The Mystery Of Banking

by Murray N. Rothbard

  He [Gilbart] was relieved that the [Peel] act did not extinguish the joint-stock banks’ right of issue and was frankly pleased with its cartelizing provisions: “Our rights are acknowledged—our privileges are extended—our circulation guaranteed—and we are saved from conflicts with reckless competitors.” (p. 79)

  Very well. But White avoids asking himself the difficult questions. For example: what kind of a dedicated “free-banking” movement is it that can be so easily bought off by cartel privileges from the state? The answer, which White sidesteps by avoiding the question, is precisely the kind of a movement that serves simply as a cloak for the interests of the commercial bankers.

  For, with the exception of the older, hard-money free-banking men—such as Mushet (long dead by 1844) and Parnell (who died in the middle of the controversy in 1842)—virtually all of White’s free bankers were themselves officials of private commercial banks. Gilbart had been a bank official all his life and had long been manager of the London & Westminster Bank. Bailey was chairman of the Sheffield Banking Company. Consider, for example, the newly founded Bankers’ Magazine, which White lauds as a crucial organ of free-banking opinion. White laments that a writer in the June 1844 issue of Bankers’ Magazine, while critical of the currency principle and monopoly issues for the Bank of England, yet approved the Peel Act as a whole for aiding the profits of existing banks by prohibiting all new banks of issue.

  And yet, Professor White resists the realization that his entire cherished free-banking movement—at least in its later inflationist “need of trade” manifestation—was simply a special pleading on behalf of the inflationary activities of the commercial banks. Strip away White’s conflation of the earlier hard-money free-banking theorists with the later inflationists, and his treasured free-banking movement turns out to be merely special pleaders for bank chicanery and bank credit inflation.

  Notes

  I. Money: Its Importance and Origins

  1 See the justly famous article by R.A. Radford, “The Economic Organization of a P.O.W. Camp,” Economica (November 1945): 189-201.

  2 At current writing, silver is approximately $13 an ounce, and the pound is about $1.50, which means that the British “pound sterling,” once proudly equal to one pound of silver, now equals only 1/8 of a silver ounce. How this decline and fall happened is explained in the text.

  3 The proportions are changed slightly from their nineteenth century definitions to illustrate the point more clearly. The “dollar” had moved from Bohemia to Spain and from there to North America. After the Revolutionary War, the new United States changed its currency from the British pound sterling to the Spanish-derived dollar. From this point on, we assume gold as the only monetary metal, and omit silver, for purposes of simplification. In fact, silver was a complicating force in all monetary discussions in the nineteenth century. In a free market, gold and silver each would be free to become money and would float freely in relation to each other (“parallel standards”). Unfortunately, governments invariably tried to force a fixed exchange rate between the two metals, a price control that always leads to unwelcome and even disastrous results (“bimetallism”).

  4 In older periods, foreign coins of gold and silver often circulated freely within a country, and there is, indeed, no economic reason why they should not do so. In the United States, as late as 1857, few bothered going to the U.S. Mint to obtain coins; the coins in general use were Spanish, English, and Austrian gold and silver pieces. Finally, Congress, perturbed at this slap to its sovereignty, outlawed the use of foreign coins within the U.S., forcing all foreign coinholders to go to the U.S. Mint and obtain American gold coins.

  5 Thus, Frederick Barnard’s late nineteenth-century book on weights and measures has a discussion of coinage and the international monetary system in the appendix. Frederick A.P. Barnard, The Metric System of Weights and Measures, rev. ed. (New York: Columbia College, 1872).

  6 This enormous charge for recoinage is called “seigniorage,” payment to the seignieur or sovereign, the monopoly minter of coins.

  7 See Elgin Groseclose, Money and Man (New York: Frederick Ungar, 1961), pp. 57–76. Many of the European debasements were made under the guise of adjusting the always-distorted fixed bimetallic ratios between gold and silver. See Luigi Einaudi, “The Theory of Imaginary Money from Charlemagne to the French Revolution,” in F.C. Lane and J.C. Riemersma, eds., Enterprise and Secular Change (Homewood, Ill.: Irwin, 1953), pp. 229-61.

