"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented."
Lord Josiah Charles Stamp (1880 - 1941), 1st Baron Stamp of Shortlands, and Bank of England director 1928 to 1941, in a public speech at Central Hall, Westminster, England, 1937.
"The process by which banks create money is so simple that the mind is repelled," wrote John Kenneth Galbraith, arguably one of the world's most knowledgeable economists. (Money, Whence it Came, Where it Went, page 18) "Where something so important is involved", he went on to write, "a deeper mystery seems only decent." Let us have a look at this process and attempt an explanation: for it is indeed simple. So simple in fact, that it is the very reason you yourself are not permitted, by law, to establish a bank and then go ahead and print your own notes. Such an activity today requires a government granted license.
So here is a question. If I owed you $100, would you accept from me a signed IOU as settlement of the debt? And if you did, could you pass this signed IOU onto someone else as payment of your own debt? Probably not. Hence metal was fashioned into coin to operate as some sort of medium of exchange to assist us in swapping or trading our goods with one another, and to pay off our accounts. Out of convenience, notes eventually followed. We accepted this because everybody else did. And it still works because of continued community confidence and trust.
Picture yourself as a businessperson in London some 500 years ago. As you ply your trade and sell your goods, you are paid for your wares in gold and silver coin. What to do with all these coins? Place them under the mattress ? Aside from perhaps some sleep discomfort, this could be risky. Fortunately at this time, one could use the facilities of the nearby goldsmith, who would accept your coins for safekeeping. In exchange, and to prove your ownership of the coin so deposited, he would give you a receipt. We should understand that these receipts came to be somewhat important, as they held the signature of a man who had acquired considerable stature and reputation within the city. It was unthinkable that such a man, a goldsmith, would ever dare cheat a client. The receipt of a goldsmith came to be regarded in fact as something as good as gold. (Now of course greed being what it is, there were isolated instances over the years of bad behavior from a goldsmith or two; clipping of gold coin, filing of the edges and other tactics to add to one's supply of gold in the vault. Such acts were rare however, and carried considerable penalties, usually death, if caught.)
In the continuing course of business, you ,the merchant, might have a large invoice to pay. You could of course trek down to the goldsmith, take out some of your coin, and then pay the invoice by delivering your gold to the relevant person. Or you might instead hand over your receipt, signing (endorsing) it to the new owner as payment of the invoice, who may now claim the amount of the receipt, in gold, from the goldsmith. A considerable saving of time and effort.
Time passes. Out of ease and business convenience, the paper receipts begin to circulate more freely. For even more convenience, the receipts came to be marked simply 'paid to bearer', obviating the need for endorsement at every exchange. These receipts, backed by the good standing of the goldsmiths, are being treated now in the same manner as coin. Money in its own right. Daily, any goldsmith might be presented with a 'paid to bearer' receipt, and not necessarily one of his own either. He would naturally and without argument pay gold out to the bearer of the receipt to the full face value, if so requested.
More time passes.
So much gold lying idle in the vaults of the goldsmiths must at times have given the goldsmiths plenty to think about. Who was the real owner ? Why was so much left uncollected ? Since it was never all claimed at once, perhaps some of it could be put to better use ?
Your son, for much time has passed, needs to buy some equipment, but does not yet have the coin to do so. (In your day one had to save hard…) He heads down to your goldsmith to ask for some credit. The goldsmith thinks; well your business is growing, you have a good name, the risk is small, it could be good for business. The goldsmith could of course lend your son some gold coin; but better still, why not simply write out a receipt to the value asked for, paid to bearer ? The goldsmith does so, which he passes to your son, who in turn promptly uses the credit so obtained to pay for the desired equipment. The receipt has gone into circulation as money. Nobody questions the receipt, for it has the backing, the signature, of a reputable goldsmith. Eventually, as the son puts the equipment to use, he will pay back the amount 'loaned', plus that bit extra the goldsmith asked for as recompense for the risk. (Just a little interest you understand.)
