So, paper currencies cannot be driven out of circulation, and, so, when they are issued in excess, the consequence is that each note is devalued, accordingly. But it retains the name £1, $1, €1 and so on, so that the result is that the prices of all commodities rise proportionally – inflation.
“The number of pieces of paper is thus determined by the quantity of gold currency which they represent in circulation, and as they are tokens of value only in so far as they take the place of gold currency, their value is simply determined by their quantity. Whereas, therefore, the quantity of gold in circulation depends on the prices of commodities, the value of the paper in circulation, on the other hand, depends solely on its own quantity.” (p 119)
It was for this reason that the issuing of paper notes was legally restricted to this gold, which they represented in circulation. In the 17th, 18th and early 19th centuries, commercial banks were able to produce their own bank notes. Much as with De Gaulle's demand to be paid in gold rather than Dollars, each of these notes entitled its owner to convert it to gold. As the notes circulated as currency there was little reason for anyone to demand the gold, which then continued to sit as money hoards in the bank vaults.
Indeed, as businesses deposited money in the banks, the banks themselves came to realise that the amount of these deposits that customers withdrew amounted to only a small proportion of their deposits. That meant that the bank could, then, lend out the remainder of the deposits, at interest, and so make a commercial profit on this operation, equal to the difference between the interest they charged to borrowers, and the interest paid to depositors. As Marx puts it, this money-capital, for them, became the equivalent of raw material for a manufacturer, or like a merchant who buys commodities below their value, and then sells them on at their value, thereby making commercial profit on the difference. If only 10% of deposits are ever taken out by depositors, the bank can lend out the other 90%. This is the basis of the credit multiplier.
Suppose £1 million is deposited. Only £0.1 million is withdrawn. The bank can lend out £0.9 million, and does this by creating an account for the borrower. In total, £0.9 million of such new deposits are created. But, these borrowers have borrowed money, because they want to spend it on something. When this £0.9 million is then spent, the recipients of this money pay it into the bank, creating an additional £0.9 million of deposits. Again, 10% of these deposits are withdrawn, leaving £0.81 million available to make further loans and so on. In the end, this process means the initial £1 million of deposits turns into £10 million of deposits, so that £9 million of new bank money has been created. This £9 million is money, because it is the equivalent form of the £9 million of value embodied in the commodities for which it is the equivalent. It raises the question of whether this equivalent form in the commodities was the consequence of the bank money/credit created, which is the foundation of the arguments surrounding MMT. This is not the place to examine that, and I have discussed it elsewhere.
But, the banks were tempted to issue their own bank notes way in excess of these limits, which, as with all such behaviour, which tends to accompany periods of speculative frenzy, ends in disaster. At a certain point, the idea circulates that this or that bank does not have enough money in its vaults to cover the bank notes it has issued. So begins a bank run of the kind frequently featured in old westerns, but was also seen in 2007 with Northern Rock, the next year with Bear Sterns, Lehman's, a series of British and European banks, and, after 2010, more banks in Greece, Cyprus, and elsewhere.
In those previous times, depositors rush the bank demanding their bank notes be redeemed in gold or silver coin. In more recent times, they simply demand to close their accounts, and payment in Bank of England notes, US Dollars, and so on. The banks often have nowhere near the gold or silver required, or the ability to convert their own notes into Bank of England notes, etc. The bank collapses, and, given the interlinking of banks and other financial institutions, the panic spreads.
At the same time, businesses that had been happy to accept bank notes as currency refuse them. In the same way as they had expanded their own commercial credit, so as to ensure continued growth in sales, they now curtail it. They begin to demand payment in gold/silver coins, or Bank of England notes etc. That is a credit crunch, as it appeared in 1847, 1857, and in 2007.
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