  II. What Determines Prices: Supply and Demand

  1Conventionally, and for convenience, economists for the past four decades have drawn the demand curves as falling straight lines. There is no particular reason to suppose, however, that the demand curves are straight lines, and no evidence to that effect. They might just as well be curved or jagged or anything else. The only thing we know with assurance is that they are falling, or negatively sloped. Unfortunately, economists have tended to forget this home truth, and have begun to manipulate these lines as if they actually existed in this shape. In that way, mathematical manipulation begins to crowd out the facts of economic reality.

  III. Money and Overall Prices

  1 Why doesn’t an excess demand for cash balances increase the money supply, as it would in the case of beef, in the long run? For a discussion of the determinants of the supply of money, see chapter IV.

  IV. The Supply of Money

  1 A minor exception for small transactions is the eroding of coins after lengthy use, although this can be guarded against by mixing small parts of an alloy with gold.

  2 See Ludwig von Mises, The Theory of Money and Credit (Indianapolis: Liberty Classics, 1981), p. 165 and passim.

  3 Similarly, the fall in M depicted in Figure 3.4 also confers no overall social benefit. All that happens is that each dollar now increases in purchasing power to compensate for the smaller number of dollars. There is no need to stress this point, however, since there are no social pressures agitating for declines in the supply of money.

  4 With apologies to David Hume and Ludwig von Mises, who employed similar models, though without using this name.

  5 Mises, Money and Credit, pp. 163 ff.

  6 One reason for gold’s universal acceptance as money on the free market is that gold is very difficult to counterfeit: Its look, its sound as a coin, are easily recognizable, and its purity can be readily tested.

  7 Often, even irredeemable paper is only accepted at first because the government promises, or the public expects, that the paper after a few years, and whenever the current “emergency” is over, will become redeemable in gold once more. More years of habituation are generally necessary before the public will accept a frankly permanent fiat standard.

  8 During World War I, the U.S. Government, in effect, suspended redeemability of the dollar in gold.

  9 Gordon Tullock, “Paper Money—A Cycle in Cathay,” Economic History Review 9, no. 3 (1957): 396.

  10 Strictly speaking, the first paper money was issued five years earlier in the French province of Quebec, to be known as Card Money. In 1685, the governing intendant of Quebec, Monsieur Meules, had the idea of dividing some playing cards into quarters, marking them with various monetary denominations, and then issuing them to pay for wages and materials. He ordered the public to accept the cards as legal tender and they were later redeemed in specie sent from France. See Murray N. Rothbard, Conceived in Liberty (New Rochelle, N.Y.: Arlington House, 1975), vol. II, p. 130n.

  11 See ibid., pp. 123-40.

  V. The Demand for Money

  1 The only exception was the period 1896-1914, when new gold discoveries caused moderate increases in the price level.

  2 In Fritz K. Ringer, ed., The German Inflation of 1923 (New York: Oxford University Press, 1969), p. 96.

  3 For a good overview of the German economy, see Gustav Stolper, The German Economy, 1870 to the Present (New York: Harcourt, Brace & World, 1967); for an excellent history and analysis of the German hyperinflation, see Costantino Bresciani-T
urroni, The Economics of Inflation (London: George Allen & Unwin, 1937).

  VI. Loan Banking

  1 We are using “dollars” instead of “gold ounces,” because this process is the same whether we are on a gold or a fiat standard.

  2 In particular, the originator of the Assets = Liability + Equity equation was the distinguished American accountant, Charles E. Sprague, who conceived the idea in 1880 and continued to advance the idea until after the turn of the century. See Gary J. Previts and Barbara D. Merino, A History of Accounting in America (New York: Ronald Press, 1979), pp. 107-13.

  3 During the sixteenth century, most English moneylending was conducted, not by specialized firms, but by wealthy merchants in the clothing and woolen industries, as an outlet for their surplus capital. See J. Milnes Holden, The History of Negotiable Instruments in English Law (London: The Athlone Press, 1955), pp. 205-06.

