From credit lending to the central bank

Photo by Asap PANG on Unsplash

Anyone who has now understood how the construct with the credit lending works can now also understand why the solabills, or rather their "mini-edition", which were actually designed as debt securities, could suddenly be regarded as a means of payment. After briefly explaining the origin of banknotes, I will go into a little more about the problems that arise as a result and finally explain an economic reason why the establishment of central banks has occurred. It will become apparent that the creation of money is analogous to that of a solabill, whereby today's banknotes no longer have a claim content, which is why the banknotes are no longer a liability of the central bank.

In particular, the latter – their emergence - is never really explained by the prevailing economics, but, as in the case of means of payment – money – it is avoided. There is a rambling and flowery chatter about what central banks are doing without ever mentioning their founding code. On the other hand, there is a lot of discussion about the wishful thinking that the central banks could provide for the stability of the price level, although this task is not at all obvious from the construction of the central banks. The reason for these misinterpretations is that the market theory of standard economics suggests these functionalities without providing a justification for why it should be so. (Evil tongues claim that someone who owns only a hammer as a tool perceives nails everywhere, but cannot distinguish a nail from a screw. It's so similar here too!) One has to put it this way: the stabilization of the price level by the central banks is a wish concert of mainstream economics, which simply superimposes its methodological worldview over the institution of the central bank, without ever providing any proof that this assignment of tasks would be justified at all.

The story of the credit lending does not end with the fact that these papers (solabills) were able to economize the existing gold stocks and at the same time launched the "fractional reserve system". It should be noted that, according to the construction of the credit loan agreement, no reserve in gold is required per se. The reason is, that the settlement of the solabill liabilities had to be paid in gold by the first solabill recipient to the bank one day before the due date of the solabill. If all contracts had expired according to this scheme, there would never have been a liquidity problem for the banks, provided that it is assumed that the income from the issuance of solabills can absorb the losses from depreciation due to defaulted and uncollectable payments.

However, bank-issued solabills were rather impractical for commercial transactions, because the denominations, especially for the payment of wages, were much too high. From this problem, the practice of discounting (dismembering) the "big" solabills developed, so that they became usable for the necessities of commercial transactions, in particular for wage payments.

The solution to this problem is very beautifully presented by Heinrich Rittershausen

see: https://reinventingmoney.com/library/

In essence, the point is that the Scottish banks accepted a bill of exchange, but did not pay it out in gold, but instead issued banknotes in the amount of the solabill, which

a) had a small denomination

b) were not individualized, but standardized, and

c) were issued by the signature of the banker as similar to a bill of exchange.

The banker's signature was important because it guaranteed that this mini-solabill could be used as a means of payment for the debt from the pledge of the solabill. The deal was as follows: the owner of the solabill, who wanted to dismember it, pawned it at the bank and in return received the "minis", which were then used for any payment purposes. The solabill, which is a claim to the actual means of payment gold, will only be returned in this amount upon return of the mini-solabills. This return option gives the minis a gold-valued status, because the gold claim from the pledged solabill had to be transferred back by returning the minis, which means that each "mini" corresponded to a pro rata gold claim. This is how the gold currency was created.

The dismembering of a solabill thus has the consequence that a "large" claim to gold has been converted into many "small" claims to gold, as a result of which the "minis" as well as the solabill represented a gold claim. However, due to the low denomination, these "minis" could now be used for wage payments and other small transactions, whereby the merchants, of course, expected that they would be able to get these "minis" back in time by selling goods. To this day, English banknotes carry the wording of a bill of exchange: "I promise to pay the bearer the sum of 10 pounds.“. The decisive factor here is that these are debt securities that are aimed at a real performance (gold / silver) and thus banknotes (the minis) were used as debt securities for payment purposes, which represented a liability for the banks, which is why they were also posted on the liabilities side. For the sake of completeness, it should also be stated that these passive entries represent the liabilities (!) from the bills, but NOT the bills themselves, because they are a genuine asset as debt securities and therefore have no business on the liabilities side.

From a practical point of view, the very small denomination of the bills of exchange made it possible at once to use these banknotes for payment of wages, which implies a standard indebtedness of companies, which they can only absorb by offering real goods and services in exchange for these very securities on the "market", where these securities are available as "consumer expenses". So what appears as the "value" of money from the perspective of the money user, the consumer, is in truth nothing other than the necessity of paying off the debt – a sober category, but which has the advantage of making division of labor processes possible on a hitherto unknown scale.

