By Dr Frank Shostak
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Originally, paper money was not regarded as money but merely as a
representation of gold. Various paper certificates represented claims on gold
stored with the banks. Holders of paper certificates could convert them into
gold whenever they deemed necessary. Because people found it more convenient to
use paper certificates to exchange for goods and services, these certificates
came to be regarded as money.
Paper certificates that are accepted as the medium of exchange open the scope
for fraudulent practice. Banks could now be tempted to boost their profits by
lending certificates that were not covered by gold. In a free-market economy, a
bank that over-issues paper certificates will quickly find out that the exchange
value of its certificates in terms of goods and services will fall. To protect
their purchasing power, holders of the over-issued certificates naturally
attempt to convert them back to gold. If all of them were to demand gold back at
the same time, this would bankrupt the bank. In a free market then, the threat
of bankruptcy would restrain banks from issuing paper certificates unbacked by
gold.