  VII. Deposit Banking

  1 Dobie writes: “a transfer of the warehouse receipt, in general confers the same measure of title that an actual delivery of the goods which it represents would confer.” Armistead M. Dobie, Handbook on the Law of Bailments and Carriers (St. Paul, Minn.: West Publishing Co., 1914), p. 163.

  2 The business of the goldsmiths was to manufacture gold and silver plate and jewelry, and to purchase, mount and sell jewels. See J. Milnes Holden, The History of Negotiable Instruments in English Law (London: The Athlone Press, 1955), pp. 70-71.

  3 These were two other reasons for the emergence of the goldsmiths as money warehouses during the Civil War. Apprentices, who had previously been entrusted with merchants’ cash, were now running off to the army, so that merchants now turned to the goldsmiths. At the same time, the gold plate business had fallen off, for impoverished aristocrats were melting down their gold plate for ready cash instead of buying new products. Hence, the goldsmiths were happy to turn to this new form of business. Ibid.

  4 See ibid., p. 72.

  5 By A.D. 700-800 there were shops in China which would accept valuables and, for a fee, keep them safe. They would honour drafts drawn on the items in deposit, and, as with the goldsmith’s shops in Europe, their deposit receipts gradually began to circulate as money. It is not known how rapidly this process developed, but by A.D. 1000 there were apparently a number of firms in China which issued regular printed notes and which had discovered that they could circulate more notes than the amount of valuables they had on deposit.

  Tullock, “Paper Money: A Cycle in Cathay,” Economic History Review 9 (August 1957): 396.

  6 Carr v. Carr (1811) 1 Mer. 543. In J. Milnes Holden, The Law and Practice of Banking, vol. I, Banker and Customer (London: Pitman Publishing, 1970), p. 31.

  7 Devaynes v. Noble (1816) 1 Met. 529; in ibid.

  8 Foley v. Hill and Others (1848) 2. H.L.C., pp. 36-37; in ibid., p. 32.

  9 See Michie on Banks and Banking, rev. ed. (Charlottesville, Va.: Michie Co., 1973), vol. 5A, p. 20. Also see pp. 1-13, 27-31, and ibid., 1979 Cumulative Supplement, pp. 3-4, 7-9. Thus, Michie states that a “bank deposit is more than an ordinary debt, and the depositor’s relation to the bank is not identical with that of an ordinary creditor.” Citing a Pennsylvania case, Michie adds that “a bank deposit is different from an ordinary debt in this, that from its very nature it is constantly subject to the check of the depositor, and is always payable on demand”. People’s Bank v. Legrand, 103 penn.309, 49 Am.R.126. Michie, Banks and Banking, p. 13n. Also, despite the laws insistence that a bank “becomes the absolute owner of money deposited with it,” a bank still “cannot speculate with its depositors’ money.” Banks and Banking, pp. 28, 30-31.

  10 Michie, Banks and Banking, p. 20. The answer of the distinguished legal historian Arthur Nussbaum is that the “contrary view” (that a bank deposit is a bailment not a debt) “would lay an unbearable burden upon banking business.” No doubt exuberant bank profits from issue of fraudulent warehouse receipts would come to an end. But grain elevators and other warehouses, after all, remain in business successfully; why not genuine safekeeping places for money? Arthur Nussbaum, Money in the Law: National and International (Brooklyn: Foundation Press, 1950), p. 105.

  11 The economist, Jevons, in a cry from the heart, lamented the existence of the general deposit, since it has “become possible to create a fictitious supply of a commodity, that is, to make people believe that a supply exists which does not exist ...” On the other hand, special deposits, such as “bills of lading, pawn-tickets, dock-warrants, or certificates which establish ownership to a definite object,” are superior because “they cannot possibly be issued in excess of the good actually deposited, unless by distinct fraud.” He concluded wistfully that “it used to be held as a general rule of law, that a present grant or assignment of goods not in existence is without operation.” William Stanley Jevons, Money and the Mechanism of Exchange, 15th ed. (London: Kegan Paul, 1905), pp. 206-12, 221.

