1. Skip to navigation
  2. Skip to content
  3. Skip to sidebar
Source link: http://archive.mises.org/7476/the-semantic-subversion-of-the-gold-standard-and-free-banking/

The Semantic Subversion of the Gold Standard and Free Banking

November 26, 2007 by

The recent Liberty Dollar raids raise the question: Why can’t people use any currency they want?

According to Kevin D. Rollins, the managing editor of Econ Journal Watch, the question goes deep into the heart of monetary policy. Two articles from the August 2005 issue point to confusion over even the terms that are used to describe ostensibly free-market policies, the “gold standard” and “free banking.” The articles trace the history of these terms and how monetary policy changed their operational meaning. How these terms are defined plays a central role in economic analysis and how that analysis translates into actual public policy. FULL ARTICLE


Tim Swanson November 26, 2007 at 1:26 pm

Good piece. Note: below is a comment I made in the other article discussing this topic today (works just the same):

In addition to the information cited in the piece, you all will be interested in the current cover story at Liberty Watch: Good as Gold, which tackles another aspect of this issue. Very germane.

Also, a couple of interesting tidbits:

Several of the Ron Paul coins have ended up on ebay. One is currently selling for over $3500.

Be sure to also check out a couple of essays by BK Marcus on this issue (“Fiat metal” and “A buck is a buck is a buck“)

And lastly, for the history buffs, Executive Order 6102 is the edict signed off by Franklin Roosevelt (as mentioned in the article), to effectively criminalize private holdings/collections of gold.

Oh, and ironically Ron Paul is the author of a minority report for a Congressional investigation on role the of gold in monetary systems. Perhaps the Feds will soon confiscate that publication too: The Case for Gold. Here is an old FEE review of it.

Mike Sproul November 26, 2007 at 3:47 pm

When you say “gold standard”, do you mean gold-denominated money backed by 100% reserves of gold? Or do you mean gold-denominated money backed by fractional reserves, where a bank might hold 10% of its assets as gold and the other 90% in interest-bearing bonds? If you advocate free banking, you should be OK with either system. But Austrian economists have a long history of hostility toward fractional reserve banking, and they advocate some very un-libertarian restrictions on banking.

ed November 26, 2007 at 4:04 pm

Good point but I think there is room for both systems, 100% backed by gold and fractional reserve. Fractional reserve would simply have to be disclosed and would have to (practically, not legally) pay a higher return, fewer fees or provide better services than 100% backed notes.

The problem is two fold. Banks that provide a note backed by gold that is not 100% backed by the physical gold are committing fraud which Austrians and most libertarians believe should be illegal (how that gets resolved is a totally different argument) A demand not that suggests gold is paid on demand absolutely requires gold to be on hand in a vault. The trouble occurs when governemnt says “well, as long as 40% (or pick a number <100%) is there, then its not fraud”. Then what happens when there is a run on the bank? You can’t put 100% blame on the customer who was told, in effect, Gold on Demand.

The other problem is when a fully disclosed fractional reserve bank has a run and then gets bailed out by the governemnt. This drives out of business fully backed banks. That said, a well run fully disclosed fractional bank in a true free market would and could be successful.

Would that it worked this way….

Kyle Butt November 26, 2007 at 4:11 pm

Mike Sproul:

Austrians are mainly concerned with fractional reserve lending on deposits. While you could argue that this is purely a semantic issue, it’s an important one. I’d disagree with the statement that all checkable liabilities need 100% reserve. However the semantics of the term “deposit” has changed, and I think they should be consistent for all irregular deposits of a fungible good, currently they are different for irregular deposits of money vs other goods. In an original irregular deposit, it never is the banks asset to begin with.

I’d be curious to find out about the 100% reservers how many would oppose fractional-reserve call-loans to bank (the equivalent of a modern day checking account) provided that deposits were restored to their older position of remaining the depositor’s property.

David Hillary November 26, 2007 at 7:31 pm


There are actually several ways to structure securities that are functionally similar to banknotes and demand deposits: For example, companies can issue redeemable preference shares that are redeemable on demand and carry no voting rights, and that can be in either registered or bearer form. Such shares can be negotiable bearer instruments and thus circulate like banknotes, and can be redeemed by a negotiable order for redemption drawn by the shareholder on the company and payable to order or to bearer like a cheque.

