How Credit Suppresses the Gold Price (with Alice and Bob)

Alternative title: How Credit Creates Inflation
Alternative title: How Gresham’s Law Destroys the Gold Standard

Our small closed economy has five main protagonists, Alice the Automobile Saleswoman, Bob the Banker, Charlie the Capitalist, Dave the Debtor, and Steve the Saver. This small economy is on a gold coin standard, i.e. gold coins circulate as cash. In order to see how the real price of gold (measured in Ferrari sports cars) depends on the creation of credit, we consider the following scenarios.

• A cash based economy without any lending and without any banks.
• An economy with banks, but without lending.
• An economy with banks and with fractional reserve lending.
• An economy without banks, but with private-to-private lending.
• An economy without banks, but with commercial Real Bills.

 
The reason for presenting the toy model is our claim in Sections 5 to 7 of The Many Values Of Gold that the fatal flaw that renders the gold standard unsustainable in the long run, is the fact that there exists credit denominated in a weight of gold and that this credit circulates as currency, i.e. that it is accepted as a form of payment for goods and services.

If you are just interested in how credit creates inflation, please ignore all the mentionings of the gold standard, imagine our economy would just use any paper currency such as the US$ or the Euro and continue reading.

Defenders of the gold standard often claim that the gold standard failed for one of the following reasons and can therefore be made viable if some specific problems are solved:

• Mismatch of maturities of bank deposits and loans. If the banking system were organized in such a way that maturities always matched, there would be no problem with the gold standard.
• Fractional reserve lending. If the banks were required to be fully reserved, there would be no problem with the gold standard.
• The fact that loans are extended for unproductive purposes. If loans were made only for productive enterprises, for example, in the form of Real Bills, there would be no problem with the gold standard.

Our toy model allows us to discover which ones of these additional measures succeed in fixing the problems of the gold standard and which ones do not.

1. The Protagonists

Our toy model economy is on a Gold Coin Standard. Its currency unit is the dollar ($). One dollar is worth precisely once ounce of fine gold, and for simplicity, all the cash in circulation is in the form of identical gold coins whose fine weight is precisely one ounce. There are no bank notes, and initially there is no credit and no debt either.

• Alice the Automobile Saleswoman plans to sell a Ferrari 458 Italia.
  
  

  Ferrari 458 Italia

  
  The car is to be auctioned in an open auction. The minimum bid is $10. The bid can be raised in increments of $2. Alice will sell the car to the highest bidder. Initially, she has no cash, but only the Ferrari.
• Bob the Banker runs the bank in our toy model economy if the scenario allows banks. Otherwise he is unemployed. He has $1 in cash which can form the shareholders’ equity of his bank. Bob is a prudent banker and never levers up his bank by more than a factor of three (by this, we mean the inverse of the cash reserve ratio). But he is always available for some good business if a favourable deal presents itself. In the scenarios in which Bob is unemployed, he cannot afford a car. In the scenarios in which he is a banker, he is content with the company car he can use, and so he does not care about the Ferrari that is for sale.
• Charlie the Capitalist has long retired from active work. He owns a number of companies and receives plenty of dividends. Right now he has $100 in cash. He, too, is always available for some good business. Since he loves his vintage Aston Martin,
  
  

  Aston Martin (1937)

  
  he does not care about the Ferrari either.
• Dave the Debtor has a well-paid position at a law firm. Unfortunately, right now, he is out of cash as he just spent everything on new furniture. He has only $1 left. But he would love to buy the Ferrari.
• Steve the Saver works as a carpenter. He earns substantially less than Dave, but he has always loved Ferraris, and he has managed to save $10 in cash.

Whenever we say “Back to square one”, this means that these initial conditions are restored: Alice has got the Ferrari, Bob has $1 and a banking licence, Charlie has $100, Dave has $1, and Steve has $10. Let us now study the various scenarios in order to see what happens to the price level in our toy model gold standard economy.

