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5 The value of money

A brief history of money and debt

It might seem as if money is just printed by the government and circulates around the economy indefinitely, via the banks, but for several reasons this is not the case. A balance must be maintained, because the quantity of money in circulation affects its value. As the economy expands, more money will be required to keep up with demand. A shortage of money will constrain overall economic activity relative to primary output, subduing demand and forcing down the price of goods; this is what we call deflation. On the other hand, if the government, or indeed the banking system, creates more money than the real wealth of the economy merits, the lower its value must become, as I explained in the previous chapter. So the value of money can vary almost day to day.

In fact money itself, being just an IOU from the government – a promise written on a piece of paper – has no intrinsic value at all these days. Its value is related to its usefulness as a medium of exchange, and therefore depends on how much of something else it will buy, and this in turn depends on a complicated series of relationships between commodities and currencies, which in turn depends on the relative strengths of national economies, which in turn depend on commodity prices, which in turn…

Perhaps we should look at it another way. A dollar is worth a dollar because the US government says it is. Okay?

Better still, let’s go back to the beginning.

A goat and two shekels

The first forms of money were commodities that were in common use and had a generally agreed value relative to other goods, and which therefore became accepted as payment. The most obvious examples are coins made of gold, silver or copper, but before coins came into general use people used all kinds of things: seeds, tobacco, rice, salt, tea, grain, linen, even goats.

The value usually depended on the weight, which is why so many currency units are still called lira (from the Latin libra) or pound. The original pound sterling, introduced to Britain in the 12th century, was equal to one troy pound of sterling silver. (Silver currently costs around £200 per pound, by the way). The troy weight system is still used for precious metals, as in the troy ounce of gold. The name comes from the French town of Troyes, an important trading center since early Roman times.

Historical evidence suggests that the first unit of currency was the shekel of Mesopotamia, which came into use around 3000 BCE. Shekel probably referred to a weight of barley initially, but by 550 BCE a coin had been introduced by the king of Lydia (in what is now Turkey) to make life easier for traders. These gold discs were stamped with an official seal to certify their purity and weight, giving them a readily accepted value. They also had the advantage of being easy to carry around, and they didn’t rot away, unlike most commodities. The use of coins quickly spread throughout ancient Greece. By around 350 BCE, Aristotle was writing about the concept of non-commodity money, such as we use today: ‘Money exists not by nature, but by law,’ he explained.

Aristotle was one of the first philosophers to write about economics, and in particular the value of money. In trying to explain how we arrive at an agreed value when exchanging goods, and how money makes this process easier, he concluded that money provided a measure of value determined by need, or demand, rather than the value being intrinsic to the goods themselves. Value is subjective – we each put different values on goods because our perception of a thing’s usefulness or desirability varies – but demand, for the purposes of trade through the market, requires a standard unit of measure, and money provides this. The price represents a threshold determined by wants; if you want something enough, you’ll pay the price.

Coins were also used in China and India by Aristotle’s time, possibly earlier, but these were more like bronze tokens than true coins, as they weren’t marked by an official stamp. By 280 BCE, the Roman Republic had begun minting coins in gold, silver, brass and copper. Initially these coins were stamped with the image of the goddess Roma, but by Julius Caesar’s time they featured the emperor himself. These early Roman coins had an intrinsic value in their content of precious metal, though as coins they tended to be worth around twice that value.

Later coinage issued in Europe and elsewhere had a lower content of precious metal relative to its face value, allowing the issuing government to mint more coins from its limited supply of gold, silver or copper. This process of ‘debasement’ of coins reduces the value of the coinage. This in turn causes inflation, which is bad for the citizens, because their money will buy less, but can be good for the government because its debts will be devalued along with the currency.

The first banknotes

Around 2500 BCE, when the shekel was being used as currency in Mesopotamia, there was also a form of credit money authorized by the Babylonian kings, who used clay tablets to record transactions of some kind. It is thought that these clay tablets, hundreds of which have been found in temple ruins, were receipts for barley paid to the temple as a tax, and there is evidence to suggest that they were also traded as a form of ‘IOU’, in which case they would have been the first form of banknote, and as such the first form of actual money, predating coins by two millennia or more. This would mean that the first forms of money were also the first forms of recorded debt; so the link between money creation and debt creation might be as old as money itself.