There are some legal problems with such structures such as:
1. Under the Corporation laws, bearer shares may be restricted, for example under the Companies Act 1993 (NZ) company shares must be in registered form. In many offshore jurisdictions bearer shares are prohibited or immobilised (must be held by recognised professional custodians).
2. Negotiable orders for redemption are not bills of exchange, nor are they cheques, and the issuing company is not a bank and the shareholder is not a customer, within the meanings of these terms at law, causing some problem with applicability of ‘crossings’ and protections for those paying and collecting such instruments. Some of these problems could be remedied by incorporating them into the terms of issue of the shares but others cannot be, since they relate to the rights and obligations of third parties.
3. Restrictions on banknote issue can catch bearer shares, e.g. in under the Reserve Bank of New Zealand Act ‘Bank note or note means any negotiable instrument used or circulated, or intended for use or circulation, as currency’ and thus would include a bearer share intended to circulate as money.

Other special entities such as Credit Unions are actually restricted from accepting deposits and ‘Every credit union shall have shares, which shall all rank equally and be of a fixed amount of $1 denomination.’ Such entities however do offer ‘banking’ services and ‘chequebooks’ and the like, although I’m not clear on the legal status of these (I think, legally, they’re not cheques, and legally the credit unions are not ‘carrying on the business of banking’, however I’d expect the courts would, as much as possible, treat them as if they were).

Building Societies, as far as I can understand their governing legislation, in New Zealand at least, are totally unrestricted in the types of financial services they can provide and securities they can issue, i.e. they can accept deposits and provide banking services, as well as provide trust, lending, foreign exchange, insurance and other services, whether to members or non-members. However, in practice, at least some of the building societies here actually offer share accounts as their main savings/transactional product. They also offer cheque books on their share accounts. When I asked them about it they explained that they can accept deposits, but the deposits have a lower interest rate and don’t have voting rights, and rank ahead of shares in the event of liquidation.

So, in banking and 100% reserves debate, many entities are already providing financial services analogous to fractional reserve banking and, legally, are structured as shares rather than deposits.

mikey November 26, 2007 at 7:44 pm

“But Austrian economists have a long history of hostility toward fractional reserve banking, and they advocate some very un-libertarian restrictions on banking.”

Prof.Sproul- I believe that no government restrictions are neccessary, the market itself would end fractional reserve banking.
Solvent(100% reserve)banks and their notes would be preferred by creditors, who would have the right to refuse payment in debased currency absent legal tender laws. This is a corollary to Gresham’s Law.
FRB cannot exist without legal tender laws, gov’t deposit insurance, and the open market operations of central banks.

Similarily, banks that issued money based on things like land and resources would also fail.
For something to work as money it must have value as a luxury good.Ideally it should have no practical use at all,yet still be highly valued.
Money based on commodities would gain or lose value due to changes in supply and demand (for the commodities in industrial use).Gold would be immune from this.
Lastly, you recently told me that solvent banks would not earn interest.This is only true for demand accounts.

TLWP Sam November 26, 2007 at 8:09 pm

Why do people who see current paper money as ‘funny money’ actually look forward to a time where people would still be using paper money yet feel warm and fuzzy inside because the note claims to be redeemable for gold? I would be far more confident in a system where the money were coins were made from gold and silver. Even more so if the coins simply have its metal content on its face, such as (.9999 oz fine gold) rather than a number next to a $.

By the way, if nickel coins were being brought into the system in a way that, lets suppose an ounce of nickel just happens to be 5c, then such a nickel would indeed be a coin and not a token because it’s circulating due to the value of its metal content and not simply a mystical face value.

David Hillary November 26, 2007 at 11:27 pm


Deposit insurance is a largely American thing, and then only since the 1930s.

Australia and New Zealand and plenty of other countries have never had deposit insurance and have no intention of introducing it.

