Originally written in early and mid-2014. Some charts updated, and it has been edited, but the content remains the same.
The story of our money starts as a simple fraud. It is a fraud that has infiltrated every facet of our lives. When one benefits from this fraud, the draw to perpetuate it is in most cases overwhelming.
Imagine an Old English goldsmith. He makes a handsome living minting coins for the local lord, and at times the king himself, along with other services associated with the working of precious metals. He has used some of the profits from this enterprise to invest in a grand safe in which to store, not only his gold but the gold of his clients. As his business grows he adds additional 24 hour trusted guards to add to the security of his vault.
This security was visible and imposing and introduced a new business opportunity to the metals worker. Clients began to request that their wealth, in the form of gold and silver, be stored in his facility. For a small fee he agreed. In return for the gold, he gave the owner a simple receipt. Among his other services he became a storage facility, a legitimate service for fair compensation.
After some time the gold smith was making nearly as much income from his storage fees as he was from his metal working. It was a lucrative business. A few new things occur, the first of which was people began to use the receipts directly to purchase goods and services. The receipts are lighter and more convenient than carrying around the gold and silver coins, but the bearer of such receipts could be confident that they could be returned to the gold smith and claim their wealth. Originally it was no different than a coat check receipt you might receive at a restaurant, but now that they were being used as money, they took on a very unique characteristic before only allotted to the precious metal coins; they were a medium of exchange. On the surface there is nothing fraudulent about this development.
One thing the use of this paper “currency” did facilitate was that gold was rarely taken from the custody of the goldsmiths vault. Once the goldsmith realized this, he felt it a shame that all that money sat there idle. Temptation started working on him, urging him to put this money to work. He had some options. He could simply use it to purchase whatever he wished, but to the bright business man, this was a sure path to disaster as he had no way of regaining the gold, and eventually the clients may want it back… imagine that. Instead a smart goldsmith could loan a portion to farmers, other businessmen, even lords, the king, and other members of the government, at interest of course. Now he could convince himself he was not stealing since he was only keeping the interest. Now this was sustainable, but very clearly fraud. To loan other people’s money and profit, without their knowledge, most would agree, is an immoral act. But even if the goldsmith started small, the returns in many cases must have been irresistible.
The people watching the goldsmith attain impressive wealth, through jealously, self-interest, or curiosity may have started paying close attention and determined that he may not be gaining his wealth through just means. These curious onlookers may have thought he was just spending the gold and silver that he was storing, or completely picked up on the whole lending scheme. Either way the result would be clear to the observer; there would be more claims on the precious metals in the vault than there was actual gold and silver stored there.
If that observer was a client of the goldsmith it would cause a loss of confidence. Those who realized it would rush to trade in there receipts for their gold. People often move as a heard and, whether the first to pick up on the fraud actually vocalize their concerns or those watching the long lines at the vault felt it’s better to be just part of the crowd, the result will be the same, what we now know of as a bank run. The remaining gold and or silver quickly disappears from the vault, many that had entrusted the storage of their wealth to the goldsmith would have been devastated at the loss of their savings. The grieving would hit the well-known anger phase and the goldsmith may have paid with his life. There is though, no question that the practice could create immense wealth for the perpetrator, and people have risked more for less.
The most cunning of these goldsmiths, attempted to make this fraud more legitimate, to at least not shut the cash cow down all together. Undoubtedly the interest on the loans, in some cases, may have been even more profitable than either their storage or goldsmith fees. Loans allow people to have now what you would otherwise have to wait for. So loans feed on a human condition for pleasure in the moment and the demand for loans, at the right terms, would always be high. So how could the goldsmith continue to feed that demand and profit from it? The answer was to become what we now know as a banker. They essentially bribed their customers to allow them to continue making loans. They would use the deposits of gold and silver to make a loan and split the interest with the depositor.
Making loans on deposits in this manner actually doesn’t appear to be fraud at all, on one condition, and that is if the depositor is willing to wait for the duration of the term of the loan to get their money and interest back. Unfortunately for the banker this does not work nearly as well. Considering the gold has been earned by the depositor through hard work, they are less likely to loan that hard earned money at an interest rate nearly as low as the banker would be willing to. The banker did not have to work very hard for the loanable funds in the previous model, it was given to him. Now on top of the already high interest the depositor demands, the banker has to tack on his cut. With higher interest rates the demand for loans would be lower. Less loans would mean that compared to the fraudulent model, not only would the banker have to pay the depositor their cut, there wouldn’t be nearly the volume. Both these conditions equal less money for the banker and after it was so lucrative, it was only a matter of time before another fraudulent version would be born. The receipts would also lose their usefulness as a medium of exchange since they could not be exchanged for gold and silver on demand.
