History of money and banking
Trade is as old as humanity itself. Long-distance commerce is according to some sources at least 150,000 years old. It is ten times older than farming. When human being first began to produce written records of their activities they did so not to write history, poetry or philosophy, but to do business.
Most types of food and perishables could be only traded locally, preferred were durable goods with large value for a small weight. Some of them have begun to be used as money, examples as diverse as cattle, seashells, beads, nails, tobacco, cotton, and so on; but since the 17th century the most common forms have been metal coins, paper notes, and bookkeeping entries. The wide use of cattle as money in primitive times survives in the words like pecuniary (coming from the Latin pecus, meaning cattle) and fee (Old English feoh, âcattle ownedâ, still used as livestock in German Vieh).
Ancient times record the rise of great civilizations, growth of trade and development of new technologies. They also show many experiments with price controls, inflation, and even attempts at total control over the market.
The use of metal for money can be traced back to Babylon more than 2000 years BC, but standardization and certification in the form of coinage did not occur except perhaps in isolated instances until the 7th century BC.
One of the precursors were metal ingots. On Crete were found copper ingots from 17th century BC, in the shape of oxskins, with writings about their purity and full weight.  Historians generally ascribe the first use of coined money to Croesus, king of Lydia, a state in Anatolia. The earliest coins were made of electrum, a natural mixture of gold and silver, and were crude, bean-shaped ingots bearing a primitive punch mark certifying to either weight or fineness or both. Some theorize, that the first stamped coins were issued by priests, and that the first mints were in temples. According to others, they were made for uniform payments of considerable value, for example for the payment of mercenaries. As many kings were overthrown at the time, some even consider them badges of conspiracy, the earliest coins would be used to buy loyalty.
Coins made payment by "tale", or count possible, rather than weight, greatly facilitating commerce. But this in turn encouraged "clipping" (shaving off tiny slivers from the sides or edges of coins) and "sweating" (shaking a bunch of coins together in a leather bag and collecting the dust that was so knocked off). The result is described by Gresham's Law ("bad money drives out good" when there is a fixed rate of exchange between them): good, heavy coins were held for their metallic value, while light coins were passed on to others. In time the coins became lighter and lighter and prices higher and higher. To correct this problem, the coins were weighed for large transactions, and there was pressure for recoinage. The problem was largely ended by the "milling" of coins (serrations around the circumference of a coin), which began in the late 17th century. A more serious problem was, that the sovereigns often attempted to benefit from the monopoly of coinage.
Banking in Ancient Times
The first precursors of banks can be traced as far back as ancient Mesopotamia, where temples, royal palaces, and some private houses served to store valuable commodities like grain, the ownership of which could be transferred via written receipts. There are records of loans by the temples of Babylon as early as 2000 BC; temples were considered safe, because they were sacred places watched over by gods, and should be protected from theft. Companies of traders in ancient times provided banking services connected to the buying and selling of goods. Many of these early "protobanks" dealt primarily in coin and bullion, money changing and supplied foreign and domestic coins of the correct weight and fineness. Around the year 3300 B.C. the temple of Uruk owned the land it exploited, received offerings and deposits and granted loans to farmers and merchants of livestock and grain, probably the first bank in history.
One of the first recorded reforms to remove corruption comes from Sumer. King Urukagina, reigning from about 2350 BC, removed excessive regulations and bureaucracy. What little remains of the records from that time contains possibly the first reference to a word for 'freedom', amargi (some sources interpret it as an exemption of taxes or cancellation of debt).
In Babylon, the Code of Hammurabi, "the protecting king", explicitly quoted many wages and prices. The decline of the number of merchants and an increase in bureaucracy was followed by an overall economical decline. It strictly regulated the rights associated with it, as well as commercial activity, limiting interest rates and even establishing public loans at 12.5 percent. Partnership agreements were also regulated, as was the keeping of accounts of operations.
The rulers of Egypt regulated the grain crops, then directed it, until finally land become the property of the monarch to be rented out. "There was a real omnipresence of the state... all prices were fixed by fiat at all levels. There was a whole army of inspectors. There was nothing but inventories, censuses of men and animals. In villages, where disgusted farmers ran away, those, who remained, were responsible for the absentees' production." Egypt collapsed economically and politically at the end of the third century BC.
