The Concept of Money

Money is something we learn to use long before we understand it. A large part of the population does not even attempt to understand the concept but is content with mastering its everyday use: how to withdraw money from an ATM, how to pay with a credit card or with a mobile phone, how to use payment gateways like PayPal, Venmo, MercadoPago, Bizum, AmazonPay, ApplePay, GooglePay. It is far less common for people to ask themselves what the euro or the dollar actually is, where it comes from, or who produces it. This is not unique to money --- the same thing happens with almost all technologies: most people do not know how a car’s combustion engine works but can drive one, do not know how email works but can send and receive messages, do not know in detail how electricity is generated at a hydroelectric plant or how it is transported to their home, yet have no trouble using the light switches and sockets in their house. And rightly so, since it would be practically impossible for any one person to learn how all the technology they use actually works.

But the case of money is special, particularly in the world we live in today, where the money we use is fiat money. Without understanding the concept and history of money, we fall into certain assumptions that are actually false. In doing so, we leave the door of our savings vault wide open, making it possible for us to be robbed without even being aware of it.

To properly understand any solution, it is first necessary to understand the problem it is intended to solve. For this reason, we will try to answer the question of why bitcoin exists before attempting to understand how it works. Since bitcoin is a new proposal for money, it is essential to analyse the concept of money, which in turn requires understanding its evolution throughout history. Unfortunately, the history of money is not taught in school, even though it explains many of the events that are studied in history class. This chapter is a very brief summary of the history of money up to the emergence of fractional reserve banking. In this way we can understand why humanity, over millennia, selected gold as the best form of money, what problems it still had, and how those problems were solved.

Money is the invention that makes the rise of civilisation possible. In a sense, one could say it is the greatest invention in human history, since it made large-scale cooperation between people possible and, in doing so, allowed civilisation to advance and further inventions to follow. Yet negative opinions about money are often heard. There are even people convinced that it is the root of all the ills of society and who would like to live in a world without it. This belief is only possible if one does not understand the very concept of money. None of those who hold this opinion about money would object to a tool that promotes voluntary and peaceful cooperation between people. And that is precisely what money is --- a tool that helps human beings cooperate voluntarily and peacefully with one another.

That said, some of the ills these people attribute to money are indeed caused by the money we use today: fiat money. But these social ills are a consequence of the fact that the money we use is fiat money, not of the fact that we use money at all. A subtle, yet very important difference.

The Birth of Money

Imagine your ship has sunk and you are the sole survivor who has swum to a deserted island. The island has trees, fruit, animals, a mountain, and a couple of rivers, so you can survive. You could build yourself a wooden shelter to keep out the cold and rain, gather fruit, hunt animals, catch some fish --- everything you need to subsist. But you are alone; there are no other human beings. Do you need money? No, not at all. You have no need whatsoever for money of any kind, because money exists to cooperate with other people, to exchange goods and services with another person in the present or in the future, and there is no one else on the island. If there is no one but you, there is nothing to exchange with anyone, so money is of no use to you.

Now imagine that a year later another castaway arrives on the island. He has managed to save himself along with his knife. It would make sense for you to let him shelter in the hut it took you a year to build, in exchange for him lending you his knife so you can hunt or fish more quickly. The cooperation makes sense; the exchange makes sense. He has something that would be enormously useful to you (it would save you a great deal of time), and you have a roof over your head, something he can enjoy from his very first day on the island.

This exchange is beneficial to both of you, not just one, and that is why it happens voluntarily. Is it necessary to have any money now? No, it is not necessary either. But if we think carefully, we can see that it would no longer be entirely absurd, as it was when you were alone. It is not necessary, since when you exchange services you always do so with the same person and the number of services you exchange is not great. You both know what you do for each other and you reach an agreement on the value of each thing you exchange. It is an economy of very few goods and services involving only two people. But it is no longer completely absurd that something should function as money, even in a society of only two people. You could use a hundred shells as a measure of the value of goods and services. That way you could exchange “I fix the roof of the hut so the rain stops leaking through” for “you go fishing and make the meals for five days”. Can it be done without money? Of course it can. But if you want to agree on “I fix the roof of the hut, and at some point you will do something for me in return”, some difficulties arise.

• How much will you do for me?

• How do we value now, in the present, something we do not yet know?

• Do we have to wait until we find something of equal value before I can fix the roof?

• Can I not fix it today, when I feel like it and it is not raining?

These are small difficulties, to be sure, but if you exchange your labour using shells as a measure of the amount of time and effort involved, you can carry out a task today in exchange for “a certain number of shells”, without having to keep track in the future of the fact that you fixed the roof, that it took you fifteen hours, and that you expect something equivalent in return. Even in a society of two people, we can see that money has some utility, since it allows exchanges of value to be somewhat more sophisticated than they would be in the absence of money. But it is certainly not essential, and it does not seem likely that money would have arisen naturally in societies of only two people.

