The Origin of Banking

There is a just-so story that explains the existence of money. Before money, the story goes, we all had to barter for the goods we wanted. If I wanted wheat and had chickens, I needed to find someone who wanted chickens and had extra wheat. Money solves this “double coincidence” problem by letting me sell my chickens to buy your wheat. If we didn’t have money we’d invent it immediately.

The problem with this simple story is that it may not match history. There has never been a pure barter economy, according to anthropologists. Pre-money economies were organized in a variety of other ways, including central planning, informal gift economies, and IOUs denominated in cows.

Sir Jon Hicks’ classic A Market Theory of Money fills this gap.  Hicks was a major figure in 20th Century economics who eventually won a Nobel, and here at last is a straightforward story that explains why we have banks at all. It’s still not clear to me that this account is historically grounded – or that we can understand what a modern bank does, or should do, on the basis of historical parable — but at least this account provides a better history than barter.

With that cautionary note, here’s Hicks’ story of banking. He begins in a world where money is already the usual form of payment, and breaks down a transaction into three pieces:

  1. Buyer and seller reach an agreement on what is to be sold at what price
  2. Buyer delivers the goods
  3. Payer delivers the cash

Step 1 has to come first, but payment and delivery may come in any order at any time after that, depending on the agreement that the parties made. The gap between contracting and payment is credit. Credit is a very old idea, and central to modern economies. Hicks argues that “payment on the spot” is actually the uncommon case, at least for orders over a certain size:

I may pay spot for a newspaper as I walk along the street, but I may also give an order to a newsagent to deliver a copy to my house each morning. I should not then pay for each issue as I received it; I should wait until the end of the month when he sent in his bill. … It is probably true that only for small transactions – small that is, from the point of view of one or other of the parties concerned – that the spot method of payment is ordinarily preferred. People are not, and never have been, in the habit of carrying about them a sufficient quantity of coin or notes to pay for a house or pay for furnishing it.

The key observation is that credit is typical, not extraordinary. Any time we pay a bill – whether a at restaurant or for a credit card — we have been extended credit.

In the gap between contracting and payment there is debt, and debt is measured in money (at least on the buyer’s side; for the seller, debt is measured in goods or services owed.) There has long been argument over what exactly money is, or more usefully what it does, but in a credit-based theory of the economy it has two clear roles:

We seem thus to be left with two distinguishing functions of money: standard of value and medium of payment. Are they independent, or does one imply the other? It is not easy to see that there can be payment, of a debt expressed in money, unless money as a standard has already been implied in the debt that is to be paid. So money as a means of payment implies money as a standard. But could a debt expressed in money be discharged other than in money? Surely it could.

It could for instance be set off against another debt, the debt from A to B being cancelled against a debt from B to A.

This is Hicks’ entry into the concept of an IOU, which seems to be fundamental to modern finance – perhaps the fundamental idea, the notion underlying every financial instrument of every kind. Yes, you can pay money to settle a debt, but you can also cancel one debt against another, netting the debts. This means that a debt owed to you has monetary value! From there, it’s a small step to the idea that a third party debt can be used as a form of payment. Suppose B owes A a debt, and C owes B a debt of a different amount.

A is then asked to accept part payment in the form of a debt from C to B, which is to offset the balance of debt between A and B, a balance we take to be in favour of A. But A can hardly be expected to consent to such an arrangement unless he considers that C is to be trusted. So there is a question of trust, or confidence, as soon as a third party is brought in.

This short paragraph states a pattern that has been at the core of trade for centuries, and is at the core of finance today: the transferability of debts made possible by the assurance of good credit. This was a common pattern in the trade fairs of Renaissance Italy, where merchants would meet to settle tangled webs of IOUs with each other and with the banks. It happens today when a bank B lends money to A to buy a house, creating a mortgage debt from A to the bank, then sells the right to collect that debt to another bank C. For this to happen, B has to guarantee to C that A is creditworthy enough to repay.  It’s less obvious, but equally applicable, when A pays B by check. B doesn’t have “money” when they have the check, but a promise from A’s bank to pay. But we’re not there yet. Here’s how Hicks builds up to tradable debt:

The quality of debt from a particular trader depends on his reputation: it will regularly be assessed more highly by those who are in the habit of dealing with him, and know that his a accustomed to keeping is promises, than by those who do not have the advantage of this information.

