A topic that is increasingly being discussed since the 2008 financial crash is that of a return to the Gold Standard. The world’s currencies were backed by gold until 1971 at which time the current fiat system was adopted. The reason that a gold standard makes sense is that all money would be backed by intrinsic value, in this case gold, a precious metal that has been associated with wealth and a store of value for thousands of years.
The question might be, why go back to a gold standard now?
Fractional Reserve Banking
In the US, the reserve requirements for private banks are 10%, meaning they have to keep 10% of deposits on reserve and can lend out the other 90%. Since everyone should know that, they had to come up with a way to keep people from starting bank runs and demand their deposits back which last happened on the 26th of September 2008 and lasted for ten days when depositors of Washington Mutual demanded their deposits back. Only about 10% of bank deposits would need to be withdrawn in order for most banks to become insolvent. In order to prevent bank failures and maintain the confidence in the banking system, in the US the Federal Deposit Insurance Corporation (FDIC) and in Canada the Canadian Deposit Insurance Corporation (CDIC) guarantee bank deposits. The FDIC guarantees personal deposits up to $250,000 while the CDIC guarantees up to $100,000. Due to these organizations depositors feel secure that their savings are guaranteed and insured.
The problem with that logic is that, should there be another shock to the financial system and depositors start to demand their money, what will happen? The FDIC has since the Dodd-Frank Act raised the minimum designated reserve ratio (DRR) to 1.35% of estimated insured deposits, meaning that only 1.35% of all deposits are covered with funding by the FDIC. That amount may be sufficient for a few small banks to fail, but is far from an insurance or guarantee that anybody will see their savings again should the whole system fail as was the case in 2008.
Instead of deposit insurance corporations to enable the fractional reserve system to maintain itself, money should be backed by gold. Depositors would not have to worry about not getting any actual physical paper money back from the bank, which would stabilize the system. Something not mentioned in the North American mainstream media are bank runs that happened last week in South Korea, the China Post reported that Busan Savings Bank was suspended; Korea’s largest by assets (US$3.4 billion). Further it was reported that,
“South Korea suspended operations at four more savings banks on Saturday after runs developed as customers rushed to get their money despite official assurances the financial sector was secure”.
One of the only US central bankers who still has his head on straight is Kansas City Fed Chief, Thomas Hoenig who last week during a Q&A gave the following reply to the statement that people are pointing the finger at the Fed for commodity price increases,
“I don’t know why not. It has got to be a factor. It is not the whole thing – you have droughts and temporary movements. But it is a contributing factor. There are drought issues, and supply issues and demand issues like the Chinese diet. But also monetary policy is accommodating demand, I think, worldwide.”
Further to the question about the recent undercurrent of anti-fed sentiment Hoenig replied,
“I say I understand. I say gold is a very legitimate monetary system. However it will not end crisis. It will not end credit bubbles”.
Hoenig is correct in saying that a gold standard will not prevent from crisis, but a gold standard will keep crisis to short periods of time as was the case until 1971. The gold standard with a fractional reserve system will not stop credit bubbles since private banks will continue to increase the money supply through bank credit. That’s one of the difficulties in implementing a gold standard with the current fractional reserve system, since the amount of gold held by the central bank would have to constantly increase due to the money multiplier effect.
Even World Bank President Robert Zoellig called for a “Bretton Woods 2” like system in an article he wrote for the Financial Times in Nov 2010. He said the system would most likely involve the US dollar, Euro, Yen, Pound, and Chinese Renminbi. He added that,
“The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values”.
These are significant statements from the President of the World Bank, considering that it is for the most part a US institution due to having veto power. What he called “Bretton Woods 2” would mean the end to the US dollar being the single world’s reserve currency. It would cause most central banks around the world to balance their treasury portfolios by buying treasuries and reserves in all other currencies than US dollars. This would make it extremely difficult for the US to refinance maturing debt as demand would drop off even more than it already has. This would leave the Fed to buy more treasuries, effectively monetizing even more debt which will further drive up the price of gold as risk of inflation increases.
Student Loan Bubble
The next crisis similar to the sub-prime crisis that caused the crash in 2008 is that of US student loans. Students are often handed empty promises that they can find employment after they are done with their degree so that they can sufficiently pay back their loans, but that is often a lie and students are loaded up with government student loans by many private for profit educational institutions. US student loan debt at $880 billion is almost the same as all US credit card debt, and since no jobs are being created these people won’t be able to pay back their student loans. Since they cannot default on government loans, these people’s wages (if any) will be garnished and they won’t be able to consume as much as before, which for a consumer driven economy is an unstable base for a sustainable recovery. The next crisis won’t be on Wall Street, but rather on Main Street.
A potential shock to the financial system in the near future could become a reality. Not just the bursting of a student loan bubble, but also that according to the recent Case-Shiller index US home prices have been continuously falling for the past five months. As long as unemployment, house price, and inflation are not kept at sustainable levels, the US economy will have a difficult time recovering as fast as most economists are predicting, but then again those same economists missed the sub-prime crisis all together in the first place.
A gold standard won’t fix all of the above, but it is a needed intervention for the world’s financial system and its addiction to credit and easy money. The current system is plagued with boom and bust cycles due to unsustainable credit expansion and speculation. The idea of “sound money” is gaining popularity, the US state of Utah might vote as early as today on adopting gold and silver coins as legal tender that can be used to pay taxes. The silver and gold coins would not replace paper money, but can be used as alternative legal currency within the state.
Thanks again for your time and continue to check back with the Capital Research Institute (CRI) as we continue to unravel The Web of International Finance!