Lecture Notes: Love, Money, and the History of Banking

Introduction

• Two great mysteries: Love and Money
• Love is a common theme in media; money is not as frequently explored
• Common misconception: Money is created by government and minted physically
• Reality: Most money is created by banks through a process involving loans

Money Creation by Banks

• Common Belief: Banks lend out money deposited by customers
• Reality: Banks create money from borrowers' promises to repay
• Process:
  • Borrower's signature on loan creates an obligation
  • The bank creates the loan amount and credits it to borrower's account
  • This is fundamentally different from using depositor's money

Historical Perspective: The Goldsmith's Tale

Early Forms of Money

• Money must be portable and trusted for exchange
• Items used as money in history:
  • Shells, cocoa beans, stones, feathers
  • Gold and silver for their malleability and attractiveness

The Role of Goldsmiths

• Goldsmiths cast coins and certified purity and weight
• Provided vaults for safekeeping gold
• Issued claim checks (early form of paper money) that were traded

Evolution to Modern Banking

• Goldsmith's Observation: Depositors rarely withdrew gold simultaneously
• Lending Claim Checks:
  • Goldsmith lent out claim checks for deposits
  • Earned interest by lending others' deposits
• Banking Expansion:
  • Grew wealthier, became primary lenders
  • Shared interest earnings with depositors

The Bold Move

• Innovation: Lending claim checks beyond actual gold holdings
• Led to immense wealth from interest on non-existent gold
• Downfall:
  • Led to bank runs when real gold was demanded
  • Resulted in loss of confidence and financial instability

Legalization and Regulation of Banking

• Importance of credit for European commercial expansion
• Legalization: Allowed creating money from nothing under regulation
• Regulations:
  • Restricted the amount of money banks could create (e.g., 9:1 ratio)
  • Surprise inspections enforced regulations
• Central Banks: Provided emergency support to local banks

Conclusion

• The banking system's history involves creating money beyond physical assets
• Despite risks, regulating this system enabled economic growth and expansion
• The tale of the Goldsmith illustrates the origins and evolution of modern banking practices.