The goldsmith profession, which used gold--the medium of exchange--as a production input in the fabrication of jewelry and other artifacts, was ideally suited to develop basic banking functions. Because goldsmiths needed to keep their one source of gold secure, they were ideally suited to safely storing gold for others. Other banking activities then evolved from this basic safekeeping function.

Fred the Goldsmith

He is one of many "smithing" artisans operating at this time who fashion products from different materials. Blacksmiths work with iron; silversmiths work with silver; coppersmiths work with copper; tinsmiths work with tin; and pewtersmiths work with pewter.

But Fred is unique among his smithing cohorts.

• Valuable Input: The primary input into Fred's goldsmithing operation--gold--is an extremely valuable commodity unto itself.


• Commodity Money: Gold is valuable because it is the economy's medium of exchange. It is commodity money. Gold has both value in use and value in exchange.


• Value Coming and Going: Unlike his smithing compatriots, Fred produces a valuable output using an extremely valuable input. Other "smiths" transform lesser valued materials--tin, iron, and the like--into products with substantially greater value.


• Under Lock and Key: With all of this value surrounding Fred's goldsmithing operation, he needs to keep everything--outputs and inputs--safe and secure. An obvious way to accomplish this is to buy a vault. As such, Fred has a lot of valuable gold stashed in his vault.

Goldsmith Deposits

Three bits of information are relevant about Bill the Knight.

• One, Bill is an adventurous type prone to slay agitated dragons and rescue distressed damsels in neighboring lands.


• Two, as a successful and prosperous Knight, Bill has oodles of money--that is, gold--which he carries around in a large satchel.


• Three, Bill would rather NOT lug around his large satchel of gold while rescuing distressed damsels and slaying agitated dragons.

• Bill calls upon his buddy Fred for a gold-storage favor. Bill needs to store ten pounds of gold in Fred's vault during an upcoming dragon-slaying excursion.


• Fred agrees. Actually Fred is afraid NOT to agree. As it turns out, Bill is somewhat of a bully.


• However, seeking some degree of retribution, Fred charges Bill a small fee for this gold-storage service.


• After doing his knightly deeds in the neighboring land, Bill returns to retrieve his gold, less the modest service charge. Bill is so pleased with this service that he informs other knights, who also begin taking advantage of Fred's gold-storage service.


• Fred quickly realizes that storing gold for the knights is an easy way to earn a living, even easier than fabricating gold artifacts. The gold fabrication business requires hours of tedious work. The gold storage business involves a few hours at the shop and a great deal of time at the local golf course.

Goldsmith Loans

Consider the business proposition over by Elizabeth the Innkeeper, a proposition that changes Fred's business forever.

• One bright, sunny day (a Tuesday), with Bill the Knight off on a knightly excursion, and Fred dutifully storing Bill's gold, Elizabeth the Innkeeper wanders into Fred's shop in need of assistance.


• Elizabeth's innkeeping business is also booming. The interstate was recently finished and she is flooded with tourists seeking Sherwood Forest, King Arthur's birthplace, and other Medieval European attractions. Elizabeth needs to expand, but she is temporarily short of money, she needs gold.


• She is seeking a temporary loan. Elizabeth knows that Fred has oodles of gold stored in his safe, gold that belongs to Bill, Bill who will be gone for months doing chivalrous deeds in other lands.


• Elizabeth has a plan. She can temporarily borrow a portion of Bill's stored gold, which she will use to pay the carpenters, plumbers, electricians, and others doing the inn-expansion work. She will then use the extra profit from her expanded inn to repay the loan. All of this will be completed before Bill returns.


• Fred likes the plan--in principle. But he shudders to think what might happen should Bill (the bully who carries a broadsword, mace, and battle axe) return to see that some of his gold is missing. But, Elizabeth is willing to pay Fred a sizable fee, an interest payment, for taking the risk associated with this loan.


• Swayed by the prospect of the interest revenue promised by Elizabeth upon loan repayment, Fred makes the loan. Elizabeth expands her inn, then repays the loan on schedule with interest using extra profit from her business. And when Bill returns from battle, he retrieves his gold, none the wiser. Everybody is happy.


• The word of this successful endeavor soon spreads. Other local merchants begin seeking similar lending services from Fred. Fred now has so much interest revenue rolling in that he: (a) gives up goldsmithing completely, (b) buys a brand new set of golf clubs forged by Barney the Blacksmith, and (c) spends even more time playing golf. Life is good.

Goldsmith Reserves

• Bill the Knight and his knightly cohorts pay Fred to keep their gold safe and secure while they engage in chivalrous deeds.


