Free “Gold Standard 100% Fractional Reserve” Banking Explained by Gary North

I ran across this on Lew Rockwell.com by economist Gary North. His explanation of 100% reserve banking is worth repeating to a wider audience. The importance of this cannot be overstated as we face the prospect of deleveraging throughout the world. The United States has leveraged up 3.7 to 1. 2.5 is generally considered 100% assured bankruptcy. The leveraging, debt, process is exacerbated by our Federal Reserve system and fractional reserve banking. As boring as banking is the general public needs to understand the relationship between wealth inequality, inflation, booms, and bust magnified by the fractional reserve banking system and fiat currencies.
The following appeared in Lew Rockwell on 12-22-2011
“Let us start simply. Let us say we live in a gold coin standard. There are no fractional reserves. Every bank-issued warehouse receipt for an ounce of gold has an ounce of gold in the vault.
Let us say that the banking system has a total of 100 million ounces of gold on deposit. Let us also say that depositors have lent the money to bankers for one year at 2%. So, the bankers go looking for borrowers who are willing to pay about 5%. (I choose these numbers for the sake of easier computation.) Let’s say that they find them.
The bankers look at the financial accounts of the borrowers. Will these borrowers have sufficient income over the year to repay the loans? Will the borrowers receive enough gold in the future in order to pay off the loans? The may be able to sell their labor. They may be able to sell some land. Maybe an inheritance check will arrive. But the bankers will not make the loans if they do not think they will be repaid with interest.
Next, the depositors cannot legally get their money back until the end of the deposit term. There are no fractional reserves. If they want a positive rate of return, they must let the banker lend their deposit money during the time specified in the deposit agreement. Otherwise, they would have to pay money to the bank for safe storage: warehouse services.
The bankers buy a future 105 million ounces of gold over the year by lending 100 million ounces today. They buy those future 105 million ounces at a discount.
Case by case, loan by loan, the borrowers collectively offer to pay back 105 million ounces of gold over the next 12 months. The bankers require monthly payments. The borrowers agree.
So, the bankers lend the money. They money goes into the borrowers’ bank accounts. Then the borrowers spend this money on whatever they want to buy. The money goes out either in the form of coins or checks or credit card payments.
The ownership of this money moves from high bidder to high bidder. Borrowers earn money – streams of income – from these other spending customers. The borrowers then begin to repay the banks.
In a free market economy where there are no laws favoring fractional reserve banking, and where bank runs are allowed by law, there is money in circulation outside of banks. There surely is today: “currency held outside of banks.” This is part of the money supply today.
How can everyone pay off these loans? Where do they get the extra 5%? By selling more goods and services to other people who use gold coins to buy items. Some of these gold coins may be held outside the banking system.
But what happens if the borrowers find that they can no longer afford to do this? They cannot earn the extra money from outside the bank-money system. They will not borrow at 5%. They will agree only to less.
The bankers will find fewer takers for the loans at 5%. They will have to lend at lower rates. They will have to pay less to depositors.
Depositors may pull money out of the banks. The money held outside of banks then increases. The money in banks decreases. The recipients of the depositors’ withdrawn money then spend this money. This makes it possible for borrowers to pay extra money to bankers.
On the other hand, some depositors may agree to be paid less interest. They may agree all the way to zero or very close to it.
Why would they hand over their gold coins to the banks at zero percent? Because, in a free market economy, the production of goods and services constantly increases. This has been the normal situation ever since 1800. The greatest unanswered question of modern history is how this compound economic growth started when it did and where it did: Great Britain and the United States. But it did, and the world changed. Sellers’ competition drives down money prices. The real price of goods falls even when the money price of goods stays the same. People get richer even though the have no extra money.
So, in a free market economy, the money (gold coins) paid by borrowers to lenders may not be more than the money borrowed – zero percent – but the real income of the lenders rises. Interest is still being paid to lenders, but it is concealed. The interest rate is the same as the decline in gold-denominated prices.
Side benefit: no one pays income taxes on this increased wealth. Why not? Because the income in gold coins is the same as the outflow.
Isn’t price deflation grand?
Say that a gold coins owner goes to a banker. “I will pay you to store my coins.” The banker says, “Fine. That will cost you 2% a year.” The coin owner says: “That’s way too high.” The banker says: “I’ll tell you what. Let me lend out your coins, and I’ll put coins of the same weight and fineness back in the vault in a year. It will cost you nothing.” The coin man says: “But I won’t make any money.” The banker says: “True, but you also won’t pay any income tax. The gold in a year will probably be worth 3% more in purchasing power. And you will worry less about burglars.”
Deal? Deal!
Modern men are deceived by the above-zero money rate of interest received by fractionally reserved banks in a price inflationary economy. This distracts their attention from the fundamental aspect of the free market economy, namely, the constantly declining real price of goods and services.”
Thank you Mr. North.