Some people have a hard time imagining the United States without a central bank. The reality is we had no central bank for most of our first 130 years. We had tremendous price stability. There was no inflation and the dollar was tied to gold. The Federal Reserve was created in 1913. The result is our dollar is worth about 4 cents compared to what it was worth at its inception. We removed the silver from our quarters and dimes in 1964. In 1971 we removed our gold backing from our dollars and have been a purely paper currency ever since.
The real reason the Federal Reserve was created was to allow the bankers to engage in fractional reserve banking without risking a bank run. See here for more on fractional reserve banking.
Consider the following story and substitute gold for the fish to understand what banking would be like with a return to the gold standard. This is an example of 100% reserve banking with an honest money. No central bank is needed for this, just a money issuer that is trusted to make good on redemptions, like the US government before it removed the precious metal backing from the dollar. Banks did engage in fractional reserve banking before the Fed and there were bank runs, but the very fact that bank runs were possible made banks much more conservative with their lending habits.
Two hundred people became marooned on a desolate tropical island. After several weeks of turmoil as they became accustomed to their new environment, they began assessing their situation. Fresh water and shelter were both in abundance. The main problem was food. There had been a modicum of success fishing. This quickly became the staple protein source. The islanders learned how to dry and salt the fish to preserve them. They had discovered a fairly large variety of food including coconuts, berries and tropical fruits. Still the salted fish remained critical to their survival.
Time passed and weeks rolled into months. It was apparent that they were not going to be rescued. The islanders, being a hardy bunch, pressed onward with improvements to their situation. Several families had grown gardens. One man was very good at crafting utensils and bowls made of wood. The farmers had no time to fish and also tend to their gardens, so deals were made. A group of people agreed to provide them with fish in exchange for a portion of the garden’s future production. Similar arrangements were made with the other people who had to devote themselves to a specialty and as a result had no time to fish. Eventually the salted fish began circulating as a form of money. People would exchange the fish not to eat immediately, but as a means to acquire other goods later. As they apparently lasted for years they were a perfect store of value.
One enterprising man had an idea. No one was quite sure at first why he was spending all his time peeling bark from birch trees and writing numbers and symbols on them. He called a town meeting of sorts and explained to everyone what his plan was. He would be an intermediary between the fishermen and the craftsmen. His plan was to open a bank and store the fish in exchange for the paper money he had made. One fish would be equal to one dollar. People, he explained, would not have to waste the time and effort of carrying around their dried fish with them whenever they wanted to make an exchange. They could just leave the fish with him and use the paper dollars to buy and sell things. If at any point anyone wanted to convert their dollars to fish they could redeem them at his hut with no questions asked.
His plan was a success and the paper money was used in day to day transactions. He had storage of a good number of dried fish, perhaps a thousand or more, and he had issued exactly that amount of dollars out in exchange for them. People became accustomed to the paper money over time and diligently converted their fish into dollars, and exchanged them among themselves for transactions. The farmers and craftsmen would regularly redeem their money for actual fish to eat.
The supply of fish and by extension the supply of dollars held constant year over year on the island. It turned out on average the excess fish production from the fishermen equaled the fish consumption of the craftsmen so the money supply held steady.
It wasn’t long before the banker implemented the next part of his plan. He made an announcement that in order to facilitate business and production on the island, he would be acting like a regular bank. He would be paying interest to people who deposited their extra dollars back to his bank and he would be loaning out those dollars to others at a slightly higher rate.
Again, his plan was greeted enthusiastically. He took in deposits and lent the money out to people who were investing in their own small businesses. It worked out perfectly. As long as he was careful to only lend money to people who he thought they would be successful in their venture and be able to pay him back, there was little risk. He was also very careful to only lend out dollars that depositors had agreed not to redeem for a period of time in standard certificates of deposit or CDs. This ensured he would never have to worry about a number of depositors redeeming their dollars for fish at a time when the fish were lent out to borrowers. There wouldn’t be enough actual fish to cover the withdrawal demands and he would be out of business forever, having fallen victim to the classic bank run.
In facilitating the transaction he was able to allow savers, those with extra fish stores, to lend to those people looking to invest in long term projects. The long term projects would eventually provide valuable goods to the island. In the interim the savings are literally consumed by the entrepreneurs. Upon completion of the project, the entrepreneur sells his new goods to the other islanders and uses the money to repay his loans. All works out fine when the end product is worth more than the inputs.
One example of this was a man who borrowed 20 dollars (20 fish) to allow him to work for a week on a building a tall ladder. Upon completion of the ladder he was able to dramatically increase the normal production of coconut harvesting. He repaid his loan and eventually accumulated some additional savings. It was a terrific system that encouraged savings and improvements in production. Those entrepreneurs that needed capital savings had access to it. Those who saved for future consumption earned a return on their money. The bank facilitated the transaction and made a profit by providing the service.