All the banker needed to do was convince the depositors that it was safe to give the bank their gold and silver while at the same time continuing to allow them to use the receipts to collect their precious metals on demand. This is known as a demand deposit. If depositors could get their savings on demand they would not insist on such a high rate of interest. The banker would continue to make loans with the deposits but would compensate/bribe the depositors with the interest. The receipts could also continue to be used as a medium of exchange. Due to the interest payments to the depositor this arrangement was not quite as good as the secretive theft. This new slightly more transparent deal didn’t protect the system from bank runs, and thus was unstable in that it could not ensure that the depositors could always get their hard earned money. Bankers certainly would make every attempt to convince them that the deposits were safe though.
It was similar to a much later scheme started by a Mr. Ponzi, the depositors who, in the event of a bank run, got out first, did just fine. They got their gold as well as all of the interest for however long the scheme held together, but the last ones out got none of the original deposit let alone interest. This was still clearly an immoral system, but the depositors certainly share in some of the blame for knowingly participating. Although, it has become a tradition in banking to make the system confusing but also, in a way, explainable to make it seem viable. The bankers give the depositors and borrowers a list of exactly what they want. Excuses as to why they can participate, collect interest, or as a borrower, get cheap loans, and in general continue the good times. I'm sure in some cases the bankers even convince themselves that these excuses were real.
Now enters the final piece of the puzzle. If the government is fair and just it, even if the depositors want such a system, will see it for what it is and shut it down through its laws, just like any other system of fraud. So to get a government to allow such a system the bankers will, in addition to the depositors, need to give the government a cut of the wealth and benefits. They can do this through paying taxes, providing cheap loans to the government, or providing other benefits to those who control the implementation of the laws.
The bankers could also attempt to convince the governmental powers that this system is actually good and healthy for the economy, and thus those in power. Direct payments to governmental officials, cheap loans, along with a healthy dose of opacity and confusion will allow the government to endorse such a system. Now this fraud has legitimacy, it is lawful, yet still immoral. Governmentally sanctioned fractional reserve banking has now been born.
A key point is fractional reserve banking was born of fraud.
This system also increases the amount of money in the economy. Initially there is only the number of gold or silver coins circulating. When those coins are deposited and the receipt is given out, that recipe will flow in the economy just as if it were the gold itself. But the gold coin is also loaned out entering the economy. The gold could also be re-deposited, adding another gold receipt, and loaned out again, repeating this cycle over and over. This increase in the money supply was originally termed inflation, because it was an inflation of the money supply.
If there was a perfectly commensurate increase in goods and services (the boom), the increase in the money supply would not affect prices. If the increase in goods and services did not keep pace with the increase in money, prices would rise. And finally in the event that the amount of goods and services increased faster during the boom than the money supply, prices would actually fall. The main takeaway is that the term inflation initially only referred to the increase in money supply and could be a cause of changes in prices although there were other variables, namely money velocity, and actual economic growth.
One other issue arising from these booms is that due to the volatile growth that is born from monetary inflation, there can be great misallocation of resources as a result of bubbles. Bubbles can be defined as overinvestment in one sector of the economy due to incorrect market signals. Usually, this incorrect market signal is increasing price action in the investment giving the false impression of assured gains, but other factors can also cause these incorrect market signals such as manipulation.
Fractional reserve systems grew and infiltrated the economies of Europe. As long as they held together, using them could be quite prosperous, but the collapse was actually inevitable. When these banking systems collapsed the economic turmoil left in their wake could be so devastating that the initial boom created by the monetary expansion as a result of the bankers loans would be erased or worse, could cause the economy to regress.
Here is how Ludwig von Mises put it:
"There is no means to avoiding the final collapse of a boom brought on by credit expansion."
The second part of that quote is more profound but that is for later on.
The boom may bring true economic growth, to some degree. It may cause farmers to produce more crops, builders to build more homes, and fisherman to catch more fish. In addition, during the boom, the depositors benefit, government benefits, even the general population may benefit from the wealth created. But the bankers benefit most of all with very little effort. During the boom none of these groups will resist, after all they are making money and living better. The splinter in the side of the system is the crash, and one of the aspects that makes fractional reserve banking an even harder pill to swallow is that one generation may enjoy the benefit of the boom and leave the crash for their children or grandchildren. This feels even against human nature to benefit at the detriment of your offspring, but again those caught up in the boom want to believe, and will justify it by any means possible, or may just not be paying attention.
A key point with the boom is that the longer it is able to continue the larger the crash can be.