2. The Basic Scenarios

2.1. Cash Based Economy

Back to square one! Alice opens the auction of the Ferrari. In this case, the auction is rather simple and proceeds as follows. The only protagonist who is interested in the Ferrari and who can afford the minimum bid of $10, is Steve. So Steve bids $10 for the Ferrari. As there is no further bid, Alice sells him the Ferrari for $10.

Our toy model has discovered the general price level. Well, it has discovered the price for one Ferrari 458 Italia, namely $10. In fact, what the model has discovered is the Free Gold Price in terms of goods and services: one ounce of unencumbered physical gold is worth 1/10 of a Ferrari. For the notion of the Free Gold Price, we refer to Section 7 of The Many Values Of Gold or to FOFOA’s Once Upon A Time.

2.2. Economy with Banks, but without Lending

Back to square one! Whereas in the previous Scenario 2.1, banks were not allowed, this time Bob is in business. But since lending is not allowed, he merely offers depository services. The opening balance sheet of Bob’s Brothers’ bank reads as follows.

Bob’s Brothers – Balance Sheet No. 1

Assets		Liabilities and Equity
Cash	$1	Shareholders’ Equity	$1

Now Bob’s clients walk in and start depositing cash. Dave deposits his $1, Steve his $10, and Alice also opens an account so she can receive the payment for her Ferrari in a direct account-to-account wire transfer.

Bob’s Brothers – Balance Sheet No. 2

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$0
		Dave’s Account	$1
		Steve’s Account	$10
		Shareholders’ Equity	$1

As soon as everyone is set, Alice opens the auction of the Ferrari. Since lending is still not possible in this scenario, the auction proceeds precisely as in the previous Scenario 2.1. Steve purchases the Ferrari for $10. As we now have a bank and Steve is lazy and does not want to carry around that much cash, he just orders a wire transfer to pay for the Ferrari:

Bob’s Brothers – Balance Sheet No. 3

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$10
		Dave’s Account	$1
		Steve’s Account	$0
		Shareholders’ Equity	$1

In particular, the price of the Ferrari (our model for the general price level) and thereby also the real price of an ounce of gold are precisely as in Scenario 2.1.

2.3. Economy with Banks and Fractional Reserve Banking

Back to square one! Also, please everyone deposit their cash, and so the balance sheet of Bob’s Brothers is precisely as Balance Sheet No. 2 above.

Whereas in Scenario 2.2, Bob’s Brothers merely offered depository services, in this scenario Bob is allowed to make use of his banking licence, and he is able to apply fractional reserve banking and to create credit.

When Alice opens the auction, Steve immediately bids his $10 for the Ferrari. But Dave is also keen on the Ferrari, and thanks to the additional banking services that have become available, he can also join the bidding. Dave rushes to see Bob and negotiates a line of credit. Bob is a prudent banker, and so he verifies Dave’s employment record at the law firm, and once he is satisfied, he extends Dave the requested loan of $12:

Bob’s Brothers – Balance Sheet No. 4

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$0
Loan to Dave	$12	Dave’s Account	$13
		Steve’s Account	$10
		Shareholders’ Equity	$1

Notice that Bob’s Brothers’ balance sheet has expanded to $24 with only $12 of cash in the vault for an overall leverage of 2. This is still within Bob’s Brothers’ regulatory requirement not to lever up beyond a factor of 3.

Now Dave rushes back to the auction and bids $12 for the Ferrari. Since Steve has saved only $10 and since he is called Steve the Saver for a good reason, he decides not to bid for the Ferrari on credit, but he rather decides to quit the auction. Dave’s $12 is the highest bid. Therefore, Alice sells the Ferrari to Dave for $12. Again, payment is by wire transfer:

Bob’s Brothers – Balance Sheet No. 5

Assets		Liabilities and Equity
Cash	$12	Alice’s Account	$12
Loan to Dave	$12	Dave’s Account	$1
		Steve’s Account	$10
		Shareholders’ Equity	$1

Again, our toy model has discovered the general price level, symbolized by the price of the Ferrari 458 Italia. This time, the sports car went for $12. Consumer price inflation!

