In the second place, we need to consider whether the coin in the vault was even available for lending—regardless of whether or not the depositors received a part of the profit. Let us suppose that we are playing a game of poker at the home of Charlie Smith. Each of us has given $20 to Charlie who, acting as the banker, has put our money into a shoe box and given us, in return, twenty poker chips.
It is the understanding that, anytime we want to go home, we can get back a dollar for each chip we have at that time. Now let us suppose that Charlie's brother-in-law, Larry, shows up, not to play poker, but to borrow some money. Since six of us are playing and each has put in $20, there is a total of $120 in the shoe box, and that turns out to be perfect for Larry's needs. You can imagine what would happen if Charlie decided to lend out the "idle" money. It is not available for lending.
Neither Charlie nor any of the players have the right to loan those dollars, because they are being held in escrow, so to speak, pending completion of the contract between Charlie and his guests.
Those dollars no longer even exist as money. They have been replaced—in concept at least—by the poker chips. If any of us are so touched by Larry's story that we decide to loan him the money ourselves, we would have to do it with other dollars or cash in our chips for the dollars in the shoe box. In that case, of course, we could no longer stay in the game. We cannot spend, loan, or give away
the deposit and also consider the chips to be worth anything.
If you are a member of an organization and have given your proxy to a friend to vote in your absence at the annual meeting, you cannot then show up and cast your own vote in addition to your proxy. Likewise, in the beginning of banking, the certificates which were circulated as money were, in effect, proxies for the coins.
Consequently, those coins were not available for lending. Their monetary value had been assigned to the certificates. If the certificate holders had wanted to lend out their coins, they should have retired the certificates first. They were not entitled to hold spendable paper money and also authorize their banker to lend that same money as coins. One cannot spend, loan, or give away the coins and also
consider the certificates to be worth anything.
All of this is just common sense. But there is another dimension to the problem which has to do with honesty in business contracts.
FOOL'S GOLD
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When the bankers used those coins as the basis for loans, they were putting themselves in a position of not having enough coin in the vault to make good on their contracts when it came time for depositors to take their money home. In other words, the new contracts were made with the full knowledge that, under certain circumstances, they would have to be broken. But the bankers never bothered to explain that. The general public was led to believe that, if they approved of putting these supposedly idle funds to work, they would be helping the economy and earning a little profit besides. It was an appealing proposal, and the idea caught on like wildfire.
FRACTIONAL-RESERVE BANKING
Most borrowers wanted paper money, of course, not bulky
coins, so, when they received their loans, they usually put the coins right back into the vault for safekeeping. They were then given receipts for these deposits which, as we have observed, were readily accepted in commerce as money. At this point, things began to get complicated. The original depositors had been given receipts for all of the bank's coins. But the bank now issued loans in the amount of eighty-five per cent of its deposits, and the borrowers were given receipts for that same amount. These were in addition to the original receipts. That made 85% more receipts than coins. Thus, the banks created 85% more money and placed it into circulation through their borrowers. In other words, by issuing phony receipts, they artificially expanded the money supply. At this point, the certificates were no longer 100% backed by gold. They now had a backing of only 54%/ but they were accepted by the unsuspecting public as equal in value to the old receipts. The gold behind all of them, however, now represented only a fraction of their face value. Thus, the receipts became what may be called fractional money, and the process by which they were created is called fractional-reserve
banking.