This story has so far been taking place at the level of the banks, which explains the etymological origin of the term "banknote". However, the resulting developments had created their own problems, which consisted of the fact that there were a large number of solabills and banknotes, all of which were based on the same standard gold, but for which the question of the bank's solvency in the "basic standard" had to be found out individually in each case. This was due to the fact that the issue of bills suddenly contributed to the emergence of the so-called "fractional reserve system". This was created because, measured by the volume of the issued bills and banknotes, the stocks of the "basic good" would not have been sufficient to service all the issued claim papers. This is not a problem as long as there is no economic crisis, in which the credit lending loans issued by the banks typically become non-performing and they receive neither the issued banknotes nor the underlying "basic good" from the debtors to a sufficient extent. So while the banknotes of the banks were usually exchanged more or less 1:1 among themselves, a kind of "variety market" is now emerging, in which it can only be speculated which bank is still solvent and which is not. (BTW: the “underlying” of the solabills is not the stock of gold in the vaults of the banks, but the “reflux” of gold due to the gold payments from the first solabill users. So the “fractional” idea of unsufficient stocks ignores the planned reflux of gold, which keeps the liquidity status of the bank sustainable and is the true “underlying” of the credit lending arrangements. The fractional proponents therefore believe that an inefficient use of gold is an optimal strategy.)

The strange thing about this is that the risk of insolvency in the gold payment medium standard affects not so much the banknotes (the minis), but the solabills issued as part of the credit lending contract. After all, these could also be submitted prematurely to a bank that could pay out the equivalent value in gold minus a discount. This works as long as the returns from the loan receivables were regularly received by the banks, because these were intended to pay off the banks' liabilities from the solabills. The cash discounting (in contrast to the banknote discounting), which led to an outflow of gold at the banks, was in normal times only a bridging problem. In times of crisis – when there are no contractual repayments - the banks quickly become illiquid, because they are directly obliged to pay out due solabills. If the times are bad, the existing gold stocks are quickly depleted, so that bankruptcy must be declared immediately.

In order to get a grip on this vulnerability through a "bank run" that is always threatening in such situations, it became attractive to pool the risk of insolvency. It is generally the case that although it is known that payment disruptions in gold will certainly occur, it is not clear when, with whom and in what amount. As for the latter, the situation is such that even a small insignificant payment disruption due to the spreading distrust can quickly lead to an avalanche of distrust, which is immediately suitable for recording even those banks that were not originally affected by the problem at all. One could put it this way that the "one for all" principle applies in such cases, since mistrust eats through to the solvent banks due to the business connections and can also affect them. In the end, only the "all for one" principle helps against this "one for all" danger, whereby you immediately end up with an arrangement that tries to solve the individual problem through a collective assistance agreement.

The cushioning of individual risks by a risk community is called risk insurance. Risk insurance works in such a way that each member makes a contribution to the losses incurred over the course of a year. For this purpose, an external fund must be formed, which pools the contributions in order to use them, if necessary, to cushion or solve the liquidity problem. This is similar to the case with the IMF: assistance loans in the event of balance of payment disruptions where conditions are imposed, which in the best but unlikely case eliminate the causes of the payment disruptions. Remember the golden rule established by Bagehot that in times of crisis the insurer (central bank) should lend freely but at a high discount rate.

As a side condition, this type of risk provisioning in this case also requires that the large number of banknotes, the creditworthiness of which had to be constantly checked, be reduced to a centrally issued banknote, which has the pleasant effect that from now on any existing banknote could be used for payment purposes at any bank of the insurance network.

It is no longer necessary to think for a long time about why the liquidity problem was the trigger, which then led to the establishment of a central bank, which, endowed with the privilege of issuing the standard for the banknotes (previously issued individually by the banks), could gradually take a central position in the payment network. A central bank is an institutionalization in the interest of banks that do not want to confront the consequences of their own failed risk assessments. Because an individual risk provision, which would mean the holding of a larger gold pool, is a relatively expensive matter and from the point of view of those who want to "make money work" nothing more than "dead capital".

One has to make the deal that the banks have entered into quite simply clear: the banks renounce the right to issue their own banknotes, but get a security line in return, which allows them to drive a higher credit commitment than their individual risk provision would have made possible. (Any parallels to today are of course "purely coincidental"!) The tacit part of the deal consisted in the fact that the central banks do not interfere in the business activities of the banks, i.e. that the central bank refrains from competing with the banks in any way. Some, especially the larger banks, were quite suspicious of this monopolistic power of the central bank, so that the introduction of the institution of the central bank was not without bitter discussions. The extensions of this silent agreement can still be seen today in the context of the discussion on how far the Central Bank may hold CBDC accounts for private actors.

