THE present worldwide inflation has done, and will
continue to do, immense harm. But it may eventually lead to one great
achievement. It may make it possible to restore (or perhaps it would be
more accurate to say to create) a full 100 percent gold standard.
That could come about in a simple manner. Our
government has made it once more legal to hold gold, to trade in gold,
and to make contracts in terms of gold. This makes it possible for
private individuals to buy and sell in terms of gold, and therefore to
restore gold as a medium of exchange. If our present inflation, as seems
likely, continues and accelerates, and if the future purchasing power of
the paper dollar becomes less and less predictable, it also seems
probable that gold will be more and more widely used as a medium of
exchange. If this happens, there will then arise a dual system of
prices-prices expressed in paper dollars, and prices expressed in a
weight of gold. And the latter may finally supplant the former. This
will be all the more likely if private individuals or banks are legally
allowed to mint gold coins and to issue gold certificates.
But even of the small number of monetary economists who
favor a return to a gold standard, probably less than a handful accept
the idea of such a 100 percent gold standard. They want a return, at
best, to the so-called classical gold standard that is, the gold
standard as it functioned from about the middle of the nineteenth
century to 1914. This did work, one must admit, incomparably better than
the present chaos of depreciating paper monies. But it had a grave
weakness: it rested on only a fractional gold reserve. And this weakness
eventually proved its undoing.
Not Enough Gold?
The advocates of the fractional gold standard, however,
saw-and still see-this weakness as a strength. They contend that a pure
gold standard was and is impossible; that there is just not enough gold
in the world to provide such a currency. Moreover, a pure gold standard,
they argue, would be unworkably rigid. On the other hand, a fractional
reserve system, they say, is flexible; it can be adjusted to "the needs
of business"; it provides an "elastic" currency.
We will come back to these alleged virtues later, and
examine them in detail; but first I should like to call attention to the
central weakness of a fractional reserve system: it embodies a long-term
tendency to inflation.
Let us begin with a hypothetical illustration. Suppose
we have a world in which the leading countries have been maintaining a
100 percent gold standard, that they begin to find this very confining,
and that they decide to adopt a fractional gold standard requiring only
a 50 percent gold reserve against bank deposits and bank notes.
The banks are now suddenly free to extend more credit.
They can, in fact, extend twice as much credit as before. Previously,
assuming they were lent up, they had to wait until one loan was paid off
before they could extend another loan of similar size. Now they can keep
extending more loans until the total is twice as great. The new credit
plus competition causes them to lower their interest rates. The lower
interest rates tempt more firms to borrow, because the lower costs of
borrowing make more projects seem profitable than seemed profitable
before. Credit increases, projects increase, and there is a "boom."
So reducing the gold reserve requirement from 100
percent to 50 percent, it appears, has been a great success. But has it?
For other consequences have followed besides those just outlined.
Production has been stimulated to some extent by lowering the reserve
requirement; but production cannot be increased nearly as fast as credit
can be. So as a result of increasing the credit supply most prices have
practically doubled. Twice the credit does not "do twice the work" as
before, because each monetary unit now does, so to speak, only half the
work it did before. There has been no magic. The supposed gain from
doubling the nominal amount of money has been an illusion.
And this illusion has been bought at a price. Lowering
the required gold reserve to 50 percent has enabled the banks to double
the volume of credit. But as they begin to approach even the new credit
limit, available new credit becomes scarce. Some banks have to wait for
old loans to be paid off before they can grant new ones. Interest rates
rise. New projects have to be abandoned, as well as some incompleted
projects that have already been launched. A recession sets in, or even a
financial panic.
And then, of course, the proposal is made that the
simple way out is to reduce the gold-reserve requirement once again, so
as to permit a still further creation of credit.
The Federal Reserve Act
Historically, this is exactly what has been happening.
