T P W I

A commercial bank and an investment bank are two common types of banking organisation. The former holds deposits of customers’ money and issues chequebooks, debit card facilities, arranges home loans for customers, and so on. The latter tends to engage in large scale financial dealings, helping governments raise debt, issuing shares on behalf of companies, and trading in financial markets, for example. Here, we’re looking at the workings of the commercial banking system.

The Invention of Paper Money

Commercial banks developed from the practices of European goldsmith bankers in the seventeenth century, many of whom operated in London. These bankers took deposits of gold coins and in return issued receipts to depositors. Often they would charge for this service of safe-keeping their customers’ gold. The receipts in due course came to be used in payment for goods and services by merchants and others, and therefore came to be seen not as receipts for money but rather as money itself. When this change in public attitude towards money became well established, the bankers saw a profitable opportunity to change their business model. They would act not only as safe-keepers of gold, but as lenders of money. And when borrowers came to the bank to borrow money, what they would be given was not gold coins, but newly printed paper receipts. The bankers had found a mechanism for creating money, and their reason for doing so was in order to earn interest on the loans that they made.

The new receipts differed in one crucial respect from the original ones. While the original receipts were issued in evidence of gold kept in the bank vault, there was no gold supporting the newly issued receipts. The newly issued receipts were in other words “unbacked”. But since all of the receipts printed by the bank looked exactly the same, no one could tell the difference between them. As far as the public was concerned, each note was indeed backed by the amount of gold stated on the face on the bank note (the “face value”).

Some commentators argued that if the banker had issued a receipt promising payment of a certain amount of gold, then he should have at least that amount in his vault in order to fulfil the promise if required. The banks, however, argued that depositors would rarely seek to cash their receipts for gold at the banker’s office and the majority of gold on deposit in their vaults would therefore remain untouched for extended periods of time. It would therefore be safe to make promises to pay a greater amount of gold than existed on deposit in the bank vault.

Fractional Reserve Banking

The process of money creation by the commercial banking system is widely known as “fractional reserve banking” or “multiple deposit expansion” and while its techniques have become more sophisticated, the key principle remains the same. Commercial banks create money from nothing and lend it to society at interest. Whereas in the past the state issued gold coins and banks issued paper receipts, today it is the state that issues paper notes (through the central bank), whilst the commercial banks use cheques and account ledgers in order to conduct their own money creating activities. We can refer to the former as state money (also called “reserve money”) and the latter as bank money. Even state money is nowadays mostly issued in the form of accounting entries on ledgers which are held at the central bank for commercial banks (a central bank is a bank for banks, so to speak), but the majority of the money supply is created by the commercial banking system in the form of ledger balances (of bank money) on their accounting systems. The reserves of state money held by the commercial banks against the total amount of bank money in customers’ accounts is called the “reserve ratio” and, as with the early goldsmith bankers, this ratio is a small fraction. Hence “fractional reserve banking”.

Measures of Money Supply

Just as there are different types of money in circulation, there are different measures of money supply. For example, “M0” measures the amount of state money in existence, “M1” measures the amount of state money plus bank money held in sight deposits, and “M4” includes longer term bank deposits. Many detailed adjustments are made to this basic picture. For example, not all state money circulates freely (some is held in non-operational accounts at the central bank), therefore more precisely the term “M0” refers to the amount of reserve money in circulation outside the banking system (cash in peoples’ pockets for example), plus the amount of state money held by commercial banks in their operational accounts at the central bank, plus cash in the tills of the commercial banks.

WHY SHOULD WE CARE IF BANKS CREATE MONEY FROM NOTHING?

There are various reasons for caring very much that banks create money out of nothing. Firstly, why should one group of people have the right to manufacture money from nothing while the rest of us have to work for it? Secondly, having the power to create money from nothing gives the creator great political and economic power over the rest of society. The money creator can decide which corporations to finance, which governments to support, when to call in loans from the society as a whole and cause a recession, when to expand money supply strongly and cause a boom, whether to finance a war (or not), and so on. These powers arguably should not be placed with anyone, let alone a private corporation run on profit seeking grounds. Thirdly, and this is a philosophical point, if the system is corrupt at such a fundamental level, then the consequences of its operation are also likely to be corrupting. The next essay looks in more detail at what these consequences might be.

It is only natural that those hearing the true story of money for the first time will demand some supporting evidence before accepting it. For a system which has remained in place for so many centuries, the rather surprising thing is to find just how widely the story is supported. The following extracts give a flavour of that support and more detailed discussions are available elsewhere on this site.

The unlimited emission of bank paper has banished all her specie [in England], and is now, by a depreciation acknowledged by her own statesmen, carrying her rapidly to bankruptcy, as it did France, as it did us …. Private fortunes, in the present state of our circulation, are at the mercy of those self-created money lenders, and are prostrated by the floods of nominal money with which their avarice deluges us. Thomas Jefferson in a letter to John Wayles Eppes on 24 June 1813,  Jefferson, Writings, 1984, New York: Literary Classics of the United States.

And I sincerely believe with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale. Thomas Jefferson in a letter to John Taylor 28 May 1816, Writings, 1984, New York: Literary Classics of the United States.

The government should create, issue and circulate all the currency and credit needed to satisfy the spending power of the government and the buying power of the consumers. The privilege of creating and issuing money is not only the supreme prerogative of government, but it is the government’s greatest creative opportunity. By the adoption of these principles, the long-felt want for a uniform medium will be satisfied. The taxpayers will be saved immense sums of interest, discounts and exchanges … money will cease to be the master and become the servant of humanity. Democracy will rise superior to the money power. President Abraham Lincoln, Senate Document 23, 1865.

I am afraid that the ordinary citizen will not like to be told that the banks or the Bank of England can create and destroy money. McKenna, R., British Chancellor of the Exchequer and Chairman of Midland Bank, Postwar Banking Policy, 1928, p. 93.

We are completely dependant on the commercial banks. Someone has to borrow every dollar  we have in circulation, cash or credit. If the banks create ample synthetic money we are prosperous; if not, we starve … It is the most important  subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it is widely understood and the defects remedied very soon.  Robert H. Hemphill, Federal Reserve Bank of Atlanta, in the foreword to Irving Fisher’s 100% Money, New York, Adelphi Co. 1935.

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. Bank of England, Quarterly Bulletin 2014 Q1.