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Many wacky fixes for our broken financial system are currently floating around cyberspace. Some are proposed and discussed right here on Cif. One particularly extravagant idea involves removing the ability of private banks to "create" money and forcing them to adopt 100% reserve banking. In effect, no banker would be able to issue credit in excess of the government-backed notes and coins deposited in his vaults.
This gem is not confined to Cif: US congressman Dennis Kucinichvoiced support for the idea – without being challenged – during a discussion with James Naughtie on last Wednesday's Today programme (scroll down to 0810 to listen).
Some even want to take the 100% reserve idea one step further and introduce what can only be described as an extremist gold standard system, where the amount of money in the world economy exactly equals the total world weight of gold (or some other commodity). This is a version of the gold standard so radical that it did not even operate during the classical gold standard era of the late 19th century. There is even a UK political party that espouses this idea, calling itself the Money Reform Party (although just how seriously it takes itself after winning just 33 votes to the Official Monster Raving Loony Party's 132 at the 2006 Bromley and Chislehurst by-election I do not know).
Hundred per cent reserve banking is dangerous and politicians should avoid proposing it at all costs. Introducing a gold standard would be pure lunacy and would do nothing to ensure future financial stability. Let me explain this position by imagining first what would happen following the introduction of the weak version of the policy (100% reserves), and then the strong version (100% reserves plus gold).
Banks fulfil a market niche for which there is great demand: they offer a variety of financial services that any one individual customer cannot carry out on her own because of the costs and risks involved. Benefiting from size and scope, a bank reduces information costs and is able to enforce the contracts required for efficient matching of borrowers with lenders. Bankers' core business involves profiting from the realisation that savers will at any one time demand back only a small proportion of deposits from their vaults. Put simply, this gives banks the ability to lend out money that they do not technically have, on trust. It is a perfect system in that it doesn't need a central planner, instead allowing the market to determine the necessary money supply; banks that lend too much will be seen as too risky and will be forced to recapitalise or fail, as is currently occurring.
If the weak version of the policy were introduced, banks would lose their money creation ability and would become mere piggy banks. There would not be enough cash in circulation as a result, so De La Rue plc would be forced to print money and hand this over to bankers to stuff their vaults with. This money would not be used much by anyone; it would have to stay locked in vaults by law to fulfil the reserve requirement. Instead of the market deciding how much money the economy can absorb, Whitehall bureaucrats would now centrally plan the money supply. There would never be a bank run ever again, but bankers would have neither incentive nor ability to lend out money. Everyone but De La Rue would be worse off.
Of course, this policy is totally unenforceable. A new class of moneylenders would be created which would emulate the old bankers' business model. They would find some way around the 100% reserve requirement and a shadow credit market would be created which would be totally unregulated. Individuals and businesses would still have access to credit for consumption and investment, but at great personal cost. Contracts would now be enforced using knuckledusters not law courts. Interest rates would be in double digits and paid weekly.
The stronger version of the policy would mean that the Bank of England would bankrupt the entire nation overnight, as there simply is not enough gold to go around. Assuming for a moment that there were enough, then the implication is that the wealth of nations would now be determined not by the goods and services they produced but instead by a weight of gold. Ludicrous.
Under a gold standard system, not even bureaucrats could regulate the money supply. They would set the exchange rate between currency and gold once only, and be forced to maintain this for fear that readjustment would end with a gold run and financial crisis. We would be at gold mining countries' mercy. And we would not be financial crisis-free. Between 1870 and 1914 – the period of the classical gold standard – there were hundreds of financial crises in both the developed and developing worlds. The gold standard stability myth is just that: a myth.
This excellent teaching article on the gold standard by Lawrence Officer at the University of Illinois explains the ins and outs of previous gold standard regimes, including how attempts at gold's reintroduction between the world wars was probably the single biggest cause of the Great Depression. The economic history of gold standards is something that everyone should know about, and this article is a good starting point for James Naughtie in preparation for his next interview with deluded congressmen like Dennis Kucinich.
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