Crypto series 2 — the Evolution of Paper Money & Central Bank

Last time, we understood what is money and the quality of money. This time, let’s have a look at how paper money and central bank were invented. Oh no, history again? Yes! If we want to know the value of cryptocurrency and the logic behind it, we definitely need to deep dive into the history and understand what’s wrong with the modern financial system.

Invention of Paper Money

In the past, people use commodity good as money to trade with each other because they are easy to access and they are necessities for human beings. Sounds reasonable! However, people just find out the commodity goods such as coffee beans or rice are too difficult to keep, so people tend to use collectible as money. Although collectibles don’t decay easily and people can keep them easily, they also have shortcomings including they are not fungible and there’s no controllable supply.

Then, people turn into using metal money as money and each countries issue their gold coin or silver coin. Metal money is such a good money and fit in the following properties we mentioned last time: durability, scarcity, fungibility and generally-accepted, but they are heavy and it is too hard to carry around.

Besides, if you own lots of gold or silver at home, you need to hire someone to protect your money from being stolen by others. More and more people realize they need to hire people to do so, so they just ask someone to protect their own properties collectively. With the scale going up, the concept of bank is formed.

When you deposit the gold coin or silver coin in the bank, they will give you a bank note as a proof for how much money you saved in there. With more and more people accepting and recognizing the concept, banknote is gradually transformed to new kind of money that represent how much money you can withdraw from bank so people can use it for trading. (Here, I just want to remind a very important thing: the original paper money is definitely backed by the precious metal.)

Panic and problem

Now we know each bank is able to issue their own banknote, but actually it’s not a good idea. Let’s take a look at the real situation.

Usually, bank will receive the deposits from depositors and make loans to its customers with higher interest rate. That’s how banks make money. But actually, bank can’t lend all of money they have on hands and needs to keep at least 10% (reserve ratio) of the deposits in case some depositors would like to withdraw money. That is so-called fractional reserve banking system.

Imagined you were a bank owner, you definitely would lend 90% of your money to maximize the profit and it’s no big deal when the economy is stable and prosperous. However, once the economy turns into a recession, people are all in panic and tends not to trust that bank being able to pay their money back. So all of the depositors flock in front of bank and eager to withdraw their money. If bank is unable to collect money in short period of time, it will make them likely to go bankruptcy and the banknote the bank issued become useless.

The existence of Central Bank

In the mid of 19th century, British government announced the Charter Bank of Act 1884 and it centralized the process of issuing money (banknote). This Act only gave exclusive power of issuing banknotes to the “Central Bank” of England.

In the contrary, US is a totally different story. USA hadn’t had a central bank for a long period of time because some founding fathers in the States were not fond of the idea of Central Bank. And USA experienced different panic of severity and the economy hadn’t been really stable in that time. In order to deal with the instability of economy, USA gov passed the Federal Reserve Act in 1913 which means USA finally had an official central bank.

Central Bank’s main responsibility is money-creator of last resort whenever there is a downward spiral in the economy. If banks lend most of deposits to its consumers and can’t pay the money back in short period of time, Central bank can provide financial support to bank and help it pass the temporary difficulty.

In the following articles, I’ll explain what is gold standard and fiat money. These are super important concept and have something to do with the reason why we need to own cryptocurrency. Stay tuned!

Reference:
Preeethi Kasireddy
Wikipedia
Bankless

Keep reading:
Crypto series 1 — Have you ever thought what is money?
Crypto series 2 — the Evolution of Paper Money & Central Bank
Crypto series 3 — what is gold standard?
Crypto Series 4 — Fiat Money comes into existence!