Many Free Market Advocates are familiar with the gold
standard, and why a gold standard is preferable to a flat standard. But
there are several different kinds of gold standards, each with its own
characteristics and its own implications for the economy.
The earliest and simplest form of gold standard is
trading for gold in the form of gold dust or gold bullion. There are no
banks or money substitutes whatever, and the total money stock is simply
the total amount of gold in the trading area. This form of gold standard
requires no government intervention in the economy at all, and requires
of the government only the prosecution of fraud, which is easy to prove
since contracts (written or verbal) are defined in terms of a specified
amount of gold in a specified form.
Gold for this purpose is constantly being provided by
gold mines or foreign trade and refined into recognizable forms by known
refiners. If the purchasing "power" of money (gold) increases, then it
will become profitable to mine or import more gold (by exporting more
products). This will bring about an expansion of the gold stock, which,
other things being equal, will reduce the purchasing "power" of money
until the profitability of mining or importing gold is comparable to the
profitability of other activity, and the marginal mines and importers
will cease production.
* I put the term "power" in quotes to avoid confusion
with political power, which purchasing "power" is not.
This is one example of how, with no government
intervention, a commodity standard money tends to keep a constant
purchasing "power" by a simple market mechanism, based on the profit
motive of the people involved. Notice that neither gold miners nor
anyone else are concerned with such things as the stock of money or
other esoteric economic concepts, yet it is they who act to stabilize
the purchasing "power" of money when it becomes necessary.
Primitive and inconvenient
This gold standard is rather primitive, as it requires
the inconvenience of weighing out amounts of gold for each purchase, and
the fact that one must carry one's gold around with him, an obvious
temptation to muggers.
The solution to the first problem is to manufacture
slugs of gold in uniform amounts with a uniform purity so that one can
tell at a glance how much gold is in the slug. Since the gold content is
known, the manufacturer can alloy the gold with other metals to harden
the coin, thus reducing wear. The manufacturer's name and the weight of
fine gold are stamped on the coin. A modern example is the Krugerrand,
which is minted by the South African Chamber of Mines (all the
government does is provide the dies). It carries the legend, "FYNGOUD 1
OZ. FINE GOLD" (in Afrikaans and English).
Because the gold is what is valued, and not the alloy
or fancy designs on the two faces, the unit of weight of fine gold
becomes identified with the coin. For example, the dollar was at one
time defined as 1/20th of an ounce of gold simply because the United
States coin of one ounce was labeled "20 Dollars."
Of course, there is always a possibility of fraud on
the part of the minter, and the objection is usually raised at this
point: "Why, we can't trust people to mint coins! That function has to
be turned over to the government!"
We can trust private manufacturers to mint coins
according to the market's specifications just as we can trust private
firms to manufacture nuts and bolts to specification, or carry the mail.
Advocates of the free market maintain that private enterprise can
provide every other product or service better than the government can.
Why not coins?
But the introduction of coins still leaves two
problems: storage and convenience. The convenience problem is two-sided.
In the case of large purchases, one must transport a lot of gold around
to make the payment. One runs into the problems of transportation and
security. Small purchases, say a piece of bubble gum, would require the
availability of a coin small enough to pay for it or make change if a
large coin is presented. This problem would be solved by the market by
the use of a bimetallic system, as where gold and silver circulate side
by side.
Bimetallism
Bimetallism here simply means that the market accepts
either gold or silver as money. This is a decision that must be left to
the market. It is like having two currencies. The idea of having two (or
more) currencies is far more disturbing to Americans than to Europeans,
who might have to deal in sterling one minute, Swiss francs the next,
and then dollars. It simply requires that people express their prices in
terms of both gold and silver, just as many European shops express their
prices in both dollars and the local currency. The bimetallic system
simply means that the monetary metal with the lower purchasing power per
unit of mass would be used to make the smaller purchases, such as bubble
gum.
Another innovation solves several problems. The
introduction of warehouses for money solves, of course, the problem of
safely storing one's money. The warehouse would store your gold for a
fee and give you a receipt for the gold. It is still your gold, and the
fact that it is in someone else's storehouse does not mean that title to
the gold passes to him or that he has any other claim to the gold
(except possibly to ensure payment of the storage fees). Because it is
your gold, the warehouse has no more right to use it for any purpose
than an employee in a furniture warehouse has to sit on your chair.
