Some half a century ago, Murray Rothbard produced the essay The Case for a 100 Percent Gold Dollar, which provided the answer as to why our past gold standard had failed and how it could be corrected. In 1971 the United States officially broke the last remaining link between the dollar and gold. Since then the dollar has existed as a fully fiat currency whose supply has been expanded at a continually increasing rate. Why should this be of concern to the average person? Because, as Rothbard points out, money and freedom are fundamentally related.
Money is the heart of any economy. In fact, it is the very basis of modern civilization itself. Without an effective medium of exchange, society cannot advance beyond a primitive barter system. Things that we take for granted, such as specialization of labor – and its associated advancements in technology, are all enabled by the existence of money. Just imagine the plight of a violin teacher in a barter economy. Every time he requires food, he is dependent upon finding a farmer who desires violin lessons.
Money then is the lifeblood of an economy. When the government comes to control the money and its creation, it effectively comes to control society itself. The ability to create new money at will is done so for the benefit of the government and its favored citizens and at the expense of everyone else. The private sector is deprived of resources and capital while the purchasing power of its savings are continually eroded.
Rothbard’s solution to this problem is a 100 percent gold dollar. In this arrangement gold backs not only the physical currency in circulation but dollar denominated bank credit as well. The gold standard employed in the United States prior to 1933 did not account for the expansion of bank credit. This is a critical difference as the bulk of the US money supply exists in the form of banking accounts and not physical currency. When banks issue credit they effectively create new money out of thin air. When they are allowed to do this, the entire supply of dollars is increased beyond the amount of gold that backs it. Eventually the imbalances become so great that calls for redemption by holders of dollars threaten to drain the treasury of all of its gold.
The crux of Rothbard’s proposal is that our system of fractional reserve banking is incompatible with a gold standard. Under the current system, deposits in savings and checking accounts are available for full redemption on demand by depositors. At the same time, almost all of those deposits have been loaned out for repayment at some point in the future. How can both of these situations coexist? The answer is they cannot. The bank relies on the fact that, under normal circumstances, only a small fraction of the money deposited will be required for withdrawals at any given time. As long as the reserves are large enough to cover those transactions, then the operation can continue. This arrangement in any other business, Rothbard notes, would be considered fraud.
To be compatible with a gold standard, all deposits that could be withdrawn upon demand would have to be covered 100 percent by reserves at the bank. Deposits that are loaned out by the bank would not be redeemable by the depositor until such time as they are paid back. By enforcing these subtle requirements, dollars are not allowed to do double duty within the money supply.
The far more radical implication of such a reform – by today’s standards anyway – would be the effective elimination of the Federal Reserve. Contrary to its stated mission of fighting inflation, the Federal Reserve serves as a backstop to maintain the inflationary system of fractional reserve banking in times of crisis. In the past, a run on a bank resulted in its failure as its insolvency was exposed. The role of the central bank is to act as a lender of last resort under such circumstances – ultimately resorting to its ability create new physical currency if necessary.
The purpose of a gold standard to is to provide stability to the money supply, thereby preventing theft through inflation and placing limits on the power of government. What Rothbard makes clear is that the existence of a gold backed dollar alongside a fractional reserve banking system reduces the notion of a gold standard to fiction. It begins the ticking of a time bomb that will ultimately lead to its destruction. Although such discussions may seem relevant only to those interested in monetary theory, they are quite useful in making sense of our current situation. At the heart of the expanding global financial crisis is the failure of its underlying monetary system. The battle between gold and the banking system will play a central role its resolution. Gold and silver investors will benefit from understanding the stakes that are in play.