Last week saw how pure barter of goods eventually gave way to standardized metal coinage, often made of gold. Once these coins were in circulation, people began to accumulate them. This accumulation increased the risk of burglary, and caused men to seek safe storage for their new form of wealth.
Usually, the only person in the area with an appropriate vault was the goldsmith. This led naturally to a practice in which the goldsmith would rent vault-space to his neighbors, just like a modern “safe deposit box”. The townspeople would then have paper "receipts" from the goldsmith which could be redeemed, at any time, for their stored gold.
As you might guess, the townspeople found it a hassle having to run and withdraw the actual gold coins from the goldsmith’s vault each time they wanted to make a purchase. So, instead of making withdrawals, they simply traded the paper receipts in the marketplace as if they were the gold itself. The receipts, backed by the gold in the vault, became the first system of “gold-backed currency”. It was a great success, and worked well to facilitate trade in a growing market.
It would seem now that the goldsmith had two jobs: the first being his original craft, that of smithing gold; and the second being his new vault rental service. However, he also had a third and lesser-known business on the side: he was a lender. Before any of his neighbors began storing gold in his vault, the goldsmith had been loaning out his personal gold, making a small income off of the interest. This means that he now actually had three jobs: he was a goldsmith, he was a lender, and he operated a vault rental service.
We need to stop and make a couple observations about this arrangement. Although the townspeople could redeem their paper receipts for their gold at any time, they did not often do so. They had become accustomed to trading only the receipts, writing transaction amounts on them, just like today’s paper checks. This means that the gold was constantly being exchanged out in the market, but only in the abstract sense, in the form of receipts. It was not going anywhere in the physical sense. This meant that on any given day the vault would have a very large quantity of actual gold just sitting there untouched, in storage.
The goldsmith saw an opportunity before him. Until that moment, his loans had been limited by the amount of gold he himself owned. With his new safe deposit service, he now had a massive collection of gold sitting before him. He realized that he could secretly loan out his neighbors’ gold as well, making a killing on the interest. As long as most of the loans were repaid, no one would ever be the wiser. It would be wealth gained in deceit, with the savings of his neighbors, but what his neighbors didn’t know would not hurt them, or so the saying goes.
Page 2 of 2 - So he began loaning his neighbors’ gold. As his fortune grew, his patrons became suspicious, wondering how he was able to wield such financial power. Eventually they banded together and went to the goldsmith demanding their deposits. The goldsmith was forced to come clean, admitting that he had been secretly lending their gold, and making a fortune on it.
But now we come to an unexpected twist in the story. Since most of the loans had been repaid, the gold of the depositors was still safe in the vault. The scheme had worked magnificently! So magnificently, in fact, that, rather than hang the goldsmith for his deceit, they joined him. Rather than withdraw their gold, they asked for a cut of the interest. They would give him their savings, he would make prudent loans, and they would receive a small percentage of the profit.
Our goldsmith was now a banker. Good old-fashioned banking and the bank loan were born, giving credence to Josiah Stamp’s earlier claim (from part 1 of this series) that “Banking was conceived in iniquity and born in sin.” Readers should take note that the goldsmith in this story is somewhat allegorical. There was no single historical goldsmith that fits this narrative, but the character does serve to relate and simplify the development of modern banking.
In summary, our goldsmith-turned-banker had created a system in which he received gold from his neighbors, loaned their gold, took interest on it, and then gave his neighbors a cut of the profit. If this system sounds familiar, it may be because many of us believe that banking still works this way, with loans being created from our deposits at the bank.
This belief is incorrect. Our modern banking system does not create loans from deposits; it creates them from nothing.
This strange arrangement, which is just as crazy as it sounds, came about through one last “innovation” by our goldsmith, which we will examine next week. You see, our gold smith learned an important lesson through his experiment in deceit: he learned that crime does pay.
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