Few people were wealthy, but banking was widespread and used by many villagers, farmers, merchants and craftsmen, doing business through banks and making payments out of their deposits and bank accounts. The Ptolemies realized how profitable private banks were, and started the first government-run bank which would conduct business with the "prestige" of the state, hold custody of tax revenues and invest in its benefit. The main innovation of Egyptian banking was centralization: the government bank in Alexandria had branches in the most important towns and cities. It has outlived its founding dynasty and was preserved during Roman rule.
Solon, on taking office in Athens in 594 BC, instituted a partial debasement of the currency (there is some disagreement on this matter). For the next four centuries the drachma had an almost constant silver content (67 grains of fine silver until Alexander, 65 grains after) and became the standard coin of trade in Greece and in much of Asia and Europe. Even after the Roman conquest of Greece in roughly the 2nd century BC, the drachma continued to be minted and widely used. The Greek city-states were largely independent, though there was an awareness of Hellenic identity. Each city-state had its own coinage. There was an active trade in these currencies, and probably few laws limiting citizens of a given city-state to the use of their own money. Debasement of the currency either for state profit or for the accommodation of changes in the ratio was rare in Greek history (with the notable exception of Dionysius of Syracuse). On the contrary, there are cases of actually raising the standard of the coinage for the greater prestige which a coinage of high intrinsic value seemed to offer. In the sixth century B.C., the Euboean unit was increased in a number of cities by about five grains, in emulation of an increase introduced by Pisistratus in Athens.
Banking, bank fraud and even banking crises were very well known. After the revolt against Mithridates, a serious banking crisis in Ephesus followed. The banking industry received here its first express, historically-documented privilege, which established a ten-year deferment on the return of deposits.
From at least the 4th century B.C.. the Roman government bought grain in times of shortage and resold it at a lower price. At 58 B.C. was the law changed: every citizen should become free wheat. To the surprise of the government, most farmers left the country to live in Rome without working. To deal with the increasing economical problems, the emperors gradually began to devalue their currency.
The silver denarius, patterned after the Greek drachma, was introduced about 212 BC. Soon after, the prior copper coin (aes, or libra) began to be debased until, by the onset of the empire, its weight had been reduced from 1 pound (12 Roman ounces) to half an ounce. By contrast the silver denarius and the gold aureus (introduced about 87 BC) suffered only minor debasement until the time of Nero (AD 54), when almost continuous tampering with the coinage began. The metal content of the gold and silver coins was reduced, while the proportion of alloy was increased to three-fourths or more of its weight. 
The prices have risen in response and reached unprecedented heights under Emperor Diocletian. The once silver denarius was by then a tin plated copper coin, silver and gold coins were no longer in circulation. Diocletian issued a new denarius from pure copper and instituted further reforms, to fix still rising prices and the wages of many workers. Death was the punishment for dealing at higher prices or hoarding, and much blood was shed before the law was finally ignored. A tax reform has bound the lower classes to the soil and made them effective serfs.
The silver currency was basically abandoned, so much that the government started to demand payment of taxes in kind and in services instead of coin. Constantine issued the golden solidus in large numbers (but taxes had to be paid in gold bullion, as the government had trouble knowing how debased its coinage was). But the inflation of lesser coins continued, even cities were free to make their own token coins. Most people had to buy gold coins to pay taxes with, those who couldn't afford it lost their lands or became delinquents. So there was a relatively stable 'gold standard' used by the growing number of soldiers and civil servants, and an increasingly worthless currency for the rest of the citizenry. A rapid decline of their fortunes and personal freedoms followed.
And so has debasement contributed to the collapse of the empire.
Banking was highly developed and subject to Roman Law, money deposits were to be safeguarded and not lent out. A specialty were banker associations or societates argentariae, where members supplied capital to form them, but they had unlimited liability to prevent fraud. Most banks failed during the economic crises of the third and fourth centuries A.D.
In China, the economic doctrines of Confucius held that "government interference is necessary for economic life and competition should be reduced to a minimum." A large bureaucracy was formed to regulate in detail commercial life and prices. In natural calamities, like famines, the merchants were not allowed to raise prices. The collection and raising of crops was regulated similarly.
But the results were not very favorable and the officials learned the lesson: "...whenever the government adopted any minute measure, it failed, with few exceptions.... since the Ch'in dynasty (221-206 B.C.), the government of modern China has not controlled the economic life of the people as did the government of ancient China. "
Even in those times, there were economic thinkers pointing out the rising prices were caused by inflation. Yeh Shih (A.D. 1150-1223), for instance, anticipated by several centuries the principle known as Gresham's Law: "The men who do not inquire into the fundamental cause," he wrote, "simply think that paper should be used when money is scarce. But as soon as paper is employed, money becomes still less. Therefore, it is not only that the sufficiency of goods cannot be seen, but also that the sufficiency of money cannot be seen."
The Roman system of coinage outlived the Roman Empire itself. Prices were still being quoted in terms of silver denarii in the time of Charlemagne, king of the Franks from 768 to 814. The difficulty was that by the time he was crowned Imperator Augustus in 800, there was a chronic shortage of silver in Western Europe. Demand for money was greater in the much more developed commercial centers of the Islamic Empire that dominated the southern Mediterranean and the Near East, so that precious metal tended to drain away from backward Europe. So rare was the denarius in Charlemagne's time that twenty-four of them sufficed to buy a Carolingian cow. In some parts of Europe, peppers and squirrel skins served as substitutes for currency.
To overcome the problem, the Europeans could export labor and goods, exchanging slaves and timber for silver in Baghdad or for African gold in Cordoba and Cairo. Or they could plunder precious metal by making war on the Muslim world. The Crusades, like the conquests that followed, were as much about overcoming Europe's monetary shortage as about converting heathens to Christianity.
Coinage and debasement
The Middle Ages saw widespread use and standardization of coins, and their extensive debasement, in almost every country in Europe. But there were also clear ideas about what constitutes good money. Charlemagne made his son Louis swear to never make the coinage worse. Louis the Pious kept his word and the following kings of this line kept the same coin. But the later Frankish emperors began to devalue their coins, and did so frequently. The dean of the church of Prague, Cosmas (~1045-1125), reports of changes in coinage 3 to 4 times a year, their effect worse than pestilence, looting armies and arson. Thomas Aquinas, the great sage of the 13th century. stressed the importance of an unchanging coin and demanded from the rulers to hold to the true inner worth of things. Nicholas Oresme, one of the first economic theoreticians, demonstrated the effects of currency depreciation. And according to the philosopher Gabriel Biel, to withdraw a good coin and issue a less worthy one with the same nominal value is clearly fraud.
The devaluations were certainly not rare. For example, in 1200, the French livre tournois was defined as 98 grams of fine silver; by 1600 it equaled only 11 grams. When the dinar, the coin of the Saracens in Spain was first coined at the end of the seventh century, it consisted of 65 gold grains. The Saracens kept the dinarâs weight relatively constant, and as late as the middle of the twelfth century, it still equaled 60 grains. At that point, the Christian kings conquered Spain, and by the early thirteenth century, the dinar, called maravedi, had been reduced to 14 grains of gold. The gold coin was soon too lightweight to circulate, and was converted into a silver coin weighing 26 grains of silver. But by the mid-fifteenth century, the maravedi consisted of only 1Âœ silver grains, and was again too small to circulate.
The modern banking industry was born and discovered the profits and bankruptcies associated with fractional reserve banking.
Banking in Europe
The fall of the Roman Empire meant the feudalization of economic and social relationships. The reduction in trade and division of labor dealt a heavy blow to financial activities, especially banking, the effects lasting for centuries, the revival started by the end of 11th century and beginning of 12th (from this period stems also the practice of double-entry bookkeeping.) Only monasteries were secure enough to guard economic resources. Particularly important were the Templars, an internationally active military and religious order, they kept deposits in safe custody, transferred funds and made loans of their own resources. Their growing prosperity aroused the fear and envy of many, until Philip the Fair, the King of France, disbanded the order to get their riches.
The bankers preserved their deposits fully at first, but later began to use them for their own purposes, creating deposits and granting credits out of nowhere. Since the canonical law banned the charging of interest on loans, bankers would instead pay "penalties" for "delays" in payment and in effect pay interest on a disguised loan, and justified any misappropriations on this basis. Fractional reserve banking has created periods of growth, followed by an economical crisis and failure of banks.
The authorities failed to enforce sound banking practices, and often granted banks a government license to operate with a fractional reserve, while taking advantage of easy loans to finance governments and public officials. Some rulers created government banks to reap the profits. But banks were still required to guarantee deposits.
