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Written by Christophe Cieters.

During the 14th century Renaissance in Northern Italy, banks as we know them today started to form in earnest.

Gold and silver were still the dominant media of exchange; people used precious metals in their daily transactions and banks acted as highly secured storage facilities and intermediaries between potential lenders and creditors.

When it came to gold and silver, a “bank” had usually simply been a gold smith at first. Due to the nature of the business, gold was always around and had to be securely stored anyway, so it made sense for a gold smith to earn some money by selling the service of storing other people’s gold as well. For the people with gold to store, it was cheaper than having to buy and secure vaults of their own.

When people deposited their gold at these banks, the banks were paid a fee for their safe-keeping service, and held 100% reserves. This means that every gold or silver unit in a deposit account was physically present in one of the bank’s vaults. Depositors would deposit an amount of gold and get a certificate of deposit (in effect, bank notes) from the private bank (with each “bank” giving out its own bank notes), which could be traded in for the same amount of gold again whenever they wished.

 

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Imagine that depositors put one hundred identical bars of gold in a banker’s vault. In return, they get one hundred bank notes, each representing a claim on one gold bar. Sometimes they come to reclaim their gold if they want to make a purchase, sometimes when making a purchase they just transfer their bank notes to the person who sold them certain goods or services (who may then go to claim the gold at the bank, or use the bank notes himself to trade them on, etc.).

People are constantly coming into the bank to claim some of these one hundred gold bars, spend them somewhere, after which somebody brings them in again for safekeeping in exchange for some bank notes, and so on.

Gradually, these certificates – especially those of well-known banks – were starting to get used in exchanges as if they were gold (“as good as gold”), since everybody was convinced that they could simply convert the notes as they wished and it saved multiple unnecessary trips to the bank if one simply paid with the bank notes (so the recipient could spend them again or go to get his gold at the bank as he pleased).

The bankers kept track of the gold going in and out of their banks and noticed that in effect, only about (for example) 10% of the total gold reserves was actually being claimed and then deposited again a while later on a regular basis, but 90% of the total gold bar reserves remained virtually untouched throughout the year.

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If the banker was therefore to lend out some of the gold bars in his vault, nobody would notice as the depositors only ever seemed to claim about 10% at once. A banker may at that point conclude that he only has to keep a fraction in reserve, instead of the full 100%.

One day, somebody comes into the bank and asks whether he could borrow ten gold bars to buy a new horse. He promises to pay the bars back within a few months, and will even pay back an additional one (eleven total) in return for the loan. The banker, assuming that nobody will notice as there are always lots of bars just lying around anyway, hands the borrower ten bars from the vault, thrilled at the prospect of getting a gold bar for free once the loan is repaid.

However, as long as the loan is not repaid, there are now only ninety gold bars in the vault, while there are one hundred bank notes – each claiming one gold bar – in circulation. The original depositors are walking around with their bank notes, thinking they could withdraw all of their gold at any time by trading them in (though they might find out that the gold was gone if too many came to claim their gold at once).[1]

Alternatively, the bankers also could also issue “fake” certificates to the borrower with “as good as gold” drawing rights on gold that already had a certificate in circulation (in the hands of the original depositor). The borrower could then use his bank notes to claim some physical gold, or he could trade his certificates around just like those of the original depositors. This has the same effect as giving physical bars along with the borrower, and, in any case, several certificates now came into circulation which, when it came down to it, actually all claimed the same pieces of gold as their own (the original depositor owned one of the notes, but also the person who just took on a loan).

This is called fractional reserve banking (FRB), as the actual, physical gold reserves in the bank’s vaults in such circumstances only represented a certain fraction of the total claims of the bank notes in circulation.

A while later, another person comes into the bank and also asks for a loan. This time, the borrower says the physical gold is not necessary, certificates are fine as well, given the fact that the stonemason said he accepts “as good as gold” bank notes too. That suits the banker just fine, and he gives the second borrower ten bank notes, each officially redeemable for one bar of gold, and the borrower promises to pay them all back in a few months’ time, with two additional gold bars as interest. Now there are ninety gold bars in the vault, but a hundred and ten bank notes in circulation, each claiming one gold bar from the vault.

The banker could even just take some of the gold out of the vault himself, spend it and then put some gold back into the vault after a while (in effect “loaning” money to himself without ever telling anybody about it). Or he could do the same by making some additional bank notes for himself and spending them to buy whatever he wants.

In all of these cases, the bank in effect “created” money out of nothing. If the original depositors all were to come and claim their one hundred gold bars, they would find that there are actually not enough bars in the vault to get their gold back. What’s more, if the second borrower also spent the bank notes to buy a millstone from the stonemason, the stonemason would also not be able to get the gold he thought he had earned in case everybody came to redeem their bank notes at once. The same is true for all of the spending the banker himself did.

Footnote

[1] Note that before, if people wanted to earn interest they loaned out the money, if need be through an intermediary who would get them in touch with a borrower and check his or her credit worthiness, but depositing meant that they simply wanted to have it stored, paying a fee for the storage. As we will see however, the banker’s actions started to turn everybody, even the depositors, into risk taking creditors – more often than not without them even being aware of it, let alone understand it.

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Christophe is a guns and gold loving anarchist from the geographical area known as Belgium. He spends his days slaying dragons and rescuing damsels in distress, invigorated by bathing in statist tears on a daily basis. He was put on this world to kick socialist ass and chew bubblegum – and he is all out of bubblegum.

If you enjoyed this post, please consider purchasing his bookThe Road to Anarchy and leave a review.

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