Did the Gold Standard Fail? A Response to David Glasner

competitive note issue, David Glasner, financial stability, Gold standard, monetary rules
"The State of the Money Market," University of Glasgow Library, Special Collections. Available at http://www.thetimes.co.uk/tto/news/uk/scotland/article3800431.ece

state-of-the-money-marketAt the Mercatus / Cato CMFA conference a few weeks ago on “Monetary Rules for a Post-Crisis World,” David Laidler and David Glasner gave interesting and informative talks on the history (and history of economic thought) regarding the evolution of monetary rules during the first panel. Video of their talks, and that of co-panelist Mark Calabria, is available here. Ari Blask recaps the entire conference here.

I haven’t seen Glasner’s paper, but he has posted a summary of it on his blog. (All subsequent quotes are drawn from that source.) There he suggests that perhaps the earliest monetary rule, in the general sense of a binding pre-commitment for a money issuer, can be seen in the redemption obligations attached to banknotes. The obligation was contractual: A typical banknote pledged that the bank “will pay the bearer on demand” in specie. (Demand deposit contracts, which preceded banknotes historically, made the same pledge.) He rightly remarks that “convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient” without which the public would not have accepted demand deposits or banknotes.

I wouldn’t characterize the contract in quite the way Glasner does, however, as a “monetary rule to govern the operation of a monetary system.” In a system with many banks of issue, the redemption contract on any one bank’s notes was a commitment from that bank to the holders of those notes only, without anyone intending it as a device to govern the operation of the entire system. The commitment that governs a single bank ipso facto governs an entire monetary system only when that single bank is a central bank, the only bank allowed to issue currency and the repository of the gold reserves of ordinary commercial banks. Under a gold standard with competitive plural note-issuers (a free banking system) holding their own reserves, by contrast, the operation of the monetary system is governed by impersonal market forces rather than by any single agent. This is an important distinction between the properties of a gold standard with free banking and the properties of a gold standard managed by a central bank. The distinction is especially important when it comes to judging whether historical monetary crises and depressions can be accurately described as instances where “the gold standard failed” or instead where “central bank management of the monetary system failed.”

As the author of Free Banking and Monetary Reform, Glasner of course knows the distinction well. So I am not here telling him anything he doesn’t know. I am only alerting readers to keep the distinction in mind when they hear or read “the gold standard” being blamed for financial instability. I wish that Glasner had made it more explicit that he is talking about a system run by the Bank of England, not the more automatic type of gold standard with free banking.

Glasner highlights the British Parliament’s legislative decision “to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold” after a decades-long suspension that began during the Napoleonic wars. He comments:

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836.

Left unexplained is why the expectations were disappointed, why the monetary regime remained unstable. A reader who hasn’t read Glasner’s other blog entries on the gold standard might think that he is blaming the gold standard as such.

My own view is that because the Bank of England’s monopoly was not broken up, even with convertibility acting as a long-run constraint, the Bank had the power to create cyclical monetary instability and occasionally did so by (unintentionally) over-issuing and then having to contract suddenly as gold flowed out of its vault — as happened in 1825 and again in 1836. Because the London note-issue was not decentralized, the Bank of England did not experience prompt loss of reserves to rival banks (adverse clearings) as soon as it over-issued. Regulation via the price-specie-flow mechanism (external drain) allowed over-issue to persist longer and grow larger. Correction came only with a delay, and came more harshly than continuous intra-London correction through adverse clearings would have. Bank of England mistakes boggled the entire financial system. It was central bank errors and not the gold standard that disrupted monetary stability after 1821.

This hypothesis about the source of England’s cyclical instability is far from original with me. It was offered during the 1821-1850 period by a number of writers. Some, like Robert Torrens, were members of the Currency School and offered the Currency Principle as a remedy. Others, like James William Gilbart, are better classified as members of the Free Banking School because they argued that competition and adverse clearings would effectively constrain the Bank of England once rival note issuers were allowed in London. Although they offered different remedies, these writers shared the judgment that the Bank of England had over-issued, stimulating an unsustainable boom, then was eventually forced by gold reserve losses to reverse course, instituting a credit crunch. Because Glasner elides the distinction between free banking and central banking in his talk and blog post, he naturally omits the third side in the Currency School-Banking School-Free Banking School debate.

Later in his blog post, Glasner fairly summarizes how a gold standard works when a central bank does not subvert or over-ride its automatic operation:

Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold.