Thus the value of a debt is sensitive to information. It’s not clear to me whether anyone would have used this language in, say, Renaissance Italy. Hicks, writing in 1989, would have been influenced by recent, eventually Nobel-wining work on information in economics. The information view of value explains how formerly solid debt-based assets – for example, mortgage-backed securities – can evaporate almost instantly if there is a credible threat of non-payment. Although debt is tradable like money in the good times, in bad times everyone wants hard currency, not promises to pay currency.

Hicks says that this information problem – really a reputation problem – leads to the creation of a market for guarantees that a bill will be paid.

Thus we may think of each trader as having a circle of traders around him, who have a high degree of confidence in him, so that they are ready to accept his promises at full face value or near it; there is no obstacle to offsetting of debts within that circle from lack of confidence in promises being performed. If he wants to make purchases outside his circles he will not be so well placed. Circles however may overlaps: though C is outside A’s circle, he may be within the circle of D, who himself is inside the circle of A. Then though A would not accept a debt from C if offered directly, he may be brought to accept it if it is guaranteed by D, whom he knows D is then performing a service to A, for which he may be expected to charge.

This is a market for acceptances of bills of exchange, a financial instrument that seems to be uncommon today, but was quite common in 19th century merchant banking, as described by Bagehot. From the merchant’s point of view, the objective of all of this is to get paid sooner. Suppose you sell goods to B in exchange for a bill with a specified due date, say 60 days from now. That’s a debt, and one way to use it is just to wait 60 days until B pays cash. Or you could trade that debt immediately with any person C who thinks B trustworthy – perhaps for cash, perhaps to settle a debt with C, perhaps to make a purchase. If you wanted to trade with someone who didn’t know B, you could first buy an acceptance and then trade the bill together with the acceptance – the debt together with its guarantee.

An acceptance is basically insurance: a guarantee that a bill will be paid, in fact the promise to pay the bill if the debtor defaults. The guarantor is willing to do this because they know, or have some way to evaluate, the reputation of the debtor, and because they charge a fee for the service. The equivalent modern instrument would be something like a “credit default swap.”

Notice that we don’t have banks yet. Instead, this story tells of the creation of the first markets for debt, facilitated by intermediaries who guarantee repayment. And here’s where I start to hesitate. It’s a nice story, certainly an account of how this could have happened. But I’m not enough a historian to know if this is how it did happen. Like barter, this could be an attractive myth. Still, it’s a useful account of a problem to be solved – how do I trade my debt assets outside the small circle of people who know the debtor personally? For if debt is tradable, then I suddenly have a lot more capital at my disposal: not just the cash I’m currently holding, but all of the cash that is owed me.

According to Hicks, the next step in the story of banking is the creation of two special kinds of intermediaries. The first sells guarantees (acceptances) on debt. They either know many debtors well, like a credit rating agency, or they know where to buy acceptances from someone who does know. The other kind of intermediary pays cash for debts along with their acceptances, at a discount from the face value of the debt, that is, a fee.

Until that point, the principal reason why the market value of one bill should differ from another is the difference in reliability; but bills, between which no difference in reliability is perceived, may still differ in maturity. A trader who is in need of cash needs it now, not (say) six months hence. So there is a discount on a prime bill which is a pure matter of time preference – a pure rate of interest.

Here Hicks is distinguishing between what would today be called credit risk, the risk of non-repayment which is solved by acceptances, and “time preference,” that is, the advantage of having cash now instead of later, which costs interest. These two components of price (and more besides such as liquidity risk) are implicit any time debt is sold. Hicks believes that separating these out is a necessary step to explaining how banking arose:

The trouble is that the establishment of a competitive market for simple lending is not at all a simple matter. The lender is paying spot, for a promise the execution of which is, by definition, in the future. Some degree of confidence in the borrower’s creditworthiness – not just his intention to pay but his ability to pay, as it will be in the future – is thus essential to it. There cannot be a competitive market for loans without some of this assurance.

It’s a fine argument, and indeed there is always both credit risk and time preference in lending (or buying debt for cash, which is nearly the same thing.) But I’m not convinced this is a historical account. Did the biblical money lenders really distinguish between credit risk and time preference when they set their interest rates? I suspect the answer is no. Yet surely there were reasons that the first money lenders came into existence – that is, motivating problems that offer hints as to what banks do. It may be possible to offer an account of the creation of banking which is both simpler, more motivating, and more historical than Hicks’ story of acceptances and discounts.