Paper money was first introduced in China around the eighth century, as a form of receipt used by merchants who didn’t want to carry large quantities of coins around. The merchant would deposit coins with a trusted person – the banker – who would write a note confirming that a certain number of coins had been deposited, or a certain weight of gold. This note could then be exchanged for goods. The person who sold those goods, on presentation of the note to the banker, or any other banker in the region, could then redeem the coins.

In the case of clay tablets, paper currency and coins that lacked intrinsic value (in other words, were not worth their weight in gold), money was representative of a value rather than actually holding that value itself. This ‘representative money’ acted like a certificate to show that a certain amount of gold or silver (or grain in the earliest cases) was stored at the central bank, or treasury, in the way that a note for one pound sterling could be exchanged for one troy pound of sterling silver. In effect, it was a promise by the government, or the bank on the government’s behalf, to hand over that amount of bullion.

By the 19th century, most of the world’s currencies had become ‘representative’ by being linked to the gold standard, and remained so until the 1970s, after which time money became nothing more than a government promise, known as ‘fiat’ money, from the Latin for ‘it shall be’.

The gold standard

Gold has been valued as a commodity, both for jewelry and as coinage, for thousands of years, and has for a long time been accepted everywhere as a trusted currency, thanks to a proven record of holding its value. Along with silver, gold was the standard medium of payment for international trade well into the 20th century. Its value is guaranteed by its rarity.

Like all elemental metals, gold was formed in space by nucleosynthesis, the process by which a nuclear explosion, a collapsing star for example, creates new atomic nuclei.

Relatively small quantities of these metals combined with more abundant elements in the formation of planets, as happened with Earth. Because of its weight, gold sank deep within the molten mantel of the newly formed planet. The traces we find today have mostly been thrown up from the mantel by deep volcanic activity. It is also likely that some of the heavy metals found near the surface of the earth, including gold, come from asteroid impacts, most of which occurred around four billion years ago.

Figure 23

Unlike the mineral wealth that we use as fuel, or metals lost through industrial process or corrosion, nearly all the gold that has ever been mined, around 175,000 tonnes by 2014, is still around today, mostly in the form of bullion or jewelry. Around 2,500 tonnes are mined every year, and this quantity is limited by the physical constraints of the mining process, so although it has generally risen with economic growth, the rate of gold production doesn’t greatly change.

At one time silver was more popular for coinage in Europe, being more available than gold but still scarce enough to hold its value. Silver ingots had been used as a medium of exchange in China since around 200 CE. As world trade began to increase in the 16th century, in particular between China and the Spanish and Portuguese, silver became the standard method of payment.

Silver dollar coins became popular. The term ‘dollar’ was originally the English term for the German ‘thaler’ – an abbreviation of the name of a place where silver was mined in what is now the Czech Republic. This region of Bohemia was part of the Holy Roman Empire in the 16th century, a time when most European currencies had become debased and were therefore unpopular with traders. The thaler was recognized as one of the few reliable silver coins and became a trade standard, remaining so until the end of the 19th century, when Germany replaced it with the gold mark.

It was during the 19th century that the silver standard was gradually replaced by the gold standard, after silver had begun to lose its value relative to gold. Britain had used silver coins exclusively from around 770 until the 14th century, when a gold coin was introduced in addition to the silver coins. Silver remained the standard until 1816, when the gold standard was adopted. This change occurred because although Britain paid for imports in silver, income from exports was mostly in gold, and consequently Britain’s reserves became predominantly gold.

The US used both gold and silver until 1873, when it adopted the gold standard. Germany switched to gold around the same time, and as gold became the dominant currency for world trade other countries followed suit.

Under a gold standard, all money has a value linked to gold, whether it be paper money or coins made of silver or any other metal. This effectively creates a fixed exchange rate between different currencies using the gold standard.

It also means that a country must retain a substantial amount of gold to back up its currency. The US Federal Reserve, for example, before the US abandoned the gold standard in 1971, was required by law to hold enough gold to back at least 40% of the total value of notes in circulation. This limited the ability of the government to manipulate the money supply, which can be seen as both good and bad; it keeps inflation down, but also constrains a government’s options when using monetary policy to boost the economy, by lowering interest rates, for example (because interest rates affect the value of the currency).

Since gold stopped being the de facto global currency, exchange rates between national currencies have varied according to the relative strengths and weaknesses of different economies, encouraging currency speculation and causing uncertainties in the pricing of goods, making international trade more complicated.

It was to eliminate such complications that the European Union introduced a single currency. Unfortunately this only succeeded in causing other complications, because it doesn’t really work to have a single currency while at the same time having lots of different governments. I will return to this theme later, but first we must take a quick walk through the woods.

The last link is broken

It was because of this unpredictable volatility between the currencies of different nations that the Bretton Woods system of monetary control was set up in the summer of 1944. Just three weeks after the D-Day landings, delegates from the 44 allied nations took a break from the horrors of the Second World War and met in a grand hotel in the peaceful mountains of Bretton Woods, New Hampshire. With the end of the war finally in sight, US President Franklin D Roosevelt and British prime minister Winston Churchill were determined to avoid the economic problems that followed the First World War, and which to some extent had caused the war still raging in Europe and the Pacific as they gathered.

Their goal was to create a new world order that would speed up post-War reconstruction and ensure lasting peace, and ultimately prosperity. John Maynard Keynes, the British economist, was one of the principal negotiators, along with senior officials from the US Treasury. They focused on two key issues: how to pay for the rebuilding of Europe, and how to form a stable exchange-rate system. For these purposes they set up the International Bank for Reconstruction and Development (later renamed the World Bank) and the International Monetary Fund.

Keynes was in favor of a single world currency, but the US insisted that fixed exchange rates should be linked to the dollar, which was itself linked to the price of gold. The US was by this time the only strong economy remaining in the world and, as most of the money that went into the new bank would come from the US, it became by far the most dominant player in this new world order.

The Bretton Woods agreement established a rules-based system of international finance that helped to restore confidence in world trade, resulting in a US-led economic revival and the boom years that endured, on and off, throughout the second half of the 20th century.

It worked initially because dollars flowed to Europe in the form of loans and grants (the Marshall Plan) and, as Europe recovered, it imported goods from the US, thus helping the American economy to keep expanding. As worldwide demand for US goods increased, this in turn led to rising US demand for raw materials, which benefited the economies of some mineral-rich nations.

But the Bretton Woods system had a few drawbacks, the biggest of which, for the US at least, was that gold was tied to the dollar at $35 per ounce, while the free-market price could vary. US policy was to try to keep the gold price close to $35 by maintaining the dollar’s value, but this proved impossible. If the free-market price of gold rose higher than $35, as it did whenever the dollar looked threatened by some event (the Cuban Missile Crisis of 1962, for example, sent gold up to $40 per ounce) there was nothing to stop other nations from converting their dollar holdings into gold at $35, then selling the gold for the higher price, a practice known as arbitrage.

By the mid-1960s, a resurgent Europe was becoming less tolerant of America’s unprecedented power and influence. France, in particular, under President Charles de Gaulle, didn’t trust the US government’s ability to maintain its currency’s value, and used dollars earned from exports to build French gold reserves, further depleting US supplies.

Burdened by the increasing cost of fighting the Vietnam War, the US could no longer guarantee to exchange all dollar holdings for gold. Its reserves had fallen to around 20% of total dollars in circulation, down from 55% in 1946, when the US held $26 billion in gold (over 60% of global reserves).

In May 1971, West Germany, wary of inflation and unwilling to devalue the mark to prop up the dollar, pulled out of the Bretton Woods agreement. Other countries, notably France and Switzerland, exchanged more dollars for gold.

On 15 August 1971, with US gold stocks down to $10 billion or so, President Nixon ended the convertibility of dollars into gold, a move that became known as the ‘Nixon shock’. This brought an end to any semblance of a gold standard and meant the dollar became fiat money, soon to be followed by all the currencies that had been tied to it. From this period onwards, the value of most major currencies would be free to float, dependent only on the fortunes of their parent countries in relation to other nations. The price of gold quickly went up, from $35 an ounce in 1971 to $190 by the end of 1974.

