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Among the various fairy tales you hear about gold standard systems,
one of the most pervasive
is the idea that there was,
or should be, a
"100% reserve" of gold to make it work.
As a corollary, the idea emerges that you can't have a gold standard
system unless you have a
100% reserve in a vault somewhere.
A gold standard system could use full-value coins exclusively, but this is quite antiquarian.
For the past 300 years, among the most financially advanced countries,
gold standard systems have used
token paper bills with value linked to gold.
These token paper bills' value was linked to gold by some mechanism of supply adjustment. If the paper bills'
value was too low, supply was
reduced. If it was too high,
supply was increased.
Who operates this mechanism? Obviously, people do, acting day
to day to manage the supply
of base money.
Now let's imagine that there is
some enormous quantity of gold in a vault somewhere. How is the paper bills' value managed? How
does base money supply increase or decrease, in order to maintain the proper gold parity? Obviously gold in a vault does nothing. It is inert metal.
It does not emit magical energy waves that adjust
the supply of paper currency without human intervention. You can
pile up as much gold as you
like, and still it will have no effect--no effect!--on the paper currency, whose value is determined by the adjustment of
the supply of paper currency, not gold.
Likewise, if you happen to have just a little bit of gold, or even no gold at all, that is fine too. A paper currency's value is pegged to gold by people acting to manage the supply of paper currency. This is the "currency board linked to gold" to which I
sometimes refer.
In the past, the mechanism
of supply adjustment typically involved redeemability. The owner of a banknote could redeem it for gold bullion. This was somewhat in the nature of a bank deposit today: a bank does not hold bank reserves in a 100% ratio
to deposits, but it must hold some reserves
to accommodate its
obligation to repay depositors.
Thus, banks held some gold bullion as a reserve. By the
end of the 19th century, banks
no longer held this reserve themselves. They mostly held U.S. government bonds, and the Treasury
held the bullion reserve. From 1880 to 1920, this reserve fluctuated between about 10%
and 40% of banknotes outstanding.
It was never 100%.
The 100% mark was reached
for a short while in the late
1930s and early 1940s. This was
due to the revaluation of the dollar in 1933, and also an influx of
gold from Europe from investors worried about the worsening political situation there. It also reflected the rise of the
dollar and decline of the British pound as a world reserve currency.
However, soon after the end of the war, the reserve ratio in the U.S. fell
to more common levels below 60%.
Much the same was true of Britain, the world's premier gold-linked reserve currency, during 1700-1914. Gold reserves
typically fluctuated between 10% and 60%.
So we see that there never
was a 100% reserve era in British or U.S. history.
The 100% reserve gold standard that
people sometimes talk about today
is a fantasy.
Gold is the same value whether or not you have a bunch of it
in a vault. Linking a paper currency to gold also does not require gold bullion itself. Thus, we can see
that gold bullion is not strictly necessary for a currency manager to issue and manage a gold-linked
currency.
Most people today do not understand
the active supply-adjustment process.
They hope that a big pile of bullion will somehow do the job for them. Of
course this can never work. Attempts
to make an inert metal take the place of active human management can only end in failure.
Nathan Lewis
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