From a network of discounters for bills – intermediaries who are willing to lend cash against a guaranteed debt – we finally come to banks proper. Hicks explains the origin of banking by asking how trade volume could ever increase when there’s a fixed supply of cash among merchants:

What then is to happen if trade expands, so that more bills are drawn, and more come in to be discounted? Where is the extra cash that is needed to come from? Any one of the dealers could get more cash by getting other dealers to discount bills that he holds. But the whole body of dealers could not get more that way. They must get cash from outside the market. They themselves must become borrowers.

The solution was to combine this business with another sort of business, which in the days of metallic money we know to have already made its appearance.

This other business is goldsmiths, or perhaps moneychangers, both of which would store a customer’s coins in their vault. There has long been a need for secure money storage, something better than cash under the mattress. The innovation of modern banking is to recognize that not every customer will withdraw all their coins all at once.

Then, once that happens, there will be a clear incentive to bring together the two activities – lending to the market, and ‘borrowing’ as a custodian from the general public – for the second provides the funds which in the first are needed. At that point the combined concern will indeed have been becoming a bank.

This, then, is the essence of banking: take deposits, make loans. Crucially, a loan is in fact borrowing from the depositors and lending at different time scale (maturity transformation). The debtor pays back the loan at a later date, or perhaps little by little as with a mortgage, but the depositors can demand the whole of their account as cash at any moment. It is only by hoping that not everyone wants their cash back all at the same time that a bank can exist. A bank which did not borrow from its depositors would be incapable of extending credit, at least beyond the capital that its owners are putting in.

This is the “fractional reserve” system which has existed for centuries. Banks are by law allowed to lend at most some large fraction of their deposits, hedging against many depositors asking for their money back all at once (though note, today banks can always borrow more reserves from the central bank, so capital reserve requirements don’t really constrain lending.)

On this account, the central features of a bank are:

  • Taking deposits, which can be withdrawn at any time
  • Making loans, which are repaid slowly

In other words: short-term borrowing to finance long term lending. There’s nothing surprising in this description, and it captures the inherent risk-taking in banking, since it may happen that everyone wants their deposits back as cash all at once. Today, US banks are insured up to $250,000 per account by the FDIC, which simultaneously pays out if needed and makes payout less necessary since the guarantee makes bank runs less likely.

But something key is missing: the banks’ central role in the payment system allows them to create high quality tradeable debt — that is, bank deposits. For most people, bank balances are money, therefore a bank can create money. To explain how, Hicks examines the evolution of a bank’s debt to its depositors.

It would however always have happened that when cash was deposited in the bank, some form of receipt would be given by the bank. If the receipt were made transferrable, it could itself be used in payment of debt, and that should be safer [than moving cash around physically.]

Hicks uses this idea of a “receipt” to trace the development of the bank check, and from there the modern reality that bank deposits are money as far as you and I are concerned. Consider how one person pays another through the banking system:

It would at first be necessary for the payer to give an order to his bank, then to notify the payee that he had done so, then for the payee to collect form the bank. Later it was discovered that so much correspondence was not needed. A single document, sent by debtor to creditor, instructing the creditor to collect from the bank, would suffice. It would be the bank’s business to inform the creditor whether or not the instruction was accepted, whether (that is) the debtor had enough in his account in the bank to be able to pay.

The key point is that with a check – or with any of our modern means of electronic payment – no cash is ever withdrawn from the bank! We have simply rewritten the amounts owed by the banks to each customer. That is, if I pay you, my bank owes me less cash and your bank owes you more. It would be no problem if in fact my cash had been loaned out to someone else during this whole time.

In fact, banks don’t really loan cash either.

When the bank makes a loan it hands over money, getting a statement of debt (bill, bond, or other security) in return. The money might be taken from cash which the bank had been holding, and in the early days of banking that may have often happened. But it could be all the same to the borrower if what he received was a withdrawable deposit in the bank itself. The bank deposit is money from his point of view, so from his point of view there is nothing special about this transaction. But from the bank’s point of view, it has acquired the security without giving up any cash; the counterpart, in its balance-sheet, is an increase in its liabilities. … But from the point of view of the rest of the economy, the bank has ‘created’ money. This is not to be denied.

Bank deposits are not cash. They are debt to customers.  But we are happy to have bank deposits because banks have become the way in which we pay each other. When someone owes us money, we are satisfied with “money in the bank” rather than cash in hand. This all goes back the the tradability of debt that Hicks started with: Banks create debt of high quality, that is, debt which can be traded from hand to hand nearly as well as cash, or perhaps better. In that very real sense, banks create money.