Think about this for a minute. The merchant's son wanted credit to expand his trade, the goldsmith issued him a receipt for the gold that he had not yet in fact deposited but would eventually do so, the goldsmith demanding just a little extra for his help. As trade grew, so did the demand for these receipts, now called 'notes', or 'bills'.
The goldsmith continually observed that not everyone came to collect the gold all at once. How much, therefore, of the gold might he 'loan out' to inquiring customers ? And there was no shortage of them at any one time. After a while it was established, at least by the more reputable goldsmiths, that for every $100 worth of gold held, $1000 worth of notes could be issued. Merchants were now being paid for their goods not just in coin, but more often in goldsmith's receipts, issued increasingly by the goldsmith turned banker, as bank notes.
Thus the process of Fractional Reserve Banking: the creation of credit for customers, out of something that does not exist. Fractional Reserve Banking: banks issuing loans and advances to customers that ultimately create their own deposits. Money from nothing and riches out of thin air. Such a simple process it is impossible to believe. Our mind is indeed repelled, is it not ?
The accounting process:
Perhaps, then, we can come at this from another angle. Returning to the era of the goldsmiths for a moment, the goldsmiths continued to issue receipts for the gold that clients chose to store with them on their premises. Eventually, as we have noted, the owners of these receipts found it more convenient to pay for their goods by handing over the receipt, rather than the (gold and silver) coin. The prospective new owner of the receipt, if confident, will accept it in payment for his side of the business transaction and can, if he wishes, duly present the receipt to the goldsmith and demand 'his' gold. For the most part though, the receipts continued in further circulation.
The goldsmith eventually discovers he can issue a note (receipt) instead of the gold itself to customers wanting credit, a loan, or an advance of money, call it what you will. The borrower will eventually repay the loan, not with the original note, but most likely with another note, issued by another goldsmith, received from another businessman in payment for whatever goods that trader was supplying.
Business grows; demand for the notes increase. The goldsmith turned banker, instead of issuing receipts, is now printing (bank) notes to those demanding credit. The balance sheet of
Gold in safe 100 (goldsmith's) notes in circulation 1000
Double entry book-keeping demands the books be balanced, assets to equal liabilities, so we would get:
Gold in safe 100 (goldsmith's) notes in circulation 1000
Advances to customers 900
By printing their own notes the bankers, it should be noticed, have actually created their own asset base; namely 'advances to customers'.
Kings and Queens were quick to notice. A process soon developed where the monarch might ask the banker for a loan of some money to help run the monarchy - or more likely to finance the latest plundering of the neighbor - promising in return to pay it back at a later date. So the banker would use some of his printed notes to buy the promises to pay – the government securities, the government then immediately spending the money into the economy for whatever use it had decided upon. (Building warships was a favorite.) And since the government has the power to tax, it will do so to pay back the loans. The banker's balance sheet now looks like this:
Gold in safe 100 notes in circulation 1000
Government securities 200
Advances to customers 700
Soon, the banks' customers are depositing not just gold, but other bank notes as well. So the balance sheet can be drawn up as follows:
Gold in safe 100 Deposits 1000
Government securities 200
Advances to customers 700
Bank deposits are created by the banks themselves, not by you and I as customers of the bank. Nor has the bank 'lent' money: there isn't actually any to lend. The bank has created credit, actually out of nothing but the original capital in the vault. (And in early US banking history, sometimes there wasn't even anything in the vault.) This process is known as fractional reserve banking.
