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In July 2001, our Editor contributed to a debate on money and gold at IBF-NET. The text of these contributions appears below. Some of the material is drawn from other articles on this site, but mostly it is a new expression of the key issues as I see them. Major criticisms from other contributors are summarised in red.

One ~ Debt and the Gold standard

Two ~ Responses

Three ~ Responses

Four ~ Responses

Five ~ Responses


Debt and the Gold standard

On the subject of debt and the gold standard, we should remind ourselves of what three American presidents and one British Chancellor knew well ... that the 'gold standard' was a semantic distortion invented by the bankers.

Let us look at a simple example. You are welcome to point out where you think my logic may be wrong.

Imagine that there are 100 gold coins in circulation. This is the money supply, all of it created by the state. Now the first and only bank opens up for business. The bank takes total deposits of 20 gold coins and issues 20 receipts of 1 each in return. A few months go by and the people begin to trust the banker's paper receipts of 1 unit each. They begin to use those receipts in payment for goods and services among one another. Now the banker advertises his service as a money lender. Clients come to his office and borrow 200 in total. The banker lends money for two years at 30% interest per year. But of course, he doesn't lend gold coins. He prints and lends some more paper receipts instead. Two years later, the loan of 200 is to be repaid in the amount of 338.

At the beginning of the loan period, 100 gold coins and 220 of receipts were in existence. That's 320 of 'money' in total. So where will the extra 18 come from to repay the loan?

I say that the extra 18 can only come from the state if it issues more gold coins, or from the bank if it creates more paper money. And I say that in our modern world, it is the banks who tend to create most of the required extra money supply. They do this by lending it into existence as we have seen above. Which means that society is in ever increasing debt to the bankers. Yesterday's debt can only be repaid by taking out more debt today. This is why total debt (public plus private) as a proportion of GDP has increased in every developed country over the last 30 years.

Now the Third World countries owe dollars, but they can't manufacture dollars in the way that the US banking system or the US government can. So they try to earn enough dollars to repay their debts by exporting their produce. And because there are not enough dollars in existence to repay everyone's debt, the Third World has no choice but to go ever deeper into debt to the banks of the First World. It is a sick and sophisticated trap. A new form of colonialism.

What use the borrowed money is put to, that is just a side-show. Let's talk about that many years from now when we have remedied the key problem.

The gold standard was the bankers' excuse to cover up their money manufacturing activity. They agreed to redeem each of their paper receipts in gold if asked to do so, only because they believed that they would not be asked to do so. Theirs was an empty promise. If everyone tried to convert receipts to gold, the bankers would fail to deliver. Their cheating exercise would be uncovered.

Whether the supply of gold went up or down was of importance because it constituted the reserve against the paper issue. But the bulk of the money supply was manufactured by the banks as paper money and so we should spend the bulk of our time discussing paper, not gold. Practice is different nowadays of course, but the principles remain the same.

The need for an elastic currency? In Hansard of 1844, the record of the British parliamentary debates, and in the Congressional Record of 1913 during the debate over the formation of the Federal Reserve, the banker mouthpieces gave this same excuse for their proposed monetary reform. And the politicians bought it. It only served to let the bankers manufacture yet more money and thus earn yet more interest. So in the long run the elastic only moved in one direction.

Today the bankers create unrepayable debts and foreclose on businesses, making themselves rich and leaving others poor and oppressed. Like Pakistan. Like Indonesia. Like so many Muslim countries. In debt because their debts are mathematically unrepayable.

Our economists should be screaming from the rooftops at this fraud, but instead they seem to be enthralled by its perpetrators. They try to use their language, their methodology. Bond market? Islamic bond market. Futures and option contract? Islamic futures and options contract. Lender of last resort? Oh dear. The lender of last resort was invented to get the bankers out of trouble when the people presented too many paper receipts for redemption in gold.

So what do you say? Where does the extra money come from to repay the bankers created money? If banks do create money out of nothing, is that fair? Why do I go to prison if I am found to be creating money at home? If Islamic bankers create money out of nothing, should they go to prison?