  12 Cf. Elgin Groseclose, Money and Man, pp. 178-79.

  13 See Murray N. Rothbard, The Case for a 100 Percent Gold Dollar (Washington, D.C.: Libertarian Review Press, November 1974), p. 25. Mises trenchantly distinguishes between a “credit transaction,” where a present good is exchanged for a future good (or IOU due in the future), and a claim transaction, such as a warehouse receipt, where the depositor or claimant does not give up any of the present good (e.g., wheat, or money). On the contrary, he retains his claim to the deposited good, since he can redeem it at any time. As Mises states:

  A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him. The depositing of money in no way means that he has renounced immediate disposal over the utility it commands.

  Ludwig von Mises, The Theory of Money and Credit, 2nd ed. (New Haven: Yale University Press, 1953), p. 268.

  14 As we shall see later, while the pyramiding process remains the same, the opportunity for inflating the base is much greater under fiat paper than with gold.

  15 Bank notes, however, were made more flexible in seventeenth-century England by the banks allowing part payment of a note, with the payment deducted from the original face value of the note. Holden, Negotiable Instruments, p. 91n.

  16 ... banking in general only became important with the development of the issue of notes. People would deposit coin and bullion with a bank more readily when they received something in exchange such as a banknote, originally in the form of a mere receipt, which could be passed from hand-to-hand. And it was only after the bankers had won the public over to confidence in the banks by circulating their notes, that the public was persuaded to leave large sums on deposit on the security of a mre book-entry.

  Vera C. Smith, The Rationale of Central Banking (London: P.S. King & Son, 1936), p. 6.

  17 The later institution of the “investment bank,” in contrast, lends out saved or borrowed funds, generally in the underwriting of industrial or government securities. In contrast to the commercial bank, whose deposit liabilities exchange as equivalent to money and hence add to the money supply, the liabilities of the investment bank are simply debts which are not “monetized” by being a demand claim on money.

  18 We should note, however, that if they wanted to, the holders of $800,000 of the bank’s demand deposits could cash them in for the notes of the Jones Bank, as well as for gold or government paper money. In fact, the notes and deposits of the Jones Bank are interchangeable for each other, one for one: deposits could, if the owner wished, be exchanged for newly-printed notes, while notes could be handed in and exchanged for newly-credited deposits.

  VIII. Free Banking and the Limits on Bank Credit Inflation

  1 This is not the place to investigate the problem whether bankruptcy laws confer a special privilege on the debtor to weasel out of his debts.

  2 From 1929 to 1933, the last year when runs
were permitted to do their work of cleansing the economy of unsound and inflationary banks, 9,200 banks failed in the United States.

  3 Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), p. 443; Human Action, Scholar’s Edition (Auburn, Ala.: Ludwig von Mises Institute, 1998), p. 443.

  X. Central Banking: Determining Total Reserves

  1 In this chapter, we will assume that cash is the notes of the Central Bank.

  2 But note that our previous concept of “cash balances” includes not only cash but also demand deposits and any other form of money, whereas now we are dealing with the public’s demand for cash per se as against deposits or other forms of money.

  3 This was one of the tenets of the “banking school” of monetary thought, prominent in the nineteenth century and still held in some quarters.

  4 J. Parker Willis, The Federal Funds Market (Boston: Federal Reserve Bank of Boston, 1970), p. 62.

  5 Interest rates on Fed loans to banks are still called “discount rates” despite the fact that virtually all of them are now outright loans rather than discounts.

  6 On the penalty rate question, see Benjamin M. Anderson, Economics and the Public Welfare, 2nd ed. (Indianapolis: Liberty Press, 1979), pp. 72, 153–54. Also see Seymour E. Harris, Twenty Years of Federal Reserve Policy (Cambridge, Mass.: Harvard University Press, 1933), vol. 1, pp. 3–10, 39–48.

  XI. Central Banking: The Process of Bank Credit Expansion

  1 Not $20 billion, as one might think, because the Fed will have to buy enough to cover not only the $100 billion, but also the amount of its own purchase which will add to the demand deposits of banks through the accounts of government bond dealers. The formula for figuring out how much the Fed should buy (X) to achieve a desired level of bank purchases of the deficit (D) is: