An edited version of this article was first published in Euromoney's Islamic Finance Information Service, 11 December 2007.
The goldsmith bankers of seventeenth century England engaged in the seemingly innocuous practice of holding precious metal coins on behalf of their depositors. In return for each deposit of coins, a goldsmith would issue the depositor with a paper receipt that promised redemption on demand. If a particular goldsmith was well trusted, many merchants would be happy to accept his receipts in payment for goods and services. A large proportion of the public therefore came to see goldsmiths’ paper not as receipts for money, but as money itself. Accordingly, depositors came to seek redemption of their receipts in ever decreasing numbers. Why bother going to the goldsmith to withdraw gold coins, if shopkeepers would accept the paper in payment anyway?
The goldsmiths soon realised the incredible business opportunity implicit in their customers’ behaviour. Instead of acting as mere safe-keepers of gold, they now offered their services to the public as money lenders. But when the public came to borrow money, they would be loaned paper receipts not gold. From the perspective of these early bankers, such a policy had one great advantage. Unlike gold, paper money could be created in the back office at almost no cost.
Naturally, many businessmen wanted to join in this new game of banking. What easier way could one find of earning a living than creating money with a printing press, and then lending it at interest? "The Bank hath benefit of interest on all moneys which it creates out of nothing", said William Paterson upon founding the Bank of England.
In those early days of banking, some commentators argued that if a banker issued a receipt promising the payment of a certain amount of gold, then he should keep that amount of gold in his vault to honour the promise when so required. The bankers argued differently. They said that because the majority of depositors did not come to the bank to claim their gold in any one period, it would be safe to issue receipts in excess of their gold stock. With this argument, the bankers attempted to justify their creation of multiple legal claims of ownership for each unit of gold in their possession.
The reserve of gold to paper in issue came to be known as the "reserve ratio", and today many major banking organisations operate a reserve ratio of less than one twentieth. Hence "fractional reserve banking". For example, HSBC’s 2006 Annual Report shows that its customers held in aggregate some £168 billion of sight deposits, yet at the same time the bank held only £3.5 billion of cash to honour requests for withdrawal of those deposits. If all of HSBC’s customers asked for their money in cash on the same day, the bank would be in a rather similar position to that of Northern Rock. The same is true for all commercial banks because the holding of a fractional reserve is the essence of their business model. They survive only so long as depositors are sufficiently confident not to ask for their money back.
Realising that heavy withdrawals might bankrupt them, early bankers made arrangements to borrow reserves of coins from one another when necessary. However, these arrangements didn’t work well in times of crisis when every bank was in need of extra reserves. It would be so much more convenient if the money of the realm could be redefined as a piece of paper, rather than a piece of gold or silver. It could then be printed in whatever quantities were necessary to satisfy calls for reserves by the commercial banking system. The government duly obliged. In 1833, Bank of England notes were made legal tender for all sums above £5.
Today’s banking practices are of course more sophisticated, though the principles remain the same. Modern commercial banks create money by crediting the borrower with an electronic entry which shows up as a balance on an account statement. But as with the goldsmiths’ paper promises of old, if all of a bank’s customers try to convert these balances into cash, the bank will soon find itself in need of extra reserves.
There is another more important similarity between these modern and early forms of banking. Whether it is a goldsmith issuing a newly printed paper receipt to a borrower, or a high street bank crediting a customer’s current account with a ledger entry, money supply increases every time a banker makes a loan. Money has become the balance sheet counterpart of debt at the macro-economic level. Therefore, widespread attempts at reducing debt also cause reductions in the supply of money and lead directly to recession. In short, society cannot repay its debt and have a job.
Given that commercial banks have the power to create new money at zero cost, it is an obvious business strategy for them to maximise the amount of money created within the existing regulatory regime. The greater the amount of money created, the greater their interest revenue and the greater their profit. The overall trend is therefore for a growth in money supply (and hence debt) over time. As a result of this tendency, every modern nation suffers from inflation. In more recent times, this inflation has been disguised by various statistical techniques. For example, although houses are the most expensive item that most individuals ever buy, they are excluded from the common measures of UK inflation.
Monetary reformers argue that the legal privilege to create money should be removed from private entities such as commercial banks and placed instead in government hands. Others go further, citing the tendency of governments to issue money for their own political advantage, and propose a commodity money system based on precious metals. Put simply, this is a system in which money is created by those who dig for it.
The American founding fathers adopted exactly this approach. Their objective was to ensure that America would not fall prey to the money creating usurers of England, amply evidenced by Jefferson’s statement that "banking establishments are more dangerous than standing armies". Gold and silver were duly enshrined as the only lawful forms of money under the American Constitution, but the struggle with the banking lobby had only just begun. Soon, Jefferson felt compelled to warn the American people against giving the banks control over their currency. Then during an address to the American people in 1837, Andrew Jackson accused the Bank of the United States of having created a recession by contracting the money supply, and this in order to damage him politically. Almost thirty years later, President Lincoln proposed measures to ensure that democracy could rise above the "Money Power". But in the long run these efforts were insufficient against the power of the banking lobby. It was Woodrow Wilson who finally conceded to the demands for a central bank by signing the Federal Reserve Act into law in 1913, a manoeuvre that effectively passed control of the American monetary system to private interests.
Alas, the coup de bank is now global. It is the culmination of some three centuries of concerted effort by a small clique of men whose interests have never coincided with those of humanity at large. These are men who were once imprisoned for their usury, and who now rule over us from the comfort of their central banking boardrooms. From here they can change the value of our money with a single announcement, and there are few greater powers than that.
The dominance of the banks is all the greater because they can choose which entrepreneurs to finance and which to overlook, and because their immense profitability allows them to support ideologies that accord with their own political agenda. The defeat of the Christian prohibition of usury is one historical example, a strategy that is being repeated with astonishing similarity in the Islamic banking sector today. In this regard, semantic distortion has always been a favoured device. Money lenders don’t practice usury anymore, they "sell mortgages". Islamic banks don’t lend money at interest, they charge a "profit mark-up".
In recent weeks, semantics has been relied upon heavily in order to minimise public awareness of the black art of money creation. At first, we were led to believe that the money used to rescue Northern Rock is taxpayers’ money. It is nothing of the sort. It is new money, created in a few keystrokes by the Bank of England. Realising the impossibility of explaining how more than £20 billion of "taxpayers’ money" could be collected and disbursed in just a few weeks, the authorities soon amended their language. The rescue package is now referred to as a "taxpayer-backed loan", which implies that if Northern Rock cannot repay the money created out of nothing by the Bank of England then the British taxpayer will. Ironic, isn't it, that the people who may be required to pay the cost of saving the British banking system are the very ones who have been hopelessly indebted by it.
If this is what happens when just one bank is caught out on its promise to pay cash to its depositors, then the consequences of a wider bank run could clearly be catastrophic. The political pressures on media organisations to avoid an open discussion of fractional reserve banking are therefore substantial. It would be a brave editor who published the headline "The Bank Doesn't Have Your Money, Mrs. Smith" but no truer words could be written.
In the immediate present, the global economy stands on a knife edge between depression and hyperinflation. The pumping into circulation of hundreds of billions of dollars in new reserve money across the world may or may not be sufficient to rescue the banking sector from its own greed. And it may or may not be enough to prevent a global recession. But in the longer term, there looms a much weightier issue. The debts of the West have now become unrepayable except by means of an inflation that will cause its empire to weaken substantially. Such a development may force the dominant banking institutions of our time to shift their commercial and political focus into the Chinese banking space, and that would be a difficult migration. The Chinese leadership will surely know that control of the money supply brings with it control of the nation, and this is a power that they will not willingly place in foreign hands. Indeed, the founding fathers reasoned likewise.
Such is the story of paper money. That innocuous receipt has given us a world in debt, a world of huge power imbalances, of booms and busts, and now perhaps a transition of empire.
Tarek El Diwany