggravate and accelerate the inflation. Eventually, if unchecked, the inflation runs away into a crack-up boom and destruction of the currency. In recent decades, absolute control over the supply of money has been in the hands, not of private enterprise or the free market, but of government.

"How does banking fit into all this? In what way does banking generate part of the supply of money? Is banking inflationary, and if so, in what sense? How does banking work?

"When one speaks of banks, there is a semantic problem, since the word bank covers several very different functions and activities. In particular, modern banking mixes and confuses two different operations with very different effects: loans and deposits. Let us first see how what we might call loan banking originated and what its relationship might be to the money supply and to inflation.

Loan Banking
"Most people think of banks as institutions which channel their savings into productive loans and investments. Loan banking is essentially that healthy and productive process in operation. (…) If the bank makes unsound loans and goes bankrupt, then, as in any kind of insolvency, its shareholders and creditors will suffer losses. This sort of bankruptcy is little different from any other: unwise management or poor entrepreneurship will have caused harm to owners and creditors. Factors, investment banks, finance companies and moneylenders are just some of the institutions that have engaged in loan banking. In the ancient world, and in medieval and pre-modern Europe, most of these institutions were forms of “moneylending proper,” in which owners loaned out their own saved money.

"Loan banks, in the sense of intermediaries, borrowing from savers to lend to borrowers, began only in Venice in the late Middle Ages. In England, intermediary-banking began only with the “scriveners” of the early seventeenth century. The scriveners were clerks who wrote contracts and bonds, and were therefore often in a position to learn of mercantile transactions and engage in moneylending and borrowing. By the beginning of the eighteenth century, scriveners had been replaced by more advanced forms of banking.

Deposit Banking
"Deposit banking began as a totally different institution from loan banking. Hence it was unfortunate that the same name, bank, became attached to both. If loan banking was a way of channeling savings into productive loans to earn interest, deposit banking arose to serve the convenience of the holders of gold and silver. Owners of gold bullion did not wish to keep it at home or office and suffer the risk of theft; far better to store the gold in a safe place. Similarly, holders of gold coin found the metal often heavy and inconvenient to carry, and needed a place for safekeeping. These deposit banks functioned very much as safe-deposit boxes do today: as safe “money warehouses.” As in the case of any warehouse, the depositor placed his goods on deposit or in trust at the warehouse, and in return received a ticket (or warehouse receipt) stating that he could redeem his goods whenever he presented the ticket at the warehouse. In short, his ticket or receipt or claim check was to be instantly redeemable on demand at the warehouse."

"Money in a warehouse can be distinguished from other deposited goods, such as wheat, furniture, jewelry, or whatever. All of these goods are likely to be redeemed fairly soon after storage, and then revert to their regular use as a consumer or capital good. But gold, apart from jewelry or industrial use, largely serves as money, that is, it is only exchanged rather than used in consumption or production. Originally, in order to use his gold for exchange, the depositor would have to redeem his deposit and then turn the gold over to someone else in exchange for a good or service. But over the decades, one or more money warehouses, or deposit banks, gained a reputation for probity and honesty. Their warehouse receipts then began to be transferred directly as a surrogate for the gold coin itself. The warehouse receipts were scrip for the real thing, in which metal they could be redeemed. They functioned as “gold certificates.” In this situation, note that the total money supply in the economy has not changed; only its form has altered. Suppose, for example, that the initial money supply in a country, when money is only gold, is $100 million. Suppose now that $80 million in gold is deposited in deposit banks, and the warehouse receipts are no used as proxies, as substitutes, for gold. In the meanwhile, $20 million in gold coin and bullion are left outside the banks in circulation. In this case, the total money supply is still $100 million, except that now the money in circulation consists of $20 million in gold coin and $80 million in gold certificates standing in for the actual $80 million of gold in bank vaults. Deposit banking, when the banks really act as genuine money warehouses, is still eminently productive and noninflationary. How can deposit banks charge for this important service? In the same way as any warehouse or safe-deposit box: by charging a fee in proportion to the time that the deposit remains in the bank vaults. There should be no mystery or puzzlement about this part of the banking process.
Free Banking
“Let us assume now that banks are not required to act as genuine money warehouses, and are unfortunately allowed to act as debtors to their depositors and noteholders rather than as bailees retaining someone else’s property for safekeeping. Let us also define a system of free banking as one where banks are treated like any other business on the free market. Hence, they are not subjected to any government control or regulation, and entry into the banking business is completely free. There is one and only one government “regulation”: that they, like any other business, must pay their debts promptly or else be declared insolvent and be put out of business.1 In short, under free banking, banks are totally free, even to engage in fractional reserve banking, but they must redeem their notes or demand deposits on demand, promptly and without cavil, or otherwise be forced to close their doors and liquidate their assets. Propagandists for central banking have managed to convince most people that free banking would be banking out of control, subject to wild inflationary bursts in which the supply of money would soar almost to infinity. (…) In fact, there are several strict and important limits on inflationary credit expansion under free banking. (…)Any bank would have to build up trust over the years, with a record of prompt redemption of its debts to depositors and noteholders before customers and others on the market will take the new bank seriously. The buildup of trust is a prerequisite for any bank to be able to function, and it takes a long record of prompt payment and therefore of noninflationary banking, for that trust to develop.
“There are other severe limits, moreover, upon inflationary monetary expansion under free banking. One is the extent to which people are willing to use bank notes and deposits. If creditors and vendors insist on selling their goods or making loans in gold or government paper and refuse to use banks, the extent of bank credit will be extremely limited. If people in general have the wise and prudent attitudes of many “primitive” tribesmen and refuse to accept anything but hard gold coin in exchange, bank money will not get under way or wreak inflationary havoc on the economy.