• Elizabeth the Innkeeper and other local merchants pay Fred to borrow some of this gold for capital investment projects.

• Dozens of knights stop by to drop off their gold deposits, and dozens more stop by to withdraw deposits.


• Scores of local merchants visit Fred in search of investment loans, scores more pay him a visit to pay off their loans.

Fred must keep gold reserves. By how many?

• Fred compares the daily intake of gold deposits and loan repayments, with the gold outflow from knightly withdrawals.


• He concludes that for every 100 pounds of gold deposits stored for the knights, he never needs more than 10 pounds on hand to balance out the inflows and the outflows. His reserve ratio is 10 percent.


• Fred uses the other 90 percent of these gold deposits for the loans, the loans that earn the interest that makes his goldsmith banking business such a profitable one.

Goldsmith Problems

But Fred is rewarded for this effort, with revenue coming from both sides of the process--fees on deposits and interest on loans. As long has he keeps 10 percent of his deposits in reserves, then he is okay. He should be able to live a long, comfortable, and profitable life.

But problems are lurking near by.

• First, note that Fred has the pervasive temptation to reduce reserves. Maybe, just maybe, he can get by with only 9 percent reserves. Perhaps 8 percent reserves will be okay. By keeping less gold in reserve, he can make more loans and earn more interest revenue. This is a powerful temptation.

  Maybe, just maybe, Fred can escape with life and limb holding less than 10 percent reserves. But the chances are that he will need ALL 10 percent of those reserves to satisfy knightly withdrawals at some point. If he does not have 10 percent, then deposit-withdrawing knights who cannot withdraw their gold are bound to be upset. This could be bad, very bad, for Fred's banking business as well has his health and well-being.



• Second, even with 10 percent reserves, unusual and unexpected events could upset the balance between daily inflows and outflows, also causing life-threatening problems:
  • Too Little Coming In: Maybe, just maybe, daily gold inflows are less than normal. Perhaps knights drop off fewer deposits than normal. Perhaps local merchants fail to make scheduled loan repayments.
  
  
  • Too Much Going Out: Maybe, just maybe, daily gold outflows are greater than normal. Perhaps an unusual number of knights return from doing knightly deeds and seek to withdraw their gold deposits.
  
  An unusual and unexpected drop in these inflows or an unusual and unexpected boost in the outflows means Fred needs more reserves, perhaps, just perhaps, more than the usual and expected 10 percent.

If Fred runs short of reserves and cannot meet withdrawal demands, then the knights, the merchants, and other townsfolk might find a tall tree and a short rope. At the very least, Fred is likely finished as a goldsmithing banker. Once customers lose faith in Fred, they will not trust him with deposits, and without deposits, he cannot make loans.

Paper Receipts

Business is so robust that Fred tracks gold comings and goings using a system of paper receipts. When a knight meanders into Fred's shop with gold for safekeeping, Fred issues a receipt noting the amount deposited. Upon returning, the knight presents this receipt and Fred returns the gold.

Fred's gold receipt system has several notable features.

• One, because gold is gold, each knight does not necessarily receive the exact same gold left for deposit. The knight receives the same amount of gold, but not necessarily the same gold.


• Two, the number of knightly comings and goings means that Fred does not personally know each knight requesting services. Of course, he knows a few by sight, such as Bill, Lance, and Sir Regis. Most of the other knights are complete strangers. But, as long as they present legitimate gold receipts, they can withdraw gold.


• Three, Fred is an honest and trustworthy goldsmith. When it comes to honesty and trustworthiness, Fred is at the top list. The reason is that Fred has NEVER failed to return any deposited gold.


• Four, Fred's honesty and trustworthiness means that most local townfolk come to accept Fred's receipts in payment just like actual gold.

Paper Money

To see how, consider this scenario.

• Bill the Knight returns late one night after months of dragon slaying in a far away land.


• Being thirsty and hungry, he stops at Elizabeth's Inn for a pint of ale and a pot of porridge.


• When payment comes due, Bill realizes that his gold remains stored in Fred's shop. Bill has nothing but a satchel of gold receipts.


• Fortunately, Elizabeth, knowing and trusting Fred, doing regular business with Fred, is willing to accept these receipts in payment. Elizabeth is confident she can redeem these receipts the following day.


• So, Elizabeth is willing to accept the gold receipts issued by Fred in payment for the pint of ale and pot of porridge.


• Fred's gold receipts are used as money. While this is only one transaction, it sets the stage for Fred's gold receipts to become the town's medium of exchange.

Because Fred's paper receipts are lighter and easier to carry, they better satisfy the transportability characteristic of money. Most townfolk actually prefer using paper gold receipts.

