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SCI LIBRARY

Libertarian Land Philosophy:
Man's Eternal Dilemma

Oscar B. Johannsen, Ph.D.



BOOK III: Banks, Saving, and Investment

Chapter 1 - Banks -- Trust Guarantors



"Economists may be right in asserting that the present state of banking makes government interference with banking problems advisable. But this present state of banking is not the outcome of the operation of the unhampered market economy. It is a product of the various governments' attempts to bring about the conditions required for large-scale credit expansion. If the governments had never interfered the use of banknotes and of deposit currency would be limited to those strata of the population who know very well how to distinguish between solvent and insolvent banks. No large-scale credit expansion would have been possible. The governments alone are responsible for the spread of the superstitious awe with which the common man looks upon every bit or paper upon which the treasury or agencies which it controls have printed the magical words legal tender." [Ludwig von Mises --- Human Action]



Of the three aspects of exchange -- barter, money and credit --- that of credit is by far the most important, certainly in modern countries. For it to attain its maximum potential the two problems associated with it -- trust and time -- must be minimized.

Trust is the more important for if a borrower is not trusted, a lender will not grant credit even if the time period involved is very short. Reducing the problem of trust to a minimum is difficult, as few are able to determine the trustworthiness of people other than those in their immediate circle. Yet for credit to exist at city, state, national and international levels, some means are required to determine people's trustworthiness. In establishing banks, men solved this problem quite unconsciously.

If one were asked to define an automobile, he might say that it is a four-wheeled vehicle usually powered by an internal combustion engine. A more fundamental view of it would be to say it is a device for transporting people over space.

Similarly, if one were asked to define a bank establishment he would probably say it is an establishment for the custody, loan, exchange, or issue of money, and for the extension of credit. But if one looks beneath the surface, one would probably decide that fundamentally it is an establishment which reduces the problem of trust to a minimum. It is a guarantor of trust.

It attains its purpose by putting its superior trustworthiness at the disposal of its borrowers by substituting its debts--its banknotes and demand deposits--for the debts of its borrowers. This is equivalent to guaranteeing the credit-worthiness of its borrowers for a bank would never hand over its banknotes or credit them with demand deposits if it did not trust them. For a bank to give its IOU's for the IOU's of one of its borrowers is the same thing as if John D. Rockefeller gave his IOU's to you in exchange for yours. As his IOU's are more acceptable than yours, people would be more willing to accept them. Similarly, a bank's IOU's are much mere acceptable than yours.

An example may help to clarify this point. A young man starts a grocery store. The little money he has is used to purchase the land, store and equipment. Other than that, he has nothing but excellent merchandising ideas and plenty of energy. He asks the wholesalers in his area for the loan of groceries with which to stock his store. Businessmen, of course, do extend credit on an individual's IOU. However, they are reluctant to do so unless they know the party quite well. The wholesalers would probably insist that the young man have his IOU guaranteed by some responsible person. If he does this, as the party guaranteeing the note has now accepted the young man's liability if he should default, the businessmen would gladly furnish him the merchandise. If the venture is successful, he pays off his debts and the food producers return his IOU's to him. He, then, destroys them in the presence of the person who guaranteed them to prove that the guarantor's responsibility has ended.

However, most people do not like to guarantee the debts of another. Usually, only a close relative night be willing, Ordinarily, then, the young man would go to a bank. After investigation convinced it that his knowledge of the business and his character made his success quite likely, the bank would back him up. It might do this by giving him money in return for his IOU. More probably, it would give him its banknotes, or establish a bank account in his name for the amount he needed. In other words, it would give him its own IOU's in one form or another. For simplicity, we will assume it gave him its banknotes. He takes them to the wholesalers. As they know the bank and are certain of its solvency, they readily accept them in return for their merchandise.

Instead of merely holding the banknotes as they might do until the young man redeemed them, they treat them as though they were money. They pass them along to their employees as wages. In turn, the employees use the banknotes to purchase groceries from the young man. Now, he has the banknotes again. He takes them to the bank to redeem his IOU, and the bank destroys its IOU's -- its banknotes.

What has occurred? In effect, the bank has guaranteed the young man's trustworthiness. It could have taken his IOU's and guaranteed them, just as some individual might have, by merely writing across the face of the notes "guaranteed by ABC Bank". He could then have taken his bank-guaranteed IOU's to the wholesalers who would have given him the merchandise without question. His bank-guaranteed IOU's could even have circulated throughout the community as banknotes do for it is the bank's guarantee which is important. Eventually these notes might have wound up in his hands in payment for his groceries. In that event, he could take them to the bank to destroy them in the presence of the bank's officers to prove that with their destruction the bank was no longer liable for them.

For a bank to use its own banknotes instead of writing "guaranteed" across the face of the young man's IOU's is primarily a mechanical improvement. Either would be acceptable as people are interested in the bank's guarantee and not particularly concerned with the young man's promises. The bank's IOU's are merely substitutes for the young man s, but much more acceptable ones.

The bank is in a position analogous to that of an individual who guaranteed the young man's note. If the young man is successful and pays off his IOU's, the guarantor of his IOU's does nothing. The guarantor does not have to redeem the IOU's . All he had done is to render the young man a service by putting his superior credit rating at the young man's disposal, for which the guarantor might or might not have received some compensation.

Similarly, the bank really did nothing but put its superior credit rating at the young man's disposal for which it received a fee -- the charge it levied for extending "credit". As the young man paid off the loan by returning the same banknotes he had borrowed, all the bank had to do was to destroy them. It did not need to draw on its money to redeem its IOU's any more than did the individual guarantor have to draw on his money to redeem the young man's IOU's.

In this example the goods have been exchanged over time -- a credit transaction -- with the banknotes as the evidence of the debt. The wholesalers could have kept the banknotes in their safes just as they would have kept the young man's IOUs if they had granted credit to him on his personal note. Subsequently, the young man could have redeemed the banknotes with money he obtained from selling the groceries. In such a case, clearly the wholesalers extended credit in the form of the goods they loaned the young man, and he paid for them in the future with another good -- money. The banknotes were merely the evidence of the debt.

It may be objected that in obtaining banknotes, the wholesalers were actually receiving more than merely the bank's IOU's as evidence of the debt. They were receiving something which they could treat, as they did in fact treat them, as though they were money, at least within their trade circle. But what this is saying is that the banknotes not only reduced the problem of trust to a minimum, but they also reduced the problem of time to a minimum. Instead of a businessman's assets being tied up during the period of a loan, in effect, the bank takes over this time problem.

A businessman ordinarily extends credit for 30,60,90. or 120 days. If he keeps his customer's IOU's he restricts his ability to replenish his own inventory. Most of his customers' debts probably cannot be passed on to others as they may not be acceptable. Although this problem can often be solved by discounting the notes at banks, the more satisfactory method is to use a bank's debts directly.

As the young man presented banknotes to the wholesalers, and as they could redeem them immediately in money at the bank, as far as they were concerned they engaged in a barter exchange in which their goods were exchanged for money. The time element in the credit transaction had been reduced to zero for them just as the problem of trust had been eliminated.

If one will trace the ramifications of this simple example it becomes apparent that not only was the young man's credit problem solved but also the credit problem of the others involved in the transaction. For instance, when the employees took the banknotes, they were granting credit to the wholesalers' in the form of their services and received the banknotes as evidence of this fact instead of the wholesalers' IOU's. Possibly they would have hesitated to accept their employers' IOU's as they might have feared that the wholesalers might not be able to redeem the debts.

Subsequently, when the employees presented the banknotes to the young man for groceries, it was equivalent to the young man granting them credit in the form of his groceries with the banknotes as evidence of the debt. Possibly, he too might not have been willing to grant credit to them on their own IOU's.

This example illustrates how efficiently credit can function when a bank's debts are used as evidence of the credit extended. If banks did not exist, while credit would still be granted, it probably would not work as efficiently nor as simply.

Each time a bank's debts are substituted for some individual's or firm's IOU's, the credit transactions tend to be treated as though they were money transactions. Money may never even be used, as shown in this example.

It should be noted that the monetary factors obscured what occurred, which was that the employees produced groceries which they, themselves, subsequently purchased. The young man, the bank and the wholesalers assisted. We come back to the simplest fundamental of all, which is that all that men do is to produce and exchange one good for another. Money, banknotes, demand deposits, all of the elaborate and sophisticated paraphernalia comprising a complex banking system merely assists the barter of one good for another.

Inasmuch as a bank by substituting its debts for someone else's, as the young roan's, is assuming the liability for making good on the credit transaction, necessarily it must be careful that it will guarantee only the debts of people who are quite likely to live up to their promises. As long as its banknote issue is reasonable. people will treat its notes as though they were money and will probably only redeem a fraction of them. But it must never abuse its issuance of banknotes. After all, a banknote is a debt of a bank, no different from the debt of any individual or business. The fact that people may treat such debts as though they were money does not make them money. They are still debts. It may he puzzling to the reader why so much stress is placed on the importance of banknotes being redeemed into money. This is because the interference of governments in monetary affairs has given rise to beliefs regarding banknotes which are not true. For the most part, governments have made the issuance or banknotes the monopoly of their central banks. They declare that such banknotes are legal tender, by which is meant that the governments will recognize that debts incurred may legally be redeemed in such banknotes. People, therefore, particularly in western countries look upon banknotes as money. Even if some do recognize that they are not, the fact that the banknotes are legal tender is sufficient for them. They have enough problems of their own without worrying about fine points in monetary theory.

Wherever governments do not interfere in monetary matters, or their interference is minimal, people do not accept banknotes so readily. On the contrary, they take hard looks at them, They investigate the bank's solvency and if they have any doubts either they may not accept then at all, or if they do, only at a discount. Since the governments have not made them legal tender, people by their actions indicate quite clearly that they are well aware that a banknote is precisely what its name says -- a debt of a bank. It must be treated with about the same caution that one applies to any IOU. Banknotes ordinarily will only circulate within the area in which the bank is located, and even there the banknotes may only be accepted by merchants whose trading activities bring them into more or less close contact with the bank.

Americans have lost sight of the fact that in the 19th Century the banknotes of state banks were carefully scrutinized. Many of them were only accepted at fairly substantial discounts. Probably few 19th Century Americans suffered from the illusion that banknotes, particularly banknotes of state banks, were money. To them money was specie, i.e., gold and silver coins.

Inasmuch as a bank's activities revolve around its debts as well as those of its customers, it became a liquidator of debts. If A owes B, and B owes C, and C, in turn, owes A, and if all are depositors of the same bank, their debts can be liquidated without the use of money. A draws a check to B's order which B deposits an his own account. The bank debits A's account and credits B's account, thereby liquidating A's debt to B. If B subsequently draws a check to C, which C deposits, and then C draws a check to A, which A deposits, the debts of all would be wiped out, and with no money changing hands. It would be similar to A handing B a banknote in payment of his debt. B then hands it over to C, and C to A. The debts would all be liquidated. The banks debts -- its banknotes or demand deposits -- were the means used to wipe out the debts.

The above is extremely simplified in which all are depositors of the same bank and owe each other the same amount. However, it illustrates the point that banks by means of offsetting transactions in its depositors' accounts helps in the liquidation of debts. Through the use of clearing houses, which are merely establishments where the debts of one bank are matched against the debts other banks owe it, the depositors need not be customers of one bank but of any bank. Essentially, the only money needed would be that required to make up any difference between what one bank owes another. Even that is hardly necessary under the present centralized systems, for any differences will usually be settled with a check on the central bank.

Most banknotes and/or demand deposits come into existence as a result of loans being granted by banks. A bank will either print banknotes to give to the borrower, or set up an account crediting him with the amount of the loan. Some students of money, alarmed at the abuse in the over issuance of banknotes and the unwise creation of demand deposits would like to prevent a bank from issuing any banknotes or setting up any demand deposits unless these debts are backed 100% by money. This is analogous to preventing an individual from going into debt unless he had the money to pay off his debt immediately. Just as any individual should be permitted to go into debt, so should any bank.

Also, just as it is not only proper but probably wise for any individual to go into debt to carry on his business as long as he pursues sound policies, so it is wise for a bank to go into debt as long as it adheres to sound banking principles. If a bank is well managed, its banknotes and demand deposits are not backed up merely by air. On the contrary, back of each banknote will be a fraction of the money in the bank's vaults. Also, back of each banknote will be the note of the borrower, as in the case of the young man. The bank will not accept the notes of irresponsible people, so the IOU's they do accept cannot he passed off as unimportant. Reputable businessmen take their debts seriously and will go to great lengths to make good on them. Some have even committed suicide so their insurance would make their debts good. Also, back of each banknote is the collateral which the bank would hold. This would be a lien on the goods coming to market for which the loan was given. In the case of the young man, it would have been a lien or the groceries. The bank could, if necessary, repossess them to the extent that any remained.

0ff-hand, it might seem that rather than goods coming to market, as groceries, serving as collateral, it might be better to have assets as buildings or land inasmuch as they are more likely to he in existence when the debt is due. They could then be repossessed if necessary. But sound practice requires that banks issue banknotes based on loans which are called short-term self-liquidating commercial paper. This means the banknotes are hacked by commodities which have a high degree of marketability. These are usually consumer items as wheat, cotton, and hardware. And there is a good reason for such assets being the basis for the issue of banknotes.

Banknotes and demand deposits are debts which must be redeemed immediately upon presentation. A bank's debt tends to reduce the element of time in credit transactions to zero by absorbing, in effect, the time problem. But that does not mean a bank can reduce any length of time to zero. If it issues banknotes based on loans due in twenty or thirty years, it is assuming a task for which it is not equipped. Its loans should be as short as possible and based on wealth which is highly marketable in order to insure that if need be it can quickly acquire the necessary money to redeem its debts. Thus, the type of wealth which a commercial bank ordinarily should not have as collateral for its circulating debts would be buildings, homes, factories, and land. Loans based on such assets should be left to savings banks and other financial institutions specializing in loans on such assets.[1]

If a commercial bank's loans are primarily on land or capital instead of on goods coming to market, it changes its character from a bank to an investor in loans on fixed assets. Since such are not readily exchangeable on short notice, the commercial bank would find it difficult to redeem its banknotes on short notice if a large number were presented for redemption.

This does not mean that banks should he prohibited from granting such loans as the freedom of individuals, firms, or banks to do as they please must not be infringed as long as they do not interfere with others doing as they please. Rather, it means that banks should adopt policies which make it unlikely that such loans will be granted, or if they are, at least only to a very limited extent.

At this point, the reader may agree that this overly long discussion may indeed indicate that a bank is fundamentally an establishment for guaranteeing trust and that it does not grant much credit, certainly not as defined in this book. But the reader may well argue that from a practical standpoint, banknotes and demand deposits are generally considered to he money and are so used every day. It can easily be demonstrated that most economists call such exchange media money and some even list savings and other time deposits of commercial banks as money. And this involves billions upon billions of dollars.

Certainly, there is no question that a banker believes he is loaning money, the borrower believes he is borrowing money, and the fee for the loan, as far as they are concerned, is determined by the relationship between the demand for and the supply of money, taking into account such factors as the period of time involved and the trustworthiness of the borrower. As a matter of fact, this loaning process is often characterized as the monetization of debts. By this is meant that the debts of individuals are changed into money by the bank substituting its banknotes or demand deposits for the individual's debts The reader is well aware by now that this is incorrect as a bank's debts are no more money than an individual's. They are just more acceptable debts.

However, although this anticipates some points to be discussed later, it might not be amiss to note that it is a question if the amount of credit guaranteed by commercial banks would be as huge as it is today were it not for the interference of the government.

For example, in the United States by the government declaring that Federal Reserve Notes are "legal tender for all debts, public and private", and forbidding banks to issue banknotes, it has usurped, in large measure, the principal function of banks -- guaranteeing credit at least where banknotes are concerned. Why is this? Because if a bank grants a loan by giving the borrower the government's banknotes (the Federal Reserve Notes) then, in effect, the government has guaranteed the loan. Its debts have been substituted for the borrower's IOU's. As the government's banknotes are considered more reliable than those of any bank's, they circulate that much more readily. And, of course, on top of that, since the government declares that its banknotes are money, the recipients of the banknotes do not merely treat them as though they were money. As far as they are concerned, they are money. No questions arise in their minds as to whether or not the banknotes can be redeemed or not.

In such instances, the bank's function has been changed from that of guaranteeing a borrower's trustworthiness to that of selecting which borrower will receive the government's guarantee. It is true that if the borrower does not repay the loan, the bank will suffer the loss and not the government. However, this merely means that such loans are similar to ones in which the bank gives a borrower actual money (gold). Such loans have always been made by banks. Loans now made by means of banknotes come under the same category as loans of money.

