WEBVTT NOTE Deposit Banking 1 00:00:00.000 --> 00:00:02.000 Deposit Banking 2 00:00:02.000 --> 00:00:19.000 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. 3 00:00:19.000 --> 00:00:27.000 Gold coins are often heavy, difficult to carry around, and subject to risk of loss or theft. 4 00:00:27.000 --> 00:00:35.000 People began to deposit coins, as well as gold or silver bullion, into institutions for safekeeping. 5 00:00:35.000 --> 00:00:39.000 This function may be thought of as a money warehouse. 6 00:00:39.000 --> 00:00:44.000 As in the case of any other warehouse, the warehouse issues the depositor a receipt, 7 00:00:44.000 --> 00:00:50.000 a paper ticket pledging that the article will be redeemed at any time on demand, 8 00:00:50.000 --> 00:00:53.000 that is, on presentation of the receipt. 9 00:00:53.000 --> 00:01:00.000 The receipt holder on presenting the ticket pays a storage fee and the warehouse returns the item. 10 00:01:00.000 --> 00:01:19.000 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 that the depositor the creditor. 11 00:01:19.000 --> 00:01:27.000 Suppose, for example, that you own a precious chair and that you place it in a warehouse for safekeeping over the summer. 12 00:01:27.000 --> 00:01:30.000 You return in the fall and the warehouseman says, 13 00:01:30.000 --> 00:01:40.000 Gee, sorry, sir, but I've had business setbacks in the last few months and I'm not able to pay you the debt, the chair, that I owe you. 14 00:01:40.000 --> 00:01:45.000 Would you shrug your shoulders and write the whole thing off as a bad debt? 15 00:01:45.000 --> 00:01:49.800 as an unwise entrepreneurial decision on the part of the warehouseman? 16 00:01:49.800 --> 00:01:50.980 Certainly not. 17 00:01:50.980 --> 00:01:56.400 You would be properly indignant, for you do not regard placing the chair in a warehouse 18 00:01:56.400 --> 00:02:01.240 as some sort of credit or loan to the warehouseman. 19 00:02:01.240 --> 00:02:04.160 You do not lend the chair to him. 20 00:02:04.160 --> 00:02:09.700 You continue to own the chair, and you are placing it in his trust. 21 00:02:09.700 --> 00:02:16.260 He doesn't owe you the chair. The chair is and always continues to be yours. He is storing 22 00:02:16.260 --> 00:02:22.880 it for safekeeping. If the chair is not there when you arrive, you will call for the gendarmes 23 00:02:22.880 --> 00:02:31.140 and properly cry, theft. You and the law regard the warehouseman who shrugs his shoulders 24 00:02:31.140 --> 00:02:36.700 at the absence of your chair not as someone who has made an unfortunate entrepreneurial 25 00:02:36.700 --> 00:02:43.700 Placing your goods in a warehouse or, alternatively, in a safe deposit box, is not, in other words, 26 00:03:06.700 --> 00:03:12.380 A Debt Contract It is known in the law as a bailment contract, 27 00:03:12.380 --> 00:03:19.540 in which the bailor, the depositor, leaves property in the care or in the trust of the 28 00:03:19.540 --> 00:03:26.420 bailee, the warehouse. Furthermore, if a warehouse builds a reputation for probity, its receipts 29 00:03:26.420 --> 00:03:32.700 will circulate as equivalent to the actual goods in the warehouse. A warehouse receipt 30 00:03:32.700 --> 00:03:37.460 is of course payable to whomever holds the receipt, and so the warehouse receipt will 31 00:03:37.460 --> 00:03:41.780 be exchanged as if it were the good itself. 32 00:03:41.780 --> 00:03:47.480 If I buy your chair, I may not want to take immediate delivery of the chair itself. 33 00:03:47.480 --> 00:03:53.420 If I am familiar with the Jones warehouse, I will accept the receipt for the chair at 34 00:03:53.420 --> 00:03:58.780 the Jones warehouse as equivalent to receiving the actual chair. 35 00:03:58.780 --> 00:04:04.740 Just as a deed to a piece of land conveys title to the land itself, so does a warehouse 36 00:04:04.740 --> 00:04:12.300 receipt for a good serve as title to, or surrogate for, the good itself. 