The “100% Reserve” Myth

The “100% Reserve” Myth
May 6, 2011

(This item originally appeared in on May 6, 2011.)

Among the various fairy tales you hear about gold standard systems, one of the most pervasive is the idea that there was, or should be, a “100% reserve” of gold to make it work. As a corollary, the idea emerges that you can’t have a gold standard system unless you have a 100% reserve in a vault somewhere.

A gold standard system could use full-value coins exclusively, but this is quite antiquarian. For the past 300 years, among the most financially advanced countries, gold standard systems have used token paper bills with value linked to gold.

These token paper bills’ value was linked to gold by some mechanism of supply adjustment. If the paper bills’ value was too low, supply was reduced. If it was too high, supply was increased.

Who operates this mechanism? Obviously, people do, acting day to day to manage the supply of base money.

Now let’s imagine that there is some enormous quantity of gold in a vault somewhere. How is the paper bills’ value managed? How does base money supply increase or decrease, in order to maintain the proper gold parity? Obviously gold in a vault does nothing. It is inert metal. It does not emit magical energy waves that adjust the supply of paper currency without human intervention. You can pile up as much gold as you like, and still it will have no effect–no effect!–on the paper currency, whose value is determined by the adjustment of the supply of paper currency, not gold.

Likewise, if you happen to have just a little bit of gold, or even no gold at all, that is fine too. A paper currency’s value is pegged to gold by people acting to manage the supply of paper currency. This is the “currency board linked to gold” to which I sometimes refer.

In the past, the mechanism of supply adjustment typically involved redeemability. The owner of a banknote could redeem it for gold bullion. This was somewhat in the nature of a bank deposit today: a bank does not hold bank reserves in a 100% ratio to deposits, but it must hold some reserves to accommodate its obligation to repay depositors.

Thus, banks held some gold bullion as a reserve. By the end of the 19th century, banks no longer held this reserve themselves. They mostly held U.S. government bonds, and the Treasury held the bullion reserve. From 1880 to 1920, this reserve fluctuated between about 10% and 40% of banknotes outstanding. It was never 100%.

The 100% mark was reached for a short while in the late 1930s and early 1940s. This was due to the revaluation of the dollar in 1933, and also an influx of gold from Europe from investors worried about the worsening political situation there. It also reflected the rise of the dollar and decline of the British pound as a world reserve currency.

However, soon after the end of the war, the reserve ratio in the U.S. fell to more common levels below 60%.

Much the same was true of Britain, the world’s premier gold-linked reserve currency, during 1700-1914. Gold reserves typically fluctuated between 10% and 60%.

So we see that there never was a 100% reserve era in British or U.S. history. The 100% reserve gold standard that people sometimes talk about today is a fantasy.

Gold is the same value whether or not you have a bunch of it in a vault. Linking a paper currency to gold also does not require gold bullion itself. Thus, we can see that gold bullion is not strictly necessary for a currency manager to issue and manage a gold-linked currency.

Most people today do not understand the active supply-adjustment process. They hope that a big pile of bullion will somehow do the job for them. Of course this can never work. Attempts to make an inert metal take the place of active human management can only end in failure.