How can deposit banks charge for this important service? In the same way as any warehouse or safe-deposit box: by charging a fee in proportion to the time that the deposit remains in the bank vaults. There should be no mystery or puzzlement about this part of the banking process.
How do these warehouse receipt transactions relate to the T-account balance sheets of the deposit banks? In simple justice, not at all. When I store a piece of furniture worth $5,000 in a warehouse, in law and in justice the furniture does not show up as an asset of the warehouse during the time that I keep it there.
The warehouse does not add $5,000 to both its assets and liabilities because it in no sense owns the furniture; neither can we say that I have loaned the warehouse the furniture for some indefinite time period. The furniture is mine and remains mine; I am only keeping it there for safekeeping and therefore I am legally and morally entitled to redeem it any time I please. I am not therefore the bank’s “creditor”; it doesn’t owe me money which I may some day collect. Hence, there is no debt to show up on the Equity + Liability side of the ledger. Legally, the entire transaction is not a loan but a bailment, hiring someone for the safekeeping of valuables.
Let us see why we are dealing with a bailment, not a loan. In a loan, or a credit transaction, the creditor exchanges a present good—that is, a good available for use at any time in the present—for a future good, an IOU redeemable at some date in the future. Since present goods are more valuable than future goods, the creditor will invariably charge, and the debtor pay, an interest premium for the loan.
The hallmark of a loan, then, is that the money is due at some future date and that the debtor pays the creditor interest. But the deposit, or claim transaction, is precisely the opposite. The money must be paid by the bank at any time the depositor presents the ticket, and not at some precise date in the future. And the bank—the alleged “borrower” of the money—generally does not pay the depositor for making the loan. Often, it is the depositor who pays the bank for the service of safeguarding his valuables.
Deposit banking, or money warehousing, was known in ancient Greece and Egypt, and appeared in Damascus in the early thirteenth century, and in Venice a century later. It was prominent in Amsterdam and Hamburg in the seventeenth and eighteenth centuries.
In England, there were no banks of deposit until the Civil War in the mid-seventeenth century. Merchants were in the habit of keeping their surplus gold in the king’s mint in the Tower of London—an institution which of course was accustomed to storing gold. The habit proved to be an unfortunate one, for when Charles I needed money in 1638 shortly before the outbreak of the Civil War, he simply confiscated a large sum of gold, amounting to £200,000, calling it a “loan” from the depositors. Although the merchants finally got their money back, they were understandably shaken by the experience, and forsook the mint, instead depositing their gold in the coffers of private goldsmiths, who were also accustomed to the storing and safekeeping of the valuable metal.2 The goldsmith’s warehouse receipts then came to be used as a surrogate for the gold money itself.3
All men are subject to the temptation to commit theft or fraud, and the warehousing profession is no exception. In warehousing, one form of this temptation is to steal the stored products outright—to skip the country, so to speak, with the stored gold and jewels. Short of this thievery, the warehouse man is subject to a more subtle form of the same temptation: to steal or “borrow” the valuables “temporarily” and to profit by speculation or whatever, returning the valuables before they are redeemed so that no one will be the wiser. This form of theft is known as embezzlement, which the dictionary defines as “appropriating fraudulently to one’s own use, as money or property entrusted to one’s care.”
But the speculating warehouseman is always in trouble, for the depositor can come and present his claim check at any time, and he is legally bound to redeem the claim, to return the valuables instantly on demand. Ordinarily, then, the warehousing business provides little or no room for this subtle form of theft. If I deposit a gold watch or a chair in a warehouse, I want the object when I call for it, and if it isn’t there, the warehouseman will be on a trip to the local prison.
In some forms of warehousing, the temptation to embezzle is particularly heady. The depositor is here not so much interested in getting back the specific object as he is in receiving the same kind of product. This will occur in the case of fungible commodities such as grain, where each unit of the product is identical to every other. Such a deposit is a “general” rather than a “specific” deposit warrant. It now becomes more convenient for the warehouseman to mix all bushels of grain of the same type into a common bin, so that anyone redeeming his grain receives bushels from the same bin. But now the temptation to embezzle has increased enormously. All the warehouseman need do is arrive at a workable estimate of what percentage of the grain will probably be redeemed in the next month or year, and then he can lend out or speculate on the rest.
In sophisticated transactions, however, the warehouseman is not likely physically to remove the grain. Since warehouse receipts serve as surrogates for the grain itself, the warehouseman will instead print fake, or counterfeit, warehouse receipts, which will look exactly like the others.
But, it might be asked, what about the severe legal penalties for embezzlement? Isn’t the threat of criminal charges and a jail term enough to deter all but the most dedicated warehouse embezzlers? perhaps, except for the critical fact that bailment law scarcely existed until the eighteenth century. It was only by the twentieth century that the courts finally decided that the grain warehouseman was truly a bailee and not simply a debtor.
