The Lost Art of Commercial Banking
Edward C. Harwood
[A paper included as an appendix to the booklet, Money,
Banking and Inflating, A Useful Description, written by Lawrence
S. Pratt and George H. Machen, of the American Institute for Economic
Research, April 1981]
THE evolutionary development of human culture extended over millions
of years. The written record of what has occurred is relatively short,
but we know not only from the written record but also from the
artifacts of earlier human societies that men acquired various arts or
special skills only to lose them in subsequent centuries.
Perhaps in most instances loss of acquired arts was not a determining
influence in the retrogressions, the decline and fall of an unknown
number of civilizations. However, in the present century an art has
been lost or nearly lost, and the consequences may have a significant
influence on the breakdown of Western civilization. This now nearly
lost art is the art of commercial banking.
As has been true for many developments in human culture, commercial
banking evolved as men attempted to cope with their problems, in
particular the exchange problems encountered in a world of rapidly
increasing production. From one point of view, the development of
modern science and its technological application to production forced
the more or less parallel development of commercial banking. Although
more and more men learned the procedures of scientific inquiry that
enabled them to create the amazingly productive modern industrial
society, they never did apply similarly scientific methods of inquiry
to the problem of effecting the tremendously augmented number of
exchanges that characterized mass production for mass markets.
Commercial banking evolved as an art by a succession of trials and
errors just as many other human arts have developed rather than as an
outcome of scientific inquiry.
Eventually the developing art of commercial banking was crudely
described and in some degree understood by its practitioners. For
about a hundred years it was sustained at an advanced level of
development before retrogression began. Today, almost no bankers and
few money-credit economists are familiar with significant aspects of
this lost art. No doubt, other lost arts that once flourished seemed
durable and assured of perpetuity, but the fact is that arts once lost
have not readily been recovered.
THE PROBLEM SOLVED BY COMMERCIAL BANKING
Medieval markets were like those existing today in the more primitive
societies. Things were produced on a small scale, were brought to the
public markets by the producers or their families or friends, and
exchanges were effected by barter in large part. Even in those early
markets where money was used, the money frequently was gold or silver
coin, and the transactions more nearly resembled primitive barter than
the modern banking and exchange procedures now widely used.
However, as the Industrial Revolution developed through the 18th and
19th centuries, mass production for mass markets became commonplace.
The flow of things to organized and continuous markets became
thousands of times the physical volume of things exchanged earlier.
Today, as anyone who has observed modern shopping centers,
supermarkets, major discount houses, and department stores can see for
himself, the problem of facilitating exchanges has become enormous
compared with the exchange problems of a village market centuries ago.
The modern-day problem may be summarized as follows:
a. Coming to the markets of any country such as the United States is
a vast flow of merchandise, transported in ships, freight cars,
trucks, and airplanes, a flow continuously in movement day and night
(with intermissions for parts of the flow at times).
b. Millions of individuals and businesses obtain varying portions of
this flow, for consumption or perhaps for facilitating the production
of other things.
c. If the flow is to continue uninterrupted and without either
accumulations of surpluses or serious scarcities in the markets,
potential claimants (buyers^ must be provided the claim checks
(purchasing media) that will enable them continuously to buy what is
offered. Neither an excess nor a deficiency of claim checks must be
If you were suddenly confronted with such a problem, and had no
experience with modern financial and exchange procedures, had never
handled what you think of .as money, the problem might well seem
extraordinarily difficult. Remember that innumerable items flow into
the markets: gold ingots from South Africa, manufactured watches,
silver in many shapes and forms, diamonds and other precious gems,
food in infinite variety from raw material to precooked TV dinners,
fabrics and clothing also of seemingly unlimited variety, millions of
automobiles, all kinds of chemicals, medicines, household appliances,
Also, remember that practically all of the buyers in the markets
have, in some manner or another, participated in the processing
efforts that have resulted in this vast flow of things. Each is
entitled to his share: this man has fitted the wheels on each of
thousands of cars; that woman has sewn the seams of hundreds of suits;
this manager has coordinated the efforts of a few hundred thousand
people engaged in processing a flow of tires to market; another man
has loaned his savings to a company that provides electricity for all
to use; still another, a barber, has just performed a service for Tom
Jones and has received from him some of the claim checks earned by Tom
during the past week, so that, although a barber sends no things to
market, he also obtains the means to buy.
Let us suppose that your problem is to provide for all the potential
sharers in the flow of things some means of claiming their shares in
the markets. We shall not suggest that you stumble down all the blind
alleys where men were frustrated in trying to solve this problem
during the long evolutionary development of useful commercial banking.