This is what those three American presidents and one British Chancellor said:

'And I sincerely believe with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.'Thomas Jefferson in a letter to John Taylor 28 May 1816, Writings (1984) New York: Literary Classics of the United States

'The distress and alarm which pervaded and agitated the whole country when the Bank of the United States waged war upon the people in order to compel them to submit to its demands cannot yet be forgotten. The ruthless and unsparing temper with which whole cities and communities were oppressed, individuals impoverished and ruined, and a scene of cheerful prosperity suddenly changed into one of gloom and despondency ought to be indelibly impressed on the memory of the people of the United States. If such was its power in time of peace, what would it have been in a season of war, with an enemy at your doors? No nation but the free men of the United States could have come out victorious from such a contest; yet, if you had not conquered, the government would have passed from the hands of the many to the few, and this organised money power, from its secret conclave, would have dictated the choice of your highest officials and compelled you to make peace or war, as best suited their own wishes.'President Andrew Jackson, Address to the American people, 4 March 1837, recorded in Richardson's Messages, volume 4, p. 1532

'The government should create, issue and circulate all the currency and credit needed to satisfy the spending power of the government and the buying power of the consumers. The privilege of creating and issuing money is not only the supreme prerogative of government, but it is the government's greatest creative opportunity. By the adoption of these principles, the long-felt want for a uniform medium will be satisfied. The taxpayers will be saved immense sums of interest, discounts and exchanges ... money will cease to be the master and become the servant of humanity. Democracy will rise superior to the money power.'President Abraham Lincoln, Senate Document 23 1865

'I am afraid that the ordinary citizen would not like to be told that the banks, or the Bank of England, can create and destroy money. The amount of money in existence varies only with the action of the banks in increasing and decreasing deposits and bank purchases. Every loan, overdraft or bank purchase creates a deposit and every repayment of a loan, overdraft or bank sale destroys a deposit.'Postwar Banking Policy (1928) Heineman, by Reginald McKenna, Chancellor of the Exchequer of Great Britain, later Chairman of Midland Bank

One other thing. On page 115 of the Feb 17 edition of The Economist magazine, in an article on Islamic banking, Fahim Khan is reported to have stated that Pakistan's "biggest challenge in the next few months will be to find a way for the government to raise money domestically without paying interest".

Well, here's your answer. The government can manufacture the money out of nothing. That's what the banks would do if the government borrowed from them. Except the banks would charge interest.

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Two ~ Responses

One of the brothers was 'surprised that an economically educated person' should ask why a man would go to prison for creating money at home, while the bankers do it for a living. Still the question goes unanswered. Why does the crime of counterfeiting become a respectable profession through the act of incorporation as a limited company? Can you give me one example in Shari`ah where something that is haram becomes halal by the granting of a commercial license?

Another brother remarks that my ideas are 'mediaeval'. I presume he means to imply 'old' and therefore no longer relevant. The Qur'an and Sunnah are old but they will be relevant for the rest of time. That is why there is no need for further revelation. Therefore, I hope we can at least agree that a Muslim should never say it is wrong to use gold and silver as currency. If our Prophet s.a.w. used them, it cannot be wrong.

Gold has a factor cost. Modern money doesn't. In the monetary system I envisage, anyone can produce money. All they need do is go out and dig for it. Then, if the amount of gold obtained by digging is more than the amount of gold that it costs to do the digging, the people will produce money. Otherwise they won't produce money. This is a simple, market-driven mechanism for the supply and demand for money, one that features an in-built tendency towards price stability. It has nothing to do with interest, nor with the arbitrary creation of money for no effort.

And if people want to dig for platinum, let them. If one man feels that another will accept copper as payment, let him dig for copper. When the people have true freedom in money, what will they tend towards? Gold and silver, of course. This is because Allah has created us with a love for 'heaps of gold and silver' (Qur'an 3:14). He has created everything for a purpose and the purpose of gold and silver is to act as money (Ibn Khaldun, Muqaddimah).

The bankers want us to think that money is a development of later times. When man was more advanced, he invented a more advanced monetary system. If we believe this story, then the bankers can go inventing any monetary system they want, based on any valueless piece of paper or electronic data they care to create, because there is no absolute value system. Just like all good secularists, they promote a man-made system in place of the God-given one. In fact, it was probably Adam a.s. who minted the first dinar (Athar of Kab quoted by As-Suyuti). So the very first man knew about gold coins.

The Companions were well acquainted with the defined weights of the dinar and dirham. And that is how they used money. By weight. When the early coins were used as payment they would be weighed NOT counted, because the weight of metal was the value of the payment NOT the number of coins.

Some 950 years ago in England, the 'pound' was adopted as the currency of England. A pound was a pound in weight of silver. It was divided into 20 shillings and each shilling into 12 pennies. Hence there were 240 pennies in a pound. But the naughty Kings just couldn't resist debasing the coinage. They undertook recoinages in which existing coins were melted down and re-issued by the mint as coins of the same weight but of lower purity, or as coins of the same purity but lower weight. The public were forced to use the new pennies by order or 'fiat' of the King, hence the term fiat money arose. Because of these debasements, by 1666, one pound of silver was being minted into more than 700 pennies. Thus 'one pound' of 240 pennies was no longer a pound in weight of silver. The NAME remained, but the intrinsic nature had changed. This is the crucial process. The transition from money as a commodity exchanged under free subjective valuation, to money as a token imposed by force. And it only happened because someone, somewhere, wanted to cheat the people of their wealth.

When the bankers arrived on the scene they took this principle to its extreme. They produced something of no intrinsic value, a piece of paper, and gave it the name 'one pound'. They had to encourage the people to use this valueless thing, for by achieiving this they could manufacture money at no cost and then lend it at interest. But the people have always preferred gold and silver to paper. So the bankers discouraged the use of the state's metal money and promoted their own paper money. Just as today they encourage us to use their electronic money instead of using the state's paper money (which is why the banks are happy to pour millions into promoting the use of 'direct debit'). In the UK, it was illegal for a private individual to purchase gold bullion for much of the twentieth century. What do we believe about prohibiting what Allah has allowed? Of what is this a sign?

The efforts of the banking establishment have stretched beyond the corporate world and into the academic institutions, so that a Western education in financial economics today is less of an education and more of a brainwashing with the values of Classicism, Marxism, Keynesianism and Monetarism. The four great schools of Western economic thought and not one of them identifies usury as a key issue. I am not expecting Ricardo, Marx, Keynes and Friedman, each a Jew, to do the Muslims' thinking. Just that we should be aware of an intellectual monoculture. You can have any theory so long as it's black.

Against this background I can understand why people make comments along the lines "countries that have lots of gold will become very rich without doing anything". This has been a standard argument of the pro-banking lobby for a very long time. Where in the world can a man produce gold without doing anything? Where? Let me set up my business there. Becoming very rich without doing anything is exactly what the bankers can do once they obtain the power to manufacture money out of nothing. Should we stop using oil because Saudi Arabia is sitting on a great lake of the stuff and hasn't done anything to earn it? No of course not. Oil is vital to us. We must use it. And the same applies to gold and silver. They are vital to us because they were created to fulfil the function of money.

I was recently at a conference in Riyadh where I gave a talk on bank lending and house prices. Currently, the Saudi government makes interest-free loans to finance Saudis who wish to buy a home. But the government feels that it cannot continue to afford this and therefore wants to find a way of allowing the banks in to provide finance. My argument was that if the banks enter the housing market, they will create money out of nothing and lend it at interest. Better, I said, for the government to create the money out of nothing and lend it interest-free.

A senior economist from the World Bank who heard my talk accused me of 'living in the Stone Age' because I advocate an interest-free currency. But the World Bank presides over policies that have bankrupted half the world and led millions of children to starve on the altar of foreign debt repayments. In almost 1300 years when Islam prevailed there never was such misery. So who exactly is living in the Stone Age?

Our response must be simple and clear. There may well exist unifying axioms of endogenous monetary theory within an Islamic paradigm. But if our Prophet s.a.w. had spoken like this, who would have come to Islam?

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Three ~ Responses

One of the brothers wrote: Banks don't "counterfeit" in any sense of the term. They don't create money out of nothing, they borrow - they are debt-financed commercial enterprises.
In the United States, Federal Reserve statistics for the end of 1997 tell us that a total of USD 429 billion in notes, coins and operational deposits had been brought into existence by the state. The same source shows that the banking system simultaneously held USD 1097 billion of money in the sight deposit accounts of customers, available for immediate withdrawal. If the banks do not create money, and if the state has created only USD 429 billion, where does the other USD 668 billion come from?

Imagine that there is just one bank in existence. This single bank IS the banking system. Now imagine customers A and B, who each start with a zero balance on their current accounts at this bank. Customer A then gives customer B a cheque of USD 100 in payment for goods, and customer B deposits this cheque with the bank. The banker credits account B with USD 100 and debits account A with the same amount. B is now in credit and A in overdraft to the amount of USD 100, and the goods have been paid for. State money was not created in the process outlined here, but there is a new amount of money in existence. It is the USD 100 in customer B's account. Do you disagree?

Why has the bank created the 100 of money in B's account? So that it can charge interest to customer A on a debt of 100, of course. Notice that one group of bank customers must always be in debt to an amount that equals the existing total of bank created money supply. Thus we live in a world full of debt. Because most of our money supply is created as the balance sheet counterpart to an interest-bearing loan, the shadow of interest falls upon the real world. We see a price premium on forward contracts and then we have long debates about the validity of cash-and-carry murabahah.

Don't look at a single bank's balance sheet .... look at the banking system as a whole. Then you will see money creation galore.

Gold was once used as backing for Bank of England promissory notes, and for foreign central banks' holdings of the US dollar monetary base under the Bretton Woods arrangements. Land and industrial property was used to back the Rentenmark (Germany 1923 - 1925). Technically speaking I agree that there is nothing to prevent the state using government assets (land or shares in publicly owned companies for example) as backing for new issues of the monetary base. But history is full of examples of the repeal of the legislation that established the backing in the first instance. The Bank of England can announce that it is no longer redeeming its paper issue in gold (1797) and Nixon can inform a press conference that the dollar has been decoupled from gold (1971). What recourse did the holder have against these decouplings? None at all. And what would be different next time? In the past, there has always been a next time.

There is one protection that can be established for the people against the manipulations of the state and/or the bankers. That protection exists where the currency has intrinsic value. Where the coin in my pocket is a piece of gold, no amount of state legislation can take my value away from me. The link to gold cannot be broken by decree if the individual holds the gold on his person or in his safe.

When I came to Islamic economics and the subject of riba, my first reaction on encountering the hadith of 'gold for gold, silver for silver, wheat for wheat ...' was that the illa of riba must surely be use as a monetary medium. This for the reasons you point out ... salt had been used as money, various types of grain too, and gold and silver obviously. It would make life much simpler if this was indeed the illa of riba. But my reading of the jurists did not conclusively confirm (or deny) this. I stand open to correction if you know better.

I wish to address one last and important issue. If a bank lends 100 it must retrieve more than 100 in order to make a profit. Now consider a banking system in which there is no state money at all. The banks create 100 of money and invest on a profit-sharing basis for one period. It is immediately obvious that the banks cannot make a profit by this means because there is only 100 of money in existence at the end of the investment period. No matter how this amount is shared between the banking sector and the entrepreneurs, the banks cannot retrieve more than the 100 that they initially created. It is a short step to go from here to the realisation that commercial banks cannot be profitable unless they fix financial rates of return in advance on money that they themselves create. The consequence is a more or less constant growth in money supply and debt.

If Pakistan Islamicizes its banking sector without addressing the nature of money then there will be no substantial change in its economic condition. Just a new layer of semantics upon the existing infrastructure. On the other hand, if it genuinely and suddenly prohibits fixed rate returns then the banking sector will probably collapse for the mathematical reason given above. The transition from interest-bearing money to Islamic monetary system will be both economically and politically dangerous. A real life demonstration that there is a better alternative to the conventional monetary system would threaten the world's richest and most powerful institution. I remember reading the debates in the Houses of Congress prior to the formation of the US Federal Reserve in 1913. In public, the great banking houses appeared neutral or opposed to the new institution. But in private they not only did much to support the Federal Reserve Bill, they went so far as to draft its key clauses. With the IMF watching over its shoulder, who knows what kind of Islamic banking system will actually be born in Islamabad?

