5 A NEW ATTEMPT AT LEGITIMATE BANKING: THE BANK OF AMSTERDAM. BANKING IN THE SEVENTEENTH AND EIGHTEENTH CENTURIES THE BANK OF AMSTERDAM

The last serious attempt to establish a bank based on the general legal principles governing the monetary irregular deposit and to set up an efficient system of government control to adequately define and defend depositors' property rights took place with the creation of the Municipal Bank of Amsterdam in 1609. It was founded after a period of great monetary chaos and fraudulent (fractional-reserve) private banking. Intended to put an end to this state of affairs and restore order to financial relations, the Bank of Amsterdam began operating on January 31, 1609 and was called the Bank of Exchange.¹⁰³ The hallmark of the Bank of Amsterdam was its commitment, from the time of its creation, to the universal legal principles governing the monetary irregular deposit. More specifically, it was founded upon the principle that the obligation of the depository bank in the monetary irregular-deposit contract consists of maintaining the constant availability of the tantundem in favor of the depositor; that is, maintaining at all times a 100-percent reserve ratio with respect to “demand” deposits. This measure was intended to ensure legitimate banking and prevent the abuses and bank failures which had historically occurred in all countries where the state had not only not bothered to prohibit and declare illegal the misappropriation of money on demand deposit in banks, but on the contrary, had usually ended up granting bankers all sorts of privileges and licenses to allow their fraudulent operations, in exchange for the opportunity to take fiscal advantage of them.

For a very long time, over one hundred fifty years, the Bank of Amsterdam scrupulously fulfilled the commitment upon which it was founded. Evidence reflects that during the first years of its existence, between 1610 and 1616, both the bank's deposits and its cash reserves came very close to one million florins. From 1619 to 1635, deposits amounted to nearly four million florins and cash reserves exceeded three million, five hundred thousand. After this slight imbalance, equilibrium was restored in 1645, when deposits equaled eleven million, two hundred eighty-eight thousand florins and cash reserves added up to eleven million, eight hundred thousand florins. Equilibrium and growth were more or less stable, and in the eighteenth century, between 1721 and 1722, the bank's deposits totaled twenty-eight million florins and its stock of cash reached nearly that amount, twenty-seven million. This great increase in the deposits of the Bank of Amsterdam stemmed, among other causes, from its role as a refuge for capital fleeing the crazy inflationist speculation that the system of John Law produced in France in the 1720s. We will deal with this more in depth later. This continued until 1772, in which both deposits and cash reserves totaled twenty-eight to twenty-nine million florins. As is evident, during this entire period, to all intents and purposes the Bank of Amsterdam maintained a 100-percent cash reserve. This allowed it, in all crises, to satisfy each and every request for cash withdrawal of deposited florins. Such was true in 1672, when panic caused by the French threat gave rise to a massive withdrawal of money from Dutch banks, most of which were forced to suspend payments (as occurred with the Rotterdam and Middelburg banks). The Bank of Amsterdam was the exception, and it logically had no trouble returning deposits. Increasing and lasting confidence in its soundness resulted, and the Bank of Amsterdam became an object of admiration for the civilized economic world of the time. Pierre Vilar indicates that in 1699 the French ambassador wrote in a report to his king:

Of all the towns of the United Provinces, Amsterdam is without any doubt the foremost in greatness, wealth and the extent of her trade. There are few cities even in Europe to equal her in the two latter respects; her commerce stretches over both halves of the globe, and her wealth is so great that during the war she supplied as much as fifty millions a year if not more.¹⁰⁴

In 1802, when, as we will now see, the Bank of Amsterdam started to become corrupt and violate the principles on which it was founded, the bank still enjoyed enormous prestige, to the point that the French consul in Amsterdam noted:

At the end of a maritime war which has kept the treasures of the mines pent up in the Spanish and Portuguese colonies, Europe is suddenly inundated with gold and silver in quantities far above what is needed, so that they would decline in value if they were put into circulation all at once. In such an eventuality, the people of Amsterdam deposited the metal in ingots in the Bank, where it was kept for them at a very low cost, and they took it out a little at a time to send to different countries as the increase in the rate warrants it. This money, then, which if allowed to flood in too rapidly would have driven up the prices of everything exceedingly, to the great loss of all who live on fixed and limited incomes, was gradually distributed through many channels, giving life to industry and encouraging trade. The Bank of Amsterdam, then, did not act only according to the special interests of the traders of this city; but the whole of Europe is in its debt for the greater stability of prices, equilibrium of exchange and a more constant ratio between the two metals of which coin is made; and if the bank is not reestablished, it could be said that the great system of the trade and political economy of the civilised world will be without an essential part of its machinery.¹⁰⁵

Therefore, we see that the Bank of Amsterdam did not try to attain disproportionate profits through the fraudulent use of deposits. Instead, in keeping with the dictates of Saravia de la Calle and others we have mentioned, it contented itself with the modest benefits derived from fees for safeguarding deposits and with the small income obtained though the exchange of money and the sale of bars of stamped metal. Nevertheless, this income was more than sufficient to satisfy the bank's operating and administration costs, to generate some profit and to maintain an honest institution that fulfilled all of its commitments.

