The history of money and banking is vast and complex. Money has evolved over millennia, from credit in 3500 BC in Mesopotamia, through to metal coins issued by the sovereign in ancient Greece and the Roman Empire, to the emergence of note-issuing banks during the middle ages. All of these events are part of the heritage of today’s monetary system, in which almost all money is created by private banks as credit.
According to the anthropologist David Graeber, the history of money is largely a history of credit and debt, originating approximately 5,000 years ago (Graeber, 2011). As long as there has been debt there have been issuers of credit, and the emergence of banking can be thought of as the institutionalisation of credit and money. Throughout history, banks have been both deposit-taking and credit-issuing institutions. On the one hand, banks have received coins, bullion and other valuables in exchange for promissory notes; and on the other, they have issued credit and money in competition with coins minted by sovereigns or notes printed by central banks. As they have grown and gained societal trust, banks have often moved from the first function to focus on to the second.
The earliest forms of banks were associated with the temple and palace complexes of ancient Mesopotamia around 3500 BC, where temple administrators made interest-bearing credit available to merchants and farmers. At this time money evolved solely as a unit of account, in the form of simple records of who owed what to whom. (Hudson, 2004)
As coinage emerged around 600 and 500 BC in northern China, northeast India, and around the Aegean Sea, banking evolved. By the fourth century BC in Greece, money changers developed into deposit-taking banks, processing payments and exchanging money. But after the collapse of the Western Roman Empire in the 5th century AD, the widespread use of coins and banking largely died out in Western Europe as the population reverted to peasant farming and local production.
During the Middle Ages, deposit-taking banks re-emerged in western Europe with a resurgence in international trade and an increase in available coinage, not least due to the founding of the Royal Mint In 886 AD (Spufford, 2002). Up to this point, the money supply had largely been under the control of sovereigns and banking had mainly been limited to deposit-taking.
Emergence of banking in Britain
As minting coins was a privilege of the sovereign, banks evolved as private competitors in the provision of money as a means of payment by issuing promissory notes and other kinds of credit. (Spufford, 2002).
In the 17th century, Britain was a major European and, increasingly, global power. Its dominance in trade had created wealthy merchants that needed a place to keep their coins, bullion and other valuables safe. Earlier they had been using the Royal Mint for safe-keeping, but in 1640 Charles I appropriated gold and silver deposited by the merchants at the Royal Mint. This move was one factor that contributed to a civil war between factions in Parliament, led by Oliver Cromwell, and the King. Cromwell seized the Royal Mint in 1642 (Turner 2017, p. 113). The events of this period destroyed the Mint’s reputation as a safe haven for merchants’ assets (Davies, 2002, p. 241).
Merchants began to deposit their coins and valuables with local jewellers or goldsmiths, who offered safekeeping facilities. Any coins deposited for safekeeping with goldsmiths were acknowledged with a note promising to pay out an equivalent sum. Provided that the goldsmith’s name was trusted in the area where they operated, holding a goldsmith’s promissory note became considered to be as good as having the actual coins in hand, as there was complete confidence that the holder of the note would be able to get the coins from the goldsmith as and when they needed. As a result, people began to accept promissory notes as money, in place of coins, and would rarely come back to the bank to withdraw coins themselves (Joslin, 1954, as quoted in He, Huang, & Wright, 2005)
Having noticed that their notes were now being used to trade in place of coins and that the bulk of the coins deposited in their vaults were never taken out, the goldsmiths saw an opportunity to issue and lend additional promissory notes (which would be seen by the borrower as a loan of money) and charge a rate of interest on the loan (Withers, 1909/2012, s. 24). The goldsmiths had managed to create a substitute for money issued by the state. Modern banks emerged through this process.
Emergence of money and banking in the United States of America
In the US, money and banking evolved much later than in the UK, and the first coins were issued after the War of Independence in 1775–1783. These were coined directly by the Treasury according to the Coinage act of 1792. Before this, individual colonies and states issued their own paper money, with the first notes produced by the Massachusetts Bay Colony in 1690. Thus, from the very beginning money creation in the US – both coins and credit – were controlled by states and government.
During the American Civil War from 1861-1865, the Northern states issued the so-called Greenbacks – the very first pure state-issued paper fiat money, not redeemable in gold or silver coins. Instead, a greenback retained its value from being legal tender, meaning that it could be used to pay taxes to the federal government (Brands, 2011).
Meanwhile, privately-owned banks in each state were allowed to issue their own banknotes under the National Currency Act of 1863. These banknotes were issued by private banks with a federal charter, backed by government bonds deposited at the US Treasury. The banks were allowed to issue banknotes worth up to 90 percent of the value of the bonds. The program was a means of financing federal deficits.