Instead we provide a summary description of the most advanced, most
efficient stage of development that was reached in the decades before
World War I.
We chose that stage of development because retrogression began with
World War I as will be described in more detail later.
HOW A USEFUL MONEY-CREDIT SYSTEM FUNCTIONED
One of the obvious requirements for solving the problem as described
is an accounting unit in terms of which the exchange values of all
things in the markets can be determined. Clearly, claim checks valid
in the markets for purchasing things being offered for sale must be
denominated in some unit of measure for exchange values. Thus, the
claim checks can be anonymous and available for general use in
claiming (buying) any thing. Unlike the situation in a baggage check
room, those who wish to claim things offered in the markets want their
claim checks to be valid for any item available, rather than valid for
claiming only one thing. The buyer in a market wishes to claim the
number of units of exchange value to which he is entitled rather than
the specific items that he may have participated in producing or in
bringing to the market.
Nevertheless, the market situation is in some respects like that in a
baggage checkroom. If claim checks for baggage were counterfeited, or
in some way were issued when baggage had not actually been left in the
checkroom, people could be trying to claim more baggage than there was
baggage to claim. Conversely, if baggage checks that had been issued
properly as baggage was received were either lost or destroyed, some
baggage eventually would remain unclaimed in the checkroom.
Similarly in a nation's markets, if the claim checks (or purchasing
media, or "money") were counterfeited or in some other way
amounts were issued to potential buyers in excess of the amounts
required to represent values of things in the markets, buyers would
have far more to spend than the usual market prices of things for
sale. In trying to use their excessive purchasing media, buyers would
bid for relatively scarce goods, and prices would rise.
In the reverse situation, that is, if claim checks (purchasing media)
were not issued in sufficient amount to represent the values of things
being offered in the markets at the usual prices, prospective buyers
would not be able to claim all the things offered. Then merchants
would be forced to reduce prices in order to sell their stocks of
things before the continuing flow of goods to market exceeded the
capacity of their storerooms.
The accounting unit finally chosen by all leading industrial nations
was a specified amount of gold by weight and degree of purity. In some
instances, different weights of gold were designated as the accounting
unit, and various names were applied by the different nations to the
weights of gold they selected, such as dollars, francs, pounds, etc.
Nevertheless, because all the accounting units were gold all were
freely exchangeable with one another in the simple proportions of
their relative weights of gold.
While these conditions prevailed, any specific number of the
accounting units designated so much gold by weight. One had no need to
talk about a "price' of gold in terms of the various currencies,
any more than one would discuss the "price" of a bushel of
potatoes in terms of potatoes. One might talk about the weight of a
bushel of potatoes as being 60 pounds of potatoes; and in similar
fashion one might talk about 100 dollars as being a specified amount
of gold by weight, because a dollar by statutory definition was
approximately one-twentieth of an ounce of pure gold.
The fact that gold was the accounting unit chosen explains neither
how that choice came to be made nor how it facilitated the issue of
claims for things in the markets. As for how the choice happened to be
made, we shall comment here only briefly.
As human culture evolved, men discovered the usefulness of gold as an
exchange medium. This was not a scientific discovery in the usual
sense involving laboratory experiments and analyses; it simply was the
result of unplanned experience. Men discovered the durability of gold,
which neither rots nor rusts; its comparative scarcity; the fact that
its exchange value for other things (or rather for the average of
other things over wide areas and prolonged times) was relatively
stable, as compared with the relative exchange value of anything else;
even its pleasing appearance to men and women; its easy divisibility;
and possibly other attributes may have been taken into consideration.
At this point we are focusing attention on some of the facts and are
not attempting to describe how those facts came to exist. These are
aspects of the entire problem that need not concern us here, however
interesting they may be to students of economic history. The fact is
that gold was the unit of account for modern industrial civilization.
We turn now to a description of the commercial banking procedure that
issued claim checks representing things in the markets, retired those
claim checks from circulation as things in the markets were sold, and
issued new claim checks to represent the new things coming into the
markets. These procedures had to occur in order to facilitate the huge
volume of exchanges essential to the orderly functioning of a modern
At this point, one must first realize that gold held in the banking
system was one of the things continually offered in a nation's
markets. As gold was brought to the banks, paper currency was issued
to represent it, or additions to individual checking accounts were
made to represent the gold; i.e., to the account of the man who
deposited gold was added, by a bookkeeping entry, the appropriate
number of gold accounting units (in the United States, dollars). These
purchasing media, i.e., currency or checking accounts, could be used
by the holders at any time to claim gold from the banks, that is to
buy the gold in that segment of the nation's markets.
