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CHAPTER III.: THE THEORY AND MECHANISM OF BANKING. - Editor of the Journal of Commerce and Commercial Bulletin, A History of Banking in all the Leading Nations, vol. 2 (Great Britain, Russian Empire, Savings-Banks in the U.S.) 
A History of Banking in all the Leading Nations; comprising the United States; Great Britain; Germany; Austro-Hungary; France; Italy; Belgium; Spain; Switzerland; Portugal; Roumania; Russia; Holland; The Scandinavian Nations; Canada; China; Japan; compiled by thirteen authors. Edited by the Editor of the Journal of Commerce and Commercial Bulletin. In Four Volumes. (New York: The Journal of Commerce and Commercial Bulletin, 1896). Vol. 2 A History of Banking in Great Britain, the Russian Empire, and Savings-Banks in the U.S.
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THE THEORY AND MECHANISM OF BANKING.
ON THE MEANING OF THE WORD BANK.
BEFORE we proceed to explain the mechanism and effects of banking, we must ascertain the meaning of the word bank, because great misconception prevails respecting it. At one time, there was considerable discussion in Italy as to the origin of the word Banco. Many writers said it came from “abacus,” a calculating machine. But Muratori entirely disapproves of such a derivation. “To me, on the contrary,” he says, “the word seems to have come from the German word banck, which is a very ancient word in that language”; and he says that the term was first used for a store of goods in the town of Brescia. Ducange also says: “Bank is of Franco-German, or Saxon, origin; no other is to be sought for.” There is no doubt whatever that these learned authors are right. The word banck in German has two meanings: (1). A heap or mound, like a sandbank; hence a store, like the goods in a shop. (2) A bench or seat; because the surface of a sandbank is usually smooth and level. Many writers who are not acquainted with the technicalities of business suppose that the word bank as a place of business comes from the second of these meanings; because they suppose that the “banco” was the counter upon which the money-changers kept their money. But the technical meaning of the word banking, and the invariable meaning of the term as used by the Italian economistes, and the invariable meaning of the word when it was first introduced into English, conclusively prove that the preceding opinion is erroneous; and that, as a technical term in commerce, it is derived from the first of the meanings given above—i. e., a heap or mound.
The word bank originated in this way. In 1171, the City of Venice was at war both with the Empires of the East and the West. Its finances were in a state of great disorder, and the Great Council levied a forced loan of one per cent. on all the property of the citizens, and promised them interest at the rate of five per cent. Commissioners were appointed to manage the loan, who were called “Camera degli Imprestiti.” Such a loan has several names in Italian, such as “Compera,” “Mutuo,” etc.; but the most usual name is “Monte,” a joint-stock fund. This first loan was called the “Monte Vecchio,” or the old loan; subsequently two other similar loans were contracted, and called the “Monte Nuovo” and the “Monte Nuovissimo.” In exchange for the money, which became the actual property of the Government to be employed for public purposes, the citizens received stock certificates, or credits, which they might transfer to any one else; and the commissioners kept an office for the transfer of the stock and the payment of the dividends. At this time, the Germans were masters of a great part of Italy, and the German word banck, meaning a heap, or mound, came to be used simultaneously with monte, and was Italianized into banco, and the public loans were called indifferently monti and banchi.
It was this office, the Chamber of Loans, which such multitudes of writers have supposed was the famous Bank of Venice. But this is a complete mistake. It was in no sense a bank, in the modern meaning of the word; it was simply the National Debt office; similar to the National Debt office of the Bank of England; it was the origin of the funding system. Thus in the “Volpone” of Ben Jonson, the scene of which is laid in Venice, Volpone says: “I turn no monies in the public bank”—meaning, “I do not dabble in the Venetian funds.” So an English writer, Benbrigge, in 1646, speaks of the “three bankes” at Venice—meaning the three public loans or monti. So in Florian and Torriani’s Italian Dictionary, published in 1659, it says: “Monte, or standing bank, or mount of money, as they have in divers cities in Italy.” That the word banco in Italian means a public debt might be proved by numberless quotations. Thus a recent writer, Cibrario, says (Economia Politica del medio evo): “Regarding the theory of credit, which I have said was invented by the Italian cities, it is known that the first bank or public debt (il primo banco o debito publico) was erected in Venice in 1171. In the thirteenth century paper money is mentioned at Milan; the credit was paid off. A monte or public debt (un monte o debito publico) was founded in Florence in 1336.” This passage shows that banco is the equivalent of monte, and of a public debt. At Genoa, during the wars of the fourteenth century, the Bank of St. George was formed of the creditors of the State.
Every economist in the south of Europe knows that the word bank means a public debt. Thus the distinguished Spanish economist, Olozaga, speaking of the Venetian loans, says: “El Monte Vecchio (Banco Viejo). * * * el Monte Nuevo (Banco Nuevo).” So Baretti’s Italian Dictionary 1839, says: “Monte, a bank where they lend or take money at interest.” So Evelyn speaks of the Monte di Pietà at Padua, where there is a continual bank of money to assist the poor. So Blackstone says: “At Florence, in 1344, Government owed £60,000, and being unable to pay it, formed the principal into an aggregate sum, called metaphorically a mount or bank.” Every one acquainted with the writings of the Italian economists knows that they invariably use the words monte and banchi as absolutely synonymous; but I am informed by my friend Professor Loria of Sienna that the word monte is not used now in Italian for a bank. This was also the meaning of the word bank when it was first introduced into English. Thus Bacon says: “Let it be no bank or common stock.” So Gerard Malynss says: “Mons Pietatis, or bank of charity. In Italy there are Montes Pietatis; that is to say, mounts or banks of charity.” Benbrigge, in his Usura Accommodata, 1646, says: “For their rescue may be collected Mons Pietatis sive Charitatis, or banks of piety or charitatis, as they of Trent fitly call it.” Again, “For borrowers in trade for their supply, as their occasion shall require, may be erected Mons Negotionis or banke of trade.” Tolet says: “Mons fidei, a banke of trust which Clement XII. instituted at Rome; he that put his money into this banke was never to take it out again”; for which the lender received seven per cent. interest, like the subscribers to the original Bank of England stock. He also speaks of Mons Recuperationis, or banke of recovery, in which the interest was twelve per cent. The difference between these two, which were public debts, was that the first was a perpetual annuity, and the second a terminable annuity, in which the higher rate of payment was repayment of the principal.
In the time of Cromwell, several proposals were made for erecting public banks. Samuel Lambe, a London merchant, recommending them in 1658, says: “A bank is a certain number of sufficient men of estates and credit joint together in joint stock; being as it were the general cash keepers or treasurers of that place where they are settled, letting out imaginary money (i. e., credit) at interest at two and a-half or three per cent. to tradesmen or others, who agree with them for the same, and making payment thereof by assignation, and passing each man’s account from one to another with much facility and ease.” So Francis Cradocke, a London merchant who was appointed a member of the Board of Trade by Charles II., strongly advocated the introduction of banks into England, and says: “A banke is a certain number of sufficient men of credit joined together in a stock, as it were, for keeping several men’s cash in one treasury, and letting out imaginary money (i. e., credit) at interest for three or more in the hundred per annum, to tradesmen or others that agree with them for the same; and making payment by assignation, passing each man’s account from one to another, yet paying little money.” And he says that, “the aforesaid bankers may furnish another petty bank (or mount) of charity.” Thus these writers perfectly well understood the nature and constitution of a bank. They knew well that the function of a bank is to advance imaginary money, or credit, and not metallic money, as is the popular delusion of the present day. In a little tract, entitled “A Discourse Concerning Banks,” and supposed to be by a director of the Bank of England, we find this description: “There are three kinds of banks; the first for the mere deposit of money [like those of Venice, Amsterdam, Hamburg, etc.]; the second for profit. The banks of the second kind, called in Italy Monti [i. e., public debts], which are for the benefit of the income only, are the Banks of Rome, Bologna and Milan. These banks were made up of a number of persons who, in time of war or other exigencies of State, advanced sums of money upon funds granted in perpetuum, but redeemable. * * * The third kind of banks, which were both for the convenience of the public and the advantage of the undertakers, are the several banks of Naples, the Bank of St. George at Genoa, and one of the banks of Bologna. These banks having advanced sums of money at their establishments, did not only agree for a fund of perpetual interest, but were allowed the privilege of keeping cash.”
