Steps on the Way to Fiat Money (1) — Goldsmiths, the Early Bankers

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Picture a world in which gold is money. There is no paper money or any other kind of money other than gold. Security is an issue. The state acts as a secure depository of your gold, but one day it confiscates all the gold that you have left with it for safekeeping. You look for alternatives and discover that goldsmiths have adequate means of protecting large stocks of precious metals. You leave your gold with goldsmiths. You are happy with the service and so are increasing numbers of other clients.

Before long, the goldsmiths discover that people find exchanging receipts (documenting their ownership of the deposited gold) more convenient than collecting physical gold from the goldsmith and exchanging it for payment. the receipts serves as money in lieu of gold, being, of course, fully backed by gold which can be retrieved from the vaults of the goldsmiths whenever needed. 

This gives rise to a new business proposition. The goldsmiths start lending out some of the gold of that they supposedly hold in safekeeping for their clients. They charge interest on the gold loan, earning more than from safekeeping fees. They have become bankers, making profits from extending loans. In fact, in good time they will actually offer interest on gold deposits to attract more species to lend it out at a higher rate. Like a modern banker their business model is based on net interest income in excess of other expenses, notably interest paid to (gold) depositors.

If the amount of gold (not lent out and) left in the vault of the goldsmith is not sufficient to give it back to depositors when they demand redemption, the banker-goldsmith goes bankrupt. Prudent goldsmiths keep a reasonable reserve of gold in their vaults, which, of course, limits the expansion of their gold loan business. 

At this stage, the goldsmith does not lend out more gold than the amount of it available from his depositor clients. If the demand for gold (loans) exceeds the deposits held in safekeeping with the goldsmith, the latter must turn down business.

The volume of gold deposited with goldsmiths could only increase if people were saving more of it or if additional gold was flowing in from abroad.

Again, goldsmiths are lending out what they have received from their depositors. They are not yet creating gold (money). They are still intermediaries passing a part of a fixed stock of deposits from savers to debtors.

This changes when goldsmiths no longer offer loans that are backed by the gold deposited with them but  issue notes (really paper money) representing claims on gold exceeding the amount of gold deposited with the issuer.

By issuing this type of paper money, goldsmiths have entered the era of fiat money, creating new money from nothing, and increasing the money supply endogenously (in the absence of new discoveries or influx of gold from abroad).

The invention of fiat money by goldsmiths in the 17th century represents an outstanding advancement for humanity. It marks the financial revolution that preceded and made possible the industrial revolution. For the first time in human history is the process of investing uncoupled from the need to reduce consumption/demand in order to divert savings toward investments. It had become possible to make investments in excess of savings (thereby enhancing savings ultimately). People had found a way to afford investments as if they were richer than they really are, only to become genuinely richer than they used to be prior to injecting fiat money into the economy.