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.


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 provided.

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, etc.

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.


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 industrial society.

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 understand.

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 been served.)

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 the markets.


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 system.


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 1971.

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.