February 18, 2021 Reading Time: 6 minutes

The most important institution for governing supply of money in a free market economy is the network of organizations and laws that we call the banking system. Banking was not consciously intended as an institution for governing the money supply. Instead it was the product of entrepreneurial merchants trying to make a profit. But as is often the case, the pursuit of profit had enormous unintended consequences. In this case, those consequences were highly beneficial.

Banking, in essence, is borrowing short and lending long. We call a “bank” any organization that takes deposits, loans out a fraction of those deposits, and earns profits on the returns on its asset portfolio minus payments to depositors. While some commenters on money and banking discuss “100% reserve banking,” strictly speaking, this isn’t banking. Banking means fractional reserve banking, because banking is financial intermediation: linking up the suppliers of capital (e.g. households) with the demanders of capital (e.g. businesses), which requires loaning out deposits. (One exception is a form of banking that perfectly matches up time deposits with loans. This technically qualifies as both 100% reserves and genuine banking, but is sufficiently technical that it’s best relegated to more specialized discussions.)

Fractional reserve banking creates money. In the ordinary course of business, a bank that takes deposits and loans them out expands the money supply. If I take $100 in deposits from you and loan out $90, I have $100 in deposits on the liabilities side of my balance sheet, and $90 in loans plus $10 in reserves on the asset side. Because people treat bank liabilities as money, both the depositor and the borrower behave as if they possess the economy’s generally acceptable medium of exchange, in the face value of the amount held. I, the banker, have expanded the money supply by $90 on this round of loans. Of course, the process doesn’t finish here: some of that $90 will find its way back into bank deposits, and a fraction of that will be loaned out. Then the process starts again. This may appear dangerous, but the vast majority of the time, it isn’t. Depositors rarely show up all at once to demand redemption of their deposits. In the meantime, it’s a good thing that the bank can put idle capital to work, financing productive investments. (Occasionally, depositors do all show up at once. Things can get tricky then, but tricky does not necessarily mean destructive. We’ll talk more about bank runs later.)

How did banking arise? Most of the money we use today is some form of a bank liability (e.g., checking accounts), rather than the narrowest measure of money (in the United States, Federal Reserve notes, as well as reserves held by depository institutions at the Federal Reserve). And once upon a time, money was gold or silver, not green pieces of paper. So how did we transition from a pure system of commodity money to a banking system, where the liabilities of banks created by financial intermediation became “just as good” as hard money? 

As it turns out, many (if not most) of the activities that we know as banking reached their mature form in the Italian city-states during the Renaissance. Banking and finance are much older than we think! However, the most illustrative process for understanding the rise of banking took place in Northwestern Europe. Although it happened later, and thus should not be taken as the canonical narrative regarding the development of banking, it’s very useful to follow this process because it helps us understand the relationship between money, bank liabilities, and the banking system itself. 

Suppose you’re an English merchant. In the course of trading you’ve acquired many gold and silver coins. In fact, you’ve acquired so many that it’s too much of a hassle to keep all of them. These things are costly to store, after all, and there’s always the risk that someone may try to steal them. So what do you do? The answer is, you deposit them with the local goldsmith. Goldsmiths were metal workers who also sometimes stored gold and silver (ore and coins) for others. For a small deposit fee, the merchant could leave his coins and pick them up at his pleasure. The goldsmith would give the merchant a deposit slip or some other record denoting the amount deposited, and the merchant would present this to pick up his coins when he needed them.

Eventually, goldsmiths realized that merchants weren’t coming around very often to pick up their coins. Gold and silver could sit still for a long time. The goldsmiths, alert to profit opportunities, expanded their operations: they began lending out the gold and silver they took as deposits. Of course, they would charge interest to borrowers for the privilege of using someone else’s capital. This was clearly good for borrowers: they had access to funds that were previously denied to them. And it was good for goldsmiths: they got the interest payments. But aren’t the merchant-depositors getting fleeced? The answer is no, because they no longer paid deposit fees. In fact, they get paid, in the form of interest. The goldsmith has become a financial middle man, i.e., a banker. He borrows deposits from merchants, and lends those deposits to other businessmen who can use the capital for productive purposes. Everybody wins.

