3. An Analysis of the Advantages of the Proposed System

In this section we will consider the main advantages a free-banking system which adheres to legal principles, a 100-percent reserve requirement and a completely private form of money (gold) offers as opposed to the system of financial central planning (central bank) which currently controls the financial and banking spheres of all countries.

1. The Proposed System Prevents Bank Crises. Even the most prominent defenders of fractional-reserve free banking have recognized that the establishment of a 100-percent reserve requirement would put an end to bank crises.⁴⁵ Indeed bank crises stem from the inherent lack of liquidity of these institutions, which use in the form of loans most of the money deposited with them on demand. If, in keeping with traditional legal principles in the irregular deposit, anyone who receives money on deposit is required to keep on hand at all times a tantundem equal to 100 percent of the money received, it is obvious that depositors will be able to withdraw the amount deposited at any time without placing any financial strain on the corresponding banks.

Of course banks, in the exercise of activities other than deposit banking, in their role as loan intermediaries for example, may certainly encounter economic problems as a result of entrepreneurial errors or poor management. However in these cases the simple application of the principles of bankruptcy law⁴⁶ would be sufficient to liquidate this type of bank operation in an orderly fashion without affecting in any way the guaranteed return of demand deposits. From a legal and economic point of view, this second type of bank “crisis” is completely unrelated, both qualitatively and quantitatively, with the traditional crises which have plagued banks since they began to operate with a fractional reserve. The only way to avoid these traditional crises is precisely to do away with fractional-reserve banking.

2. The Proposed System Prevents Cyclical Economic Crises. As we have seen based on both theory and history, successive cycles of artificial boom and economic recession have afflicted market economies since banks began to function with a fractional reserve. In addition, the damaging effects of these cycles became even stronger when governments granted banks the privilege of legally operating in this manner. The damage became most acute with the creation of the central bank as a lender of last resort designed to supply the system with the necessary liquidity in times of trouble. For while the central bank has reduced the frequency of bank crises, it has not been capable of ending economic recessions, which, in contrast, have in many cases become deeper and more severe.

A banking system in tune with traditional property-law principles (i.e., a 100 percent reserve) would immunize our societies against recurrent economic crises. In fact, under these circumstances, the volume of loans could not increase without a prior, parallel increase in society's real, voluntary saving. Under such conditions, it would be impossible to imagine that the productive structure could be distorted as a result of discoordination in the behavior of those economic agents who invest and those who save. The best guarantee against intertemporal maladjustments in the productive structure is observance of the traditional legal principles present in the innermost logic behind the legal institutions related to the irregular-deposit contract and property law.⁴⁷

Contrary to the belief of the Chicago theorists (those who advocated a 100-percent reserve requirement for banking), the eradication of economic crises and recessions also clearly depends upon the total privatization of money (pure gold standard). For if the central bank continues to be responsible for the issuance of purely fiduciary money, there will never be any guarantee that this institution, via open-market operations on the stock exchange, could not temporarily and artificially reduce interest rates and inject capital markets with artificial liquidity which, in the end, would exert exactly the same discoordinating effects on the productive structure as credit expansion initiated by private banks without the backing of real savings.⁴⁸ The key Chicago defenders of a 100-percent reserve requirement (Simons, Mints, Fisher, Hart, and Friedman) primarily sought to facilitate monetary policy and prevent bank crises (point one above), but their macroeconomic-monetarist analytical tools kept them from seeing that even more harmful than bank crises are cyclical economic crises unleashed on the real productive structure by the fractional-reserve banking system. Only the complete abolition of legaltender regulations and the total privatization of the state-issued money now in existence will prevent government institutions from triggering economic cycles even once a 100-percent reserve requirement is established for private banking.

Finally, we must recognize that the recommended system would not avoid all economic crises and recessions. It would only avert the recurrent cycles of boom and recession which we now suffer (and which constitute the vast majority and the most serious). It would not prevent those isolated crises provoked by wars, natural disasters, or similar phenomena which, due to their sudden attack on the confidence and time preference of economic agents, might cause shocks to the productive structure and thus demand considerable, painful readjustments. Nonetheless we must not be deceived, as a number of theorists are (mainly those adherents of “new classical economics”), by the notion that all economic crises stem from external shocks. These theorists fail to realize that most crises have an endogenous origin and are fueled by the very credit expansion which the banking sector brings about and central banks orchestrate. In the absence of this disruptive influence on credit, the number of shocks would fall to a minimum, not only because the prime cause of instability in our economies would disappear, but also, as we will explain later, because governments would adopt much more disciplined fiscal programs. With this increased restraint, the proposed system would act in time to abort many policies that would foster financial irresponsibility and even violence, conflicts, and wars, which without a doubt, are also ultimately responsible for the isolated appearance of external shocks which prove highly damaging to the economy.

