By Kasredin:
In order to understand how banks work, it helps if we go back in time and explain how banks first came into existence. The topic of inflation is linked to the development of banks.
As a teenager I studied the Elizabethan era in history lessons at school, and I remember reading that prices rose sharply during this period of English history. I wondered why this happened, but my history textbook did not explain.
The reason is simple. In the sixteenth century, money took the form of coins made of either gold or silver or other less valuable metals. Numerous expeditions to South America brought large quantities of gold and silver back to Europe which allowed more high value coins to be produced.
Inflation is governed by supply and demand. The supply of gold and silver increased, and so its value fell. Gold and silver coins could be used to buy goods, but the supply of goods did not increase at a rate sufficient to keep pace with the increase in the supply of coins. Consequently the prices of the various goods increased as the supply of coins increased.
In short, one of the main effects – perhaps the most significant effect – of the expeditions to South America was a decline in the value of gold and silver.
Prior to the sixteenth century, European coins tended to be made mainly of silver, owing to the scarcity of gold, and even today the French word for money – argent – also means silver. After the sixteenth century it was increasingly common for coins to be made of gold. After all, there were other uses for silver, such as making cutlery. (There was no stainless steel in those days.)
And so to banking. Money-lending has existed in one form or another since antiquity, but the institutions we now know as banks originated in northern Italy (Lombardy) in the later middle ages. (It is no coincidence that the street in London with the strongest historical association with banking is called Lombard Street.) Banking became far more widespread in most of Europe in the seventeenth and eighteenth centuries.
Suppose you live in Europe in the seventeenth century, and you save up some money in the form of gold coins. You are worried about the prospect of your coins being stolen, but you cannot afford to buy a safe to keep them in.
Fortunately you know a local goldsmith, who keeps his gold in a vault. He allows you to keep your coins in his vault, and he charges you a modest fee for his services. Other people in your town do the same thing, and soon the goldsmith has a thousand gold coins in his vault – most or perhaps all of which belong to other people.
The goldsmith then lends 900 coins to Mr A, who uses the money to buy a house from Mr B. The goldsmith will then perhaps not be able to refund you your coins if you want them back, and he certainly won’t be able to refund every person who has deposited coins with him if they all want them back at the same time. He is hoping that the 100 coins he has left will be enough to meet any withdrawals that might be requested. It is a risk he is prepared to take.
Let us suppose that Mr B then deposits his 900 coins with the goldsmith, who now once more has 1000 coins in his vault. However he will still not be able to refund everyone who has deposited coins with him, because he now has deposits of 1900 coins but reserves of only 1000 coins.
(If you don’t follow this, he has the 100 coins he did not lend to Mr A, plus the 900 coins just deposited with him by Mr B. Those are his reserves. The deposits are the 1000 coins originally entrusted to him by you and other townsfolk, plus the 900 entrusted to him by Mr B – 1900 in total.)
Now let us assume another similar set of transactions. The goldsmith makes a second loan of 810 coins (ninety percent of Mr B’s deposit) to Mr C. The goldsmith still has deposits of 1900 coins, but his reserves have now gone down to just 190 coins – ten percent of his deposits. Mr C uses the 810 coins to buy a house from Mr D, who then deposits the 810 coins with the goldsmith. The goldsmith now has deposits of 2710 coins, and once again has reserves of 1000 coins. Note that these are the same coins that you and your fellow townsfolk originally deposited in the goldsmith’s vault. No new coins have come into play, and yet the goldsmith seems to be conjuring new money into existence just by making loans.
After around sixty-five sets of similar transactions, he will eventually run out of invented money. His deposits will total roughly 10,000 coins, and based on the logic of his ten percent rule, he has to keep 1000 coins in his vault to give back to any depositor who comes in wanting his coins back. He has seemingly ’turned’ 1000 coins into 10,000 ‘coins’. He has invented 9000 purely fictitious ‘coins’.
You may be wondering why the goldsmith would want to take such a risk, and you might also wonder why you and your fellow depositors would want to entrust your precious coins to the care of the goldsmith when he is playing games with your money.
What I have so far omitted to mention is that the goldsmith’s loans are made at interest. The people who borrow from him are expected to repay the money they have borrowed, and to repay not only the capital (900 coins in the case of Mr A) but also the interest. However the goldsmith – let us now call him the banker – will not let their repayments sit in his bank vault. He will use them to finance more loans so as to make more money. In other words, my above calculations concerning the sixty-five or so sets of transactions – loan, purchase, and deposit – are correct only if we assume that these transactions are all completed before Mr A and the other borrowers have made any repayments.
