Could Fractional-Reserve Banking Work With a Gold Standard?

(FEE)—I have a question from Kyle P. for Ask an Economist this week. He wants to know how banking would work under a commodity standard, and he is also interested in what sort of commodities work best as a basis for a currency. He says:

Can you explain how commodity-backed currencies, like the gold standard, work with regards to saving and lending? As I understand it, with fiat money, if A deposits $1,000 in the bank, which then lends $800 to B, there’s now $1,800, but with a gold standard there’s still only $1,000. Would A only have access to $200 + whatever B has repaid? Where would the extra money for interest paid by B to the bank and by the bank to A come from? If B skips town, is A out $800?

Also, can you explain what would make a good commodity to back a currency? Would a plutonium standard, a distilled water standard, or prime rib standard work as well as a gold standard or silver standard?

To tackle the first question, we need to highlight the differences between a currency system and a banking system. Let’s start there.

Commodity vs. Fiat Money

So does commodity money, like a gold-standard, conflict with how banks operate today? Not really. To understand why, we need to get to the fundamental difference between commodity money and fiat money—redeemability.

A commodity money is redeemable for some quantity of a physical commodity. For example, we can imagine a paper currency which could be redeemed for one ounce of silver, gold, plutonium, or prime rib. If you can, in principle, take the note to a bank or government office (depending upon the specifics of the system) and have it redeemed for gold, the currency is a gold-backed currency.

Fiat currency, on the other hand, is only redeemable in itself. In other words, if you take your currency to a bank or government office in a fiat system to redeem it, they are going to hand you back different fiat currency. If you redeem your five dollar bill, the only thing you’re promised is five slightly different colored bills with Washington’s face rather than Lincoln’s.

This is the difference between fiat and commodity systems.

So, is a commodity-based monetary system compatible with banking as we know it today? Sure. Let’s run through an example to see why.

Let’s say you deposit $1,000 worth of gold at a bank. In exchange you receive $1,000 of redeemable gold-backed notes, which you can use to purchase products. If the notes are transferred, the person who receives them can redeem them for their portion of the gold. The bank has the gold it would be required to give for redemption.

In some historical government money systems, the government offers the right to gold redemption rather than the private bank, but there’s no reason we couldn’t imagine banks or private gold redemption businesses taking this on. For our purposes, we’ll just assume that the banks store gold for redemption and allow customers to save their notes. This system is maybe overly simple compared to reality, but it makes our example a bit easier.

You decide that instead of spending your gold notes, you’d prefer to save them, and you deposit the notes in the bank as well.

Someone comes along and borrows notes from the bank. The bank gives the borrower $800 worth of gold-backed currency from the $1,000 you deposited in the bank. So now, your bank account balance is $1,000 (recorded on the bank’s ledger), and the borrower has $800 in physical cash. This sort of banking system where the bank only keeps a fraction of the money deposited and lends out the rest is known as fractional reserve banking.

At this point, you may have noticed the problem that Kyle noticed. The bank essentially created new money when it loaned your money out to someone else. There is now $1,800 worth of promises to redeem currency in gold out there, but the amount of gold hasn’t changed. There’s still only $1,000 worth of gold. So is this an issue?

Well, it’s only an issue for the bank if everyone decides to redeem their currency for gold at the exact same time. In that case, the bank would be unable to meet its obligations, and it would go under unless something changed.

You might take this possibility as evidence that commodity-backed money is incompatible with fractional reserve banking. There’s two reasons why this isn’t necessarily the case.

First of all, this potential problem is not unique to commodity money. If banks hold fractional reserves in a fiat money system the same issue still applies. If every depositor runs to the bank and demands their fiat money, a bank will be unable to fulfill that obligation if they only kept a fraction of the fiat and lent out the rest.

In other words, this risk associated with fractional reserve banking is not specific to a commodity or fiat system. The risk of too many customers trying to secure funds exists in both systems. The type of money (commodity or fiat) is a separate question from the type of banking system (fractional or full reserves).

Second of all, as long as the bank keeps enough gold on hand to meet the actual redemption requests, then there is no issue for the bank. It’s possible in theory for a bank to not hold enough gold, just like it’s possible for all businesses to fail to meet their obligations if things go sufficiently wrong, but there is incentive to avoid this result.

To answer some specifics, Kyle’s original inquiry included several questions based on a hypothetical scenario. Let’s consider each.

