Gold, Currency, Fractional Reserves And The Tale Of The Goldsmith

The story of the town’s goldsmith helps to simplify our understanding of modern banking.  This goldsmith, so the story goes, having a secure place to store his own gold, began to be asked by the townspeople to store their gold too.  He obliged, and to keep an account of who had what in his vault he provided certificates of deposit to his customers.

In time the goldsmith realized that very few people actually ever claimed their gold because they were exchanging his certificates around town, instead of the actual gold, for goods and services.

With this in mind the goldsmith got himself an idea.  Since his signature was as “good as gold”, he began to make loans using only his signature on a piece of paper.  The net effect of this was that each certificate of deposit was actually worth less than it claimed to be worth.  Us moderns call that inflation.

The goldsmith however was confident that no one would catch on to his scheme because he was certain that they would not all want their certificates redeemed at one time.  Experience had taught him that, at any given time, there was always a fraction of the the gold, which was represented by outstanding certificates, sitting in his vault available for claim.  So he felt assured that as long as there was sufficient gold on hand to satisfy those who wanted to redeem their paper,  he was, as one might say, as good as gold.

This is what us moderns call  “fractional reserve banking“.  But instead of  actual gold, paper dollars themselves work somewhat, but not exactly like, gold. In addition,  in modern times everyone from your local goldsmith (the bank) to the federal government (via laws) to the federal reserve (currency makers) are all in on this action–for good and/or evil– with coordinated participation.


Filed under Banking, Currency, Economics, Politics

3 responses to “Gold, Currency, Fractional Reserves And The Tale Of The Goldsmith

  1. Jonathan

    After reading this I didn’t really derive a particular stance or take you have on Fractional Reserve Banking. You explained it well enough, but left me hanging on your economic opinion of the concept. Where do you stand? I feel like it can work to positively beneift an economy by “creating” more capital (albeit artificially) to boost the economy. It could also be abused and lead to really bad inflation. Your thoughts?

    • Perhaps I live in a world that is a little too idealistic, but I think there are problems with it. Here’s two reason’s why.

      First, capital can’t be created artificially. That is one of those “first things” I talked about in my last post. So where does the “increase of capital” come from then? What the goldsmith in effect did was to take, without permission, a tiny piece of the “capital” that each of his customers had entrusted to him for safekeeping, and loaned it out. The depositors experience this with less buying power because of the increase of certificates floating around. He did the same, in reality as if he had picked his depositor’s pockets.

      Second, this is an illusion and a trap. It is an illusion because people only feel wealthier because they have more money. Nevermind that that money will purchase less. It is a trap because it can never be stopped once started. Suppose the goldsmith decides to give up his little scheme. This will necessarily cause deflation as the loans are repaid because the amount of “currency” will decrease. Assuming that production remains constant, prices, as the outstanding certificates again align themselves with the value of the gold, will decrease. In a static world this wouldn’t be a problem. But people, in the daily conduct of business, agree on contracts, maybe even take out loans from each other, all of which depend on a future value of the currency. These contracts are indifferent to inflation and deflation which cause the terms of the contracts to be modified without the signer’s knowledge or consent. This is destructive to business and so therefore is destructive to the economy.

  2. Just a straight plain explanation of Fractional Reserves. No frills. Excellent.

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