Ahmed Daniyal Arif, UK – Editor, Economics Section
In the Beginning was the Goldsmith
The origin of banks dates back to antiquity. We find traces of it in Greece from the 4th century A.D. Disappearing with the end of the Roman Empire, banks reappeared in the 12th century in the north of the Italian peninsula and extended into northern Europe. The function of banker is especially devolved to money changers who are accustomed to handling hard cash, as well as to traders who are masters in the art of discounting bills of exchange. But no system was as successful as that of the London goldsmiths in the mid-17th century.
At a time when coins were struck in precious metals (gold and silver), money had intrinsic value of its own. However, gold quickly showed its limitations because of its heaviness and the fact that it was risky and impractical to walk around with. The goldsmiths therefore offered to keep the gold safe in their well-guarded vaults. The depositors received in exchange a bill of exchange, a receipt bearing the calligraphic signature of the goldsmith who promised to return the amount inscribed in gold upon request.
Everyone realized that these pieces of paper were handy, and they ended up being used instead of gold for everyday purchases. At the same time, goldsmiths noted that only a small proportion of deposits were withdrawn. As a consequence, they began to produce more bills of exchange than there was gold in their coffers. Lending sums in excess of their reserves while also charging interest on the bills, goldsmiths’ de facto turned into bankers in the modern sense of the term: they created money with the stroke of their pen.
Money Creation Today
As the years have passed, the banking industry has become more and more technologically sophisticated and trust in bankers has become absolute. Yet, technological progress is just another face of the original money creation process which, in essence, remains the same today.
Indeed, the system of central banks and fractional reserve has become the dominant one worldwide: the gold which was backing for money supply diminished until 1971, when gold was no longer the real basis for money (gold standard). The esoteric expression of fractional reserve refers to the way the modern banking system works. It is a system in which gold has been replaced by what is called ‘base money’. This money is created only by central banks and laymen do not have access to it. Bills of exchange have been replaced by ‘virtual money’. This is created only by commercial banks (Barclays, Santander, etc.).
In modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. It is said that lending creates deposits. Regulation limits how much money commercial banks can create. For example, they have to hold a certain amount of financial resources, called capital, in case people default on their loans. However, the money lent to customers is created out of thin air and it is just a question of a few taps on a computer keyboard.
That means that almost all money, in and out of circulation, came into existence as an interest-bearing loan in favour of the banking system of the world. The vast majority of the money is circulation is attached to a debt. Subsequently, as one pays off one’s debt, that money disappears and it is withdrawn from the economic circuit. The banking system is not a simple process in which only the savings of depositors are loaned and not a penny more. It is in fact the creation ex nihiloof a money supply which is destroyed as it is repaid except interest because that is precisely the raison d’être of banks.
After considering the elements mentioned above, can we say that the remuneration of the bankers and interest is justified? Certainly not. The process of money creation through commercial banks remains highly controversial, and it is evident that bankers are not taking the slightest risk. The primary rule of a fair economic and financial system should be to foreclose the door of accumulating wealth without work or assuming a risk; that is, whoever wants to earn a profit must assume risk as well.
Furthermore, we know that, within a history of longue durée, the logic of banking and finance was born out of a betrayal of the trust of depositors by goldsmiths. Are economic issues not, in the end, a question of morals? It’s solely down to us to create a new economic model where trust and commitment are at its heart.
About the Author: Ahmed Danyal Arif is a French economist by education and currently working in London. He has a Masters degree in Economics and Politics. After working for the French tax administration system, he published two books in French: Islam & Capitalism: For an Economic Justice (2016), and Economic History of the Islamic World: From Pre-Islamic Arabia to the Umayyad Dynasty (2019). He currently serves as the Editor for the Economics Section in The Review of Religions.