REPORT OF THE ROYAL COMMISSION ON MONETARY, BANKING, AND CREDIT SYSTEMS 1956
The Origin Of Creation of Money by Banks
428. The process called “creation of credit” or “creation of money” is no new development. Its origin in England in the Seventeenth century as a development of the activities of the goldsmiths is described in the following passage from the Theory Of Credit by Macleod (first published in 1891), Vol.11, Part 11, at page 520.
When a customer paid in money to his account: and when they discounted a merchants bill; they simply gave them a Credit in their books; which in the technical language of banking id termed a Deposit. Moreover, in order to diminish the demand for actual payment as much as possible, they agreed with their customers to make these Credits or Deposits as transferable as money itself: and to pay any person to whom their customers had transferred their Credits in the same way as to themselves.
These Credits or Deposits, were transfered by means of paper documents, which were in two forms;
1. Either the Goldsmith gave his customer a written promise to pay to himself, or to his order, or to bearer on demand, such a sum as he asked for: these notes were in simple writing: and were called Goldsmiths Notes.
2. The customer might write a Note to the Goldsmith, directing him to pay a certain sum to any person, or to his order, or to bearer on demand: these Notes were at first termed Cash Notes; but in modern language they are termed Cheques.
These two forms of documents were thus as transferable as Money itself, and produced all the effects of Money. And by experience the Goldsmiths soon found that they could keep a float an amount of Credit considerably exceeding the amount of cash they kept to meet the demands upon them; and this increased quantity of Credit was in all its practical effects exactly equivalent to an increase of Money of equal amount.
People found it much more convinient to lend their Money to the Goldsmiths, where they could have it whenever they pleased along with high interest, than to lend it out on real or personal security. The Goldsmiths soon received the rents of all gentlemens estates, which were transmitted to town. Five or Six stood pre-eminent among their brethren, and Clarendon says they were men known to be rich and of such reputation, that all the money in the kingdom would be entrusted in their hands. These Goldsmiths then came to be called Bankers.
429. At page 870 of the same work, Macleod defines ‘banking’ in the following terms: The business of banking does not consist, as is so commonly supposed, and stated in books and documents which might be supposed to be of authority, in borrowing money from one set of persons and lending it to another set: but in creating and issuing Circulating Rights of Action, Credits or Debts, on a given basis of bullion, several times exceeding the basis; according to the different degrees of perfection on which the system is organised. These Circulating Credits have exactly the same effects, in every respect, as an equal quantity of money.
430. The views of Macleod are supported by the following extract from An Outline of Money by Geoffrey Crowther,(1948), page 26: And finally, the goldsmith, now fully developed into a banker, makes the discovery that he can safely issue deposits – receipts in excess of his gold stock. It is immaterial whether he does this by printing off more receipts and lending them to people in need of accommodation(or indeed using them to pay his own household bills), or whether he does it by allowing his customers larger “deposits”(on which they can draw by cheque) than the value of the gold they have deposited. In either case the crucial step has been taken. The principle of “creation” of money has been discovered. At first, the goldsmith was doubtless cautious in his “creation”. Then later with growing confidence, he went to far. But gradually he accumulated experience about the proper proportion of actual gold to keep in reserve…….. But the unique function of the banker, and the one that makes him important for this book, is……the provisions of a convenient mechanism by which people can make payments to each other without having to walk around to each others houses with bags of coin. And in providing this mechanism he also provides, or “creates”, the money itself. He has discovered the secret, for which the medieval alchemists strove, of manufacturing money. So atleast it seems, though we must now examine more closely this apparently miraculous business of “creation’.
Pages 105-6;
Creation of Money and the Public Interest
434. Apart from the historical and legal aspects outlined above, the next question to be considered is whether it is in the public interest that the power to create and destroy money or credit should be withdrawn from the trading banks and reserved to the state or to institutions owned by the state.
435. The burden of the contentions of those who sought to deprive the trading banks of the power to create or destroy money was that the trading banks for their own profit sometimes expanded the money supply to an undesirable extent and so cause inflation, and in other circumstances, such as in times of economic depression, cause an undesirable reduction in the money supply by reducing advances.
438. There is, of course the possibility of bringing about necessary expansion of the money supply entirely by financing government expenditure from Reserve Bank credit, and by at the same time preventing trading banks from expanding their lending through a rigid application of the reserve ratio. We consider that the needs of industry and commerce for additional credit can be more conveniently and efficiently met by expansions of trading bank credit than by expansions of Reserve Bank credit. The trading banks in close touch with the multitude of industrial, commercial, farming, and other businesses and they are in a position to give attention to the needs of individual businesses.