There is a passage by Shaykh Abdalqadir As-Sufi from the preface to a Murabitun publication entitled 'The Return of the Gold Dinar' which I think is worth quoting here (I am not a member of this or any other group):"This text and minted gold Dinars and silver Dirhams were presented by its author to Dr. Erbakan, Leader of the Refah Party, Turkey's National Islamic Party. Dr. Erbakan then declared that on being elected the gold dinar would become the national currency. It created a sensation. Much more than any phantasm of terrorist activity, the usual instrument of the media to alienate the public, the possibility of gold coins replacing the disastrously inflated paper lire created a panic. If any proof were needed that finally the real issue had been identified, the fear of the secular political parties certainly provided it. At an Islamic conference hosted by the City of Istanbul and its Mayor, Recep Tayyib Erdogan, Dr. Erbakan called me onto the platform to hold up the Dinars to the Istanbul citizens. The vast hall erupted in thunderous applause and shouted takbirs."

Let us pray that rightly-guided men in Pakistan and Malaysia don't suffer the same fate as Dr. Erbakan.

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Four ~ Responses

A brother wrote: They [banks] *do* create money, but at a cost - the interest that they pay to their depositors. This is not counterfeiting ... banks acknowledge what they owe to their depositors. But what matter more than semantics are the rulings of informed jurists. What does this analysis contribute? We are all aware of the role of banks in the monetary system.
So you agree that banks create money but you maintain that this is not counterfeiting.

If I print a paper receipt on which appear the words 'I promise to pay the bearer one pound in gold on demand' and then lend it to you, but I don't have that pound of gold in my possession, then this is a straight lie. Today we can only see this fraud at the systemic level, not at the level of an individual bank balance sheet, because the banks operate a more sophisticated money creation scheme than the goldsmiths of old. It doesn't make the system any less disgraceful. If one person is cheating, then somewhere someone else must be loosing.

You have not challenged my numerical example showing that banks create money in order to charge interest or that bank money cannot exist without debt. The implications of this analysis are serious and are outlined at > Editorial > About Interest-based Money. That is my contribution.

No, I agree that money has been created [by the banks]. Where we disagree is that you believe that we should spend our resources digging in the ground to create money, and you consider such efforts as the only legitimate means to produce money. But it is not even the best means.
The developed economies are typically spending around 10% of their GDP on the banking system and, according to Huber & Robertson, around 20 billion Sterling is paid annually to the banking system in the UK alone for its 'service' of creating of money. This cost dwarfs anything that would be spent on mining and minting gold and silver coins in the long run. Don't misrepresent the costs of Islamic money, or the extent of its creation. Please dispel images of long bearded men in thobes digging in the earth for metallic ores. We can be more technologically advanced than this, even if my exposition employs simplicity for the sake of clarity.

More importantly, we should rid ourselves of the idea that money supply must grow in an Islamic economy. When money is the balance sheet counterpart to an interest bearing loan, then both the loan and the money supply MUST grow in order for the banking system's balance sheet to balance. Where there is no interest, the remorseless force of compounding does not act upon the monetary aggregates and money supply need not grow. Perhaps the Muslims would spend very little time digging the earth for their Islamic money. Has that occurred to you?

Actually, the government can debase gold coins and thus reduce the value of those in your pocket. Seignorage did not originate with unbacked currency, and the best protection against poor governance is democracy, not the gold standard.
We've been over this. The gold standard was a misrepresentation supported by the banks, giving the public the impression that their money was supported by gold. It was no such thing. If the state decides to issue fiat money 100% backed by gold, this measure on its own will not create monetary stability if the commercial banks are then able to expand bank money supply (M1, M2 etc.) by several multiples of the total state issuance of fiat money. That is what happened under the classical gold standard and it is what caused the demise of that system. The bankers blamed the gold standard for a multitude of monetary woes, when in fact it was their own money creating (and destroying) activities that were to blame.