New Zealand registered banks are required, if they are large, to be able to administer a ‘creditor recapitalisation’ so that if they fail they can immediately be restructured and continue trading, while depositors’ accounts are propornately reduced and they get shares in lieu of some of their deposits. In this way they intend to be able to deal with the failure of a major bank without risking taxpayer funds. Unregistered banks and non-bank financial institutions are allowed to fail without any intervention — for example the 10 than have failed in the last 18 months triggered no interventions or bailouts (other than one intervention to put a failed financial institution into receivership).

David Hillary November 26, 2007 at 11:36 pm

correction: ‘depositors’ accounts are propornately reduced’
should read
‘depositors’ accounts are proportionately reduced

David Hillary November 26, 2007 at 11:46 pm


Also legal tender laws traditionally have not made bank notes legal tender, only coin. This is the case in Scotland to this day: Bank of England banknotes, and Scottish banknotes aren’t legal tender.

Making banknotes legal tender is the essence of ‘fiat currency’ i.e. banknotes are current only as a result of government fiat, typically being used for the government’s own central bank, although in Hong Kong today it applies to the banknotes of all three note issuing banks (HSBC, Standard Chartered, and Bank of China).

Central banking is also not necessary for fractional reserve banking: in Scotland during the free banking period Scottish banks operated in a system without a central bank (i.e. quite independently of the Bank of England), and today in places without a central bank (e.g. Hong Kong) banks operate on the regular fractional reserve basis without a central bank.

So, all three of your conditions for fractional reserve banking have contemporary and historical counter-examples.

I suggest you study the history of banking a bit more.

jp November 27, 2007 at 12:25 am


Interesting comments about New Zealand and also about the analogy of bank notes to shares.

I’m curious how similiar you would consider a U.S. Federal Reserve Note to a share in the Federal Reserve. Am I just walking around with a bunch of share certificates in my wallet? (checks wallet, not a bunch)… Or am I completely misunderstanding you?


David Hillary November 27, 2007 at 3:33 am


Federal Reserve Notes are just that: notes, i.e. promissory notes, i.e. legal promises to pay money (it just so happens that it can meet these promises with more of the same, but that is a different issue).

Notes carry no voting or dividend rights, and, legally, aren’t shares but are debt securities.

So, major difference there!

However, you can set up a company that issues shares that are more like debt securities — actually it used to be common for companies to issue ‘preference shares’ in addition to ‘ordinary shares’, the former being legally equity but financially more like debt although accounted for as equity (although perhaps the accounting standards have changed to report more in line with financial effect these days, and less in line with legal form). I think these days preference shares are out of favour because of tax reasons (interest is deductible to the company and often not taxable to the creditor, but dividends are not deductible and often are double taxed in the hands of shareholders).

Banks issue debt securities that can qualify as capital (i.e. equity) for regulatory purposes provided they are subordinated, long term, and cannot be enforced for non-payment of interest until they mature. This means that they are available to absorb losses if the bank gets into trouble without having to liquidate the bank.

If all the FRN holders were shareholders they could go to an annual meeting and vote for the assets of the FRB to be distributed to them!

George Gaskell November 27, 2007 at 8:59 am

As “ed” mentioned upthread, I have no problem with fractional reserve banking per se, but I do object to the government-sponsored fraud that typically accompanies it.

The issue is one of disclosure. A note backed by 100% reserves represents a true demand deposit. Such a note would, in a free market, identify itself as a full-reserve note on its face, since it would trade in the market at a premium.

Every other form of bank note, backed by less than 100% reserves, is not a note for a demand deposit at all. Instead, it represents a loan of the customer’s money to the bank, because the fractional-reserve bank is using that money for other purposes, mainly for lending to other borrowers. The customer of a fractional-reserve bank is not a depositor, and should not be called as such. His money is at risk, which is fine, as long as it is disclosed to him that his money is at risk. Telling a fractional-reserve customer that he is a demand depositor is fraud.

There is a secondary point of potential fraud — perpetrated on the later users of the fractional-reserve note in the marketplace. It would seem that the best system to avoid such fraud would be a statement on the face of the note disclosing the minimum level (and form) of currency reserves for which the note is redeemable on demand. Such a note would likely trade in the market at a discount commensurate with its minimum level of convertibility.

