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Deposit Banking

We get closer to the nub of the problem when we realize that, historically, there has existed a very different type of “bank” that has no necessary logical connection, although it often had a practical connection, with loan banking. Gold coins are often heavy, difficult to carry around, and subject to risk of loss or theft. People began to “deposit” coins, as well as gold or silver bullion, into institutions for safekeeping. This function may be thought of as a “money-warehouse.” As in the case of any other warehouse, the warehouse issues the depositor a receipt, a paper ticket pledging that the article will be redeemed at any time “on demand,” that is, on presentation of the receipt. The receipt-holder, on presenting the ticket, pays a storage fee, and the warehouse returns the item.

The first thing to be said about this sort of deposit is that it would be very peculiar to say that the warehouse “owed” the depositor the chair or watch he had placed in its care, that the warehouse is the “debtor” and the depositor the “creditor.” Suppose, for example, that you own a precious chair and that you place it in a warehouse for safekeeping over the summer. You return in the fall and the warehouseman says, “Gee, sorry, sir, but I've had business setbacks in the last few months, and I am not able to pay you the debt (the chair) that I owe you.” Would you shrug your shoulders, and write the whole thing off as a “bad debt,” as an unwise entrepreneurial decision on the part of the warehouseman? Certainly not. You would be properly indignant, for you do not regard placing the chair in a warehouse as some sort of “credit” or “loan” to the warehouseman. You do not lend the chair to him; you continue to own the chair, and you are placing it in his trust. He doesn't “owe” you the chair; the chair is and always continues to be yours; he is storing it for safekeeping. If the chair is not there when you arrive, you will call for the gendarmes and properly cry “theft!” You, and the law, regard the warehouseman who shrugs his shoulders at the absence of your chair not as someone who had made an unfortunate entrepreneurial error, but as a criminal who has absconded with your chair. More precisely, you and the law would charge the warehouseman with being an “embezzler,” defined by Webster's as “one who appropriates fraudulently to one's own use what is entrusted to one's care and management.”

Placing your goods in a warehouse (or, alternatively, in a safe-deposit box) is not, in other words, a “debt contract”; it is known in the law as a “bailment” contract, in which the bailor (the depositor) leaves property in the care, or in the trust of, the bailee (the warehouse). Furthermore, if a warehouse builds a reputation for probity, its receipts will circulate as equivalent to the actual goods in the warehouse. A warehouse receipt is of course payable to whomever holds the receipt; and so the warehouse receipt will be exchanged as if it were the good itself. If I buy your chair, I may not want to take immediate delivery of the chair itself. If I am familiar with the Jones Warehouse, I will accept the receipt for the chair at the Jones Warehouse as equivalent to receiving the actual chair. Just as a deed to a piece of land conveys title to the land itself, so does a warehouse receipt for a good serve as title to, or surrogate for, the good itself.1

Suppose you returned from your summer vacation and asked for your chair, and the warehouseman replied, “Well, sir, I haven't got your particular chair, but here's another one just as good.” You would be just about as indignant as before, and you would still call for the gendarmes: “I want my chair, dammit!” Thus, in the ordinary course of warehousing, the temptations to embezzle are strictly limited. Everyone wants his particular piece of property entrusted to your care, and you never know he they will want to redeem it.

Some goods, however, are of a special nature. They are homogeneous, so that no one unit can be distinguished from another. Such goods are known in law as being “fungible,” where any unit of the good can replace any other. Grain is a typical example. If someone deposits 100,000 bushels of No. 1 wheat in a grain warehouse (known customarily as a “grain elevator”), all he cares about when redeeming the receipt is getting 100,000 bushels of that grade of wheat. He doesn't care whether these are the same particular bushels that he actually deposited in the elevator.

Unfortunately, this lack of caring about the specific items redeemed opens the door for a considerable amount of embezzlement by the warehouseowner. The warehouseman may now be tempted to think as follows: “While eventually the wheat will be redeemed and shipped to a flour mill, at any given time there is always a certain amount of unredeemed wheat in my warehouse. I therefore have a margin within which I can maneuver and profit by using someone else's wheat.” Instead of carrying out his trust and his bailment contract by keeping all the grain in storage, he will be tempted to commit a certain degree of embezzlement. He is not very likely to actually drive off with or sell the wheat he has in storage. A more likely and more sophisticated form of defrauding would be for the grain elevator owner to counterfeit fake warehouse-receipts to, say, No. 1 wheat, and then lend out these receipts to speculators in the Chicago commodities market. The actual wheat in his elevator remains intact; but now he has printed fraudulent warehouse-receipts, receipts backed by nothing, ones that look exactly like the genuine article.

