From Commodity to Bank-Debt Money
Commodity monies have almost entirely disappeared, having been replaced by bank-debt money. It is unlikely that you ever use a commodity money. The dollars in your wallet are debt of the Federal Reserve, and if you examine one carefully, you can determine which of the twelve Federal Reserve banks issued it. The money you have in your checking account money is debt of a commercial bank or of some closely related financial institution (such as a savings and loan association or a savings bank).1
The story of how our present monetary system evolved from commodity money is an interesting example of actions and decisions that had consequences totally unforeseen by those taking the actions. It is an important story because the quantity theory of money says that changes in the amount of money in circulation are important, and one cannot understand how changes in the amount of money come about unless one understands how the banking system creates money.
A commodity money of gold or silver has serious shortcomings. The metals are heavy, storing large amounts in one's home is risky and expensive, and carrying them on long trips is dangerous. If one uses gold or silver in an uncoined form, there is difficulty in determining the quality and there is bother in determining the weight. If gold is coined, practices called shaving and sweating appear. People will file a bit from each coin they obtain before they pass it on for face value, saving the filings (this is shaving), or they will shake coins together in a leather bag, causing tiny flakes of gold to chip off, which they save (this is sweating). In either case, not all gold coins are the same, and some of the advantages of coinage are lost.
In response to these deficiencies, banks evolved in 16th and 17th century England. The goldsmiths were an occupation that often evolved into bankers. Other merchants needed places to temporarily store large amounts of gold, and they chose to store them with the goldsmiths because the goldsmiths had the best security systems of the day. When merchants stored gold, the goldsmith would give them a statement indicating how much gold the merchant had deposited.
Once merchants began to store gold, paper money developed rapidly. When a merchant wanted to buy something, he could return to the goldsmith and reclaim his gold, or he could sign over the statement he had from the goldsmith to someone else and let that person collect the gold. Because the second option was popular, the goldsmiths innovated and issued statements made out not to a specific person, but to the bearer--whoever presented the statement to the goldsmith could collect the gold. At this point the statement issued by the goldsmith was money because it was something that people used to buy things with. The invention of paper money was successful because for some purposes it had more desirable qualities as a money than gold or silver had.
Balance Sheet A shows the situation that our story has now reached. Because all gold in the goldsmith's vault is considered something the goldsmith owns, it is an asset for him. Balancing this gold is the paper money that he has issued to people and his net worth. Remember, the paper he has issued is a promise to pay gold on demand. Thus, this newly discovered form of money was quite clearly a liability or debt to the goldsmith. The net worth indicates that he owned some gold even before he began to issue the IOUs that began to be used as money. At this point in the story, no additional money has been created. Although the paper the goldsmith has issued is money, the gold he is holding in his vaults should not be counted because it cannot be spent without retiring paper.
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100 pounds of gold |
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80 promises to pay 20 net worth |
We are not used to paper money issued by private banks. However, before 1850 all paper money in the United States was issued in this way. Click here to see the picture of such a bill.
Next we see how early goldsmiths learned to create money and thereby became bankers.
1 At one time savings and loan associations and savings banks were very different from commercial banks, but they are now almost indistinguishable.
Copyright Robert Schenk