As society grows in size, money becomes more important because it solves a problem that keeps growing. A group of ten people can still cooperate quite well without money, since the chain of favours is easy to remember and it is straightforward to agree on what each person contributes to the community. It is harder to imagine how a group of a hundred people could cooperate smoothly, voluntarily, without using anything that functions as money, relying solely on barter. With a thousand or ten thousand people, it is entirely unthinkable. Let us look concretely at the problems with barter --- the direct exchange of goods and services without money as an intermediary.

The first problem is the non-coincidence of wants. This problem arises when the thing one wishes to acquire is held by someone who does not want what one produces. One would need to find a third person who wants what we produce and who produces what the person holding what we want desires. An example makes this easier to see. Imagine that Alice produces apples and wants some oranges. Bob produces oranges but does not want apples --- he wants lemons. Alice and Bob cannot use barter on their own. They need to find a Carol who produces lemons and wants apples so that the three of them can carry out the exchange. If no such person exists, they need even more people to complete their transaction.

Another problem is the difference in scale. In the example above, Alice, Bob, and Carol could easily exchange one apple for one orange or one lemon. But in general we do not exchange one unit of a good for one unit of another, and problems arise. Imagine that Bob is a cattle farmer who has a cow farm and wants apples, and Alice wants to eat meat today. Each produces what the other wants, so they do not have the previous problem. But there is still no way to carry out the barter, because Bob wants three apples but cannot pay Alice with a piece of a cow. They agree that a cow could be exchanged for “two tonnes of apples”, but Alice could not deliver two tonnes of apples today, nor does Bob want them.

A third problem is the difference in time scale. Perhaps Alice does want the whole cow, because she is throwing a large party and is also capable of paying for it by delivering two tonnes of apples. Although Bob might eventually want many apples because he eats one every day, he does not want them all today. If he sold a cow for two tonnes of apples, the vast majority of the apples would likely rot before he could eat them.

A fourth problem is the difference in location. In this case Alice wants to sell her apples at the local market in her village, but she wants to buy a necklace from a merchant whose stall is in a village twenty kilometres away. Obviously, Alice does not want to carry twenty kilometres’ worth of apples just to exchange them there for the necklace she wants.

These four problems can also be understood as different aspects of the same problem --- the non-coincidence of wants --- but across four dimensions: the goods themselves, the scale or divisibility of those goods, the timing of the exchange, and physical location. For barter to work, everything must coincide: the desired goods, the right scale, the time, and the place.

An additional problem with barter is that there is no unit of account. This is no minor issue, since without a unit of account every market participant has to price their good in relation to all other goods and services, which is unmanageable. Moreover, the absence of a unit of account makes economic calculation impossible. Businesses need to calculate whether they are increasing or reducing their income and wealth with each transaction. Yet in a barter system, without a unit of account, calculating profit or loss would be an impossible task.

These five problems of barter (two, if the first four are considered as one problem with four dimensions) are solved by indirect exchange --- that is, by the emergence of money. Let us see how it arises.

Imagine a market, a place where people gather to offer the goods they produce and to acquire products offered by others. In a market where many goods are exchanged, one of them is the most widely traded of all, regardless of which one it is. If you cannot get what you want through barter, this good (the most widely traded of all) is the most useful for being able to buy anything else, and therefore also what you actually want. Suppose, for example, that the most widely traded item in the market is salt. That means that if you want to sell your apples to buy meat and cannot directly find someone who wants apples and sells meat, you will most likely try to exchange your apples for salt rather than for horseshoes or olives, since salt is “the most widely traded item” and therefore the thing that most quickly brings you closer to your ultimate goal.

As all the traders in the market act in their own interest in this same way, naturally, that good --- salt in our example --- begins to function as money. Once word spreads that salt is being used as a medium of exchange, more people will buy salt because they know they will be able to exchange it for other goods in the future. In this way, the more salt is used as a medium of exchange, the more that tendency feeds back on itself, and its use grows rapidly until the entire market uses it as a medium of exchange --- that is, as money.

In the book On the Origins of Money[@OriginsMoney], Carl Menger, founder of the Austrian school of economics, defined money simply as “the most saleable commodity” and therefore the most “marketable”. It is important to emphasise that although we have spoken of the invention of money, no one actually invents it --- it emerges naturally in a free market when all the individual participants try to solve the problems of barter through indirect exchange.

Money is not a product of the State but of the free market, of voluntary cooperation between people. An immediate consequence of this fact is that the State is not necessary for money to exist, contrary to what some people believe. In fact, the concept of money is far older than the concept of the State.

