BEE Partner, South Africa Economy Watch

Now let us look at modern money, which is not anchored in gold or precious metals, and consider how money that is purely a matter of convention or fiat obtains and keeps its value. In the older economy, money was anchored to metal that had ‘intrinsic value.’ Such money is an asset to its possessor, but it is no one’s liability. This connection is broken in modern systems in which money has no intrinsic value. It is an asset to its possessor, and a liability to its issuer. Between these, we have a system in which paper money and bank deposits are loosely tied to intrinsic value by being convertible into bullion, plate or coins. Such money is also a liability to its issuer. The implications of the change from money of intrinsic value to modern money are striking.

The value of money is now a matter of ‘exogenous pricing.’ There is no supply function. Nothing is supplied in the sense of being produced and having a unit cost, except a service. But the service does not have a unit cost, nor is the cost of the service in any way tied to the number of units of money issued. This service is one that the banks provide, and for which they are compensated by the rate of interest. But that does nothing to determine the value of money. There are no market processes to determine money’s value; it is set by history — in particular, the history of money wages — and by accident.

Deposits, loans and bank capital

A modern bank is generally a corporation owned by a group of stockholders.²⁹Their initial investment is the basis of the bank’s capital. Over time, this capital grows if the bank makes a profit and retains a portion of that profit in the business rather than turning it over to stockholders. The capital shrinks when the bank makes a loss. The capital is what the bank is worth to its owners.

Banks are in the business of making loans and in the process of doing so they create deposits. The role of bank capital is to make depositors comfortable with leaving their funds in the bank. The capital represents the difference between the bank’s assets and what it owes to depositors. As long as the bank has capital, any losses from bad loans will be borne by stockholders rather than the depositors. When a bank’s capital becomes too low relative to its assets, either because it has over-expanded or made bad loans, it must forgo making any additional loans. In this way, the amount of bank capital becomes a constraint on banks‘ lending and the amount of deposits they create.

The central bank

A banking system needs to have a way that checks can clear, a way that funds can be transferred from one bank to another. There are several avenues for this. The most important of these is for all banks to keep deposits at a central bank. In the US, that bank is the Federal Reserve. As checks pass from one bank to another, these deposits change hands. Since the Fed is the government bank, these deposits are a kind of Treasury money.

Banks can create currency in the same way they create deposits. When making a loan, instead of giving the borrower a checking account, they can give her a piece of paper good for that sum. Like the deposit, this is an IOU of the bank. The borrower, instead of writing checks for goods she wishes to buy, could simply give the seller this piece of paper. United States banks issued their own currency until the creation of the Fed in 1911. Since then, currency has come from the Federal Reserve and is a form of treasury money.

This means that banks now have a new problem. In order to do business, they need to have a supply of currency sufficient to meet their customers’ demand and a balance at the Fed sufficient to clear their checks. Banks can make loans and create deposits, but they cannot create balances for themselves at the Federal Reserve; they must make deposits, or have them advanced against their capital. This could be an important constraint on the ability of banks to make loans. Such a constraint is enhanced by laws in the US and other countries by requiring that banks keep a percentage of funds, beyond what is needed for clearing of their deposits, on deposit at the central bank.

But before we say this, we have to examine the point of origin of these reserves. They are not real reserves, not money of intrinsic value. Rather, they are deposits created by a special bank, the Federal Reserve. In this regard, the Fed operates like any other bank; that is, it makes loans and creates deposits. However, it only makes loans to banks and only accepts deposits from banks and the Federal government. There are other important differences. The bulk of the Federal Reserve’s assets are not loans, but government bonds. The Fed sometimes buys these bonds from the public, paying for them by creating deposits, much as an ordinary bank creates a deposit when it makes a loan. If the Fed sells some of these bonds to the public, deposits are destroyed. As long as the public is willing to buy and sell bonds, the Fed is able to create deposits and currency at will. Like banks of the nineteenth century, the Fed can create currency as well as deposits.

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