Space does not permit a detailed review of what has happened in one
nation after another, starting, say, after the adoption in England of
Sir Robert Peel's Bank Act of 1844. But we can point to a few sample
changes in our own country, beginning with the Federal Reserve Act of
1913.
That act set up twelve Federal Reserve Banks, and made
them the repositories for the cash reserves of the national banks. The
first thing that was done was to reduce the reserve requirements of
these commercial banks. Under the national banking system the banks had
been classified according to the size of the city in which they were
located. They were Central Reserve City Banks, Reserve City Banks, and
Country Banks. These were required to keep reserves, respectively, of 25
percent of total net deposits (all in the bank's own vaults), 25 percent
of total net deposits (at least half in the bank's own vaults), and 15
percent of total net deposits (two-fifths in the bank's own vaults).
The Federal Reserve Act classified deposits into two
categories, demand and time, with separate reserve requirements for
each. For demand deposits the act reduced the reserve requirements to 18
percent for Central Reserve City Banks, 15 per cent for Reserve City
Banks, and 12 percent for Country Banks. In each case at least one-third
of the reserve was to be kept in the bank's own vaults. For time
deposits the reserve was only 5 percent for all classes of banks.
In 1917, as an aid in floating government war loans,
the reserve requirements were further relaxed, to 13, 10, and 7 percent
respectively, with only a 3 percent reserve requirement for time
deposits. Though the amendment also required that all reserve cash
should thereafter be held on deposit with the Federal Reserve Banks, the
amount of till or vault cash necessary to meet daily withdrawals was
found to be small.
In addition to this lowering of the reserve
requirements of the member banks, the Federal Reserve System provided
for the building of a second inverted credit pyramid on top of the one
that the member banks could build, For the Federal Reserve Banks
themselves were authorized to issue note and deposit liabilities against
their gold reserves, which were required to total only 35 percent
against deposits.
As a result of such changes, if the average reserves
held by the commercial banks against their deposits were taken as 10
percent, and the gold reserves held by the System against these reserves
at 35 percent, the actual gold held against the commercial deposits of
the System could be reduced to as low as 3.5 percent.
What actually did happen is that between 1914 and 1931,
total net deposits of member banks increased from $7.5 billion to $32
billion, or more than 300 percent in less than two decades.1
These figures continued to grow. Gold reserve
requirements were finally removed altogether. In August, 1971, when the
United States officially went off the gold standard, the money stock, as
measured by combined demand and time deposits plus currency outside of
banks, was $454.5 billion. The U.S. gold reserves were then valued at
$10.2 billion. This meant that the money stock of the country had been
multiplied more than sixty times over that of 1914, and the gold reserve
against this money stock had fallen to only 2.24 percent. Put another
way, there was then $44 of bank credit issued against every $1 of gold
reserves.
Exhausting the Gold Reserve
The situation was actually more ominous than these
figures suggest. For under the gold-exchange system of the International
Monetary Fund, it was not merely the American dollar, but the total
currencies of practically all the nations in the Fund, that were
supposed to be ultimately convertible into the U.S. monetary gold stock.
The miracle is not that this gold exchange system collapsed altogether
in August of 1971, but that it did not do so much sooner.
In short, the fractional gold standard tends almost
inevitably to become more and more attenuated, and while it does so it
permits and encourages progressive inflation.
When the gold standard is abandoned completely and
officially, inflation usually accelerates. This has been illustrated in
the more than seven years since August, 1971. At the end of 1978, the
money stock, counting both demand and time deposits, had risen to $871
billion - early double the figure at which it stood in August, 1971.
But what happens as long as the fractional gold
standard is being nominally maintained is that the milder rate of
inflation is less noticed, and even many monetary economists are
inclined to view it with complacency. This is partly because they have a
reassuring theory of what is happening. The amount of currency and
credit, they say, is responding to the "needs of business." The loans on
which the deposits or Federal Reserve Notes are based represent "real
goods." A manufacturer of widgets, for example, borrows a six-month loan
from his bank to meet his payroll and other production costs, then when
he sells his goods he pays off the loan with the proceeds, and the
credit is cancelled. It is "self-liquidating." The money is therefore
"sound"; it cannot be over-issued, because it increases and contracts
with the volume of business activity.
