2. Loan Banking

Let us consider a loan bank, also called a savings-and-loan bank or savings-and-investment bank.  This is where a bank loans out saved funds to borrowers.

 

Suppose a wealthy merchant has a large stock of gold, held safely in his own personal storage safe.  He does not want to use the gold for his present consumption; he wants to use it for future consumption or to leave for his children after he is gone.  He has no plans to use the money any time soon.  His gold lays dormant in his safe.

 

One day, he meets a poor salesman who has a great idea for a business venture.  The salesman is certain that if he had 10oz of gold, he could make such a successful business that he will have 20oz in a year’s time.  But the salesman does not have 10oz; he spends virtually all of his meager income on consumption, and has no savings. 

 

The wealthy merchant, convinced by the soundness of the salesman’s plan, and his ability to pull it off, agrees to lend him 10oz of gold on the condition that he pay back 11oz of gold in one year’s time.  The salesman readily accepts, confident that his business idea will work as he predicts, and he will have 9oz profit after he has paid back his loan.  The merchant will earn 1oz of income for doing nothing, except for giving up 10oz of gold for a year, and choosing someone he considers a good investment.

 

Note the very important social role of the merchant here.  He is a man with no ideas about how to change the productive structure of society; he has only his saved money.  Meanwhile, the salesman has a great idea, and needs only the start-up money in order to improve the productive structure.  The merchant’s prior savings make the improvement to the productive structure possible.  The premium (1oz) that merchant earns is his payment for waiting for future goods rather than consuming present goods.  Hence, the rate for renting money, the interest rate (here, 10%), will be determined by the lenders’ time-preferences. 

 

It is clear that both parties will benefit from this loan agreement and society as a whole will also benefit through increased productivity.

 

The salesman’s business idea may or may not have worked.  It is in the interest of both men for the venture to be successful.  If it failed, and the salesman was not able to pay back his loan, the loss is suffered by the merchant.  If a contract agreement was made (i.e. a transfer of property rights) then this is considered implicit theft by the salesman from the merchant.  The merchant has a right to his money back.  If the contract included collateral (an asset like a house) then the merchant has a right to ownership of the collateral.  Often however, there may be no collateral or it may not fully recompense the lender, in which case the lender must suffer the loss.  Whatever the case, there is a strong incentive for lenders to wisely choose who they lend to.  Competition ensures that only those lenders who choose wisely will stay in business.

 

Note that clearly the merchant cannot use his 10oz for any of the year of the loan.  This is because the salesman has spent it.  It was after all a loan, not a bailment, not a demand deposit.  The merchant’s money is not available on demand, so for the year, it cannot be said to be his money.  The money supply here has obviously not been increased.  The gold in the merchant’s safe was handed over to the salesman and at that moment it became his property, to do with as he will. 

 

If the salesman’s business succeeded, and at the end of the year he had indeed turned 10oz of gold into 20oz as he predicted, he hands 11oz is handed back to the merchant.  Where the salesman gained 9oz and the merchant 1oz, the customers that bought from the new business gave up 10oz, and there is no net change in total supply.  If the business failed entirely, and the salesman lost the whole 10oz, then the merchant has simply lost 10oz and some other individuals have gained 10oz.  Again, no change in the total money supply.

 

Let us suppose that the salesman’s business venture worked.  The merchant, pleased with how he was able to make a profit merely from lending his own money, decides to find other entrepreneurs with great ideas.  He becomes an investment banker, providing a vital service for society.  He invests in several entrepreneurs, whom he has faith in.  He adds a premium for the risk that he is taking, the possibility that some ventures may fail and he will suffer the loss.

 

After investing in several entrepreneurs, the merchant-banker finds that his personal gold stock is getting low.  But there are many entrepreneurs out there with good ideas, and the merchant-banker wants to lend to them.  And so the merchant-banker will go to his wealthy friend, a doctor, who has a large personal stock of gold, and get his own loan from him.  The doctor lends the merchant 100oz (not a bailment), in exchange for the promise to pay back 102oz in a year’s time (2% interest).  With the 100oz from the doctor, the merchant-banker lends it out to eager entrepreneurs on the condition they pay back at 6% interest.  The merchant-banker will pay 2% to the doctor as agreed, and keep the 4% as profit.

 

Note here the important social function played by the doctor.  Like the merchant in the previous case, it is the doctors’ savings that make the new businesses possible, and his profits (a virtually guaranteed rate of return) are payment for foregoing present goods and instead waiting.  Unlike the merchant, though, the doctor does not need to know the entrepreneurs or even what they are doing.  This is the business of the merchant-banker.  The doctor is bearing almost no risk, because he is not trusting any single entrepreneur (like the merchant did with the salesman), but must only trust that the merchant-banker will not go bankrupt and will be able to pay him back.