The term “funny money” implies that fractional reserve (FR) credit money/bank money is somehow illegal or fraudulent. This is nonsense. Modern FR banking is fully legal in Western nations and their offshoots, and historically has been conducted under the framework of the mutuum loan contract (loan for consumption) under European civil/common law systems influenced by Roman law. FR banking goes right back to the ancient Roman Republic.
While credit money was probably more frequently recorded on the books (or accounts) of banks and transferred as accounting entries through history, a modern development has been the private bank note, which is replaced today by the modern FR demand deposit, which we access by means of cheques, ATM cards and electronic funds transfer. Today clearing takes place much more rapidly than it used to, and private bank notes have disappeared.
With regard to private bank notes that used to be common in the West, the principle involved is not difficult to understand. If one endorses a cheque and writes negotiable on it, then that cheque can become a debt instrument used as money (that is, as a medium of exchange or means of payment), which will expand the money supply. This practice is an old one, and it is in no sense fraud to use a negotiable cheque to pay for goods and services or to discharge a debt (even if a cheque bounces, this is usually breach of contract, not fraud).
Negotiable bills of exchange and promissory notes work in much the same manner, and have played a vital role in the commerce and mercantile operations of capitalist nations for centuries. Fractional reserve credit money/bank money works on the same principle, and is in no sense “funny money.”
Developed capitalist economies have always had an endogenous money supply to some degree, and (1) bills of exchange, (2) promissory notes, (3) cheques, and (4) fractional reserve credit money have always been created privately to meet the needs of trade, commerce and investment.
Historically, one might say that in certain countries the law sometimes had to qualify and define the status of FR bank notes as formal promissory notes, but even here the story is not what the Austrians cultists make it out to be.
In Holland during the early modern period (the centre of a commercial revolution), there developed a system of mercantile promissory notes, and the practice spread to England, where by 1704 they were granted by law the same status as bills of exchange:
“About the end of the Sixteenth Century, the merchants of Amsterdam, Middleburgh, Hamburgh, and some other places, began to use instruments of credit among themselves, and as they came into personal contact, these documents naturally assumed the form of an acknowledgement of the debt by the debtor, with a promise to pay it to bearer on demand, at the time fixed. These documents were called bills obligatory, or of debt, or of credit, and were transferable by indorsement in all respects like Bills of Exchange.But long before the act of Statute of 1704 domestic bills of exchange in Britain had functioned as negotiable debt instruments that endogenously expanded the money supply as well. The legislation of 1704 merely recognised what the private sector had been doing with goldsmiths’ notes after 1640. Nor were the earliest goldsmiths notes certificates of bailment: they were understood as negotiable credit/debt instruments payable on demand (though sometimes with receipt of the initial amount left with the banker), with the statement “I promise to repay upon demand ...,” which explicitly demonstrates to us that these were IOUs or debt records, not certificates of bailment (Selgin 2011: 11).
These documents are now called Promissory Notes, and an English writer in the time of Charles I., Gerard Malynes, strongly advocated their introduction into England, but he saw that the Common Law prohibited it. They first began to be used by the goldsmiths, who, as shewn afterwards, originated the modern system of banking in England soon after 1640. They were then called goldsmiths' notes, but they were not recognised by law. The first promissory notes recognised by law were those of the Bank of England in 1694, which were, technically, bills obligatory, or of credit. By the Act founding the Bank, their notes were declared to be assignable by indorsement (Act, Statute 1694, c. 20, s. 29). But this did not extend to other promissory notes. In 1701 and 1703 it was decided that promissory notes were not assignable, or indorsable over, within the custom of merchants. In consequence of these decisions, the Act, Statute 1704, c. 8, was passed, by which it was enacted that promissory notes in writing, made and signed by any person or persons, body politic or corporate, or by the servant or agent of any corporation, banker, goldsmith, merchant, or trader, promising to pay any other person, any sum of money, should be assignable and indorsable over in the same manner as inland bills of exchange.
These promissory notes, of all sorts, including Bank of England notes, as well as the notes of private bankers and merchants, were all placed exactly on the same footing as inland bills of exchange, that is, they were all made transferable by indorsement on each separate transfer.
In the case however of bank notes (by which, in law, is always meant Bank of England notes), as these were always payable on demand, and the payment was quite secure, the practice of indorsement soon fell into disuse, and they passed from hand to hand like money. In the case of private bankers of great name, the indorsement was often omitted. But, though the ceremony of indorsement was often dispensed with as superfluous, it must be observed that in no way altered the character of the instrument, and the receiver of the note took it entirely at his own peril, and ran exactly the same risks as if he took any other instrument of credit without indorsement.” (Macleod 1866: 87–88; on the historical aspects of promissory notes and bill of exchanges, see Macleod 1866: 84–87).
An early example of a goldsmiths note is one issued by the London banker Feild Whorwood in 1654. This is both a receipt for the sum delivered to the banker (but not a certificate of bailment) and, without any doubt, a promissory note:
“Recd, ye 16th [December] 1654 of Sam Tofte the some of Twenty five pounds w[hi]ch I promise to repay upon Demand I say R[eceived]The nature of the contract entered into by Sam Tofte (the holder of the FR bank account who handed over the money) and the banker Feild Whorwood is made perfectly clear to us by the words of the banker: “I promise to repay upon Demand ...”. This was a receipt of money to the banker given by Sam Tofte as a loan or mutuum, and one re-payable on demand, with interest. It was no bailment contract. Whether this note was transferable is unclear, but soon such transferable/negotiable goldsmiths notes were created too.
interest of both £2-05-0.” (Melton 1986: 101).
* = by me.
One must also distinguish here between (1) FR banking itself (where the debt was merely on the books of the bank) and (2) the private transferable/negotiable bank notes (or goldsmiths notes) offered as a new service. While FR banking itself had been legal for centuries by means of the mutuum contract, the status of the new transferable goldsmiths notes took some time to be formally recognised as in the same legal category as negotiable bills of exchange. But recognition came by 1704.
One should emphasise here that already transferable/negotiable FR credit money could be transferred merely as accounting entries (that is, on their books) between banks or other agents, so the use of transferable goldsmiths notes merely made this process easier and more convenient.
For the interested reader, one can find more here in my various posts on fractional reserve banking:
“Why is the Fractional Reserve Account a Mutuum, not a Bailment?,” December 17, 2011.GLOSSARY
“Callable Option Loans and Fractional Reserve Accounts,” December 16, 2011.
“Future Goods and Fractional Reserve Banking,” December 15, 2011.
“Rothbard on the Bill of Exchange,” December 11, 2011.
“Hoppe on Fractional Reserve Banking: A Critique,” December 11, 2011.
“The Monetary Production Economy and Fiduciary Media,” December 11, 2011
“Fractional Reserve Banking: An Evil?,” June 26, 2010.
“The Romans and Fractional Reserve Banking,” February 23, 2011.
“Lawrence H. White refutes Huerta de Soto on Fractional Reserve Banking,” February 22, 2011.
“Selgin on Fractional Reserve Banking,” June 1, 2011.
“Schumpeter on Fractional Reserve Banking,” June 12, 2011.
“If Fractional Reserve Banking is Fraudulent, Why isn’t the Insurance Industry Fraud?,” September 29, 2011.
“The Mutuum Contract in Anglo-American Law,” September 30, 2011.
“Rothbard Mangles the Legal History of Fractional Reserve Banking,” October 1, 2011.
“More Historical Evidence on the Mutuum Contract,” October 1, 2011.
“What British Law Says about the Mutuum Contract,” October 2, 2011.
“If Fractional Reserve Banking is Voluntary, Where is the Fraud?,” October 3, 2011.
an undertaking; a promise or contract, oral or written; an assumption or undertaking by one person (promiser) to undertake or perform an act for, or pay a sum to, another person.
Payable to bearer on demand
To be paid to anyone holding the instrument/note, not just an original payee.
Payable to order
To be paid only to a specific person as the payee.
Macleod, H. D. 1866. The Theory and Practice of Banking (2nd edn.), Longmans, Green, Reader, and Dyer, London.
Melton, Frank T. 1986. Sir Robert Clayton and the Origins of English Deposit Banking, 1658-1685, Cambridge University Press, Cambridge.
Selgin, G. “Those Dishonest Goldsmiths,” revised January 20, 2011