What this theory overlooks is that while the individual
loan may be self-liquidating, this is not what happens to the total
volume of credit outstanding. Manufacturer Smith's loan has been repaid.
But under the fractional reserve system, the bank, as a result of this
repayment, now has "excess reserves," which it is entitled to re-lend.
Of course if the bank is fully lent up, even under a fractional reserve
system, it cannot extend credit further. But when a substantial number
of banks are seen to be nearing this point, pressure comes from all
sides-from the banks and their would-be borrowers, and from the
government monetary authorities and the politicians who have appointed
them-to lower the reserve requirements further. If nothing has gone
wrong so far with the existing fractional reserve, indeed, there seems
to be no harm in reducing the fraction further. It will permit a further
expansion of credit, reduce interest rates, and prevent a threatened
business recession.
In sum, to repeat, a fractional reserve gold system,
once accepted, must periodically bring about business and political
pressure for a further reduction of the fractional reserve required.
The Harmful Consequences
We have now to examine the harm that the system does
whether or not the pressure to reduce the reserve requirements is
continuously successful.
Let us begin with a situation in, say, Ruritania, which
has a fractional-reserve gold standard and a central bank, but in which
business activity has not been fully satisfactory. The central bank then
either lowers the discount rate, or creates more member-bank reserves by
buying government securities, or it does both. As a result, business is
encouraged to increase its borrowing and to launch on new enterprises,
and the banks are now able to extend the new credit demanded.
As a consequence of the increased supply of money and
credit, prices in Ruritania rise, and so do employment and money
incomes. As a further result, Ruritanians buy more goods from abroad. As
another result, Ruritania becomes a better place to sell to, and a
poorer place to buy from. It therefore develops an adverse balance of
trade or payments. If neighboring countries are also on a gold basis,
and inflating less than Ruritania, the exchange rate for the rurita
declines, and Ruritania is obliged to export more gold. This reduces its
reserves and forces it to contract its currency and credit. More
immediately, it obliges Ruritania to increase its interest rates to
attract funds instead of losing them. But this rise in interest rates
makes many projects unprofitable that previously looked profitable,
shrinks the volume of credit, lowers demand and prices, and brings on a
recession or a financial crisis.
If neighboring countries are also inflating, or
expanding the volume of their money and credit at as fast a rate, a
crisis in Ruritania may be postponed; but the crisis and the necessary
readjustment are all the more violent when they finally occur.
The Cycle of Boom and Bust
The fractional-reserve gold standard, in
short-especially when it exists, as it usually does, with a central
bank, a government and a public opinion eager to keep expanding credit
to start a "full employment" boom or to keep it going brings about what
is known as the business cycle, that periodic oscillation of boom and
bust that socialists and communists attribute, not to the monetary and
credit system and central banking, but to some inherent tendency in the
capitalist system itself.
I need describe here only in a general way the process
by which credit expansion brings about the boom and the inevitable
subsequent bust. The credit expansion does not raise all prices
simultaneously and uniformly. Tempted by the deceptively low interest
rates it initially brings about, the producers of capital goods borrow
the money for new long-term projects. This leads to distortions in the
economy. It leads to over expansion in the production of capital goods,
and to other malinvestments that are only recognized as such after the
boom has been going on for a considerable time.
When this malinvestment does become evident, the boom
collapses. The whole economy and structure of production must undergo a
painful readjustment accompanied "by greatly increased unemployment.