3. The Proposed System Is the Most in Tune with Private Property. The establishment of a 100-percent reserve requirement for demand-deposit bank contracts would stamp out the legal corruption which has plagued the institution of banking from its very beginning. As we saw in our historical study of the evolution of banking, governments first overlooked the fraudulent nature of fractional-reserve banking. Then, when the effects of the system became more evident, instead of adequately defining and defending the traditional principles of property law, they became accomplices and later the driving force behind the corresponding expansionary processes, always with the goal of obtaining an easier source of financing for their political projects. The evolution of banking on the fringe of legal principles has produced solely negative results: it has encouraged all sorts of fraudulent, irresponsible behaviors; it has triggered artificial credit expansion and highly damaging, recurrent economic recessions and social crises; and it has ultimately determined the inevitable appearance of the central bank and an entire web of administrative regulations on financial and banking activities, regulations which have not achieved the objectives set for them and which, surprisingly today, on the threshold of the twenty-first century, continue to destabilize the world's economies.

4. The Proposed Model Promotes Stable, Sustainable Economic Growth, and Thus Drastically Reduces Market Transaction Costs and Specifically the Strains of Labor Negotiations. Over ninety years of chronic worldwide inflation and continuous, and during many periods completely uncontrolled, credit expansion have corrupted the behavioral habits of economic agents, and hence today, most believe inflation and credit expansion are necessary to stimulate economic development. Furthermore the misconception that any economy not in an economic boom is therefore “stagnant” has become generalized. People fail to see that rapid, exaggerated economic expansion is always likely to have an artificial cause and must reverse in the form of a recession. In short, we have become accustomed to living in manic-depressive economies and have adjusted our behavior to an unstable, disturbing pattern of economic development.

However, following the proposed reform, this “manic-depressive” model of economic development would be replaced by another much more stable and sustained one. In fact, not only would artificial expansion be prevented, along with the stress it involves at all levels (economic, environmental, social, and personal), but the recessions which inevitably follow each period of expansion would be prevented as well. In the proposed model, the monetary system would be rigid and inelastic with respect to the money supply, both in terms of growth in the quantity of money in circulation and, especially, possible decreases or contractions in it. Indeed a 100-percent reserve requirement would preclude an expansionary increase in the money supply in the form of loans, and the quantity of money in circulation would simply grow naturally and would be tied to the annual rise in the worldwide stock of gold. The worldwide stock of gold has grown at an average of between 1 and 3 percent per year over the last 100 years.⁴⁹ Therefore, with a monetary system comprised of a pure gold standard and a 100-percent reserve requirement for banking, if we assume productivity mounts at an average rate of 3 percent per year, this model of economic growth would give rise to a gradual, constant drop in the prices of consumer goods and services. Not only is this drop perfectly compatible with sustainable economic development from a theoretical and practical standpoint, but it would also guarantee that the benefits of such growth would profit all citizens through a constant increase in the purchasing power of their monetary units.⁵⁰

This model of rising productivity, economic development and a money supply which grows slowly (at a rate of around 1 percent) would generate, via a decrease in prices, an increase in the real income of the factors of production, especially labor, which in turn would result in an enormous fall in the negotiation costs currently associated with collective bargaining. (Assuming the demand for money is stable, productivity rises at a rate of 3 percent and the money supply grows at a rate of 1 percent, prices would tend to fall by approximately 2 percent per year.) In this model, the real income of all factors of production, especially labor, would be updated automatically, and hence collective bargaining, which presently creates so much tension and conflict in western economies, could be eliminated. Indeed this process would be relegated to those isolated cases in which, for example, a greater increase in productivity or in the market price of specific types of labor made it necessary to negotiate even greater rises than those automatically reflected each year in real income with the decline in the general price level. Moreover in these cases even the intervention of unions would be unnecessary (though the possibility is not excluded), since market forces themselves, guided by the entrepreneurial profit motive, would spontaneously provoke those income rises justified in relative terms. Therefore, in practice, collective bargaining would be limited to those isolated cases in which productivity rose less than average, making certain reductions in nominal wages necessary (in any case, these would generally be smaller than the drop in the general price level).⁵¹

