CB -
mises.org N.
On this page is a large 2.4Meg .pdf file 'The Mystery of Banking' which is too big to display, (at least for my dialup connection) so don't click it except to save it to disk. My pastes come from my local copy.
The Mystery of Banking
Murray N. Rothbard
Richardson & Snyder
1983
"...
Chapter VII
Deposit Banking
1. Warehouse Receipts
Deposit banking began as a totally different institution from loan banking. Hence it was unfortunate that
the same name, bank, became attached to both. If loan banking was a way of channeling savings into
productive loans to earn interest, deposit banking arose to serve the convenience of the holders of gold and
silver. Owners of gold bullion did not wish to keep it at home or office and suffer the risk of theft; far better to
store the gold in a safe place. Similarly, holders of gold coin found the metal often heavy and inconvenient to
carry, and needed a place for safekeeping. These deposit banks functioned very much as safe-deposit boxes
do today: as safe “money warehouses.” As in the case of any warehouse, the depositor placed his goods on
deposit or in trust at the warehouse, and in return received a ticket (or warehouse receipt) stating that he could
redeem his goods whenever he presented the ticket at the warehouse. In short, his ticket or receipt or claim
check was to be instantly redeemable on demand at the warehouse....
...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: [p. 94]
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 mount, 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”—constitutes 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, [p. 95] 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....
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. [p. 97] 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....
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% 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.
Where did the money come from? It came—and this is the most important single thing to know about
modem banking—it came out of thin air. Commercial banks—that is, fractional reserve banks—create
money out of thin air. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create
money out of thin air by printing something masquerading as money or as a warehouse receipt for money. In
this way, they fraudulently extract resources from the public, from the people who have genuinely earned their
money. In the same way, [p. 99] fractional reserve banks counterfeit warehouse receipts for money, which
then circulate as equivalent to money among the public. There is one exception to the equivalence: The law fails
to treat the receipts as counterfeit...
It should be clear that for the purpose of analyzing fractional reserve banking, it doesn’t make any
difference what is considered money or cash in the society, whether it be gold, tobacco, or even government
fiat paper money. The technique of pyramiding by the banks remains the same. Thus, suppose that now gold
has been outlawed, and cash or legal tender money consists of dollars printed by the central government The
process of pyramiding remains the same, except that the base of the pyramid is paper dollars instead of gold
coin.14...
Thus, fractional reserve banking, like government fiat paper or technical counterfeiting, is inflationary,
and aids some at the expense of others. But there are even more problems here. Because unlike government
paper and unlike counterfeiting (unless the counterfeit is detected], the bank credit is subject to contraction as
well as expansion. In the case of bank credit, what comes up, can later come down, and generally does. The
expansion of bank credit makes the banks shaky and leaves them open, in various ways, to a contraction of
their credit....
But if the money supply contracts, this means that there is deflationary pressure on prices, and prices
will contract, in a similar kind of ripple effect as in the preceding expansion. Ordinarily, of course, the Rothbard
Bank, or any other fractional reserve bank, will not passively sit back and see its loans and credit contract.
Why should it, when the bank makes its money by inflationary lending? But, the important point is that
fractional reserve banks are sitting ducks, and are always subject to contraction. When the banks’ state of
inherent bankruptcy is discovered, for example, people will tend to cash in their deposits, and the
contractionary, deflationary pressure could be severe. If banks have to contract suddenly, they will put
pressure on their borrowers, try to call in or will refuse to renew their loans, and the deflationary pressure will
bring about a recession—the successor to the inflationary boom. Note the contrast between fractional reserve banking and the pure gold coin standard. Under the pure gold standard, there is virtually no way that the money supply can actually decline, since gold is a highly
durable commodity. Nor will it be likely that government fiat paper will decline in circulation; the only rare
example would be a budget surplus where the government [p. 103] burned the paper money returning to it in
taxes. But fractional reserve bank credit expansion is always shaky, for the more extensive its inflationary
creation of new money, the more likely it will be to suffer contraction and subsequent deflation. We already
see here the outlines of the basic model of the famous and seemingly mysterious business cycle, which has
plagued the Western world since the middle or late eighteenth century. For every business cycle is marked,
and even ignited, by inflationary expansions of bank credit. The basic model of the business cycle then
becomes evident: bank credit expansion raises prices and causes a seeming boom situation, but a boom based
on a hidden fraudulent tax on the late receivers of money. The greater the inflation, the more the banks will be
sitting ducks, and the more likely will there be a subsequent credit contraction touching off liquidation of credit
and investments, bankruptcies, and deflationary price declines. This is only a crude outline of the business
cycle, but its relevance to the modern world of the business cycle should already be evident.... "
Regards, Don |
