In the two previous posts, we talked about the history of money in the United States, from barter trading in the colonial 1600s, to the Federal Reserve's fiat money we've been using since 1971. One aspect we didn't cover is how expansion of the money supply works.
In this article, we'll talk about how money is created under both a gold, and a fiat standard. To keep it simple, we will only be discussing gold, even though silver can be used as base money too, as it was in the United States until 1873.
Expansion Of The Money Supply Under A Gold Standard
Before paper money became common in the 1700s, people used to exchange gold coins directly for goods and services. Although it was widely accepted, the problem with physical gold is that it was heavy and vulnerable to theft.
Starting in the 1600s, goldsmiths in England began issuing paper receipts to customers who deposited their gold for safekeeping.
Over time, these receipts started to circulate as money, transforming the goldsmiths from simple custodians into bankers.
The bankers realized that not all depositors would redeem their gold at the same time, and saw an opportunity to invest their coin reserves in interest-bearing loans.
This was the start of "fractional reserve banking," in which a bank would keep only a portion of their customer's deposits in the vault, and lend out the rest.
This doesn't mean the banker would actually lend out "excess" physical gold to borrowers, but he would use it to create new credit.
Let's say a customer deposited $1000 worth of gold for safekeeping. The banker would print the customer a receipt, keep the gold locked up, and then start issuing new loans against it.
For example, assuming a reserve ratio of 10%, after receiving a $1000 gold deposit, the banker could then issue paper notes worth $900 to another borrower, or simply credit $900 to a borrower's account.
The borrower would take those freshly printed notes worth $900 and deposit them at his own bank, which would treat them like reserves, and then issue $810 in new loans to their own customers.
This is called the multiplier effect, and it expands the money supply (or credit) though the banking system.
If all banks have a 10% reserve ratio, the original $1000 could technically expand to $10,000 ($1000 + $900 + $810 +... = $10,000).
This scheme often worked just fine, so long as all the customers didn't demand their gold at once (a bank run), and leave the bank insolvent.
After a historic banking panic in 1837, some American states began to enforce stricter reserve ratios, ranging anywhere from 10% to 33%.
In the case of a 33% (if applied to all banks), the multiplier effect would only expand a $1000 deposit to ~$3000.
As long as reserve ratios were applied, basing the money on a finite resource like gold constrained the money supply, along with inflation.
Expansion Of The Money Supply Under A Fiat Standard
The end of the Gold Standard in the United States happened in two stages:
First, redemption of paper dollars for gold was halted for Americans in 1933 when FDR, in response to the Great Depression, issued an executive order demanding citizens return all gold coins, bullion, and certificates to a Federal Reserve member bank.
The second step happened in 1971, when Richard Nixon closed the international gold window, preventing nations (such as France, which had sent a warship to New York for collection) from redeeming dollars for gold, and effectively ended the post-WW2 Bretton Woods agreement.
Until the end of the Gold Standard, the Fed was legally required to hold gold equal to a certain percentage of the Federal Reserve notes in circulation. In 1913, the ratio was 40%. After WW2, it was reduced to 25%, and by 1971, reserve backing by gold was fully eliminated, meaning that now the dollar only had value by government decree (fiat currency).
These days, the amount of reserves that can be credited to member banks is no longer tethered to gold, and therefore unlimited. Based on reserve requirements (which have been set to 0% since covid), commercial banks can extend credit to businesses and individuals, expanding the money supply.
A fiat standard could work in theory, so long as the real economy of goods and services grew in tandem with the money created by banks. However, the reality is that credit has been growing much faster than GDP in recent decades, blowing an "Everything Bubble".
Untethering gold from dollars has enabled multiple rounds of Quantitative Easing (QE), which allows the Fed to credit member banks with reserves created out of thin air in exchange for government bonds and mortgage backed securities.
These additional reserves have been the basis of more credit/currency expansion in the commercial banking system, and artificially raised the price of stocks, bonds, real estate, and other assets.
Until next time...
The money supply can expand under both a Gold Standard or a Fiat Standard, but having reserve ratios and a tether to gold limits credit creation, and causes banks to think twice before issuing too many paper notes.
The United States totally severed the link to gold over 50 years ago, which initially spurred economic growth, but ultimately inflated bigger asset bubbles and consumer prices with each decade that has passed since.
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