But what about loans granted by means of demand deposits? A bank's demand deposits are not legal tender, as Federal Reserve Notes are. True, however, even here while the government has not usurped the bank's function of guaranteeing trust, it does control it.

As large commercial banks are members of the Federal Reserve System, their reserve requirements are set by the Federal Reserve. Reserves are the amounts of "money" which must be kept on deposit in the Federal Reserve Bank to which the commercial bank belongs. These reserves must be a certain proportion of a bank's deposits, which proportion is determined by the Federal Reserve System under authority granted to it by Congress. Although this percentage figure is presumed to represent the minimum amount of reserves which a bank must set aside, inevitably it tends to be the maximum amount. If the percentage of reserves which must be kept on deposit with the Reserve Sank is 17% of a bank's deposits, the bank's target is to meet that figure, and utilize the balance of its deposits for loans and investments. Small, country banks may not be so meticulous about using every dollar of the balance available on which to earn a return, but large banks feel they have no choice.

Since the System determines the proportion of reserves to be set aside, it has relieved the member banks of the extremely important responsibility of determining what their reserves to deposits ratio should be. Every bank issuing banknotes and creating demand deposits must always stand ready to redeem its circulating debts into money.[2]

There can be no half-way measures in this regard. If there is the slightest question at all, a run on the bank will develop as depositors rush to the bank to redeem their deposits. Through experience, a bank determines what is its soundest reserve-deposit ratio, and this may change over time as circumstances vary. A new, untried bank obviously would have to maintain a higher ratio than a well established, conservatively managed one. But the ratio, whatever it is, is determined by each bank in order to make sure that it will always be able to redeem any circulating debts presented to it for payment.

However, when the government, through its central bank, assumes this responsibility and arbitrarily determines what the ratio shall be, then, indirectly it is controlling how much of the banks' creditworthiness they can put at the disposal of borrowers. If the ratio is raised, each bank is forced to reduce the amount of guaranteeing of loans which it can make. If the ratio is reduced, the central bank is telling the banks to increase the quantity of guaranteeing.

This distortion of a banks function of guaranteeing trust tends to create loose banking practices. If each bank had to stand on its own feet, if it had to determine its own reserve ratio, and stand ready to redeem its banknotes and demand deposits in actual money, it seems quite likely that the amount of trust-guaranteeing would be much less than now. If it were to be the same, it would probably be distributed among a greater number of banks, so tighter control over it would be maintained, and the quality of loans would be better. It also seems likely that the amount of loans based on fixed assets, as land and capital, would be very much less than at present, probably negligible, which is as it should be.

The elaborate banking mechanism which has been erected in the United States, and the activities of the nation's central bank, the Federal Reserve System, are all predicated on the assumption that the debts of banks -- banknotes and demand deposits -- can be classified as money. And it is well recognized that the increased or decreased supply of this exchange media will have tremendous ramifications not only on the cost of hiring money but on prices generally and on the economy itself.

The monetary and economic literature which has arisen based on this assumption is so vast, so complex, and so sophisticated that one could spend a lifetime on it and still merely have skimmed the surface. Possibly all this literature would still have come into existence. much along its present lines, even if men had carefully defined money as a commodity, and the associated receipts and promises, not as money, but what they really are -- money-aids. Possibly all that would have occurred would be that a different perspective might have resulted. But such could be important and might have resolved questions which are still debated with few satisfactory answers, one way or the other.

Example: It becomes clearer why a bank should not issue banknotes ad infinitum when it is recognized that all it is really doing is guaranteeing debts. Even the most naive appreciate that there are limits to the guarantees a person or an institution can make. An understanding of what a bank does when it appears to create money out of nothing has seemed to be so mysterious that even those intimately concerned with money and banking are often puzzled by it. But a bank is not creating money. It is merely guaranteeing debts -- something anyone can do.

