Those seeking a substitute for gold labored under a misunderstanding. They believed that governments designated gold as money, and all government needed to do to change it was to decide on a different form of money.
This is simply not the case. Government did not create money; it merely recognized officially the money that was functioning in the marketplace. It was people, not government, that decided on what to use for money.
It cannot be overemphasized that people the world over were not compelled to use gold as money. They gravitated to gold because it served all the requirements demanded of money better than any other commodity.
Now let’s look into “banking” and the function of “monetary reserves.” When a medieval merchant arrived in a city for, say, a trade fair, he obviously did not wish to carry his gold around or leave it at the inn where he was staying. Consequently, he sought the local goldsmith who, for a modest fee, would store it for him. When a merchant placed his gold with the goldsmith, he received a receipt as evidence of his claim to the stored gold.
When merchants conducted their business, they could transfer these paper receipts instead of transferring the gold itself. Others would then circulate these receipts because it was more convenient than transferring gold. So these warehouse receipts for gold became “paper money” — more accurately, a “money substitute.”
It is at this point that 99 percent of the people lose all their understanding concerning money, which is why they can so easily be victimized by government dishonesty. It is, therefore, extremely important for the reader to grasp the difference between money, and paper (or coin) money substitutes. The paper warehouse receipt for money is obviously not money but merely a paper money substitute for money that is stored.
The goldsmith, who had initially charged a fee for storing gold, soon noticed that his storeroom always contained ample supply of gold since his receipts continued to circulate with relatively few being presented for redemption. The goldsmith discovered that a portion of this dormant gold could be loaned to others showing an economic need for it and having the capacity to repay it, plus interest, before it was needed for redemptive purposes. Soon the goldsmith was making more money loaning out other people’s gold than he was at goldsmithing — so he became a “banker.”
In time, bankers developed a skill for judging the community’s need for gold, based upon local economic conditions and the travel habits of the local merchants. From this, they determined how much gold they should have on hand in order to redeem all receipts that might be presented. Based on his assessment of the situation, a banker might call in some loans and suspend making others and, so, his actual supply of gold to outstanding paper might be as high as 100 percent or as low as 25 percent or even lower.
Note that the banker did not need to have a dollar in gold for every dollar in receipts issued. All that was required was that he have enough gold to honor all possible receipts when presented, and the confidence of the public that this would always be the case. The amount of gold, of course, served to limit the amount of paper that could be circulated and the ratio of gold to currency became known as the gold reserve.
It is a government’s sneaky ability to progressively make its money substitutes worth less by overprinting paper money substitutes (usually in response to short term political need) that destroys nations, empires, and civilizations.
The fact is that even when “money substitutes” become intrinsically worthless either because they have become backed by empty warehouses or bankrupt creditors and governments, they will continue to circulate simply by force of habit. Government monetar treachery relies on a people’s irrational willingness to accept and circulate worthless “money substitutes” while being under the illusion that they are accepting and saving real money.