Banks as liquidity providers
Other main classical economists view banknotes favourably, starting in the eighteenth century with James Steuart in his Enquiry into the Principles of Political Economy (1767) and then Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations (1776).
According to Steuart, economic growth is a wealth transfer process between property owners and industrialists, which he called a “vibration of the balance of wealth”. By granting mortgage credit, banks create new money, which makes property assets liquid, that is, it gives property owners the means to buy goods produced industrially, thereby allowing industrialists to make profits, then to buy the property assets. Now, while this view has been totally outshined by Smith’s economics, we must nevertheless emphasise the influence of the former on the latter’s banking theory. Steuart, in particular, shows very clearly how the cash reserve contributed by the shareholders creates the confidence necessary to allow the bank to grant credit by issuing notes in excess of the reserve. Smith sums up this approach, which links bank capital with credit and liquidity risks, just as he extends Steuart’s analysis of the role played by the Bank of England in reducing interest rates by circulating Exchequer bills.Smith integrates his banking theory into a theory of capital accumulation. Banks permit the substitution of bank notes for metallic money, without increasing the total amount. They make this substitution by discounting bills and granting credit or overdrafts (cash accounts). This reduces the maintenance costs of monetary circulation and releases a portion of capital that was previously unproductive. Banks create liquidity through lending because they have a fractional reserve ratio. They finance a part of merchants’ circulating capital:
It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country.
That part of his capital which a dealer is obliged to keep by him unemployed, and in ready money for answering occasional demands, is so much dead stock, which, so long as it remains in this situation, produces nothing either to him or to his country. The judicious operations of banking enable him to convert his dead stock into active and productive stock. (Smith 1776 [1976]: 320)Moreover, banks have to ensure that they are not lending to “projectors” who try to borrow in order to finance their whole capital, thus wasting capital. They verify that they loan money only to “prudent men”, who borrow for the purpose of transactions. Normally they can monitor borrowers by observing their current accounts and repayments. However, according to Smith, because of informational asymmetries on the credit market, borrowers can cheat. This solvency risk could entail bank failures and as a result, systemic risk through contagion. A liquidity risk will also occur because, in this case, banks would have issued too much money. That is why Smith clearly advocates the creation of “fire walls” and a banking regulation system (the convertibility of notes to metal; a maximum limit for the rate of interest, since a rate that is too high would entail adverse selection in favour of “projectors”; prohibition on notes of small denominations; criticism of the “optional clause”) and suggests that banks should be limited to shortterm lending. It is said that these ideas are related to the real bills doctrine, according to which banks should only discount bills issued on commodities already produced. This signifies that the money supply is endogenous and adjusts to the demand for it. As a result, Smith is not in favour of the quantity theory. According to him, the level of monetary prices is determined by the ratio between the cost of production of commodities and the cost of production of precious metal.
Henry Thornton continues this tradition. He opens his book An Inquiry into the Nature and the Effects of the Paper Credit of Great Britain (1802) by considering trade to be facilitated by a circulation of claims and debts that have to be maintained in liquid form.
Owing to their different liquidity features and interest rates, credit instruments have different velocities of circulation. However, this velocity may also vary in different periods depending on confidence. Banks are specific agents, “transforming” illiquid assets into less risky and therefore more liquid assets, for example, when a bank discounts a bill of exchange. Bank notes and deposits can be used in payments and can clear all other debts. The most liquid assets were Bank of England notes. They could be requested in case of “a flight to quality”, a liquidity crisis, which is a systemic crisis. Therefore, in lending these notes to the banks, the central bank is a lender of last resort on the money market, as a special market for ultimate liquidity for banks, a notion that is introduced by Thornton. In so doing, it restores confidence and calms the panic. Following this line of thought, liquidity crises can be distinguished from solvency crises. Furthermore, there is no quantitative and rigid rule for monetary policy, rather a discretionary monetary policy that allows flexibility and breaks with the Smithian rule that adjusts the quantity of notes issued to variations in the gold reserves. The inconvertibility of Bank of England banknotes may even be necessary during a given period, to maintain a sufficient money supply if the Bank is losing its reserves.Thornton criticised the real bills doctrine. Discounting real bills does not guarantee the borrower’s solvency and it is a fallacy to think that it allows the issuing of money to be limited in the event that the rate of profit remains persistently above the rate of interest for borrowing. In the latter case, banks would constantly continue to discount and issue notes. This is why Thornton suggested that the central bank could raise its discount rate in order to control the credit demand that is at the root of the money supply.
The Banking School (Thomas Tooke, John Fullarton and John Stuart Mill) favoured a broad vision of payment instruments that included all sorts of credit instruments performing the functions of money, adhering to the tradition founded by Thornton.
Notes and deposits thus have the same characteristic; both are bank debt issued through the medium of loans. They can substitute for each other. The quantity of credit and money is demand determined. However, as regards the real bills doctrine, the Banking School does not follow Thornton, but Smith. There cannot be an excess of issue because of the “law of reflux”: any issue will return to banks as reimbursement of their credit, or for convertibility into coins or deposit. As a result, the Banking School does not adopt the quantity theory. Banks issue notes and create deposits by discounting bills.For Tooke (A History of Prices, 1838-1856), economic cycles are not initiated by over-issue, but by speculation on commodities markets; however, they can be aggravated when the rate of interest on bank credit is too low or banks have been incautious in their advances. In this case of “overtrading and overbanking”, banking crises can occur. This may have an impact on the possibility of maintaining the convertibility of notes into metal. That is why he advocates raising the bank rate at the start of the speculation. Tooke distinguishes these solvency crises from liquidity crises and contemplates the possibility of runs on banks through panic or distrust. In the latter case, the Bank of England must provide ultimate liquidity to banks and raise its bank rate to allow international capital flows to enter. Hence, the Banking School opposed the 1844 law whose aim was to transform the Bank of England in a currency board.