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[This talk was delivered at the Mises Institute conference The History of Liberty, January 29, 2000.]



The historical embodiment of monetary freedom is the gold standard. The era of its greatest flourishing was not coincidentally the 19th century, the century in which classical liberal ideology reigned, a century of unprecedented material progress and peaceful relations between nations. Unfortunately, the monetary freedom represented by the gold standard, along with many other freedoms of the classical liberal era, was brought to a calamitous end by World War I.

Also, and not so coincidentally, this was the "War to Make the World Safe for Mass Democracy," a political system which we have all learned by now is the great enemy of freedom in all its social and economic manifestations.

Now, it is true that the gold standard did not disappear overnight, but limped along in weakened form into the early 1930s. But this was not the pre-1914 classical gold standard, in which the actions of private citizens operating on free markets ultimately controlled the supply and value of money and governments had very little influence.

Under this monetary system, if people in one nation demanded more money to carry out more transactions or because they were more uncertain of the future, they would export more goods and financial assets to the rest of the world, while importing less. As a result, additional gold would flow in through a surplus in the balance of payments increasing the nation's money supply.

Sometimes, private banks tried to inflate the money supply by issuing additional bank notes and deposits, called "fiduciary media," promising to pay gold but unbacked by gold reserves. They lent these notes and deposits to either businesses or the government. However, as soon as the borrowers spent these additional fractional-reserve notes and deposits, domestic incomes and prices would begin to rise.

As a result, foreigners would reduce their purchases of the nation's exports, and domestic residents would increase their spending on the relatively cheap foreign imports. Gold would flow out of the coffers of the nation's banks to finance the resulting trade deficit, as the excess paper notes and checks were returned to their issuers for redemption in gold.

To check this outflow of gold reserves, which made their depositors very nervous, the banks would contract the supply of fiduciary media bringing about a monetary deflation and an ensuing depression.

Temporarily chastened by the experience, banks would refrain from again expanding credit for a while. If the Treasury tried to issue convertible notes only partially backed by gold, as it occasionally did, it too would face these consequences and be forced to restrain its note issue within narrow bounds.

Thus, governments and commercial banks under the gold standard did not have much influence over the money supply in the long run. The only sizable inflations that occurred during the 19th century did so during wartime when almost all belligerent nations would "go off the gold standard." They did so in order to conceal the staggering costs of war from their citizens by printing money rather than raising taxes to pay for it.

For example, Great Britain experienced a substantial inflation at the beginning of the 19th century during the period of the Napoleonic Wars, when it had suspended the convertibility of the British pound into gold. Likewise, the United States and the Confederate States of America both suffered a devastating hyperinflation during the War for Southern Independence, because both sides issued inconvertible Treasury notes to finance budget deficits. It is because politicians and their privileged banks were unable to tamper with and inflate a gold money that prices in the United States and in Great Britain at the close of the 19th century were roughly the same as they were at the beginning of the century.

Within weeks of the outbreak of World War I, all belligerent nations departed from the gold standard. Needless to say by the war's end the paper fiat currencies of all these nations were in the throes of inflations of varying degrees of severity, with the German hyperinflation that culminated in 1923 being the worst. To put their currencies back in order and to restore the public's confidence in them, one country after another reinstituted the gold standard during the 1920s.

Unfortunately, the new gold standard of the 1920s was fundamentally different from the classical gold standard. For one thing, under this latter version, gold coin was not used in daily transactions. In Great Britain, for example, the Bank of England would only redeem pounds in large and expensive bars of gold bullion. But gold bullion was mainly useful for financing international trade transactions.

Other countries such as Germany and the smaller countries of Central and Eastern Europe used gold-convertible foreign currencies such as the US dollar or the pound sterling as reserves for their own domestic currencies. This was called the gold-exchange standard.

