Banking and Credit Myths - A Socialist View

BANKING AND CREDIT MYTHS

The growth of human knowledge - And the exception

Most people take it as unquestioned that year by year mankind and womankind increase their sum of knowledge, and that as the years pass our studies become deeper and richer, and this in spite of the fact that some long held truths are occasionally found to be mistaken and have to be corrected; that is indeed part of the process of getting to know more. Mankind today knows more about the world we live in than previous generations did, and those living now surely know very much more about the productive processes than did earlier generations.

Indeed Karl Marx and Frederick Engels, in their Manifesto of the Communist Party written in 1848, actually made this point about capitalism itself. They wrote thus:

“During its reign of scarcely a century, the bourgeoisie has created more powerful, more stupendous forces of production than all preceding generations rolled into one. The subjugation of the forces of nature, the invention of machinery, the application of chemistry o industry and agriculture, steamships, railways, electric telegraphs, the clearing of whole continents for cultivation, the making of navigable waterways, whole populations springing up as if by magic out of the earth and what earlier generations had the remotest inkling that such productive powers slumbered within the womb of associated labour?”

But while such growth of human knowledge applies in most fields of human study, it was Marx who pointed to an exception -- his own special subject -- economics. In this field of study Marx made a distinction between the early economists Adam Smith and Ricardo whom he described as “classical economists”, and some of their successors whom he wrote off as “vulgar economists”. According to Marx the classical economists studied the “real interrelations of bourgeois production”, seeking to find the truth. The vulgar economists, said Marx were content to study the appearance of the interrelationships. (See Capital Volume 1, Chapter 1, footnote page 93 Kerr Edition). The vulgar economists were not seeking the truth but seeking to hide aspects regarded by the capitalist class as damaging to their interests. The development or rather the degeneration of economic studies in our own day has vindicated what Marx had to say to an extent that even he would have found astonishing.

BANKS ARE ESSENTIAL TO CAPITALISM

The banks are one of several kinds of company in which capitalists invest their money in order to make a profit. Other kinds are the manufacturing companies which themselves produce the commodities they sell, Rolls Royce for example. Some other companies are engaged in exploration and extraction like Shell Oil, and yet others are trading companies buying goods already manufactured and selling them again at a profit, like Sainsburys. The function of the banks is to borrow money from mostly small depositors and lend it (at a profit) to large borrowers.

The banks are therefore an essential part of capitalism’s organisation, but it is not their size which makes them so important. Compared with the biggest manufacturing and trading companies the banks are quite modest in size. Of the four largest banks in this country, Lloyds, National Westminster, Midland and Barclays, the largest is Barclays, but its total assets of £138,000 millions and latest annual profits of £242 millions are small compared with the top manufacturing and trading companies. The chemical company I.C.I. has invested capital of £7,741 million and latest profit of £1,146 million. Sainburys, the grocers, has capital of £3,363 million and profits of £731.9 million.

INTEREST RATES AND THE BANKS

The banks are popularly credited with having the power to fix the interest rates paid by borrowers at whatever level the bank thinks fit. Consequently we read appeals being made to the banks to bring interest rates down, it being mistakenly assumed that everyone wants interest rates to be as low as possible. While borrowers want interest rates to be low, the lenders want them to be as high as possible. On 13th October 1993 a reader of The Times had a letter published commenting on the demand for lower interest rates. He said that as he got his income from the interest on his investments, as far as he was concerned the higher interest rates went the better pleased he would be. His letter ended with the threat that if interest rates did come down he would give up his membership of the Tory Party.

Interest rates are not fixed by the banks at the level chosen by them but depend on market conditions. There are times when there is a big demand by companies seeking to borrow money for expansion, so interest rates go up. At other times there are more people seeking to lend money and fewer borrowing, so interest rates then go down.

The idea that the banks can fix interest rates at any level they choose is as unrealistic as the idea, which many people believe, that the employers can fix wages at whatever level they choose. Marx showed the fallacy of that idea by pointing out that wages were higher in the USA than in Britain (see Value Price & Profit). Did that mean, he asked, that employers in the USA “willed’ wages to be higher than the wages willed by the British capitalists? The employers in the USA and Britain both “will” wages to be as low as possible, whilst the workers “will” wages to be as high as possible. In this, as in the level of interest rates, it is the conflict of interests of different sections of the capitalists, employers and employed, borrowers and lenders, and the resulting market conditions, that are the deciding factors.