As good as gold

There is no particular reason why the value of money should be linked to gold, but there is a very good reason why the quantity of money in circulation needs to be determined by something real, something related to economic activity by the real wealth of industry. Because of its rarity and long history of desirability, which guaranteed its value, gold provided a useful benchmark from which money could be valued.

Whether or not we should return to some form of gold standard is a subject that provokes even more disagreement amongst economists than most other aspects of the economy, but there’s no doubt that today’s financial problems could not have occurred if the gold standard was still in force, because there’s no way that banks could have created so much credit. The gold standard linked the value of money to genuine wealth creation, because governments had to acquire the gold (either by mining it or exporting goods that could be exchanged for gold) before they could print more of the paper stuff.

Figure 24

There is obviously a need for some form of standard that ties money creation more closely to genuine wealth creation, but it might be the case that gold is just too valuable to be used now, with money being so abundant and gold so rare. Since the end of the gold standard, the price of gold has fluctuated wildly because of speculation, but overall has shot up, as Figure 24 shows.

Gold can be traded in the same way a currency is traded, and is often bought in times of uncertainty, when currencies, especially the dominant US dollar, risk losing value through inflation. But the fact is that the value of everything, including gold, can vary relative to everything else, according to the simple free-market principle of supply and demand. The market does the valuing, which is supposedly a good thing because in theory it is the market, meaning the market traders collectively, that has the most information, and can therefore make the most accurate judgments.

But this fluidity of prices means there is no fixed value to anything, including money. And we know that markets get things wrong sometimes, that they are prone to herd instincts and can be influenced by heavy trading and deliberate attempts at price manipulation. This reliance on the market means that governments are constrained in their actions by concerns that certain economic policies will affect the value of their national currency, which in turn affects the economy.

Out of control?

Again we return to this point: that with no fixed values, the economy is governed by complicated interactions between millions of players in the global marketplace. The whole economic system has grown so large and complex that no single authority has any control or even much influence. None of it is planned; things just happen on the general basis of supply and demand, which in turn is governed by self-interest, getting the best price – by the profit motive.

The free-market system has worked quite well for much of history; better than the ‘planned’ economies of communist nations anyway, for the most part. But something has changed in the last decade or two. The market for goods and money has become truly global in a way that it never was before, and in the process it has become less accountable and less regulated.

As the proportion of accumulated wealth has risen relative to produced wealth, so the ability of governments to influence national economies has declined, because accumulated wealth, when in the form of money or financial investments at least, can be moved around easily. It often ends up in countries, or even small island dependencies such as the Cayman Islands or Channel Islands, that deliberately attract wealth by promising not to tax it, and which encourage transnational corporations to register with them by offering favorable secrecy laws and minimal regulation.

The wealth of industry, on the other hand, has traditionally been more fixed; located in a real place in a real country, where there is still some governmental control over what goes on. Industrial wealth fed into the economy because it created jobs and made the majority a little wealthier, and, until recently, most of the profits of industry were reinvested in the economy, creating more jobs.

Figure 25

This has begun to change however, as large transnational corporations become wealthier and more dominant. Jobs can be created where labor is cheapest, companies registered where taxes are lowest. And rising productivity, as I mentioned earlier, means fewer jobs. More of the profits can be kept by company owners and executives. I examine this trend in more detail later in the book, but with regard to the value of money, the point is that governments have very little control over national currencies in the truly global free-market economy, even though it is governments that supposedly guarantee the value of money. Most monetary policy these days is limited to the setting of interest-rate targets and the issuance of money, and even these critical functions are to some extent beyond government control.

I will return to the matter of accumulated wealth later in the chapter, but first there is another important topic that needs to be addressed, and this is the system of money creation itself.

There has never been a perfect monetary system. Perhaps because of the subjective and relative nature of value, such a thing is impossible. But the system we have now is very far from perfect.

Fractional-reserve banking

It might not be a term that sets the pulse racing, but fractional-reserve banking lies at the heart of the monetary system of most countries these days. It refers to the fact that banks only need to hold cash reserves that represent a fraction of their customer deposits. It works on the basis that not all customers are going to withdraw all their cash at any one time, so there is no need to hold that amount in the bank. Banks can therefore lend out more money than they actually possess, which adds ready cash, or ‘liquidity’, into the economy.

