9/3/11

Gold has left an indelible mark on almost every facet of mankind’s history, including our banking and financial systems.

The first bankers were actually goldsmiths, who charged a fee for storing other people’s gold. These goldsmiths issued paper receipts to people for their gold, and the idea of paper currency began to spread. Soon the bankers began issuing more paper money than they could back in gold, and giving the excess money to the royal family or government.

This historical anecdote is one that should resonate with and concern every investor, because it holds true to this day. At their core, one of the purposes of every bank is to help people who are in positions of authority maintain that power.

Lest anybody think otherwise, one of the main functions of central banks has always been to help the government control its money. In fact, the express purpose of the first major central bank, the Bank of England, was to loan the King of England enough money to finance his latest war.

At the time, central banks had two main purposes. Besides loaning money to the king or royal family, these banks also bailed out private banks that were overextended. The Bank of England bailed out the English aristocracy at the turn of the eighteenth century after they were caught loaning out more money than they could back in gold.

In 1844, the course of banking (and the economy at large) changed forever when the English government passed the Peel’s Bank Act, a law that ended the debate between two different schools of thought over how to issue paper money. The Banking School and the Currency School disagreed on whether banks should be allowed to issue more paper money than they could back in gold. The Banking School held that it was important to have a fluid currency that could be adjusted to meet the present needs of the currency. The Currency School, however, argued vehemently against this idea and insisted that the creation of paper money needed to be regulated.

The Currency School won the debate, although they neglected to make a provision against the issuance of checks as a form of paper money. To this day, central and private banks have exploited this oversight for their own personal gains.

The point of this article is not to lambast central banks and governments as crooked or untrustworthy. That could not be farther from the truth. Rather, the intent of this article is to point out the historical trend of paper money being coopted to help those in positions of power.

While banks (and the fiat currencies they issue) may seem like ironclad places to store wealth, the reality is that storing all of your wealth in paper money is a risky proposition. There is a history of fiat currencies failing that all investors should be aware of.