The Bank of England was of this last kind. It was a company of persons who advanced a sum of money to the Government and received in exchange for it a perpetual annuity, or a right to receive forever a series of annual payments from the State. This annuity is in legal phrase termed a bank annuity; in popular language, “The Funds.” There has only been one instance in England of a bank which did not receive cash from the public. Some time after the foundation of the Bank of England, a company of persons united to advance a million pounds to the Government. They were incorporated as the “Million Bank.” This company existed till nearly the end of the last century, and thus it resembled the original Bank of Venice. Thus, from these passages, and many more might be cited if necessary, it is perfectly clear that the word bank, as a term in commerce, is the equivalent of monte; and meant a joint-stock fund contributed by a number of persons. So when the word bank was introduced into our American colonies before the Revolutionary War, Professor Sumner says (“History of American Currency,” p. 6, n.): “Bank, as the word was used before the Revolutionary War, meant only a batch of paper money, issued either by the Government or a corporation. The impression seems to have remained popular that the essential idea of a bank is the issuing of notes. * * * The notes issued in ‘banks,’ or masses, as loans were pure paper money.” So, in a valuable history of the notes issued in the United States, it says that an issue of paper money to the amount of £50,000, authorized to be issued by the Treasury, was styled a bank.
The essential feature of all these “banks” was this: The subscribers advanced the money as a loan or mutuum; it thus became the absolute property of the borrowers, and in exchange for their money the lenders received a credit—i. e., a certificate, or promise to pay interest, which they might transfer to anyone else. And those persons whose business it was to trade like these banks—i. e., to buy money and in exchange for it to issue credit of various sorts—were termed “bankers,” and only those. Thus, as a technical term in business, to “bank,” means to issue credit.
ON THE MEANING OF THE WORD BANKER.
Here, again, great misconception prevails as to the meaning of the word banker and the nature of the business of banking. Gilbert says: “A banker is a dealer in capital; or, more properly, a dealer in money. He is an intermediate party between the borrower and the lender. He borrows of one party and lends to another; and the difference between the terms at which he borrows and those at which he lends forms the source of his profit.” So a report of the House of Commons says: “The use of money, and that only, they regard as the province of a bank, whether of a private person or incorporation, or the banking department of the Bank of England.” Notwithstanding the apparently high authority of these passages, which have misled so many unwary persons, these descriptions of the nature of the business of banking are entirely erroneous. In former times, there were many persons who acted as intermediaries between persons who wanted to lend and those who wanted to borrow. They were called “money scriveners.” The father of John Milton was a money scrivener, but no one ever called a money scrivener a banker. At the present day, many firms of solicitors act as intermediaries between persons who wish to lend and others who wish to borrow. They may have some clients who wish to lend and other clients who want to borrow; and they act as agents between them. The first set of clients may entrust their money to the firm to lend to the second set, and the solicitors receive a commission on the sums which pass through their hands. But no one ever called a firm of solicitors who transact such business “bankers”; which shows that there is an essential distinction between the business of money scriveners and such a firm of solicitors and the business of “bankers.” Solicitors who transact such agency business do not acquire any property in the money which passes through their hands. They receive it merely as a bailment or a depositum. They are only the custodians or the trustees of the money; and it is only entrusted to their custody for the express purpose of being applied in a particular way. The actual property in the money passes directly from the lender to the borrower through the medium of the trustees or bailees, and if the latter appropriated the money in any way to their own purposes it would be a felony, and they would be liable to be punished for embezzlement. But the case of a banker is wholly different. When his customers pay in money to their account they cede the property in the money to the banker. The money placed with him is not a depositum or a bailment; it is a mutuum or creditum; it is a “loan” or sale of the money directly to himself. The banker is not the bailee or trustee of the money, but its actual proprietor. He may trade with it or employ it in any way he pleases for his own profit or advantage. The banker buys the money from his customer, and in exchange for it he gives his customer a credit in his books, which is simply a right of action to demand back an equivalent amount of money from his banker at any time he pleases, and the customer may transfer this right of action to any one else he pleases, just like so much money.
When the client of a solicitor entrusts money to him, to lend to some one else, he retains the property in it until the arrangement with the borrower is completed; and then the property in the money is transferred directly from the lender to the borrower, without in any way vesting in the solicitor. But when a customer pays in money to his banker, the property in it instantly and, ipso facto, vests in the banker; and the customer has nothing but a right of action against the person of the banker to demand back an equivalent sum. So long as the money remains in the possession of the customer, it is a jus in rem; but when he has paid it into his account he has nothing but a jus in personam.
Galiani says (Della Moneta, p. 323): “Banks began when men saw from experience that there was not sufficient money in specie for great commerce and great enterprises. The first banks were in the hands of private persons with whom persons deposited money; and from whom they received bills of credit (fedi di credito), and who were governed by the same rules as the public banks now are. And thus the Italians have been the fathers and the masters and the arbiters of commerce; so that in all Europe they have been the depositaries of money, and are called bankers.” So Genovesi says (Delle dezioni di Economia Civile, part II., ch. 5, § 5): “These monti (banks) were first administered with scrupulous fidelity, as were all human institutions made in the heat of virtue. From which it came to pass that many placed their money on deposit, and as a security, received paper, which was called and is still called bills of credit. Thus private banks (banchi) were established among us, whose bills of credit acquired a great circulation, and increased the quantity of signs and the velocity of commerce.” And this was always recognized as the essential feature of banking. Thus Marquardus says (De Jure Mercatorum, Lib. II., ch. 12, § 13): “And by ‘banking’ is meant a certain species of trading in money, under the sanction of public authority, in which money is placed with bankers (who are also cashiers and depositaries of money) for the security of creditors and the convenience of debtors, in such a way that the property in the money passes to them; but always with the condition understood that any one who places his money with them may have it back whenever he pleases.”
A “banker” is therefore a person who trades in the same way as the public banks did; they acquired the property in the money paid in; and in exchange for it they gave bills of credit; which circulated in commerce exactly like money and produced all the effects of money. And, moreover, when they bought or discounted bills of exchange, they did it exactly in the same way; they bought them by issuing their own credit, and not with money. And experience showed that they might multiply their bills of credit several times exceeding the quantity of money they held; and thus for all practical purposes multiply the quantity of money in circulation. Thus the essential business of a banker is to create and issue credit to circulate as money. In the neighborhood of the Royal Exchange, many firms announce themselves as “Money Changers and Foreign Bankers.” Thus they show that they know that money changing is not “banking.” By foreign bankers they mean that, in exchange for specie, they will give their customers bills of credit on their foreign correspondents.
The following is a true definition of a “banker”: A banker is a trader who buys money and credits, debts or rights of action, payable at a future time, by creating and issuing credits, debts or rights of action, payable on demand, as will be more fully exemplified further on.
ON THE CURRENCY PRINCIPLE.
We must now explain the meaning of an expression which has acquired much importance, and which must be clearly understood before we come to the exposition of the system which the Bank Charter Act of 1844 was designed to carry out.
The express function of a bank being to create credit, it has sometimes been maintained that a bank should only be allowed to create exactly as much credit as the specie paid in, and no more; and that its sole function should be to exchange credit for money and money for credit; and thus the quantity of credit in circulation would always be exactly equal to the money it displaced. This doctrine is that which is distinctively known by the name of the Currency Principle. It is the doctrine which the supporters of the Bank Act of 1844 asserted to be the only true one, and which that Bank Act was especially designed to carry out. The doctrine is supposed to be of modern origin, and the latest refinement in the theory of banking. But this is far from being the case; it was first formulated in China in 1309. That country had been plagued for 500 years with the excessive issues of inconvertible paper by the banks. The author of a work named Toao-Min, exhibiting the evil consequences of excessive issues of paper money, and speaking of the times before such mischief arose, said: “Then it was ordered that, at the offices of the rich merchants who managed the enterprise, when the notes were paid in, the money came out; when the bills came out the money went in; the money was the mother, the note was the son. The son and the mother were reciprocally exchanged for the other.”
Several banks have been constructed on this principle, such as those of Venice, Amsterdam, Hamburg, Nuremberg and others. These places, small in themselves, were the centres of a great foreign commerce, and as a necessary consequence large quantities of foreign coin of all sorts, of different countries and denominations, were brought by the foreigners who resorted to them. These coins were moreover greatly clipped, worn and diminished. The degraded state of the current coin produced intolerable inconvenience, disorder and confusion among the merchants, who, when they paid or received payment of their bills, had to order or receive a bagful of all sorts of different coins. The settlement of these bills, therefore, involved perpetual disputes—which coins were to be received and which were not, and how much each was to count for. In order to remedy this intolerable inconvenience, it became necessary to institute some fixed and uniform standard of payment, so as to insure regularity of payments and a just discharge of debts. To effect this purpose, the magistrates of these cities instituted a Bank of Deposit, into which every merchant paid his coin of all sorts and countries. They were weighed, and the bank gave him credit in its books for the exact bullion value of the coins paid in. The owner of the credit was entitled to have it paid in full-weighted coin on demand. These credits, therefore, insured a uniform standard of payment, and were called “bank money,” “Moneta di Banco,” and it was enacted that all bills upon these cities above a certain small amount should be paid in bank money only. As this bank money was always exchangeable for coin of full weight on demand, it was also at a premium, or agio, as compared with the worn, clipped and degraded coin in circulation. The difference was usually five to nine per cent. in the different cities. The term agio is misleading, because it is evident that it was the “Moneta di Banco,” which was the full legal standard, and the current coin was at a discount. These banks professed to keep all the coin and bullion deposited with them in their vaults. They made no use of it in the way of business, as by discounting bills. Thus the credit created was exactly equal to the specie deposited, and their sole function was to exchange credit for money and money for credit. These banks were examples of the currency principle. They were of no use to commerce further than to serve as a safe place to keep the money of the merchants, and to insure a uniform standard for the payment of debts. They made no profits by their business, and no bank constructed on the currency principle can by any possibility make profits. The merchants who kept their accounts with the bank paid certain fees to defray the expenses of the establishment.