Money was a great step forward in the history of civilization and of > man’s economic progress. Money, as one of the elements of every > exchange, enables man to overcome all of the enormous limitations of > barter.¹

— Murray N. Rothbard

The primary function of money is, as we have seen, the medium of exchange, but it is not the only function. The other two essential functions of money are the store of value and the unit of account.

One could say that being a medium of exchange is the definition of money, but money must also be a good store of value. If we work more than we consume, we want to be able to use that surplus of work to obtain things in the future, so we need some way of storing the fruit of our labour. On social media one can find discussions about which function comes first --- the medium of exchange or the store of value. In my view, this discussion does not make much sense, since both must exist simultaneously. If something is a store of value but not a medium of exchange --- a house, for example --- it is clearly not money; it simply does not fit the definition of money as a medium of exchange. But something that does not maintain its value at least to some degree could not be used as a medium of exchange either. If its value evaporated rapidly, who would want to accept that supposed money as payment for their goods? One could also argue that the store of value function is simply the medium of exchange function with our future “self”.

The unit of account is the third function, and it follows from the other two. If the most widely traded thing is money, it makes sense for any producer of goods to price their good in units of whatever is considered money. In this way, in a society of n goods and services, we only need n prices. If we do not use money as the unit of account, then for each good we would need n-1 prices (the exchange rate against each of the other goods), and the total number of prices to be maintained in the economy would grow with the square of the number of goods. In an economy of just ten goods, the number of prices required would be 90, and for an economy of a hundred goods, 9900 --- which is completely unmanageable.

Properties of Money

Throughout history, many goods or commodities have been used as money: stones (the Rai stones on the island of Yap), animal skins (North America, Siberia), cowrie shells (Africa and parts of the Indian Ocean), exotic bird feathers (pre-Columbian America), livestock (on all five continents), almonds (Karnataka, India), maize (Guatemala), barley (Babylonians), coconuts (Nicobar Islands), cacao seeds (Aztecs), rice (Japan, the Philippines, and other parts of Southeast Asia), butter (Norway), salt (China, India, North Africa, and the entire Mediterranean), sugar (the Caribbean during the colonial period), tea (Mongolia), amber (ancient Prussia during the Middle Ages), tobacco (the colonies of Virginia and Maryland in present-day United States), copper, silver, gold, and other metals.

In principle, anything can be used as money, which leads us to ask: “once a society has agreed to use something as money, why change?” The answer is that although we can use anything as money, not everything performs the functions of money equally well. There are certain properties that are desirable for a good to function properly as money. Throughout history, humanity discovered that some things performed the function of money better than others. Let us look at the properties a commodity needs in order to function well as money.

::: description it is desirable that money be portable so we can carry it with us when we travel and trade wherever we happen to be.

it must be sufficiently divisible to adjust to the price of whatever we wish to buy, however small.

it must remain stable over time. If it corrodes, rots, or evaporates, it is poor money since it does not fulfil the store of value function well.

it is desirable that anyone can identify it for what it is and that we are not passed off a counterfeit. That no expert should be needed to confirm that what we are told we are receiving is actually what we are receiving.

in order to buy things of great value, we want money to be able to store a great deal of value in a small space. Something would not serve as money if the quantity needed to buy a kilogram of meat had a volume of ten cubic metres or weighed a hundred kilograms.

this is a key property. Every economic good is scarce, since without scarcity there is no need to economise. But in the case of money, scarcity is especially important. Air, sand, and grass cannot be used as money.

fungibility is the property by which every unit of a good is indistinguishable from any other and therefore worth the same. Taking the euro as an example, all ten-euro notes are worth ten euros --- some are not worth slightly more or slightly less than others. We will return to this property later, since in bitcoin individual coins can in fact be distinguished from one another. In bitcoin, fungibility is not intrinsic, as it depends on how they are used. Indeed, there are protocols external to bitcoin that are based precisely on differentiating one satoshi from another.

we do not want everyone to know that we have bought a given product or that it was Alice who sold it to us. Privacy is the ability to control what part of your personal information you reveal, when you reveal it, and to whom, and it is a basic fundamental right enshrined in the United Nations Universal Declaration of Human Rights.

ideal money must function as money without moral constraints. The only person who should decide whether to accept it or not is the person receiving the money. It is not desirable for a third party to have the ability to decide whether your money is valid based on how well you fit their model of a good citizen.

good money must be transferred voluntarily by its owner, without coercion or any form of violence. :::

This list is not exhaustive, but it gives us a general idea of what properties something needs in order to fulfil the three main functions of money well. Most of these properties are qualitative rather than quantitative, and no single good is superior to all others in every one of them --- not even bitcoin.

We have seen that money arises naturally as a mechanism for cooperation between people, that it is the foundation of civilisation, and that it needs a set of properties in order to function well. We also know that different goods have been used as money throughout history, but not all of them work equally well. Which one works best? After centuries of experimentation and evolution, humanity almost universally ended up selecting gold and silver as the best forms of money.