“But the extent of banking is a general background restraint that does precious little good once banks have become established. A more pertinent and magnificently powerful weapon against the banks is the dread bank run—a weapon that has brought many thousands of banks to their knees. A bank run occurs when the clients of a bank—its depositors or noteholders— lose confidence in their bank, and begin to fear that the bank does not really have the ability to redeem their money on demand. Then, depositors and noteholders begin to rush to their bank to cash in their receipts, other clients find out about it, the run intensifies and, of course, since a fractional reserve bank is indeed inherently bankrupt—a run will close a bank’s door quickly and efficiently. From 1929 to 1933, the last year when runs were permitted to do their work of cleansing the economy of unsound and inflationary banks, 9,200 banks failed in the United States.
“The bank run is a marvelously effective weapon because (a) it is irresistible, since once it gets going it cannot be stopped, and (b) it serves as a dramatic device for calling everyone’s attention to the inherent unsoundness and insolvency of fractional reserve banking. Hence, bank runs feed on one another, and can induce other bank runs to follow. Bank runs instruct the public in the essential fraudulence of fractional reserve banking, in its essence as a giant Ponzi scheme in which a few people can redeem their deposits only because most depositors do not follow suit.

Central Banks
“Free banking, then, will inevitably be a regime of hard money and virtually no inflation. In contrast, the essential purpose of central banking is to use government privilege to remove the limitations placed by free banking on monetary and bank credit inflation. The Central Bank is either government-owned and operated, or else especially privileged by the central government. In any case, the Central Bank receives from the government the monopoly privilege for issuing bank notes or cash, while other, privately-owned commercial banks are only permitted to issue demand liabilities in the form of checking deposits. In some cases, the government treasury itself continues to issue paper money as well, but classically the Central Bank is given the sole privilege of issuing paper money in the form of bank notes—Bank of England notes, Federal Reserve Notes, and so forth. If the client of a commercial bank wants to cash in his deposits for paper money, he cannot then obtain notes from his own bank, for that bank is not permitted to issue them. His bank would have to obtain the paper money from the Central Bank. The bank could only obtain such Central Bank cash by buying it, that is, either by selling the Central Bank various assets it agrees to buy, or by drawing down its own checking account with the Central Bank.

"For we have to realize that the Central Bank is a bankers’ bank. Just as the public keeps checking accounts with commercial banks, so all or at least most of them keep checking accounts with the Central Bank. These checking accounts, or “demand deposits at the Central Bank,” are drawn down to buy cash when the banks’ own depositors demand redemption in cash.”
“One way for the Central Bank to inflate bank money and the money supply, then, is to lower the fractional reserve requirement. When the Federal Reserve System was established in 1913, the Fed lowered reserve requirements from 21 percent to 10 percent by 1917, thereby enabling a concurrent doubling of the money supply at the advent of World War I. In 1936 and 1937, after four years of money and price inflation during an unprecedentedly severe depression under the New Deal, the Fed, frightened at a piling up of excess reserves that could later explode in inflation, quickly doubled bank reserve requirements, from approximately 10 percent to 20 percent.

“Frightened that this doubling helped to precipitate the severe recession of 1938, the Fed has since been very cautious about changing reserve requirements, usually doing so by only 1/4 to 1/2 of 1 percent at a time. Generally, true to the inflationary nature of all central banking, the Fed has lowered requirements.

“Raising reserve requirements, then, is contractionary and deflationary; lowering them is inflationary. But since the Fed’s actions in this area are cautious and gradual, the Fed’s most important day-to-day instrument of control of the money supply has been to fix and determine total bank reserves.”
Source: Rothbard, Murray N.. The Mystery of Banking, Ludwig von Mises Institute, Auburn, Alabama, 2008

Banking System