BEE Partner, South Africa Economy Watch

In its earliest and simplest forms, the gold standard meant that the money in circulation, including the money the government minted, consisted of gold coins. When the US officially joined the gold standard in 1879, the value of the dollar was set as equal to the value of 23.22 fine grains of gold, where 480 fine grains made a fine troy ounce. This was equivalent to $20.67 per ounce.

Under the gold standard, the constraint on the creation of bank money posed by reserves is critical. Bank money consists of notes issued as claims to real money, that is, to gold or silver coins, money with intrinsic value. But at any time, most of the public would prefer to use the more convenient paper money, provided they are confident that they can convert the (intrinsically worthless) paper to gold at a moment’s notice. For this purpose, reserves are kept in proportion to the note issue. Initially these were reserves of gold coins, later they were held in treasury money. But the treasury could not issue notes without itself having reserves of gold (coins and bullion), and these could not easily or quickly be expanded or contracted.

To see how this works, suppose banks had to keep 50 per cent reserves. But in a booming economy, in which business is good, a bank wants to issue more notes in order to make more loans. So the bank prints two dollars and spends one of them buying gold. The note issue rises; indeed, any individual bank can do this. So the reserve requirement does not seem a burdensome constraint. But if any significant number of banks increase their issue in this way, then the dollar price of gold will rise, which is to say, the value of paper dollars, in terms of gold, will fall. So the public will immediately turn in the paper for gold, and the additional notes will be cancelled! Any individual bank, at any time, can increase its issue, or make additional loans and shop for reserves. But taken together, the price mechanism ensures that the quantity of reserves will be an effective constraint.

The same is true for treasury money. To create more, the government must first obtain more gold, for example, from excise taxes, or from foreign exchange earnings. Or it could borrow the metal, although gold was not always readily available and sometimes had to be imported from Europe. In the nineteenth century, this could take several weeks. In the meantime, banks short of treasury money would try to borrow from other banks and to encourage members of the public holding treasury money to deposit it in their bank. To this end, banks would raise interest rates. It often took large and rapid rises in rates to attract relatively small amounts of extra reserves. When treasury money was readily available, however, interest rates tended to fall. These conditions created frequent fluctuations in short-term interest rates associated with changing needs of banks for reserves and the changing availability of gold and other reserve assets. And these interest rate fluctuations sometimes led to other sorts of financial instability.

When short of reserves, banks will raise interest rates to attract additional reserves; they will also restrict their lending. All but the best customers will be refused new loans. As loans are paid off, the amount of bank deposits will shrink, which implies, of course, that the volume of bank money declines. With fewer deposits, banks will eventually come to find their reserves sufficient for their needs. On the other hand, if banks had excess reserves, they would tend to expand their loans, creating more deposits and thus increasing the amount of bank money. In short, the amount of bank money will tend to adjust itself to the amount of reserves. This should be familiar as the traditional money multiplier story.

So in a gold standard world, without a central bank, reserves do limit lending. However, this may require the system to face severe strains.²³ In a boom, banks will lend more and will seek to create deposits or issue notes. To do this, they will have to attract additional reserves, requiring that they raise interest rates. In a slump, they will issue less and lend less, and will seek to shed reserves, lowering interest rates. In other words, interest rates are market- determined, and at least weakly stabilizing. However, they cause banks to become over-extended in booms and to be burdened with non-earning assets in slumps. Let’s look more closely at the way supply and demand work in the case of reserves and the interest rate.

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