First, they were prized for their lustre and ornamental value. Second, being relatively scarce, they held great value per unit of weight, making them well suited for transporting value. They were also divisible, since they could be cut into smaller portions that retained their value proportionally. We can examine each of the properties listed above for gold and silver and find that both satisfy the characteristics of good money quite well. Wherever they were available, they were selected by different civilisations as money. Other metals such as copper also work well and have been used as money, but gold is far more resistant to oxidation than all of them, meaning it has superior durability.

This resistance to oxidation and corrosion --- in other words, its durability --- and its relative scarcity were the fundamental characteristics that led gold and silver to be used as money for centuries.

Scarcity is an essential property for a good to function as money. Imagine for a moment that both copper and silver are being used as money at a given time and have exactly the same valuation --- that is, one gram of copper is worth the same as one gram of silver. Since copper is far more abundant and easier to extract from the earth’s surface, if the demand for both copper and silver increases and both rise in value (appreciating relative to other goods and services), more resources will be devoted to extracting them from the earth’s crust, as happens with any good that appreciates in a free market. Since copper is found in far greater quantities and can be extracted with less effort, there will be a much larger new supply of copper, flooding the market and causing its value to fall. The increase in the supply of silver (newly extracted from the earth), on the other hand, will not be nearly as large as that of copper, and silver will therefore hold its value much better. We would end up in a new situation in which copper is far more abundant than silver and therefore loses value, while silver retains it.

For a time, gold and silver coexisted and complemented each other perfectly in the function of money. Gold, being scarcer than silver, always held greater value and was used in larger transactions, while being impractical for economically small ones. Silver, being more abundant, has always had less value per unit of weight, making it useful for smaller exchanges while being impractical for very large transactions. The monetary function of silver survived until the nineteenth century thanks to its greater saleability² at small scales, but when modern banking resolved this issue with banknotes, gold became the money of the world.

The property we refer to as scarcity is related to what economists call the elasticity of supply. The elasticity of supply of a good is the amount by which the supply of that good increases when its market price rises by one unit. If the elasticity of supply is very high, as it is for copper, then that good does not perform well as money, since a small increase in its value would lead to a large increase in its supply and it would therefore not preserve its value well over time. It is in fact inelasticity that makes a good a good store of value and therefore good money.

Another point worth noting regarding the use of a good as money is the following dynamic: the more a given good is used as money, the more its value increases, which in turn increases the incentive to use it as money. This positive feedback has the effect of a winner-take-all outcome. This fact, together with relative scarcity (inelasticity of supply), is the fundamental reason why, beyond its lustre, resistance to oxidation, durability, and divisibility, humanity globally selected gold as the best money.

But this does not mean gold is perfect as money. In fact, it has some drawbacks, or properties in which it is not especially strong: verifiability and resistance to theft. In the evolutionary process of money use, humanity solved both weaknesses --- verifiability through the minting of coins, and resistance to theft through the birth of deposit banking.

The Minting of Coins

The verifiability of gold and silver, as with any metal, is not very strong. If a customer wanted to pay a merchant with gold nuggets, how was the merchant to know whether the nuggets were real gold or some other golden-coloured metal? This was solved --- not just for gold but for metals in general --- with the invention of coin “minting”.

According to Herodotus, the Greek historian of the fifth century BC, the first coins were minted around the seventh century BC in Lydia (in present-day Turkey). They were coins made of electrum, a natural alloy of silver and gold, stamped with their weight and also the head of a lion, which served as a guarantee of their purity. With the minting of coins, the king eliminated one of the most costly tasks in commerce: the weighing and authentication of silver and gold at every transaction. After coins appeared, merchants simply had to count, which was far simpler than the process of weighing and assessing the metal they had to carry out until then. Today this may seem a minor matter, an insignificant invention, but the minting of coins was a very important milestone in history, as it gave rise to a great flourishing of trade that brought great prosperity to Lydia. So much so that Lydia became one of the wealthiest kingdoms of antiquity, and from that era comes the expression still used today: “as rich as Croesus”, in reference to the last of the kings of Lydia.

The minting of coins is an activity like any other --- that is, there is no reason why it must be carried out by the State. A silver coin of one gram of silver is worth more than a gram of silver in raw form because, in addition to being a gram of silver, it is more easily verifiable than a gram of silver in any other format. It therefore has greater utility as a medium of exchange --- that is, as money. Any person could set up a coin-making business, producing a good (the coin) of greater value than the raw material it consumes (the metal of which the coin is made). But although minting need not be the preserve of the State, the invention of this process certainly made it easy for the State, through simple pretexts and by force, to seize the business and even monopolise it, declaring all private minting illegal. And so it came to pass, sooner or later, everywhere.