If the government debases the pure gold coins that I have in my hand, then I can melt down my gold coins and sell at the bullion price on the open market. This is how I maintain the value of my currency holding. The government can only stop me doing this if it prevents a free market in bullion and prohibits export, but that in itself does not devalue my private holding of gold. It only prevents me from REALISING its value in terms of the newly debased money. This is a far greater measure of security than applies to any piece of fiat money.

Secular people tend to oppose things that make worldly life more difficult. Indeed, their panicked reactions to misguided religious groups is often justified, and learned Muslims may react in the same way.
Making worldly life more difficult? Have you seen what is going on in the world because of the debt-based monetary system? Do you say that a religious group is misguided because it seeks to establish a sunnah in place of an open haram? Even if their understanding is poor, it surely cannot be as wrong as the understanding of those they seek to replace.

May Allah guide the Muslims to an appropriate solution.

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Five ~ Responses

Even when we consider abuses in the system, it does not mean that modern currencies are a bad idea, let alone Haram. Be careful in declaring something Haram; not every mufti is correct in their 'verdicts'.
Most modern money is created by banks. Banks create money by making interest-bearing loans. Interest is haram. A monetary system that is based upon interest must therefore also be haram. Be careful not to declare it halal.

Question: How does a gold-backed economy accommodate growth?? Circulation speed??
Money supply must grow under the interest based system. It may grow under the Islamic monetary system, but it doesn't have to. Perhaps velocity of circulation will increase. Perhaps the people will produce more gold/silver/copper etc. Or perhaps the average price level will fall over time. (Where prices are falling, consumption in the future might often be preferred to consumption in the present. A nice counter-balance to consumerism and positive time-preference.) And if prices do fall, then the supply of gold and silver will not need to grow so much, or at all.

I say: I've never seen it established that we MUST use Gold-backed currencies. Islam is not about keeping people backward and poor.
I don't say that we MUST use gold backed currencies. I argue for freedom in money. The people can use any item of intrinsic value. When they are truly free, I predict that they will use gold and silver. Allah says that humans love gold and silver, and it is a Sunnah to use gold and silver. Ibn Khaldun says that Allah created gold and silver to act as money. You disagree with him. I feel comfortable with Ibn Khaldun's position.

If you don't have any way of keeping this promise [to redeem paper receipts with gold coins], then yes - it was not made in good faith. If depositors of a bank believe that it won't be able to meet its commitments, there will be a run on the bank. But this is why there are reserve requirements and lenders of last resort - to ensure that banks will be able to meet such demands for redemption.
No commercial bank that I know of has the ability to pay all of its depositors if they come and ask for payment of their sight deposits in cash. But the banks still promise to do so. A small amount of the state's money is kept in reserve by the banks to allow them to meet cash requirements from some of the depositors from day to day. The banks thereby maintain the fiction that all of the depositors can withdraw in cash all of their sight deposits if they wish. So the promise to repay deposits in cash on demand is as much a lie today as it ever was. The lender of last resort was promoted by the bankers so that if they were asked to honour their unfulfillable promise to redeem in cash, then they could go somewhere to borrow that cash temporarily to meet the drain. Central banks were established largely in response to this need, allowing commercial banks to carry on creating money with impunity. Such safeguards do not make the bankers' activities acceptable. Cheating is cheating, with or without a safety net.

But if Muslims believe that it is acceptable for merchants to extend credit, and charge markups on credit sales, then why do you object so much to intermediation? One thing that seems to trouble you about it is that bank deposits are counted in economic statistics as money, (while credit extended by merchants is not). You think that a bank creates the money out of nothing (even though it is only an intermediary), yet probably would not say that the debt owed to a merchant in a credit sale was created "out of nothing".
Are you confusing trade credit with money? There is a big difference. Trade credit is created in a halal money-for-goods transaction. Most modern money is created in a haram money-for-money transaction. Even if there is only one gold coin in existence, a hundred people could still agree to buy from one another for payment in gold within one year, and all of them could honour this commitment using the one gold coin in circulation among them. None of the individual trade credit agreements requires the coming into existence of even a single extra gold coin. Creation of trade credit does not equate with the creation of money that might be used to settle trade credit.

