The method of creating new money goes back to the Middle Ages, when gold was the only form of money.
Those who owned gold, for fear of being robbed, deposited this gold in the strong-rooms of the goldsmiths, who gave gold owners receipts for the gold they kept for them in their vaults.
So, instead of paying in gold when they purchased goods, these individuals paid with the receipts they had received from the goldsmiths, which proved that they had gold in the goldsmiths' vaults. The person who was paid with these receipts thus became the new owner of the gold kept in the goldsmith's vault, and was free to go and withdraw this gold at any time from the goldsmith.
The goldsmith noticed that most of the people preferred to exchange receipts instead of coming to withdraw their gold. For each person who actually came to the goldsmith and asked for his gold, ten people did not come, preferring to exchange the receipts issued by the goldsmith.
The goldsmith soon realized that he could thus issue, without risk, ten times more receipts than he had actual gold in his vault. As long as the same ratio of people did not show up at his place and ask for their gold, the goldsmith could go on with his confidence trick, but if all of his customers showed up and wanted their gold back, the whole system would collapse, and the fraud is unveiled: the goldsmith cannot repay them all, since there is ten times less gold than he pretended to have in his vault!
Today's private banks operate exactly the same way. They realise that for each person who comes to the bank and wants to be paid in cash (paper money), about ten people will only transfer figures from one account to another one, without using any cash. ( Today, over 95% of our nation's monetary transactions are done by cheque, and less than 5% by cash.)
This is what allows the banks to lend more money than they actually have.
For example, with $1 million in cash reserve, a chartered bank can lend $10 million in credit, or bookkeeping money (not paper money, but figures written in bank accounts). The only restraint to this creation of credit is the fear that too many people show up to the bank and ask to be paid in cash, since the bank could only repay in cash about one consumer in ten. One of the ways for the banks to protect themselves against such a possibility is to encourage depositors to leave their money at the bank as long as possible, by paying higher interest in fixed deposits, which are tied up with a bank for one, two or three years.
What the goldsmith-bankers were doing might be compared to a farmer who had a fine saddle horse in his corral.
Along came a city dude who asked to buy the horse but wanted to have the farmer take care of him. The farmer agreed.
Later the farmer noticed that the new owner never rode the horse
except in the early morning.
Another city dude came along and asked to buy the horse, saying that he only rode during lunchtime, therefore the farmer felt fairly safe in selling the horse a second time.
Later he sold the horse a third time to a fellow who claimed he only rode in the afternoon, and eventually, the horse was sold a fourth time to another city dude who claimed he only rode in the
evening.
This story would have had a wonderfully happy ending for the newly enriched farmer if it had not been for the fact that these four horse lovers belonged to the same country club.
All four of them got to bragging about their horses and finally decided they would get their horses and race them to see which one was best.
Each of the depositors immediately went to the farmer to get his horse.
This is called a Run on the bank!
The differences between the Goldsmith and the modern Banker are only in sophistication and an expansion of services provided.
