(FEE)—I have a question from Kyle P. for Ask an Economist this week. He wants to know how banking would work under a commodity standard, and he is also interested in what sort of commodities work best as a basis for a currency. He says:
Can you explain how commodity-backed currencies, like the gold standard, work with regards to saving and lending? As I understand it, with fiat money, if A deposits $1,000 in the bank, which then lends $800 to B, there’s now $1,800, but with a gold standard there’s still only $1,000. Would A only have access to $200 + whatever B has repaid? Where would the extra money for interest paid by B to the bank and by the bank to A come from? If B skips town, is A out $800?
Also, can you explain what would make a good commodity to back a currency? Would a plutonium standard, a distilled water standard, or prime rib standard work as well as a gold standard or silver standard?
To tackle the first question, we need to highlight the differences between a currency system and a banking system. Let’s start there.
Commodity vs. Fiat Money
So does commodity money, like a gold-standard, conflict with how banks operate today? Not really. To understand why, we need to get to the fundamental difference between commodity money and fiat money—redeemability.
A commodity money is redeemable for some quantity of a physical commodity. For example, we can imagine a paper currency which could be redeemed for one ounce of silver, gold, plutonium, or prime rib. If you can, in principle, take the note to a bank or government office (depending upon the specifics of the system) and have it redeemed for gold, the currency is a gold-backed currency.
Fiat currency, on the other hand, is only redeemable in itself. In other words, if you take your currency to a bank or government office in a fiat system to redeem it, they are going to hand you back different fiat currency. If you redeem your five dollar bill, the only thing you’re promised is five slightly different colored bills with Washington’s face rather than Lincoln’s.
This is the difference between fiat and commodity systems.
So, is a commodity-based monetary system compatible with banking as we know it today? Sure. Let’s run through an example to see why.
Let’s say you deposit $1,000 worth of gold at a bank. In exchange you receive $1,000 of redeemable gold-backed notes, which you can use to purchase products. If the notes are transferred, the person who receives them can redeem them for their portion of the gold. The bank has the gold it would be required to give for redemption.
In some historical government money systems, the government offers the right to gold redemption rather than the private bank, but there’s no reason we couldn’t imagine banks or private gold redemption businesses taking this on. For our purposes, we’ll just assume that the banks store gold for redemption and allow customers to save their notes. This system is maybe overly simple compared to reality, but it makes our example a bit easier.
You decide that instead of spending your gold notes, you’d prefer to save them, and you deposit the notes in the bank as well.
Someone comes along and borrows notes from the bank. The bank gives the borrower $800 worth of gold-backed currency from the $1,000 you deposited in the bank. So now, your bank account balance is $1,000 (recorded on the bank’s ledger), and the borrower has $800 in physical cash. This sort of banking system where the bank only keeps a fraction of the money deposited and lends out the rest is known as fractional reserve banking.
At this point, you may have noticed the problem that Kyle noticed. The bank essentially created new money when it loaned your money out to someone else. There is now $1,800 worth of promises to redeem currency in gold out there, but the amount of gold hasn’t changed. There’s still only $1,000 worth of gold. So is this an issue?
Well, it’s only an issue for the bank if everyone decides to redeem their currency for gold at the exact same time. In that case, the bank would be unable to meet its obligations, and it would go under unless something changed.
You might take this possibility as evidence that commodity-backed money is incompatible with fractional reserve banking. There’s two reasons why this isn’t necessarily the case.
First of all, this potential problem is not unique to commodity money. If banks hold fractional reserves in a fiat money system the same issue still applies. If every depositor runs to the bank and demands their fiat money, a bank will be unable to fulfill that obligation if they only kept a fraction of the fiat and lent out the rest.
In other words, this risk associated with fractional reserve banking is not specific to a commodity or fiat system. The risk of too many customers trying to secure funds exists in both systems. The type of money (commodity or fiat) is a separate question from the type of banking system (fractional or full reserves).
