In
Part 1 of this series, How Money Is Created, we learned how the Federal Reserve
Bank creates money in the form of Federal Reserve I.O.U.s called “Federal
Reserve Notes.” In this part we will learn about the origin of another form of
money called “Bank Credit.” The story begins in the Netherlands in the 17th
century.
The
Netherlands had become a commercial crossroads where the East and West met and created
a new economic class -- the first
middlemen. They discovered how to make huge profits by purchasing
unfinished imported products, finishing them, and then selling them to exporters.
They became accomplished craftsmen and benefited handsomely.
Their
success did not go unnoticed by “old money” aristocrats, who spoke of them with
disdain. They called the middlemen “commoners who were only devoted to making
money; crude and greedy people that were cursed by bad manners.”[i]
But, as the power and wealth of the “commoners” grew, so did their innovations and
they transformed commerce -- free ports, secure titles to land, efficient
processes for settling lawsuits, teaching bookkeeping in schools, and licensing
agents to sell marine insurance.
Commercial transactions
required immediate access to gold and silver coins or bars, and that created a number
of problems and increased risks. Gold and silver were bulky to handle, heavy to
transport, robbery was always a risk, just as was the loss of value through normal
wear, as well as being “shaved” by thieves who melted down the shavings. The
Dutch middlemen looked for ways to simplify financial transactions and decrease
the risks involved. A new financial institution was created that accepted foreign
and local coinage at its real, intrinsic value. The Bank of Amsterdam was founded
in 1609 under protection of the City of Amsterdam and laws were passed that
required anyone doing business in the city to have an account at the bank.
The bank
accepted deposits of gold and silver and stored them in their vaults, after deducting
a small coinage and management fee. The bank was basically a warehouse and was nothing
like banks today. Depositors delivered their gold and silver to the bank and
received deposit receipts. The bank stored it until the depositor returned and
withdrew it. When customers needed gold or silver to transact business, they also
had to go to the bank and withdraw it. However, as time passed, customers and merchants
discovered they could transact business by simply trading deposit receipts instead
of physically handling gold or silver. Deposit receipts became known as “bank
money.”[ii]
“Bank
money” quickly became very popular and resulted in a rapid increase in bank deposits.
But, as time passed, the bankers realized that at any point in time they only needed
a small portion of the gold and silver they were holding for depositors to handle
the cash requirements of conducting business. They secretly set out to
determine the minimum amount of gold and silver they needed to keep on hand to
meet the average withdrawal demands of their depositors – and they made sure that it was done in absolute
secrecy.
Next,
they started lending money, but they gave borrowers “bank money” instead of
gold or silver. If a borrower came to withdraw gold or silver that had never
been deposited in the bank, the bankers paid him with gold or silver from that owned
by another depositor. As long as the majority of their customers did not show
up at the bank at the same time and demand gold or silver, the bankers were
able to continue the scam -- and they became
very rich. How could they not become rich when they created money out of
thin air, loaned it to borrowers, and charged them interest?
In
the beginning they only lent a small fraction of their customers’ deposits, but
slowly they increased it to more than fifty percent. The thing they feared the
most, that depositors would lose confidence in the bank and demand their gold
and silver, happened in 1791. A major panic occurred and forced the bank to
close. Depositors lost a great deal of their deposits. The bankers were tried and found guilty.[iii]
The story of the criminal actions of the bankers faded from memory as time
passed, but the huge profits their scam produced by convincing people to trade
pieces of worthless paper as if they were gold and silver was not forgotten by
an elite few.
So,
what do you think happened to the idea of creating money out of thin air? Are
you sitting down? Would you be surprised to learn that it became the model for
our modern banking system? Today, this system is called “fractional reserve
banking,” and we will discuss how it creates huge amounts of money called “Bank
Credit” today in Part 3 of this series. Unless you understand “fractional
reserve banking,” you cannot understand the facts behind the major economic and
political problems facing us now.
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