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More on the gold standard, with regret

I regret taxing readers’ patience with another post on the gold standard. As I and other bloggers here have made clear, a free banking system need not be a gold standard system. If people want the standard to be gold, that’s what free banks will offer to attract their business. But if people want the standard to be silver, copper, a commodity basket, seashells, or cellphone minutes, that’s what free banks will offer. Or if they want several standards side by side, the way that multiple computer operating systems exist side by side, appealing to different niches, that’s what free banks will offer. A pure free banking system would also give people the opportunity to change standards at any time. Historically, though, many free banking systems have used the gold standard, and it is quite possible that gold would re-emerge against other competitors as the generally preferred standard.

It is therefore distressing to see economists who should know better failing to distinguish among different kinds of gold standard. Recently, Bruce Bartlett, David Glasner, and, implicitly, David Beckworth have dumped on the gold standard by citing the Great Depression as decisive evidence against it.

The gold standard of the time transmitted the Great Depression from the United States to the rest of the world. One piece of evidence is that countries off gold generally suffered less than those on gold. That is only the first step in the inquiry, though. If the Great Depression was mainly a result of monetary mistakes, as I, Glasner, Beckworth, and probably Bartlettt would all agree, why did those mistakes not occur until 1929, even though in one form or another the gold standard and its twin the silver standard were many centuries old?

The reason, I submit, is that the period between the two world wars was the first in which all the world’s financial powerhouses had activist central banks. Before World War I, central banking was still uncommon outside of Europe. Whether in Europe or elsewhere, the central banks that did exist were often privately owned rather than government owned, and were not activist in the sense that we apply the term to monetary policy today, meaning using it to promote broad economy-wide goals. Rather, they pursued the narrower goals of making modest profits and lending liberally on good collateral during periods of financial distress. World War I changed all that. The pressures of war finance "militarized" central banks in the countries fighting the war, converting them from what they had been in the 19th century to something closer to what we are used to them being in the 21st century. Among the countries so affected was the United States, which passed a central banking law in 1913 and opened the Federal Reserve in 1914 soon after war broke out in Europe. In my view, the combination of activist central banking, a fairly rigid gold standard (which viewed devaluation not merely as undesirable, but as odious), and ignorance about the dangers of combining the two created the framework allowing the world’s leading central banks to make the mistakes that generated the Great Depression.

Among the many monetary historians whose writings on the gold standard I have read, all acknowledge that the interwar gold standard performed far worse than the pre-World War I gold standard or the Bretton Woods standard. They struggle to give a fully satisfactory answer why that was so. A free banking perspective provides an answer. The prewar gold standard was more rigid than the interwar standard, but lacked central banks that aimed at economy-wide stabilization. The Bretton Woods gold standard was full of central banks that aimed at economy-wide stabilization, but was less rigid than the interwar standard because exchange controls and devaluations were in practice accepted parts of the system. The Bretton Woods era was one of widely shared economic growth and few financial crises. (It had important flaws, but that's a subject for another post.) And the prewar period, while more volatile than the Bretton Woods period, looks no more volatile than the post-World War II years as a whole.

So, Bruce, David, and David, if you are going to pursue this line of criticism, particularly if you are going to use try to use it on Republican presidential candidates, remember that Ron Paul, who I think is the only major presidential candidate since the gold standard ended who has explicitly advocated returning to it, called his book End the Fed. It is obvious from the title alone that Paul wants a gold standard without a central bank, that is, without the body that you yourselves acknowledge triggered the Great Depression. Whether you like Paul’s proposal or not, the gold standard he wants differs in a crucial way from the interwar gold standard. Ditto for people who favor a “new Bretton Woods.”

(For a post that addresses some recent criticisms of gold from a more theoretical angle, see this post by Blake Johnson on Lars Christensen’s blog.)