Free Banking

Must money be backed by a 100% gold standard?

Apparently, some in the Austrian School believe that any issuance of money not backed by gold warehoused in the bank is a form of fraud.

If the bank issues gold or silver certificates without having the actual gold to exchange them with, that is certainly fraud.

But if it issues its own bank notes to be circulated in the community, I don't see why it has to be backed by a precious metal, so long as it is backed by other assets of equal value belonging to the bank.

Let's say a silver dollar is defined as having one ounce of silver. The Smith Bank could issue its own paper dollars. Their dollar could be defined as having the value of 1 ounce of silver, but doesn't necessarily entitle the possessor of the dollar to exchange it for an ounce of silver; it could be exchanged for other assets belonging to the bank.

Let's say Joe is a teddy bear salesman. He has 1000 teddy bears with a wholesale value of $1 (in silver dollars) each. But he needs $900 right now for some urgent needs. He goes to Smith Bank and asks for $1000. Here is the deal he is offered. He can have $900 in Smith notes. In a year's time, however, he must pay the bank:

• $1000 in Smith notes, or
  
• $1000 in Silver certificates, or
• his Teddy Bear inventory valued at $1000, or
• some combination of the above totaling $1000

Because Joe has assets equal to the amount he will be loaned and pay back with interest, there is no inflation of Smith dollars when Joe receives them and starts to circulate them in the economy with his purchases: they represent assets of equal value that already exist in the economy. The asset that the bank has is its claim on $1000 from Joe, backed by his teddy bear inventory.

It is also possible for a bank to issue loans even without much in the way of current collateral (like Joe's teddy bears) if:

• if the loan is for production of current high-demand necessities such as food and soap;
• the borrower has proof of insurance that will pay back the loan in the event of accident or natural disaster
• the loan is relatively short-term
  

If the public trusts Smith Bank's lending practices and are confident that Smith dollars constitute real wealth, then individuals will use them and merchants will accept them. If Smith issues more dollars than it has in assets, however, then the public will stop using Smith dollars and revert to the Johnson bank.

A free market in money and banking will not necessarily lead to a 100% gold standard, nor would every form of paper money have to be a certificate entitling the owner to trade it for precious metal. Instead, it will see banks issuing their own paper currency, instead of relying on the national Federal Reserve Note monopoly. The banks that make the soundest lending decisions will be the banks with the most highly-sought dollars. But it simply is not the case that these dollars must be backed by gold or some other metal. The important thing is that they are backed by real assets of some sort.

Thanks to work by Antal Fekete and Nelson Hultberg for clarifying this issue for me.