Also, the warehouse must deliver your gold upon demand, just as the
furniture warehouse must deliver your chair when you want it.
The receipts are usually in the form of bearer
receipts, which means that the warehouse will deliver the gold to
whoever presents the receipt for redemption. This carries with it the
obvious implication: don't lose your receipts! But it also carries the
implication that, instead of trading the physical gold, clients of
warehouses can trade the receipts back and forth. But, still, as with
the coins, the value is attributed to the gold, not the piece of paper.
A Modern Example
A modern example of the gold warehouse is the gold
certificate offered by the Bank of Nova Scotia. Although the
certificates are issued in ten-ounce lots with a minimum purchase of
twenty ounces, the principle of the gold warehouse is maintained, as the
Bank of Nova Scotia keeps on hand all the gold which its certificates
represent. The storage fee is defined as 3¢ per hundred ounces per day,
or $10.95 per year for up to one hundred ounces.
An alternative to issuing one or several receipts which
would circulate in place of gold is to have the warehouse give the
depositor a book of checks which he could use to make payments of exact
amounts of gold, limited only by the availability of coins or bullion to
make the exact amount of the check. (If the smallest amount of gold
available is 5 grams, it does no good to write out a check for 9 grams,
because no one makes small enough gold bars to pay the check.) This
makes it easier to make purchases in that the buyer need only fill out
the check for the exact amount of the purchase. However, the purchaser
must not only establish the trustworthiness of his warehouse, but also
whether he has enough gold in his account to cover the check.
Full Reserves
What I have described here is called 100 per cent
reserve banking, which means that for every ounce worth of receipts
outstanding, the warehouse has an ounce of gold in the vaults. The
receipts are substitutions for rather than additions to the gold in the
vault, and the money stock stays the same as gold flows into or out of
the warehouse. The 100 per cent reserve banking system also differs from
other bank systems in that the gold is considered to belong to the
holder of the receipt, not to the bank or warehouse.
Because the warehouse operator is in the business of
handling money, it is only natural that he should make a market f or the
use of it. When a warehouse operator matches up savers and borrowers so
that the savers can earn interest on their savings, he becomes a banker.
He facilitates this money market by accepting deposits of gold over a
specified time and lending the money out over the same or a lesser
period of time. He charges the borrower a higher rate of interest than
he pays the depositor, the difference being the banker's profits. A
modern example of this is the certificate of deposit, where the bank can
pay you a higher interest rate than on a regular checking or savings
account because it knows that you are going to leave the money on
deposit for a specified period of time.
However, soon enough a banker will notice that most of
the gold on deposit in his bank, even though in demand deposits, will be
left in the bank for years, as the receipts are traded back and forth.
If no one is going to redeem this gold, he reasons, why shouldn't I lend
it out to someone else? Of course, the fact that he is lending out money
that doesn't belong to him, that was entrusted to him, doesn't bother
him; no one will find out, will they?
Even easier is to continue to hold the gold in his
vault and instead lend out receipts for gold that doesn't exist. No one
will find out; our banker won't lend out so much money that receipts
brought for redemption will remove the entire gold stock from his vault.
Of course, the fact that he is lending out gold that doesn't even exist
doesn't bother him in the least, even if it is fraud.
Fractional Reserve
When the banker lends out the gold in his vaults, or
lends out false receipts, he obviously no longer has enough gold in his
bank to pay off the obligations of the bank. He has gone from 100 per
cent reserves to fractional reserve banking. He also has created more
circulating medium (money) than there was previously, but without the
limiting device of the costs of mining or importing gold. It costs less
than an ounce of gold to mine an ounce of gold, but, as more gold is
mined than lost through wear, and as the purchasing "power" of money
goes down, eventually the marginal mines find that it costs more than
one ounce to mine one ounce of gold, and so they cease production. With
pseudo-receipts, the limiting, cost of production is the cost of
printing!
