All Commentary
Monday, September 1, 1975

The Gold Standard and Fractional-Reserve Banking

Joe Cobb is Chief Budget and Fiscal Officer of the Industrial Commission of Illinois. He has written a number of articles on economic matters since graduation from the University of Chicago in 1966. This article is reprinted by permission from The Gold Newsletter, Vol. IV, No. 6, 1524 Hillary Street, New Orleans, Louisiana 70118.

There is little doubt that a gold-oriented monetary system is superior to a fiat monetary system, from the perspective of the average citizen and businessman. Monetary systems which are managed by central banks or governments, as opposed to systems which arise in the market and are self-equilibrating, are prone to inflation and repudiation. The arguments against “managed” currency are clearly set forth in the Theory of Money and Credit by Ludwig von Mises, and it is not our purpose to argue against the gold standard.

The argument of this essay is that the U.S. Dollar should not be “backed” by gold or “tied” to gold or otherwise officially connected to gold in any way. The free economy must have a metallic monetary standard (and gold is probably the best metal for that purpose), but the people who support an Act of Congress which pegs the price of gold in terms of dollars, or which defines the dollar in terms of gold, are making a big mistake. Like Oedipus, they are putting out their eyes and surrendering their monetary assets to the secret management of the U.S. Treasury without the ability to detect mismanagement. The assumption that a gold dollar is not a “managed” currency is an illusion. While it may be true that the quantity of money may be determined by the stock of gold in the nation at any point in time, the total volume of credit — including Federal credit, local government debt, and bank credit — is subject to control and management.

The problem arises because the unit of money (let us call it “one dollar” in gold) has the same name and is traded at a fixed price with the unit of credit (let us call it “one dollar” in deposits). We all understand the process by which banks create credit: the depositor brings in a quantity of gold coin and the banker puts this in his vault, issuing certificates to the depositor (or establishing a checking account in his name). At this moment, the banker has 100 per cent reserves for his deposits. The next customer in the bank, however, is someone who wants to borrow — let’s assume the borrower will buy a house. The banker accepts a secured mortgage from the borrower (the banker’s non-monetary asset) and issues to the borrower some certificates identical to the ones he issued to the depositor. The total number of certificates is now greater than the supply of gold in the vault, so the banker’s reserves are only a fraction of his total outstanding certificates “payable in gold.” There is nothing fraudulent about this; the banker’s assets equal his liabilities, and everybody knows that bankers are in business to make loans with their depositors’ money.

Banks perform a valuable service by accumulating small deposits and making large loans. It is not our point here to rant and rave against fractional reserve banking, but we need to understand the difference because there is a critical implication for any proposals to reform the monetary system and re-establish the gold coin standard.

Most students of economics have heard of Gresham’s Law: “Bad money drives out good money.” What this means is that any holder of both gold coins and paper dollars will tend to spend the paper dollars and hold on to the gold coins. He will not spend the gold coins, unless the seller demands them instead of paper. The vicious aspect of legal tender laws is that they strip the seller of the right to demand coins instead of paper. Yet, Gresham’s law only holds true when there is a fixed price between the “good” money and the “bad” money. When there is a floating price, both forms of money circulate with equal frequency and the “price” of one in terms of the other adjusts according to the demand. This is a simple phenomenon arising from the two separate uses for money — the medium of exchange, and the store of value functions. The gold coins would be preferred as a store of value, and the paper dollars would be preferred as a medium of exchange. If sellers wanted coins instead of dollars, they would offer discounts for payment in gold. These discounts can be observed in every country which is experiencing a high rate of inflation. A discount on purchases is the same thing as a floating rate between gold and paper money.

In the United States today, the medium of exchange consists primarily of checks, credit cards, and Federal Reserve Notes. The medium of exchange is entirely made up of credit. To refer back to the work of Ludwig von Mises, “money” is not in circulation at all —even though many of us are relying on gold as our store of value almost exclusively. What circulates is credit certificates, and it is the rapid expansion of credit which is causing double-digit inflation.

It is always assumed by advocates of a “gold-backed” money that the quantity of gold (“money”) will hold the supply of credit (“dollars”) in bounds which will prevent excessive credit expansion. I submit that this is a false assumption. It is true that when the runs on the banks begin, the bankers will be exposed to failure and disgrace; but the bankers are smart enough to know that the government will rescue them. This is why the Federal Reserve System was created. To be sure, maybe we ought to abolish the Federal Reserve System and freeze the ability of the government to expand the supply of credit.

This is a tall order, and it is doubtful that those of us with some knowledge of economics have sufficient political influence to triumph over (1) those who have a vested interest in the present system of credit expansion, and (2) the ignorant who would be persuaded by the first group that we are either nutty or evil.

There is, however, a more direct and easily achieved solution. Happily enough, also, the monetary authorities are playing into our hands on this one. The solution involves the utilization of two differently-named units for the two different kinds of financial assets. Let the store of value be known as “ounces of gold” and let the medium of exchange be known as “dollars” of credit. Let the buyers and traders in a free market use gold-weight coins for their store of value. The solution to the problem of inflation, of course, would remain putting an end to credit expansion by the Treasury and the Federal Reserve System. However this small change in tactics would make an enormous long-run difference. It is convenient that the Krugerrand is approximately one troy ounce because its availability as an international coin makes the above proposal even easier to implement.

When the unit of credit is called by the same name as the unit of money (“dollar” for example), the citizen simply must take the word of the Treasury that the assets are in the vault and that credit expansion is not being indulged in. The indirect consequences of credit expansion, such as rising prices for goods and services, occur only after a lag in time. Even then it is not always clear what may be happening. Aggregate supply and aggregate demand move up and down for many diverse reasons, and prices adjust accordingly. The political system takes advantage of this random, or unpredictable, free market process. The government long ago learned that it can increase aggregate demand by printing bonds, using the bonds as assets against which to create Federal Reserve Notes and demand deposits in the banking system. As we have observed during the period since 1967, on the other hand, the market price of gold in terms of the unit of credit adjusts to reflect credit expansion. This, then, would be the key to a secure gold coin standard: The coins would be measured by their common weight, and they would command a market value in terms of the unit of credit. A policy of zero credit expansion should be mandated by law, perhaps, but as a check-and-balance, the traders in the market would keep their eye on the price of gold in terms of credit. If the credit price of gold should rise, there would be strong and compelling evidence that inflation were afoot, unless proven otherwise by reports of physical movements of gold.

With the introduction of weight-measured gold coins, we might expect to see an increasing number of securities and contracts made in terms of gold-weight coins. This should be encouraged, as a manifestation of the free market principle that people will do what is in their own best interests regardless of government policy. Indeed, the greater utilization of gold coins will increase the demand of gold assets and improve the value of private gold holdings (unless the central banks start to dump their gold holdings, but even this should produce only a short term downward movement and represent an excellent opportunity for private investors to buy).

Any attempt by the government to “fix” the value of the depreciated unit of credit in terms of gold, however, should be vigorously resisted by anyone who values either economic freedom or private gold reserves.