This post continues the reading course on Charles Goodhart’s Evolution of Central Banks. Readers can enrol for an online version of this course via the registration link: https://portal.alnafi.com/enroll/735855?price_id=782356 Currently, this beta-test version of the course is being offered free in exchange for feedback on how to improve the course. The sequence of posts leading up to Chapter 4 is available from the online course linked above. The same sequence is also available in previous posts on this blog starting with Reading Course: Central Banking. So far we have covered the first two chapters, together with extensive commentaries. We now cover some preliminary materials required for understanding Chapter 3.
To understand Goodhart Ch3 Clearinghouse, it is useful to have a deeper understanding of how banks worked in 18th Century England. This is the era of gold money, and we all have a vague understanding the fractional reserve system. The banks issued credit far more than the gold supply they had. This was possible because the proportion of credit, in form of bank checks, which was actually converted into gold was small. This way of thinking about the matter – that some portion of a checking account held at the banks is backed by gold, while another portion is not backed – creates confusion. Clarity can be achieved by changing our ways of thinking about this system.
Alternative Model of Fractional Reserve Gold-Based Banking. We consider two separate monetary systems. One system is that of inter-bank transactions, and the other is the Bank-Depositor interface. It is helpful to begin with the simplifying assumption that all Depositor transactions are conducted purely by check. Everyone has an account at one or more of the banks. In each monetary transaction, the payer gives a check drawn on his account to the payee, who deposits it in her own account. Gold is not used by depositors at all.
To make the picture more concrete, assume there are ten banks labeled B0, B1, …, B9, and there are a 1000 Depositors labeled D1, D2, …, D1000. Each depositor has an account at one of the banks. During the course of the day, there are numerous financial transactions. Depositors buy goods or services from other depositors and write checks to them, which are deposited in their accounts. At the end of the day CLEARING takes place. Let us consider more carefully how this clearing takes place. First, there are internal checks. A depositor at B0 wrote a check to another depositor at B0. In this case, the bank B0 just changes the entries in the accounts of the two, reducing the deposits of one, and increasing the deposits of the other. This happens at each bank. Next, we consider the external checks. Each bank holds deposit checks which are payable by other banks. These checks are settled in gold, which is only used in inter-bank transactions. Each bank sends a runner to collect the gold it is owed from all other banks from which it has received checks. Of course, this process has a lot of duplications and cancellations. That is, suppose bank B0 has a check of GBP 100 drawn on B1, while B1 has a check of GBP 100 drawn on B0. Then the runner from B0 to B1 will get 100 pounds of Gold from B1 and bring it back B0. Later, the runner from B1 to B0 will pick up this same 100 pounds and bring it right back to B1. These runners have to do a huge amount of extra work. To illustrate this, consider an extreme case of symmetry. Suppose that depositors at Bank B0 write 10 checks of GBP 1000 each to each of the 10 banks B0, B1, … , B9. The internal check is cleared without any gold liability. There is GBP 900 in external checks and Bank B0 must pay 1000 pounds in gold to each of the other banks. But now suppose that EXACTLY the same picture holds at ALL of the other banks. Depositors at each bank have written checks of GBP 1000 to each of the ten banks. Runners at each bank will make 9 runs and collect 1000 pounds on each run from each of the other banks, and bring them back to their own bank. A total of 90 runs will be made each run will involve taking 1000 pounds of gold from one bank to the other. But at the end of the day, the gold balances at each bank will be exactly the same as they were at the beginning of the day. Note that this does not mean the runners can stay at home. Each transaction DOES involve changing the numbers in accounts of the depositors, and each transaction DOES make a difference in terms of the amount of money that depositors hold in their accounts. But there is no need for the runners to carry any gold. They just need to change the ledger entries in the accounts of the depositors. Substantial efficiency would result if the runners could just meet in a central place to adjust the account entries, and figure out the NET gold transfers required as a result of the sum of all the transactions, instead of doing each transaction separately. This is how the centralized clearinghouses emerged naturally, to create efficiency in transactions. With a central clearinghouse, 90 transactions can be replaced by 10 — one transaction for each bank. All we need to do is to figure out the NET position of each bank separately. Those with negative balance should pay the required balance of gold to the Central Clearinghouse while those with positive balance should receive the gold from the Central Clearinghouse. One transaction per bank is sufficient for clearing all the checks.
In later posts, we will cover how this model extends to situations where some depositors demand gold, and also how banks extend credit.
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