The Story of Money: The Rabbit Hole of Money Creation

Back in the day when I worked in banking, in a workshop the presenter asked “What do banks do?”, and I said “they make money”, to which his reply was “of course every institution needs its earnings”. But that’s not what I meant. Let’s today discuss the concept of money creation.Let’s meet our fictional friends to start with. Steve and Bryan have been in the silversmith and pawn-brokerage business for some time now. In recent days however, having gained the reputation of the town, they have found a way to extend their activities. The townsfolk are tired of having to carry around silver for all the payments, and as the only shop in town dealing with large amounts of silver, Steve and Bryan have offered to let customers deposit their silver in their vault in exchange for a written and signed note representing the amount deposited. Since that note represents a certified quantity of silver, the depositor can then use that note instead of actual silver on a day-to-day basis. Given Steve and Bryan are trusted people around, their promise on the note is enough to satisfy the depositor that any time they want their silver back, they can simply return the note for the amount.One weekend after a couple of weeks of such activity, Steve and Bryan are sat in the garden with Brenda and Irene and having a chat. Steve is like, so yeah we have all this silver sitting in our vault, Bryan adding, but the curious thing is nobody has come to claim their silver back even though we gave them a written promise. Brenda chimes in, well given that you’ve mentioned the amount of silver on each note, and anyone can use any note to come back to claim the silver at any time, they’re not in a hurry, after all it’s easier to handle such notes rather than heavy sacks of silver.Irene then goes, but wait, if you are sitting on all this silver, and they won’t come back to claim any of it because it’s easier to handle the notes, maybe you shouldn’t leave the silver idle, you should maybe lend some of it out?In Gold We Trust, But...So yes, that’s the birth of paper money. (And Steve and Bryan were the proto-Goldman Sachs? Or is it Silverman Sacks?!) But if you look closely something else is happening here. Imagine our friends have a thousand pounds by weight in silver in deposit, against which they have given out those notes representing a thousand pounds. And then, going by Brenda and Irene’s observation, they lend out a 100 pounds of the silver, to other people who need money. That silver goes into the economy and... you guessed it, someone along the line deposits that silver back into the vault in return for notes promising 100 pounds of silver. So now, we have 1100 pounds in the economy -- against ONLY a thousand real pounds of silver.This may sound like jiggery-pokery, but this is practically what EVERY bank does when lending you out money. Economists even give it a respectable-sounding name - Fractional Reserve Banking. In other words, only a fraction of the gold or silver representing the issued paper money is actually in the vault at any time.And guess what, governments are fine with it. Based on the state of the economy and other factors, governments have even encouraged banks to engage in such activity.You will recognize this from the following sentence on many currency notes: I promise to pay the bearer the sum of 10 pounds (or whatever other original indicator of weight, such as peso, libra/lira etc.)And different forms of this have had different names across history: in some versions, a bill of exchange, a promissory note, or an IOU (literally “I owe you”, with kind of the same gravitas as ‘BRB’ and ‘OMG’ I hear you say?)The Preserve of ReserveThe reality here is the fact that, if this is done within limits, it can actually stimulate the economy. Imagine in our story that the economic activity -- the sum total of stuff being bought and sold -- in the town was in fact to the tune of 2000 pounds of silver by value, but the actual silver in possession was only the thousand. By reusing the reserve as depicted, it’s possible to have 2000 pounds by way of those promissory notes in circulation that then facilitates the desired economic activity. Without adequate amount of money in an economy to match the productivity, productivity would decline, as we saw very vividly in Episode 023 while discussing money supply.And after all, as I’ve reiterated, ‘money’ is just the measure of value, so what’s really the difference between using some shiny metal to represent that value or a note signed by a trusted party that represents that metal that represents...?But of course life’s not that simple. First who is Steve and Bryan, or in real life, any bank to decide to multiply money in this way? In other words, as said in my introductory quip, to literally ‘make’ money? Isn’t it still on some level someone creating money out of thin air? (I can’t decide whether to make a rabbit hole or a hat-rabbit analogy here!) What privileges to such banks get by doing this? Surely when this trend first emerged, people were more than happy to substitute carrying sacks of gold and silver in exchange for those notes which was easier to hide and especially carry around. That’s why it’s persisted despite such questions.And we in the current day have taken it even further, by entrusting small pulses of electricity to move data on a spreadsheet on some central computer by waving a piece of electromagnetized plastic with a satisfying beep? In other words we have exchanged frail paper currency for even less tangible current!So yes, as I’ve also reiterated, it all depends on trust. We trust that those digital pulses or the ink on paper with that promise mean something, that they represent the stated value of money.And what happens when there’s even the smallest fissure in that trust, when someone suspects the vault has less silver than the notes floating around? And when people, all the people with those notes, then rush to the bank to get their silver back? That’s a juicy topic for another day!Article written by Ash StuartImages, video, voice narration and some footnotes generated by AINothing in this presentation constitutes as advice - financial, investment or otherFurther Reading & Reference* Seeeking Symmetry, Finding Balance, Making Harmony - on the origins of the early modern banking system This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit ashstuart.substack.com