We ended
yesterday’s posting by agreeing with the old saw that you need money to make
money. Traditionally, this has meant at
least one of two things, usually both.
One, that the only way to finance new capital formation is to restrict
your (or somebody’s) consumption, accumulate money savings, then use the
accumulation to purchase productive capital.
Two, somebody else accumulates savings that you borrow in order to
purchase productive capital.
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| Filled with loan paper, not cash, if the bank is doing its job. |
And don’t you
still need an accumulation of wealth that you own to satisfy the bank that it
will get its money back even if you don’t repay the loan? And doesn’t the bank have to be able to
satisfy its depositors and other people who ended up with the bank’s
obligations when they demand cash, i.e.,
the reserve currency instead of the bank’s obligation?
Let’s reflect on one
of these issues for our subject today: reserves.
As we saw
yesterday, the U.S. commercial banks got into trouble in 1893 because European
investors cashed out and drained gold reserves, that is, the asset-based
liquidity of the country, leaving the debt-backed reserve currency, the
National Bank Notes. European investors
had the right to do so, because they could take their securities, convert them
into National Bank Notes, then present the cash for conversion into gold. By taking gold directly, they just cut out
several steps.
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| National Bank Note debt-backed inelastic reserve currency. |
Unfortunately,
the U.S. did not have a central bank to which the commercial banks could go to
obtain additional reserves, and the gold supply would have been insufficient,
anyway, if the additional reserve currency were to be converted to gold . . .
as had happened with the massive issues of United States Notes (“Greenbacks”)
at the beginning of the Civil War, which caused the banks to suspend
convertibility. In 1893, the commercial
banks were holding massive amounts of valuable commercial, industrial, and
agricultural assets in the form of mortgages and bills of exchange, but these
could not be converted into the hard-asset reserve currency (gold) because the
gold had been drained out of the system, and the paper reserve currency, the
National Bank Notes, was backed by government debt, the amount of which was
set by law.
Both the gold
reserves and the paper reserve currency were “inelastic,” that is, more could
not be created as needed, even though good, solid, private sector hard assets
were there in plenty. What the banks did
not have was a reserve currency that could expand and contract directly with
the needs of the economy.
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| A "Bill of Credit" (above) represents government debt, not private sector assets. |
Had an elastic,
asset-backed reserve currency been available through a central banking system,
there would have been no problem. When
the gold ran out, the commercial banks would still have been able to extend
productive credit to U.S. businesses by selling (“rediscounting”) some of their
loans to the central bank in exchange for some newly created, asset-backed,
paper reserve currency.
The secret is how
commercial banks create money by expanding credit.
Commercial banks
do not make loans out of reserves. They
make loans by turning the present value of future production into money now,
and using reserves to redeem the bank’s obligations that non-borrowers present
for payment by the bank. This doesn’t
usually need to be very much, because obligations that a bank collects that
others owe the bank in most cases offset the bank’s own obligations. It’s only when you have a lot of people
redeeming the bank’s obligations all at once — as happened in 1893 on a large
scale — that the bank gets into trouble, and then only when the bank can’t sell
some of its assets for more reserves.
How does a
commercial bank create money? It’s
actually pretty easy.
Say that someone
has the chance to buy some capital that will cost a total of $80,000 and give
an annual return of 15% once it is put into operation in one year. These figures are, of course, not
realistic. We pulled them out of thin
air for ease of calculation. We’re
illustrating the concept, not presenting an actual case study.
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| Miss O. Oyl, hard-headed business tycoon, off to the bank. |
This someone
(call her Olive Oyl) draws up a contract offering to pay someone $10,000 a year
for ten years, starting in two years, if they will lend her $80,000 now. Unfortunately, nobody has $80,000 to lend
Miss Oyl.
Does that mean
the case is closed? By no means. Oyl goes down to the local commercial bank
and offers them the same deal. They look
it over and think she’s on to something.
They decide to accept Oyl’s offer.
In exchange, Oyl
signs a promissory note for $100,000, which the bank then uses to back a demand
deposit in Oyl’s name in the amount of $80,000.
The money supply in the economy has expanded by $80,000.
In due time, Oyl
buys the capital she had her eye on, puts it into production, and starts making
a profit of $12,000 a year. At the end
of Years 2 through 11, Oyl pays the bank $10,000 a year, a total of ten payments
adding up to $100,000.
The bank cancels
$80,000 — just what it created when it accepted Oyl’s contract — and books
revenue of $20,000. Out of that $20,000
the bank meets its own expenses and (we hope) realizes a profit to be able to
stay in business to create money to finance other capital projects.
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| P. Eye with plenty of green stuff in reserve. |
After paying off
the loan, Oyl continues to realize $12,000 each year for the rest of her
life. (She wisely uses the cash
“generated” by her annual depreciation expense to maintain her capital stake
instead of spending it on consumption, thereby maintaining her original
productive capacity as the old capital wears out and is replaced with new
capital.)
To make this as
safe as possible and to ensure that a commercial bank doesn’t run out of
reserves when it can’t sell its assets to other banks, we establish a “bank for
banks” — a central bank. The primary
purpose of a central bank is to ensure that a commercial bank always has somewhere
to turn to get additional reserves by converting some of its assets into the
reserve currency. (It is also supposed
to ensure a uniform and standard currency, as well as oversee clearinghouse
operations and a few other things, but adequate liquidity for industry,
agriculture, and commerce is the main thing.)
In fact, it is
possible to require that all commercial banks immediately sell all their loan
paper to the central bank in exchange for currency or demand deposits at the
central bank. In this way, there is
never any question about having adequate reserves on hand, because all a bank
has in that case is reserves — 100% reserves!
Having sold its loans to the central bank, the commercial bank already
made its profit on the loan, and simply acts as the collection agent for the
central bank to repay the loans that are now on the books of the central bank
instead of the commercial bank.
So that answers
how money can be created as needed to finance new capital formation, thereby
getting away from the necessity of a bank holding past savings. What about collateral? We’ll look at that tomorrow.
