Sunday, May 31, 2015

The Invention of Banking

First - Ancient History
The history of banking ( ) starts with record keeping of promises and transactions around goods, services and trade.

Probably the earliest forms were the holding and transport of animals, edible grains, and pelts and skins on behalf of others.

Inscribed records date from 4000 BC, and used mnemonics or symbols as short hand for the transaction and promissory details and contracts.

As precious gems, gold, silver, and bronze tools and artefacts became the currency of exchange, safe storage facilities were built - initially in the style of the granaries they were replacing, and gradually as treasuries to reflect the wealth and power of the rulers who controlled them.

Around 1000 BC in Egypt and Mesopotamia there are accounts of entrepreneurship similar to today's deposit banking - the lending of funds, and the holding of funds for a percentage payment.

In later ancient Egypt and Greece, the treasuries became better organised in record keeping, and codes of conduct raised them above the local rulers and politicians. So that deposits from private individuals and traders from outside the banks region were being made.

Rome refined the idea of deposit banking, and the concept of private capitalism. Bankers were appointed to collect taxes, or licensed to operate private treasuries or banks. Bankers also exchanged foreign coin and goods for Roman minted coin - the only legal tender in the empire.

The idea of charging interest (usury) on loans ebbed and flowed. Most societies realised that it placed a burden on the borrower, some set the upper limits, some banned it ( but allowed fees for creating the loan ), some only allowed interest to be charged against "outsiders".

By Medieval times deposit banking had evolved into private merchant families acting as banks, and also the financing of agriculture - a crop loan at the beginning of the growing season. Underwriting in the form of a crop, or commodity, insurance to guarantee the delivery of the crop to the buyer, and making arrangements to supply the buyer of the crop through alternative sources in the event of crop failure.

The size of medieval kingdoms, the growth of papal rule, and the increasing literacy of the public, allowed the expansion of promissory notes, letters of credit, and other documents of exchange.

Innovations evolved like the charging of an insurance "fee" in place of interest to avoid usury, or of selling and "interest" in the trade event that the loan made possible.

Now - The Invention of Banking
Up until the 1600's banking was mainly using actual deposits and treasuries. There was some use of confidence in the lender to underpin loans and insurance, and in the value of notes and letters of credit.

Goldsmiths and wealthy merchant families were storing gold, and other valuables, in their vaults.
They were charging a fee for this service, and issued receipts certifying the quantity and purity of the metal they held as a bailee; these receipts could not be assigned, only the original depositor could collect the stored goods - so far nothing too different from the past.

But gradually the goldsmiths began to lend the money out on behalf of the depositor issuing promissory notes backed by the gold deposited with the goldsmith.

This was a new kind of "money" - goldsmiths' debt to the depositor rather than actual silver or gold coin, issued and regulated by the monarchy.

This development required the acceptance in trade of the goldsmiths' promissory notes, payable on demand; a general belief that coin would be available; and required that the holders of debt be able legally to enforce an unconditional right to payment; it required that the notes be negotiable instruments.

This was in competition to the monarchy, so this new kind of money swung in and out of popularity until in the 1700's an acts of Parliament locked in the "customs of merchants", and the notes became fully negotiable.

Modern Banking was invented.

The new Bank of England started issuing promissory notes that looked like today's bank notes in stepped denominations in 1695. These were standardised by the 1750's and fully printed bank notes by 1850's. Cheques were invented to enable banking house to banking house payments, and this lead to central clearing houses.

William Paterson had proposed a private banking structure in 1691 of a loan of £1.2M to the government (which needed cash to rebuild the army and navy) in return the subscribers would be incorporated as The Governor and Company of the Bank of England with long-term banking privileges including the issue of notes. This was granted in 1694 through the passage of an Act of Parliament (The Tonnage Act) establishing the now Bank of England. The act also described the notes as legal tender - everyone was compelled to accept them in payment of a money debt.

Two years later 1696, with the Bank of England bankrupt - notes issues equaled UKP 760,000 and cash and gold reserves equal to UKP 36,000 - Parliament ( most of whom were shareholders in the Bank ) allowed the Bank of England to suspend paying out in gold in exchange for printed bank notes. And in 1697 Parliament also passed a law prohibiting the establishment of any new corporate banks, making the shareholder owned Bank of England the "Reserve Bank".

Although the Bank was originally a private institution, by the end of the 18th century it was increasingly being regarded as a public authority with civic responsibility toward the upkeep of a healthy financial system.

Henry Thornton wrote in 1802 An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, in which he argued that the increase in paper credit did not cause a banking confidence crisis, and he outlined ways a central bank might influence and control the monetary system and the value of the currency.

The Bank Charter Act of 1844 gave the Bank of England an effective monopoly on the printing of new notes since authorisation to issue new banknotes was restricted to the Bank of England. It also assumed the role of "bank of last resort" to the regional and smaller banks.

A similar pattern evolved in the USA - 1781 Congress established the Bank of North America with the task of funding mercantile expansion and to build the navy. Gold lent to the USA by the French was appropriated by Robert Morris as reserves for the new bank, and notes were then issued to finance the war contracts held by his business associates, governors and senators.

1791 Hamilton pushed through legislation establishing the First Bank of the United States with their notes being legal tender and able to be used to pay taxes. Millions was issued and 18 new banks established to funnel the money to mercantile and property investment businesses.

