In his excellent book The New Lombard Street, Perry Mehrling writes of "a world that never was ... Jimmy Stewart banking of blessed memory" (p. 117). This is an obvious reference to one of Jimmy Stewart's most famous roles: George Bailey in the holiday classic movie It's a Wonderful Life. In the movie, Bailey is a small banker forced into near-bankruptcy by the inadvertent misplacement of the bank's holdings, holdings that are the deposits of its customers. When those customers catch wind that the bank's holdings are gone, there comes the prototypical "run on the bank,"which precipitates Bailey's attempted suicide. For the rest of the story, watch the movie. For now, what's important is the model of banking this presents. Merhling summarizes it: "In traditional banking, so nostalgic memory reminds us, banks took deposits from households in their community and made loans to other households in their community. It was a simple business...." And this is the model that many still consider to be what banking is all about, with any deviation being a sign of imminent destruction.
But that is not at all what banking is all about. In fact, Jimmy Stewart banking has been a rarity in history, if in fact it ever really was practiced. This is because bankers have instead practiced fractional-reserve banking, which means that deposits of whatever is considered to be real money are held, not to be lent out, but to serve as a base upon which a circulating medium may be erected. That is to say, money substitutes are put into circulation as if they were real money; the banks manufacture and maintain these money substitutes, either by means of notes, checks, or whatever other medium technology can provide; and society is freed from the restrictions of a scarce money supply. In former days, when specie -- gold and silver -- were the only true forms of money (copper serving for small change only), such an "elastic" money supply was a godsend. But it could just easily be turned into a curse, as we shall see.
I said that Jimmy Stewart banking was a rarity. The best example history provides is the Bank of Amsterdam from the 17th and 18th centuries. It received deposits of specie and held them in its vaults. It did this for a fee. Depositors could conduct transactions on the books with each other, freeing them from the need to safeguard and exchange actual specie holdings. By law, the bank could not allow overdrafts. So this was a strict "warehousing" function that the bank provided, which allowed it to serve as a clearinghouse of monetary transactions for all its depositors. And its depositors were all the great ones of Europe.
There was a problem here, though. What no one knew, was that the bank was surreptitiously lending both to the city of Amsterdam and to the East India Company. In 1794, its demise became a foregone conclusion when it came to light that the bank had been making millions of guilders of loans to these entities. So even here, Jimmy Stewart banking was more a pretense than a reality.
Surreptitious lending of deposits was bad enough. The real problem with this system was the power it gave to any who might gain control -- corner the market -- on whatever served as base money. In the days of bimetallism, when both gold and silver served as base money, such overtures to manipulation were difficult to realize. The combined market for gold and silver was too large. But such manipulation did become feasible when the switch was made to the gold standard. Gold was a very scarce medium, and during the days of the gold standard, holdings of it were centralized, leading to the serious opportunity for manipulation by a coterie of banking families -- J.P. Morgan being the most conspicuous example.
Hence, the days of the gold standard were the heyday of fractional-reserve banking. The only "true" money was gold, and the bankers controlled that market, and thus the availability of true money. Banks generated money substitutes as multiples of their gold holdings; but when markets dictated gold outflows out of the country, the money supply contracted by the same multiple, leading to harrowing busts that make contemporary crises seem walks in the park.
But in the midst of -- or rather, at the start of -- the fractional-reserve era, another form of banking existed, at least in the mind of one man. And as a matter of fact, this form of banking has held sway ever since the collapse of the gold standard in the 1930s. This is not Jimmy Stewart banking, but James Steuart banking.
James Steuart was a Scottish baronet who lived in the 18th century, had once supported Bonnie Prince Charlie's bid for the throne of England, and consequently was forced to live in exile for 18 years. While in exile, he wrote a work the importance of which has yet to receive the recognition it deserves: An Inquiry into the Principles of Political Economy (1767). In that work, he espouses a view of banking derived from practice but without the prejudice towards specie that blinded his contemporaries. Steuart realized that the function of banking did not lie in extending base money into money substitutes; rather, the function of banking was to convert property into money. He used the metaphor of "melting down" property, a reference to the melting down of plate and other forms of precious metal so that it could be converted into coin. For Steuart, property was "melted down" into money -- "symbolical" money, as he put it -- when it was put up as security for a loan. This security represented the true money base, because at the end of the day, should the borrower default on the loan, the loan's real worth was simply the value of the security that had been pledged.
Now then, this symbolical money no longer represented base money, it represented the property put up as security. Therefore, it was this property that served as money base, not specie. Steuart foretold the emancipation from gold and silver that the world would only come to accept after the onerous experiences of a Great Depression and two world wars. And that emancipation was not only from a superstititious view of money, but also from a class of men who, using this money, gained control of the nations.
The money systems of today are based on Steuart's principle, not Stewart's. Nor do we practice fractional-reserve banking in any material sense of the term, although in formal terms our system is a fractional-reserve one. After all, our system of central banks is called the Federal Reserve System. But for all practical purposes, reserve requirements do not determine the money supply, nor do they precipitate bank failures the way they did in the 19th century. Rather, it is the willingness of property-owners to put up marketable assets as security for loans that determines the money supply. And it is the quality of those assets on the balance sheet that determine the solvency, and thus survivability, of a bank.