Swammerdami
Squadron Leader
From time to time IIDB sees confusion about money creation, so I think it best to post a summary of money types. But let's be clear from the outset: The distinctions between these money types are ambiguous and fuzzy. Some monetary instruments can be classified in 2 or 3 of these types.
The U.S. money supply (M2) is currently $21 trillion, almost all of which is in the form of accounts at private banks. (Assets of JPMorgan-Chase total $4 trillion.)
Another thread got hijacked when I introduced the term "intrinsic-value money" to include precious-metal money and its kin. I considered
Commodity money as an alternate term, but the very first sentence of the Wikipedia article defines that using the forbidden adjective:
Fiat money is money whose worth is decreed by government. For example, until the time of the Civil War the U.S. government minted both silver and gold coins and both were valued at essentially their market price. But as the price of silver fell the government continued to mint and redeem silver coins at the old rate: these coins then became money by government fiat. Similarly in the ancient world gold and silver were used as base money, but small-denomination coins were issued in copper and iron and treated as fiat money.
When there is no other base money, fiat money can serve as the base. Marco Polo reports that all people in China were required to trade their gold and silver to the Khan in return for his paper money. Instead of utility as money, precious metals' mere possession might have been a criminal offense!
Bank-created money is the subject of this post and will be discussed below.
Representative money is a promissory note or similar document denominated in another type of money. In early civilizations debts were often inscribed on clay tablets, denominated in a commodity like silver, barley or cattle. In the Middle Ages a merchant might deposit gold coins with a banker and be provided with a parchment document representing that deposit and permitting him to get paid by a partner bank in another city.
The U.S. government has printed banknotes of each type. Gold certificates represented the base money (gold) but became fiat when FDR revoked the promise of redemption. Abraham Lincoln famously issued "Legal Tender (fiat) Money" and emphasized its inferior status by requiring that import tariffs be paid in actual gold (or gold certificates). Silver certificates started as a representation of silver, but became fiat money when silver lost value. Eventually in the 1970's those certificates became an anomaly: The promise to redeem for silver was honored so the certificates were worth more than their fiat value. And of course, Federal Reserve notes are bank-created money.
So what is bank-created money, anyway? A usually necessary but insufficient condition is that the money be created via lending. This loaned money will usually be in representative form but that condition is neither necessary nor sufficient.
The origins of bank-created money are unclear. Lending itself wasn't particularly common. Governments sometimes imposed amnesties on debt. Both Christianity and Islam forbade the collection of interest; and loaned money was often just base money owned by the lender himself. Bank-created money derives from the loaning of depositors' money!
(One often hears the term "fractional-reserve banking" applied to denote the loaning of depositors' money whereby banks create money, with the fraction (often 1/10) of deposits which must be kept in reserve mandated by government. But let's note right away that the present-day reserve mandated by U.S. banking regulations is Z E R O .)
It might seem quite scandalous for a medieval banker to accept a deposit of gold coins, and then turn around and lend those coins to a third party; and in fact bankers made strict disincentives for borrowers or transferees to withdraw coins instead of leaving their funds on deposit. The bankers might avoid advertising this practice, thus tending to obscure the development of bank-created money. The equivalent of overdraft protection was a service banks were happy to extend to their best customers, and that may be the earliest clear example of money-creation by banks or money-changers. Because collection of interest on a per-month basis was immoral or even illegal, banks made their profits via service charges.
The trustworthiness of banks
Before a merchant would deposit gold with a bank, he had to be quite confident in the integrity of the banker. Most of us are happy to deposit money at Wells Fargo or at any big bank, but we may find it hard to believe that merchants in ancient times would place such trust in a two-man money-changing enterprise. Whether that trust existed and Why it did, might be an interesting topic for discussion but here I will just assert that apparently that trust did exist.
