From Gold to Paper to Government Money

Paper money came before London’s banks

In China, merchants used paper receipts so they would not have to carry large amounts of coin. A receipt gave them a written record they could use instead. In the 1020s, during the Song dynasty, the government took over a system of issuing these notes.

This was hundreds of years before London’s goldsmith banks. Keep that earlier history in mind as we move to England. The English story explains one way paper money developed; it does not explain the beginning of all paper money. Paper notes did not all begin as receipts for gold.

In London in the second half of the 1600s, goldsmiths worked with precious metals. They also kept customers’ money safe. When a customer left money with them, they gave the customer a written promise to repay it.

People began using these promises to pay other people. The paper could change hands while the money stayed with the goldsmith. That saved them from moving the metal for each payment.

The goldsmiths also lent some of the money left with them. They were doing the work of bankers: keeping money for customers, making payments, and making loans. Their notes promised payment when asked. To keep that promise, they needed money ready when a note holder came to collect.

The Bank of England was founded in 1694. It served the government, but private owners owned the bank. It accepted deposits and issued notes of its own.

One note that survives today is dated 18 June 1697. It promises to pay its holder £22. The holder could exchange it for that value in gold. This object gives us a real example of the promise written on an early banknote.

China and England took different paths. In the London story, the key idea is that a trusted promise could pass from one person to another. Now let’s slow that process down with the baker.

The coin stays in the vault

This is a made-up example. The baker leaves one gold coin with a vault keeper she trusts. He gives her a paper receipt. Whoever holds it can bring it back and ask for the coin.

The baker takes the receipt to the miller. He also trusts the keeper, so he accepts the paper as payment for flour. The baker gets her flour. The miller gets the right to collect the coin.

The coin has stayed in the vault through the whole payment. The miller can go and collect it. Or he can use the receipt to pay someone else who trusts the same promise.

We need two names to describe the coin and the receipt. The gold coin is an asset, something of value. The receipt is a claim, a right to ask for what someone has promised. Holding the claim is different from holding the coin itself.

The keeper’s promise is what makes this receipt useful as payment. If people stop trusting him to hand over the gold, they may stop accepting his paper.

Now add three more customers. Each leaves one coin and receives one receipt. The vault has four coins. The keeper owes one coin to each of four people.

The keeper lends two coins to a borrower. There are now only two coins ready in the vault. The borrower owes the keeper two more, but will repay them later. The four receipt holders can still ask for their coins today.

Suppose all four receipt holders arrive today. The keeper has only two coins ready. Even if the borrower will repay the loan next month, two customers must wait. This shortage of money ready now is a liquidity problem.

There is another question to ask about the same vault. Does everything it owns have enough value to cover everything it owes? That question is about solvency.

In our example, the vault has two coins and a loan for two coins. If that loan is worth its full amount, its assets can cover the four coins it owes. It can still be short of ready coins today. A cash shortage and a loss in the value of its assets are different problems.

What changes when a bank makes a loan?

The vault story helps us understand a promise to pay. A modern bank loan creates a different kind of promise. Follow the baker again, this time at her bank.

The baker borrows 60 units. The bank adds 60 to her account, so she can now spend them. At the same time, she owes the bank 60. We will leave out interest and fees in this example.

Her account balance is called a deposit. It is money the bank owes her. Her loan is money she owes the bank. Those two records are created together.

Now look from the bank’s side. It owns the baker’s promise to repay 60. That loan is an asset for the bank. The deposit is the other side of the deal: the bank owes the baker the 60 shown in her account.

The bank does not have to remove 60 from another customer’s account to create this deposit. Making the loan can create new deposit money. But it does not make the baker 60 units richer without a cost. She has a new debt as well as a new balance.

Nor does the loan create an oven or a bag of flour. Someone still has to produce those things. Creating a payment balance and producing real goods are different jobs.

Banks usually keep less cash and central-bank money than the total of their customers’ deposits. Central-bank money here includes balances banks hold at the central bank. Holding only part of the total in these forms is called fractional-reserve banking.