If a fractional-reserve bank were to deplete its reserves below the level stated on the face of its outstanding notes, it is committing fraud, since it is exposing holders of those notes to excessive risk. A bank could, of course, have multiple classes of notes, some with higher levels of reserves than others.

This method of disclosure — declaring the level of reserves on the face of the notes — would put an end to bank runs. A bank would not be required to redeem a note on demand for any more currency (in coin) than what is printed on the face. The bank would always owe the full face value of the note to be paid eventually, but only the reserve amount would be payable on demand. The rest could be payable within a standard 30 days, or payable at a minimum according to whatever terms the bank wanted to print on the note.

If bank runs were the justification for creating central banks, then adopting these simple disclosure practices would be a lot simpler (and a lot less harmful) than creating central banks. But of course, that’s not the real reason central banks were created in the first place.

jp November 27, 2007 at 9:26 am


Can I add to your comparison of Fed notes to preferred shares (legally treated as debt) with no dividend? Certain holders of these pref shares, namely the 21 primary dealers, can directly redeem them for Fed assets (treasury securities) via open market operations, but everyone else is second class and cannot redeem. I can’t imagine any companies issuing preference shares with such a characteristic.

So your overall point is that if we have a problem with banknotes, then (bizarrely) we should also have a problem with companies issuing preferred reedemable shares that don’t pay a dividend. If we don’t have a problem with the latter, than we can’t complain about the former either.

Some of the comments seem to be more like… if banknotes are indeed similiar to preferred reedemable shares that don’t pay a dividend, then why are they advertised as being “non-risky”; why is the “preference-share-like” nature of banknotes not disclosed?


Jake November 27, 2007 at 10:07 am

What about the inflationary contribution of FRB?

I don’t see any discussion about that…and THAT, if I recall correctly, is what we should find most disgusting about FRB…besides being fraud!

Without FRB, Central Banks and their buddies at the Banks are unable to expand the money supply.

Get rid of it! It’s a tool of the moneylender to line his pockets and rob and enslave the people. It has no place in a free market. Period!

George Gaskell November 27, 2007 at 10:33 am

What about the inflationary contribution of FRB?

The inflationary effect would be mitigated by the fact that fractional-notes would trade at a discount relative to full-reserve notes.

If there were adequate disclosure of the convertibility of all notes, then the money supply would be limited by the level of risk that fractional-depositors would be willing to accept.

If one were to adopt such an anti-inflationary absolutist position that would prohibit all forms of fractional-reserve banking, even fully transparent and mutually-acceptable, then you would also have to prevent any future mining of gold, too. Why allow some miner to dilute the money supply?

I believe monetary inflation becomes a real problem when people are forced by legal tender laws to accept all notes at face value, even when they obviously are not worth as much. People end up holding notes with inadequate convertibility, and thus more risk than they would voluntarily bear.

mikey November 27, 2007 at 12:58 pm

David, your examples seem to show that fractional reserve banking is risky and inherently prone to failure.Else why would the New Zealand gov’t require ‘creditor recapitalization’ in the first place? In your experience, how happy are depositors at a failed bank to receive shares in lieu of their money?
You mention ten bank failures 18 months but don’t explain why they failed.
In any event, this sounds like a classic example of government intervening on behalf of some business at the expense of others.Why does your gov’t give the big banks preferential treatment?

You have not refuted my argument that a completely free market would end or at least severely limit FRB.

Daniel M. Ryan November 27, 2007 at 1:29 pm

@TLWP Sam:

It’s a question of convenience for larger sums. Under a pure coin standard, how would you pay for (say) a house?

It’s possible to use gem-quality diamonds, I suppose, and today’s scanning tech may very well allow for expert-level assessment of a diamond’s quality by a non-expert. Nevertheless, if gold is generally recognized as money, many seller may not accept diamonds or other precious stones as money – regardless of the availability and cost of any verificatory tech.

You made a good point about base metals. The old pennies contain copper worth more than 1 cent as of now, if I recall correctly.

