Lombard Street: Part Three

Part Three: The creation of central banking and money markets

Scroll down for parts one and two

Bankers and banks are hated. Many people even think they are unnecessary, usually because they don’t understand why they need to do so much more than the basics and get paid vast amounts for their work. You often hear people complaining about how bankers were gambling in the lead-up to the crisis rather than creating wealth. There has been much written on why banks and bankers take so much blame historically. However, in this post I am going to focus on Bagehot’s theory of how modern banking in Britain came to exist and shed light on its evolution into the form we recognize today.

The modern form of banking began in the private sector, based on a metal money supply, and without a central bank. Private banks would help merchants make payments to other merchants by changing the books as opposed to physically transporting money. As they gained trust the banks eventually held deposits, which gave them credit. The ability to hold credit eventually led them to create their own paper currencies. This monetary phenomenon did not last very long as central governments wanted a monopoly on minting currency. Merchants will only switch to notes if they believe their country is safe from invasion and revolution and are willing to trust a bank. Eventually, as central banks such as the Federal Reserve come to exist, government will supplement the banking system with the insurance such as the FDIC, supporting the currency by guaranteeing bank deposits. Despite all these currency-supporting factors, people still increase their purchases of metal during recessions. I will write a future blog post on the value of metal—an argument I believe is more philosophical than economic.

While there was large debate at the time (and some debate that still exists at those awful parties where drunk libertarians try to teach you economic policy) the government first gave a monopoly on currency creation to the central bank in England that was eventually followed in all other developed nations. This was important for a two reasons: first, as people accumulated bank notes they went to deposit them in a bank. By holding the bank notes they already trusted the bank, so by depositing them they lost nothing but gained the safety of not having it robbed. Secondly, by having only one currency, money markets suffered less from transaction costs.

These prerequisites allowed fractional reserve banking to naturally come into existence throughout the process. Instead of everyone holding their own metal they begin to use notes of a single currency backed by metal such as gold. Once they deposited their notes, banks began to hold reserves. Through statistical calculations a bank can be certain with some level of confidence that not all depositors will withdraw their money the following day, so they can lend more money than they hold. As the system and note deposits increase the ratio of currency lent out vs. held in deposits slowly increases. It’s interesting that although many populists  hate central banking and claim this is an evil function of government, his practice was actually created through the private sector while on the gold standard without any government intervention.

Bagehot was famous for his theory on panics and the creation of money markets. The rest of his book is useful only as a historical economic text, with many of his theories on macro-finance being generally discredited. I will therefore end my summary here.

-Simon

2 thoughts on “Lombard Street: Part Three

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