Conclusion pages 107-8
445. The essence of the nature of the matter is that insufficient or excessive credit creation can have important repercussions on the whole economy and, for that reason, control should be exercised by the government through the Reserve Bank and, if necessary through the Bank Of New Zealand. Such control can be issued under existing legislation. Furthermore, the government has itself adequate powers to create money through the Reserve Bank or through the ownership of the Bank Of New Zealand.
446. To concentrate the whole of the trading-bank activities or the whole business of credit creation in a government monopoly of banking would, in the opinion of the Commission, lead to an undue and unnecessary aggregation of power in the hands of the Government. It would remove the highly desirable element of competition and it could not be expected to provide as good a banking service as the commercial community now enjoys.
Appendix c
THE DEFINITION OF MONEY AND A HISTORY OF THE MONETARY, BANKING, AND CREDIT SYSTEMS IN NEW ZEALAND FROM 1934-1955
Page 246
The trading banks were required by the 1934 Act to maintain at the Reserve Bank balances equal to not less than 7 percent of their demand liabilities and 3 percent of their time liabilities. Deposits to build up these balances could be made in the form of gold or foreign exchange or Reserve Bank notes(or in practice, of course, cheques drawn by the Government on their balances at the Reserve Bank which could readily be converted into notes if required). In special circumstances deposits could be made in the form of securities acceptable to the bank. The original purposes of these clauses in the Act was not mainly to provide a method of controlling the lending operations of the trading banks, but in the words of the Minister of Finance;
The centralisation of the cash resources of the commercial trading banks not only provides a method of control for the central institution, but greatly strenghtens the whole banking system. In one pool the combined reserves will safely support a much greater credit structure than the same aggregate amount held by half a dozen banks. The analogy of a water-supply is appropriate. If everybody in a town had a few buckets of water and held onto them when a fire started, the whole town would be destroyed. If, however, the whole supply is collected in a central reservoir the outbreak could be dealt with effectively as soon as it was discovered. At present each commercial bank has to carry sufficient reserves to meet any possible financial strain, but with the central institution to fall back on an appreciably smaller cash reserve is required.
Page 250
57. As far as creation of bank money by the Reserve Bank is concerned, before 1950 there was a specific legal limit on its power to expand its lending or purchases of assets. This limitation took the form of an obligation to maintain reserves of gold or sterling exchange equal to atleast 25 per cent of its notes and other demand liabilities. Now the Reserve Bank is bound merely to keep such reserves of gold, sterling, or other exchange as the Reserve Bank thinks provides ” a reasonable margin for contingencies”. But the interest of the Reserve Bank does not lie in expanding its lending in order to make profits. It is charged with the duty of doing ” all such things within the limits of its powers as it deems necessary or desirable to promote and safeguard a stable national price level and the highest degree of production, trade, and employment that can be acheived by monetary action”, and of giving “effect as far as may be to the monetary policy of the Government, as communicated to it from time to time from the Minister of Finance”. Unfortunately as we point out in section two of our report, these objectives are not at alltimes completely consistent with one another. But the Reserve Bank’s primary function is so to regulate its own creation of bank money and that of the trading banks as to contribute to their acheivements as far as possible. We consider in section seven of our report how successful it has been in the exercise of this function.
Page 254
70 – This example is, of course, over-simplified. In practice, for instance the banking system could not expand its lending as far as this, because some of the additional cash would probably withdrawn by the public wanting to hold more notes in circulation, and some might have to be used to buy overseas exchange from the Reserve Bank to satisfy an increased demand for imports. But it illustrates the proposition that, while no individual bank, by itself, can engage in a multiple expansion of credit, the banking system as a whole can do so through the process of transferring excess reserves of bankers’ cash from one bank to another.
71 – It should be noted that the converse also applies. If the cash reserves of the banks are reduced, and they were previously lending to the maximum, their deposits will have to be reduced, in the abscense of intervention by the Reserve Bank of Government, by a multiple of the reduction in their cash reserves, as they attempt to regain the required ratio between bankers’ cash and deposits.
72 – Since the deposits are money, it is clear that this process of creation and destruction of bank deposits must be closely controlled in the public interest.
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