In the early days of banking, the banks not only did not pay interest on money deposited with them but charged interest to the depositor. This happened because many possessors of money were willing, under the circumstances of the time, to pay interest to the banks for looking after their money and thus providing security for it. The June 1994 figures show that the banks pay no interest on deposits totalling some £30,000 million but do pay interest on £144,000 million. Interest rates go up when prices are rising, but not when they have stabilised at the higher level.

If a man lends £100 at 10% and if prices remain unchanged he could buy 10% more commodities at the end of the year than at the beginning. He would be 10% better off. But if prices rise during the year by 10% the £110 he receives as repayment of his loan at the end of the year will only buy as much as his £100 would have bought when he made the loan. He would have lent £100 for no return at all over the year’s loan.

THE ORIGIN OF BANK DEPOSITS

One question which the modern monetary self-styled “experts” have surrounded with mystery, and they claim to have weighty official backing for what they say is the question of bank deposits. In 1929 the MacDonald Labour government set up a committee of enquiry into finance and industry under the chairmanship of Lord MacMillan. In its report of over 300 pages, published in 1931, the Committee dealt with many different issues within its terms of reference, one of them being the origin of bank deposits. A section of Paragraph 74 reads as follows:

“It is not unnatural to think of the deposits of a bank as being created by the public through the deposit of cash representing either savings or amounts which are not for the time being required to meet expenditure

It is not only natural to think that the deposits in banks are created by the depositors, it is also true. But the Committee made that statement only to lead on to a denial of its truth. Paragraph 74 continues:

“But the bulk of the deposits arise out of the action of the banks themselves, for by granting loans, allowing money to be drawn on an overdraft or purchasing securities a bank creates a credit in its books which is the equivalent of a deposit”.

The paragraph then presented what is called “a simple illustration” It assumed a depositor lodging £1000 in a bank, and then went through a series of operations which would take several months to carry out and at the end it did indeed show the bank apparently having “created” £9000 additional deposits, making £10,000 in all.

We say “apparently’ because the whole operation was rigged to get that result. Firstly it assumed only one bank in existence so that every cheque drawn on the bank had to come back to that bank. And more importantly it assumed conditions that do not exist in the real world. In the real world of banking, day by day there are depositors depositing cash and also depositors withdrawing cash. Sometimes the net balance is inward and at other times outward. But in the Macmillan Committee’s Report, no depositors ever took any cash out of the imaginary bank, in all the operations extending over many months. The so called “simple illustration” was a simple fiction. J.M. Keynes was a member of the Committee and probably drafted paragraph 74.

The campaign by the Keynsians and others to promote their erroneous doctrine did not pass unnoticed. Professor Edwin Cannan ridiculed their theory and called them the “mystical school of banking theorists”. Cannan wrote extensively about the fallacies in the Keynsian theory. In an article with the title The Difference Between a Bank and a Cloakroom, he made the point that banks are not the only organisations in which “deposits” are made, which the depositor can withdraw at will. He had in mind the railway station cloakrooms in which people can leave their coats, cases, umbrellas etc. The cloakroom attendant cannot legally lend out the deposited items, but if he could, who would suppose that he could “create” more items than have been deposited? Why is it assumed that banks can do so? As Cannan put it:

“The most abandoned cloakroom attendant cannot lend out more umbrellas or bicycles than have been entrusted to him, and the most reckless banker cannot lend out more money than he has of his own plus what he has of other people’s”.

One curious event was the publication by the Home University Library of two books called Banking. The first published in 1926 was by Walter Leaf who had retired from being Chairman of the Westminster Bank. He rejected outright the notion that most deposits are created by the banks themselves. He wrote:

“The banks can lend no more than they can borrow- in fact not nearly so much. If anyone in the deposit banking system can be called a “creator of credit” it is the depositor; for the banks are strictly limited in their lending operations by the amount which the depositor thinks fit to leave with them”.

