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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.)


  1. "If the Great Depression was mainly a result of monetary mistakes,… why did those mistakes not occur until 1929,"

    They had occurred before, about every 10 years in the 1800's. A plausible reason for the different performance in 1929 is that when bank runs occurred in the 1800's, banks suspended convertibility on a large scale, rather than allowing bank runs to proceed until the banks (and the money supply) had collapsed. In the 1930's, laws against suspension were more effectively enforced, so banks that would have suspended convertibility in earlier times were forced to maintain convertibility until they collapsed.

    It's the same with central banks. When a central bank becomes insolvent, it can either suspend convertibility (i.e., go off the gold standard) or it can maintain convertibility (i.e., stay on the gold standard). Staying on the gold standard results in a much worse tightening of the money supply than suspension would have, so countries that stayed on the gold standard fared worse.

    1. As Kurt notes, under free banking, some banknotes promise gold and others promise silver and others promise other commodities, and people freely exchange these notes. A bank could issue notes promising gold and also issue notes promising silver.

      If a bank issues only notes promising gold, then it can experience a run when demand for gold increases precipitously, even if the bank is profitable, i.e. even if the bank's capital is worth more than the par value of its notes. In this scenario, the bank has several options.

      Suspending convertibility is one option, but a bank may also offer its note holders goods other than gold, including notes promising silver. If note holders freely accept something other than gold, the bank has not suspended convertibility. It has only persuaded note holders to buy something other than gold with their notes.

      Of course, if note holders insist on gold, because they must have gold and only gold, because they owe gold and only gold today, to pay taxes for example, the bank has more limited options.

      For note holders insisting on gold exclusively, a bank could suspend convertibility to reevaluate the value of its capital, possibly under the supervision of a bankruptcy court. If the bank cannot redeem its notes, after a period of time, during which the increased demand for gold might have subsided, it is bankrupt and divides the value of its capital among note holders in an orderly fashion.

      If the bank's terms of service entitle note holders to this orderly process, rather than racing to the bank to stand in line, "suspend convertibility" is misleading, because the bank hasn't promised convertibility on demand under these circumstances.

      People choosing to hold notes promising gold prefer banks operating this way, because they don't want to race to the bank and stand in line, possibly to receive nothing, when demand for gold increases precipitously. A bank's terms of service could promise to redeem notes strictly on a first come, first served basis, but I expect informed consumers to prefer other terms of service.

  2. The term gold "standard" is unhelpful (indeed confusing) – is gold the money, or is it a "standard" for something else that is the money?

    However, the basic point is correct – from the libertarian point of view (which I share) if buyers and sellers want to use silver (or copper – or sea shells) as money (rather than gold) that is up to them. For example, silver was used as money in the Middle East for many centuries before coins were invented – it was just used on the basis of weight (and so on).

    Your point on the roll of Central Banking in creating the credit money "boom" that led to the "bust" of 1929 is also clearly true. Indeed Ben Strong (of the New York Federal Reserve) admitted what he was doing – he was proud of it (not seeing the consequences that would flow from it).

    Before the creation of the Federal Reserve even the most daring bankers (such as J.P. Morgan) and even under the far from Free Banking "National Banking Acts" operated on the basis of one Dollar of real savings for every two or three Dollars of loan. The system was very unstable and there were (of course) booms and busts – but the Federal Reserve system made things vastly worse.

    By 1929 the gap between hard money and bank credit was around 12 to 1 – a terrible crash was ineviable. But neither gold or free banking can be justly blamed – gold can not be blamed as it was the credit bubble (not gold) that was cause of the "boom" and free banking can not be blamed – because it did not exist in the United States.

    However, further research is needed on Canada – which did not have a Central Bank in the 1920s (indeed not till 1935), yet seems to have undergone a boom-bust event similar, in some respects, to that of the United States.

    1. … gold can not be blamed …

      Gold is an inanimate, unconscious, elemental commodity and cannot be blamed for anything.

      A statutory gold standard, that made gold exclusively the standard of value for extending credit in "dollars", was responsible for an incredible credit contraction during the Great Depression. This statutory standard was an act of Congress, actually a series of acts of Congress beginning with the first Coinage Act 1792, which defined the value of U.S. dollar bills in terms of a silver coin and fixing rates of exchange between these coins and gold and silver coins minted by the federal government, and extending through the Coinage Act 1873, which ceased silver coinage and effectively initiated an exclusive, statutory gold standard, as well as subsequent acts.

      These statutory acts establishing a monopolistic monetary system, ultimately a monopoly for gold as the standard of value for extending credit, are responsible for historical, monetary instability in the U.S. A gold standard is not the problem. The statutory monopoly is the problem.

  3. I recall reading that Canada's unemployment rate during the great despression was considerably less than that of its southern neighbor, and it had few if any bank failures. Maybe Kurt, George or others with more knowledge of this could weigh in.

  4. Interestingly, the "recession" started from Germany in 1928 because of the war reparations. German banks started to fall apart. The affected BoE,Bank de france, and by 1929 the American banks found themselves caught in their own bubble too. They complain about the Gold Standard because they couldnt continue to pass the cool-aid around. Due to global currency instability, Gold poured into the US. Instead of lowering interest rates, Fed raised'em. France which was collecting War reparations in GOLD marks, just sat on it.

    So now you have France and USA sitting on Gold and Germany completely out of Gold yet with its banks financially connected to the Global trading system, why wouldnt there be a depression?

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