Judging from the state of the American economy in late 2010, most people put money, credit, banking and finance into the category of Great Mysteries That Can Never Be Understood Save By Great Experts. Frankly, the only thing “great” about these subjects is the pity that something that is inherently easy to understand has been made so complicated, and the basis for the confused (and confusing) approach to monetary and fiscal policy, not only in the United States, but throughout the world.
The confusion about banking dates back to the founding of the United States. It was in that year, 1776, that Adam Smith published “The Wealth of Nations,” an application of the theories he had worked out in “The Theory of Moral Sentiments” in 1759. In a sense, the great confusion about banking can be said to have begun with a fundamental misunderstanding of Smith’s theories, and (possibly more critical) a misunderstanding of what is meant by “money” and “credit.”
Keeping in mind, as Henry Dunning Macleod pointed out a century and a half after “The Wealth of Nations,” that “money” and “credit” are simply two different forms of the same thing, Adam Smith used the legal and accounting definition of money: anything that can be used in settlement of a debt. During the 18th century, however, a new definition of money was developing, based on the change from a labor-oriented economy to one that relies predominantly on capital instruments: “money” is whatever the State says, i.e., coin, banknotes, and (eventually) demand deposits (“checking accounts”). Smith’s understanding of money was, not coincidentally, the theory underlying the establishment of the Bank of England as the first true central bank, and was an application of the theory underlying merchant or commercial banking.
The alternate understanding of money is an application of the theory underlying a different type of banking called “deposit banking.” Thus, as the United States was being established, there were two different understandings of money being debated, based on the two types of banks that existed, “banks of deposit” and “banks of issue” (also called “banks of circulation”).
A bank of deposit is defined as a financial institution that takes deposits and makes loans. A bank of issue is defined as a financial institution that takes deposits, makes loans . . . AND issues promissory notes. A bank of deposit is thus limited to making loans out of its capitalization and whatever depositors bring in. A bank of issue can also make loans out of its capitalization and deposits, but that is not the institution’s chief purpose. Not unnaturally, the operation of a bank of issue causes massive confusion among people who define a bank solely as a bank of deposit, which, admittedly, most people do, especially academic economists and policymakers.
Banks of issue, of which the most common example today is the commercial or merchant bank, were established to “discount” and “rediscount” bills of exchange. Discounting and rediscounting transforms the present value of an owner’s private property right into a more convenient form of money (coin, banknotes, or demand deposits) that the owner may use to carry out transactions, i.e., settle debts. For providing this service, the commercial bank charges a fee, the “discount rate.”
A bill of exchange is money. In 2008, a rough calculation reveals that approximately 60% of the transactions in the United States economy were carried out not by means of coin, currency, or checks, but by bills of exchange and their derivatives in various forms, such as promissory notes and drafts. In 1839, Congressman George Tucker in his book, “The Theory of Money and Banks Investigated,” estimated that more than 95% of the money supply in the United States in the early 1830s consisted of bills of exchange, either used as money between businesses (“B2B”), or discounted at commercial banks to back issues of banknotes or the creation of demand deposits.
A central bank, such as the Bank of England or the Federal Reserve System, is designed to serve as a bank of issue for banks of issue. The idea is that this serves two purposes, 1) provides a uniform currency and 2) ensures that there is sufficient money and credit for private sector industrial, commercial, and agricultural development.
The use of central banks to finance government operations by discounting government securities or purchasing government securities on the open market is contrary to sound banking theory. This is because the essential private property link between the issue of money and what backs the money is broken or dissolved. Except in a socialist economy, the State does not own the “general wealth of the economy” that is usually cited as backing the currency issued in this way.
Banking in the United States demonstrates the ongoing struggle between the two different definitions of money that grew up in the 18th century. Best seen in the overt hostility shown to central banking, construing deposit banking as the only legitimate form of bank, and issue banking as a fraud, limits the money supply to State-issued or authorized coin, currency, and demand deposits. This limits the “supply of loanable funds” to whatever can be withheld from consumption, thereby violating Adam Smith’s dictum that the purpose of production is not reinvestment, but consumption.
The Bank of North America, established soon after the ratification of the Articles of Confederation was the first attempt to establish a central bank for the new country. It offered “accommodation” to both commercial banks and to private individuals and companies. Offering accommodation, that is, discounting and rediscounting bills of exchange drawn by individuals and companies without the intermediation of a commercial bank, while not contrary to central banking theory, was a political mistake. It gave the Bank of North America the appearance of being in competition with the commercial banking system, which, in a sense, it was. For that reason, and because of general mistrust of centralized economic power, the charter of the Bank of North America was not renewed, and it became an ordinary commercial bank, which still operates today under a different name.