David Hillary November 27, 2007 at 2:34 pm


If the issue is ‘safety’ then New Zealand registered banks are very safe indeed: 90%+ of the banking system, by assets, is sitting on AA (the Australian owned big four, plus 6 other foreign owned banks), with the rest ranging between AAA (Rabobank (Netherlands)), A (one Korean bank and one Japanese bank), and one on BBB (a small NZ owned bank). So, the probability of default of one of the major four banks that have 90% + of the banking system is about 0.02% p.a.

Registered banks are required to have a credit rating from an approved rating agency, and there is an unwriten rule that you need a BBB or better to obtain registration. BBB is a probability of default of about 0.2% p.a. Obviously depositors can choose a bank as safe as AAA, the highest rating possible, with an historical default rate of 0.00% p.a., if the want to minimise their exposure, but in practice customer satisfaction is highest from the smallest, lowest rated bank.

Unregistered banks and financial institutions are not prudentially regulated and mostly provide higher risk lending such as consumer lending and property development finance, and most do not have credit ratings from recognised ratings agencies. These ‘finance companies’ as they are called, obtain almost all of their funding from retail term deposits from the public, but some also provide call accounts and savings accounts, and often they have funding lines from major banks. The finance company sector was exceptionally profitable, attracting a large number of new entrants in the early 2000s, and so when market conditions become unfavourable in 2005-2007, three finance companies failed in 2006, all of which were lending primarily one sort of loan, automobile secured loans, and mainly in the same area (South Auckland), and all to higher risk borrowers. When fuel prices rose and marginal borrowers were squeezed and couldn’t keep up on their payments. Used car prices crashed, and many borrowers had borrowed more than the cars were worth, and the finance companies had also been lending to the car dealers, who were falling over, too, and in some cases the finance companies had been lending to related party car dealers in breach of their covenants in their trust deeds. So, these three failed for very obvious reasons: concentration of risk (loan type, security type, and geographic), and low quality assets. These facts were disclosed to investors in the registered prospectuses, but some investors apparently wanted to take these risks. In the last couple of months about 7 more finance companies have failed due to a more diverse range of reasons: a property development financier failed due to lack of diversification and undue exposure to individual projects, including a major hotel development in Fiji, which got caught up with the coup-d’tat and a tax dispute with the Fiji IRD. One of the few that failed that had a credit rating from a recognised ratings agency, a B+ from S+P was downgraded to B- when the US-subprime credit crisis and some failures in the finance company sector made raising funds more difficult, however this company has negotiaged a restructuring with its creditors and is still in business. Some ‘finance companies’ were really conduits to provide finance to their parents such as Nathan’s Finance, what was mostly funding its NZX stock exchange listed parent VTL which was in the vending machine industry and which fell on hard times. So, for a lot of different reasons a lot of finance companies have failed recently, but the basic cause is over-supply of financiers, and a deterioration of trading conditions, and a flight to quality by investors. The finance company sector is about NZ$30 billion, and about NZ$1 billion of it has failed, with a loss to depositors of about $500 million. The market is much improved already, with very attractive interest rates offered to investors, and many companies seeking credit ratings to show how safe they are.

The ‘creditor recapitalisation’ is just the Reserve Bank of New Zealand’s preferred method of dealing with a major bank failure. The reason they prefer this method is because it signals to creditors and investors that they are responsible for monitoring financial risk, and that they will not be protected from losses, while also providing a really fast way to recapitalise the failed bank and keep it’s financial services such as payments operating without interruption. It has never actually happened, but the RBNZ wants to make sure it can use it if required (and the probability of it being required is very small — about 0.02% p.a. to 0.2% p.a.)

This is not preferrential treatment, and unregistered banks can have this same method available to them if they want to set this up in their trust deeds and arrange it with their supervisory trustees. There is also a new ‘voluntary administration’ arrangement introduced under the insolvency law, similar to America’s Chapter 11, that will give companies 1 month to propose and seek acceptance of a restructuring proposal (this has been copied from Australia). So, the legal system offers quite a wide range of options for setting up their structures and dealing with distress and failure.

Comments on this entry are closed.

Previous post:

Next post: