Rothbard on “Deposit” Banking: A Critique

Rothbard’s The Mystery of Banking (2008; 2nd edn.) is one of the popular Austrian screeds against fractional reserve banking.

It suffers from many defects, not least of all an astonishingly ignorant and poor understanding of the legal basis, and history, of banking.

In chapter VI, Rothbard (2008: 75–84) engages in a thought experiment to illustrate what he calls “loan banking”: he imagines a “Rothbard Bank” which simply takes money, and then loans that money out with a strict date set for repayment.

This is a simple model of a financial intermediary giving loans of money analogous to a time deposit or term deposit, where demand deposits do not exist and where the IOUs of the bank or borrowers are never monetised.

Rothbard’s ideal and imaginary “pure” loan banking which does not expand the money supply is not applicable to anything but the most primitive form of capitalist economy.

In reality, most banks in any sophisticated enough economy are engaged in borrowing money themselves from clients/depositors either as (1) a callable mutuum loan or (2) a mutuum loan with a maturity date. Banks grant credit and create broad money by issuing IOUs, either banknotes or demand deposits, to clients/depositors and these IOUs become used in the community as credit money.

Rothbard’s thesis is that originally banking was some “pure” form of “loan banking” which never created new money nor expanded the money supply, but was only corrupted later when goldsmiths fraudulently lent out the gold or silver that was supposedly deposited with them as a bailment (or depositum regulare):

“If loan banking was a way of channeling savings into productive loans to earn interest, deposit banking arose to serve the convenience of the holders of gold and silver. Owners of gold bullion did not wish to keep it at home or office and suffer the risk of theft; far better to store the gold in a safe place. Similarly, holders of gold coin found the metal often heavy and inconvenient to carry, and needed a place for safekeeping. These deposit banks functioned very much as safe-deposit boxes do today: as safe ‘money warehouses.’ As in the case of any warehouse, the depositor placed his goods on deposit or in trust at the warehouse, and in return received a ticket (or warehouse receipt) stating that he could redeem his goods whenever he presented the ticket at the warehouse. In short, his ticket or receipt or claim check was to be instantly redeemable on demand at the warehouse. ....

But over the decades, one or more money warehouses, or deposit banks, gained a reputation for probity and honesty. Their warehouse receipts then began to be transferred directly as a surrogate for the gold coin itself. The warehouse receipts were scrip for the real thing, in which metal they could be redeemed. They functioned as ‘gold certificates.’ In this situation, note that the total money supply in the economy has not changed; only its form has altered. .... Deposit banking, when the banks really act as genuine money warehouses, is still eminently productive and noninflationary. ....

All men are subject to the temptation to commit theft or fraud, and the warehousing profession is no exception. In warehousing, one form of this temptation is to steal the stored products outright—to skip the country, so to speak, with the stored gold and jewels. Short of this thievery, the warehouse man is subject to a more subtle form of the same temptation: to steal or ‘borrow’ the valuables ‘temporarily’ and to profit by speculation or whatever, returning the valuables before they are redeemed so that no one will be the wiser. This form of theft is known as embezzlement, which the dictionary defines as ‘appropriating fraudulently to one’s own use, as money or property entrusted to one’s care.’ …

The English goldsmiths discovered and fell prey to this temptation in a very short time, in fact by the end of the Civil War. So eager were they to make profits in this basically fraudulent enterprise, that they even offered to pay interest to depositors so that they could then ‘lend out’ the money. The ‘lending out,’ however, was duplicitous, since the depositors, possessing their warehouse receipts, were under the impression that their money was safe in the goldsmiths’ vaults, and so exchanged them as equivalent to gold. Thus, gold in the goldsmiths’ vaults was covered by two or more receipts. A genuine receipt originated in an actual deposit of gold stored in the vaults, while counterfeit ones, masquerading as genuine receipts, had been printed and loaned out by goldsmiths and were now floating around the country as surrogates for the same ounces of gold. ….

Why, then, were the banks and goldsmiths not cracked down on as defrauders and embezzlers? Because deposit banking law was in even worse shape than overall warehouse law and moved in the opposite direction to declare money deposits not a bailment but a debt.” (Rothbard 2008: 83–91).

Rothbard’s view, then, is that deposit banking on fractional reserves began as fraud, and the fraud was aided by the lack of a proper legal framework for bailment and mutuum loans.

This view is false, and largely the product of Rothbard’s own overactive imagination and his laughable ignorance of history.

First, Rothbard’s grasp of the legal history of banking throughout Western civilisation is utterly abysmal and embarrassing:

“Thus, in England, the goldsmiths, and the deposit banks which developed subsequently, boldly printed counterfeit warehouse receipts, confident that the law would not deal harshly with them. Oddly enough, no one tested the matter in the courts during the late seventeenth or eighteenth centuries. The first fateful case was decided in 1811, in Carr v. Carr. The court had to decide whether the term ‘debts’ mentioned in a will included a cash balance in a bank deposit account. Unfortunately, Master of the Rolls Sir William Grant ruled that it did. Grant maintained that since the money had been paid generally into the bank, and was not earmarked in a sealed bag, it had become a loan rather than a bailment.” (Rothbard 2008: 91–92).

In reality, the legal principle and banking convention that money delivered to a banker without being sealed in a bag, sack or box was a mutuum loan to the banker (and not a bailment) goes right back to ancient Roman law and banking practice (Reden 2012: 281). In the emperor Justinian’s Digest 19.2.31, this authoritative statement of Roman law tells us quite clearly that when money was left unsealed with someone (and implicitly even a banker) it was not a bailment, but a mutuum:

idem iuris esse in deposito: nam si quis pecuniam numeratam ita deposuisset, ut neque clusam neque obsignatam traderet, sed adnumeraret, nihil alius eum debere apud quem deposita esset, nisi tantundem pecuniae solveret.

“The same rule of law applies to deposits, for where a party has deposited a sum of money without having enclosed it in anything, or sealed it up, but simply after counting it, the party with whom it is left is not bound to do anything but repay the same amount of money [tantundem]” (Digest 19.2.31; trans. from Scott 1932).

Alternatively, if a person brought money to a banker sealed or enclosed in a bag or box, then the money became a bailment (or depositum regulare) and could not be used by the banker.

These principles were also accepted in medieval and early modern European law (Dotson 2004: 183). The practice of giving over money as a mutuum loan to a banker without being sealed in a bag or box, as described above, was recognised in Talmudic law (Goldin 1913: 68), as it was from the Jewish community from which many medieval bankers came.

The convention entered European civil law well before the 19th century. For example, John Ayliffe’s A New Pandect of Roman Civil Law (1734) states the principle:

“If I deposit a Bag of Money, or the like, with another Person, which Bag is sealed up, and the Person with whom this Depositum is lodged shall purloin or embezzle the same, or meddle with any part thereof against my Will, I may have both an Action of Theft and an Action ex Deposito against him, but not both together. But if the Person, with whom the Money is lodged, shall by my Permission make use of the Money thus deposited, he shall only be compelled to pay the Interest upon that account, as in other Pleas bona fidei;” (Ayliffe 1734: 520).

Bizarrely, Rothbard states that in Europe “bailment law scarcely existed until the eighteenth century” (!) (Rothbard 2008: 89). In fact, bailment law was highly developed even in the ancient Roman world (Berger 1953: 43), and the bailment law of medieval and early modern Europe was derived from the sophisticated legal system of the Romans (Dotson 2004: 184).

Secondly, Rothbard gives us a potted history of banking as follows:

“Factors, investment banks, finance companies, and moneylenders are just some of the institutions that have engaged in loan banking. In the ancient world, and in medieval and pre-modern Europe, most of these institutions were forms of ‘moneylending proper,’ in which owners loaned out their own saved money. Loan banks, in the sense of intermediaries, borrowing from savers to lend to borrowers, began only in Venice in the late Middle Ages. In England, intermediary-banking began only with the ‘scriveners’ of the early seventeenth century. The scriveners were clerks who wrote contracts and bonds, and were therefore often in a position to learn of mercantile transactions and engage in moneylending and borrowing. By the beginning of the eighteenth century, scriveners had been replaced by more advanced forms of banking.” (Rothbard 2008: 83–84).

In fact, even in the ancient world deposit banking under the mutuum contract was widely practised (see Andreau 1999: 40–41; Reden 2007: 286–290; Harris 2006: 10–12; Harris 2011: 236; Verboven 2009: 116–117), and even Rothbard’s statement that “loan banks” “in the sense of intermediaries, borrowing from savers to lend to borrowers, began only in Venice in the late Middle Ages” is untrue.

Even the Middle ages had deposit banking by at least the 13th century:

“The medieval economy was grounded in credit, a necessity given the limited European precious metal reserves which plagued merchant and king alike. …. Along with moneylending and foreign exchange, medieval deposit banking was another fuel for the commercial economy. Term deposits and ‘on demand’ deposits were both present in medieval banking by the thirteenth century. Interest was in all likelihood anticipated on such deposits.” (Reyerson 1999: 65)

In both the ancient world and the medieval world, such deposit banking on fractional reserves was generally conducted under the framework of the mutuum contract, not the bailment (depositum regulare).

The free banker George Selgin also demonstrates that Rothbard’s view of the origin of fractional reserve banking in Britain cannot be accepted as true (Selgin 2011).

Rothbard is puzzled that English jurists in the 19th century were ruling that unsealed money given to bankers was legally a mutuum, not a bailment (Rothbard 2008: 91–92), and even ascribes to these jurists the “major share of the blame for our fraudulent system of fractional reserve banking and for the disastrous inflations of the past two centuries” (Rothbard 2008: 93).

In this, he is, yet again, utterly mistaken. The English jurists of the 19th century were simply following the legal precedents and banking practices of many hundreds of years: their description of the mutuum loan was precisely how Western legal systems had always treated unsealed money transfers to bankers.

In short, the evidence points to the conclusion that deposit banking on fractional reserves was normally based on the mutuum contract from the beginning, and that Rothbard’s history is seriously flawed.

Further Reading
“Why is the Fractional Reserve Account a Mutuum, not a Bailment?,” December 17, 2011.

“Hoppe on Fractional Reserve Banking: A Critique,” December 11, 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.

“Huerta de Soto on the Mutuum Contract: A Critique,” August 11, 2012.

“A Simple Question for Opponents of Fractional Reserve Banking,” August 17, 2012.

“Chapter 1 of Huerta de Soto’s Money, Bank Credit and Economic Cycles: A Critique,” August 31, 2012.

“Huerta de Soto on Justinian’s Digest 16.3.25.1,” September 1, 2012.

“Huerta de Soto on Banking in Ancient Rome: A Critique,” September 2, 2012.

BIBLIOGRAPHY
Andreau, J. 1999. Banking and Business in the Roman World (trans. J. Lloyd). Cambridge University Press, Cambridge and New York.

Ayliffe, John. 1734. A New Pandect of Roman Civil Law, as Anciently Established in that Empire; and now Received and Practised in Most European Nations. Tho. Osborne, London.

Barlow, C. T. 1978. Bankers, Moneylenders, and Interest Rates in the Roman Republic. University of North Carolina, Chapel Hill.

Berger, A. 1953. Encyclopedic Dictionary of Roman Law. American Philosophical Society, Philadelphia.

Dotson, John E. 2004. “Banks and Banking,” in C. Kleinhenz (ed.), Medieval Italy: An Encyclopedia. Vol. 1, A to K. Routledge, London. 89–92.

Goldin, H. E. 1913. Mishnah. A Digest of the Basic Principles of the Early Jewish Jurisprudence, Baba Meziah (Middle Gate), Order IV, Treatise II. G. P. Putnam’s Sons, New York & London.

Harris, William V. 2006. “A Revisionist View of Roman Money,” Journal of Roman Studies 96: 1–24.

Harris, William V. 2011. Rome’s Imperial Economy. Twelve Essays. Oxford University Press, Oxford.

Reden, Sitta von. 2007. Money in Ptolemaic Egypt: From the Macedonian Conquest to the End of the Third Century BC. Cambridge University Press, Cambridge.

Reden, Sitta. 2012. “Money and Finance,” in Walter Scheidel (ed.), The Cambridge Companion to the Roman Economy. Cambridge University Press, Cambridge. 266–286.

Reyerson, K. L. 1999. “Commerce and Communications,” in David Abulafia (ed.), The New Cambridge Medieval History V. c.1198–c.1300. Cambridge University Press, Cambridge. 50–70.

Rothbard, Murray N. 2008. The Mystery of Banking (2nd edn.). Ludwig von Mises Institute, Auburn, Ala.

Scott, S. P. 1932. The Civil Law. Central Trust Co., Cincinnati.

Selgin, G. “Those Dishonest Goldsmiths,” revised January 20, 2011
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709

Verboven, K. 2009. “Currency, Bullion and Accounts Monetary Modes in the Roman World,” Belgisch Tijdschrift voor Numismatiek en Zegelkunde / Revue Belge de Numismatique et de Sigillographie155: 91–121.