The Bank of the United States (later referred to as the First Bank of the United States) was the second attempt to establish a central bank. Modeled on the Bank of England, it also offered accommodation to commercial banks and private individuals and companies, as well as offering deposit services for federal funds and tax collections. While soundly run, the Bank of the United States was viewed with deep suspicion, probably due to misunderstanding of commercial banking in general, and central banking in particular, and the charter was allowed to lapse when it came up for renewal. The Bank of the United States also continues to operate today as a regular commercial bank, with the latest round of mergers bringing it under Wells Fargo and Company.
The third attempt to establish a central bank for the United States, the Second Bank of the United States, brought matters to a head. Andrew Jackson distrusted paper, did not realize that bills of exchange are just as much money as gold and silver coin, and firmly (and honestly) believed that gold and silver were the only real money. Jackson’s penchant for carrying out political acts based on personal opinion and prejudice didn’t help matters any. Due to various factors that are outside the scope of a discussion on banking, Jackson took an extreme personal dislike to Nathaniel Biddle, the president of the Second Bank of the United States. Eventually, with the assistance of Richard Taney (later the justice in the infamous Dred Scott decision), Jackson’s Secretary of the Treasury (Jackson had “fired” two previous secretaries for refusing to comply with his wishes, after his first Secretary of the Treasury had resigned in reaction in the face of Jackson’s insistence that a wife of another secretary, who had a shady reputation, be accepted in Washington society), federal funds were withdrawn from the Second Bank of the United States and redeposited in various state banks, with the selection of banks determined by how well the owners of the banks had supported Jackson.
Jackson then issued the infamous “Specie Circular” that prohibited the federal government from selling land or collecting taxes in any form other than gold or silver coin. Enforced by Van Buren, the circular almost immediately caused a nationwide depression, “Hard Times,” with effects in Europe, especially in England.
With the repeal of the circular, matters managed to get back on track until the Civil War. Unfortunately, Secretary of the Treasury Salmon P. Chase had presidential aspirations, and decided to finance the Union war effort by printing money rather than the politically unpopular raising taxes. The national debt mushroomed, and inflation went as high as 600%. Chase came to his senses (at least partially) in 1863 and established the National Bank System. Unfortunately, Chase, although Treasury Secretary, did not understand money, credit, or banking, and construed all banks as banks of deposit. A National Bank was only permitted to issue banknotes to the extent that it purchased government bonds to be held in escrow, thereby backing the currency with government debt instead of gold, silver, or the present value of industrial, commercial, or agricultural assets.
Fortunately, Chase did not realize that checks (demand deposits) are also money, especially when backed by discounted bills of exchange. The rapid economic growth experienced by the United States in the latter half of the 19th century was not financed by existing accumulations of savings, but by the expansion of commercial bank credit. When Dr. Harold Moulton published his revolutionary monograph “The Formation of Capital” in 1935, people were either astounded at his findings, or ignored them. He discovered that, contrary to popular belief, periods of intense economic growth were not preceded by increases in saving, but by massive decreases! Savings were being depleted. The only source for financing for new capital investment was not savings, but bank credit backed by the present value of bills of exchange drawn on existing and future marketable goods and services and the capital that would produce the future marketable goods and services.
Still, most people believed that money was only coin and banknotes. When something happened to disrupt the supply, or there was too much or too little issued, the economy went into a panic, followed by a depression. This happened in 1873, 1893, and 1907. The five-year economic downturn following the Panic of 1893 was, in fact, known as the Great Depression, until the 1930s.
The financial system was finally reformed in 1913 with the passage of the Federal Reserve Act. The stated purpose of the Act was to provide an “elastic currency” for private sector development by rediscounting bills of exchange from member banks for industrial, commercial, and agricultural development, supplemented with limited open market operations buying and selling bills of exchange issued by non-member banks and private companies. The provision in the Act permitting open market operations in government securities was to retire the government debt-backed National Bank Notes with government debt-backed Federal Reserve Bank Notes, which would in turn be replaced by private sector asset-backed Federal Reserve Notes as the federal government retired its debt.
The power to engage in open market operations in government securities, however, opened a back door to monetization of government deficits. The Federal Reserve System operated as intended for two years, but then the decision was made to finance the U.S. entry into World War I by debt rather than taxes. Commercial banks patriotically purchased the bonds in the First and Second Liberty Loan drives, and the Victory Loan bonds, then turned around and sold them to the Federal Reserve, which created the money for their purchase, thereby circumventing the appropriations process and the tax system.
In the wake of the Crash of 1929, caused in large measure by money creation for stock market speculation instead of productive investment, the federal government effectively took over the Federal Reserve, although “the Fed” remains nominally independent, a meaningless technicality. The current economic downturn reflects the inability of economists and policymakers to come to terms with the reality of money, credit, and banking, and their insistence on using a commercial and central banking system designed under one set of principles, to implement monetary and fiscal policy based on a contradictory set of principles.
The situation is not, however, completely hopeless. The monetary and fiscal reforms proposed in, e.g., Capital Homesteading offer a way out of the current situation based on sound principles of money and credit, banking, and finance. Policymakers in the United States and elsewhere would do well to give serious consideration to the Capital Homesteading proposal.