(Part I)

Let’s make believe you have a whole bunch of gold that you don’t want to carry around. Let’s make believe that you and I live in an area where there are not – yet – any banks. You want to keep your gold safe; and you’d still like to use it as exchange for goods and services. I happen to own, say, a general store. You and I make an arrangement in which you leave your gold with me, which I put in my safe. I write you out a whole mess of receipts, say one receipt for every one ounce of your gold in my safe. These receipts, you are able to use to purchase goods and services. In exchange, you give the requisite number of receipts to the person with whom you are engaged in business. These people understand that there is an ounce of gold in my safe for every receipt they posses, and that they can come to my store and get an ounce of gold for every receipt they give back to me. I have just become a banker.

Soon enough, I have everyone’s gold in my safe and a hold wagon load of receipts out and about, which are being used for exchange. One of these receipts (called “notes”) still equals one ounce of gold.

Then let’s say that, with your kind permission, I loan some of your gold to another, with the understanding that he will pay the loan back. And, in order to make it worth your while to loan this gold, I will charge him interest on the loan. Although some of the total amount of gold in my safe is gone, since I (the “bank”) have a note from the borrower, none of the those previously circulating notes have decreased in value: the amount of gold represented by those notes is still there. (Naturally, if everyone possessing those notes came in to redeem those notes for all the gold represented by those notes I might be in trouble, for technically some of the gold represented by those notes – having been loaned out – is not there. However, I have created what I call a “reserve” for just such occasions; and I have not loaned out more gold than I can cover both from my deposits and from my own reserve. We’re still good. If I have to make use of some of my reserve to redeem those notes, I’ll be able to pay back into my reserve as the borrower pays me back on the loan. Plus, I’ll earn a tidy bit of interest in the process. You know, for my trouble.)

Now let’s say that the city fathers have decided to declare war on a neighboring city and need to raise money to fight this war. They don't want to raise taxes because doing so will harm their chances of re-election. So they decide to borrow the money, from me, of course. But here's the scheme we actually come up with: I will simply print up the notes representing the amount they need to fund the war. Notice: there's no more gold in my vault than there ever was; I'm just going to print up notes which says, in effect, that the gold is there in my vault.

In my next posting on this, I’ll explain how the situation created by me and the city fathers creates inflation and makes the rich richer (through little fault of their own) and the poor poorer (through no real fault of the rich).

Part III