The War of 1812 saw many millions in new notes to pay for military goods and services. Between 1811 and 1815, gold reserves fell from 15 million to 13 million, but notes issued rose from 42 million to 79 million. In 1814 Congress ruled that new banks did not have to make payment in gold against a note based demand.

By 1818 there were 338 separate banks in the US - up 40% in 2 years - and $95 million had been issued in new bank notes.

Important Banking Precedents

In 1811 the English Courts ruled that money deposited into a bank, other than into a specific security box or bag, was a loan to the bank and not bailment ( or warehousing your money for you ). In 1848 this was reinforced by a second ruling that said that money paid into a bank becomes the property of the bank, though with an obligation to pay a similar amount to the depositor on demand.

So a bank is under no obligation to keep it safe, and can engage in speculative activities. The bank is also absolved of meeting the obligation to pay, if they are legitimately insolvent - a true form of "bankrupt".

Later Developments

Despite a regular history of boom and bust, of inflation and bank failure, the model of a central bank with the monopoly to issue legal tender, and as the "lender of last resort" to junior banks had huge political credibility and value. The US Federal Reserve was created by the U.S. Congress through the passing of The Federal Reserve Act in 1913;  Australia in 1920;  Colombia 1923;  Mexico and Chile 1925;  Canada and New Zealand 1934.

REF Mystery of Banking - Murray Rothbard
and download the free pdf or epub edition for more history and detail

Sunday, May 24, 2015

The Invention of Debt and Inflation

In early society a debt was generally a moral or social obligation to repay someone for a good or service rendered.

Once money became the dominant form of exchange ( a commodity ), a debt came to refer to money owed by one party, the borrower or debtor, to a second party, the lender or creditor.
And these debts are commonly subject to contractual terms regarding the amount and timing of repayments of principal ( the amount borrowed ) and interest ( the extra money charged for making the loan ).

As the Rule of Law and the concept of Property Rights expanded, so did the idea of requesting a security over the money lent - a guarantee asset to be offered in place of the commodity money should there be a failure to repay all or part of the loan.

This securitisation of the debt shifted the idea of a loan away from the personal and short term - from having trust in the person or venture receiving the loan, from carrying some of the risk that the future status matched the planned outcome, to one that was both impersonal and low risk.

Debt became a business, and markets in Debt evolved.
The first step was to use the Rule of Law to allow the loan agreement, and its attached security, to be passed to another legal entity ( person or business ). Once this concept was established, loan agreements could be legislated as Bonds and these could be traded, and regarded as assets.

Dealing with individual loans and their securities was seen as inefficient and limited the scale of debt markets - so loans were pooled, sold to securitisation trusts, who bought them using Bonds ( Securities ) sold, in turn, into the Debt Markets.

## [ ]

The critism of debt as a business is two-fold - firstly, that divorcing the lender from sharing the consequences of a future that does not match that envisaged on creation of the loan, unfairly pushes those consequences back onto the community and society that supports the borrower ( ie: can create public debt, environmental damage, social disruption ), and secondly, that as the Debt Market is a source of wealth creation, there is pressure to create levels of debt in excess of real and reasonable needs.

Economists historically identify three factors that cause a rise in the price of goods and services:
  • a change in the value or production costs of the goods, 
  • a change in the price of money, which occurs when either the coins themselves are debased or an inflow of similar commodity dilutes the value ( eg: gold and silver flooding Europe from the Spanish invasions of South America ),
  • or currency depreciation - an increased supply of currency, usually note printing.
## [ ]

Basically each unit of currency buys fewer goods and services - a reduction in the purchasing power  per unit of money – a loss of real value. The measure of price inflation is the inflation rate, the percentage change in a price index, usually the consumer price index or similar basket of goods.

Negative effects of inflation include:
  • an increase in the opportunity cost of holding money, making spending cash a priority,
  • uncertainty over future inflation which may discourage investment and savings, and 
  • if rapid inflation, shortages of goods as consumers both hoard out of concern that goods will disappear, and buy goods as inflation resistant assets or as barter items for future use.
Mild Inflation can have positive effects:
  • it gives everyone an incentive to invest, as their money will be worth less in the future.
  • it reduces the real burden of debt, but only if salary or income increases over time due to inflation, but outgoings or mortgage payments stay the same.
  • it can keep nominal interest rates above zero, allowing central banks to reduce interest rates as a means to stimulate the economy.
  • it can reduce unemployment by reducing the real value of wages, increases the demand for labor.
Historically high rates of inflation and hyperinflation have been due to excessive currency printing ( 1920s Germany), or floods of currency-like commodities (1500s Spain), or periods of failure of confidence in the government guaranteeing a note or bond based currency (1990s Yugoslavia ).

## [ ]

This is all historical information, and internally logical if simplistic. However, recent trends in country and global economies have not followed the expected patterns. Interest rates have been close to zero, wages growth is zero or negative, and in theory the increased money supply ( quantitative easing ) should have caused mild inflation and economic stimulation.

Investment in infrastructure, education, and preventative or primary health care can grow an economy in greater amounts than the investment spending. They act by reducing the cost of living, or increasing the apparent purchasing power of currency won through wages.

However, current government policy, in the face of slowing economies, is to reduce government spending, limit wages growth, and encourage private spending funded by increased debt.

One half of government is acting as if inflation was rising - using fiscal policy to reduce wages growth, and cut back on government spending on community; and the other half is using monetary policy, as if we are in recession - boosting public debt by transfers to private corporations.