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Part Three: Money and Banking > Chapter 15. The Business of Banking

5. The Granting of Circulation Credit

According to the prevailing opinion, a bank which grants a loan in its own notes plays the part of a credit negotiator between the borrowers and those in whose hands the notes happen to be at any time. Thus in the last resort bank credit is not granted by the banks but by the holders of the notes. The intervention of the banks is said to have the single object of permitting the substitution of its well-known and indubitable credit for that of an unknown and perhaps less trustworthy debtor and so of making it easier for a borrower to get a loan taken up by "the public." It is asserted, for example, that if bills are discounted by the bank and the discounted equivalent paid out in notes, these notes only circulate in place of the bills, which would otherwise be passed directly from hand to hand in lieu of cash. It is thought that this can also be proved historically by reference to the fact that before the development of the bank-of-issue system, especially in England, bills circulated to a greater extent than afterward; that in Lancashire, for example, until the opening of a branch of the Bank of England in Manchester, ninetenths of the total payments were made in bills and only one-tenth in money or banknotes.4 Now this view by no means describes the essence of the matter A person who accepts and holds notes, grants no credit; he exchanges no present good for a future good. The immediately convertible note of a solvent bank is employable everywhere as a fiduciary medium instead of money in commercial transactions, and nobody draws a distinction between the money and the notes which he holds as cash. The note is a present good just as much as the money.

Notes might be issued by banks in either of two ways. One way is to exchange them for money. According to accounting principles, the bank here enters into a debit transaction and a credit transaction; but the transaction is actually a matter of indifference, since the new liability is balanced by an exactly corresponding asset. The bank cannot make a profit out of such a transaction. In fact such a transaction involves it in a loss, since it brings in nothing to balance the expense of manufacturing the notes and storing the stocks of money. The issue of fully backed notes can therefore only be carried on in conjunction with the issue of fiduciary media. This is the second possible way of issuing notes, to issue them as loans to persons in search of credit. According to the books, this, like the other, is a case of a credit and a debit transaction only.5 It is true that this is not shown by the bank's balance sheet. On the credit side of the balance sheet are entered the loans granted and the state of the till, and on the debit side, the notes. We approach a better understanding of the true nature of the whole process if we go instead to the profit-and-loss account. In this account there is recorded a profit whose origin is suggestive—"profit on loans." When the bank lends other people's money as well as its own resources, part of this profit arises from the difference between the rates of interest that it pays its depositors and the rates that it charges its borrowers. The other part arises from the granting of circulation credit. It is the bank that makes this profit, not the holders of the notes. It is possible that the bank may retain the whole of it; but sometimes it shares it, either with the holders of the notes or, more probably, with the depositors. But in either case there is a profit.6

Let us imagine a country whose monetary circulation consists in 100 million ducats. In this country a bank-of-issue is established. For the sake of simplicity, let us assume that the bank's own capital is invested as a reserve outside the banking business, and that it has to pay the annual interest on this capital to the state in return for the concession of the right of note issue—an assumption that does correspond closely with the actual situation of some banks-of-issue. Now let the bank have fifty million ducats paid into it and issue fifty million ducats' worth of one-ducat notes against this sum. But we must suppose that the bank does not allow the whole sum of fifty million ducats to remain in its vaults; it lends out forty million on interest to foreign businessmen. The interest on these loans consitutes its gross profit which is reduced only by the cost of manufacture of the notes, by administrative expenses, and the like. Is it possible in this case to say that the holders of the notes have granted credit to the foreign debtors of the bank, or to the bank itself?