 But he then immediately remarks:

That, at any rate, was the theory of the gold standard. There were — and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

These two purported “basic problems” prompt me to make two sets of comments:

  1. While it is true that the purchasing power of gold was not perfectly stable under the classical gold standard, perfection is not the relevant benchmark. The purchasing power of money was more stable under the classical gold standard than it has been under fiat money standards since the Second World War. Average inflation rates were closer to zero, and the price level was more predictable at medium to long horizons. Whatever Glasner may have meant by “necessary reason,” there certainly is a theoretical reason for this performance: the economics of gold mining make the purchasing power of gold (ppg) mean-reverting in the face of monetary demand and supply shocks. An unusually high ppg encourages additional gold mining, until the ppg declines to the normal long-run value determined by the flow supply and demand for gold. An unusually low ppg discourages mining, until the normal long-run ppg is restored. It is true that permanent changes in the gold mining cost conditions can have a permanent impact on the long-run level of the ppg, but empirically such shocks were smaller than the money supply variations that central banks have produced.
  2. The behavior of the banking system is indeed critically important for short-run stability. Instability wasn’t a problem in all countries, so we need to ask why some banking systems were unstable or panic-prone, while others were stable. The US banking system was panic prone in the late 19th century while the Canadian system was not. The English system was panic-prone while the Scottish system was not. The behavioral differences were not random or mere facts of nature, but grew directly from differences in the legal restrictions constraining the banks. The Canadian and Scottish systems, unlike the US and English systems, allowed their banks to adequately diversify, and to respond to peak currency demands, thus allowed banks to be more solvent and more liquid, and thus avoided loss of confidence in the banks. The problem in the US and England was not the gold standard, or a flaw in “the theory of the gold standard,” but ill-conceived legal restrictions that weakened the banking systems.
  • http://miltonchurchill.com/ Milton Churchill

    Myself, I have been finding it more helpful to think in terms of a gold standard vs a fiat gold standard. It historically has been fiat gold standards that have failed. A straight gold standard, free of government intervention and regulation, would work like any other good on an open and free market. Supply and demand would determine price and, in the case of money, drive all prices relative to gold money.

    The periodic "disturbances" through new discovery and innovations in extraction, often pointed to by those critical of a gold standard, are no different than weather patterns or innovations in planting and harvesting impacting crop prices. These certainly are "imperfections", though nothing in this world is perfect. It is the governments attempt to wring out these supposed imperfections that leads to what I would estimate well in excess of 90% of all historical price disturbances and imbalances. Agriculture and money are no different in this regard.

    If a pure gold standard was left to its devices, it would certainly be far more beneficial to the users of gold money than a fiat gold standard. To take any other position would accept that mercantilism, socialism, fascism, government price controls and State planning supply better outcomes to consumers than free markets. With this said, my hope would not be to see a fiat-declared gold standard, even if that were a true gold standard. If certain banking and non-banking institutions wished to adopt a gold standard, so be it. But, if others wished to adopt a silver standard, others a commodity basket standard, etc., etc., they should be permitted to do so as well. So, I support a standard for gold, but not a gold standard through government dictate.

    • M. Camp

      I agree with your conclusion, based upon my limited understanding of economics. But I think you are wrong in thinking that money is just like any other commodity. It has a unique role and unique characteristics. Also, instability of the sort that leads to panics and depressions is unique to money (if fractional reserve banking is present).

      • http://miltonchurchill.com/ Milton Churchill

        To me, the prevailing thought that money is not like any other commodity or good, is the exact reason there is so much misunderstanding about it and why government, the Crown and more recently the State, has been able to confiscate its production for so long. Yes, money has unique characteristics. But, shoes also have unique characteristics, so does food, housing, clothing, etc. Money is an economic good, like any other scarce good.

        Unit banking, intra-state, reserve requirement, fixed redemption price laws, etc, and, in general, co-option of the production of money by government has been the driver of panics and instability. Instability of the sort that leads to panics and depressions is unique to NOT money. It is unique to government intervention.

        You mention fractional reserve. Fractional reserve does not cause the panics or instability. In cases where a central authority mismanages or improperly controls the production of anything, like food production in the Soviet Union and Communist China when millions starved to death, the devastation is wide reaching and not easily corrected. Under a decentralized system of producing money or food, or any product, certain capitalists and entrepreneurs, it is inevitable, will make mistakes, but the damage will be contained. Dislocated factors of production can be assimilated and absorbed with much greater ease.

        A fiat fractional reserve system can, and certainly has, caused panics and instability. A fractional reserve system under which free markets and prices are permitted to work, great stability has been achieved. Professor White references such historical examples above.

        • M. Camp

          I meant that the typical cycle of panics can't happen absent fractional reserve banking.

        • M. Camp

          Shoes and other commodities do each have unique particular practical and physical qualities. But I meant "unique qualities" from an economics point of view. For example, that money has no utility; every other commodity has utility. The value of EVERY other commodity is very dependent on its use-value. The value of money is dependent solely on its trade value.

          I meant money has a "unique role" in economic theory. For example, every transaction involving non-money goods is part of a chain ending in the goods being final goods. In every transaction involving money it is not final goods and will never be final goods. Money simply trades hands forever in a perpetual chain of transactions, without ever being used.

          Another unique role: almost all transactions involve money on one side of the trade.