The United States dollar was originally a silver coin. Nine years after the end of the War of Independence, the Coinage Act of 1792 established the dollar as the monetary unit and created the United States Mint, which held the exclusive privilege of minting all coins. In 1794, eighteen years after the Declaration of Independence, the first United States dollar coin was minted --- a coin of 412 milligrams of silver.

As a curiosity, the very word “dollar” also has its origin in another silver coin, a European one, far earlier, and originally minted privately. At the beginning of the sixteenth century, Hieronymus Schlick, a count of Bohemia, discovered a silver mine near his castle in the valley of Joachimsthal (in the present-day Czech Republic) and, instead of selling the silver directly, began minting coins with the silver he extracted from the mine. The coins were called Joachimsthalers, a name far too long that soon gave rise to the much more convenient thaler or taler. From that moment many mints sprang up in different regions, and by the end of the sixteenth century twelve million talers had been minted.

Coins solved an important problem --- the problem of verifiability --- at the cost of introducing the small inconvenience of having to trust the mint that struck them. This need for trust was small, since it was only necessary to trust that the minting was carried out correctly, nothing more. The silver coin of 412 milligrams did not “represent” a dollar --- it was not someone’s obligation to deliver a dollar --- it “was” a dollar. What may superficially appear to be a semantic subtlety of no great importance is actually something essential when thinking about money, about any form of money. It is very important to distinguish a real asset from a third party’s payment obligation³. Coins were originally real assets, not payment obligations of a third party. For this reason, the trust required to use coins was very different from --- and in any case less than --- what is needed for the banknotes that came later. Banknotes are a representation of the value printed on them, and one must trust that someone will honour their promise to redeem them for the quantity of gold or silver they represent.

With the invention of minting, a major problem was solved --- that of verifiability --- at the cost of introducing a minor one: the need for trust. Although that need for trust was relatively small, the initial cost would soon grow (in terms of freedom), since the invention of minting immediately led to the State’s seizure of coin issuance and therefore to the centralisation of money issuance.

Deposit Banking and Fiduciary Money

Probably your home is not the safest place in the world to store gold. Nor will you always be at home to defend it should someone attempt to steal it. It seems a good idea to have someone specialised in keeping it safe, offering that service to many customers: a gold bank. This “bank”, born to solve this problem, is in reality a kind of warehouse operator. It issues gold certificates that it hands to each customer who deposits their gold at the bank. It is a custody business that provides customers with several benefits: on one hand, better security, which is the purpose and reason for the business, and on the other, also improved portability. The receipts represent the same value and weigh far less than the corresponding metal. At first, the receipts are money substitutes, but they quickly become money themselves, since these receipts are used as a medium of exchange in the market. Although in the ancient civilisations of Mesopotamia, Egypt, Greece, and the Roman Empire there were institutions for the storage of money, modern deposit banking was born in Damascus in the thirteenth century and in Florence and Venice in the fourteenth century. The benefits of deposit banking were evident and immediate, but they also brought with them a “small” drawback, not so obvious: the need for trust.

This trust is not equivalent to what we saw in the case of coins --- that is, it is not simply a matter of trusting that the notes are well printed on good-quality paper. The notes did not “were” gold or silver --- they “represented” a certain quantity of gold or silver. This is not a minor change; it is a change in the very essence of the object used as money. It was necessary to trust that the issuer of the note would, in the future, fulfil its promise to deliver the gold or silver that the note represented whenever the bearer wished to redeem it for the metal. With deposit banking, a new type of money was born: fiduciary money. The word fiduciary has its origins in Latin and means “depending on credit or trust”, which perfectly captures its nature. The value of fiduciary money depends on how much we trust that the person making the promise (to deliver the corresponding commodity) will honour it. The appearance of banknotes therefore made the need for trust far greater than it had been in the case of coins.

This deposit banking is a completely different business from investment banking. The business of investment banking is based on channelling money from savers who wish to invest their savings into productive investments. Investment banking has existed since money itself existed, since it is nothing more than a private agreement between two parties whereby one party lends the other some of their property for a specified period of time, with the borrower undertaking to return it later in exchange for something. If you borrow your neighbour’s axe for a week because you want to chop logs to heat your house comfortably through the winter, and in exchange for the loan you give him a basket of apples, we would not consider your neighbour to be an investment banker. But if what you borrow is money, and what you give in exchange is also money (interest), then yes. Investment banking is simply the business of lending, in which the good being lent is money.

Investment banking, in addition to using the owners’ own savings, can also borrow savings from third parties. In this way it has more money to lend to its clients, and it earns money on the difference between the interest it pays to its lenders and the interest it charges its borrowers. In this business, savers lend their money to the investment bank --- they do not deposit it. It is crucial to understand this difference. By lending their money, the saver ceases to have access to it until it is returned, just as the owner of the axe ceased to have access to it for the duration of the loan to his neighbour, and naturally assumes the risk of non-payment implicit in any loan.