It’s important to emphasize that this process was not secret. Depositors definitely understood what was happening; there was no way for them to get paid, rather than paying, for their deposits otherwise. Nobody got the wool pulled over them in the transition from currency warehousing to genuine banking. As is often the case with commercial innovation, the institutional change was welfare-enhancing for all parties involved.

With the rise of banking, it was a relatively short journey from hard money to bank liabilities forming the standard circulating medium of exchange. Instead of actual gold or silver coins, people frequently carried bank notes denominated in gold or silver, redeemable by a specific bank. So long as the bank was trustworthy—it kept enough precautionary reserves to satisfy redemption demands, and didn’t use deposits to finance overly risky investments—bank liabilities were treated as good as the asset they represented, and were much easier to carry and trade with besides. 

Because there were multiple banks in a given commercial area, there were multiple kinds of bank liabilities. A gold-redeemable note drawn on the Bank of Alex may not be the same thing as a redeemable note drawn on the Bank of Will, even if they have the same face value. It all depends on how sound the banks are. This presents a potential informational problem. How do merchants evaluate the relative soundness of banks’ liabilities? Also, when banks come to acquire each other’s liabilities in the ordinary course of trade, how do they settle accounts among themselves? Enter one of the most important institutions in the banking system: the clearinghouse

Originally banks would send agents to each other to clear their liabilities. Representatives of the Bank of Alex and the Bank of Will would meet at regular intervals and square their books. If the Bank of Alex had more of the Bank of Will’s notes than the Bank of Will had of Bank of Alex’s notes, then the Bank of Will would clear the difference by transferring gold or silver. However, this bilateral process is unwieldy if there are more than a few banks in the area. Banks soon arrived at a process of multilateral clearing: representatives would meet at a specific place at a specific time, and clear liabilities against each other all at once. This was so effective that it became regularized: the multilateral clearing arrangement became permanent, becoming the institution of the clearinghouse.

Eventually clearinghouses performed a number of incredibly useful functions, besides just clearing liabilities. They created voluntary quality standards, such as minimal capital ratios, and made adhering to those standards a requirement for becoming and remaining a member of the clearinghouse. They monitored bank notes and kept an eye out for forgeries. And in financially precarious times, they facilitated emergency loans from banks with excess liquidity to banks that needed liquidity. They also occasionally created their own liabilities, usually amidst financial panics, and used those liabilities to increase the capitalization of the banking system, until operations returned to normal. Remember when we mentioned bank runs earlier? The negative effects of bank runs on the financial and economic system could be significantly blunted by a reputable and effective clearinghouse. 

The evolution of banking and its attendant institutions frequently resulted in a stable and efficient system for allocating capital to its highest-valued uses, and hence fueling economic growth. Have you noticed an entity that we haven’t mentioned as a part of this story? That’s right; we haven’t talked about government. The simple reason is, while government could (and often did!) mess up this process by imposing counterproductive restrictions, it was not necessary to create a healthy financial system. So long as banks (and related organizations, such as insurance providers) were subject to the general laws of property, contract, and torts, as well as general requirements for the formation of partnerships and corporations, the banking system had all the legal infrastructure it needed. Additional statutory regulation was not only unnecessary; it was often harmful. It’s a myth that banking and finance, if left to themselves, naturally result in an excess of cowboy capitalism that veers between unsustainable booms and painful busts. Such institutional failures occur because of too much government interference, not too little.

Now that we have a good idea about how the banking system works, we’re ready to explore just how governments often impeded this process. Unfortunately, this isn’t only due to well-intended public servants enacting policies with bad unforeseen consequences. Instead, many of the public policies that shackle the financial sector are designed to do so, because they help governments accomplish some other political objective. Engaging these political considerations, and how they impinge on banking and finance, is critical if we want to understand the history of monetary institutions, especially in the United States.

Alexander William Salter

Alexander W. Salter

Alexander William Salter is the Georgie G. Snyder 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 is a co-author of Money and the Rule of Law: Generality and Predictability in Monetary Institutions, published by Cambridge University Press. In addition to his numerous scholarly articles, he has published nearly 300 opinion pieces in leading national outlets such as the Wall Street JournalNational ReviewFox News Opinion, and The Hill.

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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