Paper Money and the Gold Standard

Many people who are hostile toward the gold standard assert or imply that all purchases have to be made with gold coins or perhaps gold bars under the gold standard. Paper money, checks, and electronic transfers are not used. Some suggest that they would be prohibited. Some hold this view out of ignorance; others, out of hatred of gold as money. Unfortunately, even some proponents of the gold standard seem to hold this view.

To the contrary, paper money and checks were used during the era of the gold standard. More purchases were made with paper money, checks, and token coins than with gold coins. When the gold standard returns, many more purchases will be made with paper money, checks, token coins, and electronic transfers than with gold coins.

The primary purpose of gold coins is to keep everyone honest. It prevents an unsustainable expansion of credit. Redemption of paper money (bank notes, government notes, checkable deposits) on demand keeps credit under control and smooths the business cycle.

Under the gold standard, people, especially business people, often deposed gold coins in checking accounts. Others exchanged their gold coins for paper money because paper money was more convenient to carry.

A check under the gold standard is an order to the bank to transfer gold from the account on which it is drawn to the bearer of the check. A bank note is essentially a check that a bank draws on itself. It is an order to the issuing bank to pay the bearer of the note the amount of gold stated on the note when redeemed.

The major problem with bank notes and checkable deposits is that banks can over issue them. It can do so either deliberately or accidentally. For example, when a bank buys treasury bills with bank notes or checkable deposits in excess of its unencumbered gold deposits, it is deliberately over issuing. When it converts a real bill of exchange to bank notes or checkable deposits and the person on whom the bill is drawn and the endorser of the bill go bankrupt, it inadvertently over issued (this loss should be covered by gold reserves set aside for this purpose).

Thus, as banks do today, banks under the gold standard can, often did, practice unsound banking — borrowing short and lending long. Also, when banks use the same money (gold) for multiple loans, it is practicing unsound banking. However, unlike the current fiat monetary system that enables unsound banking to be used for an extended time, the gold standard ends such practices fairly quickly with bank runs — the conversion of bank credit money (bank notes and checkable deposits) into gold.

This article appeared in the April edition of The Gold Standard

Written by Thomas Allen
http://tcallenco.blogspot.com.au

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