2: Money, Credit and Banking

1. Introduction: Commodity Money, Paper Money and Credit

2. The ‘functional’ view of money
3. Origin of Paper Money: The doctrines of John Law
4. The South Sea Bubble
5. Bank credit as ‘pure intermediation’
6. Origins of bank credit
7. Usury

1. Introduction: Commodity Money, Paper Money and Credit

Commodity money: a commodity used as a ‘medium of exchange’.
Paper money: ‘fiat’ money denominated by usage or as ‘legal tender’,
invented by Mongols in China in 12th century.
Credit money: transferable bank credit used as means of payment.

2. The ‘functional’ view of money

Functions of Money (unit of account [numéraire], medium of
exchange, store of value)
Properties of Money (scarcity, portability, and divisibility):
Wonderful invention that saves endless calculation in barter economy
(and double coincidence of wants)
Money becomes credit through borrowing and lending.
Finance emerges when debts provide ‘assets’ (wealth) for people.

3. Origin of Paper Money: The doctrines of John Law

Problem of loss of coinage in countries with trade deficits
→ mercantilist problématique of how a country without gold mines
may become wealthy. (cf. Antonio Serra)
Situation of Scotland in 17th century: a trade deficit (imports >
exports) causing excess of payments for imports over receipts of
money from exports → loss of coinage.
John Law (1671-1729) Essay on a Land Bank (1704), Money and
Trade Considered 1705.
Denied metallist view of money.
Money as stimulant to trade.

4. The South Sea Bubble

State financing in France through rentes (purchase of lifetime income)
John Law appointed Contrôleur Générale des Finances with mandate
to revive public finances along lines of the Bank of England (est.
1694).
Establishment of the Compagnie de l’Occident later the Mississippi
Company (the first privatisation? Actually sale by Government of
trading rights with limited liability)
and the Banque Générale later Banque Royale.
Lending of money to buy shares →Speculation in company shares →
Bursting of bubble in 1720.
South Sea Bubble in U.K.
‘Bubble’ Acts of 1720 banned the setting up of companies with
limited liability.

5. Bank credit as ‘pure intermediation’

Banks as ‘financial intermediaries’ between ‘surplus’ economic units
(‘agents’) (whose Income > Expenditure)
And ‘deficit’ economic units (whose Income < Expenditure).
Nice theory, but this is only a fraction of what banks do!
Modern banks lend out many times more than total Gross National
Income (total of incomes in the economy).
Income and expenditure are ‘flow’ variables
vs. Assets and Liabilities ‘stock’ variables in balance sheets.
Banks ‘secured’ vs. ‘unsecured’ lending → lending against ‘assets’ as
security.
Very clear today (mortgage lending),
Also in history of banking:

6. Origins of bank credit

Two origins:
Italian ‘banca’
Goldsmiths holding gold deposits:
receipts become paper money;
instruction to goldsmith to transfer ownership of gold deposits
become cheques (U.S. checks).
Or
Merchants’ banks (in U.K. ‘country’ banks)
Merchants discounting (buying for less than face value) of
Bills of exchange (written paper promises to pay for goods at future
date).
Origin of bills is coinage shortage (cf. John Law).

7. Usury
Legal limit on interest in the three religious traditions: Jewish,
Christian & Muslim.
From Church law to state law.

Adam Smith and Jeremy Bentham on Banking

Adam Smith (1723-1790)
Advocates limit on interest:
Competition reduces profits of established trades;
Innovators (‘projectors’) have uncertain, potentially large
profits.
Abolition of usury restriction on interest
 → ‘free market’ for loans,
Interest rates rise → exclusion of competitive trade.
Bank loans go to ‘prodigals’ and ‘projectors’ (entrepreneurs),
who bid up interest.
‘Projectors’ exaggerate their prospects of business success.

Credit-rationing view of Joseph Stiglitz:

Borrowers know their own credit-worthiness (return on loan);
Banks do not know credit-worthiness (asymmetric information);
High ‘equilibrium’ interest rates → ‘adverse selection’ (high risk
borrowers).
Banks charge lower interest rate and ration credit.
But Adam Smith differed from Siglitz:
Banks & borrowers know credit-worthiness of established
business;
‘Projectors’ (and banks) do not know returns on new projects
but are ‘seized of their own genius’ (J.K. Galbraith).

Jeremy Bentham (1748-1832)

Letters on Usury (1787)
Usury laws are result of prejudice (Aristotle’s doctrine of
‘sterility’ of money, anti-semitism’)
Laws widely evaded → law brought into ‘disrepute’.
Banking like any other business should be free of state
interference.
 Supported by Henry Thornton (An Inquiry into the Nature and
Effects of the Paper Credit of Great Britain 1802):
Higher interest necessary to avoid speculation.
View of David Ricardo: Usury laws ignored for government
bonds.

Abolition of Usury Laws in UK by 1844:

For reasons of practical necessity, to regulate bank reserves
under the gold standard.