Precious metal loans by goldsmiths

The goldsmith-bankers also eagerly embraced the business of providing credit. Because they over time became the custodians of many customers' deposits of gold and silver coins, they could safely provide credit in the medium of exchange, coins, i.e. without running short of coins for those who wanted to withdraw their deposits. Let us assume that Mr B obtains a loan / credit of 20 one pound gold coins from Goldsmith-banker A. Their balance sheets change as indicated in Figure 2.

The loan / credit was granted at a rate of interest. This was a significant event. Although paying interest was nothing new, the goldsmith-banker could now afford to pay an attractive rate of interest to depositors, in the hope of attracting even more depositors - because gold deposits enabled the goldsmith-bankers to provide credit (in gold coins).

Goldsmith receipts as a means of payments

An epoch-making event took place just in the mid-seventeenth century, and this was that the deposit receipts of the goldsmith-bankers, which hitherto had been issued in the name of the depositor, were now being issued to bearer, i.e. the receipts had started being used as a means of payment. The receipt holders found it possible to use the receipts as a means of payment because they were backed by gold, and were convenient. Thus the recipient of the receipt had a claim on the goldsmith-banker for the amount of gold coins stated on the face of the receipt.

loan of gold coins

Figure 2: loan of gold coins

This practice became the norm for payments and depositors came later to demand of their goldsmith-bankers receipts in smaller denominations. For example, if Mr A deposited 100 one pound gold coins the goldsmith-banker would be asked for 100 receipts, each with a face value of one pound. These receipts became the principal means of payment, i.e. money. Thus at this stage the amount of money in circulation was the sum total of gold coins in circulation plus goldsmith-banker receipts in the possession of the public. [Note that the gold coins in the vaults of the goldsmith-bankers are not included - because they are represented by tokens - the receipts.]

This historical event is described by Jevons71: "The practice arose of transferring possession by delivery of these receipts, or 'goldsmith's notes' as they were called." Jevons adds that "Such notes are.. .referred to in.. .some statutes.. .hey had become general and not special promises - mere engagements to deliver a sum of money on demand."

Goldsmith loans by the issue of receipts

It did not take long for a goldsmith-banker to realize that if the goldsmith-bankers' receipts were being used as the means of payment, then credit demand could be satisfied not by gold coins, but by the issue of new goldsmith-banker receipts. This was another historical event of momentous proportions and changed the economics of the world forever. The most significant event in banking - money creation by the new banks - was born, which endures to this day. It liberated economies from the often stifling shortage of precious metals from which money was struck.

Davies, quoting another, refers to this event as follows: "...some ingenious goldsmith conceived the epoch-making notion of giving notes [i.e. receipts] not only to those who had deposited metal, but also to those who came to borrow it, and so founded modern banking." It is appropriate from here on we refer to goldsmith-banker receipts as bank notes and to the goldsmith-banker as bank.

loan by issue of bank receipts / notes

Figure 3: loan by issue of bank receipts / notes

An example is in order. Mr B is successful in borrowing 100 pounds from Bank A. Bank A issues bank notes to the value of 100 pounds. Bank A charges Mr B an interest rate of 3.0% per annum. The balance sheets of the parties to the deal change as indicated in Figure 3. Money (= bank notes) was created by the strokes of a pen and by the accompanying accounting entries by a bank!

The earliest recorded English case of a bank note being used as a means of payment is the 29 February 1668 entry in the diary of Samuel Pepys, Secretary to the Navy. According to Davies, "...lie casually mentions sending to his father a note for £600 - issued by the goldsmith Colvill."

Bankers' reserves

It will be evident that prior to this major money creation event the proportion of gold coins underlying the notes of the bankers was 100%. As this new method of bank credit / loan provision increased over time the proportion of gold coins to notes in the collective books of the banks declined. An example may be useful. Let us assume that prior to the event, the bankers had on deposit 1 million one pound gold coins (see Figure 4: top balance sheet). Note that this is a stock - not a change - balance sheet.

gold coin reserves

Figure 4: gold coin reserves

If the banks in aggregate had after the date of this balance sheet up to another date made loans of £500 000 by the issue of new bank notes to this value, the banking sector's balance sheet would have appeared as in Figure 4 (bottom balance sheet - again a stock balance sheet). Each £1 bank note would then have been "covered" by gold to the extent of 67% (1 000 000 / 1 500 000 = 0.66666).

This new banking practice of providing credit in this manner of course rested on the principle that a certain reserve of gold coins had to be kept in the vault to ensure that gold deposit withdrawals could be met at all times. This was termed convertibility, i.e. the notes were convertible into gold to the extent of 100% of the face value (in the above example a one pound gold coin for each one pound bank note). The bank note would have stated something like (and persists in many cases to this day): "I promise to pay to the bearer on demand."

The practice of keeping a reserve of gold heralded the banking system and central banking money creation control mechanism called the fractional reserve system, on which we will have much to say later on. The control mechanism rests on the fact that a certain proportion of reserves cannot not be exceeded, i.e. when the reserve proportion is at its minimum further bank loans cannot be granted. It is to be noted that many scholars are under the mistaken impression that this system still exists (albeit in a different form) in all countries, and that money creation exclusively revolves around it.

Not much data pertaining to the growth in bank note money in the period under discussion exist. However, Davies informs us that at the time of publication of Adam Smith's Wealth of Nations in 1776, bank money exceeded bank metallic money. Bank money by this time was not just bank note money but also a close substitute: bank deposit money, the subject following this. Its appearance is yet another landmark in banking history.

However, before we get there, yet another milestone in English banking and economics, which had major relevance to bank note and bank deposit money creation, and monetary policy much later, must be revealed: formation of the Bank of England. Foreign banks had for an extended time done mainly trade-related business in England, particularly the public banks of Italy, Sweden and Holland. It was also considered prudent to have a public bank to compete with the goldsmith banks, which were becoming much disliked because of their usurious activities (= charging high rates of interest). We are informed by Davies that: "[d]islike of the usurious practices of the goldsmith bankers was a prominent motive stirring on the projectors of potential new institutions." The public, joint-stock Bank of England was formed in 1694.

Box 3: Bank of England in 2010

Bank of England in 2010

 
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