The goldsmith profession of Medieval Europe, which used gold--the medium of exchange--as a production input in the fabrication of jewelry and other artifacts, was ideally suited to develop basic banking functions, including the creation of money.

Fred the Goldsmith

He is one of many "smithing" artisans operating at this time who fashion products from different materials. Blacksmiths work with iron; silversmiths work with silver; coppersmiths work with copper; tinsmiths work with tin; and pewtersmiths work with pewter.

But Fred is unique among his smithing cohorts.

• Valuable Input: The primary input into Fred's goldsmithing operation--gold--is an extremely valuable commodity unto itself.


• Commodity Money: Gold is valuable because it is the economy's medium of exchange. It is commodity money. Gold has both value in use and value in exchange.


• Value Coming and Going: Unlike his smithing compatriots, Fred produces a valuable output using an extremely valuable input. Other "smiths" transform lesser valued materials--tin, iron, and the like--into products with substantially greater value.


• Under Lock and Key: With all of this value surrounding Fred's goldsmithing operation, he needs to keep everything--outputs and inputs--safe and secure. An obvious way to accomplish this is to buy a vault. As such, Fred has a lot of valuable gold stashed in his vault.
• Goldsmith Banking: The end result is that Fred the goldsmith develops a number of basic banking function, including deposit safekeeping, financial intermediary lending, maintaining reserves, and issuing paper currency.

Paper Receipts

Business is so robust that Fred tracks using a system of paper receipts. When a knight meanders into Fred's shop with gold for safekeeping, Fred issues a receipt noting the amount deposited. Upon returning, the knight presents this receipt and Fred returns the gold.

Fred's gold receipt system has several notable features.

• One, because gold is gold, each Knight does not necessarily receive exactly the same gold left for deposit. The knight receives the same amount of gold, but not necessarily the same gold.


• Two, the number of knightly comings and goings means that Fred does not personally know each knight requesting services. Of course, he knows Bill and Lance. And everyone knows Sir Regis. Most of the other knights are little more than complete strangers. But, as long as they present legitimate gold receipts, they can withdraw gold.


• Three, Fred is an honest and trustworthy goldsmith. When it comes to honesty and trustworthiness, Fred is at the top of everyone's list. The reason is that Fred has NEVER failed to return any deposited gold.


• Four, Fred's honesty and trustworthiness means that most local townfolk come to accept Fred's receipts in payment just like actual gold.

Paper Money

To see how, consider this scenario.

• Bill the Knight returns late one night after months of dragon slaying in a faraway land.


• Being thirsty and hungry, he stops at Elizabeth's Inn for a pint of ale and a pot of porridge.


• When payment comes due, Bill realizes that his gold remains stored in Fred's shop. Bill has nothing but a satchel of gold receipts.


• Fortunately, Elizabeth, knowing and trusting Fred, doing regular business with Fred, is willing to accept these receipts in payment. Elizabeth is confident she can redeem these receipts the following day.


• So, Elizabeth is willing to accept the gold receipts issued by Fred in payment for the pint of ale and pot of porridge.


• Fred's gold receipts are used as money. While this is only one transaction, it sets the stage for Fred's gold receipts to become the town's medium of exchange.

Because Fred's paper receipts are lighter and easier to carry, they better satisfy the transportability characteristic of money. Most townfolk actually prefer using paper gold receipts as money.

By luck and happenstance, Fred has discovered the important banking functions of issuing paper currency, fiat money, and what is comparable to the checkable deposits of modern banks.

Paper Loans

The prospects of pain, however, must be balanced by the prospects of profit. Fred is not just in the business of keeping deposits safe, he is also in the business of extending loans. Consider how Fred's lending activity is affected by the widespread use of gold receipts as money.

• Suppose that one sunny Tuesday, Elizabeth the Innkeeper enters Fred's shop in search of a loan.


• The Innkeeping business is good. Liz wants to expand. She needs a loan. In particular, Liz is seeking a 10-pound loan.