In western Europe, the use of private bank notes and deposits, redeemable in specie, had begun in fourteenth century Venice. Firms granting credit to consumers and businesses existed in the ancient world and in medieval Europe, but these were "money lenders" who loaned out their own savings. "Banking" in the sense of lending out the savings of others only began in England with the "scriveners" of the early seventeenth century. (The scriveners were clerks who wrote contracts and bonds and so were in a position to learn of mercantile transactions and engage in money lending and borrowing.) The term banker originated in Florence, where bankers were called either banchieri or tavolieri, because they worked sitting behind a bench (banco) or table (tavola).
And it was in Florence, where the growing banking industry gained great importance by the fourteenth century. From that time have the bankers begun to misuse a portion of their deposits, inevitably causing a boom and a recession. This recession was triggered not only by Neapolitan princesâ massive withdrawal of funds, but also by Englandâs inability to repay its loans and the drastic fall in the price of Florentine government bond. The public debt was financed by these speculative new loans created. A general crisis of confidence occurred, causing the most important banks to fail between 1341 and 1346. The recovery did not come until after the plague.
The powerful Medici bank initially didn't accept demand deposits. Later on, their reserve ratio gradually worsened, and by its end dropped even below 10 percent. The bank was ruined by the end of the 14th century like its competitors, and all of its assets fell into the hands of creditors.
China was a pioneer of banking practices. Deposit banking per se began in the eighth century A.D., when shops would accept valuables, in return for warehouse receipts, and receive a fee for keeping them safe. After a while, the deposit receipts of these shops began to circulate as money. Finally, after two centuries, the shops began to issue and lend out more receipts than they had on deposit; they had caught on to fractional reserve banking.
Printing was first invented in ancient China and paper money began there as well. The government sought a way to avoid physically transporting gold collected in taxes from the provinces to the capital at Peking. In the mid-eighth century, provincial governments began to set up offices in the capital selling paper drafts which could be collected in gold in the provincial capitals. In 811â812, the central government outlawed private firms involved in this business and established its own system of drafts on provincial governments (called "flying money").
The governments have tried to keep their issues constant at first, and to redeem them at predefined times. But they soon turned to solving their fiscal troubles with printing money. In the province of Szechuan, the first 'extra issues' were made in 1072. The expansion continued until around 1200 was the currency started to be abandoned. In Southern Sung, from the beginning of inflation in 1176 it took to the thirteenth century for a serious decline in value. In northern Chin was the amount of paper money held stable from 1153 until 1190. Following various experiments, attempts to pay for military expenditures have completely destroyed its value by the second decade of 13th century.
After the Mongols entered China, in 1260 were the various regional currencies replaced with a national currency fixed to silver. The issues started to multiply and even the growth of the area, where they were legal tender, didn't prevent their fall in value. Several reforms later, by 1356 was the paper money practically worthless and the dynasty ended in 1368. The Ming were similarly reckless in their monetary policy and by 1500 were the notes becoming collector's items. After some 500 years experience, the Chinese abandoned the use of state-sponsored paper money and returned to a combination of hard currency and private bank notes. The government superseded the paper money by a metallic currency, and for ever abolished paper money issued by the State.
The modern times were witness to the rise of central banks. Experiments with using multiple metals for coinage and bimetallism have led to the domination of the Gold Standard. Fractional reserve banknotes have been widespread by the end of 18th century and the trend continued. They have turned into paper money in most countries by the beginning of World War I.
But coins still freely circulated for a long time. For example, the Spanish silver dollar was from the sixteenth to the nineteenth century the relatively most stable and least debased coin in the Western world, and thus the world's outstanding coin. The 'piece of eight' became the world's first truly global currency, financing not only the protracted wars Spain fought in Europe, but also the rapidly expanding trade of Europe with Asia.
Europe was also impacted by the inflow of precious metals from the New World, but it was not a dramatic price revolution. The money stock (gold and silver) increased depending on various estimates by 50 to 500% from the year 1500 over a period of 150 years (an average growth rate of the money supply somewhere between 0.3 and 3.3 percent per annum). Where many complained about rising prices, some have recognized (often ascribed to J. Bodin in 1568, but first recognized by Azpilcueta Navarro from the School of Salamanca in 1556), that the goods have not risen in value, but silver has fallen; from 1500 to 1700 it was estimated to be 1/20 of its former value.
