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From the Gold Standard to the Fractional Reserve System
Once the world was run by gold, now it’s by paper and plastic. But how did this transition happen? Why is it important? Why does it affect our lives and did the world make the right choice in this switch?
Which Financial System is the Better Choice Today?
By Pawan Shamdasani, Staff Writer
Design by Mary Zhao, Staff Designer
Once the world was run by gold, now it’s by paper and plastic. But how did this transition happen? Why is it important? Why does it affect our lives and did the world make the right choice in this switch?
To start, the gold standard was a monetary system where each participating country fixed the value of its currency to a specific amount of gold. Most developed countries adopted this system during much of the nineteenth century and early twentieth century.
Meanwhile, the Fractional Reserve system—the most current monetary system—has existed since the early nineteenth century. This system involves banks keeping a fraction of their deposits as reserves while lending out the remaining and having the obligation to redeem all these deposits upon demand.
Amid this latest financial downturn, there has been a lot of heated debate by economists about whether the Fractional Reserve system is the still most appropriate for the current financial system. Now it’s our turn to join that debate.
Golden History
Before World War I, the world economy operated under the gold standard. The standard was adopted by England in 1717, the United States in 1834, and by other major countries in the 1870s. During 1880 to 1914, most countries adhered to the “Classical Gold Standard”; this was also a period of unprecedented economic growth and relatively free trade in goods, labour and capital.
But WWII changed everything.
The gold standard collapsed as countries demanded monetary flexibility to finance the war. Only after Germany’s defeat did developed countries initiated the “Gold Exchange Standard”, where all countries fixed the value of their currencies in terms of the U.S. dollar. Likewise, the U.S. Central Bank fixed the value of the dollar in terms of gold. But this system was no better than the last, as it broke down in the early 1930s.
Then came “the Bretton Woods System” around 1944. This system was based on the convertibility of U.S. dollars into gold (for foreign governments and central banks only) at thirty-five dollars per ounce. With this system, the majority of countries settled their international balances in U.S. dollars. However, continuous U.S. balance-of-payments deficits steadily reduced their gold reserves, thus lowering the ability of the United States to redeem its currency in gold.
Finally, on August 1971 the gold standard was abolished.
Fractional History
Since the end of gold’s dominance, the world economy has largely operated under the Fractional Reserve system.
Savers of money were in search of safekeeping depositories for their valuables, including gold and silver coins, eventually lending these to goldsmiths who would return a receipt (an IOU or note) for their deposits. Gaining the trust of people, these goldsmiths’ notes became a popular medium of exchange and an early form of paper money was created.
But during this process, goldsmiths began to notice another trend.
During trades, people would not usually redeem all their notes at once and so the goldsmiths took this opportunity to re-invest their gold coin reserves in interest-bearing loans and bills. Clearly, income was generated for the goldsmiths leaving them with more issued receipts than gold reserves. The goldsmiths’ role as a guardian of gold and charging fees for secure storage was altered to that of an interest-paying and interest-earning bank.
And that’s how the Fractional Reserve system was born.
Midas’ Tip Sheet
The gold standard was used to regulate the quantity and growth rate of a country’s money supply. It ensured that, for most countries, the money supply (and thus the inflation rate) was relatively stable as new production of gold added only a small amount to the accumulated stock. An exception to this was when Australia and California discovered many gold reserves in the early 1850’s, causing global price levels to shortly become very volatile.
The gold standard was an example of a fixed exchange rate regime where most currencies were convertible directly into gold at fixed rates, so exchange rates between countries were also fixed. Canadian dollar bills, for example, could be exchanged for approximately 1/20 ounce of gold. Likewise, the British Treasury would exchange 1/4 ounce of gold for one pound.
Because a Canadian could convert twenty dollars into one ounce of gold, which could be used to buy four pounds, the exchange rate between the pound and the Canadian dollar was effectively fixed at approximately five dollars to the pound.
As exchange rates were fixed, the gold standard was the cause of parallel movements in the price levels around the world. This movement mainly occurred through an automatic balance-of-payments adjustment process known as the “price-specie-flow mechanism.”
To explain, this mechanism operated like so: using the US as an example, if a technological innovation was the result of quicker real economic growth in the United States and the supply of gold in the short run was fixed, the U.S. price level would fall. Therefore, U.S. exports were less expensive relative to their competing imports (say, from the UK); as such, the British would demand more exports while the Americans would demand less imports.
The result?
The U.S. balance-of-payments system is at a surplus causing gold (specie) to flow from the United Kingdom to the United States. The inflow of gold increased the U.S. money supply having the reverse effect of increasing prices while the outflow of gold reduced the U.K. money supply, lowering prices. The net effect was balanced prices among the two countries.
The drawback of the gold standard is that it was known to cause both monetary and non-monetary (real) shocks. These were transmitted through flows of gold and capital between countries. A monetary shock in one country would affect the money supply, domestic expenditure, nominal income, real income, and the price level in another country. An example of a monetary shock was the California gold discovery in 1848.
If the gold standard was to function effectively, the Central Bank had to play by the “rules of the game.” Michael D. Bordo, a professor of economics at Rutgers University explains that these banks were supposed to “raise their discount rates (the interest rate at which the central bank lends money to member banks) to speed a gold inflow, and to lower their discount rates to facilitate a gold outflow. Thus, if a country was running a balance-of-payments deficit, the rules of the game required it to allow a gold outflow until the ratio of its price level to that of its principal trading partners was restored to the par exchange rate.”
The Fractional Guide
As for the Fractional Reserve system, this is where commercial banks (not the government) are ultimately involved in the creation of money. To initiate the process, people deposit their money in banks, who then lend out a fraction of their depositors money to other customers. The remaining funds are held with the banks as reserves.
These customers pay interest on the borrowed funds used to finance the banks’ expenses of conducting business (that is, to pay interest to their depositors) and as a source of profits for the banks’ owners. The bank behaves as an intermediary between the people who have a surplus of resources and those who have a lack of it. When lending out money, the bank absorbs most of the risk and must return the principal to the depositor irrespective of their return on the investment.
The practice of Fractional Reserve banking has a cumulative effect on the banking system, allowing it to create money. For instance, if Jason deposits $100 in Bank A, which lends out $50 to Ray who spends it, the money is eventually deposited in Bank B by a different person. Bank B then lends out $25 to Mary, which is spent and deposited in Bank C. The process continues indefinitely until the total amount of deposits equals a multiple of the initial amount of cash deposited in Bank A.
In this example, the total amount of deposits, $200, is exactly twice the initial amount of cash, $100. This multiple is known as the money multiplier, which depends on the required reserve ratio and the currency ratio.
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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