Honest warehousing, that is, one where every receipt is backed by a deposited good, may be referred to as “100 percent warehousing,” that is, where every receipt is backed by the good for which it is supposed to be a receipt. On the other hand, if a warehouseman issues fake warehouse receipts, and the grain stored in his warehouse is only a fraction (or something less than 100 percent) of the receipts or paper tickets outstanding, then he may be said to be engaging in “fractional-reserve warehousing.” It should also be clear that “fractional-reserve warehousing” is only a euphemism for fraud and embezzlement.

Writing in the late nineteenth century, the great English economist W. Stanley Jevons warned of the dangers of this kind of “general deposit warrant,” where only a certain category of good is pledged for redemption of a receipt, in contrast to “specific deposit warrants,” where the particular chair or watch must be redeemed by the warehouse. Using general warrants, “it becomes 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, with specific deposit warrants, such as “bills of lading, pawn-tickets, dock-warrants, or certificates which establish ownership to a definite object,” it is not possible to issue such tickets “in excess of goods actually deposited, unless by distinct fraud.”2

In the history of the U. S. grain market, grain elevators several times fell prey to this temptation, spurred by a lack of clarity in bailment law. Grain elevators issued fake warehouse receipts in grain during the 1860s, lent them to speculators in the Chicago wheat market, and caused dislocations in wheat prices and bankruptcies in the wheat market. Only a tightening of bailment law, ensuring that any issue of fake warehouse receipts is treated as fraudulent and illegal, finally put an end to this clearly impermissible practice. Unfortunately, however, this legal development did not occur in the vitally important field of warehouses for money, or deposit banking.

If “fractional-reserve” grain warehousing, that is, the issuing of warehouse receipts for non-existent goods, is clearly fraudulent, then so too is fractional-reserve warehousing for a good even more fungible than grain, i.e., money (whether it be gold or government paper). Any one unit of money is as good as any other, and indeed it is precisely for its homogeneity, divisibility, and recognizability that the market chooses gold as money in the first place. And in contrast to wheat, which after all, is eventually used to make flour and must therefore eventually be removed from the elevator, money, since it is used for exchange purposes only, does not have to be removed from the warehouse at all. Gold or silver may be removed for a non-monetary use such as jewelry, but paper money of course has only a monetary function, and therefore there is no compelling reason for warehouses ever to have to redeem their receipts. First, of course, the money-warehouse (also called a “deposit bank”) must develop a market reputation for honesty and probity and for promptly redeeming their receipts whenever asked. But once trust has been built up, the temptation for the money-warehouse to embezzle, to commit fraud, can become overwhelming.

For at this point, the deposit banker may think to himself: “For decades, this bank has built up a brand name for honesty and for redeeming its receipts. By this time, only a small portion of my receipts are redeemed at all. People make money payments to each other in the market, but they exchange these warehouse receipts to money as if they were money (be it gold or government paper) itself. They hardly bother to redeem the receipts. Since my customers are such suckers, I can now engage in profitable hanky-panky and none will be the wiser.”

The banker can engage in two kinds of fraud and embezzlement. He may, for example, simply take the gold or cash out of the vault and live it up, spending money on mansions or yachts. However, this may be a dangerous procedure; if he should ever be caught out, and people demand their money, the embezzling nature of his act might strike everyone as crystal-clear. Instead, a far more sophisticated and less blatant course will be for him to issue warehouse receipts to money, warehouse receipts backed by nothing but looking identical to the genuine receipts, and to lend them out to borrowers. In short, the banker counterfeits warehouse receipts to money, and lends them out. In that way, insofar as the counterfeiter is neither detected nor challenged to redeem in actual cash, the new fake receipts will, like the old genuine ones, circulate on the market as if they were money. Functioning as money, or money-surrogates, they will thereby add to the stock of money in the society, inflate prices, and bring about a redistribution of wealth and income from the late to the early receivers of the new “money.”

If a banker has more room for fraud than a grain warehouseman, it should be clear that the consequences of his counterfeiting are far more destructive. Not just the grain market but all of society and the entire economy will be disrupted and harmed. As in the case of the coin counterfeiter, all property-owners, all owners of money, are expropriated and victimized by the counterfeiter, who is able to extract resources from the genuine producers by means of his fraud. And in the case of bank money, as we shall see further, the effect of the banker's depredations will not only be price inflation and redistribution of money and income, but also ruinous cycles of boom and bust generated by expansions and contractions of the counterfeit bank credit.

  • 1. Thus, Armistead 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, p. 163.
  • 2. W. Stanley Jevons, Money and the Mechanism of Exchange, 15th ed. (London: Kegan Paul, [1875] 1905), pp. 206–12.
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