At the same time, our model has discovered the price of Paper Gold. Whereas in Scenarios 2.1 and 2.2, one ounce of unencumbered physical gold was worth 1/10 of a Ferrari, our model has now discovered a price of gold of only 1/12 of a Ferrari. We use the term paper gold in this case because what determines the price of gold relative to goods and services in this example is no longer unencumbered physical gold, but rather a mixture of physical gold and a loan contract.

Even if Alice had insisted on payment in physical gold rather accepting the wire transfer, the auction price would have been the same. For example, starting from Balance Sheet No. 4 above, Dave could simply withdraw cash from his bank account and pay Alice in cash. Regardless of the precise form of payment, in this Scenario, the price of the Ferrari is $12 rather than $10. What matters is only

1. That somebody (here: Bob the Banker) trusts Dave and extends him a loan denominated in ounces of gold, and
2. That this borrowed gold is accepted as payment for goods and services, i.e. that it circulates as currency. In the example, this became possible because either (Balance Sheet No. 5) Alice accepted credit money as payment (the wire transfer), or alternatively because Bob’s Brothers let Dave take out the cash in order to pay Alice in cash.

This Scenario illustrates the effect described in Sections 5 to 7 of The Many Values Of Gold that what matters for the price of gold relative of goods and services is the currency supply, i.e. the total amount of currency in circulation.

In Scenarios 2.1 and 2.2, the currency supply was $112 ($1 Bob; $100 Charlie; $1 Dave; $10 Steve), but in the present Scenario, the currency supply has been extended to $124 ($1 Bob; $100 Charlie; $13 Dave $12 of which is borrowed; $10 Steve). This was enough to cause consumer price inflation or, conversely, it suppressed the currency price of gold (paper price) below the Free Gold Price. It should come as no surprise that the availability of loans does influence the demand for Ferraris. Without the loan, Dave cannot bid for the Ferrari. With the loan, he can.

Conclusion: Extending loans denominated in ounces of gold suppresses the gold price.

Remark 1. This toy model is simplified and exaggerated (for example, the increment of the bids in the auction is a full 20%), but it is honest, i.e. the availability of loans does affect demand and thereby the market clearing price. Have you ever wondered what drives real estate prices? Demographics? Wage increases? Scarcity of space? How about the availability of credit? For empirical studies of the effect of currency supply on the price level in the case of Japan, we refer to:

Richard A. Werner, New paradigm in macroeconomics: solving the riddle of Japanese macroeconomic performance, Palgrave Macmillan, 2005.

Remark 2. In this scenario, Steve the Saver loses the auction to Dave the Debtor. The way in which this happens, contains a bitter irony: The loan to Dave is possible only because Steve deposited his cash in Bob’s Brothers’ bank where it can serve as the reserve that makes the loan to Dave possible. Had Steve kept his savings in a safe place at home or even in a safe deposit box at the bank, the loan to Dave would not have been possible, and Steve would have won the auction for $10. Morale: It is the saver who calls the shots.

Remark 3. One of the key features of the London (OTC) gold market is the availability of bank credit denominated in ounces of gold (Section 8 of The Many Values Of Gold).

Remark 4. What renders the gold standard unsustainable in the long run is the fact that under a gold standard, loans are of course denominated in a fixed weight of gold. This suppresses the currency price of gold as soon as the currency supply (physical gold plus credit created) grows. The sophisticated investors will realize that the market price of one ounce of paper gold of 1/12 of a Ferrari undervalues gold in this scenario. Therefore, by a variant of Gresham’s Law, they will tend to hoard physical gold and spend credit money, draining reserves from the system. In a crisis of confidence, a run on the banking system (in effect a run on the physical gold that forms part of the currency) is the rational response, leaving behind all the collapsing credit. We discuss this in the next Section 3.

Remark 5. Advocates of a gold standard who try to defend the gold standard, often point out that the problem is specific mistakes in the organization of the banking system. We will come back to this in Section 4.1.