And this has nothing to do with "interest-based money". If we used gold coins as money, these issues would remain as long as people bought things on credit.
If we don't address interest and bank creation of money, then of course the introduction of gold and silver coins won't change anything. Where the banking system has assets of 100 in loans and 100 in deposits, if the loans attract interest at 10% per year then there must be 110 in loans at the end of the year. So there must also be 110 in deposits at the end of the year, otherwise the banking system's balance sheet doesn't balance. Hence modern money grows at interest, just like debt. (I have omitted the bank's equity here, to which a portion of the interest charge accrues, but it makes little difference to the analysis.) Notice that if interest rates increase, money supply grows even faster and inflation may therefore also increase. Completely the opposite to what we were taught in our conventional economics courses.

If I owe you $100,000 I don't need to pay you with money. There are a number of other things that I can give you to settle my debt. If I owned a house, perhaps you would accept that. So debts can be settled, and the stock of money can decrease.
Not under the conventional monetary system. Even if I am allowed to repay the banking system with a house, the corresponding depositor still has a claim upon the banking system of 100,000 plus interest. Therefore it is not the case that money supply decreases if I repay my bank debts with a house or other non-monetary asset.

... a "monetary contraction" is a bit more subtle than you might imagine.
Not according to Irving Fisher of 'Quantity Theory' fame. Imagine the banking system has two customers, A with a 100 loan outstanding and B with a deposit of 100. If A sells something to B for a price of 50 and B pays by cheque, when A deposits the cheque into his bank account, then A will have a loan of 50 outstanding and B will have a deposit of 50 outstanding. Money supply has contracted from 100 down to 50 because A repaid some of his debt. Notice that money has been destroyed in the act of this loan repayment. That is what Professor Fisher called debt-deflation in 1935. Is he also guilty of a glaring inconsistency?

A key point is that unbacked currency is more effective in fighting/preventing recessions because we can control the money supply more carefully than we can control the world supply and demand for gold and silver, i.e. unbacked currency allows us to deal with monetary contractions more effectively.
The unwanted monetary volatility arises mostly because of the banking system's power to create and destroy money. The state would not need to correct these problems if the bankers weren't able to create them in the first place. To move a stage further, the history of fiat money is that state issuers constantly prove themselves incapable of controlling their own production of money. We cannot rely upon the state to be the guardian of our monetary stability. On the other hand, global gold supply has increased by an average of less than 3% per annum over the last 250 years or so. However 'bad' that may be, it's a lot better than what we can expect of the current monetary arrangements. As you say, if the amount of gold spent in digging for gold was less than the amount of gold obtained in doing so, then the people would dig for gold. This is a self-regulating market mechanism for the production of money that has nothing to do with interest or the arbitrary creation of money by bankers and governments. Here, the market controls money supply. Under this arrangement, money supply doesn't need to be controlled any further by the state. (I wrote this in an earlier posting.)

So this argument actually works against gold-backing of currency.
Ultimately, I am not in favour of gold backed currency. I am in favour of gold and silver AS currency. You can live in a house. But you can't live in the document that proves ownership of a house. Similarly, if gold is money, a receipt for gold deposited in a bank cannot fulfil the function of money. Don't label me with the 'gold-backing' argument.

There is only so much gold and silver to be made into coins ...
Allah has provided man with enough resources to last until the Day of Judgement.

... If we use them as money, the prices of gold and silver will keep increasing. So while the money supply might not be growing very much in a physical sense, its value keeps increasing just as if we did not use a gold standard. This is merely because the economy is growing ... The end result is reflected mostly in constantly rising prices for gold and silver, relative to other goods i.e. massive deflation.
As the Murabitun are fond of pointing out, a chicken cost a dirham during the early days of Islam. Today, it still costs around a dirham. No piece of fiat money has ever held its value so well. You use the words 'massive deflation' to shock people. But the rate of economic growth is less than 3% a year in developed economies and a few per cent more than this at best in developing economies. Even if gold and silver supply did not increase at all, such gradual growth would lead only to gradual deflation. And gradual deflation could be a wonderful thing, for the reasons that I began with.

See other discussions on this topic here and another angle here.