This week’s learning is part 2 of a 12 part series on The Ascent of Money by Niall Ferguson. (Part 1)
When money was first conceptualized, it was tied to silver and gold. But, there is very limited silver and gold and that meant demand always exceeded supply. Big leaps were made when the first banks were formed to make money lending legitimate (versus leaving people at the mercy of money lenders – Think Shylock).
It was in London, Amsterdam, and Stockholm that financial innovation began taking place with the formation of a central bank and the beginnings of banks lending depositor’s money. To illustrate the power of this, let’s imagine the central bank gives bank A $100.
– Bank A keeps $9 and lends $91 to Bank B
– Bank B then keeps $9 and lends $82 to Bank C
If you pause here, you realize that while the real money from the central bank is $100, the money in circulation is $373. This works well until the central bank wants all of its money back, of course. That means bank A needs to reliably recall money to bank B and so on.
In this case, the central bank is Bank A’s only depositor. When all/most of the depositors of a bank want their money back, it is called a “run.” Thus, the dangers of having one depositor is obvious – hence, banks need to “diversify.” And, to make sure banks don’t “default,” they need to make sure their “leverage,” or ability to call back money when depositors want it, is strong. If they do not watch their leverage (like in this example), it would result in a “bankruptcy” – literally the rupture of a bank.
Sketch by EB
This financial innovation has been critical in the progress of society. Debit and credit are the foundation of economic growth and the development of the world. The world would not have been better without money, contrary to popular belief. Credit is what enables us to ‘move up’ in financial terms and is the first building block.
Next week, we will explore the bond markets – the next building block..