Thus, when a bank goes off 100 per cent reserves, its
action results in more circulating media, which tends to lower the
purchasing "power" of money. In other words, while 100 per cent reserve
banking cannot be inflationary, fractional reserve banking must be.
Governments benefit from inflation. A very simple
example is where politicians promise to "stimulate the economy" and
proceed to inflate the currency in order to do so. Sometimes they are
under the mercantilist mistake that more currency is the same thing as
more wealth, so they encourage banks to create more currency. Obviously,
in order to create more currency, the banker has to resort to fractional
reserve banking. Usually, when the government is in on the deal, it will
help out by giving banks a special status. The government simply removes
the title to the gold from the holder of the receipt and gives the title
to the bank. Notice that fractional reserve banking in all its
variations requires this invasion of property rights, this intervention
in the market.
At this point, the biggest thing that the bank has to
fear is the possibility of a bank run, where all the depositors line up
to retrieve their gold (that isn't all there). In order to avoid the
temptation to create so much paper money that a bank run is
precipitated, the government steps in, not to enforce the fraud laws,
but to set reserve requirements, which specify what per cent of
outstanding notes the bank must have in gold in its vaults. For example,
if the government sets a reserve requirement of 25 per cent and a bank
has $250,000 in outstanding currency, then the bank must have at least
$62,500 in gold in its vaults.
The lower the reserve requirement, the more money the
bank can create and lend out. If the government raises the reserve
requirement, then banks may have to call in outstanding loans in order
to meet the new requirements.
Debtors Gain
A government in debt (like any debtor) has much to gain
from inflation. A rate of price increases of 10 per cent means that the
government gains 10 per cent while the lender loses by that amount. As
the federal government is the largest single debtor in the U.S., it
obviously has much to gain by inflation: both in reduced value of the
debt, and in having available newly created dollars which it can borrow
without the politically objectionable side effect of higher interest
rates.
One way to decrease the reserve requirements without
running the risk of a bank run is to make it more difficult for people
to redeem bank notes in gold. By raising the minimum lot for which one
could trade his paper, banks make it harder for note holders to get
gold. Thus, Britain, after World War land a great decrease in reserve
requirements - changed the minimum amount of gold from a sovereign (a
fraction of one ounce) to 400 ounces.
This restrictive gold standard is called a gold bullion
standard, and stands in opposition to the original U.S. gold standard,
where one could get gold for as little as $5, which was called a gold
coin standard. The gold bullion standard allowed the Bank of England to
continue with its wartime reserve requirements of 18 per cent instead of
returning to the pre-war level of 52 per cent. This, in turn, meant that
the British banking system did not have to deflate in order to return to
the level of credit imposed by a 52 per cent reserve requirement.
Restricted Redemption
Another way to limit gold outflow is to limit the
people to whom the bank will give tip the gold. The U.S. did this quite
abruptly in 1933 by prohibiting Americans from owning gold, and hence,
from turning in their paper for gold. This meant that only foreigners
could trade their dollars for gold.
Although still nominally tied to gold, at this point
the dollar was really a fiat currency; at any time the link between the
dollar and gold could be severed, as we saw in August of 1971. In the
late 1960's, it became apparent that Europeans were willing to buy all
the gold that the U.S. would offer on the London gold market. Rather
than deflate, the U.S. authorities ceased selling gold on the free
market, and established the two-tier market in 1968. The free market
price of the dollar soon moved down to 1/42nd of an ounce of gold, while
central banks continued to trade gold at the old price of 1/35th of an
ounce. Then, in 1971, even the central banks were banned from trading
their dollars for gold. The U.S. had, for the first time since the 18th
century, a completely fiat currency, in both the economic and legal
sense.
