The Mystery of Banking

We have so far seen how price levels are determined, showing how they are set by the interaction of the supply of and demand for money. We have seen that the money supply is generally the dominant force in changing prices, while the demand for money is reactive either to long-term conditions or to changes in supply. We have seen, too, that the cause of our chronic inflation is continuing increases in the supply of money, which eventually generate inflationary expectations that aggravate and accelerate the inflation. Eventually, if unchecked, the inflation runs away into a crack-up boom and destruction of the currency. In recent decades, absolute control over the supply of money has been in the hands, not of private enterprise or the free market, but of government.

How does banking fit into all this? In what way does banking generate part of the supply of money? Is banking inflationary, and if so, in what sense? How does banking work?

When one speaks of banks, there is a semantic problem, since the word bank covers several very different functions and activities. In particular, modern banking mixes and confuses two different operations with very different effects: loans and deposits. Let us first see how what we might call loan banking originated and what its relationship might be to the money supply and to inflation.

Most people think of banks as institutions which channel their savings into productive loans and investments. Loan banking is essentially that healthy and productive process in operation.

Let’s see how it works. Suppose that I have saved $10,000 and have decided to set up a loan business, or what we might call a loan bank.1 I set up the Rothbard Loan Company.

A must in making any sense whatever out of the banking system is to become familiar with the common accounting device of the T-account, or balance sheet. The balance sheet is a product of one of the most important inventions of modern civilization: double-entry bookkeeping, which came to Renaissance Italy from the Arab civilization of North Africa. Before double-entry bookkeeping, business firms kept single-entry books, which were simply running accounts of expenditures, income, and so on. They found it impossible to know where they had made mistakes, and therefore could not try to correct them. Double-entry bookkeeping, on the other hand, often means that any entry on one side of the ledger must immediately, and automatically, be balanced by an entry on the other side, the totals of which must be identical. It then becomes relatively easy to find out where the totals do not balance, and therefore where the error has occurred.

While the concept of double-entry bookkeeping was established during the Renaissance, the familiar T-account balance sheet was formalized only at the start of the “classical” period of modern accounting, that is, the late nineteenth century.2

On the T-account balance sheet, the left side is the monetary valuation, at any given time, of the total assets of the business firm. This side is, appropriately enough, labeled “Assets.” On the right side we have the total amount of assets owned by one or more owners. In short, any and all assets must be owned by someone, so that if we add up the assets owned by A, B, C ... etc., they should yield a total identical to the total sum of the assets. Some assets are owned in fact by the owner or owners of the firm (Equity Capital). Others are owed to, and therefore in an economic sense claimed or owned by, various creditors of the firm (Liabilities). So that, as total assets are apportioned among the various owners or claimants, the total of the right column, “Equity plus Liabilities,” must precisely equal the total assets on the left side.

Let us now return to the Rothbard Loan Company. I have saved $10,000 in cash, and place it in my firm’s account. The balance sheet of the new company is now as follows:

FIGURE 6.1 — STARTING THE LOAN BANK

The T-account shows that the assets of the Rothbard Loan Company are now $10,000 in cash, and that I own these assets. Total assets are precisely equal to total assets owned.

The purpose of forming the Rothbard Loan Company is, of course, to lend money out and to earn interest. Suppose that I now lend $9,000 to Joe’s Diner for a new counter, keeping $1,000 as a cash reserve. Joe borrows $9,000 at 10 percent interest, promising to pay me back $9,900 in one year’s time. In short, I give Joe $9,000, in return for which he gives me an IOU for $9,900 for one year in the future. My asset is now an IOU from Joe to be realized in the future. The balance sheet of the Rothbard Loan Company is now as follows:

FIGURE 6.2 — MAKING A LOAN

My assets have now happily grown, at least in anticipation. Total assets and equity are now $10,900. What, in all of this, has happened to the total supply of money so far? The answer is, nothing. Let us say that there was at the onset of the Rothbard Loan Company, $10,000 in circulation. I saved $10,000, and then loaned $9,000 to Joe. The money supply has in no sense increased; some of mine has simply been saved (that is, not spent on consumer goods), and loaned to someone who will spend it, in this case on productive investment.

Let us now see what happens one year later when Joe repays the $9,900. The IOU is canceled, and I now have in cash the loan paid back plus interest (Figure 6.3).

The loan is repaid, and my firm, and therefore myself, is $900 richer. But, once again, there has been no increase in society’s stock of money. For in order to pay back the loan, Joe had to save $900 out of profits. Again, Joe and I are transferring to each other the ownership of existing cash balances which we have saved by not consuming. My loan bank has channeled savings into loans, the loans have been repaid, and at no point has the money supply increased. Loan banking is a productive, noninflationary institution.

FIGURE 6.3 — THE LOAN AS PAID

The loan to Joe did not have to be made for business investment. It could have been a loan for consumption purposes, say, to enable him to buy a new car. Joe anticipates having higher income or lower expenditures next year, enabling him to pay back the loan with interest. In this case, he is not so much making a monetary profit from the loan as rearranging the time pattern of his expenditures, paying a premium for the use of money now rather than having to wait to buy the car. Once again, the total money supply has not changed; money is being saved by me and my firm, and loaned to Joe, who then saves enough of the existing money supply to fulfill his contractual obligations. Credit, and loan banking, is productive, benefits both the saver and the borrower, and causes no inflationary increase in the money supply.

