Study Guide to the Theory of Money and Credit
15. The Business of Banking
Summary
A banker is one who lends out other people’s money; a capitalist lends out his or her own money. The business of banking falls into two distinct categories: (1) the negotiation of credit through the loan of other people’s money and (2) the granting of credit through the issue of fiduciary media.
In their role as negotiator of credit (or credit intermediaries), banks borrow from lenders at a certain rate of interest and then lend it to borrowers at (what promises to be) a higher rate of interest.
Credit transactions involve the exchange of present for future goods. Credit transactions can be divided into two groups: (1) Those in which one party has the benefit of obtaining a good in the present while the other party has the disadvantage of providing a good in the present, and (2) those in which one party has the benefit of obtaining a good in the present while the other party does not suffer any corresponding disadvantage. Loans of the first type (in which the lender actually renounces the use of his money) involve commodity credit while loans of the second type (in which the bank issues fiduciary media) involve circulation credit.
The crucial feature in loans of fiduciary media is that the original depositor is not engaged in a credit transaction. He retains the full use of his money, even as the bank lends it to someone else. This process increases the total amount of money in the broader sense.
Only by recognizing the fundamental distinction between notes and current accounts that are either (a) backed versus (b) unbacked by money, can the economist hope to understand the broader role that fiduciary media play in economic cycles.
Chapter Outline
1. Types of Banking Activity
A banker is one who lends out other people’s money; a capitalist lends out his or her own money. The business of banking falls into two distinct categories: (1) the negotiation of credit through the loan of other people’s money and (2) the granting of credit through the issue of fiduciary media. (Recall that fiduciary media are notes and bank balances—claims on money—that are not actually covered by money in reserve.)
2. The Banks as Negotiators of Credit
In their role as negotiator of credit (or credit intermediaries), banks borrow from lenders at a certain rate of interest and then lend it to borrowers at (what promises to be) a higher rate of interest. In this activity, prudent banks will obey the golden rule by which their liabilities will not mature earlier than their assets. In other words, the banks should not “borrow short to lend long,” if they want to avoid the risk of insolvency. Following the golden rule, by matching the maturities of assets and liabilities, will not eliminate all risks of course, because any investment could go sour and the borrower default on the loan from the bank.
3. The Banks as Issuers of Fiduciary Media
Credit transactions involve the exchange of present for future goods. Credit transactions can be divided into two groups: (1) Those in which one party has the benefit of obtaining a good in the present while the other party has the disadvantage of providing a good in the present, and (2) those in which one party has the benefit of obtaining a good in the present while the other party does not suffer any corresponding disadvantage. This second class of credit transactions is possible when a creditor issues fiduciary media; this person lends without really giving anything up. Loans of the first type (in which the lender actually renounces the use of his money) involve commodity credit while loans of fiduciary media involve circulation credit.
For all goods, an absolutely secure and immediately redeemable claim will inherit the market value of the good itself. However, what makes fiduciary media special is that they can indefinitely function as money substitutes, since (unlike all other goods) nobody ever is the final “consumer” of money proper. Therefore, claims to it can circulate in the community without ever being redeemed, which allows the banks to issue fiduciary media in the first place.
4. Deposits as the Origin of Circulation Credit
The issue of fiduciary media is intimately connected with the deposit system. A customer will deposit actual money with the bank, which then is the basis upon which fiduciary media (i.e., unbacked claims to money) are issued. The crucial feature in these operations is that economically speaking, the original depositor is not engaged in a credit transaction. He is not lending the bank his money, but is merely depositing it, because he still retains the full economic use of his money in the present. Therefore by granting new loans on top of such deposits, the banks increase the total amount of money in the broader sense. They are not mere credit intermediaries, but instead are granting the economic use of money to a new group, without taking it away from the original group.
