numbers in their ledgers. Once the transfer had taken place, the lender started to earn interest, but also had to accept the risk that the borrower might default. The banks soon realized, however, that with so much unused cash in their vaults they too could use it to make loans, with or without the explicit consent of the depositors.
Something similar was happening with goldsmiths and pawnbrokers. In London in the 17th century, faced with multiple risks of plague, fire and war, many people would leave their gold coins and other valuables with various businesses for safekeeping – in particular those with strong vaults. To this day the official arbiter of British coinage is the Goldsmiths’ Company of the City of London.2 To recognize that they held these valuables, the goldsmiths would issue receipts or ‘notes’. If the depositor later wished to ‘spend’ their valuables for some purpose they could present the note and ask for them back. However, they might find it more convenient just to spend the notes. If the goldsmith was reputable, the receipt itself was ‘as good as gold’ and anyone holding it could go to the goldsmith and take the metal itself. This is thought to be the origin of the ‘promissory note’ – what we would now think of as a banknote.
Then some enterprising goldsmith took an important new step by handing notes not just to depositors but also to people who wanted to borrow money and were prepared to pay interest. These notes did not correspond to any particular deposit of gold but rather reflected the fact that there was a lot of gold in the vaults. Nevertheless, the goldsmiths still required a reassuring amount of gold and needed to attract more deposits. They thus started offering interest to the depositors.
You will have noticed a sleight of hand which, if not actually dishonest, is at best risky. If everyone awkwardly shows up with their notes simultaneously demanding the equivalent in gold or coins they might be disappointed. Once depositors suspect their funds may not be available for withdrawal, they are apt to bang on the doors, asking for their money back – and thus triggering a ‘run on the bank’. Regrettably, that was the ultimate fate of the Bank of Amsterdam. Having lent out too much to the Dutch East India Company and to the City of Amsterdam, it was forced to limit withdrawals and in 1819, after two decades of operation, had to be wound up.
Nevertheless, it had helped to establish a general model of banking that has survived largely intact. This is partly because it has proved useful for both borrowers and lenders. When Willie Sutton, a notorious bank robber in New York in the 1930s, was asked why he robbed banks, he famously replied: ‘Because that’s where the money is.’
To disguise the inherent risk, banks have done all they can to appear solid institutions. In the past, they tended to construct even their smallest branches to look as imposing as possible – sometimes with stout Greco-Roman porticos that looked as though they could withstand several earthquakes. And bank managers, until recently at least, also wore very sober suits, and were considered the epitome of respectability.
Even so, to this day, what banks do is essentially a conjuring trick. In fact they do not wait for anyone to make a deposit before making a loan. If they think that the borrower looks creditworthy they simply open a bank account and declare that the borrower has those funds in it. As the Canadian-born economist JK Galbraith memorably put it: ‘The process by which banks create money is so simple that the mind is repelled. Where something so important is involved a deeper mystery seems only decent.’
Is the loan really money? Yes it is. The borrower can write a cheque, or make a bank transfer, on this amount to buy goods. If this transaction is with another customer of the same bank then the funds are transferred from one to the other. If the check is paid into an account in another bank much the same situation applies, except that there has to be an exchange between banks. In practice the major banks have a huge number of mutual transactions every day, most of which cancel out. But what if they do not? Enter the central bank.
Central banks
Each country that issues its own currency has a central bank. In the US, for example, this is the Federal Reserve. In Australia it is the Reserve Bank of Australia. In Canada it is the Bank of Canada. There are also central banks for countries that share a currency; in the case of the euro, this is the European Central Bank. While you might assume that central banks are government operations, in fact many started out as private companies. The Reserve Bank of India, for example, was established in 1935 as a private company, though it was nationalized at independence in 1949.
The oldest of the central banks is the Bank of England which was founded in 1694 by a Scotsman, William Paterson. At that time the King of England, William III, also known as William of Orange, was in dire need of funds, not least because of his frequent quarrels with France. Paterson came up with a solution. He would create a new bank and sell shares in it. Then he could lend all the proceeds to the King, who could use these funds to fight the French. Paterson’s proposal went down well. The King awarded the Bank of England a Royal Charter and promptly borrowed all the capital – £1.2 million. Previously all banks had been privately owned. Paterson’s Bank of England, however, was to be a ‘joint stock’ company. This meant that it would not only raise its initial capital funds by selling shares but would also be a ‘limited’ company, so if it collapsed its owners would not have to pay debtors out of their own pockets – they had limited liability, in other words.
At the same time the Bank of England was a commercial operation that could take deposits and make loans. The fact that the King had already walked off with all the bank’s subscribed funds, and thus its capital, was not a problem since he had left an IOU. The King was a decent credit risk and was likely to repay eventually, if only by taxing his citizens. This meant that the shareholders got double value for their investment. First, the King was paying interest on the loans. Second, based on his £1.2 million the bank could lend out the same amount in banknotes – it could ‘monetize’ the debt for other profitable lending through the issue of Bank of England banknotes. King William was much impressed by this wizardry and wanted further loans, requiring the Bank to raise yet more capital by selling more shares. The Bank of England had thus issued the notes that formed the British money supply based on a royal debt. To this day the British Crown has not repaid this. Indeed, it has been argued that, if it did, the entire British monetary system would collapse.3
The new Bank of England maintained a reputation for sound management. It ensured that it always kept enough coins on hand so that anyone who presented one of its notes was promptly repaid in silver or gold coins. But since the bank had government backing, few people actually tried to redeem their notes. At that point other English banks were also still issuing notes, but these were considered less reliable and thus less acceptable for payment. Soon most of the notes in circulation were those of the Bank of England. Nevertheless, it did occasionally run into problems after it issued large numbers of notes and at one point was forced temporarily to suspend the right of bearers to redeem their notes for gold or silver. To correct this tendency to overlend, in 1844 a new Bank Charter established that the Bank could only print additional notes that corresponded to the gold and silver that it maintained in its vaults – akin to what would later be called the ‘gold standard’.
At that point, in most respects, the Bank of England remained just one commercial bank among many. In time, however, it started to take on what we now recognize to be the functions of a central bank. Not only did it have a quasi-monopoly on the right to issue paper money, it also became responsible for the control of other banks.
Nowadays, if any company wants to become a bank, they need a banking licence. This brings certain privileges but also a degree of regulation. The main privilege is that they can create deposits out of thin air and lend them to customers. Other institutions, such as savings and loan institutions, are allowed to make loans but these have to be with funds that have been saved with them. They are not allowed to create money. A banking licence thus sounds like a licence to print money, and in many respects it is.
But there are limitations. One is that every licensed bank is required
