A goldsmith in his shop. Peter Christus (1449).

How the financial system came to be

A goldsmiths’ tale

How the financial system came to be is an interesting story. Once upon a time when gold was internationally accepted as money, goldsmiths fabricated gold coins of standardised weight and purity. The goldsmiths were a trusted source of these gold coins. They owned a safe where they stored their gold. Other people wanted to store their gold there too because those safes were guarded.

And so some goldsmiths began to make a business out of renting safe storage. People storing their gold with the goldsmith received a voucher certifying the amount of gold they brought in. At first these vouchers could only be collected by the original depositor.

Later this restriction was lifted so that any holder of the voucher could collect the deposit. From then on people started to use these vouchers as money because paper money was more convenient than gold coin. Depositors rarely demanded their gold and it remained in the vaults of the goldsmiths.

Modern banking

Some goldsmiths also had another business, which was lending out their gold at interest. Because depositors rarely came in to collect their gold, they discovered that they could also lend out the gold of the depositors at interest. When the depositors found out about this, they demanded interest on their deposits too. At this point modern banking started to take off and paper money became known as bank notes.

Credit note's holder, Stockholm's Banco sub no. 312
Credit note’s holder, Stockholm’s Banco sub no. 312

Borrowers also preferred paper money to gold coin, so the goldsmiths, who had now become bankers, found out that they could lend out more money than there was gold in their vaults. Bankers started to create money out of thin air. This is fractional reserve banking because not all deposits were backed by gold reserves. The new money was spent on new businesses and that hired new people so the economy boomed.

When depositors discovered that there were more bank notes circulating than there was gold in the vault of the bank, the scheme could run into trouble, but mostly it didn’t. Depositors received interest. This enticed them to keep their deposits in the bank. People trusted their bank as long as they believed that debtors would pay back their loans.

Bank runs

Sometimes people started to have doubts about their bank and worried depositors came to the bank to exchange their bank notes for gold. This is a bank run. The bank could run out of gold and close down because not all the gold was there. The bank’s bank notes could then become worthless, even when borrowers had no problems repaying their debts. The money that the bank had created out of thin air suddenly vanished. This was a financial crisis.

Bank run
Crowd at New York’s American Union Bank during a bank run in the Great Depression

As a lot of money had suddenly disappeared people had less money to spend. This could hurt sales so that some businesses could go bankrupt. Those businesses could not repay their debts at other banks. Depositors at those banks could start to fear that their bank would go bankrupt too. This could cause more bank runs and more money disappearing, so that things would become even worse. This is an economic crisis. This is the way a financial crisis could trigger an economic crisis.

Regulations and central banks

Measures have been taken to forestall financial crises and to deal with them if they occur. Banks needed to have a minimum amount of gold available in order to pay depositors. Central banks were instituted to support banks by supplying additional gold if too many depositors came in to collect their gold. Central banks could still run out of gold but this was solved when the gold backing of currencies was ended. Nowadays central banks can print new dollars or euros to cope with a shortfall.

Regulations limit the amount of loans banks make and therefore the amount of money that exists. But everyone can lend to anyone. Alternative forms of financing circumvent the regulations imposed on banks. For example, corporations can issue bonds or use crowd funding. Human imagination is the only limit to the amount of debt that can exist. As long as people expect that those debts will be repaid, even if it is with new debts, there is trust in these debts. But the financial crisis of 2008 demonstrated that trust in debts can suddenly disappear.

Featured image: A goldsmith in his shop. Peter Christus (1449). Metropolitan Museum of Art. Wikimedia Commons. Public Domain.

Other images: Money As Debt. Paul Grignon (2006).

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