2. DEPOSIT BANKING AND EMBEZZLEMENT
Gold coin and bullion—money—provides an even greater temptation for embezzlement to the deposit banker than grain to the warehouseman. Gold coin and bullion are fully as fungible as wheat; the gold depositor, too, unless he is a collector or numismatist, doesn’t care about receiving the identical gold coins he once deposited, so long as they are of the same mark and weight. But the temptation is even greater in the case of money, for while people do use up wheat from time to time, and transform it into flour and bread, gold as money does not have to be used at all. It is only employed in exchange and, so long as the bank continues its reputation for integrity, its warehouse receipts can function very well as a surrogate for gold itself. So that if there are few banks in the society and banks maintain a high reputation for integrity, there need be little redemption at all. The confident banker can then estimate that a smaller part of his receipts will be redeemed next year, say 15 percent, while fake warehouse receipts for the other 85 percent can be printed and loaned out without much fear of discovery or retribution.
The English goldsmiths discovered and fell prey to this temptation in a very short time, in fact by the end of the Civil War. So eager were they to make profits in this basically fraudulent enterprise, that they even offered to pay interest to depositors so that they could then “lend out” the money. The “lending out,” however, was duplicitous, since the depositors, possessing their warehouse receipts, were under the impression that their money was safe in the goldsmiths’ vaults, and so exchanged them as equivalent to gold. Thus, gold in the goldsmiths’ vaults was covered by two or more receipts. A genuine receipt originated in an actual deposit of gold stored in the vaults, while counterfeit ones, masquerading as genuine receipts, had been printed and loaned out by goldsmiths and were now floating around the country as surrogates for the same ounces of gold.4
The same process of defrauding took place in one of the earliest instances of deposit banking: ancient china. Deposit banking began in the eighth century, when shops accepted valuables and received a fee for safekeeping. After a while, the deposit receipts of these shops began to circulate as money. Finally, after two centuries, the shops began to issue and hand out more printed receipts than they had on deposit; they had caught onto the deposit banking scam.5 Venice, from the fourteenth
to the sixteenth centuries, struggled with the same kind of bank fraud.
Why, then, were the banks and goldsmiths not cracked down on as defrauders and embezzlers? Because deposit banking law was in even worse shape than overall warehouse law and moved in the opposite direction to declare money deposits not a bailment but a debt.
Thus, in England, the goldsmiths, and the deposit banks which developed subsequently, boldly printed counterfeit warehouse receipts, confident that the law would not deal harshly with them. Oddly enough, no one tested the matter in the courts during the late seventeenth or eighteenth centuries. The first fateful case was decided in 1811, in Carr v. Carr. The court had to decide whether the term “debts” mentioned in a will included a cash balance in a bank deposit account. Unfortunately, Master of the Rolls Sir William Grant ruled that it did. Grant maintained that since the money had been paid generally into the bank, and was not earmarked in a sealed bag, it had become a loan rather than a bailment.6 Five years later, in the key follow-up case of Devaynes v. Noble, one of the counsel argued, correctly, that “a banker is rather a bailee of his customer’s funds than his debtor ... because the money in ... [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up.” But the same Judge Grant again insisted—in contrast to what would be happening later in grain warehouse law—that “money paid into a banker’s becomes immediately a part of his general assets; and he is merely a debtor for the amount.”7
The classic case occurred in 1848 in the House of Lords, in Foley v. Hill and Others. Asserting that the bank customer is only its creditor, “with a superadded obligation arising out of the custom (sic?) of the bankers to honour the customer’s cheques,” Lord Cottenham made his decision, lucidly if incorrectly and even disastrously:
Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it. ... The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it into jeopardy, if he engages in a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.8
Thus, the banks, in this astonishing decision, were given carte blanche. Despite the fact that the money, as Lord Cottenham conceded, was “placed in the custody of the banker,” he can do virtually anything with it, and if he cannot meet his contractual obligations he is only a legitimate insolvent instead of an embezzler and a thief who has been caught red-handed. To Foley and the previous decisions must be ascribed the major share of the blame for our fraudulent system of fractional reserve banking and for the disastrous inflations of the past two centuries.
Even though American banking law has been built squarely on the Foley concept, there are intriguing anomalies and inconsistencies. While the courts have insisted that the bank deposit is only a debt contract, they still try to meld in something more. And the courts remain in a state of confusion about whether or not a deposit—the “placing of money in a bank for safekeeping”—con-stitutes an investment (the “placing of money in some form of property for income or profit”). For if it is purely safekeeping and not investment, then the courts might one day be forced to concede, after all, that a bank deposit is a bailment; but if an investment, then how do safekeeping and redemption on demand fit into the picture?9
Furthermore, if only special bank deposits where the identical object must be returned (e.g., in one’s safe-deposit box) are to be considered bailments, and general bank deposits are debt, then why doesn’t the same reasoning apply to other fungible, general deposits such as wheat? Why aren’t wheat warehouse receipts only a debt? Why is this inconsistent law, as the law concedes, “peculiar to the banking business”?10,11
3. FRACTIONAL RESERVE BANKING
The carte blanche for deposit banks to issue counterfeit warehouse receipts for gold had many fateful consequences. In the first place, it meant that any deposit of money could now take its place in the balance sheet of the bank. For the duration of the deposit, the gold or silver now became an owned asset of the bank, with redemption due as a supposed debt, albeit instantly on demand. Let us assume we now have a Rothbard Deposit Bank. It opens for business and receives a deposit of $50,000 of gold from Jones, for which Jones receives a warehouse receipt which he may redeem on demand at any time. The balance sheet of the Rothbard Deposit Bank is now as shown in Figure 7.1.