While the US dollar was technically redeemable in honest-to-goodness gold coin, banks no longer held reserves in gold coin but in Federal Reserve notes. All gold reserves were centralized, by law, in the hands of the Fed and banks were encouraged to use Fed notes to cash checks and pay for checking and savings deposit withdrawals. This meant that very little gold coin circulated among the public in the 1920s, and residents of all nations came increasingly to view the paper IOUs of their central banks as the ultimate embodiment of the dollar, franc, pound, etc.

This state of affairs gave governments and their central banks much greater leeway for manipulating their national money supplies. The Bank of England, for example, could expand the amount of paper claims to gold pounds through the banking system without fearing a run on its gold reserves for two reasons.

Foreign countries on the gold exchange standard would be willing to pile up the paper pounds that flowed out of Great Britain through its balance of payments deficit and not demand immediate conversion into gold. In fact by issuing their own currency to tourists and exporters in exchange for the increasing quantities of inflated paper pounds, foreign central banks were in effect inflating their own money supplies in lock-step with the Bank of England. This drove up prices in their own countries to the inflated level attained by British prices and put an end to the British deficits.

In effect, this system enabled countries such as Great Britain and the United States to export monetary inflation abroad and to run "a deficit without tears" — that is, a balance-of-payments deficit that does not involve a loss of gold.

But even if gold reserves were to drain out of the vaults of the Bank of England or the Fed to foreign nations, British and US citizens would be disinclined, either by law or by custom, to put further pressure on their respective central banks to stop inflating by threatening bank runs to rid themselves of their depreciating notes and retrieve their rightful property left with the banks for safekeeping.

Unfortunately, contemporary economists and economic historians do not grasp the fundamental difference between the hard-money classical gold standard of the 19th century and the inflationary phony gold standard of the 1920s.

Thus, many admit, if somewhat grudgingly, that the gold standard worked exceedingly well in the 19th century. However, at the same time, they maintain that the gold standard suddenly broke down in the 1920s and 1930s and that this breakdown triggered the Great Depression. Monetary freedom in their minds is forever discredited by the tragic events of the 1930s. The gold standard, whatever its merits in an earlier era, is seen by them as a quaint and outmoded monetary system that has proved it cannot survive the rigors and stresses of a modern economy.

Those who implicate the gold standard as the main culprit in precipitating the events of the 1930s generally fall into one of two groups. One group argues that it was an inherent flaw in the gold standard itself that led to a collapse of the financial system, which in turn dragged the real economy down into depression. Writers in the second group maintain that governments, for social and political reasons, stopped adhering to the so-called rules of the gold standard, and that this initiated the downward spiral into the abyss of the Great Depression.

From either perspective, however, it is clear that the gold standard can never again be trusted to serve as the basis of the world's monetary system. On the one hand, if it is true that the gold standard is fundamentally flawed, that in itself is a crushing practical argument against the principle of monetary freedom. On the other hand, if the gold standard is in fact a creature of rules contrived by governments, and it is politically impossible for them to follow those rules, then monetary freedom is simply irrelevant from the outset.

The first argument is the Keynesian argument and the second the monetarist argument against the gold standard.

Two recent books have elaborated these arguments against the gold standard. The economic historian Barry Eichengreen published a book in 1992 entitled Golden Fetters: The Gold Standard and the Great Depression. Eichengreen summarized the argument of this book in the following words:

The gold standard of the 1920s set the stage for the Depression of the 1930s by heightening the fragility of the international financial system. The gold standard was the mechanism transmitting the destabilizing impulse from the United States to the rest of the world. The gold standard magnified that initial destabilizing shock. It was the principle obstacle to offsetting action. It was the binding constraint preventing policymakers from averting the failure of banks and containing the spread of financial panic. For all these reason the international gold standard was a central factor in the worldwide Depression. Recovery proved possible, for these same reasons, only after abandoning the gold standard.

According to Eichengreen, then, not only was the gold standard responsible for initiating and internationally propagating the Great Depression, it was also the primary reason why the recovery was delayed for so long.

