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Response to Dr. Johnson’s words on page 48
Glossary of Political Economy Terms / by Paul M. Johnson at
<<http://www.auburn.edu/~johnspm/gloss/>>
This is the online edition of A Glossary of Political Economy Terms by Dr. Paul M. Johnson of Auburn University. Use the index at the margin to select an entry to view.
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By Martin R. Carbone
1) Dr. Johnson is a luminary (a person who inspires or influences others, esp. one prominent in a particular sphere) by virtue of his writing at the above link,
2) I, a retired engineer, businessman, inventor who has no professional credentials in the sphere of economics, money and banking, nonetheless challenge all of Dr. Johnson’s opinions as expressed below. My comments are in blue type.
The following is by Dr. Johnson from: <<http://www.auburn.edu/~johnspm/gloss/banking>>
Of course, private banks cannot simply create money out of thin air without limit and still expect to stay in business. When the bank credits a borrower’s account with the amount of his new loan, it is to be expected that the borrower will very soon want to spend part or all of the money he has borrowed. After the check the borrower writes is deposited in somebody else’s account in another bank, the check will soon be presented for collection at the lending bank, and they will have to have the cash on hand to pay the other bank off at that time. (I do not believe that is true. It is my opinion that the checks from the bank to the borrower will be made good by the Federal Reserve as part of their agreement with the bank that the Fed will cover all legitimate checks made by the bank to the bank’s borrowers. The lending bank and the Fed have absolutely no responsibility for the borrower’s subsequent checks.)(mrc). The more dollars’ worth of loans a bank has extended, the more cash it will have to have on hand in reserves to meet the daily flow of redemptions. (I do not believe that to be true -- the bank/lender’s responsibility to the borrower ended precisely when it lent the money to the borrower -- from then on, the borrower must be sure that his (the borrower’s) checks are good. Everything that follows is based on the erroneous assumptions made by Dr. Johnson and discussed here) (mrc). Most or all of the check redemption demands coming in every day can normally be offset by the cash and checks drawn on other banks that the depositors and borrowers have brought in and deposited or paid that day, but an “unsound” bank that extends loans with reckless abandon sooner or later will find that the flow of checks presented to it for collection greatly exceeds the flow of outside checks and cash being brought in. Once the bank’s vaults are empty and the cash reserves are gone, the management must quickly (overnight!) either borrow the necessary additional cash elsewhere (probably at high interest rates) or else sell off some of the bank’s assets (because of the haste, probably at fire-sale prices). When the troubled bank can no longer borrow and has no assets left that can be sold on short notice, it can no longer fulfill its contractual guarantees to pay its obligations on demand and is therefore out of business with the banks owners and managers now subject to civil (and perhaps criminal) legal penalties (bankruptcy, suits for breach of contract, negligence, and fraud, indictments for fraud, embezzlement, etc.).
All the content has been written by Dr. Johnson and is updated periodically.
Where do so many experts get the idea that a bank must (a) back their loans to the borrowers and (b) back the borrowers subsequent checks?
Remember -- In the business of banking, it has never been the responsibility of the bank to “back the loan”or to make the borrowers checks good. The loan is always backed by (a) the promise of the borrower to pay the money back, (b) the collateral and (c) the legal ramifications of the contract surrounding the loan. Lots of people get confused on this issue -- they somehow think the so-called banks' reserves back the loan.
It very well may be that I am wrong on this -- here I am arguing with a more-or-less proven expert. If you know where I am going wrong -- please tell me. martycarbone@yahoo.com