Difficult to summarize the question in just a few words, so let me elaborate here. I am currently reading the Financial Times Guide to Banking by Glen Arnold, section Money creation, and there is something I cannot wrap my head around. The section of the book is explaining how goldsmiths were effectively acting as primitive banks in storing gold deposits once upon a time, and giving paper money in return:

The borrowers of the money from goldsmiths were usually content to take a piece of paper - call it a bank note - instead of taking coins out of the bank. They could then use that as currency to buy things. The goldsmiths could just create these pieces of paper off their own bat. Thus, a goldsmith bank might have a total of, say, £1,000 deposited, but hand out £500 of the coin as loans and issue another £5,000 or £6,000 or new paper money to borrowers.


[...] if you are working off a deposit base of £1,000 and you lend £4,000, and then 30% of your borrowers are unable to pay, you are bankrupt.

Why would you be bankrupt? If you are creating money that does not exist (in this case, money that you don't physically have since it is not backed up by actual gold), and someone does not pay you back, what would you be losing exactly, since you did not spend anything in the first place?

Assuming that you have £1,000, that you lend out £4,000, and that 30% of this (£1,200) is lost, would you not still get back the other £2,800 from the other loans, thus making you richer anyway?

1 Answer 1


A bank note given out by a goldsmith in that time was not just fiat money. It was actually a voucher which came with the guarantee that if it was given back to the goldsmith, that goldsmith would be obligated to give that amount of gold to the current owner of the bank note. That's why people considered those bank notes as if they were gold. Because they were assured that as long as they owned the bank note, they could exchange it back for gold at the goldsmith.

However, that would become a problem if a lot of people had that idea at once, went to the goldsmith, and they didn't have that much gold available. Now the goldsmith was indebted to all those people with bank notes.

Now to get back to the example the question is talking about.

In that case the goldsmith did not receive gold in exchange for those bank notes, they merely lent the bank notes in exchange for the debtor being indebted to them. The debtor was now obligated to either pay back in gold or in bank notes.

But then the debtor lost those bank notes and does not have gold either. So they can't pay back. At first, this seems like a zero sum game for the goldsmith. They gave out banknotes not backed by anything and they won't get any of the gold or notes they expected. But don't forget that those bank notes are not gone! They are now in circulation, owned by someone else. That someone else now has the right to go to the goldsmith and demand their gold. "But those were just a loan" isn't an answer the new owner of those bank notes has to accept.

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    "But don't forget that those bank notes are not gone! They are now in circulation, owned by someone else. That someone else now has the right to go to the goldsmith and demand their gold." I think this is the part I was missing: I mistakenly assumed that the obligation to pay would be the debtor's, rather than the goldsmith's (in your example, the someone else should have ultimately demanded the money from the debtor, not from the goldsmith). May 12, 2021 at 9:23
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    @user1301428 The insolvent debtor of the goldsmith does not necessarily have creditors. It is very well possible (in fact likely) that they lost all that money through bad business decisions.
    – Philipp
    May 12, 2021 at 9:55
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    This is why it's important to understand that a run on a bank can't bankrupt a bank. It can, however, reveal that the bank was already bankrupt -- typically due to making too many loans that are not repaid. May 12, 2021 at 21:00
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    British money still carries the inscription "I promise to pay the bearer on demand the sum of five/ten/twenty/fifty pounds". May 13, 2021 at 9:12
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    @DavidSchwartz That isn't right; a bank can easily have more bank notes outstanding than it currently has in reserves. Given time, it can call in its loans in order to pay off its obligations (circulating banknotes it issued). Banking converts a long-repayment obligation (the loans it makes) into short-repayment obligations (banknotes) based off the statistical defence of "nobody is going to come in with every banknote at once". A run is when that fails. Banks can defend with a delay and being able to borrow from other banks, except when a credit crunch makes that impossible, then boom.
    – Yakk
    May 13, 2021 at 13:57

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