Because gold is durable and highly malleable, it can be hammered into almost any shape and precisely divided into any size or unit of weight. Since it can be stamped into coins of a precise weight, the values of all other goods could, in the early days of gold coinage, be measured in terms of units of gold. Eventually gold became the absolute standard of value.
Although gold is very dense, its high value compared with its weight and bulk increased the risk of its being stolen. Nevertheless, by the 16th century and even much later, some gold-holding citizens kept their fortunes of gold in their own houses. But most people eventually became accustomed to leaving their gold for safekeeping in the goldsmiths’ vaults, where it was well protected. The goldsmiths would issue a receipt for the gold received.
Before long, gold-holding citizens realized it was much easier, when it came time to make a purchase or pay a debt, to simply issue an order to the goldsmith to pay over the gold to whomever they owed, rather than to transfer the gold itself. The recipient of the order, again, might find it easier to leave the gold he was to receive at the goldsmith’s and in turn issue orders to the goldsmith to pay specific amounts of gold to still a third person. Thus, all these monetary transactions took place without the actual gold leaving the goldsmith’s vault. This was the origin of bank notes and checks.
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As this new paper money began to circulate on its own, goldsmiths discovered they could issue paper promises that exceeded the value of the gold in their vaults. Since this made the medium of exchange more abundant, trade flourished as the amount of money increased to meet its needs. When paper money became too abundant and exceeded the goods available in the market, it was withdrawn from circulation and exchanged for gold; when paper money became too scarce, gold was returned to the banks and exchanged for its paper representative.
The goldsmiths were gambling that everyone would not demand their gold at once. This was a good risk, and in nearly every country, these new banks went on expanding their credit until the amount of bank note and demand deposit liabilities, that is, the amount of paper money, was several times the amount of gold held in the banks’ vaults.
For centuries this alternating appearance (when paper money was cashed in) and disappearance (when gold was exchanged for paper money) of gold was the only stabilizing factor in a radically fluctuating market. Paper notes were issued freely by goldsmiths, moneychangers, merchants and bankers. No government could control the system; gold was the only stabilizing influence on the market. As the international monetary system became more complex, more and more governments used this traditional method of balancing and stabilizing international trade and backing up domestic currency with gold.
Gold stands firm
From these origins came the gold standard. First adopted by Great Britain in 1821, it was the system under which governments issued paper money that was backed by and exchangeable for gold. The amount of money circulating in a country depended upon the amount of gold it had.
The gold standard had several advantages. Since governments couldn’t legally increase the money supply without obtaining more gold, citizens were theoretically protected from politically attractive, printing-press inflation. The threat that people would demand gold for their paper tended to act as a damper on politicians.