CREDIT POLICY Banks create credit. It is a mistake to suppose that bank credit is created to any important extent by the payment of money into the banks. Money is always being paid in by trades men and others who receive it in the course of business, and drawn out again by employers to pay wages and by depositors in general for use as pocket money. But the change of money into credit money and of credit money back into money does not alter the total amount of the means of payment in the hands of the community. When a bank lends, by granting an advance or discounting a bill, the effect is different. Two debts are created; the trader who borrows becomes indebted to the bank at a future date, and the bank becomes immediately indebted to the trader. The bank's debt is a means of payment; it is credit money. It is a clear addition to the amount of the means of payment in the community. The bank does not lend money. The borrower can, if he pleases, take out the whole amount of the loan in money. He is in that respect in the same position as any other depositor. But like other depositors he is likely in practice to use credit for all major payments and only to draw out money as and when needed for minor payments.
The statement that banks create credit has been the occasion of much unnecessary controversy. It does not mean that any bank can create any amount of credit at its sole discretion without limit. There are limits, and neither the theory nor the practice of banking can be fully understood without regard to those limits. When a bank lends to its customers it increases its deposit liabilities. To the customers those liabilities are money, the means of payment. They draw upon their bal ances and pay them away. The people to whom they make payments will be average members of the community. In so far as they have banking accounts they will be for the most part with other banks, and the payments to them will appear as debits against the lending bank at the clearing. At the same time previous advances and bills will be maturing. The customers of the bank who pay them off will have procured the wherewithal by selling things and doing business with other members of the community; they receive payment, and thereby there arise credits in favour of the bank at the clearing. If the bank increases its lending, the tendency will be for the debits at the clearing to exceed the credits. The bank's cash will be diminished, and to reinforce its reserves it must realize some of its liquid assets. To that extent it loses the profit on its additional lending, and at the same time its position will be weakened. On the other hand, if all the banks in the community are increasing their lending to the same proportional extent, no one of them will lose at the clearing, and this check upon them will be inoperative. But there is another check. The payments made by the borrowers out of the credit money placed at their disposal include payments to wage-earners and others who have no banking facilities. In so far as these people spend what they receive, the money comes back to the banks and there is no loss of cash. But the presumption is that when the outflow of money is increased, some will remain out ; the cash holdings of the community will grow, and the cash holdings of the banks will be reduced.
Now the banks must hold a certain amount of cash, corresponding to their deposit liabilities. Unless at the outset their cash holdings are redundant, they cannot let them be reduced. Indeed if, as we have assumed, their deposit liabilities are increasing, they would rather want their cash to increase in proportion. Banks commonly aim at keeping their cash approxi mately in a fixed ratio to their liabilities. Any bank which seeks to make good its lack of cash can do so at the expense of the other banks by damping down its lending. It will secure a credit balance at the clearing, and will receive this balance either in money or in cheques upon the central bank which can be turned into money. If one bank replenishes its reserves at the expense of the others, they will feel the shortage all the more. All will soon be impelled to curtail their lending, or, as it is called, to contract credit. But there is an alternative. If there is a central bank the other banks (which we may call the competitive banks) can replenish their cash by borrowing from it. If (as is invari ably the case) the central bank is a note-issuing bank, and its notes are either legal tender or are treated by the community as entirely equivalent to money, the central bank by lending creates money. If its assets are increased by a certain amount of new loans or discounts, its liabilities are increased by the same amount. Its liabilities are either notes, and therefore money, or deposits which can be drawn on for clearing purposes or converted into money and which are regarded by the competitive banks as part of their cash reserves.
