– January 2, 2018

Banking was a crucial development in the history of money and monetary institutions.  Banks engage in financial intermediation by borrowing short and lending long.  They take deposits—creating short-term liabilities for the bank—and use those funds to finance investment portfolios—which then adds longer-term assets to the other side of the balance sheet.  This “maturity mismatch” has been much maligned as a source of economic instability that may be, in itself, ethically suspect.  But pooling depositor resources and channeling them into long-term investment is a necessary component of any healthy capital allocation sector.  So long as depositors are not misled into believing banks are mere money warehouses—and the historical evidence is that, almost always, they were not so misled—there is nothing suspect, either economically or morally, about banking.

When banks take deposits, they issue liabilities in return.  This frequently took the form of bank notes: private liabilities drawn on the bank, redeemable in the economy’s “outside money,” which was usually a precious metal, such as gold or silver.  But because gold and silver are more costly to carry around than banknotes, traders have a strong incentive to use banknotes themselves as media of exchange so long as the bank has a sufficiently good reputation.  If merchants are willing to hold on to a bank’s liabilities, they effectively give the bank a zero-interest loan. Bankers who can maintain a larger float of their liabilities will, all else being equal, have an easier time financing their investment portfolios.  Of course, not all bank liabilities are notes.  Banks are also liable for demand deposits, which are held on the books. Unlike banknotes, banks pay depositors a positive rate of return on demand deposits.  In the aggregate, the difference between what a bank earns on its investment portfolio and what it pays to depositors and noteholders (banknotes only very, very rarely earned interest) is the bank’s profit—a reward for efficiently linking the capital of net suppliers of savings with the investment desires of net demanders of savings.

Modern banking can be traced back to Renaissance Italy.  The Medici Bank during the 15th century was universally held in esteem due to its size and success.  It was during this period that accounting innovations, such as double-entry bookkeeping, started to become widely practiced. This greatly improved merchants’ and financiers’ ability to make markets.  But it is to England in the 17th and 18th centuries we must look before we can see a banking system that, qualitatively, looks pretty much the same as those existing today.  Metalsmiths in London took deposits of precious metals and issued claim slips for them to warehouse customers.  They eventually innovated by lending out excess specie. Warehousers became depositors, who were happy that—instead of paying to store their metal—they earned a positive rate of return.  And, of course, the metalsmiths-cum-bankers were pleased with the additional profits for themselves.  Warehouse receipts evolved into negotiable instruments.  With the increasing sophistication of the fractional reserve system and credit money, permanent floats of banknotes became feasible.  The Bank of England was the first institution to maintain a permanent note issue, beginning in 1695.

With the rise and spread of banking, bank liabilities became money (exchange media).  Banks thus became the locus of the money supply, which emerged out of the profit-maximizing financial intermediation by bankers.  Due to the necessities of keeping highly accurate accounts, the unified money-and-intermediation process became much more orderly and regular.  But the increase in social legibility and intelligibility came with a pernicious side-effect: it was now much easier for rulers, always looking to expand their fiscal capacity, to constrain the financial sector with rules that would reallocate resources to the rulers themselves while indirectly imposing costs on society at large.

The most obvious example is the institution of central banking.  Early central banks were granted certain monopoly privileges by the sovereign in exchange for financing the sovereign’s activities at favorable rates.  Central bankers benefited from this arrangement because legal barriers enable them to earn monopoly profits.  Sovereigns benefited because they expanded their fiscal capacity: they were able to acquire funds at a lower price than they could have obtained in an unhampered market.  The rest of society, however, bore the costs, which include the foregone output associated with any monopolized market, as well as the resources wasted by the sovereign on privately beneficial but socially costly activities like war.

Today’s central banks are not mere fiscal agents of the sovereign in the way the earliest central banks were.  But the political roots of central banking matter for understanding why central banks have proliferated and now seem to be the bedrock monetary institution of modern developed economies. Central banks did not emerge to solve a “market failure”, as some economists suggest. The truth is much simpler: central banks have their origins in sovereign fiscal control.  They may no longer be primarily fiscal instruments, but the role they play, while significantly more subtle, is no less political.

Alexander William Salter

Alexander W. Salter

Alexander William Salter is an Associate Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute, both at Texas Tech University. He has published articles in leading scholarly journals, such as the Journal of Money, Credit and Banking, the Journal of Economic Dynamics and Control, the Journal of Macroeconomics, and the American Political Science Review. His opinion pieces have appeared in The HillThe American ConservativeUS News and World ReportQuillette, and numerous other outlets. Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.

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