Here is a tourist-oriented look at the beautiful Cathedral of St. Martin in Lucca, which was a a major venue for money-changing for pilgrims en route to Rome. The webpage mentions the famous "oath of the moneychangers", still visible today:
The rise of bank-created money is a fascinating story! Was it a necessary step for the development of the huge economies that arose with the Industrial Revolution? Maybe, I dunno. Disney once produced a brief documentary supporting such a claim. But for me, bank-created money is just an interesting story.
In some earlier posts here at IIDB I have tried to impose a sharp distinction between fiat money and bank-created money. I think the establishment of the Bank of England should yield good insight.
In 1690 the English Navy lost one of their best ships at the Battle of Bévéziers and their Dutch allies suffered greater losses. Control of the English Channel passed to France; England desperately needed money to protect their Island from the French. In 1694 the merchant William Paterson proposed forming the Governor and Company of the Bank of England to loan money to the Crown. That corporation was formed almost immediately, with 1200+ stockholders from all over England and from many social castes providing a total of £1,200,000; no stockholder was permitted to invest more than £10,000. To ensure that the government of England would be able to pay interest on its loan, Paterson required that Parliament pass a tax on tonnage.
The bank collected gold and silver from its investors, issued paper money to buy government debt paper, and collected 8% interest on that loan. Since the bank kept the coins in its vaults, if this transaction is viewed in isolation it was ALMOST the same as if the government had issued its own fiat money! The major difference is that the government paid about £100,000 annually to the bank to have it print the paper money! The bank was simply more trustworthy than the government (and did keep considerable precious metal in its vault).
The Bank of England loaned to others and performed other banking functions, e.g. providing gold or silver coins to anyone who wanted to redeem the paper money. Redeeming its paper for precious metals ("real money") might seem like a difficulty but interestingly it was the OPPOSITE difficulty that led to losses in the Bank's early years! Customers brought in clipped coins which the bank exchanged for paper money at face value, thus taking a loss.
But the key point in this anecdote was that the government of England paid out £100,000 annually instead of just printing its own paper money. Quite simply, money created by a reputable bank was more trusted than government-issued fiat money.
"Free-banking" in U.S. during the 1800's is another instructive example. These banks, despite the "free" adjective, were tightly regulated by state governments and typically had to deposit 100% of the value of any paper money they issued in government vaults. (To calculate the "100%", deposited debt instruments were evaluated at market value.) This was in addition to the precious-metal coins the bank kept in its own vaults for customers who wanted to redeem the paper. This paper money was mostly quite sound; although often traded at a slight discount in other states just due to the expense or inconvenience of transporting it for redemption.
Of course, bank-created money prior to 1933 was nominally redeemable for gold. (Never mind that there wasn't enough gold to redeem ALL of the paper money; the hope is that massive withdrawals will not occur if the banks are trustworthy enough.) After 1933, paper money issued by FedRes was partially "backed" by gold, but the backing was conceptual since only other central banks were invited to buy gold. (For several years after 1933 people all around the world were happy to SELL gold to the U.S. for what seemed like the inflated price of $35/ounce.)
The U.S. government has over 260 million ounces of gold worth $880 billion at the present market price. This is about 37% of the total value of Federal Reserve banknotes in circulation. This statistic can be viewed as irrelevant for several reasons, but it should suggest that U.S. money is not completely based on a worthless "house of cards"!
On a message board, there was once a whimsical post connecting modern bank-created money to an alleged Einstein explanation for wireless telegraphy:
Central banks create money, and private banks create money; the latter creations are subject to regulation by government regulators or the central bank. If the central bank is corrupted by political interference, trustworthiness may be lost. Even if we agree that bank-created money has a superior status to fiat money created by a government running its printing presses indiscriminately, that special status can be easily destroyed. Jamie Dimon, CEO of the world's largest bank outside China, is unhappy about rising debt, deteriorating respect for the Dollar, and a likely recession and has said that geopolitical risk is "very very very high." I don't know if Mr. Dimon is prone to hyperbole or how much attention should be given to the triplication of "very."
This should serve as a brief introduction to bank-created money. Perhaps there will be interesting discussion of likely developments in the 21st century.