Once again, Fred has discovered important banking functions--issuing paper currency, which is fiat money and is comparable to the checkable deposits of modern banks.

Paper Loans

The prospects of pain, however, must be balanced by the prospects of profit. Fred is not just in the business of keeping deposits safe, he is also in the business of extending loans. Consider how Fred's lending activity is affected by the widespread use of gold receipts as money.

• Suppose that one sunny Tuesday, Elizabeth the Innkeeper enters Fred's shop in search of a loan.


• The Innkeeping business is good. Liz wants to expand. She needs a loan. In particular, Liz is seeking a 10-pound loan.


• Fred is happy to help. In fact, Fred has oodles of gold stashed in his safe--100 pounds. He is eager to loan Liz the desired 10 pounds.


• Fred has oodles of gold because the townfolk uses Fred's gold receipts as money rather than the gold itself. Few customers actually withdraw gold from Fred's safe.


• Elizabeth, however, does not want 10 pounds of GOLD, she wants MONEY, she wants 10 pounds of gold RECEIPTS. Liz needs gold receipts to pay the carpenters, and plumbers, and bricklayers. Gold receipts are the money used by these workers and everyone else in town.

Fred faces two options:

• One, Fred can loan Elizabeth 10 pounds of gold from his safe. Elizabeth can then deposit this 10 pounds of gold in Fred's safe in return for spendable gold receipts.


• Two, Fred can simply issue 10 pounds worth of gold receipts directly to Elizabeth.

Both options have another important result.

• Fred starts with 100 pounds of gold matched by a like 100 pounds of receipts. Elizabeth's 10-pound loan increases the amount of gold receipts in circulation to 110 pounds. The total number of gold receipts in circulation is not matched pound-for-pound by an equal amount of gold in Fred's safe.


• Is this a problem? Probably not. The reason is that very few customers actually seek to retrieve their gold deposits. Most are happy to use the paper receipts as money. In fact, Fred has determined that only 10 percent of the outstanding gold receipts in circulation are ever redeemed at any given time. Fred is practicing fractional-reserve banking.
  
• With 100 pounds of gold receipts in circulation, no more than 10 pounds of gold are withdrawn. Fred ALWAYS has AT LEAST 90 pounds of gold in his safe. With 110 pounds of gold receipts in circulation, no more than 11 pounds of gold are withdrawn. Fred ALWAYS has AT LEAST 89 pounds of gold in his safe.


• Of course, if everyone holding receipts seeks to withdraw gold all at once, then Fred is in BIG trouble.

Money Creation

The key question is how many? How many receipts can Fred lend?

• Fred has 100 pounds of gold safely tucked away in his safe.


• Fred knows that 10 percent of his outstanding receipts are redeemed for gold at any given time.


• Fred can use his 100 pounds of gold to "back" as much as 1,000 pounds of gold receipts.


• With 1,000 pounds of gold receipts in circulation, 100 pounds, or 10 percent, will be redeemed at any given time.


• Fred issues 100 pounds of gold receipts to the original depositors of the 100 pounds of gold.


• Therefore, Fred can issue an additional 900 pounds of gold receipts.


• This brings the total number of gold receipts in circulation up to 1,000 pounds--the original 100 pounds, plus 900 pounds more.

What are the implications of this newly recognized function:

• First, Fred can collect interest payments on 900 pounds of gold-receipt loans. Prior to this discovery, Fred was forced to lend actual gold. With 10 percent of the 100 pounds of gold kept in reserve, Fred's lending was limited to 90 pounds of gold. His interest-generating ability is now 10 times greater.


• Second, Fred has unwittingly discovered the modern banking function of money creation. Each time Fred makes a loan by issuing gold receipts, he creates money--valuable money that did NOT exist prior to his action. This money is being used by the local merchants for capital investment that promotes economic growth. Moreover, anyone (that is, government) interested in maintaining control over the total amount of money in circulation, must control Fred's money lending and money creation activities.


• Third, Fred's gold receipt lending activities creates the precarious balancing act that is the heart of fractional-reserve banking. Should depositors seek to redeem MORE than 10 percent of the gold receipts in circulation, then Fred is in BIG trouble. Fred might end up on the short end of rope tied to a tall tree. But should this happen, the local economy also suffers. If Fred exits the goldsmith banking business, then the 1,000 pounds of gold receipts used by the local economy as money becomes worthless. The money supply shrinks from 1,000 pounds of gold receipts to the original 100 pounds of gold. As the money supply shrinks, so too will the economy, in all likelihood falling into a recession.