The amount that must be held in the bank, known as the reserve ratio, is set by the central bank and is usually somewhere between 20% and zero. The reason it can be zero, which is theoretically the case in Britain for example, is that the central bank will always provide funds to commercial banks when they are short of cash. In practice, British banks hold around 3% of deposits and the rest is either lent out or invested in other ways. The US has a reserve requirement of 10% on some instant-demand accounts, but none on other longer-term deposits.

With a 10% reserve ratio, for every $100 a bank holds in deposits, it can lend out $90 and keep $10 in reserve. But that $90 loan might be invested somewhere else, enabling another bank to hold $9 and lend out $81. This process can theoretically go on until the initial $100 deposit has resulted in $900 of new money in the form of loans, although this is unlikely to happen to the full extent, as at some point the money will most likely be spent rather than reinvested.

This uncertainty as to how much money will be reinvested and how much kept as cash, or spent, means that when a central bank creates money by crediting (lending to) commercial banks, it has no way of knowing what multiple of that money will eventually find its way into actual circulation. The reserve ratio acts as a limit to money creation, but the complexity of the system makes it a very crude and unreliable tool.

The effect of all this ‘leveraging’ (the process of multiplying money by creating credit out of thin air) is not very different from the ancient practice of debasing gold coins with copper to make the sovereign’s gold supplies last longer. Both processes, unless backed up by a corresponding increase in real economic output, have the effect of devaluing the currency.

Not so efficient

I made the point earlier that the gold standard provided a fixed link between money and real economic wealth, and that such a link would have prevented the formation of the credit bubble, which in turn would have prevented today’s economic problems from developing. But, even without a gold standard, if the banks had been forced to hold higher reserves it would not have been possible for them to lend so much money, so this also would have reduced the likelihood of such a financial crisis.

This lax regulation has its origins in the City of London in the late 1950s. The foreign-exchange department of the Bank of England, which was self-governing but had to agree to increasing controls on trades in pounds sterling, began trading in dollars internationally, to avoid such regulation. The British government, which had close ties to the City, chose to let the Bank do so, and counted this market for international deposits and loans (which became known as the Eurodollar market) as ‘offshore’.

Thus developed an unregulated but quite legal trade, theoretically based offshore but actually using banks located in the City of London. It wasn’t long before these banks started opening branches in real offshore territories, in particular the Bahamas and the Cayman Islands. In 1963, the US government tried to limit the flow of dollars overseas by introducing a tax on the interest from foreign securities, but the unintended result was to send US banks flocking to London’s offshore accounts, where they could avoid tax altogether. The US asked Britain to tighten regulation on these offshore banks, but the Bank of England resisted such measures and, when US banking interests also exerted influence on politicians, the matter was quietly dropped.

A bigger change came with London’s ‘Big Bang’ of 1986, which wasn’t really deregulation so much as the discarding of a system based on honor and trust (as well as restrictive practices), in which investment bankers were partners who shared the risks as well as the rewards. The new ‘anything-goes’ culture that followed this change was actually more regulated (because the honor-based system didn’t need much regulation) but in such a way as to leave huge loopholes, which were quickly exploited by the new wizards of finance.

The Big Bang was an essential step in Britain’s transformation from fading industrial power to global financial center; from producer of wealth to magnet for wealth produced elsewhere. The City’s square mile, and its outgrowth in Canary Wharf, part of London’s redundant docklands, became the focus of international currency dealing, bond and derivatives trading, insurance and other financial services. Once the busiest port in the world, handling 50,000 ships per year at its 19th-century peak, trade now goes through 500 banks instead. Unfortunately, for the majority at least, this is the wrong kind of trade.

Banking is supposed to be a service to industry, a means of providing funds for investment in the real economy. Real investment involves the expansion and modernization of industry; the construction of new factories, farms, infrastructure, housebuilding: the process of economic development and the creation of jobs. Real investment has nothing to do with speculating on exchange rates or profiting from other people’s wealth to make personal fortunes that don’t contribute to the real economy.

Bankers try to justify these activities by claiming they provide more funds for industry at lower rates, using the ‘efficiency of the markets’ argument, but there hasn’t been a shortage of funds for sound industrial investment for decades, as my next two charts show, and as wealth keeps accumulating faster than the economy can grow (as I explain in Chapter 8), there isn’t likely to be.