Bank.—The central bank has the power of removing the obstacle interposed by the limitation of the supply of cash to the indefinite expansion of credit by the competitive banks. This power it ought to be cautious in using. The instrument through which it regulates its lending is the bank rate, the rate of interest that it charges. As a rule the bank rate properly so called is the rate of discount charged by the central bank on bills, another and somewhat higher rate being charged for advances. The accepted practice of central banks is to lend to all comers, provided they bring the approved kinds of bills or securities, and, if they seem to be borrowing too much, to rely on a high bank rate to deter them. It occasionally happens in exceptional circumstances that the central bank refuses to lend at all, or rations borrowers, refusing to lend beyond a pre scribed limit. That is an emergency measure, only appropriate at a time when under the influence of a tendency towards in flation there is a class of speculative borrowers unamenable to any rate of interest short of one which to other and more reason able borrowers would seem extortionate. Far from being ad visable in other emergencies, a refusal to lend is disastrous in a financial crisis. A crisis is caused by a collapse of prices, which threatens the solvency of traders who are holding stocks of goods with borrowed money. It is likely to occur at a time when there has been excessive lending and the competitive banks are calling in loans. To refuse a loan is to compel a sale, and forced sales accentuate the fall of prices. If the competitive banks can bor row (at a price) from the central bank, they can afford to grant or renew loans (at a price) to their customers, and forced sales, at any rate on the part of solvent traders, can be avoided without undue difficulty.
normal conditions, when there is no crisis, the bank rate sets the standard for short term rates of interest throughout the market. The extent to which the competitive banks borrow from the central bank is governed by the extent of their own customers' borrowing from them. If bank rate is to affect the competitive banks' demands, it can only be through their customers. If the market rate moves with the bank rate, that occurs; traders borrow less if they have to pay more. Some traders, it is true, are little affected by the rate of interest on temporary loans ; it is a negligible item in the calculations of a producer with big fixed capital which he cannot afford to leave idle. But others are highly sensitive to it ; particularly the merchant who makes a narrow margin of profit on a large turnover of goods, and who can vary his stock in trade within wide limits without inconvenience. The effect of bank rate on the market depends on the extent to which the competi tive banks are compelled actually to borrow from the central bank. The central bank may hold securities bought in the open market. To support a given total of liabilities (note-issue and deposits), the more of these open market assets it holds, the less the competitive banks will need to borrow. The open market assets might be raised to such a figure that the competitive banks need not borrow at all. In that case the market rate would for the time being be dissociated from the bank rate ; bank rate would be ineffective. To make it effective, the central bank would have to reduce its open market assets (by sale or non-renewal). Its liabilities would fall by the same amount as its assets, and there would be a shortage of cash which would drive the com petitive banks to borrow.
When the com petitive banks are subjected to pressure by the central bank, they do not rely only on high interest charges to deter their customers from borrowing. They can exercise influence upon them in many other ways, by conditions as to security, by limiting the period of a loan or by simple persuasion. It is when they are more than usually indebted to the central bank that they are likely to make most use of these methods. It was pointed out above that in London the borrowing from the Bank of England is done not by the competitive banks but by the discount houses. But that does not alter the essential character of the system of credit control.
Central Bank Regulation of
central bank by adjusting bank rate, and when necessary making it effective, absolutely dominates the credit market. How is it to use this power? One answer (but as will be seen, an incomplete one) is that it is guided by the state of the foreign exchange market. If one among several countries creates credit too freely, the effect is much the same as when one among several banks does so. The borrowers pay away the deposits they acquire, and a part they pay away to international markets for imported goods, etc. The outcome is what may be regarded as a debit clearing balance against the country in the foreign exchange market. The dealers in that market receive too much of its currency. Either the ad verse balance must be settled by exports of gold (which plays the part among gold standard countries of an international cur rency) or the currency of the country will tend to depreciate in terms of other currencies in the foreign exchange market. It is the practice of central banks to aim at preventing this situation from arising. An expansion of credit that threatens to disturb the foreign exchange market they check by raising bank rate. The contrary case where credit contracts, and the currency appreciates in the foreign exchange market, they deal with by a reduction of bank rate. But this manner of proceeding is open to the objection that if all the countries expand credit simultaneously, no one of them will have to pay a balance to any other. At this point the theory of banking merges in the theory of money and a further explanation of this somewhat intricate subject is given in the article MONEY.
