Present day puzzlements shed their complexity when Guy Numa in this essay draws on some age old distinctions borrowed from Jean-Baptiste Say. Numa is a INET Research Fellow who specializes in the History of Economic Thought and Industrial Organization.
Five years ago Lehman Brothers filed for bankruptcy marking the unofficial start of the latest financial crisis. Several commentators argued that the key to understanding the root cause of the crisis lies in the partial repeal of the Glass–Steagall provisions that occurred in the late 1990s. The provisions restricted commercial banks from participating in the investment banking business and therefore institutionalized a de facto separation of the two types of institutions.
In a competitive environment where the minimization of systemic risks is a sacrosanct objective, discussions tend to revolve around two sets of questions. Firstly, do we really need a central bank? If yes, with what prerogatives? In particular, should such institution serve as a lender of last resort? Secondly, and this is the subject of this note, is it desirable to distinguish between commercial banks and securities firms? If yes, what is the underlying rationale of such distinction? What are their respective attributions?
The monetary thought of the 19th century is a rich source of insights into the organization of the banking industry. In particular the French economist Jean-Baptiste Say, often wrongfully portrayed as an unrelenting champion of Laisser faire, offered a masterful analysis of banking institutions that resonates with modern-day controversies on the topic at hand. It should be noted that he was quite familiar with banking and financial issues. Jean-Baptiste was trained as a banker in the Say family business (his father was a currency trader) and at some point he worked for an insurance company.
In the Traité d’économie politique, his magnum opus, and the Cours, Say distinguished between “banks of deposits” and “banks of circulation or discount” with no specific hierarchy. The former maintain the totality of the funds deposited at all times and do not give out loans. They merely offer the convenience of transferring funds from one account to another (in exchange for a fee) with no need to use metallic money. Simply put, “banks of deposits” function as warehouses for money. The latter play the role of financial intermediaries. They discount various forms of commercial paper (which generates interest income) using not only the capital funds of its shareholders but—this is more original—also by issuing banknotes backed by fractional reserves and/or short-term securities. They hold no deposits. The banknotes issued would lower the interest rate and thus allow businesses to grow the economy. In Say’s mind, this “enhancement of the national capital” is limited but “extremely precious” (Traité d’économie politique, p. 577) and logically concluded that “banks of circulation” were truly beneficial for society.
However, Say indicated that the public could be exposed to the potential mismanagement of bank executives and abuses resulting from the overissue of banknotes. Hence his stance—this is the key point here—in favor of public interference to ensure the stability of the banking system. In line with Adam Smith, Say considered money as a public good that legitimates government intervention to control banking activities. But details on the exact nature and the scope of public control remain sketchy.
In light of the developments of the last five years, three lessons can be drawn from Say’s banking theory.
1. The primary function of the financial sector in a capitalist economy is to serve as intermediary between savers and investors, which helps create economic growth;
2. When wisely and prudently implemented, money creation serves a double purpose: medium of exchange and investment. In Say’s words, “despite the principles that state that money is only a simple intermediary, and that in essence products are only traded for products, a more abundant money enables all sales and the reproduction of all values” (Cours d’économie politique, p. 93);
3. To ensure stability and prevent abuses, some form of public control is required. It does not mean that government supplants private banks though. Interestingly Say held this interventionist position while opposing the existence of a central bank.
The development of shadow banking contributes to attenuate the frontier between commercial and investment banking. Modern finance instruments such as interest rate swaps and credit default swaps, while making credit cheaper, disconnected the credit system from the payment system (see Mehrling 2009). Considering that regulation is mostly circumscribed to the latter, the former is left with little oversight and paves the way for greater instability; which leads to my final point.
There is a crucial lesson to learn about the crisis of the type that happened in 2008. It is important to point out that such crises do not necessarily occur because of an excess of money but because of an excess of credit. The control of both variables is a major challenge for monetary and financial institutions.