Question

Explain why merchants accepted gold receipts as a means of payment even though the receipts were issued by goldsmiths, not the government. What risk did goldsmiths introduce into the payments system by issuing loans in the form of gold receipts?

Short answer

Merchants accepted gold receipts as payment for its safety and convenience aspect.

The gold receipts payment system introduced the risk of default.

Step-by-step solution

Meaning of  gold receipts

Gold receipts, also known as Goldsmith’s receipts, are receipts received by the depositor when they deposit gold with the goldsmiths. For example, gold worth $1000 is invested with the goldsmith. The goldsmith would issue a gold receipt worth the same amount, and the depositor promises to repay $1100 worth of gold receipts in one year at 10% interest rate.

Reasons why gold receipts were accepted as a means of payment

Before the sixteenth century, traders used gold as a medium for transactions. Early traders had to carry, weigh, and assay gold whenever a transaction had to take place. Later they realized that it was neither a safe nor a convenient practice.

During the sixteenth century, traders started depositing their gold with the goldsmiths. The goldsmiths fully backed the circulating receipts with the reserve gold in their vaults. i.e., a 100 percent reserve system was introduced. Also, loans in the form of gold receipts were accepted as a medium of exchange by the borrowers.

Thus, gold receipts provided a safe and convenient way to make transactions.

Risk of issuing loans in the form of gold receipts 

Through interest-earning loans, goldsmiths issued receipts in excess of the amount of gold held by them. In this case, their reserve was only a fraction of the outstanding receipts. For example, if 2 trillion $ worth of gold was in the vaults, 4 trillion $ worth of receipts were issued. In this case, gold reserves are only half of the outstanding receipts.

In such a case, if a situation arises when all depositors demand gold simultaneously, the goldsmith would not have been able to convert all paper currency into gold. This default risk was associated with issuing loans in the form of gold receipts.