In order to appreciate the problems inherent within today’s system of money and banking, it is first necessary to understand its evolution. This article examines the origins of money, from commodity money, through representative money, to today’s money which is based on debt. It also reveals the origin of banking from the goldsmiths of medieval Europe to today’s system of fractional reserve banking.
Understanding the history of money and banking is vital for anyone attempting to profit from the financial markets.
The gift economy and barter
Before societies had money they operated using the principles of a gift economy and barter. The gift economy was based on mutual giving. In a gift economy people gave willingly with no formal quid pro quo because status was given to those who gave the most to others, rather than those who had the most. A hunter or farmer for example would bring back food to share with everyone. This sharing of food and other essentials helped ensure the survival of the whole community.
Under a barter system an individual possessing a material object of value could exchange it with another person for an object perceived to have equivalent value. Barter does however have its drawbacks. For example in order for an exchange to take place person A has to want what person B is offering at roughly the same time that person B wants what person A is offering. This dependency is known as ‘The Dual Coincidence of Wants’ and although there will be occasions when this coincidence occurs, barter on a day-to-day basis is impractical.
As societies developed it became clear that what was needed was some means of storing the value of the goods a person had sold, or the work they had done, such that could later be exchanged for other goods.
Shells, cocoa beans, various metals, even feathers have been used as money over the years. As long as it was portable, and enough people believed that it could later be exchanged for things of real value such as food, clothing and shelter almost anything could be used as money. At one stage Roman soldiers were paid in salt, from where we derive the word, ‘salary’. These early forms of money were ‘commodity money’.
The most widely and successfully used forms of commodity money were gold and silver.
The use of gold as money has been traced back to the fourth millennium BC when the Egyptians used gold bars of a set weight as a medium of exchange. Gold and silver were attractive, soft and easy to work with and so many cultures became expert with these metals casting them into coins to facilitate trade. These coins where certified by their weight and the purity of the gold or silver content. Coinage was widely adopted across Ionia (which was in present-day Turkey) and mainland Greece during the 6th century BC.
From commodity money to representative money
Since no banks existed, wealthy businessmen and entrepreneurs entrusted their wealth to their local goldsmith who was happy to store their gold and silver in his vault in exchange for a small fee. Goldsmiths would then issue paper receipts certifying the quantity and purity of the metal they held on deposit.
The emergence of paper money
After a time depositors became content to leave their physical gold and silver in the goldsmith’s vaults. That was because the goldsmiths’ receipts were being traded in the marketplace as a safe and convenient form of money backed by the real wealth stored in the vaults. World trade had slowly moved from a ‘commodity money’ to ‘representative money’.
Now that depositors were using their paper certificates for trade, goldsmiths realised that they could make more money by issuing new loans against the gold they held in their vaults and charging interest. Goldsmiths issued these loans by creating additional paper gold receipts and these were generally accepted in the market. The new gold receipts were indistinguishable from the receipts issued for the deposit of actual metal and both represented a promise to redeem the receipt in exchange for a certain amount of metal.
A 15th century engraving of the patron saint of goldsmiths Saint Eligius
Source: Wikipedia. Note: The goldsmiths of London became the forerunners of British banking.
Goldsmiths went about this practice in covert fashion for many years, and because depositors’ loans were repaid they were no worse off. Eventually however, depositors got wind of the goldsmiths’ scheme and wanted their share. Rather than taking back their gold, which was all still safely in the vault, the depositors simply demanded that the goldsmith, now in effect their banker, pay them a share of the interest. This was the beginning of banking.
The beginning of banking
These new goldsmith, bankers, would pay one low rate of interest on deposits of other people’s money, and then lend it out at a higher rate. The difference covered the bank’s cost of operation and its profit. Loans were limited by the amount of gold depositors had in the banks vault and this simple honest system worked for many years.
As Europe expanded and the demand for new loans grew however, bankers began making loans against gold that wasn’t in their vaults. Since no one other than the goldsmiths knew how much actual gold they held versus the value of receipts held by the public, the goldsmith was able to create money based purely on public trust.
When borrowers panicked however and demanded their actual gold instead of the paper certificates, bankers were simply unable to supply enough gold and silver to redeem all the paper certificates they had issued. These ‘bank runs’, as they are known, ruined individual banks and destroyed the reputation of bankers.
Although it would have been straightforward to outlaw the practice of creating money from nothing, the large volumes of credit the bankers had issued made huge European commercial expansion and indeed, the Industrial Revolution possible, so instead the practice was legalised and regulated. The monetary system had moved from ‘representative money’ to ‘debt based money’.
Debt based money, aka fractional reserve banking
Bankers agreed new regulations and limits on the amount of money that could be lent out, though these limits were still much larger than the amount of gold and silver held on deposit. Usually the ratio was nine loaned units to one actual unit of gold. This was the birth of the fractional reserve banking system. It was also arranged that, in the event of a future bank run, central banks would support local banks with emergency infusions of gold. Only if there were runs on a lot of banks simultaneously would the system break down.
This fractional reserve system, where you need only hold a fraction of the money you lend out, consists of an integrated network of banks backed by a central bank, and is now the dominant system of money and banking throughout the world. As the modern system of banking developed however, the fraction of gold backing the debt money has steadily shrunk to nothing.
In the past it was common to require banks to have at least one dollar or pounds worth of real gold in the vault to back ten dollars worth of debt money created. Today reserve requirement ratios no longer apply to the ratio of new money to gold on deposit but merely the ratio of new debt money to existing debt money in the bank.
Today a bank’s reserves consist of two things, the amount of government issued cash or equivalent that the bank has deposited with the central bank, plus the amount of already existing debt money the bank has on deposit. As Ralph M. Hawtrey, former Secretary of the British Treasury, explains, “Banks lend by creating credit. They create the means of payment out of nothing.”
A simple example of fractional reserve banking
Let’s assume a new bank wants to open and that it starts with US$10,000 capital. It would then need to make a deposit at the central bank. In the US the required reserve ratio is 9 to 1 (normally expressed as 10%) so the new bank needs to deposit US$1,000 at the central bank.
If a borrower were to come into the bank and borrow the remaining US$9,000, the bank would enter the amount into its computer system and credit the borrowers account. This money is not taken from anywhere, it is simply borrowed into existence and becomes bank credit. When the borrower spends the money, the recipient of the US$9,000 can then deposit the money into their bank account.
On the back of the US$9,000 the bank can create a new loan, this time for US$8,100. Each new deposit allows the bank to issue a slightly smaller loan.
The original US$10,000 has the ability to create US$100,000 within the banking system, and the bank can collect interest on US$90,000 it never had. This is known as the Money Multiplier Effect.
All of this new money is created entirely from debt the only real money was the original US$10,000 capital.
The key point here is that in a fractional reserve system new money is created in the form of debt.
When our money is deposited at the bank, in the form of a pay check for example, that money actually becomes the bank’s money to do with what it pleases. Though we can withdraw our money at any time, the reality is that when we make a deposit at our bank, the bank holds an IOU in our account and not the actual money we deposited. As economist & author, Irving Fisher, explains, “Our national circulating medium is now at the mercy of loan transactions of banks, which lend, not money, but promises to supply money they do not possess”
Click here for Part II of a brief history of money & banking.