The commercial banks also created claim checks (purchasing media
consisting of currency and checking accounts or demand deposits)
representing things being shipped to and offered in the nation's
markets. The procedure formerly more widely used is somewhat easier to
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 the
amount deducted from the manufacturer's account. Thus the purchasing
media created for temporary use were withdrawn when their purpose had
Those who received the newly issued purchasing media from the
manufacturer then could choose whatever they wanted that the markets
offered. Also demanding things in the markets were those individuals
who had purchasing media representing gold in the banks. Everyone who
had purchasing media at his disposal could buy anything he chose in
the markets including the gold continually being offered by the banks,
which was one segment of the entire market.
A brief digression is necessary at this point, because 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. For example, automobile manufacturers ship cars
to market practically every business day except for the few weeks each
summer when plants are closed for the changeover to new models.
Preparing new sets of documents nearly every day for all shipments for
use as a basis for bank credits would be unnecessarily time-consuming.
Consequently, a different procedure has been developed.
The automobile manufacturer arranges with commercial banks 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 route to markets. Thus a series of borrowings 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. Instead of using the receipts
from today's sales of cars to pay off the note secured by the bill of
lading for the shipment, the receipts from today's sales are used by
the manufacturer to finance his next shipment. (Whether the time
intervals involved are daily, weekly, or monthly depends in part on
customary timing for the payment of wages, salaries, dividends, bills
for materials, etc.)
Clearly, the art of commercial banking requires knowledge about many
aspects of production and exchange. The banker must be an expert judge
of financial statements and must know the customary production and
shipping procedures of those for whom he creates new purchasing media
by discounting their notes. He also needs to have some knowledge of
market prices, although much of this information is available in the
records of billings by the processors of things being sent to or in
POTENTIAL ERRORS IN JUDGMENT
The commercial banker also must have a sound basis for judging
prices. Inasmuch as gold by weight was the accounting unit when the
gold standard was in general use, as it was before World War I, prices
of all things except gold were quoted in terms of gold. For example,
at that time, "dollar" was simply another and shorter name
for about one-twentieth of an ounce of pure gold. Today, "dollar"
is a fictional unit, and judging prices quoted in it is a nightmare.
Errors by commercial bankers in judging the prices of things that are
represented by new credits (by newly created purchasing media) could
have disturbing repercussions. If, because of overoptimism about
prices generally, the bankers created so much new purchasing media
that prices in the United States increased in relation to prices for
similar things elsewhere in the world, some potential buyers would buy
in foreign markets. In that event, the banks would have had to send
gold abroad, because a foreign holder of U.S. purchasing media (or of
claims on it) would buy the relatively cheapest thing available in
U.S. markets, which at that time would be gold.
The outflow of gold would reduce the purchasing media in the United
States representing gold and thus would reduce somewhat demand for
other things. Prices of most things would fall, and the commercial
bankers' error attributable to overoptimism perforce would be
corrected. A cumulative distortion attributable to errors of
overoptimism would seem to be highly improbable, provided the basic
principle of sound commercial banking were followed. However, major
errors of a different type have created increasingly greater
distortions that have led to periodic breakdowns of the money-credit
SAVINGS AND INVESTMENT
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.
Savings are purchasing media that the original holder decides not to
spend himself; instead he requests the bank to invest it for him and
pay him interest on his savings account, sometimes called a time
deposit. The bank invests such purchasing media by lending it to a
borrower who perhaps is buying equipment for his factory or to a
borrower who may desire to buy a new car or for some other purchase.
Thus, the purchasing media (currency or checking accounts) are used by
someone to buy things in the markets although the original recipient
of those purchasing media chose not to buy but to save. He acquires a
credit to his savings account or time deposit, which shows that he is
the owner, indirectly, of whatever investments the bank has selected,
such as bonds, mortgages, installment loans, etc.
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 multitudes 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 United States the "wildcat
banks," usually small institutions in more or less remote areas,
so inextricably confused these two functions that they not only
created new deposits (by discounting notes and crediting the proceeds
to checking accounts) for typical commercial purposes but also they
followed the same procedure and created new checking accounts when
discounting mortgage notes. 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
noncommercial 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:
a. When an automobile manufacturer borrows newly created purchasing
media and distributes them among 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.
b. When an installment buyer arranges to purchase a car, he is not
claiming a share corresponding to his participation in producing
things for markets, he is claiming someone else's share. James Brown
can properly do that provided John Doe is willing to lend to James
Brown the share that Doe's purchasing media (currency or checking
account) proves he is entitled to claim. Such an arrangement usually
is effected via the savings-investment procedures with a bank as
intermediary. If the bank creates new purchasing media for James Brown
to use instead of arranging a loan from John Doe or others, the result
will be more purchasing media available to potential buyers than the
corresponding value of things in or en route to markets.