37 00:04:12.300 --> 00:04:17.700 Suppose you returned from your summer vacation and asked for your chair, and the warehouseman 38 00:04:17.700 --> 00:04:24.700 replied, Well, sir, I haven't got your particular chair, but here's another one just as good. 39 00:04:24.700 --> 00:04:30.620 You would be just about as indignant as before, and you would still call for the gendarmes, 40 00:04:30.620 --> 00:04:36.960 I want my chair, damn it. Thus, in the ordinary course of warehousing, the temptations to 41 00:04:36.960 --> 00:04:43.960 embezzle are strictly limited. Everyone wants his particular piece of property entrusted 42 00:04:43.960 --> 00:04:50.200 to your care, and you never know when they will want to redeem it. Some goods, however, 43 00:04:50.200 --> 00:04:57.200 are of a special nature. They are homogeneous, so that no one unit can be distinguished from another. 44 00:04:57.200 --> 00:05:04.200 Such goods are known in law as being fungible, where any unit of the good can replace any other. 45 00:05:04.200 --> 00:05:12.200 Grain is a typical example. If someone deposits 100,000 bushels of number one wheat in a grain warehouse, 46 00:05:12.200 --> 00:05:18.200 known customarily as a grain elevator, all he cares about when redeeming the receipt 47 00:05:18.200 --> 00:05:22.200 is getting a hundred thousand bushels of that grade of wheat. 48 00:05:22.200 --> 00:05:26.200 He doesn't care whether these are the same particular bushels 49 00:05:26.200 --> 00:05:30.200 that he actually deposited in the elevator. 50 00:05:30.200 --> 00:05:34.200 Unfortunately, this lack of caring about the specific items 51 00:05:34.200 --> 00:05:38.200 redeemed opens the door for a considerable amount of embezzlement 52 00:05:38.200 --> 00:05:42.200 by the warehouse owner. The warehouseman may now be 53 00:05:42.200 --> 00:05:46.200 tempted to think as follows. While eventually 54 00:05:46.200 --> 00:05:50.880 When really the wheat will be redeemed and shipped to a flour mill, at any given time 55 00:05:50.880 --> 00:05:56.800 there is always a certain amount of unredeemed wheat in my warehouse. I therefore have a 56 00:05:56.800 --> 00:06:03.440 margin within which I can maneuver and profit by using someone else's wheat. Instead of 57 00:06:03.440 --> 00:06:10.040 carrying out his trust and his bailment contract by keeping all the grain in storage, he will 58 00:06:10.040 --> 00:06:15.280 will be tempted to commit a certain degree of embezzlement. 59 00:06:15.280 --> 00:06:21.280 He is not very likely to actually drive off with or sell the wheat he has in storage. 60 00:06:21.280 --> 00:06:27.020 A more likely and more sophisticated form of defrauding would be for the grain elevator 61 00:06:27.020 --> 00:06:34.720 owner to counterfeit fake warehouse receipts to, say, number one wheat, and then lend out 62 00:06:34.720 --> 00:06:39.300 these receipts to speculators in the Chicago commodities market. 63 00:06:39.300 --> 00:06:46.220 The actual wheat in his elevator remains intact, but now he has printed fraudulent warehouse 64 00:06:46.220 --> 00:06:55.340 receipts, receipts backed by nothing, ones that look exactly like the genuine article. 65 00:06:55.340 --> 00:07:01.500 Honest warehousing, that is one where every receipt is backed by deposited good, may be 66 00:07:01.500 --> 00:07:08.540 referred to as 100% warehousing, that is where every receipt is backed by the good for which 67 00:07:08.540 --> 00:07:32.540 In 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% of the receipts or paper tickets outstanding, then he may be said to be engaging in fractional reserve warehousing. 68 00:07:32.540 --> 00:07:42.540 It should also be clear that fractional reserve warehousing is only a euphemism for fraud and embezzlement. 69 00:07:42.540 --> 00:07:50.540 Writing in the late 19th century, the great English economist W. Stanley Jevons warned of the dangers of this kind of 70 00:07:50.540 --> 00:07:57.540 general deposit warrant where only a certain category of good is pledged for redemption of the receipt 71 00:07:57.540 --> 00:08:20.540 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. 