Banking, a One-Trick Pony, but What a Trick

Banking started with gold. Almost by accident, the merchants who dealt and fashioned goods out of gold became the first bankers. Goldsmiths would rent out space in their vaults to folks who wanted a safe place to store their own gold. Each time someone deposited a few ducats with the smithy, he would issue a receipt for it. Before long, people found they could spend the receipts just as if they were the gold. Easier to carry. Handier in many ways.

Goldsmiths would also occasionally lend gold to trustworthy citizens at interest. After a while they found they didn’t always have to lend the gold. The receipts would serve the purpose. You could, after all, swap the receipt, the bill, for payment in gold whenever you wanted.

By and by the goldsmiths noticed it was rare for very many people to show up all at once for their gold. As long as the banker wasn’t living too large or giving people some reason to think the gold wasn’t there, it was damn rare.

Despite good intentions, most men are powerless to resist the brazen advances of Easy Money. She’s cheerful, fetching, and always has a prurient twinkle in her eye. Her hot breath thrills us as she whispers close to our ear, “Nobody will ever know.” 

Goldsmiths, mere mortals like the rest of us, eventually found they could lend receipts for gold that wasn’t theirs. And finally, gold that didn’t exist. Easy Money was no longer whispering, she was hollering like a fishmonger.

It was easy to believe that “Nobody would ever know.” It was impossible to resist picking the pockets of victims who begged you to start picking. Modern banking was born.

The sweet, larcenous promises of Easy Money and the wonderfully profitable practice of lending money that doesn’t exist supports the colossal paper edifice of modern finance. 

Gold backed systems were self-regulating because people understood that banknotes were simply receipts for the money. Gold was the money.

When the public judged the bankers were getting a little too greedy, they would demand their gold in dreaded “bank runs.” Bank runs either shut down the offending bank or put depositor’s minds at ease again. In either case, the problem was fixed.

Never the less, because Easy Money is just as fetching to customers as to bankers, there were many credit and banknote driven speculations in which the victims willingly participated.

Creating money out of thin air is the trick that makes banking so wonderfully profitable. It’s the magic that allows bankers to partner with politicians for a special exception to the laws against fraud and theft.

The bank run, or bursting bubble is nature’s way of reminding everyone the paper isn’t the money, and that you can only pile it so high before the paper mountain collapses. Today we are reminded ever more often of the limits of paper finance. Bear Stearns, the housing bubble, the dot com bubble and others we don’t know about yet are sending messages about paper money that are still being largely ignored.  But history has many examples for us to learn from.

One of the earliest paper money bubbles occurred in England in 1721/22. It began with a loan to the British government at interest in exchange for a trade monopoly granted to the South Seas Company. A blizzard of paper drove a speculation in South Seas Company stock to nosebleed heights. Fortunes were made. Copycat companies sprung up and their stock soared as well. At the top one ludicrous company attracted over £2000 in investment capital for "For carrying-on an undertaking of great advantage but no one to know what it is." It brings to mind such inspired enterprises as Koop.com.

The South Seas bubble burst and deflated as fast as it had appeared. There was widespread financial ruin. The mob who had so willingly jumped into the game on the way up, howled for blood in the aftermath.

The bankers’ trick of creating money out of thin air is at the heart of all financial bubbles. The difference between those of the past and what we face today are simply matters of scale.

For the first time in history there is a global paper money scheme. IMF rules forbid the G-7 countries from having anything but purely paper currencies.

Forbidding a gold standard is an effort to keep the game going for as long as possible. It is the banker’s trick written on a global scale. Although wrapped in the complexity of derivatives, swaps, options, futures and every imaginable flavor of paper asset, it’s the same trick banks have always pulled.

It results in the transfer of wealth from those who produce it to those who control the money supply. It is extremely successful at effecting that transfer.

The South Seas Company schemers were roundly punished in the aftermath of the bubble. It is unlikely we will enjoy such satisfactions today. Alan Greenspan, Ben Bernanke, and the other architects of our modern global bubble are unlikely to suffer for their sins. However, even without the satisfaction of public floggings, there’s still time to lay aside a little insurance against the inevitable.

Gold, which knows no tricks and speaks the truth, is trading around a thousand federal reserve chits per ounce. If we simply divided the number of dollars in the world by the number of ounces of gold in the U.S. we find there are more than $30,000 notes for each ounce.  Thousand dollar gold is still cheap insurance against continuing banker’s tricks.