In The Mystery of Banking[@MisteryofBanking], Rothbard laments that we have used the same word --- the word bank --- for two businesses that are completely different: that of the warehouse operator and that of the lender.

Deposit banking began as a totally different institution from > investment or loan banking. Hence it is unfortunate that both have > been called by the same name.

— Murray Rothbard

Although the businesses of warehouse operator and lender are completely different, let us look at how, in addition to the unfortunate use of the same name, the warehouse operator became fraudulently entangled with the lender. Imagine that Alice has just sold her house and wants to temporarily store her furniture and other belongings in a warehouse while she waits to take possession of her new home. What would happen if the warehouse operator, eager to earn some extra money beyond his warehousing business, lent Alice’s table and chairs to third parties without her consent, for a couple of months, on the assumption that Alice would not come to claim her furniture during that time? In all likelihood, this fraud involving furniture would not be a good business for several reasons: first, furniture is not fungible, and second, it can deteriorate with use. A warehouse operator who did this would sooner or later be caught red-handed when someone came to claim their belongings earlier than expected. Of course the warehouse operator would be accused of embezzlement, since embezzlement is precisely that: the fraudulent appropriation for one’s own use of money or goods entrusted to one’s care.

A grain warehouse operator, for example, would have an easier time of it, since grain is fungible and if a customer comes to collect the tonne of grain they left in storage, the operator can hand over a tonne of grain even if it is not composed of exactly the same grains that were deposited. The depositor is satisfied as long as the warehouse operator delivers the same quantity of grains, provided they are of the same quality. The deposit of fungible goods is known as an irregular deposit, in which the depositary undertakes to return the “tantundem” --- a term originating in Roman law meaning “the same quantity of the same thing”. Given this peculiarity of irregular deposits, for a warehouse operator dealing in fungible goods, the risk of being caught in the embezzlement is far lower than for the warehouse operator dealing in non-fungible goods. And if the risk is much lower, the temptation is much greater.

For a money warehouse operator (a banker), the temptation is even greater than for a grain warehouse operator, since not only is money fungible and the deposit of money therefore an irregular deposit, but also, unlike grain, money is not consumed --- which means the tendency of depositors to reclaim their deposits is far lower than for grain. And there is yet another subtle difference in the case of money. A gold warehouse operator who wishes to begin this fraudulent practice of lending out what customers have entrusted to their care need not even lend the physical gold they hold in custody. Since the gold receipts they issue are used as money in the market, if they wish to make loans in this fraudulent manner, they do not even need to hand over a portion of the gold they are custodying --- it is sufficient to issue new receipts, new notes, which the borrower will use as money.

Fractional Reserve Banking

For a money warehouse operator, the temptation to embezzle is enormous, since it offers a path to enrichment at very low risk of being caught. Even a superficial analysis might lead one to think that no one is harmed as long as the borrowers repay what they owe --- but this is not true. By issuing new gold receipts, there are more receipts than gold to back them. And this is the essence of the fraud. The gold warehouse operator has achieved something as close as possible to the alchemist’s dream, since it is as though they had created gold by mixing ink and paper in the right proportions. The temptation for the gold warehouse operator is so great that, unlike warehouse operators of other goods, this fraud did occur --- and it occurred on a widespread scale. The ancient goldsmiths of the Middle Ages had already begun to issue gold deposit receipts in greater quantities than the gold reserves they actually held --- that is, they had begun the practice we know today as fractional reserve banking.

The fraudulent behaviour of lending what they do not have is what banks do today. They create new “fake” money out of nothing, which they use to lend and earn interest on. In this way there are always more receipts issued than there are holdings in the vault --- or, put another way: there are two receipts in the market to be redeemed for the same thing. The only limit the law places on this inherently fraudulent practice is the requirement to maintain a minimum level of reserves sufficient to meet a certain minimum ratio between reserves and deposits in order to handle potential withdrawal requests. The fraction or percentage of reserves relative to total deposits is known as the reserve ratio.

You may be wondering why this fraud was not prosecuted, given that it is a fraud. In the nineteenth century there were several court cases on this subject in England, and unfortunately, as a result of them, this embezzlement was declared legal when several judges ruled that deposits were not deposits at all but loans to the bank.

Money paid into a bank becomes the property of the bank immediately, > and the bank is merely a debtor for the amount.⁴

— Judge William Grant

This sentence captures the essence of the fraud. The furniture a customer deposits with a warehousing company does not appear on that company’s balance sheet. The warehousing company has warehouses as assets, but not the items stored in them, since those items are not theirs --- they belong to their customers. In contrast to what happens with a warehousing company, today, when a customer deposits a certain amount of money in a bank, that amount does appear on the bank’s balance sheet. On the one hand, the bank’s assets increase by the amount deposited (meaning the bank is now the new owner of that amount), and at the same time, its liabilities also increase by the same amount.