Hicks has tried to explain how this combination of features we call banking arose. The story he gives is a progression from debt trading, to acceptances, to loaning cash against bills, to merging with the money storage industry, to a central role in the payment system, to creating money by lending some large fraction of customer deposits. I am not convinced that banks actually arose in this sequence. However, it does highlight some of the needs and problems that led to the creation of banking. Namely: consumers need a place to store money, businesses need credit, and everyone needs a payment system.

But the advantage of Hicks’ telling is that it highlights the central role of credit/debt. As soon as debt can be freely traded to a third party, it is a kind of money. It is this trust that allows a bank to create money. How much money a bank should create is a different question, which Hicks’ parable cannot tell.  Rather, I find this pattern of tradable debt useful for thinking about all the different forms that banking takes, including by the many financial institutions that don’t call themselves banks.

What Data Can’t Tell Us About Buying Politicians

Corruption in the classic sense is when a politician sells their influence. Quid pro quo, pay to play, or just an old fashioned bribe — whatever you want to call it, this is the smoking gun that every political journalist is trying to find. Recently, data journalists have begin to look for influence peddling using statistical techniques. This is promising, but the data has to be just right, and it’s really hard to turn it into proof.

To illustrate the problems, let’s look at a failure.

On August 23, the Associated Press released a bombshell of a story implying that Clinton was selling access to the US government in exchange for donations to her foundation. I’m impressed by the AP’s initiative in using primary documents to look into a serious question of political ethics. But this is not a good story. It’s already been criticized in various ways. It’s the statistics I want to talk about here — which are, in a word, wrong. (And perhaps the AP now agrees: they changed the headline and deleted the tweet.) Here’s the lede:

At least 85 of 154 people from private interests who met or had phone conversations scheduled with Clinton while she led the State Department donated to her family charity or pledged commitments to its international programs, according to a review of State Department calendars

There’s no question this has the appearance of something fishy. In that sense alone, it’s probably newsworthy. But the deeper question is not about the appearance, but whether there were in fact behind the scenes deals greased by money, and I think that this statistic is not nearly as strong as it seems. It’s fine to report something that looks bad, but I think news organizations also need to clearly explain when the evidence is limited — or maybe not make an ambiguous statistic the third word in the story.

So here, in detail, are the limitations of this type of data and analysis. The first problem is that these 154 are a limited subset of the more than 1700 people she met with. It only counts private citizens, not government representatives, and this material only covers “about half of her four-year tenure.” So this isn’t really a good sample.

But even if the AP had access to Clinton’s complete calendar, counting the number of Clinton foundation donors still wouldn’t tell us much. There would still be no way to know if donors had any advantage over non-donors. If “pay to play” means anything, it must surely mean that you get something for paying that you wouldn’t otherwise get. In this case, that “something” is a meeting with the Secretary of Sate.

The simplest way to approach the question of advantage is to use a risk ratio, which is normally used to compare things like the risk of dying of cancer if you are and aren’t a smoker, or getting shot by police if you’re black vs. white. Here, we’ll compare the probability that you’ll get a meeting if you are a donor to the probability that you’ll get a meeting if you aren’t a donor. The formula looks like this:paytoplayThis summarizes the advantage of paying in terms of increasing your chances of getting a meeting. If 100 people paid and 50 got a meeting, but 1000 people didn’t pay and 500 of those still got a meeting, then paying doesn’t help get you a meeting.

The problem with the AP’s story is that there was no way for them to compute a risk ratio from meeting records. Clinton met with 85 people who donated to her foundation, and 154-85 = 69 who did not. This gives us:


We’re still missing two numbers! We can’t compute the advantage of paying because we don’t know how many people wanted a meeting, whether they paid, and whether or not they got a meeting. In other words, we need to know who got turned down for a meeting. The calendars and schedules that reporters can get don’t have that information and never will.

Can we conclude anything at all from the AP’s data? Not much. We can say only a few fairly obvious things. If many more than 85 people donated, then the numerator gets small and there appears to be less advantage. On the other hand, if many more than 69 people wanted a meeting but didn’t donate, the denominator gets small and it looks worse for Clinton.

We might be able to get some idea of who got turned down by looking at the Clinton Foundation contributors list. That page lists 4277 donors who gave at least $10,000. (Far more gave less, but you have to figure that a meeting costs at least some minimum amount.) Reading through the list of donors, almost all of them are private citizens, not governments. If we imagine that any substantial number of those 4277 donors hoped for a meeting with Clinton, the 85 private donors who did meet with her are at most 2% of those who tried to get a meeting. The numerator in the relative risk formula is small. The denominator might be even smaller if many thousands of people tried to get a meeting using exactly the same channels as the donors but ¯\_(ツ)_/¯ we’ll never know.

