How (Central) Banking Really Works (I)

May 11 2015

Money and banking are increasingly becoming the subject of intense public debate. A recent example is the Dutch citizens’ initiative 'Ons geld' (Our Money); collecting more than 100,000 signatures in support of a proposal to put the power to create "money" into the hands of government. The public debate surrounding this proposal is dominated by people who confuse money and

How (Central) Banking Really Works (I)

Money and banking are increasingly becoming the subject of intense public debate. A recent example is the Dutch citizens’ initiative 'Ons geld' (Our Money); collecting more than 100,000 signatures in support of a proposal to put the power to create "money" into the hands of government. The public debate surrounding this proposal is dominated by people who confuse money and credit (money substitutes) whenever it fits their interests. That is why I will give some insights on money and banking, and explain why the 'Our Money' movement is wrong. This may end up becoming a mini-series out of this, so any feedback is appreciated.

Let’s Start With a Little History

Barter emerged when people decided to abandon their isolated existence; they started to trade apples for pears so to speak. Unfortunately, barter requires a 'double coincidence of want; ' someone who has an apple, but wants to have a pear has to find someone who has a pear and wants an apple.

So what happened over time?

People started to substitute less marketable goods for more marketable goods. In addition to their value in use, some of these goods obtained an additional ‘value in exchange;’ a price premium because they could be traded away easily in later exchanges. This evolution took place over a long time period.

A wide range of goods can be used as a medium of exchange: shells, sand, and so on. Indeed, the term 'salary' is derived from the Latin term 'salarium,' meaning salt, as the Romans at one point were paid out in salt.

Eventually, metallic money 'won' the battle. The precious metals are very suitable for usage as money; they are divisible, homogenous in nature and do not perish. A monetary metallic standard emerged.

The Evolution of the Banking System

The banking industry also developed during this time. People wanted to store their gold and vault owners — the precursors of modern banks — provided this service at a fee.

Little by little, these storage services developed into modern banking. A famous example is the Dutch Bank of Amsterdam that enjoyed international esteem. Gold was stored in the bank and all transactions (all gold deposits) were filed into a bookkeeping system. Transactions among clients could simply be balanced out in the books.

This modern bank was a 100% reserve bank; a bank that kept a 100% gold reserve against its checking deposits. The Bank of Amsterdam would be the last bank of this type. Since 1820, there have only been banks that operate with fractional reserves.

The Rise of Central Banking

In 1844, not long after the Bank of Amsterdam was dissolved, the banking act promoted by Robert Peel was enacted by parliament in England. This act made the issuance of bank notes the exclusive privilege of the Bank of England. Moreover, Peel’s act required all bank notes to be fully backed by physical gold and silver.

The 19th century was marked by a series of banking crises and recurring cycles of economic booms and busts. Robert Peel recognized that recessions had a monetary cause, and he believed that they could be ruled out by preventing the issuance of additional bank notes through a 100% reserve requirement and by concentrating this power by allowing only one bank to issue bank notes.

Incidentally, this is the reason why there is only one type of bank note in both Europe and the U.S. — those of the European Central Bank (ECB) and Federal Reserve — and why no bank notes issued by commercial banks like ING, BNP Paribas or Citibank exist, as was once the case in Scotland. Robert Peel’s banking act centralized the issuance of paper bank notes.

As a result of Peel’s act, commercial banks no longer held any gold (or silver), but simply opted for deposits at, or paper notes of, the Bank of England. As a matter of fact, Robert Peel centralized not only the issuance of bank notes, but also the banks’ gold reserves.

A tiny detail; as an 'emergency measure,' the 100% reserve required was suspended during the very first economic downturn that followed Peel’s act.

The Semi Gold Standard

Until 1971, the world operated under a semi gold standard. In 1944, at the Bretton Woods conference, the semi gold standard had made way for the dollar standard in many countries. However, at that time the U.S. dollar was still 'as good as gold.' In 1944, non-U.S. central banks started to hold dollars instead of gold. Before 1944, the gold reserves of each country were centrally held at the national central bank.

However both periods, before as well as after 1944, were marked by the fact that the gold supply of each country was in the hands of a central authority.

Since the transition to a semi gold standard — from a system in which checking deposits, payable on demand, were backed by gold held at the bank — the concept of money has changed. Gold is no longer money, the liabilities of central banks are.

Today, claims on banks are only claims to paper bank notes issued by our national central banks (that are not redeemable into something else).

Surprise: Your Checking Account Balance Is Not Money

To many, it will be a surprise to hear that the money on your checking account is not actually money; it is a loan to the bank which is payable on demand. You do not own money, but a bank liability. Usually, these claims are as good as money, but there is an important difference.

I want to stress that this difference between money and debt — or rather, bank liabilities — is of crucial importance to understand money and the monetary system.

A bank does therefore not "create money out of thin air." It issues liabilities which are redeemable into paper bank notes of the central bank, and which might also be accepted by other commercial banks as payment.

However, the government has done everything it can to underwrite these bank deposits (i.e., bank liabilities).

In almost all countries, deposit guarantee schemes have been enacted. As a consequence, deposit holders have become indifferent towards the creditworthiness of banks. A central bank is the lender of last resort. And in case that is not enough, the government — and thus taxpayers — assume the burden of the banks.

The balance on your checking account is therefore a money substitute, instead of money. Your checking account balance is a loan to the bank. The liabilities of the central bank are money.

Next week, we will discuss the granting of credit by commercial banks. If you have any remarks or questions, please do not hesitate to contact me.

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