These banks were banks of deposit, because the money and bullion placed with them were merely placed there for safe custody and keeping. But they were not banks in the true sense of the word, because the money deposited with them did not become their absolute property to deal with as they pleased. They were simply trustees of the money. They were, however, banks in a certain sense; because the primary meaning of banco is a store, and they were stores of money. They were not the bankers, but the treasurers of the merchants; and they were obliged to take a solemn oath that they would keep in their vaults all the money deposited with them. Nevertheless, both at Venice and Amsterdam, they violated their solemn oaths, and advanced large sums to the Government, which ultimately led to their ruin.
ON THE MECHANISM OF BANKING.
Banks of the nature of those of Venice, Amsterdam, Hamburg and others, founded on the “currency principle,” never existed in England; and we must now explain the mechanism of the great system of banking—or the great system of the commerce in credits, debts or rights of action, as it has been carried on in England.
It was during the great civil war, as we have already explained, that the goldsmiths of London first began to receive the cash of the merchants and country gentlemen for safe custody, on condition of repaying an equal sum on demand, and to discount bills of exchange with their own promissory notes; that commenced the business of banking. Now, this money was not placed in their hands to be locked away in their cellars, as plate and jewelry are often given into the custody of a banker for mere safe custody as a depositum, and to be restored in specie. The money was sold to the banker to become his actual property, according to the well-understood custom of bankers; that is, it was a mutuum or creditum; and was to be restored only in genere. The goldsmith bankers agreed not only to repay the money on demand, but also to pay six per cent. interest upon it. Consequently, in order to make a profit, they were obliged to trade with it.
We must now explain how a banker makes a profit by the money his customers sell to him. Suppose that customers pay in £10,000 to their accounts. They cede the absolute property in the money to the banker; it is a mutuum or creditum. The banker buys the money from his customers, and in exchange for it he gives them an equal amount of credit in his books; that is, he creates rights of action against himself to an equal amount, giving his customers the right to demand back an equal amount of money at any time they please, and also the right to transfer their rights of action to any one else they please, exactly as if they were money, and the banker agrees to pay the transferee the same as his own customer. This right of action, credit or debt, entered in the banker’s books is, in banking language, technically termed a deposit. After such an operation his accounts would stand thus:
Now, though his customers have rights of action against the banker to demand exactly an equal sum of money to what they have paid in, yet persons would not pay money to their banker if they meant to draw it out immediately; just as no one would spend all the money he has at once. Nevertheless, some will want to draw out part of their funds; but if some customers want to draw out money, others will, probably, pay in about an equal sum. Observation shows that, in ordinary and quiet times, a banker’s balance will seldom differ by more than one thirty-sixth part from day to day. The banker’s cash is, therefore, like a column of gold with a slight ripple on the surface; and, if he retains one-tenth in cash to meet any demands which may be made on him, that is ample and abundant in all ordinary times. If, then, in the above example, the banker retains £1000 in cash to meet any demands upon him, he has £9000 to trade with and make a profit by; and it is just in the method in which bankers trade that so much misconception exists. It is commonly supposed that, when a banker has the £9000 to trade with, he employs it in purchasing bills of exchange to that amount, and that he receives a profit only on the £9000; but that is a complete misconception of the nature of banking. A banker never buys bills of exchange with money. That is the business of a bill-discounter or money-lender. The way in which a banker trades is this: He sees that £1000 in cash is sufficient to support £10,000 of liabilities in credit; consequently, he argues that £10,000 in cash will bear liabilities to several times that amount in credit. One of the most eligible methods of trading for a banker is to buy or discount good commercial bills; and he buys these bills exactly in the same way as he bought the cash—that is, by creating credits in his books, or debts or rights of action against himself to the amount of the bills, deducting at the same time the interest or profit agreed upon, which is called the discount. A banker, therefore, invariably buys a bill of exchange with his own credit and never with cash, exactly in the same way that he bought the cash. That is, he buys a right of action payable at a future time by issuing a right of action payable on demand; and this right of action or credit is also in banking language termed a deposit—as the right of action created and issued to buy the cash.
Suppose that the banker buys £40,000 of bills of exchange at three months, and that the agreed-upon profit is four per cent.; then the sum to be retained on these bills is £400. Consequently, in exchange for bills to the amount of £40,000 he would create credits, debts or rights of action—technically termed deposits—to the amount of £39,600. Hence, just after discounting these bills, and before his customers began to operate upon them, his accounts would stand thus:
The balance of £400 being his own property or profit. By this process the banker has added £39,600 in credit to the previously existing cash, and his profit is clear; he has not gained four per cent. on the £9000 in cash, but four per cent. on the £40,000 of bills he has bought. This is what the business of banking essentially consists in; and thus the correctness of the definition of a banker given above is manifest.
It is also evident that a banker’s profits depend upon the quantity of credit he can maintain in circulation in excess of the cash he holds in reserve. Thus it is seen that the very essence and nature of a bank and a banker is to create and issue credit payable on demand; and this credit is intended to circulate and perform all the functions of money. A bank is therefore not an office for borrowing and lending money, but it is a manufactory of credit. As Mr. Cazenove well said: “It is these banking credits which are the loanable capital;” and, as Bishop Berkeley said, “a bank is a gold mine.” So we ought not to speak of the money market, but of the credit market.
ON THE LEGAL RELATION BETWEEN BANKER AND CUSTOMER.
It must be carefully observed that the legal relation between banker and customer is simply that of debtor and creditor.
When a customer pays in money to his account with his banker, he cedes the absolute property in the money to the banker and receives in exchange for it a right of action, or credit or debt, to demand an equivalent sum of money any time he pleases, but not the identical money. In speaking of banking, it is too often implied that the money placed with the banker still belongs to the customer. But this was decisively refuted by Lord Chancellor Cottenham. It must therefore be carefully observed that a banker in no way resembles the treasurer of a public fund, or a solicitor or a money scrivener, who are only trustees or bailees of the money placed with them by their clients. If a banker were the mere trustee of the money placed with him, he would have no right to use it for his own private profit.
It is often the custom of persons to say that they have so much money at their banker’s; but such an expression is wholly erroneous and misleading; they have no “money” at their banker’s; they have nothing but an abstract right of action to demand so much money from their banker, which they give in exchange to their banker for money. As a consequence of this relation between banker and customer, if a customer were to leave a balance at his banker’s for six years without operating on it, or receiving interest for it, the banker might, if he chose to be so dishonest, refuse to pay it, because the statute of limitations does not apply to trusts. Another consequence of this relation is that a cheque is a bill of exchange and not a draft. It is an order addressed by a creditor to his debtor, and not one addressed to his trustee or bailee. To call a cheque a draft is to mistake the relation between banker and customer.
ON THE LEGAL CONTRACT BETWEEN BANKER AND CUSTOMER.
It has been shown that the legal relation between banker and customer is simply that of debtor and creditor. Nevertheless there is an important distinction between an ordinary debtor and a banker debtor. At common law, an ordinary debtor is not bound to accept a bill drawn upon him by his creditor without his own consent, even though he admits the debt; nor, if the creditor assigns the debt, is he bound to pay the transferee. The debtor has simply engaged to pay his creditor, and no one else. Nor has the transferee any right of action against him, because there is no privity of contract between the debtor and transferee; and the creditor has no power to stipulate that the debtor shall pay the transferee unless he expressly consents to do so. The transferee can only sue the debtor under the name of the transferer, or the transferer can sue the debtor as the trustee of the transferee. If, however, the debtor had entered into an obligation, under seal, promising to pay the assignee or bearer; or if he had accepted a bill payable to order, or to bearer, then the transferee might sue him in his own name, because the consent of the debtor had created a privity of contract between himself and the transferee. But the case of a banker debtor has always been different. When persons have money in their own possession they can transfer it to any one else, any moment they please. Persons, therefore, would not place their money with bankers unless they had exactly the same facility of transferring their right of action against their banker as they had of transferring the money itself.
Consequently, from the very first institution of banking, it was always the fundamental contract that customers might either demand payment themselves from their bankers, or that they might transfer their right of action made payable to order, or to bearer, or to anyone else as freely as their money; and the bankers agreed to pay the transferee as readily as their own customers. By the very nature therefore of the consensual contract, termed the custom of bankers, a banker having funds of his customer is in the position of an ordinary debtor who has accepted a bill payable to order or to bearer. Hence, while the simple admission of funds by an ordinary debtor in no way compels him to accept, or to pay, a bill drawn upon him without his own consent, the simple admission of the possession of funds by a banker operates ipso facto as a legal acceptance of any bills or cheques drawn upon him by his customer, and gives the holder of them a right of action against him.
