John Maynard Lord Keynes believed as an article of faith that financing for capital formation could only come from existing accumulations of savings. In order to have sufficient savings to finance the almost unimaginably expensive (in individual terms) new technology that came out of the Industrial Revolution, the world needs a small, elite class of capital owners whose capital generated so much income that they can't possibly consume it. (The Economic Consequences of the Peace, 2.iii)
In consequence, excess income is necessarily invested in additional capital. This increases the rate of savings even more. This results in job creation for the majority of humanity, and ensures that wages, not income from capital, is the sole source of income for the great mass of people. This arrangement of the economy is not only financially necessary, it bestows social and psychological benefits as well that the great mass of people be kept economically (and thus politically) powerless. (General Theory, VI.24.i)
The problem is that, once we examine the process of capital formation, we realize that Keynes' assumptions were wrong. Existing savings are not the source of financing for capital investment, directly, that is. Most savings are already in the form of investment — as Keynes declared (and we do not dispute), "savings = investment." (General Theory, II.6.ii) There is a modicum of savings in the form of hoards, that is, sterile cash not put to any use even as bank reserves (which are a legally-mandated investment in transactions cash), but this is, for the purposes of this discussion at least, negligible, and may be disregarded.
This brings us, finally, to the source of financing for new or replacement capital formation. Clearly, commercial banks do not lend out their reserves, for then they would no longer have the cash or government securities (cash equivalents) in reserve.
Instead of lending their reserves, then, commercial banks create money in the form of demand deposits. This money is (or is supposed to be) backed by qualified industrial, commercial, and agricultural loans. A commercial bank (so commercial banking theory goes) should never create money for consumer loans or anything else that does not generate its own repayment. The new money is backed by a lien on whatever the loan finances. Commercial banks, of course, require collateral in the form of existing investment (this is where savings, which equal investment, come into the picture).
Collateral (accumulations of savings in the form of existing investment) thus acts as a form of insurance. Savings does, in fact, enter into the process of investment in new capital, but not in the way Keynes believed. Bank reserves — another form of savings; an investment in transactions cash to meet legal requirements — also act as a kind of insurance, but (again), not in a way Keynes would have recognized or understood, given his assumptions. Reserves "insure" that there is sufficient cash or cash equivalents on hand to meet the daily demand for cash, not (as many people suppose) to back every loan (demand deposit) in full.
Instead, what backs the demand deposits of a commercial bank are the liens on the assets financed with the loan proceeds. In theory, it is possible to have a commercial bank that has no cash reserves at all. If the only business a commercial bank carried out were to make loans and accept loan payments, it would never have to cash a check or accept a deposit other than their own loan proceeds. This was, in fact, the way the Reichs loan banks in Germany were set up to run, and did run prior to World War I. Unfortunately, to finance the war effort, in 1915 the German Imperial government added short term government loans to the list of financial instruments eligible for discounting at the loan banks. This started the first round of what ultimately became the hyperinflation of the early 1920s.
In theory, then, all demand deposits of commercial banks are backed 100% by the assets that the loans themselves finance. To provide security for the loans, banks also demand that the borrower pledge additional assets as collateral, usually in the form of existing capital investments. This is so that, should the assets financed with the loan not generate sufficient income to repay the loan, the lender can seize the collateral and be able to cancel the loan with the proceeds realized from the sale of the collateral. To provide security for the bank and assure the bank's customers that the bank is sound and can meet its obligations, a certain percentage of the bank's assets are kept in cash or cash equivalents to meet the daily demand for cash.
Thus, given, say, a 20% "reserve requirement," all loans made by a commercial bank are backed (in theory, at least) 220% by assets: 1) 100% by the present value of the assets financed with the loans, 2) 100% by the collateral pledged by the borrower, and 3) 20% by bank reserves in the form of cash and cash equivalents. We can therefore see that, contrary to Keynesian dogma, existing accumulations of savings do not, in fact, directly finance capital formation.
The empirical data and findings published by Dr. Harold G. Moulton, as we have already seen, verified that Keynes was wrong in his assumptions about how capital formation is financed. In the next posting we will examine the case why commercial banking is not by its nature usurious — and also why it does not seem to work to the advantage of everyone, causing many people to conclude (falsely) that Keynes was, after all, correct in his assumption that wealth must be concentrated, and the economy subject to strict State control. (General Theory, V.24.iii)