The Mystery Of Banking - 1

To understand the mystery of banking and credit creation, let us go back in time to when the first goldsmiths of the ancient City of London issued paper notes against gold deposits. These were nothing but “warehouse receipts”: the paper note had your name on it; it promised to pay you the amount of gold mentioned, on demand; and it was signed by the goldsmith.

The paper note was a Property Title Based On Real Property.

In time, as the number of goldsmiths grew, they discovered the magic of “bearer notes”: the gold could be claimed by anyone holding the note. These notes became “paper money”: they circulated in the markets. Clearinghouses evolved to sort out inter-goldsmith balances.

This first paper money was also a Property Title Based On Real Property.

Enter the crooked goldsmith. Once his notes had “gained currency,” and were widely accepted, the crooked goldsmith realized that he could make “loans” by just issuing paper: that is, paper that was not backed by gold. He could create credit out of thin air. This is how modern banks create “deposit money”: they open a current account in the loanee’s name and “deposit” money into it.

Deposit money created by banks begins the process of credit creation based on Property Titles Without Property.

This is why Peel’s Banking Act of 1844 failed. The paper currency issued by the Bank of England was made redeemable on demand, but banks created so much deposit money that redemption had to be repeatedly suspended, until it was finally abandoned. (Without a debate in the House of Commons, as Rothbard records in his history of economic thought.)

Understand the crux of the problem: The Rule of Law, which is based on Property, cannot work where the claims are more than the properties. When the crooked goldsmith issues more notes than the gold he holds, the precise legal problem is but this: there are more claimants to gold than the stock of gold.

Actually, this is also the precise problem with today’s “toxic paper” in the USA. As Hernando de Soto writes:

“… the primary cause of the current economic crisis: the trillions of dollars of "toxic paper" on the balance sheets of financial institutions. This poisonous paper is scaring off potential creditors and investors who lack the legal means to understand what this paper signifies, how much there is, who has it and who might be a bad risk.”

It is “property-less paper” (derivatives pyramided on debt) that is the root cause of the current crisis.

De Soto says:

“Governments have debased paper by carelessly allowing into the market a biblical flood of financial instruments derived from bad mortgages nominally valued at some $600 trillion or more than twice as much as all the rest of the world's legal paper, whether it represents cash, traditional financial assets, or property, tangible or intangible.”

This is the pyramiding of debt based on property-less property titles. 600 trillion dollars worth of debt based on the “real property” of just 19 million physical homes. The solution is not “recapitalizing banks” or “government spending”: the only real solution, which De Soto endorses, is sorting out these papers, a painstaking process, so that each individual paper is tied to a precise individual asset, or to nothing, as the case may be.

We need a Rule of Law solution to banking, the industry that supplies money, because without it banking will not be very different from gambling. We need a Rule of Law solution that ties papers to real Property, for this is the only moral course The Law can take. If we have this solution, we have Sound Money as well as Laissez-Faire Banking. We also have secure depositors – for The Law must, above all, protect the depositor.

I will discuss these ideas tomorrow.