3. Gresham’s Law and the End of the Gold Standard

Alice has always been an avid reader of FOFOA’s blog. As soon as she suspects that Dave did not pay her with his savings, but rather with borrowed money, she knows that there is paper gold somewhere in the system, suppressing the price of gold below its Free Gold Price. So Alice knows that by paying only $12 for 12 ounces of gold, she made a good bargain. By thinking through Scenario 2.1, she estimates that 12 ounces of gold should rather be worth 1.2 Ferraris (recall that Scenario 2.1 discovered that the Ferrari is worth only 10 ounces of gold) although she paid only one Ferrari in order to acquire the gold.

In currency terms and with the loans present, the Ferrari is worth $12, and so her 12 ounces of gold are truly worth $14.4. Therefore, Alice decides to take the gold out of Bob’s Brothers bank and to hide it at home until the market values this gold at its true value again at some point in the future. Her action is an example of Gresham’s Law.

Starting with Balance Sheet No. 5 above, Alice therefore withdraws the proceeds of the Ferrari sale in cash (i.e. gold coins):

Bob’s Brothers – Balance Sheet No. 6

Assets		Liabilities and Equity
Cash	$0	Alice’s Account	$0
Loan to Dave	$12	Dave’s Account	$1
		Steve’s Account	$10
		Shareholders’ Equity	$1

Grudgingly and with shaky hands, Bob hands her the cash. He knows that Bob’s Brothers has just run out of reserves, but trust is trust, and a business commitment has to be honoured. Before close of business today, he needs to phone the Federal Reserve and ask for an emergency liquidity injection and a courier shipment of additional cash. He will also call Dave and try to pressure him to pay back the loan earlier.

Unfortunately, today is not Bob’s day at all. Steve sees Alice walk out of the bank with all the cash and, just for a moment, he is worried that she might have a good reason for taking out the cash. Steve knows from the history books how devastating a run on the banking system can be (1929-1933). Just to be on the safe side, he therefore decides to ask Bob for half of his money in cash ($5), just in order to test whether withdrawals are still possible and in particular in order to see the expression on Bob’s face when he asks.

The story of our gold standard therefore ends here. In tears. It happened because the presence of gold denominated credit suppressed the real price of one ounce of gold from 1/10 of a Ferrari down to 1/12 of a Ferrari. Two rather different components of the currency traded at the same price:

• The physical gold coin, a tangible asset free of counterparty risk and an ideal long term store of value.
• The unit ($1) of credit money in Bob’s Brothers’ bank accounts (and at the same time the unit of all outstanding loans). These are contracts with counterparty risk.

The problem of the gold standard is that by construction, these two rather different assets trade at the same price. Theoretical considerations, in our case comparing Scenario 2.3 with Scenario 2.1, show that physical gold is undervalued in this system. It is therefore rational to speculate against the system. Initially, this is done only by sophisticated players (Alice), but in a crisis of confidence, it is obvious to all (Steve) that a run on the bank is the rational response.

Remark: If our toy model economy were not on a gold standard, but rather used fiat money such as the actual US$ or the Euro, the consumer price inflation from $10 to $12 for the Ferrari would have occurred in precisely the same fashion. But in this case, when Alice withdraws all her cash and Steve runs on the bank, the Federal Reserve would just buy the loan asset (Loan to Dave) from Bob’s Brothers with newly created base money (Quantitative Easing I) and thereby provide sufficient liquidity to Bob’s Brothers. By exchanging her credit money for cash, Alice would not gain anything.

Let us now see whether the problem of the gold standard can be fixed.

4. Trying to Better Regulate the Banking System

After the disastrous experience in Section 3, Bob’s regulators call in several experts on the gold standard in order to discuss how to fix the banking system. They propose various measures in order to make sure the Federal Reserve does not set the interest rates too low, that the leverage in the banking system is monitored much more carefully, and that mismatch of maturities is avoided.

4.1. Economy without Banks, but with Loans

Let us see whether this helps. Just to make a point, let us abandon the banks altogether. Poor Bob is unemployed again. Dave will not be able to just walk into a bank and get his loan. But what we cannot prevent from happening is that Dave finds somebody else who trusts him and who is willing to extend him a loan – not credit created in the banking system using fractional reserve banking, but rather lending Dave some of his savings. This is where Charlie comes in.

