Colin's Cornucopia

Welcome to my world of discovery

The Nature of Money

Return to Banks

So just where does money come from?

There are many types of money and most of them are convertible one from the other.  Money came originally from ancient history where tribes wished to trade with each other and bartered goods. If they wanted to barter more than one type of goods or with more than one person it soon became obvious that beads or bones or shells or feathers could be a store of wealth. The more desirable the object, the more useful it was as money because more people would be willing to exchange it. Eventually gold and silver tokens more or less swept the board. They can be made to look pretty and they do not decay. Later Isaac Newton, as Master of the Mint, invented knurling on the periphery to stop clipping of the coinage that debased it.

The most commonly understood form of money was, and is, based upon gold. It started in medieval times when goldsmiths needed to protect their assets. They built safe houses and soon other people were asking to store their gold in the goldsmith’s safe. It was good business but became onerous if too many people kept knocking at the door to collect a small part of their gold. 

Instead of giving individuals their stash of gold the goldsmith would issue a receipt that the individuals could trade with other people. They all knew the goldsmith and knew he could be trusted. The receipt was in fact a promise to pay the bearer a sum of gold. This is known as a promissory note and many of our banknotes still bear this promise.

The goldsmiths soon realised that all the depositors never came at the same time to collect their gold so they could safely issue more promissory notes than they had gold in store. The probability that everybody would come to demand their gold at the same time was very small. The goldsmiths soon became very rich because they could issue, within reason, as much money as they wished. They could buy whatever they wished just by putting this money into circulation.

Some of the cuter depositors soon realised what was going on and demanded a piece of the action. Foremost amongst these was the King who, of course, wanted to finance his wars and expensive court. Eventually the major goldsmiths grew into mints and ultimately Royal Mints. There are variations on this theme but essentially this system was implemented world- wide.

If the King had not got enough gold in his coffers he might well be tempted to go to war to secure new supplies and finding an El Dorado like South America made the Spanish Kings very wealthy. Having a regular currency enabled the King to impose taxes on a rational, if hated, basis.

Then came the Industrial Revolution and the amount of currency in circulation was quite insufficient to satisfy the needs of a rapidly expanding manufacturing nation. The promissory notes took on a new life. The central bank could now issue as much money as it could cover with its gold deposits and then increase that substantially on the basis that few people would actually demand the promised payment. The big problem was deciding how much money to issue. Too much and the value would fall; too little and the value would rise. Money obeys the laws of supply and demand just like any other commodity.

The people wanted a nice steady value to the notes in their pockets so that they could forward trade with confidence. Fluctuating currency values can easily destroy a manufacturing business. If a manufacturer buys materials that take him six months to convert to a saleable product and the currency value falls in the meanwhile he can easily be bankrupted. The opposite can happen, too, but the consequences are quite different. It is quite likely that someone else will be bankrupted by that action.

Governments and Central Banks have devoted the last two centuries to this question and have developed a set of tools to enable them to do a reasonable job. They don’t always get it right but trade has flourished in the main.

In the early days the system did not always work, especially in relatively isolated places like the American west. A large depositor might actually withdraw his savings and a rumour that the bank could not afford it would start a run on the bank and depositors would queue for days to get their savings out and the bank would, indeed, go broke. We saw a similar thing recently in Britain when Northern Rock collapsed and people queued round the block. In the latter case the Government had to guarantee the Bank to stop it going broke. In the former cases the Central Bank set up a system to guarantee the deposits of individual banks.

The banks were allowed to lend money at up to double their physical deposits, or thereabouts, and the deposits were kept in the Central Bank. The Central Bank could, in turn, loan above its own deposits but the overall system was still backed by some real gold. The Central bank lent money to the banks at an interest rate called the Bank Rate. The banks would then lend to their customers at a higher rate depending on what risk they thought they were taking. The control of this system was a major part of the political policy of most countries throughout the twentieth century.

By monitoring the value of the currency against other currencies, the government could issue or withdraw money to keep the value more or less constant. Several major international agreements were made to attempt to keep the system stable. For many years the relationship between the Dollar and Gold was fixed to help this process. Physical gold was actually moved around bank basements on an hourly basis to attempt to regulate the system and to decide who owned what.