The mechanism through which the crash happens is simple. After a bank run the unredeemed receipts no longer have value since they cannot be exchanged for specie (another term for gold and silver coins). They are no different than the coat tag that you can no longer use to get your coat. The receipts are no longer money. Just like the worthless coat tag the receipts can be discarded. At this point the only money left in the economy are the gold and silver coins, there is far less money than there appeared to be when the receipts were still generally accepted. This reduction in money supply is the flip side of inflation and is a factor in the opposite effects.
There are other effects that result from the boom and subsequent crash. Some of the specie may have also traveled far from the immediate economy causing even less money to circulate. Another issue is after any shock it is human nature to store what is needed, and this extends beyond just food after a famine. In an economic light this storing can cause humans to store or “save” money in an unproductive manner i.e. keep it under their mattress instead of investing it in productive assets.
Storing money hits on one of the variables that was mentioned when discussing price levels, money velocity. And now is a perfect time to explain it. Here is one example. A pig farmer and an apple orchard owner would like to trade their apples and pork chops. The owner of the orchard has one gold piece that they will use as their medium of exchange, a simple place holder. In our first example the apple orchard grower goes down the road to the pig farmer and asks if he can buy a pig for the gold piece, the pig farmer agrees and the apple man goes down the road with his pig. Later that year, in the fall, the pig farmer decides he wants to go down the street and buy some cider with his gold piece. The pig farmer and orchard owner decide that 26 casks of cider is a fair for one piece of gold, and the pig farmer loads the casks of cider in his cart and drives home for the year. So what was the income of each man if these were the only transactions that took place that year? Easy right, once gold piece.
Let’s try another example. The same two men have the same farm and orchard and one piece of gold between them. This time the apple man goes to the pig farmer on the first weekend of the year and asks for some pork chops for the coin, they agree, and the following week the pig farmer goes and gets a cask of cider for the for the same coin. Similar exchanges take part every weekend, bacon for pie, ribs for apple butter, pork loin for hard cider, and so it goes for the rest of the year, 52 weeks. Each man gets the gold 26 times and thus their annual income is 26 pieces of gold. Essentially they exchanged the same amount of goods, nothing was wrong with either way to do the transaction but their income varied by 2600%. Money velocity can have tremendous effects on economic perception, as much as or more so than the money supply.
After a bank run some may have thought they had a large store of wealth, only that wealth was not in the form of gold but paper gold receipts, which after the run, were worthless. Maybe he wants more for the precious gold piece or maybe he won’t spend his last precious piece of metal at all and will wait for the economic storm to pass. The natural reaction to store the only real money left, the gold and silver coins, after a bank run causes the money velocity to plummet making the reduction in the apparent money supply fall by even more than just the elimination of paper money in the system.
I’m sure it is easy to see that with the real reduction in the medium of exchange, as well as the perceived reduction due to the reduction in money velocity incomes would suffer and could make it difficult to pay back loans for the farmers or businessmen, say, to a neighboring towns bank. These failing, also known as non-performing loans, along with the rumor of the first bank run could cause depositors in those neighboring towns to panic and cause bank runs in their own towns. Thus the crash does not remain isolated and spreads like a plague throughout a fractional reserve banking system, causing just as much devastation as one.
Since the creation of this fractional reserve economic system there have been those that support and perpetuate its use, but this is mostly rooted in their greed and normalcy bias. Not because they think fractional reserve banking is the best for their country or its citizens. Then there are those that see it for what it is, fraud, and try to rid it from their country. Like liberty and tyranny it is a constant battle that must be waged, at times hot and at times cold but this battle has been going on for centuries.
I have left the origins abstract the originations actually took place over millennia and not just in England, but through your own research you can find examples of all that has been laid out.
There are two very real services that the bankers supplied to their clients that deserved just compensation. The first has been covered in the form of safe storage of wealth. The second was the facilitating of loans and guiding their depositor’s money into productive assets, also known as investing. These storage and investment services should be paid for, but under the fractional reserve system the compensation for the bankers is much higher than would otherwise be justified in a free market system, the profit share taken by the banks is not fair to their clients, whether the depositors or the recipients of the loans.
This also reminds me of another injustice in which real services were supplied but it did not change the deplorable nature of the arrangement. This is the instance of southern slavery during the first part of our nation’s history. The masters of the slaves certainly exploited their labor, but they were supplying a service, management of the plantation, and as businessmen of today know a good manager is a valuable part of the team. That said these managing masters took an unfair cut of the profits, and the basis of the arrangement was still rooted in an immoral system.
Now it’s time to make this notion of fractional reserve banking a little more real…in the history of the United States.