Figure 26

The only thing in short supply is real work, yet the financial sector is responsible for killing jobs by encouraging corporations to become more productive and more ‘efficient’, so they can make more profit for the owners and banks at the expense of everyone else (investment banks being major shareholders), and also by ensuring that as little tax as possible is paid on these profits and inflated earnings.

Two types of debt

As I said earlier, money can be lent for productive or non-productive purposes. When a commercial bank lends money for genuine business expansion, the debt is eventually paid off with the resulting boost in real earnings. This is productive debt; it boosts the economy. But lending for purposes other than business expansion results in non-productive debt, and this is predominantly the type of lending undertaken by investment banks and other financial traders and investors. Non-productive debt creation is by definition a zero-sum game; because no wealth is created this way, any gains must involve losses elsewhere. This means that any asset growth boosted purely by unproductive credit is inherently unsustainable, as we have seen with stockmarket and house-price bubbles.

Figure 27

As the ratio of real industrial investment to financial investment declines – as the latter grows much larger in relation to the former, as shown in Figure 26 (for the UK) and Figure 27 (for the US) – then the ability of the economy to service the debts declines with it. This has been happening since the 1980s; the financial sector generally has been attempting to profit from rising asset prices rather than from real investment in industry. But in the long run, this is impossible, because the rising asset prices represent rising debts, which in the end will have to be paid, in the process bringing down the asset prices, as happened in Japan in the 1980s (more of this in Chapter 13).

The profits made from such unproductive investments are ‘unearned’, as was recognized by the economist-philosopher John Stuart Mill in 1848, when he criticized the rentier income of landlords, who ‘grow rich even in their sleep’. There is no real work involved, and consequently there is no value added to the economy; quite the reverse, in fact.

The central-bank obsession with controlling inflation, or indeed deflation, through interest rates, ignores the point that it is this attempt by banks to profit from unproductive lending that causes the growth in unsustainable debt, which in turn threatens to bring about serious inflation. Governments and central banks should have been limiting unproductive lending and debt creation, as they did before bank deregulation, rather than holding down interest rates and encouraging more borrowing, most of which results in the wrong kind of debt. As the two charts show, the growth of unproductive debt is a recent phenomenon.

So how did banks get into this business of wrecking the economy through unsustainable debt creation?

Financial times

With all the negative publicity concerning the financial sector since the crash of 2008 – the infamous bankers’ bonuses, excessive rates of pay generally, the fixing of lending rates and so on (criticism that was entirely justified, to the point that several top bankers have been forced to resign and few have tried to defend their practices) – it would be easy to forget the vital role that banks play in the economy. Businesses need loans to invest in capital – in factories and machinery and anything else that requires large sums of cash – just as people need mortgages to buy houses and loans to buy cars. So banking is an essential business, and also one of the oldest.

As already noted, a form of banking – in which priests or monks lent grain or other commodities to merchants – predated the use of actual money. The earliest evidence of this kind of banking activity dates to Mesopotamia around 2500 BCE. In Sumeria, for example, the state agreed loans in grain, olives or dates, on condition that the loan was repaid within a year, plus a bit extra – at an interest rate of around 20%. This food bank helped people to survive between harvests. And during this period, wealthy individuals sometimes stored their gold in the temple for safe keeping.

The idea of holding other people’s money and lending it out to farmers or traders goes back to around 500 BCE, and occurred in different civilizations as a result of the growth in trade. Records show that some form of banking existed in ancient Greece and also in the Roman Empire, China and India.

Roman emperors recognized the importance of banking as a way of regulating money. Merchants had to change foreign currency into Roman coins. The moneylender set up a stall near the marketplace, on a bench known as a bancu – the origin of the word ‘bank’. The practice of charging interest on loans, and also of paying interest on deposits, developed in a regulated environment, with bankers competing to offer the best rates.

As the Roman Empire declined and Christianity spread, banking became more restricted, because the charging of interest (known as usury) was considered by early Christians to be immoral. The Jewish faith also forbade usury amongst its own people, but permitted Jews to charge interest to non-Jews. This point, combined with the difficulty that Jews often had in finding other work in a non-Jewish society, encouraged them to concentrate on the business of lending money.

