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The Move Towards Paper-based (Fiat) Money

What do gunpowder and pasta have in common? According to the Chinese both of these were invented in China long before they appeared in the West. It is generally accepted that the earliest use of paper money was in China more than 1000 years ago towards the end of the Tang dynasty. These were issued by private banks but backed by the state. The use of the paper currency reduced the need to transpor t silver to make payments. This paper was effectively a form of negotiable IOU or promissor y note. The holder of the note could present it to the issuer and receive the stated weight of silver in return.
While Italians may dispute this version of histor y as it relates to pasta they can at least claim to have laid the foundations for the modern banking system in the sixteenth centur y. This was the perfect scam because while the per petrators profited no-one was obviously hurt through their system provided it worked as intended. The per petrators were respected (or at least rich) goldsmiths.
Goldsmiths had to keep quantities of gold on their premises in the form of raw material, work-in-progress and finished products. This gold had to be kept in a secure place and yet be readily accessible. This allowed them to provide a ser vice to rich merchants and landowners to store their gold. They were able to offer one of the earliest safekeeping, or custody, ser vices to their customers. Customers would deliver their gold, usually in the form of coins, to the goldsmith who would issue a receipt for the gold. The receipt represented a claim on this stored gold. The goldsmith would return the gold when this receipt was presented.
A merchant who had to pay a supplier would present his receipt to the goldsmith, take the gold and then make the payment. The supplier would then take the gold back to the goldsmith for safekeeping and receive a receipt in turn. Over time customers realized that it was safer and more convenient to make large payments using these receipts as the medium of exchange. Two issues had to be resolved. The first was that the receipts presented were genuine and represented real claims. The second was that the goldsmith would, and could, honor these claims. The first issue was resolved through the use of wax seals. The second issue depended largely on the reputation of the goldsmiths and perceptions of their integrity and solvency. Over time the gold receipts increasingly displaced gold coins for the settlement of large payments. Coins continued to be used to settle smaller transactions and to make up any difference between the value of the receipts and the required payment. As an aside, these early forms of paper money can be viewed as an asset backed bearer security but by convention it is usually referred to as cash.
These developments led to the adoption of the equivalent of paper money but it did not involve either the creation of money or the establishment of a banking system. These required a leap of imagination. It is difficult to believe this innovation emerged from a committee but the name of the original visionary has been lost in the mists of time. As will become clear goldsmiths had ever y incentive to keep the workings of this system to themselves.
On any given day the amount of actual gold withdrawn by customers was normally only a very small propor tion of the gold that had been deposited with the goldsmith. It became clear that some of this stored gold could be lent out without the knowledge of the depositors. The latter were not concerned whether the coins they received on presentation of their receipt were those initially deposited – only that their value (weight) was the same.
The borrowers rarely withdrew gold itself but instead were issued receipts that acted as a negotiable currency just as those issued to the actual depositors did. The goldsmiths agreed terms and conditions for these loans with the borrowers. The latter paid interest on these loans. The nominal value of receipts circulating in the economy exceeded the value of the gold held by the goldsmiths. In this way money was created.
The system had two potential weaknesses. The first was that the goldsmiths might get greedy and lend out too high propor tion of the gold they held leading to a high level of receipts circulating in the system. This in turn could result in people star ting to question whether the goldsmiths could meet their claims. If enough people with a claim on the goldsmith presented his or her receipts at the same time the goldsmith would be unable to meet all of the claims. The system only worked if depositors were confident that their claims would be met.
The second weakness arose from borrowers who took their loans in the form of gold and subsequently defaulted. This was a real risk when borrowers included kings using such loans to finance wars and merchants buying goods abroad to be shipped home for resale. Members of the first group were at risk from losing their war or being held for ransom, the second of their ship sinking or being attacked by pirates and losing their cargo.
The banking system created by the goldsmiths was unregulated, there were no legal reser ve or capital adequacy requirements, for example. There was no form of depositor protection provided by the likes of the US Federal Deposit Insurance Cor poration (FDIC). It also still relied on the backing of a commodity (gold) with an intrinsic value.
We now have the basis for the modern money system but we need to get rid of the convertibility into gold. We have already discussed some of the practical problems with using gold as a currency such as the tying up of resources to produce and store it that could be better used elsewhere. This is not the major problem, however, which lies in the realm of macroeconomics. By linking the domestic currency to gold a countr y’s money supply is effectively constrained by gold supply. Although there have been periods when gold supply has risen much faster than the real economy, such as happened in Spain, the supply of gold is relatively fixed. In an expanding economy an insufficient level of money supply growth will lead to disinflation, higher unemployment and a lower level of real output. This link can be broken by prohibiting gold withdrawals. This would effectively mean that no-one would know whether the gold was there or not! Policy makers could then determine money supply as deemed necessar y by economic conditions.
These problems are, however, amplified by trade when countries have their own currencies linked to gold. This results in the adoption of what is known as the gold standard and results in a fixed exchange rate system. If holders of sterling were entitled to exchange a £100 note for one ounce of gold and the holders of US dollars could exchange $200 for one ounce this would force a fixed exchange rate of £1 for $2.
Under a gold standard countries with a trade deficit (where the value of their expor ts in terms of gold was less than the value of their impor ts) settle this difference by transferring gold to those countries with a trade sur plus. The outflow of gold leads to a fall in money supply in those countries with a deficit and lower prices making expor ts more competitive as a result. Inflows of gold at creditor nations result in increased money supply, higher prices and less competitive expor ts. As a result of these two pressures the trade balance tends to equilibrium. Higher trade levels result in higher overall output and trade has expanded much more rapidly than economic output since the time of the industrial revolution. The demand for exchange currency has hence grown much faster than the supply of gold. The only way for this demand to be satisfied is for prices to fall, and again leads to higher unemployment and a lower output level than would otherwise be the case.
A gold standard puts policy makers into a straitjacket with no effective means to determine or influence money supply other than through trade tariffs and other barriers that reduce the level of trade. The last attempt to operate using a global fixed exchange rate system failed in 1974 and today few seriously countenance the return to either a fixed exchange rate system or a gold standard.