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Banks and Credit

Here is the next installment dealing with credit and banking.  The next installment will go into the expansion of credit by banks in more detail.

A primitive credit model

Credit is a fundamentally different economic phenomenon from money, though they are often confused or conflated.  The two, of course, are intimately related but in theory, there is no reason that either one could not exist without the other.  Indeed there is some debate over which developed first.  The answer to this question is of no importance to the issues discussed here.  I have already laid out a story to explain the emergence of money from a barter economy without credit.  To understand credit, I will first develop the institution of credit in a barter economy with no money.  Then I will put money and credit together.

Consider a very small town where everyone knows everyone else and assume that they all generally trust each other to keep to their word.  In this town there is a butcher, a baker and a candlestick maker.  The butcher regularly buys bread from the baker and the baker regularly buys meat from the butcher.  One way that they could conduct this trade is to trade bread and meat directly.  The drawbacks to this method are well understood, most important is the fact that they would have to continuously trade quantities of equal value.

As an alternative to barter, they could each hold some amount of some other good such as gold or silver and trade this for bread and meat.  In this way if there were a trade surplus between them, it would be reflected in a balance of payments in gold or silver from one to the other.  If, for instance, the baker wanted to purchase meat of greater value than the bread that the butcher wanted to purchase, he could pay the excess in silver coins.  The butcher could then use those coins to buy other things from other people.  Meanwhile the baker would have to get the extra coins by selling bread to other people.

In this way some quantity of money can circulate in an economy and act as a store of value and a medium of exchange.  People accumulate money as a result of delivering more goods than they collect from others.  Money such as precious metals works well for this purpose because it holds its value well.  This is mainly due to its durable nature and the fact that the supply in the long run is limited by nature (highly inelastic).

It is possible though to carry on trade without this type of “hard” money.  Imagine the same butcher and baker but with no gold or silver nor any other good suitable to use as a store of value and medium of exchange.  When the baker wants to buy meat, he can simply promise to deliver some number of loaves of bread at some point in the future that the butcher may find suitable.  He may write ten notes that say “I, the baker, owe you, the butcher, one loaf of bread to be delivered at any time upon presenting this note” and bearing his signature.  These notes would then represent a contract which could be enforced by the courts.

Then, when the butcher wants bread, he goes to the baker, presents one of the notes which the baker retires, and receives a loaf of bread.  Similarly, if the butcher ants to buy more than ten loaves of bread before the baker desires more meat, he can write out a note redeemable for a pound of meat and give it to the baker as payment for the eleventh loaf.  In this way short-term imbalances in trade can be accounted for with credit.  And it is worth “noting” that the notes are not even necessary, the butcher and baker could simply each keep track of each other’s account in a log book or some similar device so long as they trust each other to uphold their bargains (if not, then the notes may be necessary to get the courts to enforce the bargain).

Long-term imbalances in trade are still an issue for this system of credit however.  If the butcher sells meat to the baker worth ten loaves of bread per month but only wishes to buy five loaves per month, then the butcher will simply accumulate little notes redeemable for bread that he doesn’t wish to consume.  This would certainly reintroduce the double-coincidence-of-wants problem which was present in a pure barter economy.

This issue can be overcome by making the baker’s notes transferrable.  By replacing the words “you, the butcher” on the note with “the bearer of this note,” the butcher will be able to sell to the baker any amount without having to worry whether he really wants to consume all the bread being promised him.  If instead he wants to buy a candlestick, he can go to the candlestick maker, pay with the bakers notes and then the candlestick maker can go to the baker and redeem the notes for bread.  As long as the candlestick maker knows the baker, recognizes his notes, and trusts him to have bread when he presents the notes, he will be willing to accept them from the butcher.  If everyone in the economy knows and trusts everyone else, they can all carry on trade in this way, writing out notes which circulate until they find their way back to their issuer.  Of course, they all have to regulate the amount of notes they circulate so that they will not be greater than the amount of goods they are capable of delivering should those notes be presented.