It was only after governments one after another in the 1930s severed the link between their national currencies and gold that their national economies finally began to recover. This was because, unbound by the rules of the gold standard, governments were now able to bail out their banking systems and run budget deficits financed by bank credit inflation without the constraining fear of losing their gold reserves.

Thus, the phrase "golden fetters" in the title of Eichengreen's book is a reference to Keynes's statement in 1931, "There are few Englishman who do not rejoice at the breaking of our gold fetters."

Of course, what Keynes and Eichengreen fail to understand is that the end of the classical liberal era in 1914 caused the removal from government central banks of the "golden handcuffs" of the genuine gold standard. Were these "golden handcuffs" still in place in the 1920s, central banks would have been rigidly constrained from inflating their money supplies in the first place and the business cycle that culminated in the Great Depression would not have taken place.

A second book that inculpates the gold standard as a leading cause of the Great Depression was published in 1998 and is entitled The Great Depression: An International Disaster of Perverse Economic Policies. According to the authors, Thomas E. Hall and J. David Ferguson, one of the most perverse and destabilizing economic policies of the 1920s involved the Fed violating the rules of the gold standard by allegedly "sterilizing" the inflow of gold from Great Britain.

This means that the Fed refused to pyramid inflated paper dollars on top of these newly acquired gold reserves in quantities sufficient to drive US prices up to the inflated level of British prices. This policy would have made US products more expensive relative to British products on world markets and would have helped mitigate Great Britain's ongoing loss of gold reserves through its balance-of-payments deficits.

These deficits were the result of the fact that Great Britain had returned to the gold standard after its wartime inflation at the prewar gold parity, which, given the inflated level of domestic prices, significantly overvalued the British pound in terms of the dollar.

These deficits could have been avoided if the British government had either deflated its price level sufficiently or chosen to return to gold at a devalued exchange rate reflecting the true extent of its previous inflation.

Hall and Ferguson, however, ignore these considerations, arguing that when the United States sterilizes gold,

The impact on the system is that Britain bears the brunt of the adjustment. Since the money supply in the United States did not rise, neither did U.S. incomes and prices as they were supposed to, which would have helped Britain eliminate their payments deficit. Since Britain was not aided by rising exports to the United States, Britain must experience a more severe decline in incomes and prices than would have been the case if the U.S. money supply had gone up. In this way Britain would bear the brunt of the adjustment in the form of a more severe recession than would have occurred if the United States had been playing by the rules. Thus it was critical that each country play fair.

Thus, in Hall and Ferguson's view, the rules of the gold standard dictate that when one central bank irresponsibly engages in monetary inflation and subsequently attempts to maintain an overvalued exchange rate, less inflationary central banks must rush to its aid and expand their own nations' money supplies in order to prevent it from losing its gold reserves.

But if a nation losing gold due to inept or irresponsible monetary policy can always count on those gaining gold to share "the brunt of the adjustment" by expanding their own money supplies, this is surely a recipe for worldwide inflation.

Now, this line of argument indicates that Hall and Ferguson completely misunderstand the true purpose and function of the gold standard. To begin with, a gold standard functions much better without a central bank, because these institutions, as creatures of politics, are inherently inflationary and tend to promote rather than restrain the inflationary propensities of the fractional-reserve commercial banks.

But, second, under a genuine gold coin standard, the choices of private households and firms effectively control the money supply. As I explained above, if the residents of one nation demand to hold more money for whatever reason, they can obtain the precise quantity of gold coin they require through the balance of payments by temporarily selling more exports and buying fewer imports.

This implies that, if a central bank does exist and it wishes to act in accordance with a genuine gold standard, it should always "sterilize" gold inflows by issuing additional notes and deposits only on the basis of 100 percent gold reserves and insisting that the commercial banks do the same. It should not permit these gold reserves to be used as the basis of a multiple credit expansion by the banking system.

