Goldsmiths were the first bankers beginning in the 16th century. They had secure storage vaults so in addition to keeping their own gold they offered people secure storage for their gold for a fee, in return for which they issued a receipt. Initially the receipts carried the name of the depositor, so only he or she could withdraw the gold, which they had to do to carry out transactions with it, after which the new owner of the gold would generally soon deposit it back with the goldsmith. To avoid this cumbersome business receipts began to be issued to pay the bearer, rather than or in addition to a named person, so that the receipt itself could be used in transactions without the need to disturb the gold. In this way each receipt for a given value was as good as any other receipt for the same value, and ownership of gold was easily transferred by transferring the receipt. This type of receipt became very popular and began to circulate widely as money, especially for large transactions, because it was much more convenient to carry around than large quantities of gold.
At the same time part of the goldsmiths' business was to lend gold at interest, but because of people's preference for receipts they increasingly lent receipts rather than gold. They could only legally lend receipts for gold that they themselves owned, and not for gold that was in their vaults but owned by other people, except when expressly permitted by them, but because gold was only rarely withdrawn they soon realised that they could get away with lending more receipts than the gold that they owned, and often more than the total amount of gold that was in their vaults. By this trick they obtained interest on money that people believed was backed by the goldsmith's own gold but in fact was backed either by gold belonging to others (when two receipts for the same gold were circulating at the same time) or by nothing more than the agreement to repay that the borrower had made. This was of course fraud but very lucrative. In spite of the fact that the receipts weren't legitimately backed they were still accepted in payment so they were in all respects genuine money. The amount of money circulating in the form of receipts consisted of the receipts held by depositors of gold left for safe keeping, plus the receipts lent out for the goldsmith's own gold, plus the additional receipts lent out by the goldsmith for gold that was either not owned by the goldsmith or for gold that didn't exist at all. When this total exceeded the amount of gold owned by the goldsmith money had been created fraudulently because there was now more money in circulation than there was gold in the vault (Ryan-Collins et al. 2012 p38).
The fact that the goldsmith held debts (promises to repay) to cover the fraudulently issued receipts was important because provided that the borrower didn't default the debt would eventually be repaid and all would be as it was, except that some of the gold that had belonged to another person now belonged to the goldsmith because of the interest payments. When a debt was repaid the money that had been created and entered circulation was withdrawn from circulation by the borrower giving it back to the goldsmith and thereby in effect it was destroyed. There was nothing of course to stop the goldsmith from keeping the receipt for re-issue to someone else for a new debt, but this procedure was no different to the original receipt being destroyed and another identical one being created when needed.
In due course goldsmiths found that they could safely lend out receipts for several times the amount of gold in their vaults because it was rare that people withdrew significant amounts in gold, and when they did withdraw gold and transfer it in a transaction it soon came back to the goldsmith for safe keeping from the new owner. All the time the goldsmith pocketed the interest on money that had been created out of thin air, so it is easy to see why they grew so rich so quickly.[158]
This is an extract from a letter written by the Rothschild brothers of London to associates in New York in 1863:
The few who understand the system will either be so interested in its profits or be so dependent upon its favours that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.[159]
Although there was nothing to stop goldsmiths from creating receipts for direct spending by themselves, if they did this to any significant extent then they risked exceeding the safe limit of receipts in circulation because in this case there was no corresponding debt to be repaid so these excess receipts would add to the total without ever being recycled - far better to await the interest and spend that.
When gold depositors suspected or realised what the goldsmiths were up to they demanded a cut of the interest, so eventually the fees for gold storage had to be dropped and interest paid instead, at a lower level of course than that charged to borrowers.
This is an instance where the earlier definition of money as entitlement to wealth can be seen as important, because what had happened was that the goldsmiths had created money with negligible effort without creating any wealth, but were repaid with more money than they had created because of the interest, and by these means they became entitled to wealth that others, the borrowers, had created.
From these beginnings grew the banking sector, which still creates money by the same means, still charges interest on it, still becomes entitled to wealth created by others, and still enjoys just as lucrative a business. A major difference is that banking activities are no longer classed as fraud in the legal sense, provided that the bank is in possession of a banking licence.
Banks claim that they provide a valuable service to borrowers, and there is some truth in this, so in chapter 49 the value of the service is examined.