Part IIIn yesterday's post I told you about economist Edward C. Harwood's 1928 prediction of the 1929 Great Depression, in published and unpublished articles.He saw imbalances in the banking sector that were going to lead the country into a quagmire (although he could not have predicted the depth to which it would sink through government and global mismanagement).In his unpublished article entitled "A Sharp Distinction Should be Made Between Capital Funds and Commercial Credit," written in mid-1928, he gives us a layperson's understanding of sound commercial banking by explaining the relationships among the various participants as though they were characters in a play. Let me introduce you: The Earners, the Investor, the Manufacturer, the Retailer, and the Bank.- Earners - all who are entitled collectively to a share in a country's GDP, i.e. those who participated in its production. In other words, all of us who work for a living. In reality, all of the characters are Earners, but some have different functions.- Investor - the risk-taker who lends his capital funds to the Manufacturer in exchange for a piece of the profits.- Manufacturer - the producer of all products, agriculture, and services.- Retailer - the selling agent for Manufacturer.- The Bank - the financial intermediary between Manufacturer and Earners, between Retailer and Manufacturer, and between Earners who save at the Bank and the Retailer or Manufacturer, to name a few of the relationships.[Thanks to JohnDClare.net for the photo.]In Act I, all goes well. Manufacturer receives a loan (capital) from Investor with which to buy his building, equipment, and raw materials. Then he plans an amount of production based on expected sales. With the help of Earners, he produces goods (or services) to ship to Retailer for selling to the public. Retailer promises to buy the products and signs the purchase order.At shipping time, the Manufacturer wants to be able to pay Earners even though he hasn't received payment from Retailer for his products, because Retailer will need to sell the products first, and guess who are his customers? Why, Earners, of course. (What goes around, comes around.)Here is the first point to remember about a healthy monetary system: Manufacturer always distributes 100% of his gross sales among his expenses, his profit, his Investor, and his Earners; and the only way he can do this at this point is to get a loan at the Bank, and give each Earner a claim for the value of that portion of the products each has helped to produce, so that the claimant can claim it (or its equivalent) when he wants it.A particular Earner may not want the five cars his annual work entitles him to; he may want down payment on one car, some bread, some meat, rent money--any number of things. Money is, in essence, a claim--no more, no less, and it is generic, accepted everywhere,. (More about that later.)So to give the claims (we could have named them "purchasing power") to each participant, the Manufacturer goes to the Bank with Retailer's order for the goods. On the basis of the order the Bank grants Manufacturer a loan by creating credit out of thin air, so to speak, and puts the credit representing almost the total future sales in a checking account to allow the Manufacturer to pay Earners. (The rest is Bank's income.)Once the goods are ready for shipment, Manufacturer pays himself and the Earners, including the Investor, in cash or equivalent; and everyone accepts these claims (paper cash bills, a check, or an electronic transfer) representing a piece of the production.It is important to retain the notion that the income from the wholesale sale of the product is divvied up between the Manufacturer and the Earners, because they each are entitled to a share of the whole production, down to the last penny. There can be no more or less money (claims) handed out than the total wholesale price of the things manufactured. This is an essential point. Also realize that the wholesale sale value is only a part of the final retail sale value. This is normal, because there are others who are going to participate in the distribution process who will also have a right to claim a share representing the work they have done to get the product to market.Next, the Manufacturer will require Retailer to make good on his signed purchase order and pay the wholesale price before the items are sold. So Retailer too goes to the Bank as soon as he receives the title to the goods in shipment; and the Bank, on the basis of the title, grants a loan (credit) and deposits the sum in a checking account so that the Retailer can pay Manufacturer for the goods, who in turn pays back his own loan from the Bank.The Bank then destroys Manufacturer's loan document and finds itself with a new loan document signed by Retailer for a higher amount. The Manufacturer's loan account is zeroed out, all sums being paid. Remember, the credit previously issued to Manufacturer and paid out is now claims in the hands of those who produced the products and who deserve their share of its value.Retailer, who now owes the Bank, sells the products within a few months and pays back his loan. The Bank then destroys the Retailer's loan document. The Retailer, like the Manufacturer, pays the remaining sales proceeds to cover expenses, then himself, his own employees (earners), and investor (another earner), and they all become owners of claims to a piece of the production value.Soon, someone will have bought all the products that were manufactured, ending the cycle. A few of the paper claims will end up in a savings account at the Bank.Let's stop the carousel here and take stock of things. What I have described above is the commercial relationship of every company in the world with its bank's commercial department. In the past, banks created credit (in the form of checking accounts) that was, as described here.To do so would have been risky unsound banking, proven in the past to lead to trouble.In Part III of this series on sound commercial banking, I will delve into how banks dealt with savings.

Labels: commercial banking, economics, Edward C. Harwood, real bills