Example: When it is recognized that banks are trust guarantors, it is obvious that guarantees should be restricted in quantity and length of time. The arguments are interminable as to whether banks should restrict their lending to short-term, self-liquidating assets, or whether they should expand their lending to any type of asset. But if it is understood that all a bank does is to guarantee loans, it becomes clear that guarantees should be short-term, for the vicissitudes of life, being what they are, to make guarantees for long terms is not only unwise but worthless. Who can guarantee what he will do twenty or thirty years from now? The long term debts of corporations or governments, even if guaranteed by some individual, or institution are actually not guaranteed debts. People are only deluding themselves. In the 1920's, there were many guaranteed mortgages issued. These were supposed to guarantee the mortgagee against a default by the mortgagor. Most of these guarantees became worthless in the ensuing depression. In the world of chance in which men live, guarantees are only good for a short period of time, the shorter the better. Thus, a bank, if it is to be run on sound principles, must concentrate on short-term loans and stay clear of long-term loans, no matter what rationalizations may be adduced to urge otherwise. The bank that consistently violates this policy will eventually find itself in difficulties. (No doubt, at the present time, bankers may feel they can shrug off such warnings. This may be because they expect to be bailed out by the Federal Reserve System it any serious depression erupts. They may expect the System to increase the so-called money-supply, that is, its banknotes and demand deposits to such an extent that the resulting rise in prices will tend to make unsound long-term loans good. But inflation of money-aids results in economic chaos and the ruin of millions of people.)

Example: When a government nationalizes the banking system, the central bank in issuing banknotes or writing up demand deposits is still doing what any bank can do. However, as it is a political instrument, it is beholden to those in control of the government and not to the people. Therefore, it is quite likely that it will ignore any limits on its issuance of exchange media if it appears politically wise to any administration that it should do so.

Example: Inasmuch as a central bank is a guarantor of debts, when it issues banknotes or writes up demand deposits on the basis of a loan to the government, all it is doing is substituting its debts for the government's. It is this action to which the term "monetization of debts" is usually given. Many believe that the government's debts are changed into money and have even advocated stuffing the central bank with all of a government's long term debt in return for banknotes or demand deposits. They think that this changes the government's debts into money. All that happens is that its debts are being guaranteed by its central bank. But that is absurd. It is on a par with a person guaranteeing his own debts.

Subsequently, more instances of the distortion and corruption of banking by central banks will be discussed. At this juncture, our concern is to emphasize what a bank really is -- a trust guarantor. There is no need in this work to become too involved in the minutiae revolving around banks as this is not a textbook on banking. All that is necessary is to have some understanding of the true function of banks in order to acquire some knowledge of how money and money-aids can contribute to fostering the freedom and well being of the individual. Those interested in a detailed understanding of banking should consult the bibliography which lists some recognized authorities in the field. This book is an attempt to synthesize land, money and freedom. It is an attempt to see the forest rather than to be bewildered by looking at all the trees.


Recapitulation


Banks are trust guarantors. They guarantee the debts of individuals, institutions and corporations by substituting their own debts -- their banknotes and demand deposits -- for the debts of others. Because their debts are so acceptable, they circulate throughout the community much as money does. They appear to be substitutes for money. Actually, they aid in effecting the barter of goods over time, that is, they aid in the consummation of credit transactions. They assist money to act as a medium of exchange.

A bank's circulating debts take the place of the debts of others as evidence that credit has been extended. As its debts are so acceptable, their circulation throughout the community amounts to a reduction of the problem of trust and of time in credit transactions to a minimum.

Men, unconsciously, are attempting to make credit transactions as efficient as ordinary barter. By reducing the twin problems of trust and time to a minimum, banks help to make credit transactions approximate ordinary barter.

The desire on the part or people for the funds of banks is essentially a desire for the superior creditworthiness of these banks so those using it can more easily obtain the goods they require than if they used their own creditworthiness.


NOTES


  1. Savings institutions are not banks. They are similar to open end investment trusts.
  2. The assumption here is that reserves are what they really are and should be. The character of reserves is quite different under a governmentally controlled centralized system. Cf. Chapter on Centralized Banking.
Preface and Introduction

BOOK 1

Chapter 1 * Chapter 2

BOOK 2

Chapter 1 * Chapter 2 * Chapter 3 * Chapter 4
Chapter 5 * Chapter 6

BOOK 3

Chapter 1 * Chapter 2

BOOK 4

Chapter 1 * Chapter 2

BOOK 5

Chapter 1 * Chapter 2

BOOK 6

Chapter 1 * Chapter 2

BOOK 7

Chapter 1 * Chapter 2 * Chapter 3

BOOK 8

Chapter 1

BOOK 9

Chapter 1 * Chapter 2

BOOK 10

Bibliography