Tuesday, September 28, 2010

The Gold Standard, Abolishing the Federal Reserve and Money and Banking 101

Last Wednesday night I was at a Liberty on the Rocks event and got into a discussion with someone who advocated abolishing the Federal Reserve and returning the U. S. to the gold standard. This is a reoccurring theme on the part of supporters of Ron Paul and a lot of tea party members. You see "Abolish the Fed" signs at rallies and any call for abolishing the Fed gets cheers. I am always surprised that so many people care so passionately about this issue. I am really surprised that they know enough about the issue to have a passionate opinions.

While I am not an expert on the Federal Reserve, I tend to think we need the Federal Reserve or something like it. I am also not convinced that returning to a gold standard would end inflation and solve our economic problems. I am open however to hearing the arguments from those who advocate the gold standard and abolishing the Fed. I am open to being persuaded.

In my discussion with this guy on Wednesday night, it was clear that he had strong views on the topic, but I discovered he had very little knowledge about money and banking. He did not know how money is created. If one is going to argue passionately for the gold standard and abolishing the Federal Reserve, it would help your credibility to understand a few basics about money and banking. It would help your cause if you knew what you were talking about.

Now, I am not an economist. In college, I earned enough credit-hours to have a major in economics and have continued to stay informed on economic issues since then, but there are many people who know more than I do. I think, however, that I have an understanding of a few economic basics. Here are a few essential, elementary things anyone who wants to speak intelligently about monetary policy should understand.

  • Most money is not currency. The money supply includes coins, currency, traveler's checks, checking account balances, NOW accounts, and balances in credit unions accounts and more. Currency is only small part of money.
  • Government does not determine the money supply; the government only controls the amount of currency. Currency and money are not the same thing.
  • Money was never backed by gold, only currency.
  • Money is created when people borrow and repay loans.
  • An expanding money supply facilitates economic growth.
  • An expanding money supply is not inflationary if goods and services are increasing by the same amount.
Many people are totally mystified about how the money supply expands and think it only expands when government prints money. I suspect many of those carrying signs to abolish the Fed and who cheer at rallies when someone advocates abolishing the Fed do not understand the basics. Below is an explanation of how money is created.

Modern money developed from the trade of goldsmithing at the end of the middle ages. At that time people began storing their excess gold and silver with the local goldsmith for safekeeping. When gold or silver was put in storage, a receipt was issued by the goldsmith to the owner, as a record of ownership. The paper receipts were much easier to carry than the gold or silver, especially for larger transactions, so they began to be used instead of the precious metal itself.

Then the enterprising goldsmiths figured out that they could loan out the gold they held for their customers, to third parties. Or better yet, they could issue receipts instead of actually loaning the gold. The next step was recognizing that they could print more receipts and make even more loans than they held in gold. In the idea of loaning the value of gold they did not own, but only held in trust, and the value of gold that did not even exist, was the germ of the invention of modern money.

As long as not everyone wanted to redeem their receipts and loans for gold at one time, this system created by the goldsmith/bankers did facilitate trade when there was a shortage of the commodity, gold, which was used as currency. The fact that the goldsmiths provided an adequate money supply made possible the industrial revolution. Meanwhile, the goldsmith/bankers had a good thing going. They were receiving interest by loaning the gold assets that they were being paid to hold in trust for others, and additional interest from loans based on gold that did not even exist.
However, the system was not perfect. When economic conditions changed or trust in this shell game waned, there were bank runs, and people lost their money and their gold as a result. If a goldsmith could not come up with enough gold to satisfy all claims to redeem receipts for gold at a given time, the system broke down.

Banks are the modern successors to the goldsmiths. The way they operate is basically the same, although money can no longer be redeemed for gold; it is now only a token or medium of exchange. (link)
If this explanation of how money is created is not right, then please explain why it is wrong. If I am wrong on some of the basics, please correct me. If we are on the same page about the basics, then we can move on to talking about abolishing the Federal Reserve and returning to the gold standard. I'm ready to listen.

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