Gold Money and Banking

Pure gold is scarce, perfectly homogenous and divisible, but it is hardly perfectly portable. If all producers were willing to trade their goods and services only for physical gold, then large transactions involving large amounts of gold would be difficult to execute. The resultant costs and inconvenience of these transactions would tend to inhibit trade – and thus limit the extent of a society’s division of labour, specialisation, growth of wealth and standards of living. Historically and logically, then, the spontaneous rise of a medium of exchange is followed sooner or later by the development of a banking system and credit instruments (such as bank notes and deposits) that substitute for but are convertible into gold.

A “free banking” system based upon gold is able to extend credit and create bank notes (currency) and deposits according to economic requirements (see, for example, Lawrence H. White, Free Banking in Britain: Theory, Experience and Debate, 1800-1845, The Institute of Economic Affairs, 1995, ISBN: 0255363753). Owners of gold are induced by payments of interest to deposit their gold in a bank’s vault. Once it is deposited they can write cheques against their deposits. But since depositors will rarely want to withdraw all of their gold at the same time, the bank need keep only a fraction of the gold in its vault as an unencumbered reserve. Indeed, unless the bank extends credit to borrowers and charges interest upon these loans, then it cannot pay interest to its depositors.

If a bank lends beyond its reserves, i.e., in excess of the savings represented by the gold deposited in its vaults, then its “excess” notes (paper money) are effectively counterfeit. If, in other words, a monetary unit can be replicated at will with little or no regard to cost, whether it is a paper currency or a computer entry, it is physically and morally identical to the counterfeiter who prints currency. It is economically damaging and morally fraudulent.

America’s Founders, utterly unlike today’s politicians and economists, understood thoroughly the economic and moral hazards posed by bank notes not backed by savings. Rep. Ron Paul’s outstanding speech Paper Money and Tyranny notes that they “warned against the temptation to seek wealth and fortune without the work and savings that real prosperity requires. James Madison warned of ‘the pestilent effects of paper money,’ as the Founders had vivid memories of the destructiveness of the Continental dollar. George Mason of Virginia said that he had a ‘mortal hatred to paper money.’ Constitutional Convention delegate Oliver Ellsworth from Connecticut thought the convention ‘a favourable moment to shut and bar the door against paper money.’ This view of the evils of paper money was shared by almost all the delegates to the convention, and was the reason the Constitution limited congressional authority to deal with the issue and mandated that only gold and silver could be legal tender. Paper money was prohibited and no central bank was authorised. Over and above the economic reasons for honest money, however, Madison argued the moral case for such. Paper money, he explained, destroyed ’the necessary confidence between man and man, on necessary confidence in public councils, on the industry and morals of people and on the character of republican government.’ The Founders were well aware of the biblical admonitions against dishonest weights and measures, debased silver and watered-down wine. [Hence] the issue of sound money throughout history has been as much a moral issue as an economic or political issue.”

Critically, then, under free market banking arrangements monetary shenanigans are possible. Equally importantly, however, they will tend to be infrequent, localised and limited to a single bank or a small number of banks. The total amount of loans that a bank can extend under these circumstances is rather strictly circumscribed. It depends upon the size of the bank’s reserves, the quality of its investments and the extent to which its borrowers are creditworthy. When banks lend money in order to finance productive and profitable endeavours, its loans are repaid predictably and relatively rapidly; and bank credit, for those who can afford it, is generally available. But when business ventures financed by bank credit are less or suddenly unprofitable, and therefore when their loans are repaid more slowly and erratically, bankers soon find that the total amount of the loans they have extended is excessive relative to their gold reserves. Hence they curtail new lending – usually by imposing additional conditions upon borrowers, reducing the terms of loans and charging higher rates of interest. These actions tend to restrict the extension of credit to new (and hence unproven) ventures, and encourage existing borrowers to improve the profitability of their operations before seeking additional credit to finance further expansion. In this way a gold standard and free market banking system, like laissez-faire capitalism more generally, provide a self-correcting feedback mechanism that promotes balanced growth and economic stability.

Further, when gold is accepted as the medium of exchange within most or all nations, as it was during the nineteenth century, an unhampered international gold standard and international free banking foster a world-wide division of labour through international trade. From the conclusion of the Battle of Waterloo until the outbreak of the First World War, in other words, international monetary arrangement based upon gold reserves facilitated free trade, capitalism and therefore higher standards of living for countless millions around the world. Even though the units of exchange (U.S. dollar, British pound, Swiss franc, etc.) differed from one country to another, when all are defined as particular weights of gold – so long as there are no restraints on trade or on the movement of capital – then commerce within and between countries is co-ordinated by the peaceful and enlightened self-interest of large numbers of producers and consumers. Under these conditions interest rates and prices tend to follow similar patterns in all countries. To give a prominent example, if banks in one country extend credit too liberally, then interest rates in that country will tend to fall. The fall of interest rates in Country A, in turn, induces depositors in A to shift their gold to higher-interest-paying banks in other countries. This will immediately shrink bank reserves in the “easy money” country. This shrinkage will induce tighter credit standards and a return to competitively higher interest rates.

Alas, a fully free banking system and fully-fledged gold standard have never existed. But before the First World War the banking system in Britain, United States and their major trading partners was based upon gold. Governments, it is true, occasionally meddled and intervened – indeed, during and after its Civil War the U.S. Government intervened to such an extent that America effectively left the gold standard for fifteen years. But as a rule, during the nineteenth century banking was much more laissez-faire than dirigiste. Periodically, and as a consequence of an overly rapid extension of credit, banks lent to and beyond the limit of their gold reserves. Interest rates then rose sharply, new credit was severely curtailed and the economy went into a sharp but short-lived (typically six to nine month) recession. Compared with the Depressions that began in 1920 and 1930, for example, nineteenth century slumps were mild; and compared to the recessions since the Second World War they were short. It was the bulwark of a finite resource that prevented the development of unbalanced expansions of business activity. The existence of limited gold reserves, in other words, rendered virtually impossible the type of monetary disaster that occurred after the First World War.