From the Vault: How goldsmiths became bankers

When goldsmiths figured out that they could make loans not only on their own assets but also on the gold on deposit with them.

By John Steele Gordon

With the Spanish conquest of Mexico and Peru in the early 16th century, a flood of gold and silver flowed into the European economy. This caused considerable inflation as the money supply increased much faster than the production of goods and services, about 400 percent over the course of the century. It also caused the circulation of gold coinage, rare since the height of the Roman Empire 1,500 years earlier, to greatly increase.

But gold has always had a very high value per unit of weight, making it a very tempting target for thieves and robbers. (A single cubic inch of gold today is worth almost $20,000.) Storing it safely was a problem. The solution was to store it with goldsmiths who, of course, had ways of storing it safely.

When a goldsmith received a deposit of gold, he would issue a receipt for it. But soon a strange thing began to happen. When the gold was wanted to buy something, the owners—instead of retrieving the gold—would simply sign over the receipt to the seller, the gold staying safely in the goldsmith’s vault.

This, of course, did not go unnoticed by the goldsmiths, and when they made a loan—as they had long done as a side business—they now would simply issue a receipt that, if the goldsmith had a good reputation, circulated at par.

Soon the goldsmiths figured out that they could make loans not only on their own assets but also on the gold on deposit with them as well. After all, as long as the receipts for gold passed as money, nobody wanted to truck around the actual metal. So the goldsmiths, who by this time had become bankers, could safely issue more receipts than there was gold to back them.

There was, of course, one big problem. The marketplace had to have faith in the integrity and, even more important, the solvency of the banker. If that faith was lost, holders of the receipts, now called banknotes, would rush to redeem them while the redeeming was good, and the last in line would be out of luck while the banker would be out of business. Thus, prudent bankers were careful to keep adequate reserves on hand to redeem any notes that were proffered for gold. As long as everyone who asked for gold received it, few would ask.

There was one more thing that was needed to truly turn the goldsmiths’ banknotes into real money. They had to be negotiable.

A deed to real property, say, is not negotiable, so when it is signed over to a new owner, the owner’s title is no better than the seller’s title had been (which is why in the United States, people buy title insurance). But if a seller receives a negotiable instrument in good faith, it is the seller’s absolutely, regardless of how illegally the buyer had obtained it.

England made banknotes negotiable in 1704, and Great Britain became the first country in Europe to have much of its money supply in reliable paper form. The money supply remained reliable because in 1694, the Bank of England had been created to handle the government’s banking and borrowing needs. Other British banks gradually stopped issuing their own banknotes, using Bank of England notes instead. They also began storing their gold reserves at the Bank of England, which became the only major gold reserve in the country.

This advanced and well-disciplined banking system would prove to be Britain’s secret weapon in the endless wars of the 18th century.

Acclaimed economic historian John Steele Gordon is the author of An Empire of Wealth, The Great Game and Hamilton’s Blessing.