Back to the beginning:
The early banks were very familiar with this process. (The word 'bank' derives from the word 'banco', used to describe the old merchant's benches set up in the medieval market places of Italy. Such money traders in the market places of Lombardy preferred to set up their own dealing benches, rather than have a permanent stall or shop. The breaking of a money merchant's bench in medieval Italy was the signal of his failure, which indicates of course that even then banks went out of business.) It was reported about the early banking houses of Venice for example, (The Bank of Venice, quarterly Journal of Economics, Vol. VI No 3, April 1892), and quoted also in Galbraith, that: "Banks of deposit to the number of a hundred or more came into existence in Venice in the 13th 14th and 15th centuries. A very considerable number also failed with varying degrees of resonance. Numerous efforts were made by the Senate at regulation, including such details as the hours that banks were required to be open and their obligation to count out the depositor's cash in his full view. The results of the regulation were less than perfect. A 16th century Senator, one Tommaso Contarini, told in a speech of the difficulties. He noted that a banker can accommodate his friends without the payment of money, merely by writing a brief entry of credit. The banker can justify his own desires for fine furniture and jewels by merely writing two lines in his books, and can buy estates or endow a child without any actual disbursement."
For such early European bankers, the best borrowers soon proved to be the kings and princes and their principalities; of which there were dozens in Europe centuries ago. The king or prince would borrow by issuing securities - debt acknowledged by the principality or government - which were then bought by the banks in exchange for their bank notes. The notes would then be spent by the government into the economy, (often by the King to wage war on his neighbour), the debt to the bank paid off out of future tax revenue. The king's ambitions were now being easily financed. (I have heard it said that the great Rothschild banking concern's Paris office would lend generously to Napoleon, whilst the English office was lending generously to Wellington. Just one condition attached, loans being approved to either side only if the victor assumed payment of the loser's debts….)
The process is little different today; it was used actively by the United States government to pay for its recent foray into Iraq, some eighty to one hundred billion dollars worth of created credit. The US treasury simply issued bonds, which were snapped up eagerly by banks, pension and insurance funds (mostly foreign) for the interest payable thereon. Risk free (or at least as good as the solvency of the government) and as good as gold.
Early US bankers were keenly aware of where their profits came from under this system. "The profit," said Senator George Cabot, a board member of the First Bank of the United States in 1792, "depended upon the circulation of credit instead of specie." The President of this same bank, Thomas Willing, expressed a similar sentiment around the same time, suggesting to his New York board members that: "the banks profits (depended) essentially upon its ability to keep in constant circulation its own credits instead of specie." (David Jack Cowen, The Origins and Impact of the First Bank of the United States, note 180 page 85.)
The process is basically a good one, however…
Individual banks no longer issue their own notes - at least not in the Western world. And the note issue is pretty much standard to each individual country, or even to a large region as we recently saw with the introduction of the Euro. It wasn't always this way. The US had as many different styles of notes as there were banks by the mid 19th century.
Notes now represent less than about 10% of the debt in circulation in any country. A debt no longer backed by gold, but backed instead by the production of the country, for that is what the credit issued by banks is loaned against. This is a far more substantial backing than just gold.
This process of fractional reserve banking is a good one, and works well if left to its own proper devices. Let me repeat that. The fractional reserve process is a good one, and very important, for it greases the wheels of economic activity and exchange. And a bank, like any business, is entitled to a (reasonable) profit from its work. The are four problems with all of this however. (Perhaps also a fifth.)
Banks, now more than ever before, lend not only against the production of the country, but also against government granted licenses and privileges, the largest of which is land value. Banks do not ever make this distinction of course, but it is important for our understanding. The value of these government granted licenses and privileges is not one that is actually produced, or 'manufactured' by labor and capital; such value being in fact created by government in the awarding of the license. A value that also comes out of nothing. This is explained further, in the section on government granted licenses and privileges. The process of credit creation is a worthwhile one; it is vital to business and helps boost trade. But the process will at times fail when credit is created on a value not backed by the productive enterprise of the nation. The situation goes critical when the value of the asset mortgaged to obtain the loan in the first place subsequently falls below the value of the loan currently outstanding. Here is the crux of the issue, and why we get real estate cycles of boom and bust. This is the first problem; the problem of the trade and real estate cycles.
