Banks play a crucial role in any economy. They not only provide a safe place for you to store your money, they also use that money to give loans to small business and families taking out mortgages to buy homes.
The theory of the gold standard revolves around its ability to cap the supply of money to avoid inflation. However, government isn't the only entity that "creates" money in a system, as we'll see in the example below.
Let's go back to Bananastan:
- Mr. and Mrs. Peel (two banana farming residents of Bananastan) have been model citizens. They have worked hard, lived frugally and saved some money from selling their bananas at the local market in their hometown, San Manzano.
- They decide that the best place to put this money is downtown at the Bank of San Manzano.
- The manager at the Bank of San Manzano is delighted to take their deposit of $50 BB and place it into their savings account, assuring the family that their money will be safe and available whenever they need it.
- One entrepreneurial resident of Bananastan, Mrs. Split, wants to open up a chocolate banana stand in town, but needs a small business loan. So she goes down to the Bank of San Manzano where she passes a credit check and the manager gives her a loan of $50 BB. The source of the loan is all the deposits that the citizens of Bananastan have placed in the bank (including those of Mr. and Mrs. Peel).
- Mrs. Split takes the money and buys timber, nails, a 55 gallon drum of chocolate and 100 bananas from the Peel banana farm. Then she opens the chocolate banana stand and pays a local teenager a week's salary (5 BB) to run the place. Mrs. Split has spent all the money.
- The teenager, at the guidance of her parents, then places her 5 BB in the Bank of San Manzano to start saving for college.
This is great. Times are good. Business is booming. But wait. Something is weird here.
- By all accounts, Mr. and Mrs. Peel are correct to believe that they have $50 BB. Every time they log into their account on the bank's website, it's right there.
- Mrs. Split may have spent the loan by building the stand, but she has $45 BB worth of stuff (wood, nails, etc.) that she didn't have before she got the loan.
- All the vendors who sold Mrs. Split her supplies are now holding that same $45 BB in cash that Mrs. Split had a short while ago.
- As far as the teenager is concerned, she has 5 BB sitting in the bank that she worked hard for at the stand and responsibly put into the bank.
This bank just created money out of thin air. If Mrs. and Mrs. Peel are the only people with deposits at the bank, and if they want to withdraw their money today it is not there. "Money" was created without any government printing or intervention. There was $50 BB in the system, now there is at least $100 BB.
This is what is called the money multiplier effect, and it can certainly cause inflation even in the presence of a gold standard. When the government (central bank) creates a dollar, its very likely that that dollar will multiply in the economy. Image how complicated it gets once the Bank of San Manzano lends out the teenager's $5 BB deposit - that's a double lending of the Peels' original 5 BB. And in reality a single dollar can be re-lent many many times*.
So, it should be obvious given the example above that the gold standard does not make inflation impossible. There are other forces that can cause inflation in an economy beyond printing money.
In fact, inflation during a gold standard has happened lots of times in the real world. Take a look at this chart below (source):
The US dollar was pegged to a gold standard until 1933, and inflation from 1919 until 1922 ranged from -16% to +24% in a short period after WWI, and wobbled around thereafter. Numbers that extreme today would be incredible and would have very detrimental effects on expectations in the economy (For example, "We can't plan that vacation until we know what my salary is going to be next year.")
Another extreme example in history is when Musa Keita of Mali went on his pilgrimage to Mecca in 1324. He rolled through Egypt and thought he would do the poor a favor and give them all gold (literally tonnes of gold). This sudden influx caused the value (price) of gold to plummet and inflation to skyrocket, devastating the economy of Egypt for a decade. Holding gold in that time was no hedge against inflation.
*Bonus material:
In an environment where banks are allowed to just keep lending all the money they take in, crises can develop when people want to collect their deposits - and bank runs happen. Governments reduce the likelihood of this happening through a few mechanisms, one of them being reserve requirements. The government says "If you are going to give out $1000 (USD) in loans, then you need to have at least $200 cold hard (or digital) cash reserved in your vault". This creates a 1:5 deposit to loan ratio. The higher that reserve number, the fewer loans a bank is able to give out.
This is what is called the money multiplier effect, and it can certainly cause inflation even in the presence of a gold standard. When the government (central bank) creates a dollar, its very likely that that dollar will multiply in the economy. Image how complicated it gets once the Bank of San Manzano lends out the teenager's $5 BB deposit - that's a double lending of the Peels' original 5 BB. And in reality a single dollar can be re-lent many many times*.
So, it should be obvious given the example above that the gold standard does not make inflation impossible. There are other forces that can cause inflation in an economy beyond printing money.
In fact, inflation during a gold standard has happened lots of times in the real world. Take a look at this chart below (source):
The US dollar was pegged to a gold standard until 1933, and inflation from 1919 until 1922 ranged from -16% to +24% in a short period after WWI, and wobbled around thereafter. Numbers that extreme today would be incredible and would have very detrimental effects on expectations in the economy (For example, "We can't plan that vacation until we know what my salary is going to be next year.")
Another extreme example in history is when Musa Keita of Mali went on his pilgrimage to Mecca in 1324. He rolled through Egypt and thought he would do the poor a favor and give them all gold (literally tonnes of gold). This sudden influx caused the value (price) of gold to plummet and inflation to skyrocket, devastating the economy of Egypt for a decade. Holding gold in that time was no hedge against inflation.
*Bonus material:
In an environment where banks are allowed to just keep lending all the money they take in, crises can develop when people want to collect their deposits - and bank runs happen. Governments reduce the likelihood of this happening through a few mechanisms, one of them being reserve requirements. The government says "If you are going to give out $1000 (USD) in loans, then you need to have at least $200 cold hard (or digital) cash reserved in your vault". This creates a 1:5 deposit to loan ratio. The higher that reserve number, the fewer loans a bank is able to give out.
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