How bankers rule the world

We look at the four hundred-year journey of the banks to today's banking crisis.

How banking works is not a new subject, but it's surprisingly poorly known by the general public. I'm going to explain how it's all developed using Larry Hannigan's excellent parable as a model.

1. Goldsmiths have their first big idea

Goldsmiths –  early bankers – create coins and release them into the system by loaning them out and charging interest. The replacement of barter with money has begun, as has the dominance of banks in our societies.

2. Problems emerge

As time goes by, the best craftspeople and businessmen have more money than they started with, and are able to pay off their debts. However, as there is just a fixed amount of money, it meant that others don't have enough. If there are 100 gold coins but 105 are owed because of the interest, it's impossible for the whole country to get out of debt.

3. Goldsmiths expand their services

Yet the people need somewhere to store all their gold safely, so they ask the goldsmiths to keep it in their vaults. The goldsmiths are happy to oblige and to write receipts for the deposits, in return for a storage fee.

4. The first bank notes were an accident

Rather than collecting their money from the banks every time they want to pay for something, people start giving their gold receipts to merchants, which are taken in good faith, because the goldsmiths by now have a high social standing, as they provide valuable services.

5. Goldsmiths have their second big idea

With receipts being passed around as paper currency, most people stop dropping by for their gold altogether. The goldsmiths realise that they can lend out the money they're storing in their vaults, even though it isn't theirs.

6. Goldsmiths back bank notes further

But rather than lending out the gold again, the goldsmiths persuade new borrowers to take more receipts instead of gold, because they're so much easier to carry. This way the gold reserves are not depleted and they can create even more notes to lend to other people based on the same gold in the vaults.

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7. How money is created

Now the bankers agree to start paying interest to attract more deposits. The people are pleased, thinking that the wise and respectable goldsmiths are merely lending out that money. In reality, the bankers are lending out the same gold many times over by writing notes to new borrowers instead of giving them the physical gold. They know that only a small number of people come to collect physical gold, because everyone uses paper.

Hence, they take in 100 gold coins, paying three gold coins – or 3% – in interest to the depositor. To borrowers they lend out ten times as much by creating paper money, instead of giving them gold. They have now lent out 1000 gold coins-worth of paper money for each 100 gold coins in their vaults, and at an interest rate of 5% - which is 50 gold coins. Hence, 100 gold coins in the vaults gives them 50 gold coins in interest, minus three to the depositor and that's 47 gold coins or 47%.

Yet if everyone was to ask for their money at once, the fraud would be exposed.

8. Goldsmiths have their final big idea

In a master stroke, the goldsmiths convince government's that they should legitimise bank notes to reduce counterfeiting by printing and signing them officially. It's now seen to be governments who are creating all the money, making the goldsmiths seem like the servants, not masters.

Read the full parable

There are a lot of quotes from politicians, economists, bankers and other thinkers stretching back to the 1800s that nicely sum up the power that our money system gives to banks. Here's a great page of quotes. One of them is from Reginald McKenna, chairman of Midland Bank in the 1920s:

“I am afraid that ordinary citizens will not like to be told that the banks can and do create money. And they who control the credit of the nation direct the policy of Governments and hold in the hollow of their hand the destiny of the people.”

I urge you to read Larry Hannigan's full parable, written in 1971 but still relevant today, on what he sees as a catastrophe waiting to happen. It might be that he'd argue the US sub-prime collapse in 2007 was the beginning of this very disaster. He would surely say that the evidence for the banks' dominance is right before us, as we have been forced to bail them out for their bad behaviour – just so they can do it all over again.

Although Hannigan published his story in the year that we removed all pretences of a 'gold standard' – where the value of money is tied to the value of gold – it was decades earlier that bankers had established the money system I've been writing about today, which we call fractional-reserve banking. It's how banks create most of our money (the Bank of England the rest) and it's why our national and personal debt to banks grows and grows. It's why we have inflation, ever-rising taxes, and Hannigan, might argue, it's why we still have such things as strikes and poverty in rich countries in the 21st century.

It's interesting that there were no major banking crises between the 1930s and 1980s, and during this time banks were much more tightly regulated, which shows that we could make the system work a little better, even if the banks will continue to rule the world.

For the purposes of balance, you could also read the positive case for the fractional-reserve system. read this partial view – which is cunningly disguised as a criticism of the system, and so quite possibly written by a modern goldsmith.

Fight back against the bankers

• Earning some savings interest is better than nothing. If you can't change the system, do the best you can and earn more interest on your savings.
• Reduce your indebtidness to our rulers! Take up the goal to pay off your credit-card debt.
• Tell us what you think of the bankers and the banking system using the comments box below

More: Free online banking tool