That does not mean every stored coin automatically turns into a fixed number of loans. Before lending, a bank must judge whether the borrower can repay. It also needs money ready to make payments and money of its own to cover losses.

The cost of getting funds matters too. So do banking rules and central bank policy. These limits help explain why a bank cannot simply keep lending any amount it chooses.

The baker now spends her 60 units. The seller receives money in a bank account. If the seller uses a different bank, the banks must also settle the payment between themselves. Changing the two customer balances is only part of that payment.

Later, the baker repays some of the amount she borrowed using money in her account. Her loan balance falls. The deposit money used for that repayment falls too.

This applies to the original amount borrowed, called the principal. Interest is handled separately. We will follow the payment and repayment steps more closely in Navigate the Financial System.

The promise on a note can change

Return to the paper receipt. Its holder expects to receive gold. What happens if the rules no longer require the issuer to hand over that gold? A note can continue to be used as money even after that promise changes.

Britain did not keep the same gold-payment rules without a break. It stopped exchanging notes for gold during some periods, including 1797 to 1821. Governments could change the rules around the bank’s promise.

Governments also took a larger role in deciding who could issue notes. In England and Wales, the Bank Charter Act of 1844 limited other banks’ note issues. It also stopped new banks from starting to issue notes. This made the Bank of England’s role stronger, but it did not end every private banknote overnight.

In September 1931, Britain left the gold standard. A Bank of England note no longer gave its holder the right to demand gold. People could still use the note to pay, but the gold promise had ended.

Other countries followed different paths. To understand the US dollar’s later gold link, we need to follow a separate set of events. These begin with a plan for money after the Second World War.

1944 — Countries agree on a plan. Leaders from 44 countries met at Bretton Woods. They wanted rules for exchanging their currencies after the war.

An exchange rate says how much of one currency you can get for another. The plan linked other currencies to the dollar at set rates. Those rates could be changed under the system; they were not fixed forever.

The dollar, in turn, had an official gold price of $35 per ounce. The dollar’s gold link connected the other currencies to gold. This arrangement is what we mean here by the Bretton Woods system.

1971 — The US stops official gold exchanges. On August 15, President Nixon stopped foreign official holders, such as central banks, from exchanging dollars for gold at the set rate.

That detail matters. Ordinary Americans had already lost the general right to exchange dollars for gold decades earlier. The 1971 decision ended the promise to foreign official holders; it did not take that right away from American households for the first time.

1973 — Major exchange rates start to float. Countries tried to repair the system after 1971. By March 1973, major currencies had moved to floating rates. Their prices against other currencies could move in currency markets. The Bretton Woods system had broken down.

Why people still accept dollars

Think of the baker accepting a dollar today. She does not expect to take it to the government and collect a set amount of gold. She accepts it because she expects the miller, the power company, and other sellers to accept dollars from her.

Today’s dollars are fiat money. They do not promise a fixed amount of gold, silver, or another physical good in return. People use them within a system of laws, banks, and payments, and expect others to accept them. The material in a dollar bill does not explain what it can buy.

This leaves a question about those rules: who should be able to change them? John Maynard Keynes helped design Bretton Woods. He wanted public institutions to have room to respond when the economy was in trouble.

People still debate how much power these institutions should have. They also debate how to prevent misuse and who bears the cost of their decisions. Removing a gold link does not remove the need for rules or good judgment.

In the US, the central bank is the Federal Reserve, often called the Fed. Its goals include maximum employment and stable prices. In everyday terms, it seeks a strong job market and low, steady price increases.

The Fed can influence interest rates. That can affect the cost of borrowing and the amount people spend. It also uses other tools, but it does not choose every worker’s pay or set every shop’s prices.

The Fed’s price goal is 2 percent inflation over the longer run. It uses a measure called the Personal Consumption Expenditures price index, or PCE, to track that goal. The index follows prices across a broad range of consumer spending.

The Fed adopted this clear 2 percent goal in January 2012. It was not part of the 1944 Bretton Woods plan. And it is a goal for a broad measure over time, not a promise that every family’s bills will rise exactly 2 percent each year.