How precious metals will replace fiat money

Alasdair Macleod – 17 March 2011

It is only a matter of time before the global banking system unravels. For those of us planning for life after such an event, it is time to think what might replace fractional reserve banks and the paper money that is their stock in trade, but first we must understand why modern banking is certain to fail.

The seeds of the banks’ destruction lie in the fractional reserve system, whereby banks lend out many times their capital. The problem with fractional reserve banking is that if a number of a bank’s depositors decide to withdraw their money at the same time, the bank might only be able to satisfy a fraction of the demands. This is the permanent state of modern banking.

In our hearts we know this, but we have confidence that bank runs will not happen. In the current financial climate this view is dangerously complacent. The five to ten per cent of core capital in each of the large international banks is badly impaired, with these impairments swept under the carpet by accounting standards designed to conceal the true position instead of inform creditors. Again, we all know this.

However, it is increasingly clear there will be a global slump in business activity, as higher inflation kicks in and interest rates inevitably rise. Banks will face an escalation of bad debts as a result of higher interest rates that will eliminate much, if not all, of their remaining capital. Unfortunately, the abilities of governments to back-stop the banks are now very limited, because of the unprecedented deterioration in government finances since the first banking crisis.

The international nature of modern banking exposes even relatively sound banks to risks from bad debt contagion, if not at first hand, then through interbank relationships that were previously sound. The collapse of Irish, Portuguese or Spanish banks has the potential to undermine British, French or German banks, and therefore all their counterparties elsewhere. There are many chains of risk like this, respecting no borders. While there is much that can be done out of the public’s sight, it will be very difficult for governments to foist a second banking rescue on their electorates, because they have unwisely encouraged everyone to believe banks and bankers are evil and do not deserve public support. For this reason the only option central banks have is to continue to flood the financial system with new money to compensate for the deflationary effects of contracting bank credit. This new money in the central banker’s mind can be directed to supporting the weaker members of the banking system, and in the Keynesian mind, provide vital economic stimulus. But since successive tranches of new money are having less effect, the amount required continues to escalate.

This is why central banks are unable to stop issuing paper money, because to turn off or even to restrict the flow of the money-tap would fatally undermine the commercial banking sector. For this reason central banks have no option but to deny that inflation is a growing problem, otherwise they have to stop printing money and let interest rates rise.

So put simply, the future we face is that the entire banking system will sink, along with the purchasing power of paper money. Fractional reserve banking has been with us too long, so we have to consider what will replace it, having no working knowledge of any alternative. In doing so, we also have to consider what we want the bank of the future to do.

The original function of a bank was to hold deposits safely, and facilitate customers’ payments. If a bank lent money to a borrower, it had to be the bank’s own money and not taken from deposits entrusted to them by depositors for safe-keeping. It was clearly set out in Roman law that to take a deposit and then use it for your own purposes is theft, and that is still true for all of us today, unless you have a banking licence. However, a loan to a bank is an entirely different thing, because the relationship between the parties is clearly established. Like any business, a bank can use a loan for its own benefit, and in the event of the borrower’s bankruptcy the lender is simply a creditor. It is these two basic relationships, depositor and lender, that get rolled up into one by fractional reserve banking.

There have been many instances of governments exempting banks from Roman legal principals over deposits, usually because it has allowed governments to borrow money in greater quantities. This is as true today as it was in ancient Greece and Rome, for the Florentine and the Catalonian banks in the fourteenth century, the Medici Bank in the fifteenth, the banks of Salamanca in the sixteenth, John Law in France in the eighteenth, and finally the fractional reserve system supervised and guaranteed by central banks since Peel’s Banking Act of 1844.

These are just some examples of banking systems which start off respecting the custodianship of deposits and then sequester them for their own use. The fact that all this has happened before with predictable outcomes nails the lie that this time is different, or that we are now more sophisticated in our financial knowledge. The co-mingling of deposits, loans and bank capital almost always ends with bank failures, which is the true precedent for today’s banking outcome. Our banks have highly-geared balance sheets in uncertain times: these are precisely the conditions that end with a run on deposits, and because the global banking system is already under great financial strain, it is hard to see how they will avoid the mass failure predicted by the history of human behaviour.

The failure of the banking system does not deny the usefulness of an institution whose function is to look after customer deposits, but the business model will have to be entirely different. Since these deposits cannot in future be loaned out, they gain no interest; so paper currencies that lose purchasing power are unsuitable as a store of value. The only secure bank deposit system that truly works has to be based on gold and silver.

This true depository service already exists in bullion dealing and depository facilities, the model for which is provided by GoldMoney, based in Jersey[i]. They store customers’ bullion in secure storage facilities with no bank involvement. And they offer the further advantage of storage in a choice of different jurisdictions. With little or no modification to their businesses, bullion-dealing depositories can provide this facility to a wider public, allowing customers to access their deposits and make payments without going through a fractional reserve bank.

For example, assume you employ a local tradesman. To pay his bill, you get him to open an account with your bullion-dealing depository, and transfer to him the gold or silver equivalent of what you owe him. His bill is settled without the involvement of the banking system, and he has the wherewithal to pay his bills in the same way. It is also possible to envisage a network of these bullion-dealing depositories settling transactions for each others’ depositors. This network could grow rapidly as the payment system spreads.

The advantages of such a system include self-regulation, because bullion-dealing depositories are not required to be licenced to misappropriate customers’ deposits. And in the event of a banking wipe-out, customers of these bullion-dealing depositories will be in a powerful position, because at the outset they will be the only people able to settle transactions without resorting to barter, physical metal or Weimar-style cash.

It seems ironic that the greatest danger posed to personal wealth, apart from inflation, is from respected, regulated banks. With their demise, and the end of fractional reserve banking, the need for bank regulation will entirely disappear. Since bank regulation is one of the two primary responsibilities of central banks, the collapse of paper currencies will leave them wholly redundant, and finished as institutions.

While advocates of sound money will welcome the end of central banks, it will nevertheless be important to protect oneself from the event. A store of value in precious metals held and accessed independently from the banking system appears to be the logical conclusion.

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[i] GoldMoney was set up by James Turk, who foresaw the need for a post-banking settlement and bullion storage facility. It is the only precious metals depository business of which the writer has first-hand experience. There are others, that may not share quite the same vision, and it goes without saying that the reader must make his own inquiries before opening an account with any of them.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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