Second of all, as long as the bank keeps enough gold on hand to meet the actual redemption requests, then there is no issue for the bank. It’s possible in theory for a bank to not hold enough gold, just like it’s possible for all businesses to fail to meet their obligations if things go sufficiently wrong, but there is incentive to avoid this result.
To answer some specifics, Kyle’s original inquiry included several questions based on a hypothetical scenario. Let’s consider each.
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“…if A deposits $1,000 in the bank, which then lends $800 to B, there’s now $1,800, but with a gold standard there’s still only $1,000.”
In both a gold and fiat standard, the depositor has an account balance that reflects the bank’s obligation to give them $1000. In both standards, the borrower has notes worth $800. If the depositor requested all their currency notes back, the bank would be unable to issue them unless the bank had deposits from other customers, because $800 of A’s deposits is in the hands of B. This is an issue, but it isn’t an issue unique to the commodity system.
“Would A only have access to $200 + whatever B has repaid?”
How much money A has access to depends on the situation. Does the bank have other customers with partial deposits? If not, the bank might have a problem if A wants more than $200. Again, this is true in both the fiat and gold-backed system.
“Where would the extra money for interest paid by B to the bank and by the bank to A come from?”
The interest money paid by B would come from the wealth created by B in the process of paying back the loan. For example, if B started a business and the business sold a product to a customer in exchange for the customer’s gold-backed currency, that’s the money B would use.
“If B skips town, is A out $800?”
Again, that depends on the particulars. A bank could buy deposit insurance or sell bank assets if it wanted to eat the cost of the failed loan (assuming there is no way to cancel those redeemable notes). We could also imagine a bank that tells customers they’re on the hook if borrowers skip town, though I have a tough time imagining many customers would be interested in that arrangement.
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You might be tempted to think the theft of the redeemable notes doesn’t hurt the bank because the bank didn’t lose any of the $1,000 in gold. The problem is, when B skips town and spends the notes, the person who accepted the notes has the option of redeeming them. In other words, when the notes are stolen the gold is as good as gone too (again barring some fancy note-canceling technology).
What Makes for Good Commodity Money?
So now we know the difference between commodity money and fiat money. Commodity money should be redeemable for something. But can it be redeemable for anything? We could imagine the commodity that backs a money being anything at all, but in reality certain features of commodities make them better or worse for money.
The economist Carl Menger (1840-1921) provides one of the seminal accounts on how money developed. Menger highlights how the system of barter suffers from several shortfalls including the very important double coincidence of wants (which you can read about here).
As a result of this and other issues, people in barter economies will tend to discover goods which are universally accepted. These universally accepted goods then evolve into being a medium of exchange for most transactions.
So what sorts of qualities do these medium-of-exchange goods have? I don’t claim that this is an exhaustive list, but these goods tend to be: universally enjoyed, portable, durable, divisible, fungible, and recognizable. There’s one final quality that’s hard to put into a single word. Sometimes people say “scarcity”, but I think this is a bad label because it confuses some concepts. I think there are two concepts that this gets at. First, the supply of the good should not be able to grow too quickly. Second, the good should have a high value per unit of weight/space (value density).
Let’s think of some examples to see why some commodities succeed while others fall short. Let’s take copper, for example. Copper has all the first six qualities listed above, however, copper is pretty heavy relative to its value. Copper hovers for around $4 per pound. That means if you wanted to buy a $400,000 house in a copper standard, you’re going to have to somehow transfer ownership of 100,000 pounds of copper. That’s not exactly impossible, but that doesn’t make it ideal. Not only that, the copper supply is so large it lends itself to rapid supply expansion. You’d probably need a rarer and more valuable metal to pair with copper for a working system.
Kyle mentioned a standard with a pretty similar problem to copper—a distilled water standard. Water is similar to copper in a lot of ways as it relates to our qualities. It’s universally enjoyed, portable, durable, divisible, homogeneous, and recognizable. Technically proving it’s distilled maybe makes it a little less recognizable or homogeneous, but the main problem with water (like copper) is it’s pretty cheap per pound (between $1-$4 in stores near me).