At the beginning of the 16th century, the currency reforms of Charles V proved unpopular, although he was able to suppress any upheaval. Under his son Philip II. and his lack of religious tolerance, the revolution broke out in full. One of the first measures of the revolutionary government was "free" or "individual" coinage, where the state would coin any metal delivered to it at no or very small cost. Free coinage was an immediate success. As the seventeenth century began, the Dutch were the driving force behind European commerce. The coins, that had legal tender status were often worn and damaged, so it was not easy to exchange them. To do so, the Bank of Amsterdam was founded in 1609. Coins were taken in as deposits based not on the face value, but on the real value of their metal weight, with credits, known as bank money, issued against them. And so was created a perfectly uniform currency. This, along with the convenience and security of the new money - and the guarantee of the city of Amsterdam, caused the bank money to trade at an agio, or premium over coins.
The Bank was at first a strictly deposit bank with 100 percent backing, but secretly allowed some depositors to overdraw their accounts as early as 1657 and later provided large loans to the Dutch East India Company and the Municipality of Amsterdam. By 1790 these loans became public and the premium on the bank money disappeared, by the end of that year the Bank virtually admitted insolvency by issuing a notice that silver would be sold to holders of bank money at a 10 percent discount. The City of Amsterdam took the Bank over, and eventually closed it for good in 1819.
But throughout 17th century, precious metals from the New World, Japan and other locales have been channeled into Europe, with corresponding price increases. Thanks to the free coinage, the Bank of Amsterdam, and the heightened trade and commerce, Netherlands attracted even more coin and bullion. One of the results of the boom was the Tulip mania (1634-37). The popular flower became a status symbol, the rare bulbs were hard to reproduce and in great demand. A large futures market formed for the seasonal flower and the speculation escalated. At its peak, the prices rose twenty-six times in January 1637, only to fall to one-twentieth of its peak price a week later. Finally, the Court of Holland judged the tulip sales to be bets under Roman law and basically cancelled all contracts. The growers of the bulbs absorbed the most of the damage and the number of bankruptcies increased.
Ironically, as kings throughout Europe debased their currencies, the Dutch provided a sound money policy with money backed one hundred per cent by specie. Free coinage laws (later limited) created more money from the increased supply of coin and bullion, than what the market demanded. The acute increase in the supply of money fostered an atmosphere, that was ripe for speculation and malinvestment, and led to one of the first recorded panics or speculative bubbles.
In England there were no banks of deposit until the civil war in the mid-seventeenth century. Merchants used to store their surplus gold in the kingâs mint for safekeeping. But when Charles I needed money in 1638, shortly before the outbreak of the civil war, he confiscated a huge sum of ÂŁ200,000 of gold, calling it a "loan" from the owners. Although the merchants later got their gold back, instead of the mint they chose to deposit their gold in the coffers of private goldsmiths. The warehouse receipts of the goldsmiths were soon used as a substitute for the gold itself. By the end of the civil war, in the 1660s, the goldsmiths fell prey to the temptation to print pseudo-warehouse receipts not covered by gold and lend them out; in this way fractional reserve banking came to England. When they refused to grant the king even more loans, he has stopped paying interest, to resume it later at a lowered rate. The new government of William and Mary, ushered in by the "Glorious Revolution" after 1688, has simply refused to pay the debt. Finally, the House of Commons settled the affair in 1701. Half of the capital sum of the debt should be simply wiped out; and the interest on the other half be paid at the remarkable rate of 3 per cent. Even that low rate was later cut to two-and-a-half. Most of the leading goldsmith-creditors went bankrupt by the 1680s, and many ended their lives in debtors' prison.
Paper money, as we know it today, originates from the European fractional reserve banks of the 17th century, while the search for more money by governments was the main driving force.
The drive for more money for the crown led to the creation and special privileges of the Bank of England. It and the English banking system has become a model for many other countries.
In 1720s has the Prime Minister Sir Robert Walpole introduced the sinking fund, a funding system designed to pay down England's public debt. Taxes, which had before been laid on for limited periods, were rendered perpetual, and the fund should not be used for any other purpose. The government obtained a reduction on the interest of the public debt. The savings were added to the fund and it was for some time regularly applied to the discharge of debt. But soon, the principle of an inviolable sinking fund was abandoned. During the wars which were waged while it subsisted, the whole of its produce was applied to the expense of the war; and even in time of peace, large sums were abstracted from it for current services. The sinking fund has greatly increased debt instead of diminishing it.
