Well, banking should be boring. And
we're sure officials at central banks all over the world today -
many of whom have trouble sleeping - wish it were.
As a result, the world's economy is now
based upon unsound banks dealing in unsound currencies. Both have
degenerated considerably from their origins.
Those capacities segued easily into the
business of lending and borrowing gold, which is to say the business
of lending and borrowing money.
Bankers had become goldsmiths without
Although the distinction between them
has been lost in recent years, respecting the difference is a
critical element of sound banking practice.
With a time deposit - a savings account, in essence - a customer contracts to leave his money with the banker for a specified period.
In return, he receives a specified fee
(interest) for his risk, for his inconvenience, and as consideration
for allowing the banker the use of the depositor's money. The
banker, secure in knowing he has a specific amount of gold for a
specific amount of time, is able to lend it; he'll do so at an
interest rate high enough to cover expenses (including the interest
promised to the depositor), fund a loan-loss reserve, and if all
goes according to plan, make a profit.
To avoid loss, bankers customarily preferred to lend on productive assets, whose earnings offered assurance that the borrower could cover the interest as it came due.
And they were willing to lend only a fraction of the value of a pledged asset, to ensure a margin of safety for the principal. And only for a limited time - such as against the harvest of a crop or the sale of an inventory.
And finally, only to people of known
good character - the first line of defense against fraud. Long-term
loans were the province of bond syndicators.
Demand deposits were a completely
Demand deposits were so called because, unlike time deposits, they were payable to the customer on demand.
These are the basis of checking accounts. The banker doesn't pay interest on the money, because he supposedly never has the use of it.
To the contrary, he necessarily charged the depositor a fee for:
An honest banker should no more lend out demand deposit money than Allied Van and Storage should lend out the furniture you've paid it to store.
The warehouse receipts for gold were called banknotes. When a government issued them, they were called currency. Gold bullion, gold coinage, banknotes, and currency together constituted the society's supply of transaction media.
But its amount was strictly limited by
the amount of gold actually available to people.
But banking all over the world has been
fundamentally unsound since government-sponsored
central banks came to dominate the financial system.
On the surface, this appears to be a "free lunch." But it's actually quite pernicious and is the engine of currency debasement. Central banks may seem like a permanent part of the cosmic landscape, but in fact they are a recent invention.
The US Federal Reserve, for instance, didn't exist before 1913.
A banker, seeing other people's gold sitting idle in his vault, might think,
People are writing checks against it and using his banknotes. But the gold itself seldom moves.
A restless banker might conclude that,
even though it might be a fraud on depositors (depending on exactly
what the bank has promised them), he could easily create lots
more banknotes and lend them out, and keep 100% of the interest for
But most would be careful not to go too far, since the game would end abruptly if any doubt emerged about the bank's ability to hand over gold on demand. The arrival of central banks eased that fear by introducing a lender of last resort.
Because the central bank is always standing by with credit, bankers are free to make promises they know they might not be able to keep on their own.
But when a central bank authorizes all
banks to do the same thing, that's less likely - unless it becomes
known that an individual bank has made some really foolish loans.
As has happened in so many cases, an occasional and local problem was "solved" by making it systemic and housing it in a national institution.
It's loosely analogous to the way the government handles the problem of forest fires:
Banking all over the world now operates on a "fractional reserve" system. In our earlier example, our sound banker kept a 100% reserve against demand deposits: he held one ounce of gold in his vault for every one-ounce banknote he issued.
And he could only lend the proceeds of time deposits, not demand deposits.
A "fractional reserve" system can't work
in a free market; it has to be legislated. And it can't work where
banknotes are redeemable in a commodity, such as gold; the banknotes
have to be "legal tender" or strictly paper money that can be
created by fiat.
When that seller of the widget re-deposits the dollar, a banker can lend it out at interest again.
In each country, the central bank periodically changes the percentage reserve (theoretically, from 100% down to 0% of deposits) that banks must keep with it, according to how the bureaucrats in charge perceive the state of the economy.
In any event, in the US (and actually most everywhere in the world), protection against runs on banks isn't provided by sound practices, but by laws.
In 1934, to restore confidence in
commercial banks, the US government instituted the Federal
Deposit Insurance Corporation (FDIC)
deposit insurance in the amount of $2,500 per depositor per bank,
eventually raising coverage to today's $250,000. In Europe, €100,000
is the amount guaranteed by the state.
I'll be surprised if the FDIC doesn't go
bust and need to be recapitalized by the government. That money -
many billions - will likely be created out of thin air by selling
Treasury debt to the FED.
To do so, they must prevent a deflation at all costs.
And to do that, they will continue
printing up more dollars, pounds, euros, yen, and what-have-you.