The great prestige of the Bank of Amsterdam is also evidenced by a reference to it found in the incorporation charter of the Spanish Banco de San Carlos in 1782. Although this bank, from its very inception, lacked the guarantees of the Bank of Amsterdam, and it was created with the intention of using its deposits, authority, and clout to help finance the Treasury, it could not escape the immense influence of the Dutch bank. Thus, its article XLIV establishes that private individuals may hold deposits or

equivalent funds in cash in the bank itself, and whoever wishes to make deposits shall be allowed to do so, either in order to draw bills on the money or to withdraw it gradually, and in this way they will be exempt from having to make payments themselves, their bills being accepted as payable at the bank. In their first meeting, the stockholders will determine the amount per thousand which merchants must pay the bank in relation to their deposits, as they do in Holland, and will establish all other provisions concerning the best dispatch of discounts and reductions.¹⁰⁶

DAVID HUME AND THE BANK OF AMSTERDAM

A sign of the enormous prestige of the Bank of Amsterdam among scholars and intellectuals, as well as merchants, is the express mention David Hume makes of it in his essay Of Money. This essay first appeared, with others, in a book called Political Discourses, published in Edinburgh in 1752. In it David Hume voices his opposition to paper currency and argues that the only solvent financial policy is that which forces banks to maintain a 100-percent reserve ratio, in accordance with traditional legal principles governing the irregular deposit of money. David Hume concludes that

to endeavour artificially to encrease such a credit, can never be the interest of any trading nation; but must lay them under disadvantages, by encreasing money beyond its natural proportion to labour and commodities, and thereby heightening their price to the merchant manufacturer. And in this view, it must be allowed, that no bank could be more advantageous, than such a one as locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce. A public bank, by this expedient, might cut off much of the dealings of private bankers and money-jobbers; and though the state bore the charge of salaries to the directors and tellers of this bank (for, according to the preceding supposition, it would have no profit from its dealings), the national advantage, resulting from the low price of labour and the destruction of paper credit, would be a sufficient compensation. ¹⁰⁷

Hume is not completely correct when he claims the bank would not earn a profit, since its safekeeping fees would be sufficient to cover operating costs, and it might even generate modest profits, as in fact the Bank of Amsterdam did. However his analysis is categorical and reveals that, in defending the creation of a public bank with these characteristics, he had in mind the success of the Bank of Amsterdam and the example it had already set for over one hundred years. Furthermore the third edition of his Essays and Treatises on Several Subjects, published in four volumes in London and Edinburgh, 1753–1754, includes a note by Hume in reference to the phrase, “no bank could be more advantageous, than such a one as locked up all the money it received.” Footnote number four contains the following words: “This is the case with the Bank of Amsterdam.” It appears that Hume wrote this footnote with the intention of more clearly emphasizing his view that the Bank of Amsterdam was the ideal model for a bank. Hume was not the very first to propose a 100-percent reserve requirement in banking. He was preceded by Jacob Vanderlint (1734) and especially by the director of the Royal mint, Joseph Harris, for whom banks were useful as long as they “issued no bills without an equivalent in real treasure.”¹⁰⁸

SIR JAMES STEUART, ADAM SMITH, AND THE BANK OF AMSTERDAM

Sir James Steuart offers us an important contemporary study of the Bank of Amsterdam's operation in his treatise published in 1767 entitled, An Enquiry into the Principles of Political Oeconomy: Being an Essay on the Science of Domestic Policy in Free Nations. In chapter 39 of volume 2, Steuart presents an analysis of the “circulation of coin through the Bank of Amsterdam.” He maintains that “every shilling written in the books of the bank is actually locked up, in coin, in the bank repositories.” Still, he states,

Although, by the regulations of the bank, no coin can be issued to any person who demands it in consequence of his credit in bank; yet I have not the least doubt, but that both the credit written in the books of the bank, and the cash in the repositories which balances it, may suffer alternate augmentations and diminutions, according to the greater or less demand for bank money. ¹⁰⁹

At any rate, Steuart indicates that the bank's activities “are conducted with the greatest secrecy,” in keeping with the traditional lack of openness in banking and especially significant in the case of the Bank of Amsterdam, whose statutes and operation demanded the maintenance of a continuous 100-percent reserve ratio. If Steuart is correct and this ratio was at times violated, it is logical that at the time the Bank of Amsterdam tried to hide the fact at all costs.

