Chapter xv.


“ The peculiar essence of our banking system is an unprecedented trust between man and man, and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.”

WALTER BAGEHOT, in “Lombard Street.”

THE practice of modern banking may be instanced as further proof of the contention made in the preceding chapters regarding the falseness of our current theories of finance.  A system founded upon unsound theories must—sooner or later—create trouble, and conversely a system which periodically fails may be said to have a false basis.

A nation’s industries necessarily depend upon its banking facilities, and it is impossible to form a just estimate of the banking system of any country without considering its effects upon and its relation to the industries and trade of that country.  If ever a true history of modern banking is written it will be found to consist largely of a record of industrial failures and business disasters.  There is not a bank in the world—established for any considerable period—that has not experienced difficulties threatening its stability and existence, and if custom did not prevent us from seeing things in their true light, modern banking would be regarded as both crude and dangerous in the extreme.  Banking has been facetiously termed “ the great confidence game,” and has been odiously compared to the art of jugglery—and certainly there is some foundation for such criticism, for when public confidence is shaken and creditors demand fulfilment of obligations, banks close their doors, since their obligations greatly exceed their powers of redemption.  It is safe to say that any business man who attempted to carry on an industrial pursuit on the same principles as those followed by ordinary banks would be considered foolhardy.  Take for instance a bank of deposit where deposits are received from one class of customers and loaned to another class ;  a comparatively small percentage of currency is retained as a reserve fund.  Now, deposits are received on the understanding that they are payable on demand—on the other hand loans are made for definite periods, 10 days, 30 days, 60 days, and even longer.  So long as depositors are satisfied to leave their deposits, all goes well, but a mere rumour or flurry is often quite sufficient to lead to a sudden demand for withdrawal, and then the unsafety of modern banking becomes apparent.  Even the Bank of England, which is regarded as a Gibraltar of financial security, and upon the solvency of which England’s commerce depends, is removed but a few degrees above the danger line upon which all other banks conduct their business.  In his excellent work called “Lombard Street” Walter Bagehot says :—

“ English trade has become essentially a trade on borrowed capital, and it is only by this refinement of our banking system that we are able to do the sort of trade we do, or to get through the quantity of it.” ... “ There never was so much borrowed money collected in the world as is now collected in London.  If any large fraction of that money really was demanded, our banking system and our industrial system too, would be in great danger.” . . . “ We see then that the banking reserve of the Bank of England—some 10,000,000* on an average of years now, and formerly much less—is all which is held against the liabilities of Lombard Street ;  and if that were all we might well be amazed at the immense amount of our debts payable on demand, and the smallness of the sum of actual money which we keep to pay them if demanded.  But there is more to come.  Lombard Street is not only a place requiring to keep a reserve, it is itself a place where reserves are kept.  All country bankers keep their reserve in London.  They only retain in each country town the minimum of cash necessary to the transaction of the current business of that country town.  Long experience has told them to a nicety how much this is, and they do not waste capital and lose profit by keeping more idle.  They send the money to London, invest a part of it in securities, and keep the rest of it with the bankers and the bill brokers.  The habit of Scotch and Irish bankers is much the same.  All their spare money is in London and is invested as all other London money now is ;  and therefore the reserve in the banking department of the Bank of England is the banking reserve not only of the Bank of England, but of all London—and not only of all London, but of all England, Ireland and Scotland too.”  And again, “ In consequence all our credit system depends upon the Bank of England for its security.  On the wisdom of the Directors of that one joint stock company it depends whether England shall be solvent or insolvent.  This may seem too strong, but it is not.  All banks depend on the Bank of England, and all merchants depend on some banker.”  In another place he says, “ So far from our being able to rely on the proportional magnitude of our cash in hand, the amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it.”  No greater condemnation of a system upon which the entire commerce and wealth of a nation is built could possibly be made ! !

A comparison has been drawn between banking and the system upon which life insurance companies conduct their business.  It is said that a bank of deposit is quite as secure as a life insurance company, and that the objection above raised regarding the dangers of modern banking apply with equal force to insurance companies.  If more than a certain proportion of the holders of insurance policies should die within a given period, the effect on the companies would be similar to a run on the bank, and insolvency would result.  But consideration will shew that there is no proper analogy between the two systems.  The natural love of life induces members to avoid unnecessary danger and prompts them to use every means for prolonging existence.  But it is this very desire for self-preservation that often precipitates bank failures.  The moment depositors believe their money to be in danger they seek to withdraw it.

