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

How the financial system came to be

A goldsmith’s tale

Once upon a time goldsmiths fabricated gold coins of standardised weight and purity. This made them a trusted source of gold coins. The goldsmiths also owned a safe where they stored their own gold. Other people wanted to store their gold there too because those safes were well-guarded. And so the goldsmiths began to rent out 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 on any holder of the voucher could collect the deposit. Another innovation was making standard vouchers representing 1, 2, 5 or 10 units. From then on people began to use them as money as paper money is more convenient than gold coin. And so depositors rarely came to collect their gold and it remained inside the vaults of the goldsmiths.

Modern banking

Some goldsmiths also lent out their own gold at interest. As depositors rarely came in to collect their gold, they soon discovered they could also lend out the gold of the depositors. When the depositors found out about this, they demanded interest on their deposits too. At this point modern banking took 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 preferred paper money too so the goldsmiths, who had become bankers, found out that they could lend out more money than they had gold in their vaults. They began to create money out of thin air. This is called fractional reserve banking as not all deposits were backed by gold reserves. The new money was spent on new businesses that hired new people so the economy boomed.

When depositors discovered that there were more bank notes circulating than there was gold in the vaults of the bank, the scheme could run into trouble if all depositors came in at the same time to demand their gold, but this rarely happened. Depositors received interest so they kept their deposits in the bank. They trusted their bank as long as they believed that debtors were paying back their loans.

Bank runs

But sometimes people began to doubt that the bank was safe and worried depositors would come to the bank to exchange their bank notes and deposits for gold coin. This is called a bank run. If too many people came in at the same time the bank could run out of gold and close down because not all the gold was there. As a result the bank’s notes and deposits could become worthless.

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

People who lost their money had less money to spend. This could hurt sales so businesses could run into trouble and default on their debts. As a consequence depositors at other banks might fear that their bank could go bankrupt too, leading to more bank runs. This could escalate into a financial crisis and an economic depression. This happened in the United States during the Great Depression of the 1930s.

Regulations and central banks

To forestall financial crises and to deal with them if they occur, banks were required to have a minimum amount of gold available in order to pay back depositors. Central banks were created to support banks by supplying additional gold if too many depositors came in to collect their gold at the same time. Central banks could still run out of gold but this was solved by ending the gold backing of currencies. Nowadays central banks can print new dollars or euros to cope with any shortfall. Regulations limit the amount of loans banks make and therefore the amount of money that exists.

But everyone can lend to everyone. There are ways to circumvent the regulations imposed on banks. For example, corporations can issue bonds or use crowd funding. And a lot of lending nowadays happens outside the official banking sector in institutions that are not subject to these regulations. Human imagination is the only limit to the amount of debt that can exist. And as long as people expect that those debts will be repaid, even if it is with new debts, there can be trust in these debts. But the financial crisis of 2008 demonstrated that this trust can disappear very suddenly.

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