In other words, there is no way of finding evidence of “pay to play” by looking only at who got to “play,” without also looking at who got turned down.

The inability to calculate a risk ratio is a problem with many types of data that journalists use, but not others. Imagine looking for oil industry influence in a politician’s voting records. If you have good campaign finance data you know how much the oil companies donated to each politician. You also know how each politician voted on bills that affect the industry, so you know when oil money both did and didn’t get results. Meeting records are not like this, because they don’t record the names of the people who wanted to meet with a politician but didn’t.

Then there’s the problem of proving cause. Even when you can compute a relative risk, and the data suggests that more donors than non-donors got a meeting, corruption only happened if the payment caused the meetings. There are all sorts of possible confounding variables that will cause the risk ratio to overestimate the causal effect, that is, overestimate what money buys you. What sort of factors would cause someone both to meet with Clinton and donate to the Clinton Foundation, which does mostly global health work? All sorts of high-level folks might have business on both fronts. For example, there are plenty of people working in global health at the international level, coordinating with governments and so on.


Of course, people working together without the influence of money between them can still be doing terrible things! That is a different type of crime though. It’s not the pervasive money-as-influence-in-politics story that data journalists might hope to find statistically, and that’s the kind of story the AP was after.

Unfortunately, most people don’t think about the influence of money in this way. They only see evidence of an association between money and outcomes, without thinking about 1) those who wanted something and never got it, and 2) factors that would align two people without one paying the other, like shared goals. It’s all guilt by association.

In short, political science is hard and we can’t conclude very much from looking at meetings and donors! Yet I suspect it will still be quite difficult for many people to accept that the AP story is largely irrelevant to the question of whether Clinton was selling access. It is the association that seems suspicious to us, not the relative advantage. Suppose we know that half of the people who got promoted brought a bottle of wine to to the boss’s garden party. That means nothing if half of the company brought a bottle of wine to boss’s the garden party. But suppose instead that half of the people who got promoted slept with the boss. Now that seems like an open and shut case of “pay to play,” no? Not if the boss also slept with half of the rest of the employees. While that would be wildly inappropriate, it’s not trading favors.

It seems that our perception of the association between acts and outcomes depends far more on our judgment of the act than whether or not it actually gives you an advantage. Yet “advantage” is the whole idea of quid pro quo.

Which is not to say that Clinton wasn’t influenced by donations to her foundation. Who can say that it was never a factor? In fact she wouldn’t even need to give actual advantage to donors. Just the appearance, promise, or hope of advantage might be enough to shake people down, and that could be called corruption too. All I’m saying here is that we’re not going to be able to see statistical evidence of pay-to-play in meeting records.

We can, however, look in the data for specific leads about specific fishy transactions. To the AP’s credit much of the long story was exactly that, though having a meeting about helping a Nobel Peace Prize winner keep his job at the head of a non-profit microfinance bank may not feel like much of a smoking gun.

The AP, being the AP, was extremely careful not to make factually incorrect statements. It’s merely the totality of the piece that implies malfeasance. Or not. Let the readers make up their own minds, as editors love to say. I find this a monumental cop out, because the process of inferring corruption from the data is subtle! Readers will not be equipped to do that, so if we are using data as evidence we have to interpret it for them. The story could have, and in my opinion should have, explained the limitations of the data much more carefully. The statistics are at best ambiguous, and at worst suggest that donors got no special treatment (if you compare to the total number of donors, as above.) The numbers should never have been in the lede, much less the headline.

But then, would there have been a story? Would have, should have, the AP run a  story saying “here are some of the people Clinton met with who are also donors?” That’s not nearly as interesting a story — and that is its own kind of media bias. The tendency is towards stronger results, even sensational results. Or no story at all, if not enough scandal can be found, which is straight up publication bias.

The broader point for data journalists is that it is extremely difficult to prove corruption, in the sense of quid pro quo, just by counting who got what. To start with, we also need data on who wanted something but didn’t get it, which is often not recorded. Then we need an argument that there are no important confounders, nothing that is making two people work together without one paying the other (of course they could still be co-conspirators doing something terrible, but that would be a different type of crime.) The AP counted only those who got meetings and didn’t even touch on non-corrupt reasons for the correlation, so the numbers in the story — the headline numbers — mean essentially nothing, despite the unsavory association.