There are advantages and disadvantages to this type of credit.  The main advantage is that notes or credit would simply be more convenient to carry and use for transactions than goods like precious metals.  However, in an economy with many participants, even if everyone knew and trusted everyone else and could recognize all of their notes, the prices of all goods would have to be posted and/or negotiated in terms of all other goods.  Someone could walk into the candlestick maker’s shop with notes from either the butcher or the baker which would mean that the price of a candlestick would have to be quoted in both meat and bread.  With only three goods this might not be that bad but if there were hundreds or thousands of goods being traded on credit, this would get very tedious.

The most obvious solution to this problem would be for everyone to hold some amount of some good which would act as a universal medium of exchange and denominate all of their notes in quantities of this good.  For instance, the butcher could keep some gold in a safe under his bed and when he wants to buy bread from the baker, he writes an IOU for some quantity of gold.  If the baker then accumulates some of these IOUs he can settle the balance of trade with the butcher by redeeming them for gold.  This would solve the trade imbalance problem just as if the butcher had paid in gold to begin with.  If instead, the baker wants to buy a candlestick, he can go to the candlestick maker and he doesn’t need to negotiate a price in bread and/or meat, he can simply negotiate a price in gold and pay using either the butcher’s notes or his own (assuming he also has some gold) or some combination of the two.

In theory, trade can be carried on like this with no need for anyone to ever actually trade their gold so long as everyone buys a value of goods (denominated in gold) equal to what they sell since someone will eventually bring the butcher’s gold-notes back and use them to buy meat just as if he had issued meat-notes.  But in this way, the ability to convert all notes to a single good removes the necessity of negotiating many different prices for every good.

Banks

We have seen how having a single unit of exchange is more convenient than barter and we have seen, given our assumption that everyone knows and trusts everyone else, recognizes their notes and nobody abuses this fact to buy more than they can afford, that using credit can be more convenient than actually trading that good for every transaction.  Credit eliminates the need to transport, divide and measure the medium of exchange for every purchase.  It also allows a limited quantity of the medium of exchange to carry out far more trade than would otherwise be possible and allows its value to be less sensitive to changes in the overall quantity of trade being conducted in the economy.  However, this assumption is a very strong one which is not likely to hold in any economy of significant size and complexity.  If it does not hold, then the use of credit in this way will most likely not be possible.

If this is the case, clever entrepreneurs can provide a solution.  Someone can build a big stone building in the middle of town with a large vault.  They can then let the butcher, the baker and the candlestick maker all deposit their gold there and they can issue notes to each one which are redeemable in gold.  Call this person the banker.

The banker is a specialist.  Whereas the butcher and the baker specialize in meat and bread, the banker specializes in reputation.  Reputation has large economies of scale.  The butcher and the baker may not be able to build their reputations for being trustworthy in the redemption of IOUs enough that everyone in the economy will be willing to take them.  This would require them to issue a great deal of credit and keep a great deal of gold on hand which the production of meat and bread does not require.  (If one of them did accomplish this they would be the banker as well.)

But the banker can aggregate all of their stocks of gold along with those of many other people in the economy into one pool and issue notes against that single large pool.  Then he can issue notes with the name of the bank in very large quantities which allows them to be recognizable by everyone in the economy.

Furthermore, since all of the mutual benefits which come from the banker are due to maintaining a strong reputation for solvency, his livelihood depends on managing this reputation and advertising it.  He will need to be careful to always have enough gold to redeem all of the notes which are presented to him and will try to make this fact public by publishing his books so that everyone will be able to see how much he has and how much he owes.  If the butcher were to issue his own notes, people might have no idea whether he actually had any gold at all.  But if the butcher uses the bank’s notes, people will be more likely to trust that the bank actually has gold because they know that every day people walk into the bank and walk out with gold.

In this way, similar to the way in which having one standard medium of exchange removes the necessity to negotiate prices in many different goods, a bank allows trade to be carried out using credit without needing to verify the credit-worthiness of many different market participants.  In a sense, the bank acts as a seal of approval, verifying that the butcher has enough gold to cover his notes by taking the gold and holding it, issuing only as many notes as the butcher has gold.

Part III: Credit Expansion

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