The establishment of central banks
As successive British monarchs fought expansive wars during the 17th century, coinage and taxes became insufficient sources of funding, so the sovereign slowly turned into one of the main borrowers from the goldsmith banks. After the crushing naval defeat for Britain at the Battle of Beachy Head in 1690 the sovereign needed to raise £1.2 million in order to rebuild Britain’s navy. This led to the creation of the Bank of England in 1694.
The Bank of England was founded as a private institution with private shareholders, for the purpose of financing the wars of the sovereign. However, it evolved into a modern central bank fulfilling the role of clearing house and lender of last resort for the banking system.
Banker to the banks
In the period between 1694 and 1770, the liabilities (banknotes) of the Bank of England were increasingly being used by other banks as a means of payment between themselves, and a means of final settlement. (Norman, Shaw, & Speight, 2011). Thus the Bank of England begun to take on the role of banker to the banking system.
Later, following a series of banking crises in 1866, and the failure of the Overend, Gurney & Company Bank, which triggered a financial crisis, the Bank of England took on the responsibility of lender of last resort. A central bank serving as lender of last resort commits to providing liquidity for the banking system at all costs in the event of a crisis. Up until that point the Bank had often refused to intervene and provide emergency loans to struggling banks, with the result that crises were often exacerbated.
By agreeing to be the lender of last resort, the Bank of England provided a further guarantee to banks that funding would be available should they need it. In effect, that guarantee placed a limit on the difficulties banks would encounter if they over-extended themselves.
In the US, the Federal Reserve System was founded as a private institution in 1913, to meet the need for a clearing house for banks and a lender of last resort at a federal level, following the bank panic in 1907.
Central bank monopoly on note issuance
At the transition to the 18th century, many employers outside London found it increasingly difficult to acquire sufficient coins to pay their workers, and resorted to issuing their own tokens or credit notes. This led many into the business of banking and the creation of private paper money.
Eventually, increasing trade following the Napoleonic war and the Industrial Revolution sparked a wave of speculation in company start-ups, which drove many country banks to issue and lend too much paper money. This increased the amount of money in the economy, pushing up prices and de-stabilising financial markets (one crisis was particularly embarrassing for the Bank of England – in 1839 it had to borrow £2 million of gold from France to rescue failing banks).
In 1844, the government of the day, led by Sir Robert Peel, realised that they had allowed the power to create money to slip into the hands of privately owned banks, and therefore passed a law to take over the full control of the creation of bank notes. This law, the Bank Charter Act, prohibited the private sector from (literally) printing money, transferring this power to the Bank of England. The new law was proclaimed as “an Act to regulate the Issue of Bank Notes, and for giving to the Bank of England certain Privileges for a limited Period.”
In the US private bank notes were being issued by National Banks throughout the country in parallel with Treasury notes (and later Federal notes from 1863), until the Banking Act of 1935 gave the Federal Reserve System a monopoly on note issuance. Until then Treasury notes, Federal Notes and National bank notes issued by private banks had circulated simultaneously.
The banking charter acts in the US and UK only stopped the creation of paper bank notes, but didn’t refer to other substitutes for money, such as bank deposits. Central bank monopolies on issuing of paper money limited the banks ability to issue their own credit money. But the law didn’t limit the banks ability to issue credit in the form of accounting deposit entries in their books.
Because of this, banks could still create ‘bank deposits’ by making loans – so they could still create money by opening accounts for people or companies and adding numbers to them, just without creating any physical cash to match. As cheques were used with increasing frequency, bank deposits could be transferred to make payments, thereby serving as money. When a cheque is used to make a payment, no cash is withdrawn from the bank.
The gold standard
Ever since central banks were first founded, the ‘art of central banking’ has been to balance different roles and tasks. Besides being banks for government and private banks, there has always been an expectation for central banks to keep the value of the nation’s currency stable.
In order to ensure stability of the currency it became mainstream thinking that the Bank of England and other central banks should run a gold standard, whereby notes were redeemable in gold on demand from 1717 to 1931. During this period the value of the pound was redefined only once (by the Coinage Act of 1816), at 113 grains of pure gold (about 7.3 grams). However, the gold standard was suspended twice (from 1797-1819 and 1914-1925), in order to conserve gold to help finance the Napoleonic War and the First World War. Central banks continually had to balance their functions of banker for the state and securing a stable value of the currency.
Banking in the modern era
The Great Depression and World War II
World War I was followed by a period of great economic optimism, and an increase in the use of credit issued by private banks. During the 1920’s in the US creation of private credit money went out of control, fuelling a debt financed bubble on the stock market, leading to an unprecedented high level of private debt (Keen, 2017; Eichengreen, B, and Mitchener, K., 2003). In 1929, the US stock market bubble burst and sparked off a debt deflation scenario: a combination of unsustainable high level of debt, with decreasing wages and incomes (Fisher, 1933) eventually leading to what is known today as the Great Depression.