Another thing I have not yet mentioned is that the banker has decided to share his repayments with his depositors. Just as the borrowers pay interest on their loans to the banker, so the banker pays interest to the people who have deposited his coins with them. Remember that initially you and your fellow depositors were paying the goldsmith to keep your coins safe in his vault, but now he –the banker – is paying you. It is this fact which encourages you to trust the banker to play fast and loose with your money. Whether or not doing so is a smart move depends upon how skilfully the banker makes his loans.
You risk losing all of your money by trusting the banker, but maybe you think the risk is outweighed by the potential to earn money as depositor.
The above is an explanation of how our ‘Fractional Reserve’ banking system works and lending through this system is linked to inflation.
By creating new money which does not really exist, the total amount of money – both real and artificial – increases, just as the supply of actual money – gold and silver coins – increased in the sixteenth century. If the supply of goods does not increase to a similar extent, then prices can be expected to rise.
If you have trouble following this, then think back to the initial loan. Mr B wishes to sell a house, and Mr A wishes to buy it, but he is 900 coins short of the asking price. When the goldsmith lends him the 900 coins, Mr A is then able to pay the asking price for the house.
By contrast, if the goldsmith refuses to lend out any of the money in his vault, then Mr A will be unable to buy Mr B’s house. It is therefore possible that Mr B will have to cut the asking price of the house in order to sell it. Bank lending tends to keep prices higher than they would otherwise be.
If Mr A, having borrowed money to buy a house, is unable to meet his repayments, then the banker has the option of going to court to seize the said house as recompense. The sale of the house should then raise enough money to clear whatever money is outstanding. While this might seem to put the banker in a strong position, it is important to note that if the house does not raise enough money, then the banker is in difficulty. He can have Mr A thrown into the debtor’s prison, but that would not help the banker to repay his depositors.
The above situation is most likely to occur when a large number of borrowers default on their loans at the same time. This is perhaps the biggest danger for the banking system.
I now come to the matter of paper money. As a depositor at the bank, you have a receipt for your money. Before you deposited your coins with the bank, you ran the risk of having your coins stolen. Now a thief could still deprive you of your receipt, but the receipt would be useless to him unless he were able to go to then bank, pretend to be you, and withdraw your coins.
While the receipt has its advantages, its main drawback is that you cannot spend it. The only way you can make a purchase is by taking your receipt to the bank, making a withdrawal, and then buying whatever you want with your coins.
Eventually the banker will offer to replace your receipt with a promissory note. This note is made payable not to you personally, but instead to the bearer. The upside of this is that you can now use your promissory note to make purchases. Another upside is that a paper bank note is easier to carry than so many gold coins. The downside is that a thief can now steal your promissory note and spend it on your behalf. You have exchanged security for convenience. These promissory notes were the first bank notes.
Another downside is that no one will accept your promissory note as payment unless that person believes that your bank has the ability to honour its promissory notes. The novel Cranford by Mrs Gaskell is set in a provincial English town in the nineteenth century, and features a scene in which a farmer tries to buy something at a bazaar and offers a bank note as payment, but the stallholder refuses to accept it. He is not certain that the bank which issued the note will be able to exchange this note for five gold coins on demand.
It may seem surprising nowadays, but people in the nineteenth century did not regard bank notes as money. Bank notes were seen as promissory notes which stood in place of real money.
Eventually, real money gave way to what is technically known as fiat. Fiat (Latin = let it be done) is money which derives its value not from the fact of being made of silver or gold or some other precious substance, but rather from the fact that the government decrees its value. Bank notes and coins today are legal tender because the government says they are. A debt paid in fiat is – with a few minor exceptions – deemed in law to be a debt cleared.
Fiat has benefits, and I don’t imagine that many people would happily return to the days when gold and silver were the common currency. Nevertheless, fiat is all part of how banks operate.
The recent fashion for quantitative easing is basically the invention of new money which is not even based on deposits in a bank vault. It is based on nothing. That in itself is not wrong. After the Russian revolution, new bank notes were issued, but the pre-revolution bank notes continued to exist and also to be traded. The pre-revolution currency was based on nothing except its own existence, but it had value because people accorded it value. This value was however based upon the fact that the pre-revolution bank notes did not increase in supply. Their quantity was fixed, and so was their value.
The problem with quantitative easing is that the new money is not limited in supply. More and more new money can be created in an instant. The fact that its supply is not fixed results in its value not being fixed. In other words, quantitative easing is the last economic refuge of a scoundrel, as Dr Johnson might have said.
It is easy to inveigh against the banking system, but we need to be able to understand the banking system if we are to be able to make serious recommendations for its improvement. By far the most important thing though is that there should be no more quantitative easing. It is dangerous, and we don’t need it.
By Kasredin © 2013
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