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.
When the borrowers from "wildcat banks" attempted to buy,
they discovered that merchandise was scarce; they bid prices higher
and higher for the available things. Soon, those having purchasing
media tried to buy more cheaply in more distant markets. The sellers
in those markets did not wish to buy most things in the local markets
but used their claims to demand gold from the "wildcat banks,"
which then were unable to meet their obligations and collapsed.
This disastrous practice has been repeated again and again in human
experience. Another notorious instance was that of the Scottish banks,
of which a multitude collapsed after similarly neglecting to apply
what might be called the basic principle of sound commercial banking.
Finally, the lesson was learned. During nearly a century prior to
World War I, the leading English banks applied the basic principle of
sound commercial banking most of the time with outstanding success.
The basic principle became more widely understood and applied among
industrial nations. Even U.S. bankers, who were "slow learners,"
embodied this basic principle in the original legislation for the
Federal Reserve System in 1913. The Federal Reserve banks originally
were permitted to rediscount for the member banks only commercial
paper directly tied to the volume and value of things flowing to
markets. Such widespread application of the basic principle of sound
commercial banking marked the farthest advance achieved by the human
race in the evolutionary development of a money-credit system that
could serve a modern industrial society.
During World War I the prolonged evolutionary development ended, and
retrogression began that has continued to date. Perhaps the decisive
influence was the political decision by each leading combatant finance
the war by inflating. This procedure was not justifiable on economic
grounds (as Napoleon had demonstrated a century earlier), but
apparently it was politically expedient. The basic principle of sound
commercial banking was simply disregarded when the governments used
the various banking systems to monetize government debt. Not only the
central banks but also the commercial banks generally were stuffed
with government promissory notes of short and long duration, the
latter called bonds in exchange for credit to the checking accounts of
governments. As the new purchasing media or claim checks were used to
buy things in the markets, things already represented by other
purchasing media in use, demand exceeded supply at the original
gold-exchange values. This was inflating, and of course prices rose.
During the 1920's, similar inflating occurred by means of the
overexpansion of private debt. The gold-exchange-standard experiment
then under way facilitated nearly simultaneous inflating in most
industrial nations by the double-counting of gold reserves. When the
credit bubble finally burst, the aftermath was the worldwide deflation
and depression of the early 1930's.
Before World War II, the Keynesian notion that perpetual prosperity
could be sustained by perpetual inflating was applied. It was
continued through World War II, and thereafter it was applied on an
increasing scale. The basic principle of sound commercial banking was
forgotten. Perpetual inflating became the new way of life.
As the currencies of several leading nations deteriorated, that is,
as prices generally rose at increasing rates, gold was demanded from
the banking systems. After the gold held by U.S. banks had decreased
to only 40 percent of the amount held shortly after World War II, the
pretense that the dollar still was a unit of gold was abandoned in
No longer was gold by weight the accounting unit of all leading
industrial nations. The "governor" of modern banking that
had made possible dynamic equilibrium was abandoned. The depreciating
paper currencies provided no standard of value.
From then on, lacking both a warning signal in the form of an outflow
of gold and any definite restraint on the expansion of purchasing
media, bankers based commercial loans on current inflated prices and
made other loans and investments at similarly inflated prices. All
increases in wages and other prices were validated by more and more
increases of purchasing media by the central banks and the other
commercial banks. Thus all the leading industrial nations became
trapped in an inflation spiral of ever-increasing wages and other
prices, in other words, a spiral of depreciating currencies. For this
situation there is no certain end snort of complete depreciation of
the currencies, depreciation to the point that currencies no longer
are used to effect exchanges.
From time to time during a prolonged inflationary spiral temporary
setbacks occur. Overspeculation in various aspects of the economy,
such as building construction in major cities or excess tanker
construction, may be followed by recessions or even more severe
depressions. Nevertheless, in the absence of the gold governor or any
other sound basis for judging comparative exchange values, the
inflationary spiral continues as long as the banks create more
inflationary purchasing media to finance government deficits and/or
excessive private borrowings.