With the outbreak of World War 1, as with all the historical examples we’ve covered in this book, the combatants halted redemption in gold, increased taxes, borrowed heavily, and created additional currency. However, because the United States did not enter the war for almost three years, it became the major supplier to the world during that time. Gold flowed into the U.S. at an astounding rate, increasing its gold stocks by more than 60 percent. When the European Allies could no longer pay in gold, the U.S. extended them credit. Once the U.S. entered the war, however, it too spent at a rate far in excess of its income. The U.S. national debt went from $1 billion in 1916 to $25 billion by the war’s end.
The world currency supply was exploding.
After the war, the world longed for the robust trade and economic stability of the international gold standard that had worked so well before the war. Thus, throughout the 1920’s most of the world governments returned to a form of the gold standard. But the standard employed wasn’t the classical gold standard of the prewar period. Instead, it was a pseudo-gold standard called gold exchange standard.
Building Pyramids
After the war, the United States had most of the world’s gold. Conversely, many European countries had large supplies of U.S. dollars (and depleted gold reserves) from the world’s central banks and that the US dollar and the pound will be redeemable in gold.
In the meantime, the U.S. had created a central bank (the Federal Reserve) and given it the power to create currency out of thin air. How can you create currency out of thin air and still back it with gold, you ask? You impose a reserve requirement on the central bank (the Federal Reserve), limiting the amount of currency it creates to a certain multiply of the units of gold it has in the vaults. In the Federal Reserve Act of 1913, it specified that the Fed was to keep a 40 percent reserve of “lawful money” (gold or currency that could be redeemed for gold) at the U.S. Treasury.
Fractional reserve banking is like an inverted pyramid. Under a 10 percent reserve, one dollar at the bottom can be expanded, by layer upon layer of book entries until it becomes $10 at the top. Adding a fractional reserve central bank, underneath fractional reserve commercial banks, is akin to placing an inverted pyramid on top of an inverted pyramid.
Before the Federal Reserve, commercial banks, under a 10 percent reserve ratio, could hold a $20 gold piece in reserve and create another $180 of loans, for a total of $200. But with the Federal Reserve as the foundation under the banking pyramid and having a reserve requirement of 40 percent, the Fed could put $50 in circulation for each $20 gold coin it had in the vaults. Then the banks, as the second layer in the pyramid could create loans of $450 for a total of $500.
Now there was an inverted pyramid, on top of an inverted pyramid, on top of an inverted pyramid. This was highly unstable. Ultimately the gold exchange standard was a faulty system that governments imposed on their citizens, which allowed the governments to act as if their currencies were as valuable as before the war. This system was destined for failure.
From the book: “Guide to Investing in Gold and Silver” by Michael Maloney