But first, back to square one! Alice opens the auction. Steve bids his $10 for the Ferrari. Dave is also keen on the Ferrari and now that the regulators have closed all banks, he has to consider other options. Fortunately, he remembers his dad’s old friend Charlie. Charlie knows that Dave has the job at the law firm, he knows Dave’s annual salary and estimates that Dave will have no trouble servicing the loan. He trusts Dave, and so he lends Dave $12 from his $100 of cash savings. They both sign a formal contract and determine that the term of this loan is 24 months. Dave rushes back to the auction, bids $12 for the Ferrari and, since this is the highest bid, he manages to purchase the sports car for $12.

Where do we stand? Alice has $12. Bob has $1 (and on top of that, he is unemployed). Charlie has $88 in cash and a $12 claim against Dave. Dave has $1 and the Ferrari. Steve as $10. The total currency supply is therefore $124 of which only $112 is physical gold.

Precisely as in Scenario 2.3, our model has discovered the price of paper gold which is 1/12 Ferraris per ounce. This happened although there was no fractional reserve banking (Bob is out of business). There was no mismatch of maturities either. Both Charlie and Dave agree about the term of the loan. What matters is only that

• There is debt denominated in ounces of gold (the $12 that Charlie has lent to Dave).
• That Dave can use this borrowed money in order to bid for goods and services.

Again, the weakness of this financial system in which lending of gold is possible, is Gresham’s Law. Alice will hoard the cash, Steve will be reluctant to lend his gold to somebody else, and they will wait until there are some loans that go bad. In this case, the Charlies of this world would get fleeced, and once the run on the credit has taken place, the market might one day discover the true value of the gold hoarded by Alice and Steve. (In the real world, the Ferrari would probably be crude oil, Alice be a sheikh, Steve a FOFOA reader, and Charlie a pension fund).

Remark 1: Charlie has a lot of cash at hand, and he is willing to invest some of it in the loan to Dave in order to earn some interest. Notice that, precisely by doing this, he creates consumer price inflation and thus lowers the real value of his savings. Again, it is the saver who calls the shots.

Remark 2: We said above that the currency supply in this example was $124. This is incorrect because Charlie has only $88 in cash plus a $12 claim against Dave. These $12 are not fungible, and Charlie cannot use them to buy groceries. One might therefore object and claim that while the loan enables Dave to consume the $12, it prevents Charlie from consuming the very same $12. The inflationary effect of the loan caused by Dave would therefore be compensated by a deflationary effect caused by Charlie’s lack of consumption.
The problem is that Charlie never intended to spend his $100. He is rather saving the sum for his retirement and, as he is very wealthy, he will probably pass most of it on to his children. Since Charlie intends to hold on to his savings for longer than the term of the loan to Dave (24 months), there is no deflationary effect that would compensate Dave’s spending.
In fact, basically all of the country’s retirement savings fall in this category: They are not intended to be spent any time soon, and so as soon as the savers lend this money (either directly to Dave or by depositing it in their bank accounts), they contribute to the consumer price inflation that devalues these very savings and that renders Alice’s speculation rational.

4.2. Vendor Financing

Before we finally mention Real Bills, let us sketch yet another variant of gold lending. This time, we not only outlaw banks, but we also regulate Charlie so heavily that he cannot lend his savings to other people. But the seller of the goods, Alice, might still be willing to accept deferred payment.

First, back to square one. Alice opens the auction. Steve bids his $10. In absence of Bob’s Brothers’ bank and in absence of Charlie, Dave can nevertheless approach Alice for a what is in effect a supplier loan. As long as Alice trusts Dave, Dave can simply bid for the Ferrari by offering deferred payment of $12 (plus interest, of course). Dave and Alice formalize this arrangement and sign a credit note, stating that Dave will pay $12 (plus interest) to the holder of the note as soon as 24 months have passed. Alice accepts this note as the highest bid and awards the Ferrari to Dave.

