The Gold Standard and Fractional-Reserve Banking; J. Cobb

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 metaa 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 mon etary assets to the secret manage ment of the U.S. Treasury with out the ability to detect mis-man a.gement. 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 569 570 TIRE FREEMAN September 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 can it "one dollar" ion 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 aU 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 check ing account in his name). At this moment, the banker has 100 per cent reserves for his deposits. The next customer in the bank, how ever, is someone who wants to borrow - let's assume the borrow er 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 identi cal to the ones pe issued to the de positor. The total number of cer tificates is now greater than the supply of gold in the vault, so the hanker's reserves are only a frac tion of his total outstanding cer tificates "payable in gold." There is nothing fraudulent about this; the banker's assets equal his lia bilities, 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 bank ing, but we need to understand the difference because there is a crit ic'al 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 hold er of both gold coins and .paper dollars will tend to spend the pa per 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 be tween the "good" money and the "bad" money. When there is a floating price, both forms of mon ey circulate with equal frequency and the "price" of one in terms of the other adj usts according to the demand. This is a simple phenom enon arising from the two sepa rate 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 pre1975 THE GOLD STANDARD AND FRACTIONAL-RESERVE BANKING 571 ferred as a m~dium of exchange.

If sellers wanted coins instead of doUars, they would offer discounts for payment in gold. These dis counts 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 pri marily of checks, credit cards, and Federal Reserve Notes. The medi um of exchange is entirely made up of credit. To refer back to the work of Ludwig von Mises, "mon ey" is not in circulation at all even though many of us are rely ing on gold as our store of value almost exclusively. What circu lates is credit certificates, and it is the rapid expansion of credit which is causing double-digit in flation. It is always assumed by advo cates of a "gold-backed" money that the quantity .of gold ("mon ey") will hold the supply of credit ("dollars") in bounds which will prevent excessive credit expansion.

I submit that this is a false as sumption. It is true that when the runs on the banks begin, the bank ers 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, may be we ought to abolish the Federal Reserve System and freeze the ability of the government to ex pand 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 tri umph over (1) those who have a vested interest in the present sys tem of credit expansion, and (2) the ignorant who would be per suaded by the first group that we are either nutty or evil. There is, however, a more direct and easily achieved solution. Hap pily enough, also, .the monetary authorities are playing into our hands on this one. The solution in volves the utilization of two dif ferently-named units for the two different kinds of financial assets.

Let the store of value be known as "ounces of gold" and let the medi urn 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 prob lem of inflation, of course, would remain putting an end to credit expansion by the Treasury and the Federal Reserve System. How ever 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 avail572 T'HE FREEMAN September ability 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, oc cur onJy 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 divers reasons, and prices adjust accord ingly. The political system takes advantage of this random, or un predictahle, free market process.

The government long ago learned that it 'Can increase aggregate de m,and by printing bonds, using the bonds as assets against which to create Federal Reserve Notes and demand deposits in the bank ing 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 m'andated 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 compeHing 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 mani festation of the free market prin ciple that people will do what is in their own best interests re gardless of government policy. Indeed, the greater utilization of gold coins will increase the de mand 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 oppor tunity for private investors to buy). Any attempt by the government to "fix" the value of the depre ciated unit of credit in terms of gold, however, should be vigor ously resisted by anyone who values either economic freedom or private gold reserves.