72 00:08:20.540 --> 00:08:42.540 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. 73 00:08:42.540 --> 00:08:53.540 In the history of the U.S. grain market, grain elevators several times fell prey to this temptation, spurred by lack of clarity and bailment law. 74 00:08:53.540 --> 00:09:08.540 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. 75 00:09:08.540 --> 00:09:21.540 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. 76 00:09:21.540 --> 00:09:33.540 Unfortunately, however, this legal development did not occur in the vitally important field of warehouses for money or deposit banking. 77 00:09:33.540 --> 00:09:56.540 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 good even more fungible than grain, that is money, whether it be gold or government paper. 78 00:09:56.540 --> 00:10:26.540 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. 79 00:10:26.540 --> 00:10:33.380 to be removed from the warehouse at all. Gold or silver may be removed for a non-monetary 80 00:10:33.380 --> 00:10:40.040 use such as jewelry, but paper money, of course, has only a monetary function, and therefore 81 00:10:40.040 --> 00:10:46.580 there is no compelling reason for warehouses ever to have to redeem their receipts. First, 82 00:10:46.580 --> 00:10:52.780 of course, the money warehouse, also called a deposit bank, must develop a market reputation 83 00:10:52.780 --> 00:10:58.260 for honesty and probity and for promptly redeeming their receipts whenever asked. 84 00:10:58.260 --> 00:11:03.980 But once trust has been built up, the temptation for the money warehouse to embezzle, to commit 85 00:11:03.980 --> 00:11:07.660 fraud, can become overwhelming. 86 00:11:07.660 --> 00:11:13.040 For at this point, the deposit banker may think to himself, for decades this bank has 87 00:11:13.040 --> 00:11:17.960 built up a brand name for honesty and for redeeming its receipts. 88 00:11:17.960 --> 00:11:24.280 By this time, only a small portion of my receipts are redeemed at all. People make money payments 89 00:11:24.280 --> 00:11:29.880 to each other in the market, but they exchange these warehouse receipts to money as if they 90 00:11:29.880 --> 00:11:36.880 were money, be it gold or government paper itself. They hardly bother to redeem the receipts. 91 00:11:36.880 --> 00:11:42.520 Since my customers are such suckers, I can now engage in profitable hanky-panky and none 92 00:11:42.520 --> 00:11:44.900 will be the wiser. 93 00:11:44.900 --> 00:11:50.740 The banker can engage in two kinds of fraud and embezzlement. He may, for example, simply 94 00:11:50.740 --> 00:11:55.620 take the gold or cash out of the vault and live it up, spending money on mansions or 95 00:11:55.620 --> 00:12:02.180 yachts. However, this may be a dangerous procedure. If he should ever be caught out and people 96 00:12:02.180 --> 00:12:07.740 demand their money, the embezzling nature of his act might strike everyone as crystal 97 00:12:07.740 --> 00:12:14.840 clear. Instead, a far more sophisticated and less blatant course will be for him to issue 98 00:12:14.840 --> 00:12:32.840 The New 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. 99 00:12:32.840 --> 00:12:48.840 In that way, insofar as the counterfeiter is neither detected nor challenged to redeem an actual cash, the new fake receipts will, like the old genuine ones, circulate on the market as if they were money. 100 00:12:48.840 --> 00:13:06.840 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. 101 00:13:06.840 --> 00:13:16.840 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. 102 00:13:16.840 --> 00:13:24.840 Not just the grain market, but all of society and the entire economy will be disrupted and harmed. 103 00:13:24.840 --> 00:13:34.840 As in the case of the coin counterfeiter, all property owners, all owners of money are expropriated and victimized by the counterfeiter, 104 00:13:34.840 --> 00:13:41.840 who is able to extract resources from the genuine producers by means of his fraud. 105 00:13:41.840 --> 00:14:05.840 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.