Curbing credit misses point

This is my latest column for Fund Strategy

It is strange how some subjects once confined to dusty economics textbooks are finding their way into public debate. In particular there seems to be a growing discussion of both returning to the gold standard and ending fractional reserve banking.

Underlying the debate is mounting anxiety over the huge increase in the amount of credit circulating in the global economy. Both schemes are, in different ways, designed to bring the amount of money into line with real economic activity. The idea is to find ways to restrict what is in effect the debasement of money.

This concern is well illustrated by the accompanying graph. From one perspective, when adjusted for inflation, it could be used as an argument for investing in gold. Over the long term there is a strong case for holding the precious metal.

But look at the graph from another viewpoint and it shows something else. Money is becoming less valuable relative to gold. Back in 1970 it cost about $15 to buy an ounce of gold whereas the current price is over $1,500. In other words, so the argument goes, the currency is being debased.

These two perspectives are not mutually exclusive. Often it is those who are most upbeat about gold as an investment, often called “gold bugs”, who are the most critical of excess credit creation.

I first became aware that this topic was entering into a wider discussion in an unlikely venue. I was taking part in a debate on austerity at an arts festival when one of the audience asked me about fractional reserve banking. It was not something I was expecting so I had to dredge the deep recesses of my memory to explain how it worked.

Since then I have noticed such schemes creep into the public arena in other ways. Perhaps the most high-profile example is Ron Paul, a Republican presidential candidate in America, who spoke publically against the gold standard. A similar argument is put forward by Peter Schiff, a fund manager and author, in his new book, the Real Crash.

Both Paul and Schiff are avid free marketeers but more mainstream figures have also raised the case for tighter control over credit. Mervyn King, the governor of the Bank of England, raised the possibility of the end of fractional reserve banking in a speech in October 2010. Robert Zoellick, the president of the World Bank, advocated a return to a modified gold standard shortly afterwards.

Nor are such schemes confined to one side of the political spectrum. It is true that free marketeers such as Milton Friedman spoke against fractional reserve banking while Ludwig von Mises was in favour of a gold standard. But John Maynard Keynes himself advocated a scheme based on what he called Bancor: to tie the value of currencies to a basket of commodities.

Although fractional reserve banking and a gold standard are not identical they share similar characteristics. Both are designed to curb the creation of artificial money.

In a gold standard the value of a currency is pegged to a certain quantity of gold. For example, a gram of gold might be set as worth a particular amount of a given currency.

Historically the value of currencies has often been pegged to gold and sometimes silver too. From the 1870s until the outbreak of the first world war in 1914 a gold standard was widely used worldwide. It briefly remerged in the late 1920s before collapsing again during the Great Depression of the 1930s.

In the quarter century after the second world war there was a form of indirect gold standard. The value of the dollar was pegged to gold and other currencies were in turn pegged to the dollar. This system broke down in the early 1970s with the world shifting to a system of floating exchange rates.

Fractional reserve banking is more complicated but still fairly straightforward. It provides a mechanism through which the banks can in effect create credit.

Imagine, for example, Alfred depositing £100 into Bank A. Under a fractional reserve system the bank might keep a certain amount in reserve, say £10, and lend out £90 to Bert. In effect then the bank has magically created more money from the initial £100: on paper Alfred has £100 while Bert has £90.

This process can then go even further. Bert could deposit his £90 into Bank B which could in turn lend 90% of it, that is £81, out to Colin and so on. The initial £100 is creating, at least nominally, considerably more money.

Of course the amount of real wealth is not increasing. The economy is still producing the same amount. But the level of paper wealth has increased enormously. As a result there is the potential for high inflation as the value of paper money becomes debased.

There is therefore a rational basis for both sets of proposals to tackle this problem: the introduction of a gold standard and the end of fractional reserve banking. Both are designed to close the huge gap that has opened up between paper and real wealth.

Ultimately both of them fail though because they attempt to tackle a fundamental economic problem with a technical solution. Simply devising new types of institutions will not deal with the economic weaknesses that have led to the massive expansion of credit.

The real challenge is to bolster productive economic activity. To foster a climate where there are durable increases in investment and economic output. A world where there is a shift back to the production of real economic value.

In the absence of such a movement any restrictions on credit will simply stall economic activity. They will reduce paper wealth without increasing real wealth. Indeed many green-tinged economists favour such schemes precisely because they are likely to reduce economic output.

The fundamental challenge is to create more economic dynamism rather than simply curbing the proliferation of paper money.