At any given time, there is flow of goods and services coming to market. The problem which the instrument called money seeks to solve is to provide each person who has a part in its production with a means of acquiring his/her share of the total value. Col. Harwood describes the typical money creation process which prevailed prior to World War I. While banking had serious problems even then, sound principles on the basis of issue were still being followed by most of the larger banks.
"As a manufacturer shipped completed things to market, he would prepare a document describing the shipment, take it to his bank, and borrow purchasing media that, in practical effect represented the things en route to market. The bank made the loan by crediting an appropriate amount to the checking account of the manufacturer, but this amount was not deducted from other checking account liabilities of the bank. Thus new purchasing media were created and were placed in circulation when the manufacturer used the addition to his checking account to pay wages, salaries, suppliers, and other costs of processing the things sent to market. (As the things were sold, the receipts from sales were used to repay the bank loan by having that amount deducted from the manufacturer's account. Thus the purchasing media created for temporary use were withdrawn when their purpose had been served.)
"Those who received the newly issued purchasing media from the manufacturer then could choose whatever they wanted that the markets offered... The procedure described above has been modified in recent decades as mass production has developed on a broader scale and now occurs almost continuously throughout the year. ...
"The automobile manufacturer arranges with a commercial bank for a 'line of credit' and gives a promissory note that may be paid off only once each year during the model changeover period when no cars are en rout to markets. Thus a series of loans continually being repaid as cars are sold is replaced by a single borrowing resulting in the creation of purchasing media that remain in circulation as long as the flow of cars to markets continues...
"As commercial banking developed, especially in the United States, two quite different functions have been performed by the same institutions. In addition to the commercial banking function already described, most banks performed an investment function, accepting saved purchasing media and investing it.
"The borrower from the bank in the savings-investment transaction is not at that time sending to or otherwise offering things of equal value in the markets to be sold. He does not desire purchasing media so that he may distribute it to employees and suppliers who participated in preparing things for the markets. His desire is to claim things from the markets, either equipment for his factory or a new car for personal use, or any of the multitude of other things available, such as new bricks for construction of a factory, etc. Consequently, the bank should not create new purchasing media for such a borrower but should lend him purchasing media already in existence that some present owner or owners save and deposit in the bank.
"Probably because the same banks have been performing two functions, each of which involves lender-borrower transactions, similar forms (such as promissory notes), and related procedures, many bankers have confused the two functions. .. In the first type of procedure, the new purchasing media created represented the exchange value of things en route to or being offered for sale in the local markets; however, in the second, the new purchasing media represented things ( such as land, factories, or consumer goods) not being offered by the borrowers for sale but on the contrary being removed by them from the markets.
"Perhaps the clearest example of the confusion between commercial and non-commercial banking is provided by the financing of automobiles in or en route to markets in contrast with consumer installment borrowing to purchase a new car. The important distinction that makes all the difference between sound and unsound commercial banking is:
- When an automobile manufacturer borrows newly created purchasing media and distributes them to employees, suppliers, and others, he is arranging for those potential buyers to obtain their shares (in dollar value) of things in or en route to markets.
- When an installment buyer arranges to purchase a car [with money he/she borrows], he is not claiming a share corresponding to his participation in producing things for markets, he is claiming someone else's share." [In order for this to be possible, someone else must be willing to forego claiming his share for the term of the loan, i.e. be desirous of saving his share rather than spending it. -- t.g.]
"Thus, one can see that a bank's lending transaction may reflect additional things offered in the markets or it may not. If it does, creation of new purchasing media (for use until retired by repayment of the loan by the seller) is sound commercial banking. If the lending transaction does not reflect additional offerings in the markets, it should be financed by the savings-investment procedures."
The above makes clear that there are two very different things going on in commercial banking. Commercial banks have the primary responsibility of issuing new money into circulation, which they do by making loans. They also act as depositories, accepting deposits of existing money which people and businesses wish to save. This money is held as "reserves" against which new loans are made. Much of the problem seems to stem from confusion caused by the fact that the terminology, forms and procedures for the two functions are the same. It would probably be best to completely divorce the creation of new exchange media from any association with the borrowing-lending process.