From then on, government debt never needed be repaid. It was enough to create a regular and dependable source of revenue and use it to pay the annual interest and the principal of maturing bonds. Then for every retired bond would be sold a new one. In this way, a national debt could be made perpetual. Walpole's system proved its worth in financing British overseas expansion and imperial wars in the eighteenth and nineteenth centuries. The government could now maintain a huge peacetime naval and military establishment, readily fund new wars, and need not retrench afterward. The British Empire was built on more than the blood of its soldiers and sailors; it was built on debt. The ever-growing debt had the ancillary benefit of attaching the interests of wealthy creditors to the government. This example was not lost on some leaders of the infant American Republic, Alexander Hamilton for one.
In the first decades of the Industrial Revolution, Great Britain was confronted by a very serious small change shortage. The bimetallic legislation then in effect undervalued silver, so that few if any silver coins were minted, while those already in circulation tended either to be melted into bullion or to be very badly impaired. The Royal Mint suspended copper coinage altogether for a generation beginning in 1775, leaving British factory owners and retailers more desperate than ever for small change.
British businessmen, starting in 1787 with Thomas Williams (who owned what was then the worldâs biggest copper mine, in Wales), took to minting and issuing their own token coins. Between 1787 and 1797, when the government finally attempted to reform its own token coinage, a score of private mints had supplied several hundred private coin issuers with some 600 tons of custom made copper pennies and halfpennies, which was more copper coin than the Royal Mint had issued over the course of the previous half century. By 1811 change was again in very short supply, the governmentâs reform efforts having proven inadequate. Consequently, another round of private coinage took place, this time involving silver as well as copper tokens. That round ended several years later, when the government decided to outlaw private coins.
In the British colonies of North America, the local governments pushed for paper notes with legal tender privileges. The first to do so was the province of Massachusetts in 1690, after a failed raid against French Quebec. It paid off its soldiers with paper notes and pledged to redeem them out of taxes soon and that no more notes would be ever printed. Both promises were quickly broken.
This practice was replicated in five other colonies before 1711, and eventually spread to all British colonies. The merchants forced to accept the rapidly depreciating paper notes complained to the British Parliament, which first limited and in 1764 prohibited the issue of any legal-tender paper in all colonies. To some, this might have been one of the roots of the American revolution.
After winning independence, the opponents of inflation have been for long successful. The "founding fathers" strove to avoid paper money, and using anything but gold and silver as legal tender was even forbidden in the constitution. The power to coin money was given to the federal government, not the states.
The first central bank lasted from 1792 to 1812. To finance the war of 1812â14, the federal government issued legal-tender treasury notes and a second bank was founded. In the 1830s, President Jackson refused to extend the charter of the Second Bank of the United States (1816-1836), withdrew all public funds from private or state (fractional-reserve) banks, and cut down the public debt from some $60 million at the beginning of his administration to a mere $33,733.05 on January 1, 1835. His successors neutralized these reforms to some extent, especially by bringing the public debt back to more than $60 million within fifteen years of the end of the second Jackson administration.
For a long time, foreign coins of gold and silver circulated freely, in general use were Spanish, English, and Austrian gold and silver pieces. Finally, Congress outlawed the use of foreign coins within the U.S. by the Coinage Act of 1857, forcing all foreign coinholders to go to the U.S. Mint and obtain American gold coins.
The breakthrough for the inflation party came with Abraham Lincoln and the War Between the States. To finance it, the federal government issued a legal tender paper money in 1862, the so-called greenbacks. This experiment ended in 1875, when the government turned the greenbacks into credit money, by announcing that as from 1879 they would be redeemed into gold. Meanwhile, in 1863â65, the Lincoln administration had created a new system of privileged "national banks" that were authorized to issue notes backed by federal government debt, while the notes of all other banks were penalized by a 10 percent federal tax. As a consequence was American banking centralized around the privileged national banks.
In the "classical" gold standard was a central bank of each country expected to hold enough gold in its reserves, while the commercial banks would rely mainly on its banknotes. The advantage were greater possibilities of inflation for the banks and more power for the central bank.
