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Banks and Money

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Published : March 08th, 2021
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At some point, I will actually talk about E. C. Harwood’s writings, but before then, I want to make some points about Money (the currency) and Credit (the banking system, and other credit such as bonds). Much confusion has taken place over the decades by mixing these together. It seems very complicated.

Let’s imagine two things. First, the only money in existence is gold and silver coins. Actually, this is the system defined in the U.S. Constitution, so it is not too fanciful. To simplify things, we will ignore the problem of small denominations, and consider a system with gold coins alone. (You could have silver coins as a token currency, which is what the U.S. actually had in the 1920s.) There are no paper banknotes, and no issuers of paper banknotes, such as central banks or commercial banks.

Now, let’s imagine that banks are funded entirely with time deposits, of a maturity of at least 90 days. There are no demand deposits, such as checking or savings accounts. This is entirely possible. In 1929, US banks had about $28 billion of time deposits, at $22 billion of demand deposits.

Since banks don’t have demand deposits, banks also do not offer any payment services. You can’t make any payments using a bank check, or something like a debit card. There are no credit cards. To make a payment, you have to deliver gold coins directly to the payee, in person. Employees are paid in gold coins.

To modernize things a bit, we can imagine an institution — traditionally called a bank, but let’s call it a payment house — that facilitates payments, so we don’t have to deliver gold coins in person. You have an account at this Payment House that is very much like a checking account. You can use this to pay other people who also have an account at the Payment House, or perhaps, people who have an account at another Payment House. Unlike a lending bank, these Payment Houses hold gold coins in 100% reserve against account balances. Their liabilities consist of the checking accounts, and their assets consist entirely of gold coins. To be profitable, they would have to make a small charge on payments, or perhaps charge a fee on balances. The contemporary equivalent of something like this would be GoldMoney, or perhaps a cryptocurrency that held 100% bullion assets such as Kinesis Gold. In the past, this was the model of the Bank of Amsterdam (which they did not quite follow) and the Bank of Hamburg (which did).

It is easy to see that using these Payment Houses is very much equivalent to delivering gold coins to the payee directly.

Lending banks are not in the payments business. They are in the lending business. They borrow at a low interest rate (here, time deposits), and lend at a higher interest rate. A modern bank makes almost no money from providing payment services. They don’t make much revenue from facilitating check or debit card payments, or ACH payments. They provide these services so that people will hold checking account balances with them, which is a low cost form of funding.

Now we can see that we have a payments system (gold coins and the Payment Houses), and a credit system (banks and bonds), and there is no overlap between them. There is nothing very much moneylike about a 90 day time deposit. Unlike a short-term bill, you can’t even sell it on the secondary market.

Because we wouldn’t have checking accounts at banks, for our cash needs we would have to hold either larger amounts of gold coins, or have an account at a Payment House, which is nearly the same thing.

In our last item, we imagined a theoretical Credit Contraction, in which banks would all require repayment of mortgages. Let’s now imagine that again, but in our system where banks are entirely funded with time deposits, and the money/payments system consists only of gold coins and Payment Houses, entirely separate from lending banks.

It does not take very long to see that the scenario is almost the same in either case. Repayment of mortgages would require paying gold coins (in person or via the Payment Houses) to banks. This would involve selling other assets, and also, probably drawing down the time deposits at banks. A similar thing happens to corporate bond issuers. Their old bonds come due, but nobody is willing to buy new bonds to roll over the debt. The corporations must come up with a lot of cash in a hurry. No banks are involved, but it is basically the same process.

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Nathan Lewis was formerly the chief international economist of a firm that provided investment research for institutions. He now works for an asset management company based in New York. Lewis has written for the Financial Times, Asian Wall Street Journal, Japan Times, Pravda, and other publications. He has appeared on financial television in the United States, Japan, and the Middle East.
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