The West London supporters of Militant (the Trotskyite group which still believes in infiltrating the Labour Party) have recently republished a pamphlet, which first appeared in 1977, entitled Inflation and the Financial System.
It begins by explaining, using arguments first developed by Marx in Value Price and Profit, how a rise in wages leads to a decrease in profits rather than an increase in prices and goes on to draw the correct conclusion that
“since we have a paper currency which is not convertible into gold, inflation is caused by the printing of paper money in excess of the actual requirement of circulation.”
So far so good—very good in fact. Things start to go wrong, however, when the pamphlet discusses credit. After explaining how the modern credit system originated in the discounting of trade bills issued by capitalist enterprises to overcome the cash problem that would otherwise have arisen out of the time-lag between production and sale, it goes on
“So far we have assumed that the banks, the main lenders of money, have only lent money which actually exists in their vaults in the form of deposits so that total, overdrafts are never greater than total deposits.”
This was a valid assumption, since how can a bank lend money it does not have? But we are then told:
“Actually this is not the case. Banks found at a very early stage in their development that much of the money deposited with them lay untouched from one year’s end to another. As the main holders of money in society people had full confidence that if they allowed a customer an overdraft the money actually existed in the bank to back it up. As the main holders of money they were sorely tempted to base themselves on this confidence to lend out more money than actually existed in their vaults.”
This is absurd. To talk of banks lending out “more money than actually existed in their vaults” and, later on, of them lending “much more than they borrow” is to indulge in the purest currency crankism. It is Alice-in-Wonderland economics.
Banks are intermediary financial institutions which make profits by borrowing money at one rate of interest and then re-lending it at a higher rate. They can only lend what has been deposited with them (less in fact, as we shall see) and possess no magical ability to lend “extra money conjured out of nowhere”, as the pamphlet puts it.
It is quite true that banks do not have to retain all the money deposited with them in the form of cash. If they did, they would never be able to make any profit, since it is only by re-lending, at a higher rate of interest, the money they have in effect borrowed from their depositors that they make profits. Experience showed that, in normal times, they needed to retain only about 10 per cent of the money deposited with them as cash to meet the withdrawals their depositors were likely to wish to make in any period of time. The other 90 per cent was thus available for re-lending and it is this that is the’ source of the money loaned by banks.
Of course, if for some special reason depositors wish to withdraw as cash more than 10 per cent of what they have collectively deposited, then the bank is in trouble. The extra money won’t be there as it has been lent out, or rather it exists but as a loan and not as cash.
This proportion of deposits which must be retained in cash form is known as the “cash ratio”. In Britain, the Bank of England required, until a few years ago, the Big Four clearing banks (Midlands, Lloyds, Barclays and National Westminster) to maintain this ratio at 8 per cent. Now they are required to maintain a “liquid assets ratio” of around 30 per cent (see later).
Militant’s West London supporters have completely misunderstood what the cash ratio is. If this ratio is 10 per cent, it means that for every £100 deposited the bank must retain £10 as cash and that the amount available for lending is £90. It does not mean that the bank, on receiving a deposit of £100, can retain all of this as its cash basis and lend up to the amount of which £100 is 10 per cent, or £1000.
If banks could lend £1000 for every £100 deposited with them then there would be virtually unlimited credit. The Militant supporters believe that this could in theory happen but argue that the government intervenes to impose a limit: the liquidity ratio we have just mentioned. This is the proportion of assets which has to be held in “liquid” form, which can be very quickly converted into cash. The liquid assets which in Britain go to make this up are, besides the 8 or so per cent held as cash (notes and coins and non-interest bearing deposits with the Bank of England), so-called “money at call” lent to the Discount Houses on a daily basis and Treasury Bills nearing maturity.
The other assets of banks in Britain consist of what are called in banking circles “advances” and “investments”. Advances are loans made to capitalist enterprises and to private individuals. Investments are the banks’ holdings of long-term government bonds. It is clear that Militant’s West London supporters think that the government bonds held by banks serve as backing for the loans they) make:
“Since the ‘liquidity ratio’ is 28% and since government securities count as a backing asset for every £100 of gilt-edged the banks buy they can issue about £350 in overdrafts and make money out of them as well.”
Here in black and white is the mistake we mentioned earlier over the cash ratio though in this case it is about the liquidity ratio. For the “about £350” is amount of which £100 is 28 per cent. Just as a cash ratio of 8 per cent means that 8 per cent of the money deposited with a bank has to be retained as cash, so a liquidity ratio of 28 per cent means that 28 per cent of deposits have to be held in liquid form. In neither case does it mean that the amount a bank can be lend can more than has been deposited with it.
In any event, the proportion of “investments” (government bonds) to “advances” (loans, overdrafts) is not the 28 per cent liquidity ratio as the pamphlet seems to suppose, but is a quite different ratio which varies depending on the higher interest rate is to be got from holding government bonds or from lending to firms and individuals.
Since the Trotskyites are so confused on other issues (Russia, leadership etc) it comes as no surprise to us that they am confused about money and credit too. In fact we fail to understand all the fuss earlier this year about the “Militant tendency” being in the Labour Party. In view of their confusion we would have thought that the Labour Party was good a place as any for them to be.