Only the government was allowed to issue money and only they could take any profit there might be. Indeed the concept of profit in this matter is meaningless. If the government is truly democratic (Ha!), the money is issued on behalf of the people so that they benefit from any money their government issues. Of course, the quite large body of people necessary to issue this money into being would be in a fine position to ensure they were first in line to benefit – but that is not part of this story. 

The banks were very strictly regulated and it was very difficult to start a new one. The whole business was tied to the value of the currency and the amount of gold on deposit in the central bank. The bankers, of course, ensured that they were always well paid for their services but the banks became another service industry much like any other – except the price of entry was virtually infinite – only the government could licence it.

The government could, and did, simply print money to try and tide people over bad times. The classic was President Roosevelt’s New Deal in the 1930’s when the American government spent huge amounts of money building dams and roads for which there was little immediate need. Much of it was to prove very useful to their war effort a few years later but at the time it was a spendthrift act; but in general it was beneficial. There were lots of beneficiaries and it is hard to see anyone who suffered. The claim that taxpayers paid for it is not necessarily true. The government can simply create the money. The only danger is possible inflation – but that is not necessarily the case.

The British government spent in a similar manner at that time and some good was done. The point is that the government has the power to do this without necessarily causing disruption of the value of the currency.  Indeed such action could actually stabilise the currency. There are no profiteers and the benefits can be directed to the best effect. This process can, of course, be beset by a whole raft of political dogma, arguments and problems, but at least the citizens keep some sort of control over the basic asset of their industrial life. The financial system we have developed over the last twenty years is quite different.

The economy has now become one driven by debt. “Real” money – that backed by some gold is now a tiny fraction – less than one percent - of the total money in circulation. Debt was first created around 1930 by selling goods – mainly furniture – on credit terms. The terms were very strictly regulated by law and generally demanded a fifty percent deposit and a controlled repayment term and also controlled interest rates. But it worked for the times. At the same time it was almost impossible to take money out of this country.

America and Canada were wealthy and much more conducive to credit but their only serious world trading partner, Europe, was a bomb ravaged smoking ruin. The Marshall Act brought massive American investments in Europe but it took over fifteen years to reconstruct the continent. Things continued to improve until the European Union is a larger trading block than America. The development of international trade led to great competition in financial services. Companies operating in several countries could obtain their finance in whatever currency they wanted. Moving currencies between countries but within the same company became big business and severely strained the value of a number of national currencies. 
There were a few major corporations who made more money from their international currency trading than they did from manufacturing. International manufacturing became extremely lucrative and successful and its finance required another major increase in money. There was no longer enough gold on earth to finance this expansion so an array of promissory notes grew up  - too many to list here. The essence of many of these devices was that they were backed by the activities of major corporations. They were mortgages on future expectations of the production of goods of many kinds.

Now the whole world is financed by credit: but with credit must come debt and the relationship between creditor and debtor is similar to than between master and slave. Indeed, in many ancient societies, debtors became slaves in order to pay off their debts. Often the state of the economy would become such that an amnesty had to be called to wipe all the slates clean and free the slaves. We look as though we are approaching that situation again. There has been much call over the last twenty years to forgive the debts of third-world countries and much debt has been written off. Now it appears to be the turn of the first world countries. They certainly cannot pay their debts off.

Many western countries are now printing money with the quaint, and misleading, name of Quantative Easing. What that means is inflation. Inflation means that the value of the currency reduces and the debts become rapidly easier to pay off. The creditors suffer the loss. Usually this means bond holders, savers, pensioners, the thrifty and careful. Those with debts are literally laughing all the way to the bank. The real winners in this are the bankers who stuff their pockets full of salaries and bonuses for doing a lousy job of controlling the economy and the money supply.

I would like to say that the job of controlling the money supply is too important to be left to the bankers. But the reality is it is probably too important to be left to the government. What is needed is a firm and clear constitutional statement of the terms and limitations of money supply so that the benefits of performing the task return to the people and not to a few rather filthy rich individuals. This is not just a matter of taming objectionable greed but is a vital constitutional principle, without which our civilisation is unlikely to survive let alone thrive.

Colin Walker

12 October 2012

Return to Banks