The Home University Library’s second book called Banking, published in 1948 was by W.J. Thorne. It made no reference to Walter Leafs argument and simply put, as if it were the only theory, the “creation” argument that Leaf had rejected. It ignored the figures quoted by Leaf which showed that the changes of total bank advances and total bank loans, were in conflict with the argument of the “creationists”. If it is bank loans which create bank deposits then deposits ought to increase in parallel with bank loans. Instead of this happening, Walter Leafs figures showed that bank deposits fell when bank loans increased.

ABOUT THE MACMILLAN COMMITTEE

The Macmillan Committee on Finance and Industry under the chairmanship of Lord Macmillan had 13 members as well as the Chairman; it consisted of businessmen, bankers and economists. One of them was J.M. Keynes, another was the chairman of the T.U.C. Ernest Bevin. There was also an M.P. Walton Newbold. It happened that some members of the SPGB knew some of the members of the Committee and were quite certain that they did not agree with the idea that banks created deposits, though they had signed the report. What actually happened on the MacMillan Committee, as on most government appointed committees, was that some members who signed the report expressed reservations about particular sections, but none of them expressed any reservations or their dissent from the creationist nonsense.

One member of the Committee, a banker, said that of course he did not agree with the report, and then admitted that though he had signed the whole statement he had in fact not read it! An economist, (Gregory) at the London School of Economics had publicly repudiated the creationist theory before the Committee reported and continued to reject it afterwards. Another banker, Reginald MacKennan, publicly rejected it. An SPGB member wrote to Walton Newbold saying that he was surprised that he should support such stuff. He received back an angry letter saying that of course he did not support such stuff When asked why he had signed the report, Newbold said that he had been nominated by the TUC. and Labour Party to support Bevin, and as Bevin signed Newbold had to do the same.

At that time the Labour Party and the TUC. supported Keynes because Keynes, along with Lloyd George, claimed to have an economic policy which would find jobs for the millions of unemployed. Two other members of the Committee were approached and asked whether they supported or opposed the theory that banks create deposits. They gave the odd reply that they did not want to be involved in controversy. It was odd because by signing the report they were already involved in the controversy. They probably did not understand the issue and were reluctant to commit themselves one way or the other. Out of the 13 members of the Committee, we found at least 4, and possibly 6, who either did not support the creationist theory to which they had put their signatures or did not know anything about the issue.

As often happens with government committees, the MacDonald government had picked the members, not to give an independant view, but to get the kind of report they wanted ie one which supported Keynes’ views. Before the Committee met it had been taken for granted that Professor Edwin Cannan would be appointed because of his leading position in the academic world of economics, but at the last moment a movement was organised by Keynes’ supporters to keep Cannan off.

So Keynes had a clear free run on the Committee. If Cannan had been appointed there would have been a very useful contest between Cannan and Keynes representing two rival schools of theory. But of course that was not what the government wanted.

THE “MYSTERY” ABOUT BANK DEPOSITS AS CASH

The modern economists, or some of them, have created a mystery about bank deposits. Quite alot of people, including some newspapers columnists, think that bank deposits totalling some £400,000 million, are huge sums of money which the banks possess in their vaults. So from time to time there are appeals to the banks, or to the government, to spend the huge sums the banks possess to make work for the unemployed. It is of course a myth.

The figures of so called “bank deposits” are not sums of money the banks possess, but merely a record of the amount the banks no longer possess because they have lent it to borrowers. Banks cannot make profits by what they have in their vaults, but only by passing it on to borrowers and getting interest on it.

The authorities used to publish each month figures representing the total amount of notes and coin the banks hold, but the figures are no longer published. At one time, by a mutual agreement, not by law, the banks reckoned to hold in cash ten per cent of money deposited with them. It has progressively decreased and it is probable that the banks hold in cash possibly three per cent of deposits or even less. Usually the banks only need to hold small amounts of cash to meet the relatively small demands to withdraw cash. Given some notice of pending withdrawals a bank can sell some of its securities to meet the demand for cash withdrawals.

THE “MYSTERY” OF WHAT MONEY MEANS

In the 19th century the monetary authorities and most of the economists knew that money meant notes and coin. Working on that basis the authorities succeeded in maintaining a stable price level from 1800 to 1914. The modern economists have changed all that. It began by including what was called “bank deposits” as money. It has now gone much further and has become totally incomprehensible.

An official statement about money is published each month in the journal Financial Statistics. The following is taken from the

December 1993 issue. Under the heading Money Stock it is stated “there is no single correct definition of money”. It goes on to quote two definitions MO and M4. Both show totals far in excess of the £17,458 million of notes and coin.

M4 totals £389,185 million made up as follows: -

Notes and Coin £1 7,458m
Non-Interest bearing Bank Deposits £30,486m
Other Bank Deposits £1 44,420m
Building Society Retail Shares & Deposits £196,819m
Total £389,185m

For Marx money meant notes and coin, likewise for professor Cannan, and of course they were right. There is no possibility of making sense of the monetary system based on such nonsense as the definition of M4 quoted above.

KEYNES & THE RETAIL PRICE LEVEL

In 1923 Keynes published a book entitled Tract on Monetary Reform. In it he put forward the theory that the price level and its rises and falls are determined by the banks. In Keynes’ own words:

“The internal price level is mainly determined by the amount of credit created by the banks, chiefly the Big Five…..” And later on:

“…thus the tendency of today- rightly I think- is to watch and control the creation of credit and to let the creation of currency follow suit, rather than, as formerly, to watch and to control the creation of currency and to let the creation of credit follow suit”. In the same book Keynes was strongly in favour of a stable price level. He wrote (page 143) that:

“...deflation is not desirable, because it effects, what is always harmful, a change in the existing standard of value and redistributes wealth in a manner injurious..., to business and to social stability”. Also (page 4): “...each process, Inflation and Deflation alike, has inflicted great injuries”

There is no doubt however that his view that the present tendency to rely less on “control of the currency” encouraged his followers and others to disregard the continuous increase in the amount of notes and coin in circulation and its necessary result in promoting the continuous rise of prices in the past half century.

THE AMOUNT OF CURRENCY

& THE PRICE LEVEL

It is appropriate at this stage to restate the simple and direct relationship between the amount of notes and coin in circulation and the retail price level. Prices were stable from 1850 to 1914 because the gold standard kept the amount of notes and coin in circulation at the appropriate limited amounts. Prices rose sharply from 1914 to 1920 because an excess amount of notes and coin was put into circulation. Prices (including wages) were brought down sharply between 1920 and 1926 because a large amount of notes and coin was withdrawn from circulation.

Prices have gone on rising continuously for over the past half century because the monetary authorities have kept up a continuous issue of notes and coin in excess of the amount needed to keep pace with the increase of production. It appears that this continuous excess issue of notes and coin was not carried out because the monetary authorities wanted to achieve a continuous rise of prices. They appear ignorant of the nature of inflation and of its connection with excess currency circulation. They were, and still are, unaware that it is their own policy which causes inflation.

MARX IS VINDICATED

Whilst in most areas of human endeavour we expect the sum total of knowledge to increase with time, this has not proved to be the case with economics. Whilst Marx criticised the “vulgar economists” of his time, the way in which most modern economists have abandoned scientific study and thought up mystical theories, (about banks creating deposits, the meaning of money, inflation for example), would have astonished Marx. It is no exaggeration to say that in the hands of modern economists the serious study of economics has almost ceased. The serious student of capitalist economics must return to the basic theories, particularly those of Marx, which worked well in the 19th century, and are still relevant today. Worth particular study is Marx’s theory of Value.

Marx studied the economics of capitalism not to show how best to run the economic system, as is the job of most modern economists. In his studies Marx showed the anarchic nature of capitalist production and how it had developed historically. From this historical development Marx postulated that the next stage in human society would be the overthrow of capitalism and its replacement with Socialism, a system of society marked by “…the absence of buying and selling”. Marx did not just want to understand capitalism he wanted to get rid of it. To this end the Socialist Party of Great Britain continues to work.