“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.”
John Kenneth Galbraith
Money: Whence it Came, Where it Went (1975)
This is the eighth in a series on how banking facilitates economic inequality. The series begins here.
We cannot reform banking unless we understand that commercial banks not governments are the front line creators of money.
In 2013, in the wake of the 2008 Crisis, the former head of the British financial regulator, Lord Adair Turner, renewed J.K. Galbraith’s warning of 1975 that the generally believed theory of how money was created was still misleading. Turner observed that the common understanding of money creation was still based on the myth that banks make their profit by paying a low rate of interest on deposits and lending that money out at a higher rate. Not so, he said:
“Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo — extending a loan to the borrower and simultaneously crediting the borrower’s money account.”
Ex nihilo is a reference to the Latin version of Genesis, which says that God created everything out of ( ex) nothing ( nihilo). The Latin version of the famous “Let there be light” is fiat lux -also a creation from nothing. And therefore, this form of money is called ‘fiat’ currency. We will see that that name is well justified.
Crypto currency is a fiat currency.
A Medieval Financial Wizard At Work
T here are several versions of how the creation of money was discovered. Some mainstream historians credit it to jewelers, then-called goldsmiths. They downplay the role of the alternative and more likely possibility, the curious and colorful Knights Templar, the mysterious group now so popular in B movies and video games.
No historian telling their account today was there, so I will tell the version that uses the Knights to demonstrate how modern money likely was invented.
The Knights had discovered something about money. It was not using paper to represent money. That was far from the genius of money creation. The Knights had devised away to make money out of nothing.
In those far-off days, there were no police. There were lots of wars, lots of desperate wandering mercenaries and some very wealthy people with lots of gold in their homes. Home invasions were inevitable. A vault was no security against a knife at the owner’s throat, but no mercenary would dare attack the fortress of the elite fighting force of the era. The upper .01% of the 1% of the day asked the Templars to store their gold and got a receipt.
The local Knight commander’s receipt might say something like this:
“Received from Guy Duchenne, Merchant, of Paris, one (1) bar of gold. Dated at Paris this 13th day of October in the year of our Lord 1307. Jacques DeMolay, Grand Master, Paris Encampment”
An observant Templar noticed something peculiar — the wealthy rarely wanted their gold. They preferred to exchange the paper receipts signed by a Templar grand master with each other. Even better, a Paris merchant could travel to Damascus. If in need of a new camel costing one bar of gold, he could go to the Templar encampment in Damascus, present the receipt from Paris, and get a bar of gold to give to Sayid the camel seller. (Note the innovation of the first travellers’ checks)
However, Sayid also preferred the paper note. So, the merchant wrote, “Pay to Sayid of Damascus” on the back of the note and got his camel.
Nobody wanted the real thing.
Our medieval financial genius may have reasoned: If nobody wants to lug the heavy bars around, how does anyone know there is enough gold in our vault to honor the demands? People trusted the paper as long as they got the gold represented on demand.
Thus, our intrepid Templar watched. Depositors only ever asked to withdraw 10% of the vault contents. In the greatest “aha” moment in financial history, he understood that the Knights could issue receipts as loans for 10 times more gold than they had and get paid back in real gold — or goods and services.
The Templars transformed from warriors to bankers by this financial alchemical feat.
The medieval mastermind saw that it was a confidence game. The key was to always have enough metal on hand, go into the vault and instantly hand over whatever was required.
Money Making Today
Money is not just currency. Consider this: Old Macdonald decides he wants to expand his farm. The commercial bank approves his business plan and lends him $100,000 by entering that amount on a bank computer. By his credit card, he uses that money buying piglets to raise. The farmer sells the mature pigs to purchasers, who pay with credit cards. The Farmer applies the credits against his loan until it is paid off-a perfect circular series of banking transactions involving only blips on a computer screen, not a penny of hard currency.
The Gold Standard Goes
Why gold? In a famine, you can’t eat it; in a war, you can’t make weapons out of it. You can’t even make a warm blanket of it. However, in the most desperate times, when currency devalues to useless, someone will give you something for it.
Why? You can make jewelry out of it. The value of gold is firmly founded in vanity. What could be a more durable basis for money than a human weakness?
For hundreds of years a dollar bill stated, “Will pay to the bearer on demand one dollar in gold.” Bank buildings looked like a meld of fortress and mansion, leaving no doubt as to their strength.
Many economic disasters were blamed wholly or in part on restricting a country’s money supply to how many pieces of gold it happened to have. By the 1930s, most countries had abandoned the promise of converting paper currency to gold. People adjusted. They had gotten one bubble gum for one penny during the gold standard and they still got one-for-one afterwards.
Experience confirmed that all our money system needed was a way to maintain confidence. Gold backing was not necessary. As long as a bank teller could immediately reach into their drawer and produce cash at the request of a depositor, the system would survive. Because banks only had to keep a fraction of hard money on hand, it was called “the fractional reserve system.”
As consumer confidence grew, bank buildings changed to look like retail stores in shopping plazas. Current currency gives no promise of gold; it baldly recites “legal tender for all debts public and private”. There is no longer a need for gold: In dollars, we trust.
The Debt Bondage
Money can’t be created without creating a debt that someone has to repay. The money to pay back every dollar created with interest can only come from more money that was also created with more interest that must be paid in addition to the money provided. As a result, a large group of citizens will always be in debt; and there will also be a small number of people who have no debt.
There are economists who are considering ways of creating money without debt. These ways have names like positive money creation or modern monetary theory. Little more can be said here than to point out the harm that debt is necessary in our money creation system, and that there are those trying to devise a system in which debt does not happen on money creation.
Bank failures are common. Commercial bankers can make money out of nothing, lend it out, charge interest and administration fees-and can still screw it up. There are limits to how much money can be created to cover their bad judgment. Governments have devised regulations to attempt some control of banker irresponsible management. These will be the subject of the next chapter.