Thursday, September 18, 2008


(Week 8 - Thursday, Sept. 18)

The mode of banking now in use is commonly described as "fractional reserve banking." The expression "fractional reserve" is one that is carried forward from an earlier form of the craft known as "goldsmith banking." As applied to modern practice, this expression is a misnomer that effectively obscures any true understanding of how our present monetary system operates, and why it is currently in such distress. To get a clear picture of this, it is first necessary to gain an understanding of what "fractional reserve" originally meant, and then how the concept has been misapplied.

In Europe of the 15th century there were many smiths that worked with gold, and therefore required vaults to securely store this precious material of their craft. Over time citizens and merchants that owned their own gold and used it in trade found the metal to be inconvenient and hazardous to keep in their personal possession. Consequently goldsmiths engaged in the sideline business of storing people's gold in their vaults, and issuing a receipt for the storage.

These receipts began to circulate as a currency with tradable value, as if they were the gold itself, and so became a form of paper money redeemable in gold. As payment the goldsmith charged a percentage of the value of the gold stored.

The goldsmith noticed that under normal circumstances only a very small percentage of his customers at any given time would redeem their receipts (i.e. take possession of their gold). For long periods the great majority of their metal merely gathered dust in his vault. At length it occurred to him that he could write more receipts and offer to "loan" the gold he was entrusted to hold to others, with an "interest" charge attached of course. In actuality he had nothing to loan because the gold already belonged to another customer, but who would know the difference. He could, in effect, profit on gold that he had, in a figurative sense, "created out of thin air."

The key to making this scheme work is that he would need to limit the amount of receipts issued such that the gold that he had on hand would, in the normal course of business, represent at least a certain "fraction" of the face value of the outstanding paper claims against it. This gold on deposit, then, would act as a "fractional reserve" that could be dipped into in the event that he experienced an unusually high demand for redemption at any given time.

The goal of the whole arrangement to the goldsmith was to issue as much "interest-bearing" paper as he dared against the stock of gold in his possession (thereby maximizing his income), while guarding against the possibility that the day might come when he would not be able to redeem with gold a receipt that was presented to him.

At first the scheme was a trade secret. As its workings became an open secret, many people regarded it as simple fraud, but others deemed it a necessary way to get the quantity of medium into circulation that a growing commerce demanded. In any case, the populace was eventually obliged to accept the goldsmiths' methods as the accepted way of doing business, or effectively forego much of its money supply.

By this mechanism the goldsmiths effectively began to operate as "banks-of-issue" (banks that create and issue money), and "fractional reserve banking" was born. The scheme worked well as long as there was not a "run on the bank"; that is, a rush by depositors to redeem their receipts for the gold because they had lost confidence in the institution.

As a sidebar to the goldsmith-banker story, it bears mentioning that this group has borne a great onus in the historical reckonings of many would-be monetary reformers. It is easy to find good reason for that assessment, but the whole story is not so simple. It could be argued that they were in effect coming up with a money–creation mechanism that did in fact put a great deal of currency into circulation in an age when that was sorely needed for its own inherent reasons. They operated in a time when the society itself did not have a sufficient sense of the science of money to create an adequate system in the public sphere where it rightly belongs (the same might be said of the situation with respect to money and banking that we find ourselves in today).

Were the goldsmiths simply a class of scam artists, or were they people who saw an essential need of the society around them and found an innovative way, however imperfect, to meet it? The answer presumably is both, and all degrees in between. They were, after all, people. Many deem the legacy they left behind as threatening the demise of civilization. It could also be argued, however, that had they not initiated such a practice, the evolution of Western society would have been seriously hindered. I leave that question to the reader's judgment.

In tomorrow's column we will begin to examine how a pseudo version of the goldsmith's method, recreated in our time as the "fractional reserve system," has planted the seeds of the present collapse of the financial sector.

Richard Kotlarz

The complete set of columns from this series is posted at the following websites:

No comments: