I have been in discussions with friends regarding 100% reserve banking and a commodity standard, and I was asked a question that seems simple but has me stumped. It's best to look at it in the form of a hypothetical situation:
A country has a gold standard and practices %100 reserve banking (loan and demand). There is a single central bank for the entire country. The total gold in this country's reserves is 1000 kilos, split evenly among 100 people (10 kilos per person, or roughly US$350000).
So now Joe wants Jane to lend him 1 kilo of gold. Jane agrees, and they agree to a pay-by date, and Jane wants 10g of gold as payment for the loan.
Now where does this extra 10g of gold come from in a 100% reserve system? The kilo that Jane lent came from her own stock of gold, so that's no problem. But that 10g has to come from somewhere, right?
Doesn't more gold have to keep coming into the system to handle things like profit, interest, etc?
So my answer was that the central bank would have it's own stores of gold and would steadily increase that central store via exports, investments, etc so that the money supply grew as the need for more money grew. But with a gold standard there is a finite amount of gold in the world, so it would eventually become impossible to add more money into the system.
Does this make any sense? Am I missing some important variable that would help explain this system?
You're looking at it from a closed-system standpoint. Therein lies your problem.
Therein lies your problem
Uh, okay. How do you make it an open system? There is only so much gold in the world. How do you make it an open system without making more gold?
The only two ways I can see this working is:
1) you have 100% reserve for deposit only and allow loan banking to be fractional
2) you bring new money into the system via exports (like I already said). This assumes the country will have a net income by increasing exports over imports...but you're screwed if you have a bad year and you end up with a trade deficit or your investments don't pan out.
That 10g comes from Joe selling goods on the market (i.e. other market participants, including Jane). So for example Jane could accept as payment 10g worth of Joe's services and clear away the debt.
The whole point of 100% reserve is that there is no new money, and therefore no inflation. If the bank increases the money supply by the exact amount of the debt, then there is no point for Jane to lend the money at all as her share of the money supply is the same in the future as the present.
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Jonas:Uh, okay. How do you make it an open system? There is only so much gold in the world.
And why would one have to have loan banking be fractional when there's the concept of time deposits? You "loan" the bank your money for a specific time, get interest on it, and the bank then lends it out at a higher rate for profit (in a nutshell).
Your condition that some authority that can determine what is money will only allow gold. The ancient Romans solved this by using other materials for money. When gold became to valuable to use in small transactions they went to silver, then to copper. We could easily do the same thing today. As gold becomes more valuable relative to stuff, real deflation, simply use other metals whose increase in value relative to stuff will not be as great.
That 10g comes from Joe selling goods on the market
That's what you would think, but that 10g had to come from somewhere outside the system since there is a fixed amount of money in the economy. Jane is asking for 10g of gold that does not exist in the system. There was 1000kg of gold in the economy, but now there needs to be 1000.01kg of gold so that Joe can pay Jane.
And don't people mine gold?
Like I said, the only way it works is to add gold (money) into the system. But now you are increasing the money supply and risk inflation, which is not the point of a 100% reserve system. And once you have mined all the gold, then what? The planet is a closed system...you cannot create gold out of thin air like you can with fiat currency.
time deposits
This is the same problem as Jane charging a loan fee. That interest is new money that has been injected into the system, increasing the money supply.
using other materials
I mentioned moving to a bi-metallic system, but I don't see how that helps keep the money supply at a flat rate. Doesn't that just increase the money supply by adding a whole new commodity to the market?
Jonas: time deposits This is the same problem as Jane charging a loan fee. That interest is new money that has been injected into the system, increasing the money supply.
No it's not. That interest represents some type of capital (a product produced, for example). The money the producer made to pay that interest rate back doesn't have to be new money. It can be money already in the system. What happens is deflation, not inflation.
using other materials I mentioned moving to a bi-metallic system, but I don't see how that helps keep the money supply at a flat rate. Doesn't that just increase the money supply by adding a whole new commodity to the market?