ON THE MEANING OF DEPOSIT IN THE TECHNICAL LANGUAGE OF MODERN BANKING.
The word depositum is one of that class of Latin words which, in classical Latin, meant a material thing, but which in modern times has come to mean only an abstract right. A depositum, in Roman law, means anything which is placed in the gratuitous charge or custody of some person for the sole purpose of safe-keeping, without the property in it passing to him, or his being allowed to use it in any way for his own advantage, or even being allowed to retain it as a security for a debt due to him.
It is part of the duty of a London banker to take charge of his customer’s plate, jewelry and securities, if required to do so. This plate, jewelry and securities so committed to their charge for safe custody is what in Roman law is called a depositum. The banker acquires no property in such a depositum; he can make no use of it for his own advantage; he receives no remuneration for keeping it, and he has no lien on it if his customer becomes indebted to him. So, if a customer tied up a sum of money in a bag and placed it in the custody of his banker, it would be a depositum; and the banker would be bound to redeliver the specific bag of money to him on demand, untouched. It is said that in the 1893 crisis in America, numbers of customers withdrew their balances from their current accounts, tied them up in bags and redelivered them to their bankers to keep for them as deposita; and then of course the bankers could not touch them. It is almost universally supposed by lay writers that when a customer pays in money to his account with his banker, it is a deposit; and that the deposits of a bank are the cash held in reserve. This, however, is a pure delusion. When a customer, in the ordinary way, pays in money to his account with a banker, he loses all property in it; the banker acquires the absolute property in it to use for his own advantage; such money, therefore, is not a depositum; it is a mutuum or a creditum. If the money so paid in were a depositum, it would mean that the banker acquired no property in it; that the property in it remained with the customer who placed it in his banker’s hands for pure safe-keeping, and that he could demand back that specific sum of money at any time he pleased. But every person who thinks knows that such ideas are erroneous.
In exchange for the money the banker makes an entry of an equal sum in credit in favor of his customer; that is, he issues a right of action to him. And it is this entry of a credit or right of action in his customer’s favor which in the technical language of modern banking is termed a deposit; that is, he buys the money by creating a deposit. So when a banker discounts a bill for a customer, he buys a right of action from him exactly in the same way as he bought the money. He creates a credit in his books in his favor; or he issues a right of action to him. This credit, or right of action, is the price the banker pays for the bill. And this credit or right of action created to purchase the bill is termed a deposit, equally as the right of action created to purchase the money. The money and the bills are the banker’s assets. The deposits are the rights of action he has created to purchase his assets. Every advance a banker makes is done by creating a deposit. His depositors are those persons who have rights of action against him to pay money, or his creditors. A deposit is simply a banking credit.
IN BANKING LANGUAGE A DEPOSIT AND AN ISSUE ARE THE SAME.
It must therefore be observed that, in the technical language of modern banking a deposit and an issue are the same thing. A deposit is simply a credit in a banker’s books. It is the evidence of the right of action which a customer has to demand a sum of money from the banker. As soon as the banker has created a credit, or deposit, in his books in favor of a customer he has issued to him a right of action against himself.
The word issue comes from exitus, a going forth; and in mercantile law to issue an instrument is to deliver it to any one so as to give him a right of action against the deliverer or issuer. It in no way increases the banker’s liability to write down this credit, or deposit, on paper in the form of a bank note or cheque. Such documents are only made after the credit or deposit has been created; and their sole purpose is to facilitate the transfer of the credit or deposit to some one else. Now, as every advance a banker makes is by issuing a right of action against himself to his customer, and as a banker has an unlimited right of buying any amount of debts or obligations from his customers which he thinks prudent, every banker has the right of unlimited issue. Bank notes and cheques, then, do not increase a banker’s liability. The liability is created as soon as the banker has entered the amount to his customer’s credit in his books. The note, or cheque, is merely a convenient method of transferring from hand to hand the pre-created liability which has already been issued. Deposits, then, instead of being so much cash, as is so commonly supposed, are nothing but the credits or rights of action the banker has created as the price to purchase the cash and bills which figure on the other side of the account as his assets. A sudden increase of deposits is, therefore, nothing more than an inflation of credit, exactly similar to a sudden increase of bank notes. Deposits are nothing but bank notes in disguise.
ON THE METHOD OF UTILIZING BANKING CREDITS.
The banker, then, having issued these credits, deposits or rights of action against himself to his customers, they cannot, of course, transfer them by manual delivery in that form to any one else. In order to be capable of manual delivery they must be recorded on paper or some other material. And this might be done in two forms: 1. The banker might give his customer his own promissory notes, promising to pay a certain sum to his customer, or to his order, or to bearer on demand. 2. The customer might write a note to his banker directing him to pay a certain sum to a certain person; or to his order, or to bearer on demand. These orders were formerly called cash notes, but they are now termed cheques. These paper documents do not create new liabilities; they merely record on paper the credits, debts or deposits which have already been created in the banker’s books, and their sole use is to facilitate the transfer of these rights of action to other persons. There is one juridical distinction between bank notes and cheques. A bank note is the absolute obligation of the banker to pay it; a cheque is only the contingent obligation of the banker to pay it, provided that the customer has sufficient credit on his account to pay it. If, however, he has, then the obligation of the banker is absolute. The holder of a cheque with funds to meet it on the drawer’s account has the same right of action against the banker as upon one of his own notes. So far as regards economics, bank notes and cheques are absolutely identical. They are both equally circulating medium or currency. Bankers’ notes were at first merely written on paper like any other promissory notes, and they were for any sums the customer might require. In 1729, Child & Co. introduced the practice of having their notes partly printed and partly written like a modern cheque. They were not, like modern bankers’ notes, for fixed definite sums; but, like modern cheques, for any sum that might be required.
London bankers appear to have issued their own notes till about 1793, when perhaps the panic of that year may have shown them the danger of having large amounts of their notes in the hands of the public, which their enemies might collect and present for payment. In 1793, they discontinued issuing notes of their own accord, but they were never forbidden to do so until the Bank Act of 1844. Most erroneous conclusions have been drawn from the fact of the London bankers having voluntarily discontinued issuing their own notes. Lay writers, who know nothing of the mechanism of banking, have asserted that the London banks are, like the banks of Venice, Amsterdam, etc., pure banks of deposit; that they do not create credit, and that their whole business is to “lend” out the money they “borrow” from their customers. All such ideas are, however, pure delusions. Bankers now, as ever, make all their advances by creating credits or deposits in their books. But instead of giving their customers two methods of circulating these credits, by means of notes or of cheques, they are now restricted to one method—cheques. But whether a bank credit is circulated by means of a note or a cheque makes no possible difference in economics.
The Bank Charter Act of 1844 allowed the banks which were then issuing notes to continue to do so to a certain limited amount, but forbade any new bank to commence doing so. A considerable number of the banks which issued notes in 1844 have disappeared, and the notes of private banks have diminished by several millions. Many ill-informed writers have drawn the conclusion from this circumstance that the currency of the country has been diminished by so much. This, however, is a pure delusion. The system of banking has enormously increased since then, and the amount of banking credits has increased by scores of millions, and these increased banking credits being circulated by cheques are currency in exactly the same way as notes.
OPERATIONS BY MEANS OF NOTES AND CHEQUES.
When, therefore, a banker has created a credit or deposit in favor of his customer, he can put this credit into circulation either by means of the banker’s own note or by means of a cheque, and when he does so, the following different results may take place: 1. The customer himself or the holder of the note or cheque may demand payment of it; if they do so, the banker’s liability is extinguished. It is a resale of money to the holder of the note or cheque, and the banker buys up the right of action against himself. 2. The note or cheque may circulate in commerce and effect any number of transfers of commodities or payments exactly like an equal sum of money; and it may ultimately fall into the hands of a customer of the same bank, who pays it into his own account, and the whole series of transactions is finally closed by the mere transfer of credit from the account of the drawer to that of the holder, without the necessity of any coin. 3. The note or cheque may, after performing a similar series of operations, fall into the hands of a customer of another bank. So the banker becomes debtor to the customer of another bank. But if the bank A becomes debtor to the customers of bank B, the chances are that about an equal number of the customers of bank A will have about equal claims against bank B. If the mutual claims of the customers of each bank are exactly equal, the respective documents are interchanged, and the credits are readjusted among the accounts of the different customers without any payment in money. Thus, if the mutual claims among any number of bankers exactly balanced, any amount of credits, however large, might be settled without the use of a single coin. Formerly, if the mutual claims did not balance, the differences only used to be paid in money or bank notes. But now, by an ingenious arrangement of the Clearing House, which will be described shortly, the use of coin and bank notes is entirely dispensed with, and all the banks which join in the clearing are really and practically formed into one huge banking institution for the purpose of transferring credits among each other, just as credits are usually transferred from one account to another in the same bank, without a single coin being required.
