How Fractional Reserve Banking Started


Once upon a time people produced goods which they traded for other goods with other people. As the economy grew more diverse and larger ranges of goods and greater bulks of goods were produced, this sytem of exchange became inadequate for a number of obvious reasons.

People began to use small, valuable items as ‘tokens of exchange‘. Many different things were used, but peices of metal, then much less commonplace than today, became the most popular exchange media. Gold, silver, copper, bronze and even iron was used. Pieces of metal had a direct value in their own right and so people felt secure accepting payment in metals as they could be sold to smiths and jewelers as materials. Metal can also be cut into smaller pieces of less value creating ‘change‘. Unlike other valuables like food, metal does not rot and lose value. It is also small, easy to carry and conceal.

This ease of trade produced merchants who did nothing else. Traveling from place to place, they would buy cheap where demand was low and supply high and then trade in places where supply was low and demand high. They became very wealthy and built up large stocks of gold and silver. This left them with a problem. They only needed to take a small percentage of their wealth with them at any time, just enough to trade with, so what to do with the rest?

The merchants had a few choices, each of rather limited appeal. They could carry ever larger hoards of wealth around until they got robbed, they could bury it or they could trust somebody else to look after it.

The goldsmiths, oddly all Jewish, proposed a solution to the merchant’s problem. They offered to hold the wealth of the merchants in their vaults. Goldsmiths, not traveling around to do business, had long since established secure means of storing gold. It was their business to use gold, to have gold and they obviously couldn’t leave it lying around at night etc. Merchants would deposit their gold and silver and would be issued with a reciept. Silver would be accepted, but the reciept was for the silver’s value in gold, this later led to the Gold Standard. Everything in the economy from this point could be priced by it’s value in gold.

These receipts were exchangable for gold by the bearer upon demand. It wouldn’t be your old gold back, you may have deposited silver, but you would by given the amount of gold the receipt declared you entitled to. You would pay a fee when you made the deposit so you would get the full sum on the receipt. Goldsmiths, now bankers, made their money from the fees charged for deposits.

No con so far. All seems well.

Over time people began to trade the receipts themselves, hence the saying “as good as gold“. Merchants would accept a receipt happy in the knowledge it was payable to the bearer upon demand. Bankers began issuing a range of receipts of different values. You could deposit ten pounds of gold, minus fees, and receive a receipt for five pounds and five for one pound. This encouraged the trading of receipts. As this became common practice the bankers began to get very rich, not rich with paper money, that was useless to them, but with hoards of gold.

Receipts were often destroyed by water or fire and many people never returned from trips to far away places, different things happened, but the end result was that these pieces of paper, the value of which was nothing, were often never reverted back into gold, something people actually valued.

Because there was, at any given time, tons and tons of this ‘good as gold‘ paper money in the economy, the bankers not only had their ever growing fortunes, but also held untold wealth in the form of deposits. This was not theirs, but they had control of it until it was claimed back.

Here comes the scam.

The bankers then began money lending. They offered loans and people borrowed money. They issued paper money, but, if you wished, you could demand gold with the paper money you were given. Most people didn’t bother as they thought the money was as good as gold, meaning that all that actually happened most of the time is people borrowed pieces of paper and owed gold.

Because the huge bulk of the gold was always in the vaults and it never went below a certain amount, it was safe for the bankers to issue more money, there was gold in the vaults to cover it. They issued tons of money. They had already issued receipts for the gold upon deposit, but had now reissued more ‘reciepts’ without actually holding the relevant gold. The value of all the receipts in circulation was now many times the value of the gold in the vaults, which was no small sum.

The bankers were now printing gold. This would of course go very badly wrong if even a significant percentage of people tried to convert their paper back to gold as the gold didn’t exist for the most part. The bankers now needed to ensure this never happened, easier said than done, but done it they have.

The money we all spend is not real and is exchangable for material things as long as we only spend a small amount of it. People and companies always have money, not all of them, but enough of them, enough to make it work. Once this system starts to work it is self supportive, people just have to make sure that most of them don’t want most of their wealth in actual things of value. These days most people have been conned into accepting a figure on a pc screen as wealth and often do a weeks solid labour for an entry in their account.

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