The “laws” of physics change very slowly. The technology we use to apply those laws, however, can change rapidly. We have been able to calculate the amount of power in a gallon of gas for a relatively long time. The amount of that power transmitted to the road has changed significantly since the invention of the automobile. Compression ratios have changed. Gear ratios changed. A plethora of other changes have been made to increase the efficiency of burning that gallon of gas.
The very same concept applies to money and banking. Economists have known for a long time that increasing the quantity of money in the system distorts the pricing mechanism. This principle has not changed. The mechanisms by which the banking system changes the quantity of money have changed over the years.
In this article, I will explain how the original models of deposit banking, loan banking, and fractional reserve banking, have been replaced with what I refer to as “claim banking.”
In the “deposit banking” model, the miner 49er takes a sack of gold into the bank and exchanges it for banknotes or a checking account. To make transactions, he can pay with banknotes or checks or withdraw some gold and use that for payment.
In the deposit banking model, banks offer two basic services. Banks store commodities used as money and honor claims against those commodities. Because these deposits would be available to the customer at any time on demand, their accounts were referred to as demand deposits. For these services, banks receive a fee.
In exchange for interest payments, some depositors would delay withdrawals and permit their bank to loan the gold or provide the borrower with notes or checking privileges for use as payment.
Because the bank would loan these deposits at interest, this was called “loan banking.” Because the depositor could only withdraw his money from one of these accounts at a specific time, they were referred to as time deposits.
Fractional Reserve Banking
Someone figured out that banks could have the best of both worlds. The people who had demand deposits would probably not show up to withdraw their funds at one time. Thus, banks could create unbacked claims they could use to make loans. The banks could charge interest on these loans while not having to pay interest to depositors.
This banking structure, in which banks created deposit liabilities for which they had only a fraction of the deposits, became known as “fractional reserve banking.”
Although many people considered fractional reserve banking fraudulent, the practice was institutionalized (and legalized) with the formation of the Federal Reserve System. Under the Federal Reserve System’s authority in the fractional reserve banking model, banks adopted what I refer to as “claim banking.”
I coined the term “claim banking” because it best describes the banking structure after combining fractional reserve banking and The Federal Reserve System.
Although monetary commodities could still be deposited in this new banking model, “deposits” consisted almost entirely of claims against monetary commodities. When a person “deposited” a check from another bank, that transaction consisted of an exchange of claims. The bank that received the check would create a new claim in the name of the “depositor/payee.”
(How banks transfer claims from bank to bank is a topic for another day.)
Something very similar to deposit claims happened with bank “loans.” Seldom did banks give a borrower commodity money in exchange for a note (a claim on future money). Loans became the exchange of a current claim from the bank for a future claim from the “borrower.”
What people refer to as loans consist of exchanges of claims, not loans.
Death of Deposit Banking.
Although claim banking became the norm, it did not yet mean the demise of deposit banking. The death of deposit banking occurred in about 1932 when Franklin Roosevelt confiscated all commodity-based dollars. The public could no longer own gold as a form of money. This marked the “death of deposit banking.”
For those who continue to believe that commodity money has any objective value, the death of deposit banking and the acceptance of claim banking represent a problem of infinite regression. Similar to the mythological idea that the earth rests on the back of a turtle and what exists below the turtle is “turtles all the way down,” the banking system rests on a system of claims backed by nothing physical. In other words, it’s only “claims all the way down.”
Popular models of banking and the money creation process need a significant update. Although claim banking has been with us for approximately 90 years, the deposit banking model has given us a reasonable approximation of how banking works. With the massive expansion of bank reserves under the Bernanke administration and now the zero reserve requirement, the time has come to update our banking models.
Bank customers do not make “deposits.” They exchange money claims – dollar bills or checks.
Bank “borrowers” do not borrow money. They exchange claims for future money for claims for current money.
These distinctions play an essential role in understanding the role of The Federal Reserve System in the creation of money by banks.
We cannot fix a system that we do not fully understand.