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What would happen to an economy if physical precious metals were legal tender currency?

Imagine money that had intrinsic value. How would this affect banking, government spending, saving, and consumer spending?

Better or worse than fiat money?

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  • Mar 17 2013: To Brian:
    Yes, it is possible to have recessions and bank runs similar to our current situation with a physically backed or a commodity currency, especially following an era of easy credit. There were many recessions and bank runs before the US went off of the gold standard, as well as before the existence of the Federal Reserve System. When people do not believe that a bank can meet demand for withdrawals, there will be a bank run, which may lead to a bank panic (systemic).

    In this recession, the packaging/ sale of mortgage backed securities and under the table derivatives trading, combined with Fed policy & regulations incentivizing banks to make poor loans. The market for mortgage backed securities collapsed (people realized borrowers were not creditworthy) and the market for them dried up, leading to a liquidity spiral (banks dump securities at the same time, leading to lower prices and more dumping -> need for a lender of last resort). It would still be possible for banks to package and sell loans if there was only a commodity currency, and a commodity currency would not prevent derivatives trading.

    Any time there is a fractional reserve system (+ mix: poor national bank policy, perverse incentives & non-disclosure) this can happen.

    Also, there can be problems with the purity of the commodity (i.e. gold) as it can be diluted which can increase transaction costs relative to a fiat currency.

    To Alan:
    Yes, I agree, if there were a transition back to a physical currency standard, it would be very difficult and likely cause a collapse. In my response I was focused more on the long term consequences on funding liquidity, abstracting from the transition. You bring up a good point; I don't know if there would be a satisfactory and orderly way to go back without bank runs & panics to redeem the currency for the commodity. It would probably require a complete financial collapse beforehand or a temporary, complete government control of the financial system. Bad.

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