In this way, a nation's money supply would be completely subject to market forces. By the way, this is precisely how the distribution of the supply of dollars between the different states of the United States is determined today. There is no government agency charged with monitoring and controlling New Jersey's or Alabama's money supply.

Hall and Ferguson reveal their uneasiness with and lack of insight into the operation of the money supply process under a genuine gold standard with the following example:

Suppose a fad had swept the nation in 1927 because Calvin Coolidge appeared in public wearing one gold earring. Then every teenager in America wanted to wear a gold earring "just like silent Cal".… The result would be an [increase] in the commercial demand for gold. Since more gold would be used in earrings less would be available for money.… It would be beyond the power of government to do anything about this fact. What a scary thought, the teenagers of America would have caused the U.S. money supply to decline.

While it is true that the commercial demand for gold does play a role in determining the supply and value of money under a gold standard, it is hardly cause for alarm. Rather, it highlights the important fact that the gold standard evolved on the market from a useful commodity with a preexisting supply and demand and was not the product of a set of arbitrary rules promulgated by governments.

Now, Hall and Ferguson conclude that by breaking the rules of the game and persisting in sterilizing the gold inflows from 1929 to 1933, the Fed caused a monetary deflation in Great Britain and throughout Europe. The nations losing gold were forced to contract their money supplies and this contributed to a financial collapse and a precipitous decline in real economic activity that marked the onset of the Great Depression.

Thus while the authors blame the initiation of the Great Depression on Fed sterilization policies, they attribute its length and severity to the gold standard. According to the authors, as long as European countries remained on the gold standard and US sterilization continued, there could be no end of the Depression in sight. The US gold stock would become a huge pile of sterilized and useless gold. Starting with the British in 1931, our trading partners began to recognize this fact, and one by one they left the gold standard. The Germans and ironically the United States were among the last to leave gold and so were hurt the worst, experiencing the longest and deepest forms of the Depression.

So although Eichengreen emphasizes the gold standard as a restraint on government monetary policy and Hall and Ferguson the failure of governments to play by its rules, in effect, they reach the same conclusion: the gold standard, and with it monetary freedom, stands indicted as a primary cause of the greatest economic catastrophe in history.

In the face of the historical evidence they adduce, can any defense be mounted in favor of the gold standard? The answer is a resounding "yes," and the defense is as simple as it is impregnable. As I have tried to indicate above, the case against the gold standard is from beginning to end a case of mistaken identity. The genuine gold standard did not fail in the 1920s, because it had already been destroyed by government policies after 1914.

The monetary system that sowed the seeds of the Great Depression in the 1920s was a central-bank-manipulated and inflationary pseudogold standard. It was central banking that failed in the 1920s and stands discredited to this day as the cause of the Great Depression.

A detailed case in support of this view can be found in the works of Murray N. Rothbard, particularly in his book America's Great Depression and a forthcoming book on A History of Money and Banking in the United States: The Colonial Era to World War II.

In these works you will read that the US money supply, properly defined, increased from 1921 to 1928 at the annual rate of 7 percent per year, a rate of monetary inflation that was unseen under the classical gold standard. You will also learn that during the 1920s the Fed, far from operating as the deflationary force on the money supply portrayed by some monetarists, increased the categories of bank reserves within its control at the annual rate of 18 percent per year.

Finally you will read that from 1929 to 1932, the Fed continued to exercise a highly inflationary impact on the money supply, as it feverishly pumped new reserves into the banking system in a vain attempt to ward off the cyclical downturn entailed by its own earlier inflation of the money supply. The Fed was defeated in this endeavor to pump up the money supply and "reflate" prices in the early 1930s by domestic and foreign depositors who reclaimed their rightful property from an inherently bankrupt US banking system. They had suddenly lost confidence in the Fed-controlled monetary system masquerading as a gold standard, when they perceived at last the dwindling prospect of ever redeeming the rapidly expanding mountain of inflated paper claims for their gold dollars.