Finally, we should point out that the chief virtue in the rigidity of the proposed monetary system is that it would completely prevent sudden contractions or decreases in the money supply such as inevitably occur now in the recession stage which in the economic cycle follows every expansion. Thus perhaps the greatest advantage of the reform we suggest is that it would totally eliminate the credit squeeze which succeeds every boom and is one of the clearest signs of the economic crises that repetitively grip our economies. The worldwide stock of gold is unchanging and has accumulated over the history of civilization. Hence it is inconceivable that its volume will suddenly plunge at some future point. One of the most salient features of gold, and possibly the most influential in gold's evolutionary predominance as money par excellence, is its homogeneity and immutability throughout the centuries. Thus the main advantage of the proposed model is that it would preclude the sudden reductions in the volume of credit and, hence, in the quantity of money in circulation, which until now have been repetitive in the “elastic” monetary and credit systems which prevail in the world. In short, a pure gold standard with a 100-percent reserve requirement would prevent deflation, understood as any drop in the quantity of money or credit in circulation.⁵²

5. The Proposed System Would Put an End to Feverish Financial Speculation and its Damaging Effects. We could liken banks' creation of money through credit expansion to the opening of Pandora's box. To close it again, we must eliminate the incentives that tempt individuals to indulge in all kinds of unscrupulous, fraudulent behaviors. Such incentives are extremely harmful, since they corrupt the established habit of saving and working conscientiously; that is, the habit of making a constant, honest, responsible, and long-term economic effort.⁵³ Furthermore wild stock-market speculation would also be thwarted, and take-over bids, which are harmless in themselves, would only be made in the presence of true, objective, economic reasons for them. They would not be a mere result of great ease in obtaining external financing due to ex nihilo credit expansion in the banking sector. In other words, as Maurice Allais indicates:

Take-over bids are essentially useful, but the legislation governing them should be revised. It should not be possible to finance them using means of payment created ex nihilo by the banking system or newly-issued junk bonds, as occurs in the United States.⁵⁴

In the market, the expansionary supply of loans unbacked by saving creates its own demand, which is often embodied in unscrupulous economic agents whose only intention is to obtain a short-term benefit from the enormous advantages which, to the detriment of all other citizens, they derive from using newly-created means of payment before anyone else.

6. The Proposed System Reduces the Economic Functions of the State to a Minimum and, in Particular, Permits the Eradication of the Central Bank. The system we recommend would eliminate the need for the Federal Reserve, the European Central Bank, the Bank of England, the Bank of Japan, and in general any authority, central bank or official, public or government body with a monopoly on the issuance of money and, as a central monetary-planning agency, on the control and management of the banking and financial system of any country. Even certain distinguished politicians, such as the nineteenth-century American President Andrew Jackson, understood this idea perfectly and, motivated by it, fiercely opposed the establishment of any central bank. Unfortunately their influence was not strong enough to prevent the creation of the current central-planning system in the sector of banking and finance, nor any of this system's harmful effects, past or present, on our economies.⁵⁵

Moreover, as the Public Choice School indicates, privileged special interest groups and politicians will tend to exploit any fiduciary monetary system based on a state monopoly on the issuance of money. In fact, politicians face the irresistible temptation to try to buy votes with funds created from nothing, an enticement analyzed by theorists of the “political cycle,” among others.⁵⁶ Furthermore the possibility of expanding money and credit allows politicians to finance their expenditures without resorting to taxes, which are always unpopular and painful. At the same time, with this course of action, the decrease in the purchasing power of money works in politicians' favor, since income taxes are generally progressive. For these reasons it is especially important that we find a monetary system which, like the one proposed here, permits the discontinuation of state intervention in the field of money and finance. Mises sums up this argument quite well:

The reason for using a commodity money is precisely to prevent political influence from affecting directly the value of the monetary unit. Gold is the standard money... primarily because an increase or decrease in the available quantity is independent of the orders issued by political authorities. The distinctive feature of the gold standard is that it makes changes in the quantity of money dependent on the profitability of gold production.⁵⁷

Therefore we see that the institution of a pure gold standard with a 100-percent reserve requirement has emerged from the choices made by millions and millions of economic agents in the market throughout a prolonged evolutionary process, and it provides the vital opportunity to check the tendency of all governments to meddle in and manipulate the monetary and credit system.⁵⁸

