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Paper Money: Worse than precious metals but better than bank credit

The banks in Sweden, and many other countries, are doing their best to demonize cash transactions. In short, a cash transaction consists (in most cases) of a debt settlement that is enacted and settled simultaneously, and it is done so without the bookkeeping process that banks provide. As of today, a bank’s role is not to keep money in a vault as they did in the childhood of banking business, but of acting as a bookkeeping agency that keeps a record of debit and credit in their ledger and thus keeps track of every customers “score” in the “economic game”. Does this mean that they have no money and are, in fact, broke? To answer this question we must go back in time

Published: 18-06-2013 14:34

Paper Money: Worse than precious metals but better than bank credit

The beginning of banking

The first bankers where goldsmiths who took upon themselves to safekeep their customers gold in their vaults. At the time, gold acted as a unit of account and a medium of exchange. When a customer deposited gold in the goldsmiths vault, he or she got a receipt for the given amount of gold deposited. These receipts then circulated the economy. After some time, certain goldsmiths started to surreptitiously issue more receipts than gold available in the vault for redemption. The gold/receipt ratio was no longer one to one. This is more or less how modern banking was born. Today, the basis of our money system is certainly not gold, but the principle remains the same. There is, however, one significant difference, and that is that the state has interfered in the process and adopted the right to give the banks a charter - a bank license if you will - that allows them to create money out of thin air in the form of bank credit.

Moral hazard

Except for the privilege of creating money out of thin air, the state has made sure that banks will not have to carry the risk that the goldsmiths did when they issued more receipts than gold available in the vault. To understand why and how this works me must investigate what the equivalent of gold and the receipts are in today's banking system.

Today we do not use gold, but national currency, (in Sweden SEK) as a unit of account, and it is in this state issued national currency that prices are expressed. The “receipts” that we use for trading today consists of not gold but bank credit in the form of an account balance in the ledger of the bank. We exchange this bank credit, or “receipts”, by using our debit card when shopping for groceries in the store, or buying stuff on eBay. When doing this, our electronic “receipts” is transferred from one account holder to the next. The underlying “asset” that the electronic bank receipts represent is the government issued national currency. It is therefore not, by any definition, actual national currency that is being used in a debit or credit card transaction. Seems confusing? Think about it for a while.

The bank credit that you see on your bank account statement is a promise to pay in national currency upon demand. The easiest way to do this is of course to find an ATM and simply make a withdrawal, thereby redeeming cash (national currency) in exchange for bank credit (receipts).

Even though - just as in the example with the goldsmith - the amount of bank credit (receipts) is not on par with the amount of national currency, there’s usually no problem to redeem cash, but if too many people start to ask the forbidden question: “Is there actually any money in the bank?” things may get ugly. The latest events in the banking system of Cyprus make it clearer than ever that the system has been resting on a lie ever since the days of the goldsmiths.

The fact that the state acts as a guarantor of depositors money creates the moral hazard which means that taxpayers will have to bear the burden during financial difficulties while the bank owners reap the profits under the economic booms. It also means that the bankers do not fear their depositors as much as they should, and depositors do not fear the bankers as much as they should either. Why should they? After all, the state protects their deposits using taxpayer money.

Except for this, private vendors can not choose whether to accept a specific “receipt” (which equals bank credit in today's system) at a discount to its value. If you, for example, walk into a store with a debit card from bank A, the vendor has no right to say: “I will only give you 80 percent of the value on that one, for I do not trust bank A”. To clarify: the vendor can not make the choice to only give you goods for 80 dollars if you offer him receipts - bank credit - for a hundred dollars. If you have, on your debit card, the modern type of receipts that we call bank credit, then the vendor must accept them at their full value because they are considered “legal tender”.

Free banking

In the “cradle of banking” the moral hazard of today did not exist. Vendors and bankers of those days - the goldsmiths - had to carry the risk on their own. Contrary to what one might believe this was not necessarily a bad thing. There was a sound suspicion against the goldsmiths which meant that they were “shaking in their shoes” in fear that too many depositors at once might call their bluff by requesting redemption on their receipts.

Since legal tender laws did not exist, it meant that vendors could voluntarily accept or refuse payment in gold receipts. Alternatively, they could accept them at a discount to their full value. Either way was voluntary. If there were several goldsmiths in a country or region, it was not unthinkable that receipts from certain goldsmiths granted a higher value than receipts from others. Perhaps it was rumored that goldsmith A was not as trustworthy as goldsmith B and, therefore, certain vendors chose to not accept receipts issued from goldsmith A. They could also choose to accept the receipts at a discount. The discounting that the vendor makes is due to the risk involved of not being able to redeem the receipts at the goldsmiths vault.

In fact, Sweden went thru a long and successful period of “free banking” during the 1800s, which you can read about in Erik Lakoma's report: Free Banking in Sweden 1830–1903: Experience and Debate

Paper on paper

We’re seeing more and more signs that our banking system of today is becoming more and more shaky and that the banks are infringing their depositors privacy and right to ownership of their national currency. You do not need to look to Cyprus to find examples of the instability of the system, and it is not just about cash money either. One example is the closedown of the cash currency market that has happened in Sweden in a very short time and at an incredible scope. Three out of the four major banks has terminated cash handling at 530 out of 780 offices nationwide. The rest has only unbacked “receipts” in the form of bank credit - ones and zeros - in their vaults.

Some banks are even tightening their belts when it comes to digital transfers of wiring money from one bank to another. They are now speaking of transfer limits of 150 000 SEK per day, for a regular bank account. Since an overwhelming part of all transactions of today is conducted digitally, and often in between banks, this is also a form of withdrawal limit. Regarding the question whether banks have any money or not, the answer must be no. They have money substitutes - receipts - or put in another way: “Paper on paper”

The conclusion must be that the physical cash money of the state (USD, SGD, AUD, etc.) must after all be better than the unbacked receipts on paper money that the banks want us to use for trade. Despite this fact, it is questionable if government printed paper money meets any of the classic criteria for something to be called money.

In today's tsunami of different paper assets, derivatives, and money substitutes, it is easy to see that precious metals, such as gold and silver, constitutes a hugely attractive investment alternative when it comes to storing value long term. The value preserving properties of gold and silver have been appreciated for thousands of years before the winds of paper started to blow. When this wind calms and all paper denominated assets starts its the descent to the ground, they will probably try to land on the small pile of gold and silver that is available for investors to buy.

Most likely, this means an explosion in the value of gold and silver, regardless of the price in paper money.