5. The Granting of Circulation Credit
The specific method of issuance of fiduciary media is irrelevant for its effects on the value of money. The bank might (1) literally lend out the original depositor’s money (while the original depositor still believes he has full and immediate claim to it), (2) issue other bank clients banknotes which may be redeemed with the depositor’s money, or (3) grant new loans in the form of checkbook accounts, with the depositor’s money serving as part of the reserves behind the new loan.
Some writers treat the expansion of banks’ note-issue as akin to an increase in the community’s demand for credit. But if the community tries to borrow more, perhaps by issuing more bills of exchange, then the interest rate tends to go up. In contrast, the bank supplies credit: when it issues more notes, the rate of interest (at least initially) goes down.
6. Fiduciary Media and the Nature of Indirect Exchange
Only by recognizing the fundamental distinction between notes and current accounts that are either (a) backed versus (b) unbacked by money, can the economist hope to understand the broader role that fiduciary media play in economic cycles. On the other hand, it is also a mistake to deny fiduciary media’s ability to facilitate indirect exchanges. When someone sells a commodity for a banknote, and then uses the banknote to purchase another commodity, this is an indirect exchange just as surely as if the person had used money proper.
Important Contributions
• In the beginning of this chapter, Mises divides banking into two categories: the negotiation of credit through the loan of other people’s money, and the issue of fiduciary media. (Murray Rothbard, in his work on banking, classifies the two activities as loan banking versus deposit banking.) Although other writers are familiar with these concepts, Mises shone a spotlight on the distinction and will go on to point out the problems with the issue of fiduciary media (i.e., deposit banking) that some earlier economists had discovered.
• Continuing with the previous note, Mises explains his settling on the terms commodity credit and circulation credit on pages 264–65. Precisely because he believes the issuance of fiduciary media play such a crucial role in the boom-bust cycle in market economies, Mises is designing his theoretical edifice to highlight the phenomenon.
New Terminology
Banker: A person who lends out other people’s money.
Capitalist: A person who lends out his or her own money.
Credit intermediaries: Institutions that act as “middlemen” between lenders and borrowers.
Golden rule (of bank lending): Matching the maturities of assets and liabilities, so that the bank is not dependent on the ability to “roll over” maturing debt. If a bank does not follow the golden rule, increases in short-term interest rates can lead to disaster, when the bank must pay its own creditors while its assets are not yet due.
Commodity Credit: A loan granted through the renunciation of the use of present goods by the lender. Commodity credit may involve money certificates but not fiduciary media.
Circulation Credit: A loan granted even though the lender does not sacrifice the use of present goods. Circulation credit involves the use of fiduciary media.
Bill of exchange: A non-interest-bearing written order that binds one party to a pay a fixed sum of money to another party at a specified future date or upon demand. A bill of exchange is generally transferable through endorsement.
Current accounts (in banking): Accounts held with a bank, giving the owner the ability to write drafts or withdraw money upon demand. (Today a standard “checking account” would be an example.)
Loan banking: Banking through the use of commodity credit, where the bank receives loans from one group of savers in order to itself make loans to another group of borrowers. The savers do not consider this money as part of their cash balances during the term of the loan to the bank.
Deposit banking: Banking through the use of circulation credit, where the bank receives deposits into current accounts from one group of clients in order to make loans to another group of borrowers. The depositors consider this money to be part of their cash balances, even though much of it has been lent out to others.
Study Questions
1. Does Mises realize that modern banks perform other operations besides the two types of banking he mentions? (pp. 261–62)
2. Explain: “A person who has a thousand loaves of bread at his immediate disposal will not dare to issue more than a thousand tickets each of which gives its holder the right to demand at any time the delivery of a loaf of bread. It is otherwise with money.” (p. 267)
3. Why does Mises say that fiduciary media “can therefore be created only by banks and bankers”? (p. 269)
4. How does the issue of fiduciary media affect the objective exchange value of money? (p. 268)
5. Explain: “[Credit circulation] loans are granted out of a fund that did not exist before the loans were granted.” (p. 271)