It is a strange anomaly that finance, which is the life blood of trade and industry, should be conducted upon rules the very opposite of those that govern the industrial arts.  In the construction of a bridge, a vessel, or a machine, provision is made that it shall withstand the greatest strains and the roughest usage to which it may be subjected, and a margin known as the “factor of safety ” is allowed.  Our financial system, however, seems to be based upon the opposite theory.  In banking, the margin appears entirely on the other side, and may with justice be termed the “factor of unsafety.”  A banker’s success is usually shewn by the smallness of the reserve he keeps on hand in proportion to the amount of his liabilities, since this is in reality the measure of his profits.  In fact this “ margin of unsafety ” is, under our present system, unavoidable ;  for the direct object pursued by the directors of a bank is to make profits for their shareholders, and these profits are made by lending the money of depositors to whom it is returnable on demand.  For a bank to hold a reserve at all commensurate with its liabilities is pronounced a waste of capital and an unprofitable policy to shareholders, and all that is necessary—it is claimed—is to maintain the confidence of customers by making them believe that their claims can be satisfied whenever presented.  The art of banking is, therefore, similar to the well-known stage device of representing an army marching.  A few men, by marching in an endless chain across the stage and behind the scenes, complete the illusion ;  and just so long as one does not venture behind the scenes, the illusion can be maintained.  So with banking.  A small amount of money is made to do duty for heavy liabilities.  The banker is therefore “between the devil and the deep sea.”  To make his position secure and satisfy depositors he must retain a reserve equal to his liabilities, in which case his profits are nil.  To satisfy his shareholders he must earn dividends, and thus endanger the safety of depositors.  What are known as “ safe ” banks strike a medium between the two and trust to luck !

It has already been shewn that our currency laws restricting the volume of currency to the amount of gold available necessitates the creation of a substitute in the shape of credit which consists in promises to pay gold, promises which at all times are precarious, and in times of trouble become impossible of fulfilment.  And when Gold Standard advocates extol the English currency system they ignore altogether the credit system which is its necessary partner, and without which English trade could not possibly be carried on.

The money of the country, scientifically speaking, includes not merely legal tender, but all forms of credit, bills of exchange, promissory notes, cheques, etc., all of which perform the money function, and it is only by viewing the question from this standpoint that we can adequately grasp the enormous risks to which trade and commerce are now subjected !

In reading works on banking the student cannot fail to notice the absence of all reference to the principal functions of money.  Instead of treating money as the medium of exchange it is regarded merely as a loanable commodity.  To the banker money is a commodity to be bought and sold and let out on hire.  And the scarcer the supply in relation to the demand the higher the price of the loan.  Hence dear money is a condition sought by the money-lender just as eagerly as the farmer desires high-priced wheat or the butcher dear meat.  This is the natural result of regarding banking as a “trade” and money as a commodity.  The dividends made by banking institutions are of much greater importance to the banker than the growth of commerce, and there is far more commotion over the loss of 100,000 by the failure of a bank than the loss of a hundred millions by failures in trade.  The evils arising from this system are simply incalculable.  It is the parent of industrial troubles, stagnation and bankruptcy.  That banking should be subordinate to trade and to its necessities does not seem to have occurred to writers on this subject, and yet this is its true and proper position.  A rational banking system would be adjustable and subservient to the needs of commerce, but our present system is quite the reverse.  Commerce is compelled to adjust itself to certain rigid rules formulated a generation ago, when business was a very insignificant affair compared to what it is to-day.  The question then naturally arises, can a banking system be devised which will facilitate commerce, and enable business to proceed without the possibility of a panic arising to endanger its stability ?  Can such a system be established which will enable wealth producers to exchange their products fairly and without the dangers and evils enumerated ?  Unquestionably yes.  Ricardo has said, “ On extraordinary occasions a general panic may seize the country when everyone becomes desirous of possessing himself of the precious metals as the most convenient mode of realizing or concealing his, property—against such panics banks have no security on any system.”  And this undoubtedly is true so long as laws give to the precious metals the sole and supreme privilege of functioning as legal tender.  As we have already seen, panics arise from knowledge of the fact or fear that banks have undertaken obligations which they are unable to fulfil, and it is this knowledge or fear which leads depositors to seek to withdraw their holdings.  The following principles should underlie sound banking :  first, bank notes should be issued against wealth and not against debt ;  second, banks should not undertake obligations which they cannot always perform ;  third, banks should be established and operated for the convenience and assistance of commerce, not for enriching bankers and shareholders.  These conditions are admirably fulfilled in what is known as the Mutual Banking System.  A mutual bank is one established by commercial men for the purpose of issuing notes or paper money against satisfactory credit, or wealth, and for the sole purpose of facilitating trade.  There is no bank stock, and there are therefore no dividends.  Any member of a community can become a member of the bank, providing his credit is good and he has wealth suitable for monetization.  No regular rate of interest is exacted for monetizing wealth or for borrowed money, but charges sufficient to defray the running expenses of the bank, and for insurance, are made.

