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Creating Money

(This is the second part of the story telling how bank-debt money was invented.)

After the goldsmiths began issuing paper notes that circulated as money, they quickly noticed that the gold deposited in their vaults was rarely withdrawn because the gold-backed paper notes were a popular way of making payments. They saw an opportunity to profit from this situation. They could lend gold and collect a fee, or interest, in the transaction. If the goldsmith lent 30 pounds of gold, his balance sheet would change from that in Balance Sheet A to Balance Sheet B. As a result of this transaction, the amount of money in circulation increased. The promises to pay depositors, which were circulating as paper money, were still there, but now 30 pounds of gold that had previously been in the vault "backing up" the paper was also circulating as money.

Balance Sheet B
Liabilities + Net Worth

70 pounds of gold

30 promise to pay
gold to goldsmith


80 promises to pay
gold to depositors

20 net worth

Balance Sheet C shows another way that borrowing could take place. Here someone borrowed 30 pounds of gold from the goldsmith, but instead of taking the loan in the form of gold, the person accepted the paper IOUs of the goldsmith. Since people accepted these paper IOUs as money, this transaction also increases the amount of money in circulation. When the goldsmiths began to create money, their careers as bankers began.

Balance Sheet C
Liabilities + Net Worth

100 pounds of gold

30 promises to
pay gold


110 promises to pay
gold to depositors

20 net worth

Note that it was not the intention of the goldsmith to create money. He simply wanted to rearrange his portfolio. Money creation was a by-product of the making of the loan. As a result, it is not surprising that many bankers have not understood that they do create money. Some scholars maintain that during the first ten years that the Federal Reserve System was in existence, that is, until the middle of the 1920s, most of the officials of the system, almost all of whom were successful commercial bankers, did not understand that banks created money.

If one focuses on the amount of money, one sees that as a result of the loan, the paper money is no longer 100% backed by gold. Yet from the goldsmith's view, it is still completely backed. It is partially backed by gold in his vault and partially by other people's promises to pay him in gold.

Although the bank created money, it was limited by the possibility that holders of the paper would bring in the paper and demand gold. To maintain the ability to pay off the paper money, banks held reserves of gold, and they needed larger amounts of gold as they issued more paper money. There was no fixed ratio of gold to paper money, but rather the ratio depended on the optimism or pessimism of the bankers. When bankers were optimistic and times were good, they would issue more paper for each pound of gold than when they were pessimistic and worried about redemptions of paper money that they issued.

This system of bank-issued money partially backed by gold had many of characteristics of a commodity money but it did not have as much stability. The amount of money could change not only because the amount of gold changed, but also because changes in the optimism or pessimism of bankers changed the amount of paper money in circulation.

Although the logic of money creation is easiest to see in the case of paper money issued by the banks, our banks no longer issue paper. Because they rely on checking account money, we next turn to that.

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Copyright Robert Schenk