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Free banking and the historical gold standard

Over at his recently established blog “Uneasy Money,” David Glasner has a post on “Gold and Ideology.” (He has started fast out of the gate, writing prolifically; I hope he doesn’t burn out, but there’s a lot to write about when the subject is money.)  He claims that  “the gold standard never managed itself; in its classical period from 1870 till World War I it was under the constant management of the Bank of England with the occasional assistance of the Bank of France and other major banking institutions.”

I disagree. First, it is a mistake to begin in 1870. The gold standard is centuries older, and countries that were not on the gold standard before the late 1800s, such as Germany and India, were generally on the silver standard, which works on just the same principles. So when we discuss the gold standard, we are discussing a system whose roots stretch into antiquity, not one that lasted less than half a century.

Second, every study I have read about the gold standard acknowledges that the pre-World War I version worked much better than the interwar version, and at least in some respects better than the post-World War II Bretton Woods version. But hardly anybody has expressed clearly what I think is the reason for the differences in performance: the pre-World War I standard was much less heavily managed than the subsequent versions. Many countries did not have central banks. Instead, they had free banking or highly rule-bound government issuance of currency. These cases included three of the world’s largest economies: the United States, China, and India. The central banks of the era were typically fully or partly privately owned, and aimed at making profits rather than at managing the economy, although at times, especially during crises, they did act in what they perceived to be a broader interest. The spread of central banking was the other side of the coin of the decline of free banking: by the end of 1935, free banking had shrunk to such a point that the most important place where it still existed was Venezuela.

John Maynard Keynes called the Bank of England the “conductor of the international orchestra” of the pre-World War I gold standard. I prefer a different metaphor, from a kind of music that I suspect Keynes had little use for. The pre-World War I gold standard was more like a jazz jam session, where the players were riffing variations on a standard tune. The Bank of England was the piano player, who had a major role but did not conduct the session. The piano player was sometimes off key, making the music sound discordant. A number of major financial crises in the 19th century originated in England. Before 1845, when Scotland had free banking while England had central banking, the crises were more severe in England. Central banking, even though less oriented at overall economic management than it later became, seems to have been a destabilizing rather than a stabilizing force.

Since this is a post, not an essay, that’s all for now. I will return to the subject later.

  • What influence did Britain have on the gold standard prior to WWI on a global scale? For example, what influence did Britain play in the deflationary period between ~1875 and 1893? I know only about this episode in the United States, but if individual countries' experiences were different from each other, then it follows that domestic policy was more important than whatever control Britain exercised over the gold standard (or, it suggests that Britain did not take advantage of whatever control it had).

  • Kurt, Thanks for your interesting discussion of my post. Luckily, I have had a bit of spare time of late, and have been able to give this blog some attention. I don't expect that to continue, but who knows? On your substantive point. I agree that the gold standard goes back much further than 1870. However, it was in the 1870s and 1880s that the gold standard became, for the first time, the monetary framework for most of the world. That's why I used 1870 as a starting point. One could have gone back to the early 1820s when England restored the gold standard that had been suspended in 1797 at the outbreak of the Napoleonic Wars, and prior to that the gold standard came into existence as a result of Isaac Newton's selection around 1700 of a parity for gold that undervalued gold relative to silver causing Gresham's Law to operate to drive silver out of circulation. That's my memory at least. In addition, I totally agree with you that the fact that the gold standard did in a sense evolve from the system of coinage of antiquity was a great advantage that was an important factor helping the gold standard operate relatively smoothly in its heyday.

    I didn't mean to suggest that the reason why the interwar gold standard failed while the prewar gold standard succeeded was because the prewar gold standard was more intensely managed than the interwar gold standard. My point was that neither system operated without being steered. In the prewar gold standard the steering was done by the Bank of England, largely by frequent adjustments in Bank Rate that kept the gold reserve of the Bank of England sufficient to handle its requirement to meet demands for payment from abroad and to meet internal demands for hand to hand currency. That this was no trivial operation will be evident to anyone who has read up on the history of the Bank of England or Ralph Hawtrey's wonderful book A Century of Bank Rate.

    The reason that the gold standard collapsed in the interwar period was, in my view, that once the gold standard collapsed it turned out to be impossible to put Humpty Dumpty back together again. The adjustments at the margin that were sufficient to keep the prewar gold standard operating relatively smoothly most of the time were not sufficient in the interwar period after the enormous dislocations and inflations created by World War I and its aftermath. Many smart people, Irving Fisher, Ralph Hawtrey, Milton Friedman and Anna Schwartz to name a few, believe that if Benjamin Strong had not been taken ill and passed away prematurely in 1928, he might have steered a course that would have avoided the subsequent disaster, but who knows if one man could have saved kept such a precarious and delicate situation from falling apart.

    On Jon Catlan's question, my distinct impression is that there was very little local variation in prices and economic activity under the gold standard. The price level was more or less determined internationally for all gold standard countries and there was very little scope for prices in one country on the gold standard to depart from the level in other countries, because of a) gold shipments from high to low price countries, and b) even more importantly direct commodity arbitrage.

  • RickDiMare

    Excuse me if the following link is unrelated to this thread, but I think it's important to let the group know about the relationship between non-coin money and the income tax system in the United States. Here is a link to Rothbard's "Friedman Unraveled" that explains Friedman's reliance on the income tax to fairly distribute the wealth and fiduciary media created by banks, corporations, employers, etc. under a fiat system:

    Also, if I may interject my legal views again, contrary to what Rothbard expresses in this article, Friedman was correct to follow the legal precedent of Lincoln, Story, Chase and others, by giving Congress a monopoly, via its taxing powers, over non-coin money creators and users. The word "monopoly" is understandably objectionable to free banking advocates, but currently it's an economic and legal reality that requires the IRS to deal firmly with users and creators of non-coin money, yet softly with users of current U.S. coin, but dealing softly with coin-only users is something I don't think the IRS knows how to do yet. (Whether the coin is made of gold is an incidental matter in my view.)

  • Lars Christensen

    Thanks George…I agree 100%.

  • adithic

    I think that along with this issue, something else to consider when discussing the gold standard at least here in the United States is the idea of free silver. This method opted for using silver to back money instead of just gold. The idea was simple and was based on the principle that you could bring silver into the United States mint and walk out with the cash value of it, just like you could with gold. Many poor farmers and workers in the south favored this policy as it helped them and hurt creditors. Because the face value of silver was higher than the commodity value of it, backing money with silver created inflation without any real economic growth. In response to high demand from farmers and other free silver proponents, the Sherman Silver Purchase Act was passed in 1890, forcing the government to buy more amounts of silver and driving its price up. This in fact, you could argue, was one of the contributors to the Panic of 1893, since it depleted most of the gold reserves when people exchanged the new coin notes for gold dollars.