HOW CREDIT IS CAPITAL TO A BANKER.
It is now seen how credit is capital to a banker. For what is the commodity which a banker deals in and makes a profit by? He opens his place of business and has an array of clerks with their desks, ledgers, etc. He then gives notice that he is ready to buy gold from any one who has it to sell. And what is the commodity with which he buys the gold—what does he give in exchange for it? His own credit. The commodity he gives in exchange for the gold is a right of action to pay an equivalent of gold on demand, i. e., his own credit. He then gives notice that he is ready to buy good commercial debts—which are credits or rights of action—which any one has got to sell. And what does he buy these credits, debts, or rights of action with? Again, with nothing but his own credit—with rights of action against himself. His own credit is the commodity with which he buys these other credits. The banker charges exactly the same price for his credit as if it were money. The only commodity the banker has to sell is his own credit, for which he charges exactly the same price as if it were money. Hence he makes exactly the same profit by selling his credit as if he were selling money. Now, as we have seen, anything which gives a profit is capital. Hence, as a banker’s credit produces him exactly the same profit as money would, it is evident that his credit is capital to him just as much as money is.
Again, credits, debts or rights of action are goods, chattels, commodities, merchandise. Now, under the term circulating capital, Smith expressly includes the goods or commodities in shops. The trader buys them at a lower price from one person and sells them at a higher price to another person, and so makes a profit by them; and thus the goods in the shop are capital to him. And Adam Smith expressly includes bank notes or banking credits and bills of exchange under the term circulating capital. So a banker buys the goods or commodities termed credits, debts or rights of action from one person, his own customer, and sells them at a higher price to another person—namely, the acceptor or debtor. The debt the banker buys is increasing in value every day from the time he buys it until it is paid off. These goods or commodities termed debts in the portfolio of a banker produce him a profit just in the same way as the goods, commodities or merchandise in the shop produce profits to the trader. Hence the bills in the portfolio of a banker are circulating capital, exactly in the same way as the goods, commodities or merchandise in the shop of a trader are circulating capital.
ON THE SCOTTISH SYSTEM OF BANKING.
The credits, or rights of action, created by bankers in the operations which we have been describing, were employed to buy commercial bills which arose out of the transfer of commodities; and it has been shown that they create credit to several times the amount of the cash in their possession. And some writers suppose that this is the limit of legitimate credit. It is very commonly imagined that credit can only be used to transfer existing commodities. We have now to describe a species of credit of a totally different nature, invented in Scotland, to which the marvelous progress of that country is mainly due. It is credit created, not for the purpose of transferring or circulating commodities already in existence, but for the express purpose of calling new products into existence. It is entirely of the nature of accommodation paper; and it will show that there is nothing in the nature of accommodation paper more dangerous or objectionable than there is in real paper, as it is called; but, on the contrary, that they stand on exactly the same footing of security; and also that credit is equally applicable to call new products into existence as to transfer those already in existence.
When, after a long period of inactivity, the energies of a people are suddenly turned into an industrial direction, they find innumerable enterprises which would be profitable if only they possessed the means of setting them agoing. The quantity of money which was sufficient for a non-industrial people is now found to be wholly inadequate for the increased demand for it; and the only consequence will be that, if there is a greatly increased demand for the existing quantity of money, the rate of interest will rise enormously; and to such an extent as to preclude all possibility of profit from such enterprises, even if effected. It is, therefore, invariably found, that whenever this takes place, multitudes of schemes are set afloat for increasing the quantity of money. For many centuries after the Conquest, England was essentially a feudal and military—an agricultural and pastoral people. Its law was almost entirely feudal, and related to the tenure of land. Merchants and commerce were held in very subordinate esteem, and commercial law had no existence. In the sixteenth century, the energies of the nation were absorbed in religious controversies; and in the first half of the next century in constitutional struggles and politics. At length, in the reign of Charles II., men, weary of polemics and politics, began to devote themselves more to industry and commerce; and this was greatly stimulated by the manifest advantages of banking which had just been introduced into England. Among fields of enterprise at that period, none seemed more promising than agriculture. But unfortunately all the available specie was absorbed in commerce; none was to be had for agriculture; or, at least, only at such rates as to be practically prohibitive. In no species of industry are the profits so moderate as in agriculture. Hence, if capital has to be borrowed to effect improvements in agriculture, it is requisite that it should be at a very low rate of interest. The usual rate of interest in the time of Charles II. was ten per cent., and few improvements in agriculture could bear that. But by the introduction of banking and the foundation of the Bank of England, the rate of interest in commerce was reduced to three per cent. It was this real want, and the enormous advantage which banking had been to commerce, which gave rise to the schemes of Asgill, Briscoe, Chamberlen, Law, and others, for the purpose of creating paper money based upon land; and to found land banks, to assist agriculture, as the mercantile banks had assisted commerce, which were so rife at this period.
One of these schemes was attempted to be carried out in 1696. The Ministry of William III. was not, as is now the case, formed exclusively of one party of the State. William III. reigned and governed; and the Ministry was his Ministry, and not that of the Parliament, as it is now. His Ministry was partly Whig and partly Tory. The Whig portion of it, who were in close connection with the mercantile community of the city, succeeded in founding the Bank of England in 1694, which was essentially a Whig project, and intended to assist the finance of the Government and commerce. The immense benefit of the Bank of England was so evident that the Tory portion of the Ministry endeavored to found a bank which should also assist Government, and besides that, be specially for the benefit of agriculture. It was attempted to be founded in 1696, and it was called the Land Bank. But the attempt did not succeed, and its failure was one of the causes which produced the stoppage of the Bank of England in 1697. There were, no doubt, defects in the scheme which fully accounted for its failure; but the want was very real, and the idea was perfectly sound. Among the projectors of a scheme for basing paper money on land, the most celebrated was John Law. He has given an elaborate exposition of his theory in a work entitled “Money and Trade Considered”; and he laid a scheme before the Parliament of Scotland in 1705, which they fortunately rejected, or there would have been a catastrophe in Scotland as great as that of the Darien scheme in 1699. Law had the opportunity of reducing his theory to practice in France in 1720, under the name of the Mississippi scheme. This is not the place to give an account of Law’s scheme. But ten years after its failure in France, the Scotch banks, by the admirable invention of cash credits, pushed credit to the utmost extent of its legitimate limits, and realized all that was practicable in the schemes of Asgill, Briscoe, Chamberlen and Law. And it is to these cash credits that the principal progress of Scotland in agriculture and all public works is due, as well as the personal wealth of its merchants. Moreover, after the end of the Seven Years’ War in 1763, an ingenious merchant devised a scheme of land banks in Germany, and it is to these land banks that the principal part of the progress of agriculture in central Europe is due.
ON CASH CREDITS.
The Bank of Scotland was founded in 1695 with unlimited powers of issue, both in amount and denomination. At first it only issued notes of £100, £50, £10 and £5. Though several times urged to do so, they did not issue £1 notes at first, but in 1704 they began to do so. The bank received a monopoly of banking for twenty-one years; but in 1716, when the monopoly expired, it was not renewed. In the year 1727 the proprietors of the Equivalent Fund were endowed by royal charter with powers of banking, and they assumed the name of the Royal Bank. In the very contracted sphere of commerce in Scotland at that time there were not sufficient commercial bills in circulation to exhaust the credit of the banks. They had, as it were, a superfluity of unexhausted credit on hand; and the bank devised a new scheme for getting its credit into circulation, which was the most marvelous development of credit ever imagined. It agreed, on receiving sufficient guarantees, to open credits of certain limited amounts in favor of trustworthy and respectable persons. A cash credit is a drawing account created in favor of a person who pays in no money, which he may operate upon precisely in the same manner as on an ordinary account; the only difference being that, instead of receiving interest on the daily balance of his account, as used formerly to be the case in Scotland, he is charged interest on the daily balance at his debit. A cash credit is, therefore, an inverse drawing account. Cash credits are applicable to a totally different class of transactions to those which give rise to bills of exchange, one difference being that bills of exchange arise out of the transfers of commodities, and are payable in one sum at a fixed date; whereas cash credits are not issued on the transfer of commodities or on any previous transactions. They are expressly intended to promote the formation of future products. They are not repayable at any fixed date; but they are a continuous working account which continues open as long as the operations are satisfactory. It is a condition of all cash credits that the persons to whom they are granted should accept all advances in the bank’s own notes.
If every future commercial profit has a present value, which can be brought into commerce and exchanged, the same is equally true of the land and of every commercial work or enterprise. The present value of every future profit from land or any commercial work can be brought into commerce and bought and sold exactly like the present values of the future profits of traders; and if the credit be strictly limited and redeemed by the future profits of the land or commercial work, credit may be created to purchase the present value of these future profits from land and commercial public works, exactly in the same way as it is created to purchase the present values of the future profits from traders.