Now, the pooling of risks may lead to the fact that one can absorb punctual events, such as the (temporary) payment problems of an individual bank, with a reasonable effort. Only the fact that we now have a global authority to monitor compliance with the partial reserve regulations does not make the associated risk disappear, but only shifts it to a superlevel. As you know from history, the risks have not been fully manageable here either, as can be seen from the various collapses of central banks, or the various suspensions of the gold redemption obligation. Because it doesn't really matter whether the individual banks or the higher-level central bank has to comply with the fractional reserve regulations, because a frachtional reserve system with an external (real) means of payment standard is always vulnerable to crises. A single bank that has overexposed itself with its bill or banknote issue can still be absorbed by the (gold) “reserves“ of the central bank, if this is a whole banking system or even the central bank itself, which cannot meet the (international) gold requirements in a crisis, the whole risk pooling is all for nothing. The collapse of a single bank is only about manageable sizes, if the entire banking system is affected, even a central bank is quickly overwhelmed. The postponement of risk has just a postponement effect - but no risk neutralization effect, a lesson that the last real estate crisis with the subsequent liquidity crisis has impressively raised awareness.

Apparently, the double partial reserve standard – by banks on the one hand and the central bank on the other – is not suitable for ensuring the stability of the financial system sufficiently, because even a central bank cannot autonomously create the "basic asset" on which the now "central bank notes" are denominated. The solution to this problem was then to simply abolish the gold redemption obligation for the central bank notes bit by bit, so that only the banks have to cope with the problems of the fractional reserve standard. Interestingly, compliance with the fractional reserve standard will at some point no longer refer to the gold means of payment that used to be the basis for cashing, but to the common "central banknote" means of payment standard. The fact that the abolition of the gold redemption obligation did not arise from a rational decision, but from the stupid emergency to avert a bankruptcy declaration of the FED and thus of the US state, is not devoid of a certain comedy, because it is shown here that leaps in development are more often caused by coincidences than by human more-or-less ingenuity.

If you like, there is currently a financial system in which only the banks have to operate under the regime of a partial reserve system (which caused an awful regulation mess), while the Central Bank exercises the right to issue basic money and, moreover, is no longer under pressure to redeem the issued central bank notes in an external standard. (For the FED dollar, this is not so clear, because the issue of FED dollars must be collateralized. However, collateralizing FED dollars with USTs is just a joke, because they are denominated in FED dollars. It is not clear whether FED dollars are redeemable in so-called "lawful money" – which, however, completely fails due to the lacking amount of available silver dollars.) On the contrary: in the FIAT-money regime the Central Bank creates exactly the means of payment, which is the standard for the repayment of debts. (Not to forget, that the establishment of debt relations in most cases must be carried out by using the standard means of payment.)

This "creation" takes place in the same way like the solabills were created in the past: the payment standard now freed from the gold redemption obligation is transferred instead of by the booking

Bill of exchange TO (gold) liabilities from emittet bills of exchange

or

Standard banknotes TO (gold) liabilities arising from banknotes in circulation

now in the form

Cash register TO (central) banknote circulation

Even the bookkeeping technique has not changed the means of payment (cash) money is increasingly blurring its traces to the former credit loan arrangement. To prevent a typical misunderstanding: the cash register postings are postings that happen in financial accounting framework – but are not balance sheet postings! There are those who consider this way of accounting for the issue of banknotes to be a (false) historically grown custom and think that the issue of banknotes should actually be activated. This is wrong in several respects: on the one hand, the passive position "banknote circulation" is not synonymous with "banknotes", i.e. no bank notes are posted on the liabilities side, but only the number or the amount of the issued banknotes are listed. Due to the fact that the banknotes were not assigned a claim content (as with the solabills), the counter-posting of the issue is therefore also not a liability. Just as there are not only accounts receivable listed on the assets side, the liabilities side contains more items than only liabilities. So the claim that the banknotes are liabilities of the central bank, because they are on its liabilities side, belongs to the category of "naive conclusions". This is further underlined by the fact that for a central bank, its own banknotes do not represent an asset position (but in the financial accounting cash ist activated of course), which impressively demonstrates the absence of a banknote entry in the balance sheet of central banks – in contrast to the coins, which, of course, are listed there.

With these findings, the function of a central bank can be precisely outlined: it is about maintaining smooth payment transactions with the aim of preventing payment disruptions from the outset. This aim implies monitoring the creditworthiness of banks' credit commitments so that developments that could lead to an avalanche of mistrust do not arise in the first place. There is no sign of the task usually assigned to central banks of ensuring the stabilization of the price level. The misuse of the interest rate instrument to influence inflation can, due to the effects of the interest rate on the profitability of banking transactions, create the very problems that the establishment of the central bank was actually supposed to eliminate...