7. The Proposed System Is the Most Compatible with Democracy. One of the key principles of democracy is that the financing of public activities must be the object of discussion and explicit decision-making on the part of political representatives. The current monopoly on the issuance of money, which is held by a public agency and a banking industry that operates with a fractional reserve, permits the ex nihilo creation of purchasing power which benefits the state and certain individuals and companies, to the detriment of the rest of society. This possibility is exploited mainly by the government, which uses it as a mechanism for financing its expenditures without having to resort to the most obvious and politically costly route, an increase in taxes. Although governments try to conceal this financing mechanism by rhetorically demanding that budgets be financed in an “orthodox” manner, and that the deficit not be directly funded through the issuance of currency and credit, in practice the result is quite similar when a significant number of the treasury bonds governments issue to finance their deficit are later purchased by central and private banks with new money of their own creation (indirect process of monetization of the national debt). Furthermore we should emphasize that the hidden expropriation of citizens' wealth, an action permitted by the process of fiduciary inflation, profits not only governments, but also bankers themselves. Indeed, because bankers operate with a fractional reserve and governments do not oblige them to devote all credit expansion to financing the public sector (through the purchase of treasury bonds), banks also carry out a gradual, diffuse expropriation of a major portion of the purchasing power of citizens' monetary units, while banks' balance sheets reflect the amassment of considerable assets which are the cumulative result of this historical process of expropriation. In this sense, bankers' protests against the suggestion that they be required to devote such a large percentage of their assets to financing the public deficit must be understood as one side of an argument between the two “accomplices” in the socially detrimental credit-expansion process, accomplices who “negotiate” between themselves which share of the “profits” each will take.

In contrast to the above system, a pure gold standard with a 100-percent reserve requirement would oblige states to fully specify their expenditures and the sources of their income, which would prevent them from resorting to the covert financing available in inflation and credit expansion. Moreover, such a system would also preclude private bankers from profiting from a large portion of this “inflationary tax.” Maurice Allais has given an abundantly clear assessment of this point. He states:

Given that any creation of money exerts the same effects as would a true tax imposed on all whose income is diminished by the rise in prices which inevitably follows the issuance of new money, the profit derived from it, which is actually considerable, should return to the state and thus permit it to reduce the overall amount of its taxes.⁵⁹

Nonetheless, we suggest a much more favorable option: that the state should relinquish its power to issue money and thus accept an obligation to rely on taxes in order to finance all of its expenditures, which it would be required to do with complete transparency. As a result of the above, citizens would directly perceive the entire cost involved and would hence be sufficiently motivated to subject all public agencies to the necessary monitoring.

8. The Proposed System Fosters Peaceful, Harmonious Cooperation among Nations. An analysis of the history of military conflicts over the last two centuries plainly reveals that many of the wars which have ravaged humanity could have been completely prevented or would have been much less virulent if it had not been for states' mounting influence in monetary matters and, ultimately, their acquired control over credit expansion and the creation of money. Indeed, governments have concealed the true cost of military conflicts from their citizens by largely financing these costs using inflationary procedures which, under the pretext of each particular military emergency, states have employed with absolute impunity. Therefore we can confidently assert that inflation has fueled wars: if in each case the citizens of the nations engaged in battle had been aware of the true cost involved, either hostilities would have been averted in time by the corresponding democratic mechanisms, or citizens would have required governments to negotiate a solution long before the destruction and damage to humanity reached the immense degrees which, sadly, they have reached in history. Thus we conclude with Ludwig von Mises:

One can say without exaggeration that inflation is an indispensable intellectual means of militarism. Without it, the repercussions of war on welfare would become obvious much more quickly and penetratingly; war-weariness would set in much earlier.⁶⁰

At the same time, the establishment of a pure gold standard with a 100-percent reserve requirement would amount to a de facto adoption of a single, worldwide monetary standard. There would be no need for an international central bank, and thus no risk that such a bank would manipulate the worldwide supply of money and credit. In this way, we would enjoy all the advantages of a single, international monetary standard, yet suffer none of the disadvantages of intergovernmental agencies related to money. Furthermore this system would not provoke suspicion concerning a loss of sovereignty to the corresponding states, while all nations and social groups would benefit from the existence of a sole monetary unit which no one would govern nor manipulate. Therefore a pure gold standard and a 100-percent reserve requirement would promote international economic integration within a harmonious juridical framework of mutual satisfaction, a framework which would minimize social conflicts, thus encouraging peace and voluntary trade between all nations.