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 incomplete 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 US 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 US 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 — nearly 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 overissued, 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 relend. 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 overexpansion 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-reserve 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.
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