Although there are signs that at the end of the 1770s the Bank of Amsterdam began to violate the principles upon which it had been founded, in 1776 Adam Smith still affirmed in his book, An Inquiry into the Nature and Causes of the Wealth of Nations, that

The Bank of Amsterdam professes to lend out no part of what is deposited with it, but, for every guilder for which it gives credit in its books, to keep in its repositories the value of a guilder either in money or bullion. That it keeps in its repositories all the money or bullion for which there are receipts in force, for which it is at all times liable to be called upon, and which, in reality, is continually going from it and returning to it again, cannot well be doubted.... At Amsterdam no point of faith is better established than that for every guilder, circulated as bank money, there is a correspondant guilder in gold or silver to be found in the treasure of the bank.¹¹⁰

Adam Smith goes on to say that the city itself guaranteed the operation of the Bank of Amsterdam as described above and that it was under the direction of four burgomasters who changed each year. Each burgomaster visited the vaults, compared their content in cash with deposit entries in the books and with great solemnity declared under oath that the two coincided. Adam Smith remarks, tongue-in-cheek, that “in that sober and religious country oaths are not yet disregarded.”¹¹¹ He ends his commentary by adding that all of these practices were sufficient to guarantee the absolute safety of deposits in the bank, a fact which was demonstrated in various Dutch political revolutions. No political party was ever able to accuse the prior of disloyalty in the management of the bank. By way of example, Adam Smith mentions that even in 1672, when the king of France marched into Utrecht and Holland was in danger of being conquered by a foreign power, the Bank of Amsterdam satisfied every last request for repayment of demand deposits. As we stated before, this acted as an even more impressive reinforcement of the public's confidence in the absolute solvency of the bank.

As additional evidence that the Bank of Amsterdam maintained a 100-percent reserve ratio, Adam Smith offers the anecdote that some coins removed from the bank appeared to have been damaged in the building fire that struck the bank soon after its creation in 1609, which shows those coins had been kept in the bank for over one hundred fifty years. Finally, Adam Smith, in strict keeping with the true legal nature of the irregular-deposit contract, which requires that it be the depositors who pay the bank, indicates that the bank's income stemmed from safekeeping fees:

The City of Amsterdam derives a considerable revenue from the bank, besides what may be called the warehouse-rent above mentioned, each person, upon first opening an account with the bank, pays a fee of ten guilders, and for every new account three guilders three stivers; for every transfer two stivers; and if the transfer is for less than three hundred guilders, six stivers, in order to discourage the multiplicity of small transactions.¹¹²

In addition, Adam Smith refers to other sources of income we have already mentioned, such as the exchange of money and the sale of gold and silver bars.

Unfortunately, in the 1780s the Bank of Amsterdam began to systematically violate the legal principles on which it had been founded, and evidence shows that from the time of the fourth Anglo-Dutch war, the reserve ratio decreased drastically, because the city of Amsterdam demanded the bank loan it a large portion of its deposits to cover growing public expenditures. Hence, deposits at that time amounted to twenty million florins, while there were only four million florins' worth of precious metals in the vaults; which indicates that, not only did the bank violate the essential principle of safekeeping on which it had been founded and its existence based for over one hundred seventy years, but the reserve ratio had been cut from 100 percent to less than 25 percent. This meant the final loss of the Bank of Amsterdam's long-standing reputation: deposits began to gradually decrease at that point, and in 1820 they had dwindled to less than one hundred forty thousand florins.¹¹³ The Bank of Amsterdam was the last bank in history to maintain a 100-percent reserve ratio, and its disappearance marked the end of the last attempts to found banks upon general legal principles. The financial predominance of Amsterdam was replaced by the financial system of the United Kingdom, a much less stable and less solvent system based on the expansion of credit, deposits and paper currency.

