Banking system has not always been like it is now. This is perhaps no surprise. However the fact that it seems now to be more sophisticated does not necessarily signifies progress. In fact it’s something else. What do we really know about banks?
This article is also available in Spanish in the translation of Rodrigo Betancur and published in his blog Rodrigo Diaz
Those of us who studied economics will recall the banks’ ability to create money. This is introduced in every undergraduate course of economics and most commonly referred to as ‘banking multiplicator’. The idea is quite simple and here I am not going to recite the whole logic; nor is it the purpose of this note to tell some generally known truth. I am more concerned with the very fact that the whole idea of banking multiplicator is perceived as generally known truth. Let’s reinvent the wheel to see how it works.
Some background
Just to set the scene, and also as introduction to those of you who did not study economics I will outline the theory. ‘Banking multiplicator’ is a very simple and purely accounting phenomena, it works as follows (simplified scenario, read disclaimer at the bottom):
- you bring a dollar to a bank and make a deposit in a current account
- the bank gives you, let’s take the modern time, a debit card
- the bank then treats the dollar as money stock
- under general assumption that money should work the bank lends this dollar to another person
- this other person opens a current account in the same bank and deposits this borrowed dollar
- the bank gives him a debit card
- the bank then treats the dollar as money stock (again)
- under general assumption that money should work the bank lends this dollar to another person in cash
- the third person happily walks away with a dollar
- you, the second guy and the third guy come all to, let’s say, the same shop
- all of you spend the money you have: you pay by debit card, the second person pays by debit card, the third person pays in cash
- please note, there have been just spent three (3) dollars in the shop
- please recall, that it all has started with just one dollar and in fact there has existed in nature just this particular one dollar that you have brought to the bank
- the two dollars have been created on paper out of nothing by the bank, just by making double entries in the accounting books
Now you should be able to imagine how much of this ‘out-of-nowhere’ money a modern bank can create. This ability, or process, is called ‘banking multiplicator’.
So what?
Three of you have just spent three dollars, whereas there only exists one dollar in nature. The consequence is very simple, when the shop sends the invoices for you and the second guy to the bank (recall that you have paid by debit card), the bank will not be able to pay them (because the dollar it had was given to a third person in cash as a loan).
In practice, however, the bank normally pays your invoices. It does so because and only when someone else has brought some cash in the bank sufficient to pay the invoices. Let’s say after the third guy gets his loan, the fourth person comes in and opens a current account in which he deposits two dollars. The problem is now solved, the bank will use this two dollars to pay two one-dollar invoices received from the shop.
If the fourth person decides to spend his two dollars (or withdraw cash), the bank will in the same manner use the cash of the fifth person to settle the matter, and so on ad finitum.
Isn’t it cool?
Sure. However, doesn’t it look like the bank is trying to hide something? To most of those who studied economics it doesn’t because, as I say, most courses in economics present this phenomena as normal attribute of banking system and it is not a secret. However, in substance it is the process of hiding and interestingly enough it has always been the mechanism of hiding.
Hiding what?
Hiding the theft. When you deposit a dollar in a current account you actually retain constant and irrevocable right to expend (by using your debit card in the shop) this dollar or withdraw it as cash. The substance of this arrangement with your bank is to have this dollar always available for you and to keep the right of ownership to this dollar. The bank is therefore only authorised to give out the dollar it has in your name upon your instruction to do so. In this sense the current account existed always starting from Ancient Greece through Roman Empire (where it was more properly named ‘contract of custody’) and further throughout Europe until approx. 15-th century.
By giving out the dollar without your permission the bank committed a crime of theft and in Italy and Spain, for example, the bankers were beheaded for this crime.
The fact that there was a punishment for such an act means there were attempts to commit it. In fact, as shown above, it was very easy to give out somebody’s money as a loan (and earn interest) without this to be noticed; so long as the bank enjoyed new cash inflows and predictable cash outflows. The main trick in hiding this extra-lending activity was to make sure enough money were returned or newly deposited on the dates when the deposit-holder(s) would normally withdraw money, or invoices in their names were received by the bank for payment. Not all bankers were equally successful in predicting these patterns.
Although the punishment, if revealed, was severe, the risk was worth taking - the possibilities to earn extra interest were extraordinary.
Seems like the bankers could not lend at all, but you say ‘extra’-lending?
Sorry for the confusion. Of course the bankers could lend. They could lend out of the money for which the ownership title had been temporarily transferred to the bank. This was known as ‘contract of lending’ whereby the parties agreed (in contemporary terms) that the customer lent 1 dollar to the bank for a defined period of time, let’s say one year, and would receive back in year’s time one dollar plus interest. Normally under this contract the customer would not have the right to demand the repayment earlier, however specific terms could be agreed. What was not possible was the right of the customer to withdraw the loan in any given time during the term of the loan, because this would de jure constitute the ‘contract of custody’ and thus there would be no interest paid.
