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Changing the monetary regime

currencies

A recent article on Zero Hedge talked about how the folks Switzerland are considering eliminating fractional reserve lending. The piece starts off by sharing the results of a recent vote in which a referendum requiring the Swiss National Bank (SNB) to increase it’s proportion of reserves in gold up to 20%. It called that a failure to move toward more “sound money”.

Any time someone talks about money backed by something – gold, silver, whatever – being “sound” I can’t help but shake my head.

Having currency backed by something doesn’t make it sound by itself. The issue is fractional reserve lending. That’s the process by which banks lend out some multiple of the amount of money they actually have on-hand. For example, banks in the US are only required to have 10% of the money they lend out on-hand in the form of reserves.

If you have a currency backed by gold and still allow fractional reserve lending, you don’t have sound money. As long as financial institutions can lend more than they have on-hand, then the same problems exist as in a non-backed currency situation. Banks can create money. If you ascribe to the idea that inflation is caused by too much money chasing too few goods, then here you have a contributing factor.

Essentially, if Switzerland were to eliminate fractional reserve lending it would mean banks could no longer create money. That would be paradigm shifting in modern finance.