This archived content originally appeared at, the predecessor site to, and does not carry the sponsorship of the Cato Institute.

A Qualified Defense of Goldbuggery and Some Related Observations on the Regressive Effects of Inflation

[Note:  This was originally posted at Bleeding Heart Libertarians and directed at that audience, but I will repost here as well.]

In my recent post responding to Matt Yglesias on the gold standard, at least one commenter was surprised to find a defense of “goldbuggery” here at BHL. I’m guessing this reaction is due to one or both of the following:  1) defenses of the gold standard are associated with more “right wing” forms of libertarianism and 2) the lack of an obvious connection between monetary policy issues and the typical concerns of bleeding heart libertarianism.  Let me try to address both of those here by doing two things.  First, I want to explain exactly the sort of thing I wish to defend when I argue for a monetary role for gold.  Second, I want to argue that such a system will do better by the least well off among us by reducing or eliminating inflation and business cycles/recession, the effects of which are disproportionately felt by the poor.

Let me note that monetary theory is one of the most complex, difficulty, and subtle parts of economics (as Yglesias’s ham-handed post shows), so there’s no way I can do justice to all of the possible nuances here, but I’ll try provide links or responses in the comments as my time allows.  I would also point readers unfamiliar with the basics of monetary policy tothis primer of mine, from which some of the material in the next section is taken.

Monetary Competition and Commodity Standards

As I pointed out in the earlier post, the term “gold standard” can mean any number of things, from a system with a monopoly central bank that redeems its money in gold, to a gold-coin or 100% gold reserve system, to “free banking” systems in which all forms of money are produced competitively and banks can make that money redeemable in whatever commodity customers appear to prefer.  All of these and others might be considered “the gold standard.” However, I want to make the case for the last of them: monetary competition or “free banking.”  (I should also note that such a free banking system should be distinguished from the “Free Banking Era” of the US from 1837-1863, as that period was anything but free of government interventions and those interventions were responsible for the problems of that system, and the National Banking System that followed it.  Central banking is not the only way in which government intervention can undermine good monetary systems.)

Over the last several decades, a growing number of economists (see my own work, which builds on the work of colleagues such as Larry White and George Selgin and others) have explored the institutional features and macroeconomic properties of free banking systems, to the point where there is now a substantial literature on the subject.  Free banking systems would do away with central banks and their monopoly privileges and allow the competitive market process to produce the kinds and quantity of money that the public demands, just as it does for so many other goods and services. Certainly one long-standing concern of left-libertarians has been an end to all kinds of monopoly privileges, and ending those of central banks are among the most important, especially given the ways in which they have been used to finance wars (about which more later).

Rather than having currency produced monopolistically by a central bank, individual banks in such a system would produce it in the same way that they currently produce their own “brands” of deposits. My checking account deposits at my bank would be held as “private money” that the bank produces competitively against the checking account dollars from your bank. Banks have developed ways of clearing those checkable liabilities through various clearinghouse arrangements, and the same was true historically in those systems where currency production was private. Banks developed very sophisticated institutions for coordinating and overseeing their behavior, even during times of crisis.

Perhaps the greatest advantage of a free banking system is its ability to avoid inflation and deflation. Free banks would want to make their currency and checking accounts redeemable in some sort of commodity as a way to assure customers of their value. Historically, this commodity has been gold, though it need not be. This is the sense in which I am defending a gold standard:  historically, the closest models to the kind of banking system I would like to see in place have been ones in which gold played this role as the preferred commodity of redemption. Again, it need not but there are good reasons to think it would, none of which have to do with any magical qualities of gold.

Given that banks will want to provide redeemable currency and deposits, they have reason, even in the absence of regulation, to hold a stock of gold on hand (in addition to the deposits they keep at clearinghouses).  Historically, banks in early 19th century Scotland got by on about 3% reserves or less with almost no bank failures. With modern electronic payment systems, banks in such a system would need to hold only a small fraction of their liabilities in the form of gold reserves, so fears that such a system would require a great deal of gold are misguided. It’s more the promise to redeem in gold than holding a great deal of gold itself that makes the system stable.  Of course the promise has to be backed up if customers invoke it, but, historical experience and theory suggest that will not happen very often.