This is the Austrian Theory of the trade cycle, which I
need not expound here in all its complex detail because that has already
been done fully and brilliantly by such writers as Mises, Hayek,
Haberler, and Rothbard.2
The World Adrift in Turbulent Seas of Paper Money
My chief concern in this article has been to show that
in addition to being the principal institution responsible for bringing
about the cycle of boom-and-bust that has plagued the civilized world
since the early nineteenth century, the fractional-reserve standard,
once its principle of "economizing the use of gold" has been fully
accepted, itself encourages an inflation that has no logical stopping
place until gold has been "Phased out" altogether, and the world is
adrift in the turbulent seas of paper money.
In emphasizing this weakness of a fractional-reserve
standard, I do not intend to imply that I have solved the baffling
problem of creating an ideal money - assuming that that problem is even
soluble. An opportunity now exists - for the first time in a couple of
centuries-to introduce a 100 percent gold reserve standard. But if
sufficient new gold supplies were not regularly available, such a
standard could conceivably result over time in a troublesome fall in
commodity prices. Moreover, unless there were rigid prohibitions against
it, a private no less than a government money would soon tend to become
a fractional-reserve standard. And if we allowed this, would we not soon
be on the road once more to a constantly diminishing fraction, and at
least a constant mild inflation?
I confess I do not have confident answers to these
questions. But that does not invalidate my criticisms of a fractional-re
serve standard. I should like to point out, incidentally, that expanding
the money supply through a fractional-reserve standard-mainly for the
purpose of holding down the exchange-value of the individual currency
unit and thereby preventing a fall in prices-could also be accomplished
under a full gold standard by constantly or periodically reducing the
weight of gold into which the dollar (or other unit) was convertible.
Such a proposal was once actually made by the economist Irving Fisher. I
am unaware of any economist who accepts such a proposal today. But it is
no different in principle from steadily expanding the money supply-under
either a paper or a fractional-reserve gold standard for the purpose of
holding down the purchasing power of the monetary unit. Is this a power
we would want to trust to the politicians?
As a result of what has already happened, I regret that
I cannot join some of my fellow champions of the full gold standard in
urging their respective national governments to return immediately to
such a standard. I believe such a step at the moment to be both
politically and economically impossible. Confidence in the monetary good
faith of governments has been destroyed. If any one government were to
attempt to return to gold convertibility, at even today's free market
price for gold, it would probably be bailed out of its gold within a few
weeks.
That is because holders of the currency would doubt not
only that government's determination but its ability to maintain that
conversion rate. People have seen their governments casually abandon the
gold standard, and they are more aware of how slim and insecure the new
gold-backing might be against the enormous volume of credit and paper
money now outstanding. Gold convertibility of an individual currency
could probably now be restored only after a few years of balanced
budgets and refrainment from further currency expansion.
Meanwhile, if governments would permit private
individuals or banks to mint gold coins and to issue gold certificates,
a dual currency system could come into existence that could eventually
permit a smooth transition back to a sound gold currency.
No Shortage of Gold
IN a free market economy it is utterly irrelevant what
the total stock of money should be. Any given quantity renders the full
services and yields the maximum utility of a medium of exchange. No
additional utility can be derived from additions to the money quantity.
When the stock is relatively large, the purchasing power of the
individual units of money will be relatively small. Conversely, when the
stock is small, the purchasing power of the individual units will be
relatively large. No wealth ran be created and no economic growth can be
achieved by changing the quantity of the medium of exchange.
Hans F. Sennholz, Gold is Money
At the time of the original publication, Henry
Hazlitt, noted economist, author, editor, reviewer and columnist, was
well known to readers of the New York Times, Newsweek, The Freeman,
Barron's, Human Events and many others. The most recent of his
numerous books is The Inflation Crisis, and How to Resolve it.
1 See Money and Man, by Elgin Groseclose (University of
Oklahoma Press), pp. 215-219.
2 In addition to larger works of these four writers
that include discussions of the subject, the interested reader may
consult the pamphlet, The Austrian Theory of the Trade Cycle, which
contains an essay by each of them.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
May, 1979, Vol. 29, No. 5.
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