Although the first step has begun on the slippery slope to fraudulent and deeply inflationary banking, the Rothbard Bank has not yet committed fraud or generated inflation. Apart from a general deposit now being considered a debt rather than bailment, nothing exceptionable has happened. Fifty thousand dollars’ worth of gold has simply been deposited in a bank, after which the warehouse receipts circulate from hand to hand or from bank to bank as a surrogate for the gold in question. No fraud has been committed and no inflationary impetus has occurred, because the Rothbard Bank is still backing all of its warehouse receipts by gold or cash in its vaults.
FIGURE 7.1 — A DEPOSIT BANK
The amount of cash kept in the bank’s vaults ready for instant redemption is called its reserves. Hence, this form of honest, non-inflationary deposit banking is called “100 percent reserve banking,” because the bank keeps all of its receipts backed fully by gold or cash. The fraction to be considered is
Reserves/Warehouse Receipts
and in our example the fraction is
$50,000/$50,000
or 100 percent. Note, too, that regardless of how much gold is deposited in the banks, the total money supply remains precisely the same so long as each bank observes the 100 percent rule. Only the form of the money will change, not its total amount or its significance. Thus, suppose that the total money supply of a country is $100,000,000 in gold coin and bullion, of which $70,000,000 is deposited in banks, the warehouse receipts being fully backed by gold and used as a substitute for gold in making monetary exchanges. The total money supply of the country (that is, money actually used in making exchanges) would be:
$30,000,000 (gold) + $70,000,000 (warehouse receipts for gold)
The total amount of money would remain the same at $100,000,000; its form would be changed to mainly warehouse receipts for gold rather than gold itself.
The irresistible temptation now emerges for the goldsmith or other deposit banker to commit fraud and inflation: to engage, in short, in fractional reserve banking, where total cash reserves are lower, by some fraction, than the warehouse receipts outstanding. It is unlikely that the banker will simply abstract the gold and use it for his own consumption; there is then no likelihood of ever getting the money should depositors ask to redeem it, and this act would run the risk of being considered embezzlement. Instead, the banker will either lend out the gold, or far more likely, will issue fake warehouse receipts for gold and lend them out, eventually getting repaid the principal plus interest. In short, the deposit banker has suddenly become a loan banker; the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors. Instead he is taking someone else’s money and lending it out at the same time that the depositor thinks his money is still available for him to redeem. Or rather, and even worse, the banker issues fake warehouse receipts and lends them out as if they were real warehouse receipts represented by cash. At the same time, the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in. Here we have the system of fractional reserve banking, in which more than one warehouse receipt is backed by the same amount of gold or other cash in the bank’s vaults.
It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud in which fake warehouse
receipts are issued and circulate as equivalent to the cash supposedly represented by the receipts.
Let us see how this works in our T-accounts.
The Rothbard Bank, having had $50,000 of gold coin deposited in it, now issues $80,000 of fraudulent warehouse receipts and lends them to smith, expecting to be repaid the $80,000 plus interest.
FIGURE 7.2 — FRACTIONAL RESERVE BANKING
The Rothbard Bank has issued $80,000 of fake warehouse receipts which it lends to Smith, thus increasing the total money supply from $50,000 to $130,000. The money supply has increased by the precise amount of the credit—$80,000—expanded by the fractional reserve bank. One hundred percent reserve banking has been replaced by fractional reserves, the fraction being
$50,00/ $130,000
or 5/13.
Thus, fractional reserve banking is at one and the same time fraudulent and inflationary; it generates an increase in the money supply by issuing fake warehouse receipts for money. Money in circulation has increased by the amount of warehouse receipts issued beyond the supply of gold in the bank.
The form of the money supply in circulation has again shifted, as in the case of 100 percent reserve banking: A greater proportion of warehouse receipts to gold is now in circulation. But something new has now been added: The total amount of money in circulation has now been increased by the new warehouse receipts issued. Gold coin in the amount of $50,000 formerly in circulation has now been replaced by $130,000 of warehouse receipts. The lower the fraction of the reserve, the greater the amount of new money issued, pyramiding on top of a given total of reserves.
The Mystery Of Banking Page 9