With currency and deposits redeemable in gold, customers and other banks can take any excess balances of such liabilities to the issuer for gold.  Should any bank produce more money than its customers wish to hold, those customers will either bring it back to the bank directly for redemption or they will spend it, where it will most likely end up in the possession of a different bank. The other bank will not want to hold stocks of a competitor’s money.  Instead, it will prefer to redeem it for gold or reserves at the bank directly or at a clearinghouse, either of which will impose a cost on the competitor by taking away the gold or reserves it needs to create loans. This process of “adverse clearings” ensures that if any bank creates too much money, it will pay an economic price for it in the form of reduced reserves.  Lower reserves not only limit what the bank can lend and thereby earn in interest, insufficient reserves put the bank at risk of not being able to pay depositors. Should a bank create too little money, it will also pay a price, but in the form of having too many reserves on hand and thereby sacrificing the interest it could earn by expanding its lending. Free banks would avoid deflation because under producing money is costly. If we assume that banks are profit seekers, they would have every reason to avoid both inflation and deflation.

What a free banking system produces is the right degree of flexibility necessary for sound money. Because this system is separate from the government, we need not worry about political incentives working at cross-purposes with sound money. Free banks do not face the lag and information problems of central banks. With banks operating in a truly competitive market, they are able to make use of market signals, such as their reserve holdings and profits, to show them quickly and accurately whether they have produced the right quantity of money.  These are exactly the signals that monopoly central banks lack, which helps to explain their inability to get the money supply right. Although banks will not get the money supply exactly right at every moment, a competitive free banking system will ensure that they know they have erred and that they have the knowledge and incentives needed to correct mistakes, and it will do so better than any alternatives. A free banking system also has the advantage of being able to respond to changes in the demand for money, while still being constrained to not over- or under correct, unlike the rule-bound central bank. This “flexibility within constraints” is a product of the competitive environment that free banking creates.

Again, I can’t do justice to the full argument here. My real concern is to demonstrate that such a system fits neatly into broader libertarian arguments about the problems of monopolies and the benefits of competitive markets, and does not reify gold in the way that other proposals made by right-wing defenders of the gold standard tend to do.  Gold (really “some commodity”) plays a role here, but the key is allowing competition to drive the production of all forms of money.

Why Competitive Money Matters

If my fellow free banking theorists and I are correct about the system’s ability to dramatically reduce or eliminate inflation, then this has important implications from a BHL perspective as the damage done by inflation disproportionately harms the poor. One of the most important problems inflation creates is that it does not, in the real world, affect all prices equally.  Some go up a lot, some not as much. This injects static into communication process of the price system and makes prices much less reliable guides to producers and consumers. Most of inflation’s problems begin there.

As a result, the existence of inflation (or, more precisely, an expectation of a positive rate of inflation), imposes costs on households and firms that can only be avoided by undertaking costly defensive measures themselves.  These “coping costs” of inflation are significant and often under-appreciated.  They also harm the poor much more than the rich.  In addition, inflation redistributes toward those who get the new money first and away from those who get it last.

Once the threat of inflation is real, consumers must start to pay more attention to interest rates and the terms of contracts.  If banks start to offer adjustable rate loans, this complicates the borrowing process for consumers and might require additional expertise to make sense of the loan.  One can raise similar issues about employment contracts with cost of living clauses.  In both cases, it is likely that those with the least resources will be at a disadvantage in dealing with the changing reality of contracts.  Not only will the wealthy be more likely to have the knowledge themselves to cope with these costs, if they do not, they have the resources to hire those who do.  The result will be a net gain for the wealthy as they are able fend off these costs of inflation better than the poor.

Beyond just contracts, inflation gives both firms and households reasons to reallocate their resources, especially their financial assets, to protect themselves against inflation.  For both, either making these changes themselves or hiring someone else to do so involves real costs. And here too, those costs can more easily be borne by the rich.  In the case of firms, large firms can more easily bear these costs as they can either spread them across a larger scale of operation and/or are more likely to have in-house expertise to draw upon.  Smaller firms will find it more of a struggle to cope either by trying less efficiently to do it themselves, or by having to bear the higher average cost of purchasing such help on the market.  Though the effect may not be large, inflation imposes more costs on small firms than large ones.  The story across households is similar.  Wealthier households, who certainly have more at stake, will be more able to afford financial advice or to hire a financial planner, whereas poor households will find doing so that much more difficult.  The result is that wealthier households are better able to protect the value of their assets, while poor households see losses.

Perhaps the most damage that inflation harms the poor is the way in which those who get access to the excess money supply first gain at the expense of those who get it later.  This manifests itself several different ways.  As excess supplies of money make their way through the economy, those who get the money first are able to spend before prices rise, while those who see it later see prices rise before they see the increase in their nominal incomes resulting from the increased money supply.  The most well known example of this process is the way in which inflation harms those on fixed incomes.  Workers locked into labor contracts or retirees on pension plans that adjust annually to the cost of living are always running a year behind.  Normally, the cost of living adjustments are based on the prior year’s inflation rate, which means that for that year, these people have had no income increase even as prices were rising.  They will have been compensated, after the fact, for the past year, but for the year to follow, they will now lose if there are any inflation-driven price increases.  It does not matter whether these fixed incomes are public or private;  the issue is that they only adjust after the fact.

