LONG RUN, MICROECONOMICS: In terms of the microeconomic analysis of production and supply, a period of time in which all inputs in the production process are variable. The long run is primarily used to analyze production decisions for a firm and is also referred to as the planning horizon. The long run is a period of time in which a business can change the quantities of ALL resource inputs--labor, capital, land, and entrepreneurship. Nothing is fixed. If your factory is to small, well then, build a bigger one. The long-run analysis of production is used to better understand economies of scale, diseconomies of scale, and long-run market supply.
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An analysis of banking functions based on the semi-realistic activities of the goldsmith profession of Medieval Europe. Because the gold used a production inputs by goldsmiths was also used as money, they developed many modern banking functions, including maintaining deposits, making loans, keeping reserves, and creating money. While the story of goldsmith banking is often embellished for instructional purposes, it does contain the essence of how goldsmiths operated as banks. The analysis of goldsmith banking helps to illustrate the development of several modern banking functions, especially providing for the safety of deposits, the development of fractional-reserve banking, using excess reserves for loans, and in so doing the creation of money.
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 GoldsmithThe analysis of goldsmith banking can illustrated with the hypothetical activities of one particular goldsmith named Fred. Fred the Goldsmith is a professional goldsmith, as this hypothetical store goes, who lives in Medieval Europe and makes his livelihood as artisan who fabricates jewelry and other artifacts using gold.
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 DepositsThe fact that Fred the Goldsmith has a vault for securing his own gold is not lost on others. One particular hypothetical character that takes particular interest in Fred's vault is, Bill the Knight (also an old acquaintance of mine).
Three bits of information are relevant about Bill the Knight.
Bill must find a way to keep his gold safe and secure during his damsel-rescuing, dragon-slaying adventures. The obvious solution to Bill's dilemma is Fred's vault.
- 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.
Fred's gold storage service is the forerunner of the depository safekeeping function of modern banks.
- 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 LoansWith his gold storage business booming, Fred the Goldsmith has established a nice lifestyle. Knights pay him to store their gold and he spends an increasing amount of time playing golf. But it gets better.
Consider the business proposition over by Elizabeth the Innkeeper, a proposition that changes Fred's business forever.
Fred's new found business of extending loans to local merchants for capital investment is, of course, the forerunner of the key investment-lending function of modern banks. Fred has become a financial intermediary.
- 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 ReservesIn short order, Fred has revenue coming in from both sides of his balance sheet.
But Fred soon realizes that the banking business is more that just counting profits and playing golf. Fred conducts numerous transactions every day.
- 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.
Fred quickly realizes that he must perform a delicate balancing act between the gold coming in and the gold going out. Fred must, he absolutely must, make certain that he has sufficient gold on hand to satisfy any withdrawals sought by returning knights. If not, he is dead, literally.
- 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?
The realization that Fred does not need to keep ALL deposit in reserve, means he has discovered modern fractional-reserve banking. Fred has further stumbled onto the modern banking notion of excess reserves. The extra gold deposits are what Fred transforms into interest-paying loans.
- 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 ProblemsAs his goldsmith banking operation expands, Fred finds he has less time for golf. In fact, he seems to be working harder than he ever did as a goldsmith artisan. He has loan applications to approve, deposits to count, and a balance sheet to keep in balance.
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.
These alternatives indicate the potential problems faced by a fractional-reserve goldsmith, and by modern fractional-reserve bankers. If Fred's profit pursuits cause him to foolishly keep too few reserves or if an unexpected change in inflows and outflows cause an unexpected imbalance in reserves, then Fred is in serious trouble.
- 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 ReceiptsFred's potential problems notwithstanding, his endeavor into the world of banking has been a successful one, so far. His safekeeping activity is particularly robust. Bill and his knightly cohorts come and go, day in and day out, leaving and retrieving their gold deposits.
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 MoneyBecause Fred is an honest, trustworthy sort of guy, because Fred never fails to redeem gold receipts, because Fred does not know if the redeemer is the original depositor, his gold receipts become, quite literally, as good as gold. Merchants, knights, and other local townfolk treat Fred's receipts as if they are gold. They become money for the local economy.
To see how, consider this scenario.
This transaction is the start of something big.
- 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 LoansAs an honest, trustworthy guy who is extremely concerned about avoiding the pain inflicted by angry knights, Fred issues paper receipts ONLY for deposits received. The 100 pounds of gold in Fred's safe is matched pound-for-pound by 100 pounds of receipts. This is a good system. This is a safe system. This is a system that avoids the wrath of angry knights.
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.
This creates a dilemma for Fred. Fred ONLY issues receipts for gold deposits. While he has a stack of blank receipts stored in his desk awaiting his signature, he cannot just give out receipts, can he?
- 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:
With both options, Elizabeth ends up with 10 pounds of paper receipts and Fred ends up with 100 pounds of gold in his safe. While Fred might consider the first option, why bother? Both options end up the same.
- 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 CreationMaking loans with paper receipts, rather than gold, creates a profitable opportunity for Fred. Before the introduction of paper gold receipts, Fred made loans with gold. With gold receipts--receipts issued BY Fred--now used as money in place of gold, Fred can increase lending activities.
The key question is how many? How many receipts can Fred lend?
The end result is that Fred can make loans of up to 900 pounds of gold receipts. All he needs to do is retrieve blank gold receipts form from his desk, fill in the amounts, sign them, then hand them over to loan-seeking merchants.
- 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.
GOLDSMITH BANKING, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2022. [Accessed: December 5, 2022].
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