During the depression central banks increasingly came under the influence and management of governments and the gold standard was abandoned in 1931. In Germany this was very explicit, when the Reichsbank started issuing the mortgage-backed Rentenmark (1923-1948) to stop hyperinflation in the Weimar republic and make the transition to the new Reichsmark.
In the US, war financing by the Federal Reserve System was more implicit, and consisted both of the issuance of war bonds as well as direct and indirect monetization of government securities; first during the depression to support Roosevelt’s New Deal, and later to support the war. This was in many ways a monetary policy equivalent to modern time Quantitative Easing with the Fed balance sheet expanding from 5% to 23 % of GDP during the period 1929-1939.
The Bretton Woods monetary regime
By the end of the second World War in 1945, it was clear the United States was the global superpower – both militarily and economically. This became clear during the Bretton Woods Conference held in 1944, where the dollar gained status as the world’s international reserve currency. In order to restore international trade following the war, nations agreed to manage their currencies to maintain a fixed exchange rate against the dollar, and America agreed to fix the value of the dollar against gold. This new arrangement led to national central banks around the world holding accounts at the US Federal Reserve Bank, which would settle payments between accounts that were redeemable, if necessary, in gold.
The maintenance of fixed exchange rates established by the Bretton Woods system placed a lot of focus on the flow of capital in and out of countries. To prevent these flows from interfering with exchange rates, most countries had to use a combination of capital controls (to limit the outflows due to the acquisition of foreign assets), quantitative and qualitative restrictions on bank lending, and control of interest rates (to limit the availability and demand for domestic credit which could fuel imports).
Along with the Marshall Plan, the Bretton Woods regime sparked off a period where American culture and economy dominated globally, but also a period where many Western countries experienced high economic growth and increases in employment, stability, and their standard of living. The period 1945-1971 is commonly referred to as the ‘golden age’ of capitalism, thanks to high growth rates in most of the Western world. At this time, the United States was a creditor country with balance of payments surplus: more goods and services were sold than purchased.
The end of Bretton Woods and the arrival of modern banking
During the 1960’s a new dynamic emerged. Due to the dollar’s status of international reserve currency and unit of account for the global oil trade, the US had a significant increase in average income and standard of living. New norms such as mass car ownership led to an international increase in the demand for oil and petroleum and thereby also an increase in the demand for dollars. This power gave the US an ‘exorbitant privilege’ of being able to create almost endless amounts of money and credit without institutional restrictions.
The privilege of the US made it possible to finance two costly wars in Korea and Vietnam as well as implementing various domestic social programs transforming the country by running a so-called twin deficit, in the form of both a fiscal and current account deficit (Varoufakis, 2015). In 1965, the French President, Charles de Gaulle, decried the world’s dependence on the US dollar and called for a return to a national gold standard, and in 1971 Switzerland and France each demanded redemption in gold of its central bank’s holdings of dollars. This was basically a run on the US gold reserves by the rest of the world.
America declared it would no longer redeem dollar holdings for gold, defaulting on its Bretton Woods obligations and leading to the collapse of the Bretton Woods system. The final link between national currencies and gold was thereby abolished, and from this position a new monetary regime emerged both nationally and internationally.
Internationally, major trading currencies were allowed to float freely against each other, and minor currencies were either fixed informally against one of the majors or abandoned in favour of currency union. The dollar retained its status as reserve currency without a linkage to gold, and the US continued to run a twin deficit, with the expansionary and inflationary effects from the dollar issuing, often in the form of government securities, to a large extent being exported through the purchases of oil and other goods and services. As described by the economist Yanis Varoufakis (2015): ”The twin deficits of the US economy, thus, operated for decades like a giant vacuum cleaner, absorbing other people’s surplus goods and capital. ”
Most national central banks are now independent from government, and monetary policy has switched to targeting price stability (known as ‘inflation targeting’) and acting as lender of last resort in order to ensure the public’s confidence in the banking system. Overall the post-Bretton Woods system has been characterized by a build-up of debt in the private sectors and more frequent banking and financial crises.
In recent decades technological advances, such as the adoption of debit and credit cards and electronic fund transfers, have lessened the public’s reliance on cash as a means of payment, with banks today needing to hold only a tiny amount of cash (around 3%) relative to the total balances of customers’ accounts. In conjunction with deregulation during the 1980’s and 90’s and the inadequacy of the Basel accords, banks face little restriction on their ability to create new money by making loans. Consequently, most of the money in circulation today takes the form of deposits created by private banks in parallel with debt.
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