The second problem flows from the first; an inherent weakness in the system being readily apparent. Should all the depositors come to the bank all at the same time, for whatever reasons, and demand what is owed to them, their money isn't actually there. (This will come out more in the chapters describing each real estate cycle.) The first problem intensifies the second of course. For it is only when the ability of any bank to continue paying depositors is questioned - mostly in a downturn - that depositors all come to the bank at the same time. This was one reason for the development of a central bank: acting as banker to the banks in time of trouble.
Theoretically, if banks were doing their job properly, in a society where government granted licenses were not permitted to capitalize in price into tradable commodities, defaults would never be so damaging to the economy. The trouble only starts when credit is created and backed not by produced wealth but by the price of the licenses, the capitalized rent. The inevitable downturn often sees the price of the license, (a mortgage as far as the bank is concerned), fall below the outstanding level of the credit so created. If this happens on a large scale, banks fail. Roughly every 18 years it seems.
The third problem is one of debt. Banks no longer issue their own notes as they once used to, nor are our notes backed any longer by gold. But the fractional reserve banking process is still very much in operation through the use of demand deposits, creation of overdrafts, and cheque facilities. Today's credit still comes into existence and spent into the economy as a debt. Every dollar in circulation was at some time in the past borrowed into existence. (In fact it could probably rightly be said; if everyone decided to pay out his or her loan, no one would have a bank deposit.) The debt problem is not our concern here, though it continues to escalate out of all proportion to what it rightly ought to be if society chose to conduct its banking in a different form, for example, allowing only the government to print and issue notes. Such notes would still be spent into the economy in the normal fashion, but, significantly, are debt free. Abraham Lincoln made this process work in 1862. This does not however solve the riddle of the real estate and other trade cycles, since speculation could still proceed in those all-important government granted licenses.
The fourth problem is one of inflation (or deflation). The credit creation process is a good one, for it is mostly backed by the production of the nation. When a loan is taken out, it is paid back out of the future income stream. If, however, the bank creates credit not backed by production, then too much money will be produced chasing the existing quantity of the nation's goods and services and prices will rise. This is called inflation. The reverse may also occur, though in practice less often, if the banks cease granting credit; then trade and industry will be stifled, resulting in deflation.
Now, more than ever, governments are some of the biggest borrowers from banks; borrowing vast sums of money that is not backed by the productive wealth of the country, being secured instead against future tax revenues. This is also inflationary. Banks are willing lenders to governments. Such lending - read credit creation - is now international in its scope.
The fifth problem is perhaps one of financing for war. Fractional reserve banking makes it too easy to pay for war simply through the use of the government issue of bonds. A history of any country's debt clearly shows this to be the case. In the US, government debt has increased most in wartime, then been slowly reduced afterwards. Only once has the debt ever been paid off completely, in 1836 / 37. Again, this issue is not our story, but worth noting in passing. Future generations are burdened with the consequences of course; heavier taxes on their labor and enterprise to pay back the borrowing.
So much for the problems of banking. They will be highlighted further in each of the real estate cycle chapters. It is important at this stage to simply remember two facts:
- Bank deposits are created by the banks themselves, not by you the customer.
- Banks create credit, they do not lend money: the basis upon which that credit is created, backed by government granted licenses or the production of the nation being the critical difference. To view the real estate cycle in this fashion is to see something few others will ever see.
Money may not have sex, but it sure can reproduce.
Galbraith, John Kenneth. Money: Whence it Came, Where it Went, Andre Deutsch publishers, 1975
Rowbothom, Michael. The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics, Jon Carpenter publishing, second printing, 2000
Acres USA: acresusa.com/magazines/archives/0204newsletter.htm
Ps: a note for readers.
There is an unbelievable amount of information on the net about banks; much of which is either misinformed or downright misleading. Banks do create credit out of thin air: a process known as fractional reserve banking and one that can be extremely useful for society. It is corrupted when the rent of government granted licenses is permitted to capitalize into a tradable value, upon which banks create not only credit, but a mortgage and indebtedness as well. In this way, banks end up owning the world, so to speak. Or at least we the people end up mortgaging the world to them. When this happens; society works for the banks; not the other way around as it should more correctly be.