          Furthermore, money is the most common commodity for credit, by a large margin. Loans at interest of houses or wheat, or whatever is in second place are so rare by comparison that the financial newspapers don't even list the interest rates for them.

          For economists this unique role is extremely important because disruption in credit markets has a profound effect on the economy. A shock in the demand for loans of oil, resulting in a big change in the oil interest rate, would not cripple an economy.

        • M. Camp

          I will echo your thought on the idea of money not being a unique commodity, with one important restriction:

          "To me, the prevailing thought that money is not like any other commodity or good" *in micro-economics* "is the cause of much misunderstanding about it among economists."

          I wish I could remember where I first came across this profound truth. It might have been Rothbard but I just can't remember.

          Thus, it is a mistake to speak of "price" in micro-economics, because it implies a unique property of money. We should speak only of exchange rates, with "price" and its inverse being of equal value, and even then only a special case of a transaction rate: one involving current money goods for current useful goods.

          Favoring money, in expressing micro-economic ideas is so useful (it allows us to pretend to quantify what are inherently subjective values) that we sometimes forget that it is only a useful convention.

          But in analyzing the cause of social problems caused by bank runs and credit market collapses and changes in the exchange value of the class of useful goods as an aggregate relative to money, we have to consider money separately because it is used so differently than other commodities. If almost all the economic transactions in the world involved the exchange of speculative IOUs for oil for other goods, then we would have to treat oil as special in understanding economics. But in fact, almost all the economic transactions in the world involve the exchange of some gambler's IOUs for useless MONEY for useful NON-MONEY goods or for more gamblers' money-IOUs.

          Note that by "gamblers" I mean "banks" and by "speculative IOUs" I mean bank drafts and other soft money instruments, representing the gambler's bet: he trades short term obligations for long, in the hopes that not too many of his creditors will notice that he is permanently and highly insolvent, in the real sense of being incapable of fulfilling the promises he has made if called on to do so.

          • http://miltonchurchill.com/ Milton Churchill

            "But in analyzing the cause of social problems caused by bank runs and credit market collapses and changes in the exchange value of the class of useful goods as an aggregate relative to money, we have to consider money separately because it is used so differently than other commodities."

            The reason these problems are associated with money and banking is that government has, with very few exceptions, always had control over money and banking. It's like saying roads in major cities are and will always be plagued by heavy traffic so government must step in. It is not the roads that are causing the traffic, it is government itself and its control of nearly all major roads and other infrastructure in the US, and its inability or unwillingness to price appropriately, that is causing the traffic jams.

          • M. Camp

            I think that you are partially right, that one reason there are bank runs and credit market collapses in money is that government usually controls them, but it can't be that that is the only reason, and that there's no difference between money and other goods and services that contributes to the cause. If you were right about that, then there would be runs on goods and services banks, and credit collapses in goods and services credit markets, and fractional reserve banking in goods and services. There aren't ever any of those things.

  • W. Ferrell

    Critical distinctions lucidly expressed. Thank you.

  • econfinjunkie

    Interesting article. Can this article serve as a rebuttal to Barry Eichengreen's arguments against the gold standard as well? It seems like Eichengreen has similar misunderstandings about the gold standard and how it was meant to work.

    • Andrew_FL

      Eichengreen commits the worse sin of failing to distinguish between the classical gold standard from before World War I from the interwar Gold Exchange Standard. See Richard Timberlake on this.
      (The only thing I would disagree with Timberlake about, is that Strong's price level policy was unproblematic. It was actually quite problematic)

      • econfinjunkie

        Thanks for the reply and for the reference to Timberlake. Has Eichengreen ever acknowledged his error, or do you think he is too invested in it to admit that he missed something in his analysis? His thesis of the golden fetters is certainly more in line with what politicians and central bankers want to believe and want us to believe. "If we could only have done our jobs, the Great Depression never would have happened," I can hear them saying.

  • Daniel Klein

    Great piece, thanks.

  • Ray Lopez

    Good article. A useful corrective to the errors advanced by Eichengreen and Sumner in their books, about the (managed) Gold Standard. Since the evidence shows (Bernanke FAVAR 2002 paper) that money is largely short term neutral, by definition any sort of money supply cannot be that bad, but it's true that fiat centralized money seems more unstable (for what that's worth, and probably not that much) than a decentralized hard currency. Keep in mind even 19th century free banks had clearing houses where they helped each other, at times arbitrarily suspended the right of depositors to withdraw money from a bank, and that caveat emptor and the lack of moral hazard from bank depositors due to little if any deposit insurance made for less instability (some academic papers support this view). Last but not least, except for the UK and US, devaluing currency backed by gold during the Great Depression had no effect on real GDP (eyeball the graph on Wikipedia under "Gold Standard" and draw your own conclusions; note Argentina went off gold in 1929 yet continued to decline). In short, a gold standard seems as good as any other standard, and, arguably, even better when it comes to less volatility, if you are afraid of volatility.