Let us alter our example in a nonessential point. Let the bank lend the forty million not to foreigners but to persons within the country. One of these, A, is indebted to B for a certain sum, say the cost of goods which he has bought from him. A has no money at his disposal, but is ready to cede to B a claim maturing in three months, which he himself holds against P. Can B agree to this? Obviously only if he himself does not need for the next three months the sum of money which he could demand immediately, or if he has a prospect of finding somebody who can do without a corresponding sum of money for three months and is therefore ready to take over the claim against P. Or the situation might arise in which B wished to buy goods immediately from C, who was willing to permit postponement of payment for three months. In such a case, if C was really in agreement with the postponement, this could only be for one of the three reasons that might also cause B to be content with payment after the lapse of three months instead of immediate payment. All these, in fact, are cases of genuine credit transactions, of the exchange of present goods for future goods. Now the number and extent of these transactions is dependent on the quantity of present goods available; the total of the possible loans is limited by the total quantity of money and other goods available for this purpose. Loans can be granted only by those who have disposal over money or other economic goods which they can do without for a period. Now when the bank enters the arena by offering forty million ducats on the loan market, the fund available for lending pur poses is increased by exactly this sum; what immediate influence this must have on the rate of interest, should not need further explanation. Is it then correct to say that when the bank discounts bills it does nothing but substitute a convenient note currency for an inconvenient bill currency?7 Is the banknote really nothing but a handier sort of bill of exchange? By no means. The note that embodies the promise of a solvent bank to pay a sum to the bearer on demand at any time, that is, immediately if desired, differs in an important point from the bill that contains the promise to pay a sum of money after the passage of a period of time. The sight bill, which as is well known) plays no part in the credit system, is comparable with the note; but not the time bill, which is the form regularly assumed by the bills that are usual in credit transactions. A person who pays the price of a purchased commodity in money, in notes, or by the transfer of any other claim payable on demand, has carried through a cash transaction; a person who pays the purchase price by the acceptance of a three-month bill has carried through a credit transaction.8

Let us introduce a further unessential variation into our example, which will perhaps help to make the matter clearer. Let us assume that the bank has first issued notes to the value of fifty million ducats and received for them fifty million ducats in money; and now let us suppose it to place a further forty million ducats in its own notes on the loan market. This case is in every way identical with the two considered above.

The activity of note issue cannot in any way be described as increasing the demand for credit in the same sense as, say, an increase in the number of bills current. Quite the contrary. The bank-of-issue does not demand credit; it grants it. When an additional quantity of bills comes on to the market, this increases the demand for credit, and therefore raises the rate of interest. The placing of an additional quantity of notes on the loan market at first has the opposite effect; it constitutes an increase in the supply of credit and has therefore an immediate tendency to diminish the rate of interest.9

It is one of the most remarkable phenomena in the history of political economy that this fundamental distinction between notes and bills could have passed unnoticed. It raises an important problem for investigators into the history of economic theory. And in solving this problem it will be their principal task to show how the beginnings of a recognition of the true state of affairs that are to be found even in the writings of the Classical School and were further developed by the Currency School, were destroyed instead of being continued by the work of those who came after.10

  • 4. See Fullarton, On the Regulation of Currencies, 2d ed. (London, 1845), p. 39; Mill, Principles of Political Economy (London, 1867), p. 314; Jaffé, op. cit., p. 175.
  • 5. See Jaffé, op. cit., p. 153.
  • 6. This is the "surplus profit" (Übergewinn) of the business of banking, referred to by Hermann (op. cit., pp. 500 f.).
  • 7. As, for example, even Wicksell does (Geldzins und Güterpreise [Jena, 1898], p. 57).
  • 8. See Torrens, The Principles and Practical Operation of Sir Robert Peel's Act of 1844 Explained and Defended, 2d ed. (London, 1857), pp. 16 ff.
  • 9. Ibid., p. 18.
  • 10. Since the appearance of the first edition of the present work numerous books have been published that still do not recognize the problem of circulation credit. Among the works that have grasped the nature of this problem the following should be mentioned: Schumpeter, Theorie der wirtschaftlichen Entwicklung (Leipzig, 1912), pp. 219 ff.; Schlesinger, Theorie der Geld-und Kreditwirtschaft (Munich and Leipzig, 1914), pp. 133 ff.; Hahn, Volkswirtschaftliche Theorie des Bankkredits (Tübingen, 1920), pp. 52 ff.