Where do we stand? Alice has a credit note for $12. Bob has $1 and is unemployed and without banking licence. Charlie has $100 which he is not allowed to lend. Dave has $1 and the Ferrari. Steve has $10. Again, the total currency supply is $124 of which only $112 is physical gold.

Our model has again discovered the price of paper gold which is 1/12 Ferrari per ounce, simply because Alice has extended a loan to Dave that is denominated in ounces of gold. Notice that there is no fractional reserve banking and no mismatch of maturities in this scenario either.

4.3. Real Bills

Some defenders of the gold standard propose that the problem is not lending per se, but rather lending for unproductive purposes. The Ferrari might a good case in point.

It is quite obvious though that the Scenario 4.2 of vendor financing also applies to the trading of industrial goods and services. So in order to address potential objections that involve real bills, let us adapt our selection of protagonists.

• Alice Inc. is a steel mill who sell raw steel. They have already sold almost all of their production. The last remaining ton of raw steel is to be sold in an open auction. The starting bid is $10 with bid increments of $2.
• Bob has $1 and is unemployed as there are no banks in this scenario.
• Charlie has $100, but he is not allowed to act in this scenario.
• Dave & Co. is a manufacturer of tools. They have only $1 in cash, but they need one ton of raw steel for their ongoing production. They are willing to take on a loan in order to finance this purchase of steel.
• Steve Plc is a car manufacturer. They have $10 in cash and should they be able to acquire a ton of steel for this price, they plan to do so. Should the steel be more expensive though, they will not expand their production any further and not purchase any steel.

After going through the Scenarios 2.1 and 4.2, it is clear that in a world without loans, Steve Plc will be able to purchase the ton of raw steel for $10. This is the Free Gold Price: 1/10 ton of steel per ounce.

Let us now assume that we live in a world with real bills. We assume that Alice Inc. have a very efficient cash management due to their high turnover of steel. For the last ton that is on auction, it does not matter to them whether they receive $x in cash or a real bill for $x from which they would receive interest. So they will accept either one of the two forms of payment as long as the $x is the highest bid.

In this case, Steve Plc will bid $10 in cash for the ton of steel. But Dave & Co. will offer a real bill for $12 (plus interest) which Alice Inc. promptly accept as the highest bid. So in this case, our model discovers the price of paper gold: 1/12 ton of steel per ounce.

Note that when we write that Dave & Co. offer a real bill for $12 (plus interest), we mean that the bill they present has a present discounted value of $12 and will mature at some face value above $12 at some point in the future. The difference is equivalent to the interest on the loan that Alice Inc. provide to Dave & Co.

In a world with real bills, however, this simplified example is no longer honest. Although credit is created and causes price inflation of unfinished goods (the raw steel), the credit allows Dave & Co. to expand their production. This will eventually lead to an increase in the available amount of goods and services which has a deflationary impact on consumer prices. The two effects, inflation in the price level of unfinished goods and an increased amount of finished goods available, counteract each other:

Here is the currency supply, its velocity, the price level and the real Gross Domestic Product (GDP). Assuming constant velocity, the currency supply is allowed to increase without affecting the price level as long as GDP increases accordingly.

And so, indeed, as long as the total volume of outstanding Real Bills remains at a constant proportion to GDP, the credit created in the form of Real Bills would not cause price inflation in the same fashion as in the previous examples. In order to guarantee this, Real Bills would have to be allowed only in order to finance additional production of existing businesses.

In practice, if one were to suggests to reintroduce a gold standard with Real Bills, it remains to resolve the problems of Scenarios 4.2 and 4.3. In particular, one would have to prevent Charlie in Scenario 4.2 from lending his savings and the vendor, Alice, in Scenario 4.3 from accepting deferred payment from the consumer, Dave.

5. Summary

We have seen that the problem of the gold standard was not fractional reserve banking, nor mismatch of maturities, but rather the presence of credit denominated in a weight of gold. This leads to an undervaluation of physical gold in terms of the currency and renders the speculation against the system trough Gresham’s law profitable. Furthermore, in a crisis of confidence, the run on the bank (better: run on the physical gold) is the optimum strategy.

