There has been a great deal of discussion about the gold standard and related issues of fractional reserve banking, money creation, and inflation in recent years. In order to have a useful conversation and debate, however, we must begin with a serious discussion of money and intermediation. What follows is a broad discussion of money. The reason is both to organize my thoughts and to define and contrast public and private money as well as what is meant by backed versus fiat money. Subsequently, the discussion turns to the interaction between money as a store of value and medium of exchange. Finally, I discuss private note issuance on the part of banks and the “backing” of such notes.
Money: Public and Private
Our current monetary system consists of both public and private money. By public money, I am referring to what is typically called base money (although it might even be more accurate to refer to the physical currency in circulation). Private money is that which is created by banks. This naturally raises questions as to whether there is something that distinguishes each from one another. In order to understand this, we need to think about what banks are and what banks do.
Banks are financial intermediaries. They issue liabilities in order and invest the proceeds in assets. In this sense, they are no different than an insurance company or a pension fund. Where they differ is in the types of liabilities that they issue. An insurance company issues state-contingent liabilities (i.e. if there is an auto accident, the insurance company pays out to the policyholder). A pension fund pays out state-contingent liabilities. Bank liabilities, however, most often offer immediate redemption in base money. There is nothing, however, that states that banks need to offer this type of liability. It is entirely possible that banks could offer time-contingent liabilities just like a pension fund. For example, a bank could issue a deposit liability and promise redemption a date in the future. The bank could then serve as intermediary between borrowers and lenders.
The primary difference between banks and the other financial intermediaries is the type of liability that they issue and its characteristics. Insurance and pension liabilities do not routinely circulate as medium of exchange. What makes bank liabilities special is that they do circulate as medium of exchange. When one uses a check at the store, it is like saying, “I don’t have any physical currency on me, but if you contact these people, they will give it to you.” Why do bank liabilities have this quality? Conceivably, it is because the liabilities promise immediate redemption. I can take the check to the bank and cash it whereas I would have to wait until the purchaser reached retirement age to redeem a liability tied to the pension fund.
Thus, banks are not only financial intermediaries, but money creators. A natural question is then where does the money come from? Do banks simply create money out of thin air?
Money: Backed and Fiat
Under a gold standard, money is redeemable in gold. In other words all money (both publicly and privately issued) is redeemable in gold. Assuming that there is a central bank, it is possible that I could show up at a bank and redeem my deposit for currency issued by the central bank or in gold (or a gold certificate). Even if I redeem the deposit for currency, I could always go back to the bank and redeem the currency for gold. (If there is no central bank, there is no public money, but we will leave this until later.)
In modern economies, there is no gold standard. If you show up at the bank to redeem a deposit, you will be handed physical currency. If you try to redeem that currency, say a $20 bill, you will receive a $10 bill and two $5 bills or some such combination.
Under a gold standard, money creation is directly tied to the stock of monetary gold (this is true even under a fractional gold standard). An over-issuance of money results in a wave of redemptions (either by individuals or foreign central banks) thereby providing a natural mechanism for controlling the money supply. Under a fiat currency, this mechanism does not exist. However, it doesn’t mean that no mechanism exists.
Critics of fiat money often assert that there is a direct correspondence between money creation and fractional reserve banking. As a result, a common neo-Austrian argument is that fractional reserve banking combined with fiat money will lead to excessive money creation. An extreme Austrian argument is therefore to require banks to hold 100% reserves that are backed by gold.
Defenders of fractional reserve banking often point out that the fractional reserve system is one that naturally arises as a result of profit-seeking. For example, a bank that accepts deposits will, over time, realize that only a fraction of the deposits are actually redeemed on any given day or in any given week and that other deposits are issued during this time. If deposits and withdraws are random, there might be a net inflow or a net outflow to the bank on any given day. By the Law of Large Numbers, the bank would not need hold reserves equal to the amount of deposits over this period, but rather only an amount of reserves that are a fraction of the amount of deposits (enough to cover net outflows of reserves caused by excessive redemptions).
I believe that this defense of fractional reserve banking is correct, but it goes above and beyond the critique leveled by neo-Austrians. What 100% reservists are arguing is that fractional reserve banking leads to money creation. However, as noted above, this is not the source of money creation. For example, insurance companies and pension funds are both financial intermediaries and hold an amount of cash that is a fraction of the liabilities that they issue. However, nobody accuses these intermediaries of money creation. Why? The reason is because their liabilities do not circulate as medium of exchange. Bank liabilities do. But why do bank liabilities circulate? Conceivably it is because they offer immediate redemption. It is not because of fractional reserve banking.
Indeed it is entirely possible that a bank with 100% reserves could create money. Banks could issue deposit liabilities with the promise of redemption at some date in the future and then invest the proceeds in assets in the intermediate term. Barring legal restrictions, it is entirely plausible that deposit holders could write a check for less than or equal to an amount of their deposit and this claim to the deposit could circulate as a medium of exchange just as a standard checking deposit. The reason that this does not seem probable (but is completely plausible) is because of the characteristic of the liability. The deposit issued by the 100% reserve bank is less liquid than a deposit that is instantly redeemable. This counterfactual would again seem to lend credence to the view that it is not fractional reserves that create money creation, but rather the unique characteristics of the deposit liability.
This similarly leads into another issue regarding banks and fractional reserves. A related argument to the link between fractional reserve banking and money creation is that money is being created out of thin air. Since there does not exist any sort of physical commodity for which money can be redeemed, there is a view that money is simply created out of thin air. But is money being created out of thin air? Let’s consider an insurance company. The insurance company issues a state-contingent liability and uses the proceeds to purchase assets. Among the assets is a cash reserve that is a fraction of the liabilities issued. Has money been created out of thin air? No, money hasn’t even been created. So long as the value of the assets are greater than or equal to the liabilities issued, the liabilities are completely “backed” by those assets. The same is true of a deposit issued by a bank. The bank issues deposits and uses the proceeds to purchase assets. So long as the assets on the bank’s balance sheet are greater than or equal to the deposits, the liabilities are completely “backed” by those assets. Thus, deposits are no more created out of thin air than are insurance of pension fund liabilities. What is different is that bank liabilities circulate whereas the others do not.
This represents a very broad overview of money and intermediation. An obvious question, however, is why we care about these properties and what the implications are. As alluded to in the introduction above, in part 2 I will discuss the role of money both as a medium of exchange and as a store of value and why the interaction between these two characteristics might matter. In addition, if we are to take such interactions seriously, what are the possible implications for monetary institutions? In particular, I will consider the implications of private note issuance on the part of banks and whether it matters if these notes are “backed” by some type of commodity. Finally, part 2 will conclude with a summary of the implications for the gold standard and other monetary arrangements.