The Creation of Money

In the 1660s, London merchants who needed somewhere safe to store their gold and silver began using the vaults of goldsmiths, who already had the locks and the reputation. The goldsmith would issue a paper receipt; merchants quickly discovered that it was easier to pay each other with receipts than to cart metal through the streets. The receipts circulated as currency. The goldsmiths making these transactions noticed that at any given time, only a fraction of depositors came to claim their metal. The rest left it in the vault, trusting the paper. A goldsmith willing to issue more receipts than he actually had gold in the vault could lend out the extras and collect interest, as long as depositors never all came at once. This is the origin of fractional reserve banking, a name that makes it sound more principled than it is. This matters for understanding the modern financial system because the same basic mechanism is still operating, at much larger scale, with slightly more oversight,…