THE BANKS OF SWEDEN AND ENGLAND

The Bank of Amsterdam was a forerunner of the Bank of Stockholm (Riksbank), which began operating in 1656 and was divided into two departments: one responsible for the safekeeping of deposits (using a 100-percent reserve ratio) and modeled after the Bank of Amsterdam; and another devoted to loans. Although the departments supposedly functioned separately from one another, in practice they were separate only on paper, and the Bank of Stockholm soon abandoned the standards set by the Dutch bank.¹¹⁴ The Swedish authorities nationalized it in 1668, making it the first government bank of the modern world.¹¹⁵ Not only did it violate the traditional principles which guided the Bank of Amsterdam, but it also initiated a new fraudulent and systematic practice: the issuance of banknotes or deposit receipts for a sum higher than actual deposits received in cash. This is how banknotes were born, along with the lucrative practice of issuing them for a higher amount than the total of deposits. Over time, this activity would become the banking practice par excellence, especially in the centuries that followed, during which it deceived scholars, who failed to realize that the issuance of banknotes had the same repercussions as artificial credit expansion and deposit creation, two practices which, as A.P. Usher has noted, had been at the core of the banking business from its origins.

The Bank of England was created in 1694 and was also patterned after the Bank of Amsterdam, due to the considerable influence Holland exerted on England following the accession of the House of Orange to the English throne. However, the bank was not constituted with the same legal guarantees of safekeeping as the Bank of Amsterdam. Instead, one of its main aims from the outset was to help finance public expenditures. For this reason, although the Bank of England was intended to stop the commonplace, systematic abuses committed by private bankers and the government,¹¹⁶ in practice this goal was never achieved. In short, the Bank of England eventually failed, despite its privileged role as the government's banker, its monopoly on limited liability in England and its exclusive authorization to issue banknotes. As a result of its systematic neglect of the safekeeping obligation and its practice of granting loans and advances to the Treasury against the bank's deposits, the Bank of England eventually suspended payments in 1797 after various colorful vicissitudes, including the South Sea Bubble.¹¹⁷ Also in 1797, the same year the Bank of England was forbidden to return deposits in cash, it was declared that taxes and debts were to be paid in bills issued by the bank, and an attempt was made to limit advances and loans to the government.¹¹⁸ This was the dawn of the modern banking system, based on a fractional-reserve ratio and a central bank as lender of last resort. In chapter 8 we will analyze in detail the reasons central banks were created, their role and theoretical incapability of fulfilling it, as well as the central banking vs. free banking controversy and its influence on the different theories of money, banking and economic cycles. The current chapter would not be complete, however, without a brief reference to the development of banking and paper money in eighteenth-century France.

JOHN LAW AND EIGHTEENTH-CENTURY BANKING IN FRANCE

The history of money and banking in eighteenth-century France is closely linked to the Scottish financier John Law and the “system” he concocted and put into practice there. Law persuaded the French regent, Philippe d'Orleans, that the ideal bank was one that made use of the deposits it received, since this increased the amount of money in circulation and “stimulated” economic growth. Law's system, like economic interventionism in general, arose from three different, though interconnected factors. First, disregard for traditional legal and moral principles, particularly the requirement for continual safekeeping of 100 percent of deposited money. Second, a reasoning error that appears to justify violating legal principles to attain seemingly beneficial goals quickly. Third, the fact that there will always be certain agents who view in proposed reforms an opportunity to make huge profits. The combination of these three factors allowed a political dreamer like Law to launch his “banking system” in France at the beginning of the eighteenth century. In fact, once the bank had earned people's trust, it began to issue banknotes far exceeding deposits on hand and to extend loans against deposits. The quantity of bills in circulation increased very rapidly, and as is logical, a significant artificial economic boom resulted. In 1718 the bank was nationalized (becoming the royal bank) and began churning out even more bills and granting more loans. This encouraged stock market speculation in general, and in particular speculative buying and selling of shares of Law's Compagnie de la Lousiane ou d'Occident or Mississippi Trading Company, aimed at fostering trade and advancing colonization of this French territory in America. By 1720 the absurd proportions of the financial bubble had become clear. Law tried desperately to stabilize the price of the company's stock and the value of his bank's paper money: the bank and trading company were merged, company stock was declared legal tender, coins lost part of their weight in an attempt to restore their relationship to bills, etc. However, all was in vain and the inflationary bubble burst, bringing financial ruin not only to the bank but also to many French investors who had placed their trust in it and in the trading company. The losses were so heavy and the suffering so immense that for over a hundred years it was even considered a faux pas in France to utter the word “bank,” a term which for a time was synonymous with “fraud.”¹¹⁹ The ravages of inflation plagued France again a few decades later, as evidenced by the serious monetary chaos during the revolutionary period and the uncontrolled issuance of assignats at that time. All these phenomena made a permanent impression on the collective psyche of the French, who are still aware today of the grave dangers of paper money inflation and preserve the custom of storing considerable amounts of gold coins and ingots. In fact, France, together with India, is one of the countries whose people hold the largest stock of gold on a private basis.