“…if A deposits $1,000 in the bank, which then lends $800 to B, there’s now $1,800, but with a gold standard there’s still only $1,000.”

In both a gold and fiat standard, the depositor has an account balance that reflects the bank’s obligation to give them $1000. In both standards, the borrower has notes worth $800. If the depositor requested all their currency notes back, the bank would be unable to issue them unless the bank had deposits from other customers, because $800 of A’s deposits is in the hands of B. This is an issue, but it isn’t an issue unique to the commodity system.

“Would A only have access to $200 + whatever B has repaid?”

How much money A has access to depends on the situation. Does the bank have other customers with partial deposits? If not, the bank might have a problem if A wants more than $200. Again, this is true in both the fiat and gold-backed system.

“Where would the extra money for interest paid by B to the bank and by the bank to A come from?”

The interest money paid by B would come from the wealth created by B in the process of paying back the loan. For example, if B started a business and the business sold a product to a customer in exchange for the customer’s gold-backed currency, that’s the money B would use.

“If B skips town, is A out $800?”

Again, that depends on the particulars. A bank could buy deposit insurance or sell bank assets if it wanted to eat the cost of the failed loan (assuming there is no way to cancel those redeemable notes). We could also imagine a bank that tells customers they’re on the hook if borrowers skip town, though I have a tough time imagining many customers would be interested in that arrangement.

You might be tempted to think the theft of the redeemable notes doesn’t hurt the bank because the bank didn’t lose any of the $1,000 in gold. The problem is, when B skips town and spends the notes, the person who accepted the notes has the option of redeeming them. In other words, when the notes are stolen the gold is as good as gone too (again barring some fancy note-canceling technology).

What Makes for Good Commodity Money?

So now we know the difference between commodity money and fiat money. Commodity money should be redeemable for something. But can it be redeemable for anything? We could imagine the commodity that backs a money being anything at all, but in reality certain features of commodities make them better or worse for money.

The economist Carl Menger (1840-1921) provides one of the seminal accounts on how money developed. Menger highlights how the system of barter suffers from several shortfalls including the very important double coincidence of wants (which you can read about here).

As a result of this and other issues, people in barter economies will tend to discover goods which are universally accepted. These universally accepted goods then evolve into being a medium of exchange for most transactions.

So what sorts of qualities do these medium-of-exchange goods have? I don’t claim that this is an exhaustive list, but these goods tend to be: universally enjoyed, portable, durable, divisible, fungible, and recognizable. There’s one final quality that’s hard to put into a single word. Sometimes people say “scarcity”, but I think this is a bad label because it confuses some concepts. I think there are two concepts that this gets at. First, the supply of the good should not be able to grow too quickly. Second, the good should have a high value per unit of weight/space (value density).

Let’s think of some examples to see why some commodities succeed while others fall short. Let’s take copper, for example. Copper has all the first six qualities listed above, however, copper is pretty heavy relative to its value. Copper hovers for around $4 per pound. That means if you wanted to buy a $400,000 house in a copper standard, you’re going to have to somehow transfer ownership of 100,000 pounds of copper. That’s not exactly impossible, but that doesn’t make it ideal. Not only that, the copper supply is so large it lends itself to rapid supply expansion. You’d probably need a rarer and more valuable metal to pair with copper for a working system.

Kyle mentioned a standard with a pretty similar problem to copper—a distilled water standard. Water is similar to copper in a lot of ways as it relates to our qualities. It’s universally enjoyed, portable, durable, divisible, homogeneous, and recognizable. Technically proving it’s distilled maybe makes it a little less recognizable or homogeneous, but the main problem with water (like copper) is it’s pretty cheap per pound (between $1-$4 in stores near me).

The prime rib standard is an interesting proposal because it helps us see some problems. The glaring issue is that prime rib is not very durable. Banks would have to have a lot of freezer space to support that commodity standard.

Admittedly, the list of qualities is not a perfect predictor of what flies as money. We can find historical exceptions to the qualities on the list. But it seems consistent that high-value metals like gold and silver rise to the top on average.

Ask an Economist! Do you have a question about economics? If you’ve ever been confused about economics or economic policy, from inflation to economic growth and everything in between, please send a question to professor Peter Jacobsen at [email protected]. Dr. Jacobsen will read through questions and yours may be selected to be answered in an article or even a FEE video.

Additional Reading:

• In Defense of Fiduciary Media by Drs. George Selgin and Larry White
• On the Origins of Money by Carl Menger