A short and (hopefully) mildly entertaining essay.
Gold and the Money Multiplier
Banks accept deposits, and sometimes pay interest on those deposits. Taken
all by itself, that's not a good path to making a profit. What they do to
earn money is they lend out the money they accept as deposits, and
charge interest on those loans. This is a simple fact, and has been true
pretty much as long as there have been banks -- certainly banks were
operating this way long, long before there was a Federal Reserve Board.
However, this very simple scheme has unexpected consequences, and these
consequences depend in no way on whether a country is on the gold
Bankers, it is generally agreed, have little sense and cannot anticipate
economic difficulties nor their consequences. So, in an effort to assure
that banks have a little cushion against unexpected withdrawals, the
government (any government, not just the U.S. government) typically requires
that banks retain a fraction of their deposits, and not lend out absolutely
everything down to and including the pictures on the office walls. For the
rest of this essay we'll assume that banks are limited to lending out no
more than 90% of their primary deposits.
Now, here is a little parable about the gold standard.
Consider a country named Smallworld. Smallworld is on the gold
standard, with a vengeance: the only form of money is gold coins. One might
think, therefore, that in Smallworld the money supply would be fixed.
In the beginning, the only person in Smallworld with any money at all is a
deep-rock miner named Joe Fed. Joe has $100, in the form of gold
coins, which he received as pay for digging stuff out of the ground.
Joe has, quite literally, all the money in the world.
So, in the beginning, the money supply of Smallworld is $100.
Joe doesn't need to buy anything just now so he goes down the street to
Smallbank and deposits his $100. Now, the bank has $100 in cash, but
they have a liability of $100 as well, which is the record of Joe's
deposit. Their net worth is, consequently, $0.
The money supply, which includes bank deposits, is still $100; all of Joe's
money is in the bank.
Fannie wants to buy a house, but she has no money. She decides to settle for
a tent (it's cheaper) and she goes to Smallbank to make a loan. She
borrows $90. The banker hands her .... $90 in gold coins (that's the
only kind of money there is).
She buys a tent from Omar the Tentmaker, puts it on the back of her camel,
and heads off to look for a place to pitch it.
Omar now has $90. He has no immediate need for the money so he goes
down to Smallbank and deposits it.
Smallbank now has $190 in deposits, all in the form of gold coins. $90
is currently out on loan, but that doesn't affect the total of size of the
primary deposits in the bank. The money supply, which includes bank
deposits, is now $190.
Let's look at the money supply in detail:
|Omar the Tentmaker
Freddie already has a house (actually, it's a cave), but he needs someplace
for his dog Henry to sleep, and since all the money in the world is
currently in Smallbank, he must borrow to buy it. He borrows $81, which is
all that Smallbank can lend him while staying within their reserve
requirement. From there he goes to visit Omar, and buys a pup tent. He puts
it in a dog cart and Henry pulls the cart back to Freddie's cave.
Omar doesn't need to buy anything just now so he deposits the $81 -- in
gold coins -- in Smallbank. Now let's look at the primary bank deposits at
|Omar the Tentmaker
The money supply now consists of $271, all in gold coins.
Sallie wants a television for her dorm room. She has no money (Joe and Omar
have it all, of course) so she goes to the bank to borrow some. The bank can
lend her $72 while staying within their reserve requirement (actually they
could lend her $72.90 but Smallworld has no pennies -- gold pennies being
almost too small to see and impossible to keep track of). She takes her $72,
and buys a television from the well known French firm "Lafayette" for $50,
and two cases of Coca-Cola for $22 from Big Coke Company. She gives
Lafayette and Big Coke gold coins in payment, of course.
Lafayette gives one $5 coin to Pawn1, the clerk who sold the T.V., and puts
the remaining coins, totaling $45, into their business account at Smallbank.
Big Coke pays $12, in the form of a $10 piece and two $1 coins, to Fargo,
the stage coach driver who delivered the soda, and deposits the rest in
Smallbank. Fargo and Pawn1 also deposit their money in Smallbank for safe
keeping until they next go grocery shopping.
Deposits now total:
|Omar the Tentmaker
The money supply now consists of $343, all in gold coins.
The TRICK is that most of those coins now
belong to multiple people.
DISASTER strikes Smallworld
For years one of Joe Fed's responsibilities has been purchasing mining
equipment. A big item is overalls for the miners, and he's been buying them
from Omar the Tentmaker (who makes clothing as well as tents). Now it's come
to light that Omar has been giving kickbacks to Joe.
Joe and Omar both decide to leave town. Rather than carry cash, they use
their bank deposits as security to obtain letters of credit (which have existed for a long time, and
are basically an IOU by a bank), and they run for the border. Once over the
border into Otherworld, they deposit their letters of credit in Otherbank.
Otherbank sends the letters of credit back to Smallbank for redemption.
Everything is fine for about two weeks, which is how long it takes the
camels carrying the letters of credit to get to Smallbank.
The letters of credit constitute a demand for $271 in cash, and Smallbank
only has $100 of cash on hand (plus a bunch of "non-cash assets" in the form
of loans they've made). They can't make good on the letters until they can
raise more cash. Either they need to raise more cash right away or they need
to cut a deal with Otherbank, perhaps involving transfer of a package of
some cash and some loans ("non-cash assets").
The camel drivers go down to the local bar to talk it over while the bank
presidents (there are 12 of them) try to figure out how to solve this
problem. A local reporter hears the camel drivers talking, and the very next
morning, the local paper, Smalltalk, has a screamer headline:
"SMALLBANK INSOLVENT! IS SMALLWORLD DOOMED?"
As soon as they see the headline in Smalltalk, everyone in town runs down
to Smallbank to get their money out. Now, a situation which was bad has
become worse: Smallbank needs to pay out $343 immediately, but they still
only have $100 of cash on hand.
They do the only thing they can think of: They chase everybody out, lock the
doors, and call in all their loans in an effort to raise cash.
Sallie, Freddie, and Fannie find themselves with demands for money they
don't have. Sallie, who is a poor student and doesn't care anyway,
immediately files for bankruptcy. Freddie runs to Fannie for help, and they
pool their resources, which is useless because they don't have any. They try
asking Henry for advice but his only contribution to the discussion is an
Pawn1 and Fargo find out that they can't buy groceries, because their assets
are frozen due to the collapse of Smallbank. Worse, they've lost their jobs,
because Lafayette and Big Coke are laying off workers because they can't pay
them because of the banking system collapse.
Finally, the $100 -- which is all that's left of the money supply -- is
given over to a passel of lawyers who try to figure out who's to blame for
And as far as I know they're still arguing over it.
Page created on 03/22/2018 from a bit of email which was sent to a
defunct discussion group a large number of years ago