The whole idea was to have the funds in total possession of the bank for the specified period with one simple objective - to enable the bank to lend this money to someone else for the period equal to, or generally shorter than, the term of initial loan agreement. In this way the bank would earn the difference in interest it charged in the two transactions.
Now it should make clear why giving out money from custody accounts was extra-lending.
Okay, this is all history, now we live in 21-st century; why this should be relevant to our situation at all?
Well, if you recall the scenario we’ve started with, you will recognise that there have been three dollars spent in the shop whereas there only exists one in nature. Although this fact can be successfully concealed by the banks so that there would appear to be no problem, there is quite real consequence for the economy which cannot be concealed by the bank and which does constitute a problem.
Let’s take a simplified scenario (read disclaimer at the bottom) to understand the idea:
- you, the second guy and the third guy have just spent three dollars in the shop
- the owner of the shop recognises this as an increase in demand as in previous period there were only you as a customer spending one dollar
- the owner of the shop contacts the supplier of the good (let’s have just one good to keep it simple) and asks to deliver more units
- the supplier answers that his production capacity does not allow for extra units to be delivered immediately, but that he will install a new production line and starting next period will supply more
- the supplier borrows money from the bank, buys and installs the new production line, hires more staff
- new period starts and increased number of units is supplied
- you come to the shop to buy the good and you buy as usual the same amount you normally do
- the second and third guys are not coming as they do not have extra dollar to spend, they prefer to repay the loans they have taken in prior period (one dollar each)
- the shop owner recognises that he has overestimated the demand and returns to prior ordering levels
- the supplier now has idle capacity - the production line he has installed needs to be stopped as there is no more market for the extra units it produces
- extra workers are dismissed
- probably loan taken from the bank cannot be repaid and the supplier goes bankrupt
Now imagine the magnitude of the effect of this basic process if concerned the real-world complex economy. It results in a ‘Boom’-’Bust’ economic development. The economic activity increases rapidly and significantly due to expenditure of the ‘out-of-nothing’ money. This is called ‘boom’ (three dollars spent in the shop, higher ordered quantity, supplier invests in new production line and hires people). When it comes to be discovered that initial level of expenditure is not sustainable (as in our case the two guys have decided to repay the loans, rather than going to the shop), the level of economic activity shrinks almost as rapidly as it has boomed (the shop drops the orders, supplier stops the production line and dismisses the workers). This is called ‘bust’.
Another real consequence is the falling purchasing power of the money as a direct relation of its quantity and increase in prices. This is how it works:
- just when the owner of the shop calls the supplier, the latter says that he is only able to increase supplies as from period following the next period
- the owner of the shop realises that the stock is now limited given the anticipated demand
- he decides to double the price because he thinks the increased demand will otherwise quickly leave him out of the stock, whereas more and more buyers will be coming to buy until the end of the next period (if there are no units available, the willing buyers will probably turn to substitutes and increased number of units supplied in the periods to come would be difficult to sell)
- with your dollar next period you will only be able to buy half of the unit of the good
The purchasing power of your dollar has decreased. Please note, that the purchasing power of any dollar-savings has decreased as well. Thus part of your wealth has been destroyed.
So you are talking about ‘inflation’?
Inflation was always defined as the process of increasing the quantity of money. The increase in prices is a consequence of this process as has been demonstrated above. So yes, in fact I am talking about inflation - this whole mechanism of banking multiplicator is indeed ‘inflation’.
How come that textbooks most commonly define inflation as ‘overall increase in prices’?
This substitution of cause for consequence was committed by monetarists. Monetarists believe the banking system should be regulated in order to control the supply of money it generates (so that the increase in money supply is in line with increase in real production). As described above, the process nowadays includes inflation (we can call it inflationary generation of money). For monetarists, therefore, to keep the traditional definition of inflation would be to literally say ‘we stand to maintain inflation in the economy’. Inflation was never popular enough to encourage monetarists to do that.
The confusion they created led some less sophisticated economists to actually think of ‘fighting’ inflation, which in practice meant to ‘fight’ the increase in prices by imposing government controls.
Okay, what’s the conclusion?
The conclusion is quite simple - contemporary banking system is the only source of inflation in the economy; construction of the banking system is the reason of ‘boom-bust’ economic development that puts us through economic recessions once in a while.
Disclaimer to the critics
Relax, this is not a scientific publication. Scenarios are simplified but reasonable, terminology is avoided where possible on purpose - to keep things simple. If you have inescapable desire to dismiss my argument, please first read
this scientific publication (which was reference material for the author) and you are more than welcome. Seriously, I will be very glad to have more sophisticated discussion with any interested person. Non-sophisticated comments are also welcome. Questions will be very much appreciated as the author could not include all aspects of the problem in one article (some questions may be answered in the later parts of this essay therefore the author will kindly refuse to give answers to them).