As inflation causes prices to less accurately reflect the tastes, preferences, and knowledge of market actors, it becomes ever more difficult for both entrepreneurs and consumers to figure out what is happening in the market, which in turn leads to more discoordination and more frustration for market actors.  As the market becomes a less reliable resource allocation process, people will, on the margin, turn toward government to address the particular problems or take over more of the responsibility for resource allocation.  In addition to the direct gain in wealth that comes from governments creating new money, there is an induced gain in government power from the chaos that inflation produces in the marketplace.  As the locus of resource allocation shifts from the decentralized nodes of market power checked by competition to the centralized nodes of monopoly power of the state, the ability of those with fewer resources to make their voices heard shrinks accordingly. Rent-seeking societies favor those with resources to access politics.

If, as Austrian school economists like myself, are correct in arguing that inflation is the cause of the boom and bust of the business cycle, we have yet another way in which a free banking system would work to the benefit of the least well off, as recession and depressions have less impact on those already better off. Concern for the least well off should drive us to find ways of minimizing or eliminating business cycles.

Finally, to the extent that the history of central banks is about being created and having their powers expanded as a way to finance government, especially its imperial adventures, without recourse to taxation or borrowing, bleeding heart libertarianism might have an interest in eliminating them if possible.  After all, war and empire have historically taken their worst tolls on the most vulnerable, both in terms of the aggressor countries and the populations they have aggressed against.

All of this adds up to a number of reasons why those sympathetic to bleeding heart libertarianism might take an interest in questions of monetary policy, and why they might reconsider a hasty dismissal of a desire to once again have gold play a monetary role as right wing nonsense.

  • Steve: Good piece.

    All too many of those who promote the gold standard are quick to dismiss the concerns of the working man, or worse yet tell him that those concerns are invalid. I am no "bleeding heart" but I write about the falling real wage, and I say that no good can come of denying it or telling people "if you want to make more money, go to college." Yeah, right. I think this is why the gold standard is mistaken for a "right wing" policy.

    I think it's important to help show people that gold and especially silver are the money of the working man. When you get paid your wages in silver, you have real money. You can put it under the mattress. You can deposit it in a bank if you choose, but only if you like the deal you're offered. You can't be screwed by the Man.

  • Mike Sproul

    The rule that free banks adhere to above all (even more than the gold standard) is to only issue money (usually meaning bank notes) in exchange for short-term real bills of adequate value. But here at, support for the real bills doctrine is (ahem) less than enthusiastic.

  • Steve,
    There are several aspects of free banking that it's advocates regularly fail to explain, probably because it is so well known and obvious to them. These have to do with the natural monopoly character of money (i.e. its usefulness derives in part from its universal acceptance). It would not be very useful, for example, for stores to need to post their prices in Chase dollars, Citi dollars, BofA dollars etc. or to only accept the notes of the bank they know, etc.

    You compare bank issued bank notes to bank deposits, each resting on the brand name credit worthiness of the issuing bank. But there is a big difference obviously between paying with a bank check or a bank note. Payment with a check is not final until the check has been cleared and settled. Thus any one accepting a check does not need to worry about or evaluate whether the writer of the check has money in his account or whether the bank is sound—payment is not final until the check has been processed and good fund deposited to the payees account at her bank. It can’t work that way for banknotes, the receipt of which is final. So how does that work in free banking with many different issuers of different notes?

    A bigger issue is your underlying assumption that there is one underlying numeraire (one unit of account). Specifically, that as long as Chase, Citi, BofA etc are solvent, one dollar of each has the same value. Your discussion of adverse clearing regulating bank note issues etc depends on their all being fixed to (redeemable for) the same numeraire. No one wants to have competitive provision of weights and measures. You implicitly and correctly and necessarily assume that all bank liabilities are fixed (making them redeemable) to he same thing (the monopoly numeraire) such as an once of gold. But at other times you don't seem to care much whether all of the bank issuers are using the same numeraire, which seems to me to destroy the very purpose and usefulness of money rather than barter.

    Thus your discussion of competition is misleading, as is your discussion of inflation. Inflation means money is losing value, but relative to what? Even if you concede that free banking needs a numeraire such as gold, which will then anchor money’s value to that of gold, that doesn’t illuminate inflation, if, as is common, we mean general purchasing power (stable CPI).

    I agree with your discussion of the harm of inflation.

    • Warren: I don't think one should call it a monopoly when a single commodity emerges from the winner-take-all competition in the market. Money (like many other things) benefits from the network effect.