Money placed in the custody of a banker is, to all intents and > purposes, the money of the banker, to do with it as he pleases; he is > not guilty of any breach of trust in employing it; he is not > answerable to the principal if he puts it into jeopardy, if he engages > in a hazardous speculation; he is not bound to keep it or treat it as > the property of his principal.⁵

— Judge Lord Cottenham

An even clearer ruling than the previous one, in case any doubt remained. From that point on, if a banker “does as he pleases” with depositors’ money and then cannot meet his contractual obligations, he is merely an insolvent person who cannot pay his debts --- not a fraudster. This different legal treatment has profound implications, of course, implications that determined the future of banking and of humanity.

Let us then ask: are bank deposits loans today? After all, the words deposit and loan mean two very different things, so one might think it must be one or the other. Strangely, we have managed to make them neither one nor the other, but some nonsensical hybrid in between. If you want to withdraw the money you have deposited, you can do so at any time --- which is characteristic of a deposit, not a loan. Moreover, the State considers you the owner of that money, especially when it comes to paying taxes. But at the same time, the bank does with it as it pleases, it merely owes you a debt, and in fact the deposited money is part of the bank’s assets on its balance sheet, which in turn carries a liability on the other side --- clearly indicating that it is a loan. In legal terms the money is yours, and it is also the bank’s, but not in any sense of co-ownership at fifty percent --- the entirety is yours and the entirety is also the bank’s at the same time. The Schrödinger’s cat of the current banking system.

The consequence of this error --- the practice of lending money that does not exist --- persists to this day, and curiously nobody seems to find it strange. Commercial banks are licensed to create money out of nothing. This is taught in every university degree in economics, business, business administration, and so on. But although textbooks mention that money is created out of nothing, they do not explain that this is a fraud that ought to be stopped --- they simply describe it with a new name, as though it were an invention or a brilliant idea: the fractional reserve banking system.

It is well enough that people of the nation do not understand our > banking and monetary system, for if they did, I believe there would be > a revolution before tomorrow morning.⁶

— Henry Ford

Some people think that “money works differently” from any other good and that this can be done with money even though it cannot be done with other things. But this is not some mysterious intrinsic property of money. Consider what would happen if instead of a bank, it were your brother who lent you money. If your brother lent you 1000 euros, for example, the loan would work in exactly the same way as if he lent you his car. Lending 1000 euros implies two things: first, that he has them; and second, that when he lends them to you, he no longer has access to them until you return them. Exactly the same as if he lent you his car. It is not that money works in some mysterious way, different from any other good. It is simply that embezzlement with money is far easier to carry out and therefore the temptation to do so is far greater. Worse still, it was declared legal and is today part of the privilege of commercial banks --- a kind of “licence to embezzle”.

Due to the ever-present human temptation to embezzle and to that conceptual error made by the English judges, today’s commercial banks do not need money to exist before lending it. Commercial banks lend money that did not exist a second before they lent it. It is created at the moment of the loan, since it is the very act of creating the loan that creates the money. When Alice “deposits” 1000 euros in a bank and the bank immediately lends them to Bob, the result is that 2000 euros now exist: the 1000 that still appear in Alice’s account and the 1000 that appear in Bob’s. This is why the expression “money is debt” is not a metaphor in the style of “time is gold” --- in the current fractional reserve system it is true in the literal sense of the word. The process of money creation and the process of credit expansion are not equivalent processes --- they are the same process.

The very moment a bank lends us one hundred thousand euros, the global money supply has just increased by one hundred thousand euros. There are one hundred thousand more euros circulating in the economy at this precise moment. Total debt has also increased by one hundred thousand euros, but we will have to repay more than one hundred thousand euros, because the loan carries interest. This process cannot end well, obviously, because since debt must always be repaid with interest, the total volume of debt grows faster than the money available to repay it. And it never ends well. The expansion of credit beyond saved capital --- that is, the expansion of the money supply under the fractional reserve banking system, in which money is created out of nothing --- is the root cause of the “mysterious” economic cycles.

In periods of monetary expansion --- that is, of low interest rates --- entrepreneurs launch many projects, since there are many projects that appear profitable. If interest rates are, say, 1%, a project yielding 5% looks attractive, whereas if interest rates were at 5%, that same project would not look attractive and would not be launched. During these periods of artificially low interest rates, commercial banks lend large sums of money which, due to fractional reserve banking, means a large increase in the money supply --- a great deal of new money is created.