The prime rib standard is an interesting proposal because it helps us see some problems. The glaring issue is that prime rib is not very durable. Banks would have to have a lot of freezer space to support that commodity standard.
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Admittedly, the list of qualities is not a perfect predictor of what flies as money. We can find historical exceptions to the qualities on the list. But it seems consistent that high-value metals like gold and silver rise to the top on average.
Ask an Economist! Do you have a question about economics? If you’ve ever been confused about economics or economic policy, from inflation to economic growth and everything in between, please send a question to professor Peter Jacobsen at [email protected]. Dr. Jacobsen will read through questions and yours may be selected to be answered in an article or even a FEE video.
Additional Reading:
- In Defense of Fiduciary Media by Drs. George Selgin and Larry White
- On the Origins of Money by Carl Menger
Five Things New “Preppers” Forget When Getting Ready for Bad Times Ahead
The preparedness community is growing faster than it has in decades. Even during peak times such as Y2K, the economic downturn of 2008, and Covid, the vast majority of Americans made sure they had plenty of toilet paper but didn’t really stockpile anything else.
Things have changed. There’s a growing anxiety in this presidential election year that has prompted more Americans to get prepared for crazy events in the future. Some of it is being driven by fearmongers, but there are valid concerns with the economy, food supply, pharmaceuticals, the energy grid, and mass rioting that have pushed average Americans into “prepper” mode.
There are degrees of preparedness. One does not have to be a full-blown “doomsday prepper” living off-grid in a secure Montana bunker in order to be ahead of the curve. In many ways, preparedness isn’t about being able to perfectly handle every conceivable situation. It’s about being less dependent on government for as long as possible. Those who have proper “preps” will not be waiting for FEMA to distribute emergency supplies to the desperate masses.
Below are five things people new to preparedness (and sometimes even those with experience) often forget as they get ready. All five are common sense notions that do not rely on doomsday in order to be useful. It may be nice to own a tank during the apocalypse but there’s not much you can do with it until things get really crazy. The recommendations below can have places in the lives of average Americans whether doomsday comes or not.
Note: The information provided by this publication or any related communications is for informational purposes only and should not be considered as financial advice. We do not provide personalized investment, financial, or legal advice.
Secured Wealth
Whether in the bank or held in a retirement account, most Americans feel that their life’s savings is relatively secure. At least they did until the last couple of years when de-banking, geopolitical turmoil, and the threat of Central Bank Digital Currencies reared their ugly heads.
It behooves Americans to diversify their holdings. If there’s a triggering event or series of events that cripple the financial systems or devalue the U.S. Dollar, wealth can evaporate quickly. To hedge against potential turmoil, many Americans are looking in two directions: Crypto and physical precious metals.
There are huge advantages to cryptocurrencies, but there are also inherent risks because “virtual” money can become challenging to spend. Add in the push by central banks and governments to regulate or even replace cryptocurrencies with their own versions they control and the risks amplify. There’s nothing wrong with cryptocurrencies today but things can change rapidly.
As for physical precious metals, many Americans pay cash to keep plenty on hand in their safe. Rolling over or transferring retirement accounts into self-directed IRAs is also a popular option, but there are caveats. It can often take weeks or even months to get the gold and silver shipped if the owner chooses to close their account. This is why Genesis Gold Group stands out. Their relationship with the depositories allows for rapid closure and shipping, often in less than 10 days from the time the account holder makes their move. This can come in handy if things appear to be heading south.
Lots of Potable Water
One of the biggest shocks that hit new preppers is understanding how much potable water they need in order to survive. Experts claim one gallon of water per person per day is necessary. Even the most conservative estimates put it at over half-a-gallon. That means that for a family of four, they’ll need around 120 gallons of water to survive for a month if the taps turn off and the stores empty out.