CASH CREDITS GRANTED IN AID OF PERSONS.
Every man in business, however humble or however extensive, must necessarily keep a certain portion of ready money by him to answer immediate demands for small daily expenses, wages and other things. This could, of course, be much more profitably employed in his business, where it might produce a profit of fifteen or twenty per cent., instead of lying idle. But, unless the trader knew that he could command it at a moment’s notice, he would always be obliged to keep a certain amount of ready money in his till, unless he were able to command the use of some one else’s till. Now, one object of a cash credit is to supply this convenience to the trader, and to enable him to invest the whole of his capital in his business; and, upon proper security being given, to furnish him with the accommodation of a till at a moment’s notice, in such small sums as he may require, on his paying a moderate interest for the accommodation. Almost every trader in Scotland has a cash credit at a bank, by which he can draw out such sums as he may want for his daily business, and replace such as he does not want before the close of the bank hours. Almost every young man in Scotland commencing business does it by means of a cash credit. Thus, for instance, lawyers, or writers to the signet, commencing business, have occasion for ready money from day to day before they can get in payments from their clients. It is a great bar to any young man to commence the business of a solicitor without capital, which must either be furnished to him by his friends or others. It is an immense advantage to him and to them to have it supplied by a bank, by means of a cash credit, on a mere guarantee, a mere contingency, which they never would give if they thought there was any danger of its being enforced. So the great employers of labor, manufacturers, builders, ship-builders and others, have cash credits by which they can pay their laborers. These credits are granted to all classes of society; to the poor as freely as to the rich. Everything depends upon character. Young men in the humblest walks of life may inspire their friends with confidence in their steadiness and judgment, and they become sureties for them on a cash credit. This is in all respects of equal value to them as money; and thus they have the means placed within their reach of rising to any extent that their abilities and industry permit them. Multitudes of men who have raised themselves to immense wealth began life with nothing but a cash credit. As one example among thousands, Mr. Monteith, M. P., told the committee of the House of Commons in 1826 that he was a manufacturer, employing at that time 4000 hands, and that, except with the merest trifle of capital lent him, and which he soon paid off, he began the world with nothing but a cash credit.
The banks usually limit their advances to a certain moderate amount, varying from £100 to £1000 in general, and they take several sureties in each case. These cautioners, as they are termed in Scottish law, keep a watchful eye on the proceedings of the customer, and of inspecting his account with the bank and of stopping it at any time if irregular. These credits are not meant to degenerate into dead loans, but they are required to be operated upon by constantly paying in and drawing out. The enormous amount of transactions carried on by this kind of account may be judged of by the evidence given before the committee of the Commons in 1826. It was then stated that on a credit of £1000 operations to the extent of £50,000 took place in a single week. Others stated that on a cash credit of £500 operations to the amount of £70,000 took place in a year. One witness stated that in a very moderately sized country bank operations to the amount of £90,000,000 took place in twenty-one years, and that the whole loss to the bank during that period was £1200. At that time, it was conjectured that there were about 12,000 cash credits guaranteed by about 40,000 sureties, who were interested in the integrity, prudence and success of the customers. The witnesses before the Lords declared that the effects of these were most remarkable on the morals of the people.
ON CASH CREDITS GRANTED TO PROMOTE AGRICULTURE AND THE FORMATION OF PUBLIC WORKS.
We have now to consider the way in which the Scottish system of cash credits has been applied to promote agriculture and the formation of all manner of public works.
The two Scottish banks which were first founded applied their cash credits to assist the industry of traders, and tended much to foster it. Agricultural industry had not then awoke. The Scots were a fierce, turbulent people, who thought a great deal more of harrying their neighbors than of peaceful agriculture. The land was bound down under the fetters of the feudal system. But, after the suppression of the rebellion in 1746, the feudal system was to a great extent broken up, and a great spirit of enterprise awoke; and then, for the first time, Scotland became an industrial nation. At this time, there were in many parts of Scotland large tracts of reclaimable land and multitudes of people, but they remained unemployed, because there was no money in the country to set their industry in motion. Now, suppose that a proprietor of one of these tracts of land had had £10,000 in money, and that he employed it in paying wages to laborers and in buying seed to sow; then, in course of time, the value of the produce of the land would replace the sum expended in bringing the land into cultivation. Then the money so employed would have been expended as capital. But at that time there was, comparatively speaking, no money in the country. It was just then emerging from the bonds of feudalism. The chiefs had vast tracts of lands, and no doubt lived in a state of rude abundance, from their herds and flocks and the natural produce of the soil. But commerce had never penetrated into these Highland strongholds; and consequently the greatest chiefs were very seldom blessed with the sight of coin. But at this period began the transition from feudalism to industrialism, in which money was absolutely indispensable. It was at this time that the banks, having habituated the people during forty years to receive their £1 notes in all respects as money, and having acquired their thorough confidence, threw out branches in all directions, and sent down boxes of their £1 notes. Farmers at that time had no votes in Scotland, and consequently the landlords had no motives to keep their tenants in political thraldom, as was too much the case in England. They adopted every means possible to develop the resources of the soil. And as it was not to be expected that the farmers would lay out their capital and industry on the soil without security of tenure, it became the custom, almost universal in Scotland, for landowners to grant their tenants leases of nineteen years; and in many cases, for particular reasons, much longer than that. Upon the security of these leases, and also upon that of personal friends, the banks everywhere granted cash credits to the farmers, the advances being made exclusively in their own £1 notes. From the strong constitution of the banks, and the universal confidence they had acquired, their notes were universally received as cash; and though they were demandable in cash at the head office, no one ever dreamt of demanding payment for them. With these advances in £1 notes, the farmers employed the laborers in reclaiming the land, bought seed and sowed the crops. The notes were employed in exactly the same way as money would have been, and they produced exactly the same effects as money would have done. The land was reclaimed, and sown, and stocked; and, in a few years, bleak and barren moors were everywhere changed into fields of waving corn, and they produced a continuous series of profits. With the value of the produce, the farmers gradually repaid the loans and reaped a profit.
Now, if it be admitted that money expended in agricultural improvements is used as productive capital, how can it be denied that credit, employed in exactly the same way, and which produces exactly the same effects as money, and produces exactly the same profits, is also equally productive capital? The £1 notes were universally received by the people as of exactly the same value as money; and therefore they were in all respects money; they produced exactly the same profits that money did. Now, as we have seen, that capital is anything which produces a profit, it is evident that the £1 notes were just as much productive capital as the money. The only difference was that, in using money, the employer made capital of the realized profits of the past; in using credit he made capital of the expected profits of the future. But the results are exactly the same in either case. Every one acquainted with Scotland knows perfectly well that the prodigious progress in agriculture made in that country during the last 140 years has been almost entirely effected by means of these cash credits. Not only has almost the entire progress in agriculture been effected by these cash credits, but all public works of every description—roads, canals, docks, harbors, railways, public buildings, etc., have also been made by the same means. It was stated to the committee of the House of Commons in 1826, that the Forth and Clyde Canal was executed by means of a cash credit of £40,000 granted by the Royal Bank. So when a road has to be made, the trustees obtain a cash credit, and pay it off out of the rates. So when a railway, a dock, a harbor, a public building, a canal, is to be made, the directors obtain a cash credit and so pay the wages of the men.
It is thus seen how credit is applied to the formation of new products equally well as to the transfer of existing ones. Credit is purchasing power equally as money; and it may be applied to purchase labor to form new products equally well as to transfer existing ones. The principle of the limit, however, being exactly the same in both cases—namely, that it is the present value of the future profit. When money is used to produce a profit, it is expected that the profit will replace the money advanced; when credit is used to produce a profit, it is expected that the profit will redeem the debt incurred. Hence credit can do whatever money can do; but we have shown that credit is the inverse of money. Hence, in mathematical language, all the propositions which are true with respect to money are equally true with respect to credit, only with the sign changed.
Exactly the same effects were produced in England by the use of bankers’ notes. The success of the Bridgewater Canal had exactly the same effect as the success of the Liverpool & Manchester Railway eighty years later. The period from 1776 to 1796 was just as great an era in canal making as the subsequent period in railway building, considering the wealth of the country at the respective times. In the course of twenty years, England, from being the most backward country in Europe in water communication, was covered with a network of canals such as no other country but Holland can boast. These canals were made by the notes issued by the country bankers. Burke says that when he first came to London there were not twelve bankers out of London. In 1793 there were 400. However, these bankers, not having the solid constitution of the Scottish Banks, were swept away in multitudes in the panics of 1793 and 1797. But, nevertheless, though the bankers were swept away, the solid results of their issues of notes remained. Thus it is now clearly demonstrated that credit may be used as productive capital, exactly in the same way and in the same sense, and for all the purposes, that money is.
THE SCOTTISH SYSTEM OF CASH CREDITS.