By the 14th century, in Renaissance Italy, Jewish traders had moved into the grain-trading business of Lombardy, setting themselves up, in the tradition of the Roman moneylenders, on benches around the trading halls and squares of the main towns, offering loans to farmers while accepting the future grain harvest as collateral.

As this business grew, the Jewish merchants began offering insurance against crop failure, and they also took deposits in the form of bills of settlement. The funds from these deposits, which were held for merchants until they needed them to settle grain trades, could be lent out to other farmers, as long as the bankers kept enough to settle other deals. If they didn’t, they risked a broken bench (Latin bancus ruptus, from which we get the term bankrupt).

When wars disrupted business in Italy, some of these Jewish bankers migrated northwards, taking their merchant-banking practices into Germany and eventually the Netherlands and Britain, often becoming goldsmiths as well as bankers, charging fees for storing other people’s gold in their vaults. The goldsmith would write a deposit receipt, which the owner would then show when wanting to take out some gold. As with those eighth-century Chinese banknotes mentioned earlier, it became the custom to use these deposit receipts as currency in themselves, instead of carrying the actual gold around. A goldsmith would hand over the specified quantity of gold in exchange for the note, whether it was presented by the original depositor or by someone else.

By lending out more money, or bank notes, than they held on deposit, bankers had begun to create money out of nothing. For example, if a merchant deposited a pound of gold with the bank, they received a note for that pound. The note represented the gold, and could itself be used as money. At the same time, the banker could lend out some of the gold to a farmer who needed to buy seed, and who would repay it with interest after the harvest had been sold. If the merchant returned for the gold, or spent the bank note and another trader wanted to redeem that note, the banker would repay the pound of gold from other deposits.

Thus begins a process by which the banker makes money – the interest on loans – from lending out gold that belongs to someone else. The business depends on taking in more gold to cover the repayment of previous deposits. The banker is effectively creating money, but also getting stuck into a cycle of debt creation that is dependent on new gold coming into the bank. The system works as long as new wealth is being created in the economy. If people stop bringing in gold, the banker can no longer repay all the depositors and goes bankrupt.

The banking system today is little changed in principle, apart from the addition of central banks, which supposedly guarantee the deposits of the nation’s citizens. The main difference is one of scale. The financial sector has grown into a dominant force that affects everyone’s lives, and the effects are mostly bad. Figure 28 shows the growth of debt in various countries.

The grand illusion

Wealthy people don’t need to borrow money. When the wealthy borrow, it’s usually because they can use the money to make more money. This is what banks do.

The really poor of the world don’t borrow either, because nobody will lend money to a person who has no assets, and no prospects of earning more than pennies. It is mostly the middle classes that borrow, though one of the features of the credit boom was that banks had started lending to people on the margins of poverty, people who wouldn’t have been granted mortgages in the days before bank deregulation.

Figure 28

But effectively, the financial system represents a massive transfer of wealth from the middle classes to the very rich. In the boom years, the middle classes were happy to accept this, or at least they mostly didn’t question it, because they were buying houses that were going up in value. They were becoming quite wealthy themselves, and even if this wealth was tied up in the value of the houses they lived in, and therefore wasn’t actually available for spending, the banks were happy to offer new loans based on that increasing equity. The good times kept rolling along on this rising tide of debt.

There was only one problem: the whole thing was an illusion and the credit bubble had no basis in reality. As I’ve already pointed out, the real wealth of the economy was growing at a much lower rate than GDP figures implied.

As the banks invented increasingly elaborate ways of profiting from the build-up of wealth, both real and artificial, they lost sight of the true value of the assets they were using as collateral. In particular, they lost sight of the true value of housing, as shown in Figure 29, but to some extent they also became detached from the true value of everything else, including money.

Figure 29

Perhaps the problem goes so deep that it’s impossible to see from a skyscraper window but, whatever the reason, these highflying traders and gamblers appear to have lost sight of a simple truth: there is no real value to be gained from unproductive credit creation and speculation. Such activity is not real work, which perhaps explains why so many traders can’t wait to take their final bonuses and move on to something more genuinely rewarding.