The Theory of Money and Credit

The business of banking falls into two distinct branches: the negotiation of credit through the loan of other people’s money and the granting of credit through the issue of fiduciary media, that is, notes and bank balances that are not covered by money. Both branches of business have always been closely connected. They have grown up on a common historical soil, and nowadays are still often carried on together by the same firm. This connection cannot be ascribed to merely external and accidental factors; it is founded on the peculiar nature of fiduciary media, and on the historical development of the business of banking. Nevertheless, the two kinds of activity must be kept strictly apart in economic theory; for only by considering each of them separately is it possible to understand their nature and functions. The unsatisfactory results of previous investigations into the theory of banking are primarily attributable to inadequate consideration of the fundamental difference between them.

Modern banks, beside their banking activities proper, carry on various other more or less closely related branches of business. There is, for example, the business of exchanging money, on the basis of which the beginnings of the banking system in the Middle Ages were developed, and to which the bill of exchange, one of the most important instruments of banking activity, owes its origin. Banks still carry on this business nowadays, but so do exchange bureaus, which perform no banking functions; and these also devote themselves to such business as the purchase and sale of securities.

The banks have also taken over a number of functions connected with the general management of the property of their customers. They accept and look after securities as “open” deposits, detach interest and dividend coupons as they fall due, and receive the sums concerned. They superintend the allotment of shares, attend to the renewal of coupon sheets, and see to other similar matters. They carry out stock exchange dealings for their customers and also the purchase and sale of securities that are not quoted on the exchange. They let out strong rooms which are used for the secure disposal of articles of value under the customer’s seal. All of these activities, whatever their bearing in individual cases upon the profitability of the whole undertaking, and however great their economic significance for the community as a whole, yet have no inherent connection with banking proper as we have defined it above.

The connection between banking proper and the business of speculation and flotation is similarly loose and superficial. This is the branch of their activities on which the general economic importance of the banks nowadays depends, and by means of which on the continent of Europe and in the United States they secured control of production, no less than of the provision of credit. It would not be easy to overestimate the influence on the organization of economic life that has been exerted by the change in the relation of the banks to industry and commerce; perhaps it would not be an exaggeration to describe it as the most important event in modern economic history. But in connection with the influence of banking on the exchange ratio between money and other economic goods, which alone concerns us here, it has no significance at all.