• Fred is happy to help. In fact, Fred has oodles of gold stashed in his safe--100 pounds. He is eager to loan Liz the desired 10 pounds.


• Fred has oodles of gold because the townfolk use Fred's gold receipts as money rather than the gold itself. Almost no one withdraws their gold from Fred's safe.


• Elizabeth, however, does not want 10 pounds of GOLD, she wants MONEY, she wants 10 pounds of gold RECEIPTS. Liz needs gold receipts to pay the carpenters, and plumbers, and bricklayers. Gold receipts are the money used by these workers and everyone else in town.

Fred faces two options:

• One, Fred can loan Elizabeth 10 pounds of gold from his safe. Elizabeth can then deposit this 10 pounds of gold in Fred's safe in return for spendable gold receipts.


• Two, Fred can simply issue 10 pounds worth of gold receipts directly to Elizabeth.

Both options have another important result.

• Fred starts with 100 pounds of gold matched by a like 100 pounds of receipts. Elizabeth's 10-pound loan increases the amount of gold receipts in circulation to 110 pounds. The total number of gold receipts in circulation is not matched pound-for-pound by an equal amount of gold in Fred's safe.


• Is this a problem? Probably not. The reason is that very few customers actually seek to retrieve their gold deposits. Most are happy to use the paper receipts as money. In fact, Fred has determined that only 10 percent of the outstanding gold receipts in circulation are ever redeemed at any given time. Fred is practicing fractional-reserve banking. With 100 pounds of gold receipts in circulation, no more than 10 pounds of gold is withdrawn. Fred ALWAYS has AT LEAST 90 pounds of gold in his safe. With 110 pounds of gold receipts in circulation, no more than 11 pounds of gold will be withdrawn. Fred will ALWAYS have AT LEAST 89 pounds of gold in his safe.


• Of course, if everyone holding receipts seeks to withdraw gold all at once, then Fred is in BIG trouble. But this probably never happens.

Money Creation

The key question is how many loans can Fred make? How many receipts can Fred lend?

• Fred has 100 pounds of gold safely tucked away in his safe.


• Fred knows that 10 percent of his outstanding receipts are redeemed for gold at any given time.


• Fred can use his 100 pounds of gold to "back" as much as 1,000 pounds of gold receipts.


• With 1,000 pounds of gold receipts in circulation, 100 pounds, or 10 percent, will be redeemed at any given time.


• Fred already issued 100 pounds of gold receipts to the original depositors of the 100 pounds of gold.


• Therefore, Fred can issue an additional 900 pounds of gold receipts.


• This brings the total number of gold receipts in circulation up to 1,000 pounds--the original 100 pounds, plus 900 pounds of loans.

What are the implications of this newly recognized function:

• First, Fred can collect interest payments on 900 pounds of gold-receipt loans. Prior to this discovery, Fred was forced to lend actual gold. With 10 percent of the 100 pounds of gold kept in reserve, Fred's lending was limited to 90 pounds of gold. His interest-generating ability is now 10 times greater.


• Second, Fred has unwittingly discovered the modern banking function of money creation. Each time Fred makes a loan by issuing gold receipts, he creates money--valuable money that did NOT exist prior to his action. This money is being used by the local merchants for capital investment that promotes economic growth. Moreover, anyone (that is, government) interested in maintaining control over the total amount of money in circulation, must control Fred's money lending and money creation activities.


• Third, Fred's gold receipt lending activities creates the precarious balancing act that is the heart of fractional-reserve banking. Should depositors seek to redeem MORE than 10 percent of the gold receipts in circulation, then Fred is in BIG trouble. Fred might end up on the short end of rope tied to a tall tree. But should this happen, the local economy also suffers. If Fred exits the goldsmith banking business, then the 1,000 pounds of gold receipts used by the local economy as money, becomes worthless. The money supply shrinks from 1,000 pounds of gold receipts to the original 100 pounds of gold. As the money supply shrinks, so too does the economy, in all likelihood falling into a recession.