- base money, for example precious-metal money
- fiat money
- bank-created money
- representative money
The U.S. money supply (M2) is currently $21 trillion, almost all of which is in the form of accounts at private banks. (Assets of JPMorgan-Chase total $4 trillion.)
Another thread got hijacked when I introduced the term "intrinsic-value money" to include precious-metal money and its kin. I considered
Commodity money as an alternate term, but the very first sentence of the Wikipedia article defines that using the forbidden adjective:Just as well. "Base money" serves our purpose better! We may use gold coins as an example of base money, but of course few if any countries actually rely on precious-metal money today!Wikipedia said:
Fiat money is money whose worth is decreed by government. For example, until the time of the Civil War the U.S. government minted both silver and gold coins and both were valued at essentially their market price. But as the price of silver fell the government continued to mint and redeem silver coins at the old rate: these coins then became money by government fiat. Similarly in the ancient world gold and silver were used as base money, but small-denomination coins were issued in copper and iron and treated as fiat money.
When there is no other base money, fiat money can serve as the base. Marco Polo reports that all people in China were required to trade their gold and silver to the Khan in return for his paper money. Instead of utility as money, precious metals' mere possession might have been a criminal offense!
Bank-created money is the subject of this post and will be discussed below.
Representative money is a promissory note or similar document denominated in another type of money. In early civilizations debts were often inscribed on clay tablets, denominated in a commodity like silver, barley or cattle. In the Middle Ages a merchant might deposit gold coins with a banker and be provided with a parchment document representing that deposit and permitting him to get paid by a partner bank in another city.
The U.S. government has printed banknotes of each type. Gold certificates represented the base money (gold) but became fiat when FDR revoked the promise of redemption. Abraham Lincoln famously issued "Legal Tender (fiat) Money" and emphasized its inferior status by requiring that import tariffs be paid in actual gold (or gold certificates). Silver certificates started as a representation of silver, but became fiat money when silver lost value. Eventually in the 1970's those certificates became an anomaly: The promise to redeem for silver was honored so the certificates were worth more than their fiat value. And of course, Federal Reserve notes are bank-created money.
So what is bank-created money, anyway? A usually necessary but insufficient condition is that the money be created via lending. This loaned money will usually be in representative form but that condition is neither necessary nor sufficient.
The origins of bank-created money are unclear. Lending itself wasn't particularly common. Governments sometimes imposed amnesties on debt. Both Christianity and Islam forbade the collection of interest; and loaned money was often just base money owned by the lender himself. Bank-created money derives from the loaning of depositors' money!
(One often hears the term "fractional-reserve banking" applied to denote the loaning of depositors' money whereby banks create money, with the fraction (often 1/10) of deposits which must be kept in reserve mandated by government. But let's note right away that the present-day reserve mandated by U.S. banking regulations is Z E R O .)
It might seem quite scandalous for a medieval banker to accept a deposit of gold coins, and then turn around and lend those coins to a third party; and in fact bankers made strict disincentives for borrowers or transferees to withdraw coins instead of leaving their funds on deposit. The bankers might avoid advertising this practice, thus tending to obscure the development of bank-created money. The equivalent of overdraft protection was a service banks were happy to extend to their best customers, and that may be the earliest clear example of money-creation by banks or money-changers. Because collection of interest on a per-month basis was immoral or even illegal, banks made their profits via service charges.
The trustworthiness of banks
Before a merchant would deposit gold with a bank, he had to be quite confident in the integrity of the banker. Most of us are happy to deposit money at Wells Fargo or at any big bank, but we may find it hard to believe that merchants in ancient times would place such trust in a two-man money-changing enterprise. Whether that trust existed and Why it did, might be an interesting topic for discussion but here I will just assert that apparently that trust did exist.