It was during this period that the concept of a "price
of gold" first came into use. When a currency is divorced from gold so
that its purchasing "power" becomes different than that of the amount of
gold which the currency originally was defined to be, then it can be
said to be a fiat currency. It still may have ties to gold, such as the
rather tenuous link between the dollar, the SDR, and gold from 1971 to
1973; but these are mere legalisms. As the fiat currency loses
purchasing "power" relative to gold, then an ounce of gold will buy more
and more units of the currency. This readjustment can be done
occasionally and abruptly, via the mechanism of devaluations, or over a
period of time via daily quotes on an organized private market such as
the London Gold Market or the Commodity Exchange in New York. Thus, the
monetary unit was divorced from gold in the eyes of the market as well
as the government, and the dollar, for example, became defined as . . .
well, a dollar, instead of 1/20th of an ounce of gold. Once this mental
division is made, it is possible to talk of a "price of gold" just as
one can talk of a "price of Swiss francs" or a "price of roast beef":
each is a separate commodity from the unit of account - the (fiat)
dollar.
Central Banking
During this century, the United States also moved away
from free banking by modifying the reserves that banks could use for
their deposits. Before the establishment of the Federal Reserve (in
1913), banks used gold, either bullion or coins, as reserves. However,
with the establishment of the Fed, banks were allowed to deposit dollars
with the Fed and count these deposits as reserves (still fractional).
The Fed learned rapidly how it could manipulate these
reserves. Not only could it modify reserve requirements, but it could
change the level of reserves in the banking system. The mechanism is
very simple: the Fed buys an asset, any asset. To pay for it, the Fed
writes out a check to the seller. The seller deposits the check in his
bank, and the bank credits his account with the proper amount. Then, the
bank presents the check to the Fed for collection. Instead of simply
paying the bank so many dollars, the Fed credits the bank's reserve
account with the Fed with the amount of the check. The bank's reserves
are now expanded by the amount of the check, and the bank can now create
and lend out additional dollars.
Any Debt Will Do
It is important to note in passing that the Fed can
expand reserves by buying any asset. The most popular assets with the
Fed are Treasury debts; and why not: they are buying the obligations of
their parent organization, the U.S. government. But simply balancing the
Federal budget will not deprive the Fed of assets to buy; simply
balancing the budget will not stop inflation. After all, if the Fed
couldn't get Treasurys, it could always buy New York Citys!
This system of expanding reserves means that the
banking system can expand its reserves without regard to gold. Now, the
Fed can inflate the money supply whenever anyone wants to go into debt,
a not uncommon event! Even if the U.S. were to sell off all the gold in
the Treasury stock, the Fed could continue to inflate, simply because
someone would be willing to go into debt to buy that gold, or something
else.
We have traced an evolution away from free banking
toward the completely state-managed money system. Each step in between
has been given a label, such as "gold exchange standard" or "gold
bullion standard," each calculated to imply that the new setup was some
form of gold standard. Even the Bretton Woods system was called a
"gold-dollar standard" (not that the central banks even traded gold
among themselves unless they had to - Gresham's Law applies to central
bankers too).
Market Money or Political Money
The essence of the gold standard is that the gold in a
bank's vaults regulates the credit that it can extend, and that the
stock of money is regulated by the free market (specifically, the
profitability or lack of profitability of gold mining), and not by the
decisions of the bankers, especially the central bankers! Each step that
was taken away from a 100 per cent reserve gold standard also made it
both more necessary and easier to take the next step toward regulation.
Each step also reinforced the idea that every time the banking system
got into trouble, the government could bail it out, and do so by
changing the banking system. Thus, later standards were gold standards
only by virtue of a formal, legal link to gold. There was no commitment
to gold, so whenever the banking system got itself into trouble, it was
bailed out by the government-by another step away from gold.
Each step was supposed to make the banking system "more
flexible," to make it easier to "meet the legitimate needs of business."
But, as we have seen, each step has really had the effect of making it
easier for the banking system to inflate. If we turn this around, we can
see that each step was a step away from sound money, market controlled,
toward money controlled by a government with a vested interest in
inflation.
It is in the interest of the free market advocate to
understand the different varieties of gold standards and mixed gold-fiat
standards that have existed. This is the only way in which one can
answer the many myths that surround money and banking. For example,
careful study shows that it was not capitalism that failed in the
1930's, but central banking that failed in the 1920's.
At the time of the original publication, Charles
Curley was the author of The Coming Profit in Gold (Bantam), and is a
founding member of the National Committee to Legalize Gold.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
June, 1975, Vol. 25, No. 6.
Yourname@libertyhaven.com