Gold was legal tender in Great Britain since 1821 (when the Bank of England resumed redemption of its notes) and the de facto currency in the US since the 1834. Australia and Canada followed 20 years later. The breakthrough for gold and the era of the classic gold standard began after the war between France and Germany (1870-1871). The German government received war damages of 5 billion francs in gold and made it fiat currency instead of silver, that was losing popularity at the time. The Prussian Bank ('Preusische Bank') was turned into a central bank ('Reichsbank'). Its notes became legal tender in 1909, following the example of the British system.
There were several reasons for using gold. Great Britain, with the largest capital market in the world, was using it. Several major lands using silver (Russia, Austria) have suspended payments by the time. Finally, silver has less purchasing power than gold, making its weight for large transfers rather problematic. Practically all western lands and many of their colonies have followed suit.
The gold standard has eliminated the fluctuations between gold and silver (though they were less than between today's paper currencies). It also caused a significant forced deflation. But the gold standard was still coupled with the practice of fractional reserve banking, and hence unstable. The coming of World War I. ended it before it could collapse.
The Gold Exchange Standard enhanced the already existing international cooperation between banks. The American Fed and the Bank of England would be the central banks for the whole world (with a few exceptions, notably France). Inflating slowly, others would rely on the pound and the dollar for backing, and could inflate much more. This unstable system lasted only from 1925 to 1931, the Great Depression of 1929 caused a rise of protectionist policies and foreign exchange controls, that choked the international currency trade. The Bank of England could not renew its gold reserves and suspended its payments, followed by other banks. From then on currencies fluctuated freely, which lasted until the end of World War II. But the actual gold standard was abandoned, instead of coins could be notes converted only to gold bullion, suitable only for large international transactions. The people were de facto prohibited from using gold as their medium of exchange.
The history from the gold standard into the present.
Bretton Woods system
A new system was designed in 1944 in Bretton Woods (New Hampshire US), to make the production of banknotes even more 'flexible'. The gold reserves of the whole world should be concentrated in a single pool, the Fed would redeem its notes while all others would keep the US dollar as reserve. It was a logical choice, as the United States have attracted much gold and after WWII Fort Knox became the largest gold storage in the world. (England, represented by Lord Keynes, tried to push for a pure paper money, but it didn't come to be.)
To reduce the resulting dependency on the Fed, and to make it politically acceptable, two organizations were created: the International Monetary Fund (IMF) and the World Bank, both to influence the distribution of new banknotes. They would supply short-term (IMF) and long-term (WB) credit to member states in trouble, primarily the board members. They survived the collapse of Bretton Woods.
The growth of inflation, the main purpose of the Bretton Woods, was so successful, that the Fed eventually ran out of gold and had to suspend its payments in 1971. That was the end of the so-called gold standard and its variants.
The Paper Standard
After the last link to gold was broken, a large number of paper currencies was created. Every country could set its monetary policies as it desired and their exchange rates fluctuated wildly. But attracting foreign investment is much easier in stable conditions. Many states float bonds in other currencies than their own, like in the Euro or the U.S. dollar. Some give public or implicit guarantees that the exchange rate to important currencies will be maintained. It is claimed, that the Fed gave such guarantees to several countries in the 90s, and after they were ended, financial crises in these countries followed (Mexico 1994, Asia 1997). Some states have created currency boards, issuing notes, that backed by and mere substitutes for foreign paper money. It is used by e.g. Hong Kong, Bulgaria, Estonia, Lithuania, Bosnia and Brunei. Lastly, some abandon their national currency completely and use the currency of their lenders. This is called "dollarization" (the currency does not have to be U.S. dollars). Recent examples include Ecuador, El Salvador, Kosovo and Montenegro.
After the fall of the Bretton Woods system began the governments of Wester Europe to amass public debt to grow their welfare states. But it was soon recognized their wildly fluctuating currencies hindered international trade and could so undermine their income.
The first attempt was the European Monetary System (EMS, founded 1978). It was a cartel of paper money producers, who agreed to stabilize the exchange rates between their currencies at certain levels, or parities. In practice, those inflating the least would determine the inflation rates of all others. If someone were to inflate more, they would have to persuade others to do the same, or risk a change of parity. The German Bundesbank was the most conservative of the central banks. A few years after the rejoining of East and West Germany were the paper money producers united in the European Central Bank (ECB, started operation in 1999 and issued Euro notes and coins by 2002.
The Great Recession
- Matt Ridley. "Matt Ridley: When ideas have sex" (video), 11:00-11:30, filmed in July 2010. Referenced 2010-07-23.
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