Re: Another View on Money and Credit

[Greg Nowell <GN842@xxxxxxxxxxxxxxxxx>]

As early as the 18th c commercial paper in England was said to circulate and
collect hundreds of endorsements before being "redeemed" --against more paper,
more often than not.  -gn.

GGard97342@xxxxxx wrote:

> In a message dated 27/01/2000 02:54:21 GMT Standard Time,
> wfhummel@xxxxxxxxxxxx writes:
>
> > Banks are not ordinary intermediaries.  When a bank creates a
> >  credit to fund a loan, it draws on its line of credit from the
> >  Fed.  Ultimately that credit line is limited by a bank's capital.
> >  As the banking system increases its aggregate issue of credit,
> >  the minimum reserve ratio requirement forces the Fed to add
> >  reserves.  If the Fed failed to do so, it would lose control of
> >  the interbank lending rate, i.e. the Fed funds rate, its primary
> >  monetary policy instrument.  Thus net lending by the U.S. banking
> >  system automatically brings forth new credit from the Fed.
> >
>
> An excellent paper but I would make two small amendments. Firstly I would say
> that an IOU only has the capacity to be "money", i.e. a medium of exchange,
> if it is assignable, and assignable without the consent of the debtor. Under
> English Common Law (a derivative of German Tribal Law), unless the terms of
> the debt say otherwise, the creditor has a legal right to assign the debt,
> but the assignment must be notified to the debtor, otherwise the original
> creditor can still enforce it. This is too complex for a commercial system,
> and to make debts more useful as a means of exchange the debt to "bearer" is
> necessary. Another snag with German Tribal was that it did not give specific
> performance of promises, and that prevented contracts to supply goods being
> used as a means of exchange. International commercial law is not therefore
> derived from German Tribal Law but from Babylonian Law which did enforce
> promises, and not merely give damages for breach of contract as English
> Common Law did. Europeans learnt of the difference in these laws in the
> course of the Crusades, and indeed in order to make the Frankish client state
> of Palestine economically viable the Babylonian principles were adopted into
> its laws. I gather that English Law did not make all the changes needed by a
> great international trading nation until abut 1840. The authority on all this
> is Ned Swan, an American lawyer working in London for the derivatives market,
> and his dissertation on it is to be published by his law firm.
>
> Secondly I think I would change the statement quoted above to explain
> slightly differently, but the final effect is the same.
>
> When a bank (bank A) grants a loan it can either give an overdraft facility
> or it can credit the sum to the borrower's current account, and debit it to
> his loan account. In the latter case the borrower draws a cheque in favour of
> his own creditor who pays it into his own bank account which we will assume
> is with a different bank (bank B). Bank B credits his account and debits its
> own "central bank account" in its own books. It presents the cheque through
> the clearing, and bank A gives bank B a cheque drawn on its account with the
> Central Bank, and that is cleared. Assuming no other transactions, that
> payment will take bank A's balance at CB below the legal limit. It can cover
> that by either selling an asset to the CB, by selling an asset to someone who
> will pay with money from an account at CB, or by borrowing from someone who
> has a credit balance at the CB. Bank B's account will automatically have gone
> above its required limit, and as the balance at CB is not interest earning it
> will seek to lend it out. The sensible thing to do would be lend it direct to
> bank A. But even if that is not done, one way or another the borrower of that
> money at CB WILL be bank A, whose deficiency will be remedied. Moreover when
> the account of bank B rises, the CB HAS to lend the excess somewhere, and the
> only taker will of necessity be bank A. With any other lending the CB will
> find that the money bounces back to it via some other account, and is
> therefore still available to lend to bank A.
>
> The matter is easier to follow and understand if one takes the view that cash
> at Central Bank is a special category of money, which indeed it is. (And cash
> at all other banks are special categories too.) The CB's accounts have to
> balance, and as long as it investments (loans) are the same, so must be its
> liabilities. Therefore if one bank runs down its balance at CB the
> ineluctable laws of double-entry bookkeeping ensure that some other bank's
> cash at CB will rise by the same sum. In Britain it used to be the task of
> the Discount Houses to be the intermediaries which effected the necessary
> flow between commercial banks, but it can equally well be done through the
> Central Bank. As the Central Bank holds the valve which controls at least
> some of the flow between banks it can sometimes use that control valve to
> determine short term interest rates.
>
> It will, I hope, appear from my explanation that the crucial factor is
> whether every bank strives to keep its balance at CB down to the minimum
> legal requirement. If bank B in the example allowed its balance to rise above
> the minimum, bank A would be dependent on the CB to sort it out of its lack
> of liabilities to balance its increased assets, and would be vulnerable to
> whatever interest pressure the CB wished to exert upon it. But if the banks
> all make sure they all keep their balances at CB to the minimum, the
> deficiency of one will always be met by a loan from the surplus of another,
> and the capability of commercial banks to increase the credit supply is
> limited only by their capital adequacy ratios. And that limit is only
> temporary because the banks can insist that some borrower funds his borrowing
> in the direct credit market (usually the bond or equity market), and that
> action frees up some of its capital base to enable it to effect new lending.
>
> Money/credit is created in the indirect credit market, that is by banks, but
> leaks into direct credit market by funding. If textbooks on monetary theory
> on your bookshelves do not explain this, you may safely pulp them.
>
> On this analysis the capacity of banks to increase the credit supply is
> potentially infinite. It will be claimed that the need to supply cash will be
> a limit if the government restricts the supply of bank notes and coin. The
> answer to that is that in practice governments no longer try to restrict the
> supply - or at best just pretend to do so. The demand for cash and the supply
> are always in balance, which is of course why cash earns no interest. At
> equilibrium the rate of interest on a specific category of credit (not credit
> generally) is nil. (Adam Smith did not know that, hence his opposition to
> paper currencies.) If the supply of cash is restricted, the public is
> perfectly capable of manufacturing its own medium of exchange, one which
> neither the CB or the government can control. It reverts to the form of money
> which existed long before central banks, coins, bank notes or currencies were
> thought of. That is the bill of exchange, often evidencing trade credit.
>
> Geoffrey Gardiner

--
Gregory P. Nowell
Associate Professor
Department of Political Science, Milne 100
State University of New York
135 Western Ave.
Albany, New York 12222

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