Suppose now that my loan bank is flourishing and I expand the firm by taking in a partner, my brother-in-law, who contributes another $10,900 in cash to the firm. The Rothbard Loan Bank now looks as follows:

FIGURE 6.4 — EXPANDING BANK EQUITY

The firm has now expanded, and the increased assets are owned equally by my brother-in-law and me. Total assets, and total assets owned, have grown equally and accordingly. Once again, there has been no increase in the stock of money, for my brother-in-law has simply saved $10,900 from the existing supply, and invested it. Then, when more loans are made, cash shifts into IOUs and interest receipts eventually add to cash, total assets, and equity.

As the loan bank expands, we might decide to keep raising capital by expanding the number of partners, or perhaps by converting to a joint-stock company (legally, a corporation), which issues low-denomination stock and can thereby tap the savings of small investors. Thus, we might set up the Rothbard Loan Bank Corporation, which sells 10,000 shares at $10 apiece, and thereby accumulates $100,000 for making loans. Assume that $95,000 is loaned out and $5,000 kept in cash. The balance sheet of the Rothbard Loan Bank Corporation would now be as shown in Figure 6.5.

We could list the shareholders, and how many shares thus owned in proportion to the total assets of the newly-expanded Rothbard Loan Corporation. We won’t, because the important point is that more savings have been channeled into productive credit, to earn an interest return. Note that there has been no increase in the supply of money, and therefore no impetus toward inflation.

FIGURE6.5 — BANK GOING PUBLIC

Let us now expand the bank further. In addition to shareholders, the Rothbard Bank now decides to float bonds or other debentures, and thereby borrow from some people in order to lend to others. Let us assume that the Rothbard Bank issues $50,000 worth of bonds, and sells them on the bond market. The bonds are to be repaid in 20 years, paying 10 percent per year on their face value. Now $50,000 in cash is added to the bank’s coffers. We can also sell certificates of deposit, a relatively new banking instrument in which the owner of the certificate, Jones, buys a certificate worth $20,000 for six months, at 10 percent interest. In effect, Jones lends the Rothbard bank $20,000 in exchange for the bank’s IOU that it will repay Jones $21,000 in six months’ time. The Rothbard Bank borrows these moneys because it expects to be able to lend the new cash at a greater than 10 percent rate, thus earning a profit differential between the interest it pays out and the interest it earns. Suppose it is able to lend the new money at 15 percent interest, thereby making a profit of 5 percent on these transactions. If its administrative expenses of operation are, say, 2 percent, it is able to make a 3 percent profit on the entire transaction.

The new balance sheet of the Rothbard Bank, after it has issued $50,000 worth of long-term bonds, and sold a $20,000 short-term certificate of deposit to Jones, looks like this:

FIGURE 6.6 — BANK ISSUING DEBENTURES

The balance sheet of the Rothbard Bank has now become far more complex. The assets, cash and IOUs are owned or claimed by a combination of people: by the legal owners, or equity, and by those who have money claims on the bank. In the economic sense, the legal owners and the creditors jointly own part of the Rothbard Bank, because they have joint claims on the bank’s assets. To the shareholders’ invested $100,000 are now added $50,000 borrowed from bondholders and a $20,000 CD (certificate of deposit) sold to Jones. Once again, of course, the Rothbard Bank takes the newly acquired cash and lends it for further IOUs, so that the balance sheet now looks like Figure 6.7.

The Rothbard Bank is now doing exactly what most people think banks always do: borrowing money from some (in addition to investing the savings of the owners) and lending money to others. The bank makes money on the interest differential because it is performing the important social service of channeling the borrowed savings of many people into productive loans and investments. The bank is expert on where its loans should be made and to whom, and reaps the reward for this service.

FIGURE 6.7 — BANK LENDING BORROWED FUNDS

Note that there has still been no inflationary action by the loan bank. No matter how large it grows, it is still only tapping savings from the existing money stock and lending that money to others.

If the bank makes unsound loans and goes bankrupt, then, as in any kind of insolvency, its shareholders and creditors will suffer losses. This sort of bankruptcy is little different from any other: unwise management or poor entrepreneurship will have caused harm to owners and creditors.

Factors, investment banks, finance companies, and moneylenders are just some of the institutions that have engaged in loan banking. In the ancient world, and in medieval and pre-modern Europe, most of these institutions were forms of “moneylending proper,” in which owners loaned out their own saved money. Loan banks, in the sense of intermediaries, borrowing from savers to lend to borrowers, began only in Venice in the late Middle Ages. In England, intermediary-banking began only with the “scriveners” of the early seventeenth century.3 The scriveners were clerks who wrote contracts and bonds, and were therefore often in a position to learn of mercantile transactions and engage in moneylending and borrowing. By the beginning of the eighteenth century, scriveners had been replaced by more advanced forms of banking.

• 1We are using “dollars” instead of “gold ounces,” because this process is the same whether we are on a gold or a fiat standard.
• 2In particular, the originator of the Assets = Liability + Equity equation was the distinguished American accountant, Charles E. Sprague, who conceived the idea in 1880 and continued to advance the idea until after the turn of the century. See Gary J. Previts and Barbara D. Merino, A History of Accounting in America (New York: Ronald Press, 1979), pp. 107-13.
• 3During the sixteenth century, most English moneylending was conducted, not by specialized firms, but by wealthy merchants in the clothing and woolen industries, as an outlet for their surplus capital. See J. Milnes Holden, The History of Negotiable Instruments in English Law (London: The Athlone Press, 1955), pp. 205-06.