All these marvelous results, which have raised Scotland from the lowest depth of barbarism up to her present proud position in the space of 200 years, are the children of pure credit. It is no exaggeration, but a melancholy truth, that at the period of the revolution in 1688, and the foundation of the Bank of Scotland in 1695—partly owing to such a series of disasters as cannot be paralleled in the history of any other independent nation; partly owing to its position on the very outskirts of civilization, and far removed from the humanizing influence of commerce; divided into two nations, aliens in blood and language—Scotland was the most utterly barbarous and lawless country in Europe. And it is equally undeniable that the two great causes of her rapid rise in civilization and wealth have been her systems of national education and banking.
Her system of banking has been of infinitely greater service to her than mines of gold and silver. Mines of the precious metal would probably only have demoralized her people, and made them more savage than they were before. But her banking system has tended immensely to call forth every manly virtue. It has taught them industry, steadiness and moral rectitude. In the character of her own people, Scotland has found wealth infinitely more beneficial to her than all the mines of Mexico and Peru. The express function of the banks was to create credits, incorporeal entities, created out of nothing, for a transitory existence; and, when they had performed their functions, vanishing again into the nothing from whence they came. And has not this credit been capital? Will anyone, with these results staring him in the face, believe that there are some persons who are supposed to be economists who maintain that the results of credit are purely imaginary? That credit conduces nothing to production and the increase of wealth? That credit only transfers existing capital? But even if it did no more than that, it has been shown that circulation or transfer is one species of production; as is indeed now admitted by all economists of note, and that these persons who say that credit is capital are such puzzle-headed dolts as to maintain that the same thing can be in two places at once!
Circulating credits of all kinds have exactly the same effects as money, both in circulating existing commodities and in promoting the formation of new products. And they may be used as productive capital, exactly in the same way and in the same sense that money is. It must be observed that all these cash credits are for a distinct purpose, quite different from the discount of mercantile paper. The marvelous results they have produced are due to a system of pure accommodation paper. They are not founded on any previous transactions; nor are they for the purpose of transferring existing commodities. They are created for the express purpose of bringing new products into existence which, but for them, would either have had no existence at all, or at all events would have been deferred for a very long period, until solid money could have been accumulated to effect them. They are founded on exactly the same principles as the discount of mercantile bills. In discounting mercantile bills, the banker merely buys up the right to a future payment to be made out of the profits of the transaction. In creating cash credits the banker merely buys the right to a future payment to be made out of the future profits of the land or other public works.
The invention of cash credits has advanced the wealth of Scotland by centuries. We have an enormous mass of exchangeable property created out of nothing, by the mere will of the bank and its customers, which produces all the effects of solid gold and silver; and when it has done its work, it vanishes again into nothing, at the will of the same persons who called it into existence. What the Nile is to Egypt, that has her banking system been to Scotland; and it was fortunate for her that the foundations of her prosperity were laid broad and deep before the gigantic fallacy was dreamt of that the issues of banks should be inexorably restricted to the amount of gold they displace; that no increase of money can be of any use to a country; and before Mill had proclaimed to the world that to create credit in excess of specie is robbery!
The reader will now perceive the gigantic utility of the £1 note system to Scotland; and comprehend the consternation and fury of the Scottish people when various attempts have been made by Parliament to suppress them. When Parliament suppressed £1 notes in England, in consequence of the evils they were alleged to produce, owing to the bad organization of the English banking system, before the monopoly of the Bank of England was first broken up in 1826, it was intended to have suppressed them also in Scotland. But all Scotland rose up against it; and, headed by “Malachi Malagrowther,” raised such a commotion that an inquiry was granted which first made the Scottish system of banking understood, and the attempt was abandoned. Still, however, constant jeers and gibes were addressed to the Scotch people by persons who knew nothing about the subject, about their fatuous attachment to their “dirty £1 notes.” But the Scotch knew their value to the country far better than their assailants. The Scotch knew that the prosperity of their country was bound up with the cash credits; and cash credits were bound up with the issue of £1 notes. To have suppressed the Scotch £1 notes at that time would have destroyed two-thirds of the business of the banks. The extent of commerce in Scotland at that time was not sufficient to support the public banks. It was stated that at that time two-thirds of the business of the Scottish banks consisted in cash credits, though we are informed that now, in consequence of the great development of commerce, the ratio of cash credits to the mercantile business of the banks has considerably diminished.
Happily, however, no such attempts will ever be made again, now that the subject is better understood. Parliament is, however, justified in taking any measures it may be deemed necessary to secure their perfect safety and convertibility. So completely has the tide of opinion changed, that the question now is whether £1 notes can be reintroduced into England. But, with the present transitional state of banking in England, it is premature to discuss that question.
ON THE CLEARING HOUSE.
One of the great improvements in modern times, in the organization of credit, is the institution of clearing houses; and as the effect of these, like everything else in banking, is the subject of great misconception, we must explain their operation. It is usually stated that the Clearing House is an example of the principle of compensation, like that effected by the foreign merchants at the Continental fairs. In foreign treatises the Clearing House is usually called a Maison de Compensation, or de Liquidation. This, however, is a complete error.
It has been shown that if any number of customers of the same bank have transactions among themselves, and give each other cheques on their accounts, any number of transactions may be settled by mere transfers of credit from one account to another without a single coin being required, so long as the receiver of the cheque does not draw out the money. Such transfers are novation. The clearing system is a device by which all the banks which join in it are formed, as it were, into one huge banking institution, for the purpose of transferring credits from one bank to another without the use of coin; just in the same way that credits are transferred in the same bank from one account to another without the use of coin. The Clearing House is, therefore, not a Maison de Compensation, but it is a Maison de Novation. Every banker has every morning claims on behalf of his customers against his neighbors, and they have claims on behalf of their customers against him. These claims are called bankers’ charges. Formerly it was the custom for every banker to send out his clerks the first thing in the morning to collect these charges, which had to be paid in money or bank notes. Having collected these charges, he credited his customer with the sums due to him. Now, when the banker had paid the charges against him, there was of course so much credit extinguished. The money and bank notes collected by the banker became his actual property, but he was obliged to create an equal amount of credit on behalf of his own customers; so that, on the whole, an exactly equal amount of credit was recreated to what had been extinguished. And so the final result was that there was exactly the same amount of credit in existence. But each of his neighbors had also claims on behalf of their customers against him. Consequently, every banker was obliged to keep a large amount of money and bank notes to meet these claims. By this a very large amount of money and bank notes had to be retained for the purpose of meeting these bankers’ charges; it was simply transferred and re-transferred from bank to bank; it never got into general circulation at all so as to affect business or prices, and it could be made no other use of.
It was stated before the House of Commons, many years ago, that one bank alone, the London and Westminster, was obliged to keep £150,000 in notes for this sole purpose. And if one bank alone, then comparatively in its infancy, was obliged to keep such a sum in notes idle for this purpose, what would have been the sum necessary to be retained at the present day by all the banks, if it were not for the Clearing House? To remedy this inconvenience, an ingenious method was devised, it is said, by the banks at Naples in the 16th century. The banks instituted a central chamber to which each sent a clerk. These clerks exchanged their different claims against each other, and paid only the difference in money. By this means the different credits were readjusted among the different customers’ accounts just as easily as before; and a large amount of money and notes were set free for the purpose of circulation and commerce; and were in fact, for all practical purposes, equivalent to so much increase of capital to the banks and to the country.
This system was first adopted in this country by the banks in Edinburgh. And we have now to show that no permanent extinction of credit takes place as in compensation; the final result is only a transfer of credit, that is a novation. Suppose that a customer of the Commercial Bank has £100 in notes of the Royal Bank paid to him. He is then creditor of the Royal Bank. He pays these notes into his account with the Commercial Bank. He desires the bank as his agents to collect the proceeds of these notes from the Royal Bank, and to place the amount to his credit. Suppose that, in a similar way, a customer of the Royal Bank has £100 in notes of the Commercial Bank paid to him. Then he is creditor of the Commercial Bank. He pays these notes into his account with the Royal Bank, and constitutes them his agents to collect the proceeds from the Commercial Bank and place them to his credit. Each bank is then debtor to the customer of the other. The full way of proceeding would be for each bank to send a clerk to the other to collect the notes in money. Each bank then having obtained payment of the notes in money would place to the credit of its customer, and put the money which would become its own property into its own till, just as if the customer had paid in the money himself. In this case it is evident that there is no permanent annihilation or extinction of credit; because by the process each bank, instead of being debtor to the customer of the other, becomes debtor to its own customer. Thus it is evident that in each case there is a novation, and not a compensation. This method of settling the claims of the customer would require £200 in money.
