But then there is gold’s second shortcoming. The villagers discover that some of the very qualities that make gold such an excellent choice as money also make it a favorite target for thieves! It is valuable, easily transported, easily divided, and, since everyone’s gold and coins look alike, they can’t be identified as stolen property.
Listening to the concerns of his customers, Ben comes up with another inspiration— he’ll add a special vault inside his mint so that people can store their gold in safety. He will issue receipts each time they put gold on deposit, and they can come by and claim their gold anytime they want. All for a modest service charge, of course.
It isn’t long before Ben’s “gold warehouse” business is up and running. And as more and more of the townspeople use Ben’s vault for keeping their gold safe, a curious thing begins to happen.
When negotiating a purchase, shoppers engage in this kind of conversation with storekeepers: “Say, do you have a gold storage account at Ben’s warehouse? You do? I thought you might since you take in a lot of gold here at your business. How about saving both of us a little time and trouble? Rather than me going over to the warehouse to pick up my gold, and then coming back here to give it to you, I’ll just sign this receipt over to you. Then the gold would legally be yours, and you wouldn’t have to go to the trouble of placing it in safekeeping—it’s already there.”
As this way of doing business catches on, people begin exchanging the receipts rather than the actual gold. The receipts are being accepted as a means of exchange because of what they represent. They aren’t really the money; they are simply substitutes for money. The gold is the real money; it is the commodity with the accepted value.
The paper receipts, in and of themselves, have no intrinsic worth. They take on value only because they can be exchanged for gold. If, through fraud, bankruptcy, or natural disaster, the gold in the warehouse were no longer available, the receipts would be worthless.
For the paper receipts to keep their value as money substitutes, three conditions have to prevail.
•Ben’s warehouse has to build widespread patronage throughout the village. A merchant would be less inclined to accept the receipt in exchange if he didn’t also have an account at Ben’s, or if he didn’t expect to be able to trade the receipt to someone else who had an account at Ben’s.
•Ben’s warehouse has to keep regular and convenient hours for business. The villagers needed confidence that the gold (i.e., the real money) is actually there, and that they can get it out anytime they want.
•Ben’s warehouse has to never let gold out of the warehouse without getting a corresponding receipt back. Otherwise, there would be more receipts in circulation than there is gold to back them up. Then, how could a receipt-holder know for sure that his gold is there?
Money substitutes will retain their value and enjoy widespread acceptance to the extent they are readily and assuredly convertible into real money. Since Ben pays careful attention to such details, his business is a successful one. Furthermore, the townspeople reap the benefits of an effective system of money. All is going well—and the best is yet to come: Ben is about to invent banking.
Banking and the lending of money
As the village grows, it becomes apparent to Jim, owner of the local general store, that he has outgrown his building. The growth of his business is being limited because he doesn’t have room to store or display more merchandise. He begins to dream of building a new store, where he would have more room for stocking and displaying a wider variety of groceries and dry goods.
Jim estimates it would cost $12,000 to build and stock his new store. Unfortunately, he has managed to save only $5,000 over the past several years, which he has stored at Ben’s gold warehouse. He calculates that if he could borrow the remaining $7,000, he is sure that an increase in sales would enable him to repay it within 9-12 months. But who will lend him $7,000? He takes his problem to Ben.
“Sorry, Jim,” Ben says, after looking over his list of customer accounts, “There are very few people in the village who have that much on hand right now. If you’re going to pull this off, you’ll stand a much better chance of borrowing $1,000 from seven people than trying to borrow $7,000 from just one person.”
“How can I do that? I wouldn’t know who to go to. But, wait—you do! Would you do it for me? I’d be glad to pay you for your time.”
Ben considers the idea. “Well, I do talk with my customers when they bring their gold in for storage, and I know a few who might be willing to lend theirs. But I’m not sure they would be interested in taking a chance on your expansion idea—they’d want more of a sure thing. Let me think it over.”
Jim’s dilemma is familiar to Ben. From the daily talks he has with his customers, he knows there are always some looking to borrow while others have more gold than they need for the coming months. Sometimes the grapevine gets borrowers and lenders together. But for the most part, few customers are willing to lend their money. There is just too much risk that something could go wrong and they wouldn’t get it all back. Even though Ben knows Jim is a good businessman and believes there is little risk in the loan, he knows it would be a “hard sell” to convince his cautious customers to take a chance on Jim.
Then this thought occurs to Ben: “Maybe they’d take a chance on me.” Based on his track record of success and integrity at the warehouse, he has an excellent reputation. If his customers would lend their money to Ben, he could turn around and re-lend it to Jim. In effect, Ben would be taking the risk instead of his customers, even though it is their money being used. In return, Ben would expect a profit based on the amount of money at risk.
So Ben posts a large sign in his warehouse. It offers to pay an annual rate of interest of 5% to customers willing to give up the right to use their gold for a period of one year. It would still be their gold, of course. They would merely be agreeing that they wouldn’t come and demand it back until the year was over. In return for surrendering their gold receipts (which represent their right to take their gold at any time) they’ll get a one-year note from Ben. The note entitles them to claim their gold, plus 5% interest, at the end of the year.
Ben’s offer is a success. Over the next month, $10,000 worth of gold receipts are exchanged by their owners in return for Ben’s one-year 5% notes.
What Ben has done is create a distinction between demand deposits that cannot be lent out, and time deposits that can. Thus, he provides a structure for the safe creation of credit—one person is paid a fee for temporarily giving up the use of his or her money in order to allow someone else to use it. And by “inventing” commercial banking, Ben once again prospers by providing a valuable service to the village.
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