Every member of the bank agrees to accept its notes in payment for services and goods.  In case of loans, the bank is forbidden to lend more than a fixed proportion of the wealth pledged—say 25 per cent.—leaving an ample margin for fluctuations.  The notes are made returnable within a definite period, and if desired they can be again issued after a further valuation of the property has been made.  Return of the bank notes releases the property pledged.  Such notes issued against wealth and with a proper margin for fluctuations in price, are a perfectly safe form of money, and it is evident that no panic can arise under such a system.  For the bank is merely the holder of wealth pledged for the return of notes issued.  Mutual Banking is exceedingly simple and by no means new—it was proposed by Beck in England, Proudhon in France, and Col. Greene in the United States, many years ago.  Beck suggested the application of what is known as “ credit in account,” whilst Proudhon advocated generalizing the “ bill of exchange ” and using this as the money token, but neither of these advocates were allowed to put their ideas into practice for a time sufficient to demonstrate their practicability.  Proudhon’s system was peremptorily stopped by the French Government, and its author thrown into prison (a simple and summary method adopted by Governments for demonstrating the impracticability of economic innovations).  The unsafety of modern banking is in fact wholly due to the restrictions and interference of Governments in matters which properly belong to the industrial and commercial branch of society.

The monetary system advocated by Col. Greene, in a pamphlet published by “ The New England Labour Reform League,” contains, however, a very serious fallacy, which if practised would lead to all the disasters already enumerated.  Col. Greene insists that a given weight of some commodity (gold or silver) must be employed as a “ standard of value,” and that paper money issued by the mutual bank must always bear a fixed relation to this amount of specie.  The contention of Col. Greene and his disciples is, that the evils of a specie currency result from the specie basis, i.e. agreeing to redeem paper money in specie.  They contend that a promise of specie redemption is not necessary in order to maintain mutual notes at a parity with gold or silver.  In other words, they insist upon retaining the so called “ standard ” and abolishing the basis.  But it is evident that the one necessitates the other.  To say that a paper dollar is on a par with gold is merely another way of stating that this piece of paper will exchange in the market for the legally fixed weight of gold which is made equivalent to the dollar, viz., 23.22 grains.  And it remains at par only so long as this exchange can be effected at the desire or on demand of the holder of the paper dollar.  But what guarantee has the holder of a mutual bank note that it will always remain at par with gold ?  Col. Greene maintained that the mere agreement of the members of the bank to accept its notes always in lieu of gold would be sufficient to maintain the parity.

Now mutual banking—to be successful—must provide for the accommodation of the members of all branches of industry, including jewellers and dealers in specie.  A guarantee from this class would therefore be needed to always accept mutual notes at a fixed ratio with gold.  In other words, it would involve a promise of redemption in gold on the part of its dealers.  The only difference then between Greene’s Bank and a specie paying bank, is that in the latter the bank promises gold redemption, in the former individuals would be required to do so.  But why should gold merchants agree to accept mutual notes always at a fixed ratio with their commodity, any more than the butchers, bakers, farmers, and other producers at some predetermined ratio for their products ?  The idea is preposterous.  On the other hand, assuming that the mutual bank excludes specie dealers from its field of operations, what sense is there in requiring members to agree to accept notes in lieu of and as an equivalent for a certain commodity which—as Col. Greene intimates—they do not need ?

The demand for money is one thing.  The demand for a commodity is another.  And why people should seek to tie together totally different, independent desires is incomprehensible.