      There is nothing in a free market that prevents bank A from saying its notes are redeemable in seashells and banks C through Z saying they're redeemable in gold. I think it's obvious which banknotes will not be accepted and which will. Unless government forces people to accept something else, they have always and will always go for gold.

      So long as every note is redeemable in gold, then the value of a note does not slip with respect to gold except if the creditworthiness of the issuer is called into question.

      Numeraire (or more properly, what a note is redeemable for) is a separate issue from the question of creditworthiness. If every bank note is redeemable in gold or silver, then the notes from less creditworthy institutions can trade at a discount. This is because some people will refuse to accept them, and others will take the risk–for a profit.

      • Keith,
        I take it from the second half of your note that you accept the desirability for a common numeraire (gold or whatever) for money in order for it to play the very useful role that gave rise to it in the first place.

        But lets look at your statement that: "There is nothing in a free market that prevents bank A from saying its notes are redeemable in seashells and banks C through Z saying they're redeemable in gold." I have said that the numeraire is a natural monopoly (inches or pounds). It a free market, what will prevent Bank A from issuing notes redeemable for seashells is that fact that no one will want them because they will not be widely accepted and are thus useless as money. Go ahead and try it.

        • I agree. I should have said "there is no law or coercion forcing bank A to make its notes redeemable in gold."

          Just as today, there is no law forcing a computer company from making a laptop that talks some protocol that isn't TCP/IP. Or forcing from using some kind of web server that isn't HTTP.

          To say a market is free does not mean that participants can get away with anything!

          • Indeed. So the real question, when discussing natural monopolies, is what is the best way of getting market convergences to a dominant standard. Gold was pretty much a market process then formally adopted by a lot of countries. The decimal system was worked out and sold to government as the standard to adopt by scientists (I think). For me the monetary anchor, as long as it is reasonable (gold is fine but I prefer my real SDR basket), is secondary to the need for all issuers of currency (whether free bankers or central bankers) to allow the supply of such money to be freely convertible (redeemable) for it or something of equivalent value (indirect redeemability). This is how currency boards work and how, as I understand it, free banking is supposed to work. The means of payment (a totally different issue) should be fully free market developed and operated (paypal, western union, visa, etc).

          • I am not sure who said this (it may have been Bastiat), but it's important not to confuse:
            A) the government should force people to do XYZ
            B) XYZ is important

          • Keith,
            Indeed the distinction between good and required is important. The Constitution of the United States saw value and little risk in giving the Federal Government the right to determine the standards of weights and measures including the value of money (by which I understand the numeraire).

          • Warren,

            At the time of the Founding, there was no question that people deposited gold and silver in banks, or that the bank had to return the same amount (plus interest). What the government did was, as you noted, standardize the unit of weight used for coins and deposits. This makes a common numeraire, and also makes bank notes fungible. We didn't get into what if Bank A has notes in increments of grams and Bank B has notes in increments of Newtons, and Bank C in slugs, and Bank D in ounces?

            Standards are good, though the Internet shows us that the government is, at best, unneeded in setting them. At least, in the case of the dollar, the government's standard setting was benign. It was not any kind of "monetary policy" with one exception. They fixed the value of gold to silver. That was an unmitigated disaster, and the shock waves were reverberating over a hundred years later.

            Today, if the government says that we all have to treat irredeemable dollars or SDRs as if they were money, that is a policy that will have far reaching consequences, that will be called "unintended" decades later. Even if it says we have to treat a basket of copper, wheat, zinc, oil, and aluminum, this is a policy that has the effect of creating incalculable incentives throughout the economy.

  • Philo

    "[T]hose who get access to the excess money supply first gain at the expense of those who get it later. . . . As excess supplies of money make their way through the economy, those who get the money first are able to spend before prices rise, while those who see it later see prices rise before they see the increase in their nominal incomes resulting from the increased money supply." This analysis is misleading. First, it applies only to an unexpected increase in the money supply. Second, the advantage of spending money before prices rise accrues not just to those who get new money but also to those who get, or who already had, old money. And it accrues only to those who actually spend money; hoarders–whether the money they hoard is new or old–are victims rather than beneficiaries of unexpected inflation. In short, the advantage goes to those who foresee, or act as if they have foreseen, the coming rise in prices; it has little to do with who has new versus old money, whether early or late in the inflationary process.

    • Exactly right.

    • You are ignoring that "those who get the money first" *have* that money to spend *before* prices rise, whether or not the price rises are perfectly and universally predicted. The late receivers don't get to use that money until after prices have already risen. This effect is particularly important among those whose wealth is small or illiquid, such as the poor–i.e. just those people the author is writing about.