The solution is therefore to embrace Gresham’s law and to separate the store of value from the currency: Freegold. See, for exmaple, FOFOA’s The Return to Honest Money.

The idea that the flaws of the gold standard cannot be fixed by better regulating the banking system, was also discussed in FOFOA’s Reply To Bron and in the discussion section at FOFOA’s blog starting here.

Aquilus at FOFOA’s blog pointed us to the following comment by FOA on this topic:

Trail Guide (05/11/01; 14:32:34MT – usagold.com msg#: 53425)
[…]
The ongoing over taxation, deficit spending, fiat inflation, deficit trade balances and mismanagement of private economies has always been with us. Yes, under different names and different degrees, that’s true, but no recent period in money history, gold or not, was without an ongoing effort to cheat the system. It was always in a process of decay, no matter what the books tell you. To think otherwise is to disclaim humans as they are.

How often have we heard that some special “hard school of thought” has all this terrible process documented and neatly explains where it all went wrong? Then, goes on to show us how to set it all up again so as to start over on the right foot.

So, trying to present the society as a whole, as “the awful, all controlling big government” on one side and the “good private economy on the other side” argues the lesser side of the larger issue;

—–hard money policy cannot work for long in a credit based system—-!

It makes absolutely no difference if we are even on a 100% gold use money system, if we as a society engage in credit commerce, we will break links with gold.

Consider:

I borrow 100oz of money gold from ten people so as to spend that gold doing commerce business. The hard money theory has us thinking that if I fail and cannot pay back the gold, this little portion of the money supply contracts. Thereby the gold system is perfect, as it slows the economic excess.
This is a minor example of gold banking. On a tiny scale. It works, as long as we don’t act out our motions in a political way.

Conversely, if gold was not part of a banking,,,,, credit,,,,, lending system,,,, rather it is just a tradable, non-lendable non-official money asset,,,,, then those ten people would have given me their gold and became part owners in my (ours now) enterprise. When it fails, our gold money is gone and no credit contract is lost in the process. Society at large will not come to our collective defense, no matter the scale of the loss. You see, we lost our assets, not society’s official money!

The difference:

When gold is lent,,,,, when it’s part of the banking system,,,,, when it becomes the object of a credit contract,,,,,, this whole hard money system falls into political RISK! No matter how perfect the “schools” have show this to work, in real life, political risk degrades our perfect credit money. This is the gray area that’s not ironed out because we cannot iron out society’s emotions. Let’s see:

In the above, the ten people I borrowed gold from would be holding my IOUs for that 100 ounces. Be they private citizens, banks or corporations they have effectively lost their gold money. The very money of the nation state!

Rather than see their losses made final, and cause harm, they partition the government to intervene by recognizing those money (gold) loans as good on the books. Further, the government is asked to lend some of it’s gold (collected through taxes) to me to extend my business life. I continue to function in a small way as I pay on those gold (money) loans. Further, those loans (held by ten lenders) become marketable as they become seasoned. Then, at a discount to their face value, they can be sold or kept as collateral assets. Over time, this is the political risk that seeps into any hard money system. Over time, even a gold credit system is expanded,,,,,, inflated,,,,,, until outright fiat must come into play.

It never starts out as “big corrupt government and their awful bankers” controlling the “good honest people”,,,,,, rather,,,,, it’s when a large enough segment of the “good honest people” are threatened with losing enough (gold) money that it could take down the economy,,,,,, they demand (elect into office) that their government and therefore bankers, expand the (gold) credit enough so as to slow the fall.

Acknowledgements

Many thanks to Aristotle at FOFOA’s blog for suggesting improvements to this article and to Motley Fool and costata for pushing me to give Real Bills a fair treatment.

Comments

If you have comments, suggestions or corrections concerning this article, please comment here (comments are moderated, and it may take a while until I have time to check for new comments). For the general discussion on the role of gold in the monetary system, please go to the comments section at FOFOA’s and so we do not fragment the discussion.