The History of Paper Money – Part 5: Working Out the Kinks

Over the last few episodes, we’ve seen the intellectual underpinnings of paper money slowly come into place. But having nebulous ideas about why paper money might be good is one thing, getting people to really believe and to trust in it is another matter entirely. And so today we’re going to tackle the development of the one thing that brought the whole system together; the thing we now used to prevent the very problem John Law ran himself into.

Very rarely does humanity find ideas that are simply ‘good’. Most of the time when a revolutionary new idea is introduced, we’ve got a stumble around in the dark for a bit; figuring out all the terrible ramifications and pitfalls that come with it before we can use it well. Paper money was no different; because when you start printing money, it comes with a lot of questions. Now you might think that the first question would be – how much money should we print? But actually before you can even figure out things like how to regulate how much money is being printed, you first have to ask – who’s going to print the money?

Now today this might seem like a bizarre question as we’re all used to there being some central authority in each country or currency bloc issuing one currency that everybody accept at face value. But you have to remember that paper money didn’t enter the world as part of some top-down system, instead it basically started with a bunch of bankers realizing that they could give people receipts for gold and silver instead of actually giving customers their gold and silver back; which means that one by one, every bank basically started printing their own banknotes and that is a mess to deal with. If you’ve ever had to go overseas and deal with exchanging money, you’ve gotten just a tiny fraction of an idea of what a hassle this would’ve been, but it gets worse. Imagine having a few hundred different banks issuing notes in your own country. Now imagine a world where our modern international currency exchange that makes it easy for banks to trade money, doesn’t exist. And then imagine having to deal with all of this just a shop in the next town over.

This is basically the scenario you end up with; you deposit $10 worth of gold in your local village bank, they hand you back $10 worth of their shiny bank specific banknotes. Now you go off to the big city to spend your money, but when you bring out your money to spend it on something there, the big city merchants might simply not take it or more likely they’ll pull out some big chart and say to you – let’s see, your bank is pretty far away, so if we or more likely our bank ever wanted to redeem these banknotes of yours, we’d have to travel all the way to your tiny podunk village. So since that’s going to be such an expensive hassle for us to do, we’re only going to take your banknotes at 75% value.

Now of course you would probably grumble a bit over this, but then the merchant would say; wait hang on I’m not done. It says here that your bank only has one branch, that’s an issue. It means we’re going to have to redeem these notes as soon as possible because your tiny bank might go belly-up at any time, which would render these banknotes you just gave me worthless. That additional risk and the inconvenience forces me to accept these bills at another 25% off face value. And so your $10 that you deposited in your bank would only have $5 worth of purchasing power in a neighboring city, leaving you probably a bit less than jazzed about this whole paper money thing. Clearly every country needed a unified currency that everyone could believe in. But this also had to evolve sort of organically and it ended up happening in a similar way in most countries, because almost all of the problems we’re going to see with the move to paper money are solved in nearly every country with one great innovation; ”the central bank”.

Central banks didn’t always solve all of the functions they do today, and in fact most weren’t established to solve any of them at all. The truth is, calling a central bank a singular big innovation would be a lie, they were really more like a patch server and a hot fix machine for paper money. So let’s talk about the story of the Bank of England, because it was really the first institution that we would call a central bank and many early central banks share a similar tale. The year is 1694; the government desperately needs a way to service its debts. The 17th and the 18th centuries would be times of unbelievably costly wars. For the first time, troops had to be deployed and supplied across the globe. Navy’s had to be maintained in every ocean. Powder and shells were expended on an unprecedented scale, this drove most major nations of Europe to the brink of financial collapse. To some the answer was clear; establish a bank to service the national debt. So after much debate, the Bank of England came to be.

This is a powerful thing, because having the government do all of its banking with your bank makes your bank pretty secure and the means that that bank is going to need to have branches or at least banks that they work closely with all over the place. And because of the security, people started to value Bank of England banknotes over most of the other ones out there. At times, people would even pay a premium for them offering 1.1 or 1.2 pounds per 1 pound note simply because they were reliable and universally accepted. But the Bank of England note really wouldn’t become the official bank note of the country until 1844 – the middle of the 19th century.

With the bank charter act of 1844; no new bank would be granted the right to print banknotes and every time a bank was bought, it would have to remove its notes from circulation – meaning that eventually the Bank of England banknotes would be the only paper money in the land. But even with this system, it wasn’t until 1921, less than 100 years ago that the last non-Bank of England bank in the country stopped printing their own banknotes. And in Scotland and Ireland, there are still to this day a few banks that retain their ancient right to print pound sterling notes. So this system of having one unified currency that we think of as being money, we take it for granted now, but it really isn’t that old. In fact in the United States, non-Federal Reserve banknotes were being issued as late as 1935. But even with this issue resolved, the lack of a centralized currency wasn’t the only problem we were going to have to figure out with these new banknotes, there was also the problem of bank runs.

With the invention of the banknote, modern fractional reserve banking really came into its own. Fractional reserve banking is where the bank lends out more than it can actually pay for with the money it has on hand based on the idea that not everybody is going to try to collect at once. So for example; let’s say that you deposit $100 in gold at your bank and the bank is required to keep a 10% fractional reserve, that when you deposited that $100 in gold, you enabled your bank to lend out an additional $1,000 in banknotes. This system is a great thing because it means that the money supply can expand far past the amount of gold or silver in an economy and can meet the needs of a growing economic base, which is the very problem we were trying to solve with this whole paper money thing in the first place. But it does have one problem; what happens if everybody does try to get their money out of the bank at the same time? Well, if people believe that a bank won’t be able to repay them, whether it’s because they’ve issued too many banknotes or simply because they’ve made too many bad loans, those people start flocking to the bank to get their money out of there. This of course leaves the bank unable to pay anybody because they only give a fraction of what they need to pay everyone on hand at any given time, so the bank collapses and everybody loses. Anyone with money left in the bank is simply wiped out, and if this starts happening on a broad scale it creates another problem. People stopped depositing money in banks at all and instead start hoarding it because they’re afraid that the banks are going to go bust. Meanwhile the banks are trying to hold up as much real money with gold, silver and central banknotes as they can, so that they can somehow pay all of the people rushing the bank to withdraw their accounts without going bust.

This ultimately means that a lot of money is just sucked out of the economy. It just stops circulating and we’re back to our original problem of literally having too little money to make the economy run. This happened in England throughout the 19th century, but here again the central bank patch was applied. By having a central bank serve as a lender of last resort, meaning a bank that could lend real capital to other banks (banks that were in good shape, but didn’t have the funds on hands to withstand a panic where everybody tried to withdraw their money at once could survive) and the money supply for the nation wouldn’t dry up.

Over the last hundred years, we have found dozens of other little ways that the central bank can be used to hot fix problems resulting from our ability to print money and we’re certainly not done yet. There is incredible power in having one bank that basically can’t fail unless the government does, whose function is much more about keeping an economy strong and stable than about making a profit. Because so long as the government is doing well, so is that central bank and this has helped fuel the growth of a world no longer bound by the amount of gold and silver that’s being passed around. But there’s one more step to go before we get to the world we live in today where currency is divorced from any real value except the value we give it, where money works because we believe it works and that step is ‘abandoning the gold standard’. So join us next time as we wrap up the history of paper money.

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