History of Banking: The Gold Standard & Fractional Reserve Banking

Under a gold standard, the value of a unit of currency, such as a dollar, is defined in terms of a fixed weight of gold and bank notes or other paper money are convertible into gold accordingly. Although the monetary systems of individual countries have been based on the gold standard at times, all the economically advanced countries of the world were on the gold standard for a relatively brief time—roughly from 1870 to 1914, sometimes called the period of the classic gold standard.

The Gold Coinage

The coinage of gold dates back to 700BC in the Mediterranean world, and it continued during the Roman Empire. Gold coinage disappeared from Europe during the middle ages, but during the thirteenth century Florence popularized gold coinage among Italian cities. The influence of the Italian cities seems to have brought the practice of gold coinage to England, where it caught on, particularly after the mid-fourteenth century. Charles II introduced a new English gold coin called a guinea in 1663. From England gold coinage then spread to the rest of Western Europe.

The Gold Standard – The Beginning

At the opening of the nineteenth century, no European country was on a gold standard or had developed a gold standard system. England and other countries coined both gold and silver and set the conversion ratio at which gold could be exchange for silver. England was still officially on a sterling silver standard, but in the eighteenth century the English government overvalued gold relative to silver, causing an outflow of silver and an inflow of gold and lifting gold to a position of preeminence in England’s monetary system. In normal times banks redeemed paper money out of reserves of specie (precious metal coinage), but during the wars with revolutionary France and Napoleon, the Bank of England suspended the redemption of its bank notes in specie. After Napoleon’s defeat in 1815, Parliament turned its attention to the resumption of specie payments, and passed the Coinage Act of 1816. This act placed England definitely on the gold standard, while the rest of Europe remained on a silver or bimetallic standard. In 1819 Parliament passed the Act for the Resumption of Cash Payments, which provided for the resumption by 1823 of the convertibility of Bank of England bank notes into gold specie. By 1821 the gold standard was in full operation in England. Except for England, most countries operated bimetallic systems until the 1870s. Under a bimetallic system both gold and silver coins circulated as legal-tender mediums.

The English banking system evolved toward the use of Bank of England bank notes as reserves for commercial banks, and the Bank of England became the custodian of the country’s gold reserves. The Bank of England learned to protect its gold reserves by adjustments in interest rates, using its bank rate and open market operations to raise interest rates and stem an outflow of gold. Higher interest rates attracted foreign capital that could be converted into gold, and lower interest rates had the opposite effect. Low interest rates were the natural results of a gold inflow.

Gold Standard – The Golden Age

By the end of the 1870s France, Germany, Holland, Russia, Austro-Hungary, and the Scandinavian countries were on the gold standard. The bimetallic system became awkward because official conversion ratios between gold and silver often differed from the ratio that existed in the precious metals market. Gold discoveries in California and Australia flooded markets for precious metals and gold began to replace silver as the circulating medium in France and other European countries. The wars and revolutions of the mid-nineteenth century again forced governments into issuing inconvertible paper money. Governments often restored convertibility by establishing the gold standard. If the gold standard had a golden age, it was between 1870 and 1914, when it acted as a brake on the issuance of paper money. If prices in Country A rose faster than prices in Country B, residents of A would start buying more goods from Country B. Gold would flow out of Country A into Country B, increasing the money supply in Country B and decreasing it in Country A. These money supply changes lowered prices in Country A and raised prices in Country B. These adjustments restored equilibrium, eliminating the need for further gold flows, and stabilizing prices at an equilibrium level.

The End of Gold Standard

World War I brought an end to the gold standard, partly because the export of gold was not feasible after 1914, and partly because governments wanted the freedom to print extra paper money to finance the war effort. The end of World War I set the stage for an international scramble for gold as countries tried to reestablish national gold standards. Britain and France kept their currencies overvalued in terms of gold, hurting the competitiveness of their export industries in foreign markets and causing recessions at home. The economic debacle of the 1930s spelled the end of the gold standard for domestic economies. Governments wanted the freedom to follow cheap money policies in the face of severe depression. The United States Gold Reserve Act of 1934 authorized the United States Treasury to buy and sell gold at a rate of $35 per ounce of gold in order stabilize the value of the dollar in foreign exchange markets. This legislation laid the foundation for the world to return to the gold standard for international transactions after World War II. The value of the dollar was fixed in gold, and the value of other currencies was fixed in dollars. The system only became fully operational after World War II, when most countries lifted bans on the exportation of gold. This gold exchange standard for international transactions remained in effect until 1971.

In 1971 the United States, after experiments with devaluation, suspended the conversion of dollars into gold as the only means of stemming a major outflow of gold. Abandonment of the gold standard preceded the strong worldwide surge of inflation in the late 1970s, and critics attributed the inflation to the loss of discipline provided by the gold standard. The inflation of the 1970s can be attributed to many factors, such as shortages of important commodities, powerful unions, monopolistic pricing, and undisciplined monetary growth.

Gold Standard becomes History

Most economists see the gold standard as a relic of history. In the absence of the gold standard, governments and monetary authorities enjoy more flexibility to adjust domestic money stocks to meet the needs of domestic economies. The experience of the 1980s and 1990s suggests that countries can control inflation without the gold standard. The Swedish currency was until 1931 backed by gold and the paper-certificates could be exchanged for gold coins. The bank was obligated until 1975 by the Swedish constitution to exchange the paper-certificates for gold, but in 1931 a specialized temporary law was written to free the bank from this obligation. This law was renewed every year until the new constitution was ratified 1975 which split the bank from the government into a stand-alone organization not obligated to exchange notes for gold.

Fractional Reserve Banking

The principle of fractional reserve banking lies at the heart of the modern commercial banking system. During a given period of time a bank will receive fresh deposits while existing deposits are withdrawn. Normally the fresh deposits and the withdrawn deposits cancel each other out. Despite daily deposits and withdrawals, a bank maintains an average level of deposits that represents funds the bank can largely keep loaned out. For safety banks hold back a certain fraction of deposits, called reserves (thus fractional reserve banking), to cover themselves over periods of time when withdrawn deposits exceed fresh deposits. Because these reserves earn no interest, banks are tempted to cut the margin of reserves a bit thin. If adequate, these reserves enable a bank to weather a crisis of confidence when masses of people suddenly withdraw deposits out of fear.