The Mystery Of Banking - 5

Permit me to offer some constructive criticism to the “Islamic judgment on paper money” that I have been citing favourably all along. It is this: The error is in the language; indeed, in the very title.

Paper is always a debt – as with an IOU. And money is always hard. We err grievously when we call paper “money.” It is nothing of the kind. The term “paper money” can be called a oxymoron. We must correct our language.

For example: Suppose I strike a deal for 1 kilo ganja @ 10,000 rupees. If I pay by paper notes, I should politely ask the dealer, “Will you accept this debt for 10,000 rupees signed by the governor of the RBI?” If our language is exact, then so is our understanding. When I use this language, I mean that I am NOT paying money: further, that the money is to be paid by the issuer of the paper.

We would all understand then that the RBI is not honouring its debts. We would understand that, in our markets, we are just passing meaningless debts around. We would be able to easily identify the criminal: Our The State. When the RBI gives its figures of “money supply,” we would all laugh. And we would laugh at all the “economists” too.

Should debts circulate in markets? I would say: If the people are doing this voluntarily, accepting payments in debts, they should be allowed to continue to do so. Islamic law prohibits the use of State force in the matter – so there cannot be “legal tender.” Anything else goes.

As far as the Rule of Law is concerned, it should “stand above” the issuer of debt. In case of default, the issuer should be incarcerated in a debtors’ prison, on a diet of bread and water. Indeed, nowadays we have gold ETFs in India. What happens in case the issuer of the gold ETF defaults? The same punishment should befall all note issuers in case of default.

Add to this the Contract in case of demand deposits: that they are for “safekeeping”; Property has not been transferred; hence lending out any portion of these amounts to criminal misappropriation. This means 100 per cent reserve banking. All depositors are secure. And all note-holders are also protected Under Law. Islamic jurisprudence should not have any problems with this, since All Property Titles are Based on Real Property.

Let us now turn to a historical example: that of the Municipal Bank of Amsterdam, established in 1609, which maintained a 100 per cent reserve for over 170 years. What follows is an extract from one of my unpublished books (in case there are any serious publishers of non-fiction out there).

After a period of great monetary chaos and fraudulent banking based on fractional reserves, the Dutch people set up the Municipal Bank of Amsterdam in 1609, intending to put an end to these troubles and establish “an institution committed to universal legal principles governing the monetary irregular deposit.” [This is the technical term de Soto uses for the demand deposit.]

More precisely, the bank was founded on the principle that the obligation on the part of the bank in a deposit contract was to maintain the constant availability of the deposit money in favour of the depositor: that is, a 100 per cent reserve with respect to all demand deposits. For over 170 years, the Bank of Amsterdam faithfully kept this commitment and no matter what the crisis, every depositor was always easily paid. This made the bank a Pillar of Capitalism at a time when the City of Amsterdam’s trade spanned the globe. As inflations and wild speculations occurred in many parts of Europe, money went to Amsterdam in order to find a safe haven. The commerce and wealth of the city of Amsterdam flourished. The Dutch bank was admired all over Europe, finding praise in the writings of Adam Smith and David Hume.

Smith wrote that the bank “professes to lend out no part of what is deposited with it, but, for every guilder for which it gives credit in its books, to keep in its repositories the value of the guilder either in money or bullion.” He added that this was ensured by the City itself, for the bank was under the direction of four burgomasters who changed every year. Each of them had to visit the vaults, match their contents with deposits in the books and declare under oath that all was well. Adam Smith noted how, in 1672, when the King of France marched into Holland and the Dutch were in danger of being conquered, the Bank of Amsterdam withstood the crisis, satisfying every last claim for payment. We can only conclude how this reputation for solidity must have mattered in making Amsterdam the financial capital of Europe at a time when John Law had wrecked the financial system of France, and Britain too had suffered many a financial crisis.

Between 1780 and 1820, things went wrong and the Bank of Amsterdam began to violate the principles upon which it was founded. The result: “The financial predominance of Amsterdam was replaced by the financial system of the United Kingdom, a much less stable and less solvent system based on the expansion of credit, deposits and paper currency.”

Did the Bank of Amsterdam make any profits? Adam Smith had noted that the City of Amsterdam derived a fair bit of revenue from the bank, because it charged a ‘warehouse rent’ for the money deposited with it; and a fee of 10 guilders was charged for every new account. But the crucial point about the bank’s profits comes from De Soto:

"… the Bank of Amsterdam did not try to attain disproportionate profits through the fraudulent use of deposits. Instead… it contented itself with the modest benefits derived from fees for safeguarding deposits and with the small income obtained through the exchange of money and the sale of bars of stamped metal. Nevertheless, this income was more than sufficient to satisfy the bank’s operating and administration costs, to generate some profit and to maintain an honest institution that fulfilled all of its commitments."(p. 101)[Download pdf file here.]

If this was done once, it can be done again. Banks are central to Capitalism, and they must be Under the Law – traditional legal principles rather than democratically fabricated legislation. These principles should also be widely understood amongst the populace, so that the moral consensus of society gives them requisite force. All paper notes will be convertible and all depositors will then be secure Under Law. Most importantly, there will be neither inflation nor the recurrence of boom-bust cycles. The poor will be able to slowly accumulate Capital – with which to play the great game of Capitalism. And it will be Real Capitalism – in which the most important ingredient of the market, Money, will be produced by The Market itself, and not by the government.

I will discuss how we go “from here to there” tomorrow. Stay tuned.