For simplicity, suppose that in a given period of expansionary policy an additional 10% of money is created. This newly created money causes an increase in demand for all other goods. This additional 10% of money competes in the market for the entire pool of physical resources. But physical resources have not magically increased with the creation of new money out of nothing, so this greater demand for resources, faced with the same supply of resources, pushes prices upward. Although in reality the price rise is not equal for all goods, nor does it occur simultaneously, for clarity let us assume that all prices rise by 10%. Companies that had launched projects with a 5% return start to see those projects turn to negative returns. The project that had a cost of 100 and was intended to be sold for 105 now costs 110. Companies that cannot adjust their selling price now face a project with a negative return of 5% and must decide whether to abandon the project halfway through to stop losing money --- resulting in capital destruction --- or to try to complete it even at a loss. Both options entail significant losses for the company, which in some cases may drive it to bankruptcy. And this does not only affect companies that had launched low-return projects. Other companies with ongoing projects at better returns --- say 15% --- but which had relied in their production process on goods from companies now forced to close, find themselves having to change suppliers and pay more for their inputs, possibly even more than the general 10% price increase, due to the scarcity of products caused by the initial bankruptcies. Companies with returns even above the general 10% price increase may also slip into losses, triggering a chain reaction in a spiral of capital and output destruction.

The expansion of the money supply distorts the production structure of the free market and generates unsustainable investments. This is the root cause of economic cycles --- the reason why a period of credit expansion and apparent prosperity is followed by one of contraction, bankruptcies, and recession. The mysterious economic cycles are a consequence, not a cause, of the manipulation of the money supply. Governments make us believe that our hens are dying despite having hired a fox to guard the henhouse. Worse still, they even make us believe that the solution will be to hire more foxes so they can keep a better watch over the henhouse. The enormous destruction of capital and the inequality produced by these economic cycles are consequences of having normalised and declared legal something that is in essence a fraud: fractional reserve banking.

The Central Bank

One problem inherent to the fraudulent practice of fractional reserves is that a bank can never meet the withdrawal of all its customers’ deposits. In contrast, any traditional warehouse operator is perfectly capable of returning their deposits to all customers who request them, even if all do so on the same day. The warehouse could be left with an empty premises for a day or a week. Having its customers take their belongings does not bring it to instant bankruptcy. Even if it ultimately went under for lack of new customers, the customers who had belongings in storage would have already recovered them. But banks do not work this way. All banks would be insolvent in the face of a request for withdrawal of all their customers’ deposits. Not just some poorly managed banks --- all of them. This is the reason for the fragility of the current banking system.

In a fractional reserve banking system, it is extremely dangerous for a bank to face liquidity problems at any given moment, since if word of this were to reach depositors, the most distrustful would begin to withdraw their money as a precaution, which would further worsen the bank’s liquidity problems. This worsening would in turn lead other customers who were not initially very concerned to begin worrying and eventually withdraw their money as well, worsening the bank’s liquidity still further --- and so on, causing an avalanche effect that would end in the bank’s bankruptcy. Worse still, the failure of one bank can also alarm the customers of other banks, who may begin the withdrawal process, thus lighting the fuse at another bank. And since none of them can meet the withdrawal of all deposits, the fragility of the entire system is enormous.

To prevent commercial bank collapses, the function of lender of last resort was created, a role performed by central banks. The central bank can lend to commercial banks in the event of liquidity problems, thereby considerably reducing the risk of bank runs and the subsequent bankruptcy of commercial bank customers. At first glance, one might think the central bank is a great idea, since it solves the serious problem of bank panics. Of course, the central bank brings new problems, though they are not obvious and do not manifest immediately. The reality hidden beneath that superficial analysis is that it is simply a patch to conceal the fraud --- and, worse, to potentially make it larger. Since a commercial bank earns more the more it lends, and since the only limit on its lending is the risk of a bank run, the appearance of the central bank gives commercial banks the dangerous incentive to take on ever greater risks.

Power tends to corrupt and absolute power corrupts absolutely.⁷

— Lord Acton

Central banks give more power to those who already have power. And, as a song by the Mexican band Molotov goes, “if you give more power to power, they will come down harder on you”⁸. History is replete with episodes demonstrating that the concentration of power brings catastrophic consequences for humanity. We should be more aware of this instead of so readily and unreflectively accepting every idea that proposes to solve a problem by further concentrating power in the State.

To summarise this first chapter, one could conclude that the creation of deposit banking and subsequently the creation of central banks introduced new problems --- long-term problems that were not obvious at the time. Due to the ever-present human temptation to embezzle, deposit banking, which is not inherently bad, gave rise to fractional reserve banking, which is indeed pernicious since it is based on a fraud. Fractional reserve banking, in turn, gave rise to the central bank, a system in which the creation of money out of nothing carried even less risk. Had we stopped there --- even with fractional reserve banking and central banks in place --- if paper money had remained a representation of a certain quantity of gold, there would still have been a limit to inflationary monetary expansion, to fraud, and to theft. But both steps ultimately led to the creation of the fiat system, in which the remaining limits on fraud and theft were eliminated entirely.