Unlike gold coins or silver coins, paper receipts could not be clipped or debased, and so their value was relatively more secure. Paper receipts (commonly referred to as goldsmith notes, and later promissory notes) were also a more portable form of money and better suited to transacting large purchase amounts, such as for land or property.
The big problem with this system of promissory notes is similar in essence to the problems of the fractional reserve banking system that we have today i.e. the whole money supply can be expanded or contracted quite rapidly in a relatively short time.
When the goldsmiths, now banks, increase their lending they create additional new money, and that creates extra spending in the economy. In turn this extra spending implies extra demand for goods relative to supply, and thereby causes price level rises (inflation). Speculative bubbles can arise from this as consumer spending drives up prices until, as with all such bubbles, a peak is reached after which prices start to decline.
Since some speculators will now start to lose money, the banks will start to get nervous about the money that they have lent out - especially for loans that were secured with assets whose values are now falling (causing negative equity). They will cut their lending and increase their interest rates; the money supply will now contract rapidly, and an economic downturn will ensue.
Some of the speculators who borrowed money will be unable to repay their loans and, because of that, some of the banks may now find that they are insolvent. If word of this gets around then anyone with paper money issued by these banks will immediately want to retrieve their gold, and that’s a problem since the banks have already lent it out to speculators who have defaulted on their loans!
Banking Regulations & Money Supply
Due to the problems of excessive money supply growth and contraction, banking regulations have been introduced at various times by different countries in order to try and promote stability. Some countries had brief experiments with ‘free-banking’, a self-regulating system similar to the goldsmiths’ notes described above, where individual banks were free to issue their own notes but were forced to maintain responsible amounts of gold to back their lending.
Free banking, with plentiful gold as backing for the representative money it creates, is a system favored by many Austrian economists as a replacement for the current fiat monetary system.
Most countries never experimented with free-banking, and the economic dominance of the United Kingdom in the 18th century meant that most countries followed its lead in joining a gold standard instead.
This would involve a single institution that would have sole authority to issue paper money, and that paper money would be convertible into gold at a fixed rate. The commercial banks could not issue their own notes, and their ability to expand the money supply through excessive lending was thereby controlled by the government.
The Classical Gold Standard to Fiat
The classical gold standard formed the basis of the international monetary system from the late 1870s until 1914, and it offers the best example of a successful representative currency. There are, as always, diverging opinions from economists about whether the successful period of growth and stability that accompanied the gold standard was causative, or merely coincidental.
With gold used as backing for national currencies, any country that over-expanded its money supply would develop a trade deficit, because it would stimulate extra domestic purchasing of foreign imports relative to exports. This in turn would increase the demand for foreign currency relative to domestic currency (in order to pay for all the extra imported goods), which would have to be offset by selling domestic gold stocks to foreigners in order to plug the gap.
As gold flows out of the domestic economy it is ultimately forced to reduce its money supply in order to reduce its excessive spending on imports. Only this would reduce the outflow of gold. If the domestic economy simply allowed its currency to devalue, it would have broken the rules of the gold standard, since its currency would no longer be worth its agreed price in terms of gold.
In other words, the gold standard forced restraint and encouraged responsible monetary policy. For a period of about 40 years many countries, and especially the United States, enjoyed both unparalleled rates of economic growth and a very stable money with stable inflation.
Unfortunately, World War 1 would put an end to all that!
It is not only commercial banks that have an incentive to ‘create’ new money, governments also have this incentive in order to fund various projects, and a world war is a project that demands funding like no other!
As western countries began printing money and borrowing money to fund their war chests, it was not possible to contain inflation, and the classical gold standard had to be abandoned.
There were various monetary systems employed in the years and decades that followed the war but, due to the political and economic instability of the period, these never attained the same degree of monetary policy restraint. They were either not true gold standard systems, or they were but were also ill-conceived, unsuccessful, and short-lived.
Ultimately, the general population lost the ability to convert their paper money into gold at a fixed rate of exchange, and for that reason it could no longer be considered as representative money.
The age of fiat money had begun.
Lessons about Money, Currency, & Value
In the words of J. P. Morgan in his 1912 testimony to Congress:
“Gold is money. Everything else is credit.”
Representative Money Dangers
Whilst the statement above might be somewhat of an exaggeration, there is still a great deal of truth within it. Currency i.e., bank notes that are issued to regular people to use as money is not in fact money. In a system of representative money those bank notes are merely promissory notes, issued in return for the money that the banks' customers deposit with them.
This is an important distinction, because once money is deposited with a bank it becomes the property of that bank. The customer has made a type of investment in that bank and received access to currency in the form of notes, credit, and whatever other services are provided by the bank. However, if that bank fails then the customer's money is lost (although part of it may be insured by another party, usually the government).
Fiat Money Dangers
In a Fiat system the value of the currency is even less secure, because it is not backed at all by real money like gold or silver. Only the mere promises of the government to redeem the legal tender form the backing, and governments have invariably undermined that promise by debasing the currency i.e., by printing too much money in order to fund their misguided programs and endeavors.
This excessive money printing by the government in turn allows banks to create excessive amounts of credit via fractional reserve practices, leading to periods of rapid growth in spending (usually a housing market boom) and the emergence of the boom & bust business cycle. If left uncorrected (as it invariably is) it eventually threatens the entire monetary system via the conclusion of the long-term debt cycle.
Representative money is far preferable to Fiat money but, as our experience of the Gold Standard demonstrates, it still requires a sensible government to operate within the confines it creates. Promises by politicians to the electorate to spend more money on this or that thing may work to win votes, but it undermines the value of the currency if it leads to excessive debt and/or money printing.
At times when this situation presents itself, and 2022 looks like a prime example, investors and savers are well advised to consider switching part of their portfolio/savings into real money like gold or gold mining stock. If not then they may lose purchasing power when the government either defaults on its debt, or debases the value of its currency via inflation. I leave it to the reader to decide how secure his/her investments are in this sort of financial environment, and whether or not his/her 'money' is losing its purchasing power.