Here is a tourist-oriented look at the beautiful Cathedral of St. Martin in Lucca, which was a a major venue for money-changing for pilgrims en route to Rome. The webpage mentions the famous "oath of the moneychangers", still visible today:
The Oath of the Moneychangers translated from Italian said:
The rise of bank-created money is a fascinating story! Was it a necessary step for the development of the huge economies that arose with the Industrial Revolution? Maybe, I dunno. Disney once produced a brief documentary supporting such a claim. But for me, bank-created money is just an interesting story.
In some earlier posts here at IIDB I have tried to impose a sharp distinction between fiat money and bank-created money. I think the establishment of the Bank of England should yield good insight.
In 1690 the English Navy lost one of their best ships at the Battle of Bévéziers and their Dutch allies suffered greater losses. Control of the English Channel passed to France; England desperately needed money to protect their Island from the French. In 1694 the merchant William Paterson proposed forming the Governor and Company of the Bank of England to loan money to the Crown. That corporation was formed almost immediately, with 1200+ stockholders from all over England and from many social castes providing a total of £1,200,000; no stockholder was permitted to invest more than £10,000. To ensure that the government of England would be able to pay interest on its loan, Paterson required that Parliament pass a tax on tonnage.
The bank collected gold and silver from its investors, issued paper money to buy government debt paper, and collected 8% interest on that loan. Since the bank kept the coins in its vaults, if this transaction is viewed in isolation it was ALMOST the same as if the government had issued its own fiat money! The major difference is that the government paid about £100,000 annually to the bank to have it print the paper money! The bank was simply more trustworthy than the government (and did keep considerable precious metal in its vault).
The Bank of England loaned to others and performed other banking functions, e.g. providing gold or silver coins to anyone who wanted to redeem the paper money. Redeeming its paper for precious metals ("real money") might seem like a difficulty but interestingly it was the OPPOSITE difficulty that led to losses in the Bank's early years! Customers brought in clipped coins which the bank exchanged for paper money at face value, thus taking a loss.
But the key point in this anecdote was that the government of England paid out £100,000 annually instead of just printing its own paper money. Quite simply, money created by a reputable bank was more trusted than government-issued fiat money.
"Free-banking" in U.S. during the 1800's is another instructive example. These banks, despite the "free" adjective, were tightly regulated by state governments and typically had to deposit 100% of the value of any paper money they issued in government vaults. (To calculate the "100%", deposited debt instruments were evaluated at market value.) This was in addition to the precious-metal coins the bank kept in its own vaults for customers who wanted to redeem the paper. This paper money was mostly quite sound; although often traded at a slight discount in other states just due to the expense or inconvenience of transporting it for redemption.
Of course, bank-created money prior to 1933 was nominally redeemable for gold. (Never mind that there wasn't enough gold to redeem ALL of the paper money; the hope is that massive withdrawals will not occur if the banks are trustworthy enough.) After 1933, paper money issued by FedRes was partially "backed" by gold, but the backing was conceptual since only other central banks were invited to buy gold. (For several years after 1933 people all around the world were happy to SELL gold to the U.S. for what seemed like the inflated price of $35/ounce.)
The U.S. government has over 260 million ounces of gold worth $880 billion at the present market price. This is about 37% of the total value of Federal Reserve banknotes in circulation. This statistic can be viewed as irrelevant for several reasons, but it should suggest that U.S. money is not completely based on a worthless "house of cards"!
On a message board, there was once a whimsical post connecting modern bank-created money to an alleged Einstein explanation for wireless telegraphy:
Central banks create money, and private banks create money; the latter creations are subject to regulation by government regulators or the central bank. If the central bank is corrupted by political interference, trustworthiness may be lost. Even if we agree that bank-created money has a superior status to fiat money created by a government running its printing presses indiscriminately, that special status can be easily destroyed. Jamie Dimon, CEO of the world's largest bank outside China, is unhappy about rising debt, deteriorating respect for the Dollar, and a likely recession and has said that geopolitical risk is "very very very high." I don't know if Mr. Dimon is prone to hyperbole or how much attention should be given to the triplication of "very."
This should serve as a brief introduction to bank-created money. Perhaps there will be interesting discussion of likely developments in the 21st century.