The same result may be obtained in a much simpler way. Let the agents of the two banks meet. The agent of the Commercial Bank says to the agent of the Royal Bank: “In consideration of your giving up to me the notes held by your customer by which I am debtor to him, and so releasing me from my debt to him, I agree to credit my customer with their amount, and so become debtor to him.” This is a novation. The agent of the Royal Bank says to the agent of the Commercial Bank: “In consideration of your giving up to me the notes held by your customer, by which I am debtor to him, and so releasing me from my debt to him, I agree to credit my customer with this amount, and to become debtor to him.” This is also a novation. The agents of the two banks then exchange notes, and each bank having received £100 in its own notes—that is, being released from its debt to the customer of the other, which, as we have seen, is equivalent to a payment in money—enters the amount to the credit of its own customer. By this means, each bank, instead of being debtor to the customer of the other, becomes debtor to its own customer, and the use of £200 in money is saved. The release of the debt of each bank to the customer of the other is the consideration for the creation of the debt to its own customer. No doubt the £100 of notes from each bank are withdrawn from circulation and replaced in its own till. But an equal amount of credit is created and placed to the credit of each customer, so that upon the whole the quantity of credit remains exactly the same. Thus, the debt of each bank to the customer of the other is extinguished by the new debt created in favor of its own customer. And the whole transaction consists of two novations.
The reason why the operations of the merchants at the Continental fairs were compensations in which both credits were extinguished, and the operations of the Clearing House are novations, in which new credits are created, which pay and extinguish the prior ones, but create an equal amount of new credits, so that the whole amount of credit remains exactly the same as it was before, is this: In the case of the merchants they were principals; they were mutually indebted to each other; when, therefore, they exchanged their mutual debts they were canceled and extinguished, and no new debts were created to replace them. But, in the case of the Clearing House, the banks are not principals, they are only agents for their customers; consequently, when they receive their own notes, and so are released from their debts to the customer of the other, they are bound to create an equal amount of credit in favor of their own customer, which cancels and extinguishes the former debts, but leaves exactly the same amount of credit existing. Hence, the Clearing House is a Maison de Novation, and not a Maison de Liquidation or Compensation.
The system of clearing was adopted by the city bankers in 1776, but the Bank of England was not admitted to it. Nor were the joint-stock banks admitted to it till 1854; when the charges of the joint-stocks pressed so heavily on the private bankers that they were obliged to admit them. The Bank of England was not admitted till 1864. The charges of the London bankers consist of cheques and bills of exchange, and not in notes; but that makes no difference in the principles of the case. A cheque or bill on a bank by a customer who has funds on his account to meet it is in all respects equivalent to a note of the banker himself. They collect the cheques and bills due to their customers and rearrange the credits due to the various parties exactly in the same way as if they were notes. Before 1864, the differences payable by the banks were settled by bank notes, and it is said that about £250,000 were required for that purpose. But in 1864, when the Bank of England was admitted, the system of clearing was further improved, so that the use of coin and bank notes is now entirely dispensed with. Every clearing bank keeps an account with the Bank of England, and the inspector of the Clearing House keeps one also. Printed lists of the clearing banks are made out for each bank with its own name at the top, and the others placed in alphabetical order below it. On the left side is the debtor’s column and on the right side the creditor’s. The clerk of the Clearing House then makes up the accounts between each bank, and the difference only is entered in the balance sheet according as it is debtor or creditor. A balance is then struck between the debtor and creditor side, and the paper delivered to the clerk, who takes it back to his own bank. The balance is then paid to or received from the Clearing House. If the bank is debtor it gives a white ticket to, and if it is creditor it receives a green ticket from, the Clearing House. By this most ingenious system not a single coin or bank note is used, and the sums transferred by this means at the present time are about £7,000,000,000 a year.
HOW MERCANTILE BILLS OF EXCHANGE ARE PAID.
We have now to show how erroneous are the ideas of those writers who, like Torrens and Mill, and the sect who supported the Bank Act of 1844, think that all bills of exchange are paid in money or bank notes.
All merchants and traders not only buy goods on credit, but they also sell them on credit. Hence, they are not only indebted on their own acceptances to those from whom they have bought goods, but they hold the acceptances of those to whom they have sold goods. Now, a merchant knows when his own acceptances are coming due, and if he has not sufficient funds on his account to meet them, he has only two methods of providing for them. He must either sell his goods in the market or he must discount the acceptances he holds with his banker. The latter is, of course, the preferable plan. Accordingly, when his balance is low, and his own acceptances are falling due, he simply takes a batch of the acceptances he holds and discounts them with his banker, who buys them by creating a credit, debt, right of action or deposit in his favor, and thus increases his balance. The merchant, of course, makes his own acceptances payable at his banker’s; consequently, on the day they mature and become debts, they are simply cheques; and the whole mass of bills and cheques pass through the Clearing House; and, as we have shown in the description of the operations there, the whole transactions are settled by pure transfers of credit, without the use of a single coin or bank note. Hence, in our present highly organized system of credit, bills of exchange are not paid in money or bank notes at all, except only in a very few isolated cases; but they are paid exclusively by the constant creation of new banking credits. Hence, in our present system, the constant creation of banking credits is a matter of vital necessity. If the London bankers were suddenly to give notice that next day they would stop discounting, the result would be that nineteen out of twenty merchants would be ruined. But more than that. As the merchants would, of course, exhaust all their means to maintain themselves, they would instantly draw their balances, and thus the bankers would draw upon themselves a run for gold. It is perfectly well understood by all bankers that “an excessive restriction of credit causes and produces a run for gold.” And thus bankers and merchants will all come down in one universal crash.
ON THE TRANSFORMATION OF TEMPORARY CREDIT INTO PERMANENT CAPITAL.
We shall now give an example of the doctrine that the release of a debt is in all cases equivalent to a payment in money, which may surprise some of our readers, and of which we have not seen the slightest notice anywhere else.
When it is published to the world that the Bank of England has a paid-up capital of £16,000,000, and that the several joint-stock banks have paid-up capital of some millions, most persons take it for granted that the banks have these sums paid up in hard cash. Nevertheless this is a profound error. Of course it is impossible for any outsider to have any precise knowledge as to how much of these amounts was ever paid up in actual money. But it may probably be said with safety that not so much as one-half of these various amounts was ever paid up in real money, but by another method which we shall now describe; by which it will appear that at least one-half of these millions of “capital” was never anything more than the bank’s own credit turned into “capital.” To explain this, we may observe that the first subscription to the Bank of England was £1,200,000; paid of course in actual money. It was advanced to Government, and the bank was allowed to issue an equal amount in notes, which were of course an augmentation of the currency. In 1696, the bank stopped payment, and its notes fell to a discount of twenty per cent. In 1697, Parliament undertook the restoration of public credit; and it was determined to increase the capital of the bank by £1,000,000. But not one penny of this was paid up in actual money. The act directed that £800,000 of the subscription should be paid up in exchequer tallies or exchequer bills; and the remaining £200,000 in the bank’s own depreciated notes, which were received at their full value as cash. Thus, of its first increase of capital, £200,000 consisted of its own depreciated notes. The bank was authorized to issue an additional amount of notes equal to its increase of capital. At subsequent increases of capital the subscribers might pay up any amount they pleased in the bank’s own notes, which were always held as equivalent to a payment in money, and an increase of capital. In 1727, the Bank of Scotland increased its capital. The subscription was paid up partly in the bank’s own notes. An outcry was made against this. But the directors justly answered, “But the objectors do not at all consider this point, for the payments are many of them made in specie; and bank notes are justly reckoned the same as specie, when paid in on a call of stock; because when paid in, it lessens the demand on the bank.” Hence the directors clearly understood that the release of a debt is in all respects equivalent to a payment in money. The bank had issued its notes, and was, of course, debtor to the holders of them. These debts were negative quantities. The subscribers might either pay in money, which was + × +, or release the bank from its debts, which was − + −; and the effect of either transaction was exactly the same. At every increase of capital the same operations would be repeated; payment in money and in the bank’s own notes would always be treated as equivalent. And hence, at every fresh increase of capital, a certain amount of the bank’s own temporary credit was turned into permanent capital. Thus we see that the Parliament of England and the directors of the Bank of Scotland, who were probably equally innocent of Roman law and algebra, simply from their own mercantile instinct treated the release of a debt as in all respects equivalent to a payment in money.
Banks, therefore, which issue notes may increase their capital by receiving their own notes in payment, by which they turn their own credit into capital. But banks which do not issue notes may increase their capital exactly in the same way. A customer of the bank who has a balance to his credit is in exactly the same position as a noteholder. If he wishes to subscribe to an increase of capital he simply gives the bank a cheque on his account. This is equally a release from a debt as a payment in the bank’s own notes, and an increase of capital. If the customer has not sufficient on his account to pay for the stock he requires, he may bring the bank bills to discount. The bank discounts those bills by creating a credit or deposit in his favor; which, of course, is a negative quantity exactly like a bank note. The customer then gives the bank a cheque on his account—that is, he releases the bank from the debt it has created, and that debt released becomes increase of capital. This is the way in which the capital of all joint-stock banks is increased; and it may go on to any extent without any payment in money. And, consequently, it is wholly impossible for anyone who has not had access to the books of the bank to ascertain what proportion of the capital consists of payment in money, and what proportion consists of the bank’s own temporary credit turned into permanent capital.