I'm not sure why new currency would come into the market arbitrarily. The mint has to introduce new coins.
Jonas: That 10g comes from Joe selling goods on the market That's what you would think, but that 10g had to come from somewhere outside the system since there is a fixed amount of money in the economy. Jane is asking for 10g of gold that does not exist in the system. There was 1000kg of gold in the economy, but now there needs to be 1000.01kg of gold so that Joe can pay Jane.
No. The 10g comes from other market participants. Joe works at his job and makes back the 20g he will eventually pay back. That money comes from his employer. No new money has to be made.
No it isn't. The whole idea behind time deposits is that a bank can't loan out your money and then allow you to take it out at the same time. You are agreeing not to withdraw your money until a certain date. Let's say you put $1000 into an 8 month CD at 5%. Bank A then loans out the money to a business at 6% on the stipulation that they pay back the loan + interest in 8 months. The business is able to pay it back because it is making a profit by providing goods and services on the market. When they pay back they money the bank's profit is the 1% and you get your 50 bucks. No new money is being created.
Jonas:Like I said, the only way it works is to add gold (money) into the system. But now you are increasing the money supply and risk inflation, which is not the point of a 100% reserve system.
If all the gold is mined--then people will find good uses for it.
Jonas:This is the same problem as Jane charging a loan fee. That interest is new money that has been injected into the system, increasing the money supply.
Stranger: The whole point of 100% reserve is that there is no new money, and therefore no inflation.
The whole point of 100% reserve is that there is no new money, and therefore no inflation.
There can be new money (commodity money, for instance) if someone is willing to risk his capital and labor in an attempt to procure more commodity from the earth...
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David Z
"The issue is always the same, the government or the market. There is no third solution."
I have been doing more research on this issue, and I'm just getting more and more confused.
I'm talking about Milton Freidman's money supply equations and monetarism...specifically that if you assume the velocity of money stays constant then the supply of money in a system must increase to allow for economic growth. Put another way, the money supply must grow along with GDP.
So it seems that a gold standard would not be acceptable, because:
1) The money supply (i.e. gold) is finite. There is only so much gold on the planet. Once all of the gold is mined and in your system you can no longer increase the money supply and your economy cannot grow.
2) You become dependant on other nations for your economic growth. If other nations decide to decrease the rate at which they mine gold then you cannot bring new gold into your system...thus you cannot increase your money supply and your economy cannot grow.
I have read some critics who say a gold standard is good for this exact reason...it keeps growth under control and stable. But that doesn't address the issue of what happens when all the gold is mined and there is no more left. What do you do at that point?
Any thoughts on this? Is the whole idea of monetarism flawed? Does allowing fractional reserves for non-deposit accounts fix the equation?
Jonas: Is the whole idea of monetarism flawed?
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Fools! not to see that what they madly desire would be a calamity to them as no hands but their own could bring
The ground.
Jonas:I'm talking about Milton Freidman's money supply equations and monetarism...specifically that if you assume the velocity of money stays constant then the supply of money in a system must increase to allow for economic growth. Put another way, the money supply must grow along with GDP.
A silly assumption and a sillier conclusion. The supply of money does not have to increase - prices could fall instead.
Jonas: So it seems that a gold standard would not be acceptable, because: 1) The money supply (i.e. gold) is finite. There is only so much gold on the planet. Once all of the gold is mined and in your system you can no longer increase the money supply and your economy cannot grow.
As the gold's value increases relative to other goods (as gold becomes scarcer relative to other goods), prices fall. This is extremely basic supply and demand.
Jonas:2) You become dependant on other nations for your economic growth. If other nations decide to decrease the rate at which they mine gold then you cannot bring new gold into your system...thus you cannot increase your money supply and your economy cannot grow.
Same answer. Money is not wealth.
EDIT, Fixed major typo.
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