Being near a fresh water source, whether it’s a river, lake, or well, is a best practice among experienced preppers. It’s necessary to have a water filter as well, even if the taps are still working. Many refuse to drink tap water even when there is no emergency. Berkey was our previous favorite but they’re under attack from regulators so the Alexapure systems are solid replacements.
For those in the city or away from fresh water sources, storage is the best option. This can be challenging because proper water storage containers take up a lot of room and are difficult to move if the need arises. For “bug in” situations, having a larger container that stores hundreds or even thousands of gallons is better than stacking 1-5 gallon containers. Unfortunately, they won’t be easily transportable and they can cost a lot to install.
Water is critical. If chaos erupts and water infrastructure is compromised, having a large backup supply can be lifesaving.
Pharmaceuticals and Medical Supplies
There are multiple threats specific to the medical supply chain. With Chinese and Indian imports accounting for over 90% of pharmaceutical ingredients in the United States, deteriorating relations could make it impossible to get the medicines and antibiotics many of us need.
Stocking up many prescription medications can be hard. Doctors generally do not like to prescribe large batches of drugs even if they are shelf-stable for extended periods of time. It is a best practice to ask your doctor if they can prescribe a larger amount. Today, some are sympathetic to concerns about pharmacies running out or becoming inaccessible. Tell them your concerns. It’s worth a shot. The worst they can do is say no.
If your doctor is unwilling to help you stock up on medicines, then Jase Medical is a good alternative. Through telehealth, they can prescribe daily meds or antibiotics that are shipped to your door. As proponents of medical freedom, they empathize with those who want to have enough medical supplies on hand in case things go wrong.
Energy Sources
The vast majority of Americans are locked into the grid. This has proven to be a massive liability when the grid goes down. Unfortunately, there are no inexpensive remedies.
Those living off-grid had to either spend a lot of money or effort (or both) to get their alternative energy sources like solar set up. For those who do not want to go so far, it’s still a best practice to have backup power sources. Diesel generators and portable solar panels are the two most popular, and while they’re not inexpensive they are not out of reach of most Americans who are concerned about being without power for extended periods of time.
Natural gas is another necessity for many, but that’s far more challenging to replace. Having alternatives for heating and cooking that can be powered if gas and electric grids go down is important. Have a backup for items that require power such as manual can openers. If you’re stuck eating canned foods for a while and all you have is an electric opener, you’ll have problems.
Don’t Forget the Protein
When most think about “prepping,” they think about their food supply. More Americans are turning to gardening and homesteading as ways to produce their own food. Others are working with local farmers and ranchers to purchase directly from the sources. This is a good idea whether doomsday comes or not, but it’s particularly important if the food supply chain is broken.
Most grocery stores have about one to two weeks worth of food, as do most American households. Grocers rely heavily on truckers to receive their ongoing shipments. In a crisis, the current process can fail. It behooves Americans for multiple reasons to localize their food purchases as much as possible.
Long-term storage is another popular option. Canned foods, MREs, and freeze dried meals are selling out quickly even as prices rise. But one component that is conspicuously absent in shelf-stable food is high-quality protein. Most survival food companies offer low quality “protein buckets” or cans of meat, but they are often barely edible.
Prepper All-Naturals offers premium cuts of steak that have been cooked sous vide and freeze dried to give them a 25-year shelf life. They offer Ribeye, NY Strip, and Tenderloin among others.
Having buckets of beans and rice is a good start, but keeping a solid supply of high-quality protein isn’t just healthier. It can help a family maintain normalcy through crises.
Prepare Without Fear
With all the challenges we face as Americans today, it can be emotionally draining. Citizens are scared and there’s nothing irrational about their concerns. Being prepared and making lifestyle changes to secure necessities can go a long way toward overcoming the fears that plague us. We should hope and pray for the best but prepare for the worst. And if the worst does come, then knowing we did what we could to be ready for it will help us face those challenges with confidence.