All of the above notwithstanding, and in spite of his ill-fated banking experiment, John Law made some contributions to monetary theory. Although we cannot accept his inflationist and proto-Keynesian views, we must acknowledge, as Carl Menger did, that Law was the first to formulate a sound theory on the spontaneous, evolutionary origins of money.

RICHARD CANTILLON AND THE FRAUDULENT VIOLATION OF THE IRREGULAR-DEPOSIT CONTRACT

It is a remarkable fact that three of the most noted monetary theorists of the eighteenth and early nineteenth centuries were bankers: John Law, Richard Cantillon,¹²⁰ and Henry Thornton. Their banks all failed.¹²¹ Cantillon alone escaped relatively unscathed, not only because he stopped his risky speculation in time, but also (and most importantly) because of the large profits he fraudulently obtained by violating the obligation to safeguard his customers' assets.

Indeed, Cantillon clearly violated the contract of irregular deposit, however in this case the deposit was not of money, but shares of stock in the Mississippi Trading Company, founded by John Law. Cantillon's fraudulent scheme was as follows: he loaned large amounts of money to his customers to allow them to buy shares in the company, on the condition that the stocks act as collateral and remain at Cantillon's bank as an irregular deposit, in this case of fungible and indistinguishable shares. Later Cantillon, unbeknownst to his clients, misappropriated the deposited securities, selling them when he thought their market price was high and keeping the money from the sale. Once the shares had lost practically all of their value, Cantillon bought them back for a fraction of their old price and restored deposits, securing a hefty profit. Finally, he demanded repayment of the loans he had initially made to his clients, who were unable to return the money, since the collateral they had at the bank was worth close to nothing. These fraudulent operations led to multiple criminal charges and civil suits against Cantillon, who, upon being arrested and briefly incarcerated, was forced to leave France in a hurry and flee to England.

Cantillon, in defense, put forward the same argument so often used throughout the Middle Ages by writers determined to confuse the irregular deposit with the loan. In fact, Cantillon tried to defend himself by claiming that the stocks deposited with him as unnumbered fungible goods had not actually constituted a true deposit, but a loan implying the full transference of ownership and availability to the banker. Thus, Cantillon considered his operations perfectly “legitimate.” Nevertheless, we know his legal argument was unsound and even though the deposit of securities was considered an irregular deposit of fungible goods, the obligation to safeguard the shares and maintain continual possession of all of them remained. Therefore, when Cantillon sold the shares to the detriment of his customers he clearly committed the criminal act of misappropriation. F.A. Hayek explains Cantillon's attempt to justify his fraudulent actions:

His point of view was, as he later explained, that the shares given to him, since their numbers had not been registered, were not a genuine deposit, but rather—as one would say today—a block deposit so that none of his customers had claim to specific securities. The firm actually made an extraordinary profit in this way, since it could buy back at reduced prices the shares sold at high prices, and meanwhile the capital, for which they were charging high interest, lost nothing at all but rather was saved and invested in pounds. When Cantillon, who had partially made these advances in his own name, asked for repayments of the loans from the speculators, who had suffered great losses, and finally took them to court, the latter demanded that the profits obtained by Cantillon and the firm from their shares be credited against these advances. They in turn took Cantillon to court in London and Paris, charging fraud and usury. By presenting to the courts correspondence between Cantillon and the firm, they averred that the entire transaction was carried out under Cantillon's immediate direction and that he therefore bore personal responsibility.¹²²

In the next chapter we will explain that the violation of the irregular deposit of securities is just as corrupt from a legal standpoint as the violation of the irregular deposit of money and gives rise to very similar economic and social evils. A perfect example in the twentieth century was the failure of the Bank of Barcelona and of other Catalonian banks that systematically accepted the irregular deposit of securities without keeping full custody of them.¹²³ Instead, to attain a profit, they used them in all sorts of speculative operations to the detriment of their true owners, just as Cantillon had done two hundred years earlier. Richard Cantillon was brutally murdered at his London home in 1734, after twelve years of litigation, two arrests, and the constant threat of imprisonment. Although the official version was that he was murdered and his body burned beyond recognition by an ex-cook who killed him to rob him, it is also plausible that one of his many creditors instigated the murder, or even, as suggested by A.E. Murphy, his most recent biographer, that Cantillon staged his own death to escape and to avoid more years of lawsuits and legal action against him.¹²⁴