From Goldsmiths to Bankers, from Money to Currency, 4

Second reason, in fact, this “in between” position is geared to be exploited. Those above are just a couple of examples of all conceivable swindles based on this ambiguous type of money, I chose them because they are basics going to lay the foundations of banking. But these all head us to a situation whereas there is more gold backed paper money circulating than actual gold in the reserves to back it up. And increasingly more and more paper than gold. A nice house of cards that invites to be blown away by a bank run – and what are the consequences when it happens?

Let’s return to Example Island. Gone is the time when someone induced intrinsic value into gold and profited from that, and now everybody agrees that one unit of gold is a valid medium of payment worth, say, 1,000 units of food. There still live 100 people, and each one owns one unit of gold; in all, 100 units of media of payment in gold. One of them becomes a goldsmith, and fifty other people entrust him their gold; not to forge it, just because they believe it’s better for handling and safety. The goldsmith in turn gives them 50 receipts for the 50 units of gold. People begin to accept those fifty receipts as valid security redeemable in actual gold at any time. As long as the 50 deposited units of gold sit in the goldsmith’s vault, the amount of gold media of payment circulating is still 100: 50 in gold and 50 in receipts redeemable at once. The deposit is a service so the goldsmith may be charging a fee for it, but its amount is trivial. As the receipts catch on, the gold sits more and more idle, and less and less of it gets actually handled. Too bad. So one fine day the goldsmith begins to take that gold from his vault and use it. If he uses it as if it was his own, for instance, he loans it at interest, and the interest ends up in his pocket. Otherwise he may agree with the gold owner on loaning it and divvy up the interest. If the goldsmith decides to loan the receipts, instead, he just agrees with the borrower to simply write them out of thin air – without any gold to back them up – and loan them to the borrower at interest.