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From the Gold Standard to the Fractional Reserve System
The Benefits
The main advantage of the gold standard was it ensured long-term price stability. Between 1880 and 1914, the average annual inflation rate was 0.1 percent, whereas under the Fractional Reserve system, between 1946 and 2003, the average was 4.1 percent.
On the other hand, the Fractional Reserve system benefits a large number of players in the economy including depositors, borrowers, bankers and society. Depositors are able to earn interest on their deposits instead of having to pay to keep their money at the bank. Borrowers have access to these funds at competitive interest rates that they would not otherwise obtain. Bankers are able to generate profits and society can efficiently channel idle resources into economic productive use.
The Costs
The main disadvantage of the gold standard was that prices were highly volatile in the short run, mainly because economies were so susceptible to real and monetary shocks. A measure of short-term price instability is what D. Bordo states as the “coefficient of variation—the ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change.”
For the United States, the coefficient of variation was 17.0 between 1879 and 1913 under Gold, while it was only 0.88 between 1946 and 1990 under Fractional.
Also, under the gold standard, the government could not use monetary policy to stabilise output, so economies were not able to avoid or offset monetary or real shocks. This meant that real output was more variable under the gold standard. Unemployment was also higher during the gold standard era, averaging at 6.8 percent in the United States between 1879 and 1913.
The most common issue with the Fractional Reserve system however, is that it is responsible for inflation. Money creation by banks causes the money supply to grow faster than the commodity supply, resulting in the price of goods and services to rise and generate higher inflation.
Meanwhile, a problem claimed by few Austrian Economists is that the system subjects the economy to boom-bust cycles it cannot avoid.
Conclusion
As of today, the consensus among most economists is that it would not be wise to return back to the gold standard.
The key issue with gold functioning as a monetary standard is that there is no guarantee gold stocks will grow at rates necessary to keep prices stable.
In the past, new discoveries of gold reserves created substantial inflation and had adverse macroeconomic effects. At other times, it was observed that prices would fall as a result of the gold stock failing to grow fast enough.
But the core problem occurred when the public began doubting the redeemability of the currency. There was a rush to convert those currency notes back to gold, causing the total money supply to shrink.
As mentioned earlier, the severity of the Great Depression was largely a consequence of staying with the gold standard. Once the United States withdrew from its commitment to operate on the standard, the money supply stopped shrinking.
With the Fractional Reserve system however, it is more difficult to determine whether the costs outweigh the benefits or vice versa. The 2008 financial crisis has spurred much debate about reforming the financial system and how the banking system operates. Returning to a system of one-hundred percent reserve banking (but with a gold standard) is a possibility, yet the main consequence of this would be deflation, which is strictly more harmful than inflation. In fact, some inflation is vital to stimulate a growing economy and lowering unemployment levels. So at least for now it’s safe to say that we won’t be seeing any dramatic changes in the financial system … at least not until the next financial disaster.
Arbitrage Magazine
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