The purchasing power of gold is due to two causes.  These are, first and principally the privilege accorded it by law of functioning as legal tender and as a debt-discharging instrument, and secondly, its utility in the arts.  The demand for a debt-paying instrument is an almost unlimited demand and is now centred upon gold, solely because laws have been passed by many nations giving it this privilege and giving it to no other commodity.  The demand for this instrument is wholly independent of the material of which it is composed, and hence paper functions as a substitute for gold—a sufficient demonstration of the fact that gold is altogether unessential for currency purposes, and that but for laws, it would never be used outside of the Arts.

The demand for gold in the Arts is quite distinct from the demand for it as legal tender.  The former demand is due solely to natural causes, and can be satisfied by no artificial substitute, such as paper.  It is in the Arts that the qualities of gold—ductility, malleability, non-corrosiveness, etc.,—lead to a genuine demand for this particular metal, since it can be satisfied only by something possessing these qualities.  But a debt-paying instrument requires no such qualities as those pertaining to gold.  “ General purchasing power ” is the only attribute that is needed to make an instrument effective as money.  The fundamental error of Greene and his followers, is in regarding value as a positive quantity, and as having an objective existence.  This fallacy pertains to the “ intrinsic value ” theory, a theory long since exploded.  Had Col. Greene perceived that value is merely a relation of quantities—expressed by a numerical ratio—he would have realised the absurdity of the expression “standard of value.”  Considering that the world’s present stock of gold held for coinage purpose is sufficient to supply the demand in the Arts—at the present rate—for more that 50 years, it is quite certain that the high price of gold is due almost entirely to its legally acquired money functions.

Take an analogy.  Supposing a substitute for wheat was discovered which could be furnished for 1/100th part of its cost, a substitute which proved as nutritious, as healthful, and as palatable as wheat.  It is certain that the price of wheat would fall so low as to make its production an unprofitable industry.  But if a law were passed compelling every adult to eat so much wheaten bread per day—in spite of the cheapness and efficacy of the substitute—the price of wheat could be maintained at a very high level.

It is strange that the one system which, above all others, requires the co-operation of all the members of society for its very existence, should have been so overlooked by the organisers of co-operative societies.  These societies have been engaged for many years in the production and distribution of commodities, and with very satisfactory economic results ;  but the control of the medium of exchange has been left in the hands of private institutions which exist and are conducted entirely for personal gain, although their stock-in-trade is furnished wholly by the community.  Far greater benefits are to be derived by co-operative societies adding the function of banking to their businesses—that is, the function of issuing paper money against wealth as here suggested in the form of a mutual bank.  Naturally many objections will be raised to the introduction of such a system—those who live on usury and the sale of credit will obviously object to any plan which would rob them of their gains.  The dangers of a paper currency will be pointed out, and the well-known examples of “ Lawism ” and the “French Assignats ” cited as warnings.  Those who make use of these illustrations forget that the disasters resulting from such paper-money experiments have been due to promises or attempts to redeem such paper in specie, in seeking to maintain a parity between the paper and gold or silver, or in issuing it without any basis of wealth.  The money of a mutual bank requires no redemption, as it is issued against wealth itself.  The wealth is to be redeemed by the return of the notes.  Moreover, there would be no demand to maintain paper at any fixed ratio with any single commodity.  The existence of baseless credit money is due almost entirely to the “ gold standard ” theory and the laws restricting the issuance of sound currency.  The baneful effects of this credit money are far greater and more pernicious than all the paper that was ever issued under Law’s system.

One question will naturally arise, viz., how international banking is to be carried on in the event of the mutual system being established.  It is believed by many that the gold coinage provides an international currency, and that if this were abolished international commerce would cease.  International commerce is a system of barter pure and simple, and there is no such thing as an international currency.  Gold is used as a commodity to adjust balances, and there is no reason why a mutual bank in one country should not balance accounts with a foreign bank in specie, as is done at the present time.  There is no fixed ratio of exchange between the money of any two countries, whether they use the gold “ standard ” or not.  Gold is bought and sold by weight, and does not function as money internationally.  Money is always local in its circulation, never universal, and when one exchanges the money of one country for that of another one is simply practising barter.  Whilst the establishment of a universal currency would in many ways be a convenience, it is not an absolute necessity, and there is no greater reason for establishing an international currency than an international postage stamp, or an international system of weights and measures.

1 Since this was written the reserve of the Bank of England has been greatly increased.  Considering its enormous responsibilities the present reserve even now is surely insufficient for all contingencies ! !