What Is Money, Part 5
Welcome back to our journey through the evolution of money. We’ve explored how societies moved from barter systems to commodity money, and how the discovery of gold and the minting of coins revolutionized trade and commerce. Today, we take the next step: examining the rise of fractional reserve banking, what it is, and how it fundamentally transformed our relationship with money.
The Origins of Banking
Picture the bustling markets of ancient Mesopotamia, filled with traders hawking and bartering goods, with the imposing temples of Greece and Rome in the background. They not only served as places of worship, but also were secure vaults for wealth. In these early societies, as wealth grew, merchants faced a pressing need for safety and convenience in storing their gold, silver, and other valuables. Over time these temples and palaces emerged as the earliest forms of banking institutions. Initially, they focused on safeguarding physical wealth—protecting from theft and loss.
Over time that role expanded. Priests and officials began issuing receipts to certify the value of deposits. And it was these receipts which evolved into instruments of trade, eliminating the need for cumbersome physical transfers of gold or precious metals from one merchant to another.
These temple receipts solved several key problems. First, imagine a merchant in Ur who has deposited gold at the temple. Rather than withdraw and transport heavy metals to Babylon for a trade, they could simply transfer the receipt to their trading partner. The partner could then either keep the receipt as stored value or redeem it for physical assets at the temple.
This technological innovation sparked several important developments:
First: The receipts needed to be standardized in order to be trustworthy. Temples and palaces developed sophisticated systems of record-keeping, using clay tablets to track deposits and obligations. They began marking their receipts with official seals and distinctive markings to prevent forgery.
Second: As these receipts circulated more widely, people began accepting them not just for their redemption value, but as a medium of exchange in their own right. A receipt from a prestigious temple might trade at full value even far from its origin, based on the temple's reputation.
Third: The ability to transfer value without moving physical goods also enabled trade across greater distances and in larger volumes. Merchants could now conduct business across Mesopotamia without organizing expensive and dangerous caravans to transport precious metals.
Fourth: This system also laid the groundwork for more sophisticated financial instruments. Once people grew comfortable with the idea that value could be represented by markings on clay or paper, it opened the door to concepts like promissory notes, letters of credit, and eventually standardized currency issued by state authorities.
It wasn’t long before temples and palaces realized they could be lending out a portion of the wealth stored with them, and charging interest. This transition marked a critical shift: from mere safekeeping to active participation in the economy. By providing loans, these early banks enabled merchants to fund ventures, expand trade, and invest in larger enterprises, laying the foundation for a far more complex economic system. Banking as we recognize it took shape through these practices.
Banking as a Technology
As these paper instruments gained acceptance, bankers made another profound observation: most depositors rarely withdrew their entire holdings at once and it was this insight that led to one of banking's most transformative innovations.
Much like money itself, banking is a technology. It’s a tool crafted to solve specific problems. Early banking systems addressed inefficiencies in trade and enabled merchants to transact over greater distances with reduced risk. However, the true revolutionary leap came with the development of fractional reserve banking.
Fractional Reserve Banking
These early bankers, through careful record-keeping, noticed that on any given day, only a small portion—perhaps 20%—of depositors came to withdraw their gold. Recognizing this pattern, bankers realized they could lend out more gold than they physically held in their vaults—provided they kept enough in reserve to satisfy routine daily withdrawals.
Here’s how it worked: imagine someone deposits $100 at their local bank. The bank doesn’t just keep the $100 in a vault gathering dust. Instead, it keeps only a fraction—let’s say $10—on hand as a reserve, for customers who need to withdraw some money. The remaining $90 is then lent out to someone else, such as a small business owner needing funds to buy supplies.
Now here’s the interesting part: when that $90 loan is spent—say, at a hardware store—the hardware store will then deposit the $90 into their own bank account and use it to buy more inventory, make payroll and pay other bills. The hardware store’s bank then repeats the process, keeping $9 (10% reserve) and lending out the remaining $81.
This cycle continues. Each time, a fraction of the money is kept as a reserve, and the rest is lent out. Even though only $100 was originally deposited, the repeated lending and redepositing create new deposits in the system. This is called the multiplier effect. In the end, that initial $100 might support $900 or more in total deposits and loans across the banking system.
This system served multiple purposes. For merchants, it provided access to capital for new ventures. For depositors, it offered security and the potential to earn interest. Most importantly, for society at large, it allowed the money supply to expand, fueling economic growth that would have been impossible with physical coins alone.
However, these advantages came with risks. If too many depositors demanded their gold at once—a "bank run"—the system could collapse. Banks had to carefully balance lending to stimulate growth with maintaining enough reserves to uphold depositor confidence. This delicate balancing act would define banking for centuries, as institutions sought to harness the benefits of fractional reserve banking while mitigating its vulnerabilities.
Banking's Impact and Evolution
As banks evolved, their influence expanded beyond individual transactions. They became engines of economic growth, funding merchants, explorers, and artists, and fueling trade and cultural advancement across Europe. Banks also financed critical public works—roads, bridges, and aqueducts—that supported thriving civilizations.
Yet, with this growing influence came new risks. As banking systems became more interconnected and complex, a failure in one region could ripple across economies. The establishment of the Bank of England in 1694 marked an early attempt to address these challenges, as governments sought ways to stabilize increasingly intricate financial systems.
By the late 19th century, the United States had risen as a global economic power, yet its banking system remained fragmented and prone to crises. Without a central authority to manage responses, even minor disruptions could escalate into widespread economic chaos. The Panic of 1907 exposed these vulnerabilities, setting the stage for a transformative debate on the future of modern banking.
Conclusion
The rise of banking transformed money from a mere medium of exchange into a powerful tool for growth and innovation. By enabling credit, fostering trade, and driving economic development, banks have profoundly shaped human progress. Yet, as history has shown, their power must be wielded responsibly.
In our next discussion, we'll explore how these challenges ultimately led to one of the most significant transformations in banking history—a change that would reshape not just American finance, but the global economic system itself.
