Personal Finance & Money Asked by user1301428 on May 13, 2021
Difficult to summarize the question in just a few words, so let me elaborate here. I am currently reading the Financial Times Guide to Banking by Glen Arnold, section Money creation, and there is something I cannot wrap my head around. The section of the book is explaining how goldsmiths were effectively acting as primitive banks in storing gold deposits once upon a time, and giving paper money in return:
The borrowers of the money from goldsmiths were usually content to take a piece of paper – call it a bank note – instead of taking coins out of the bank. They could then use that as currency to buy things. The goldsmiths could just create these pieces of paper off their own bat. Thus, a goldsmith bank might have a total of, say, £1,000 deposited, but hand out £500 of the coin as loans and issue another £5,000 or £6,000 or new paper money to borrowers.
[…]
[…] if you are working off a deposit base of £1,000 and you lend £4,000, and then 30% of your borrowers are unable to pay, you are bankrupt.
Why would you be bankrupt? If you are creating money that does not exist (in this case, money that you don’t physically have since it is not backed up by actual gold), and someone does not pay you back, what would you be losing exactly, since you did not spend anything in the first place?
Assuming that you have £1,000, that you lend out £4,000, and that 30% of this (£1,200) is lost, would you not still get back the other £2,800 from the other loans, thus making you richer anyway?
A bank note given out by a goldsmith in that time was not just fiat money. It was actually a voucher which came with the guarantee that if it was given back to the goldsmith, that goldsmith would be obligated to give that amount of gold to the current owner of the bank note. That's why people considered those bank notes as if they were gold. Because they were assured that as long as they owned the bank note, they could exchange it back for gold at the goldsmith.
However, that would become a problem if a lot of people had that idea at once, went to the goldsmith, and they didn't have that much gold available. Now the goldsmith was indebted to all those people with bank notes.
Now to get back to the example the question is talking about.
In that case the goldsmith did not receive gold in exchange for those bank notes, they merely lent the bank notes in exchange for the debtor being indebted to them. The debtor was now obligated to either pay back in gold or in bank notes.
But then the debtor lost those bank notes and does not have gold either. So they can't pay back. At first, this seems like a zero sum game for the goldsmith. They gave out banknotes not backed by anything and they won't get any of the gold or notes they expected. But don't forget that those bank notes are not gone! They are now in circulation, owned by someone else. That someone else now has the right to go to the goldsmith and demand their gold. "But those were just a loan" isn't an answer the new owner of those bank notes has to accept.
Correct answer by Philipp on May 13, 2021
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