I was reading David Glasner's good post on the 1920-21 recession . As expected, I learned some monetary history. But David has also caused me to re-think my views on the theory of the gold standard.

In the olden days, under the gold standard, central banks promised to convert their currency into gold at a fixed exchange rate. Did this make gold the super-alpha?

Central bank currency is alpha; commercial bank deposits are beta. Commercial banks promise to convert their deposits into central bank currency at a fixed exchange rate; the central bank does not promise to convert its currency into commercial bank deposits at a fixed exchange rate. It is the commercial banks' responsibility to keep their exchange rates fixed. The alpha goes where he wants to go; and the betas follow the alpha. The central bank decides monetary policy.

Central banks issue currency. (They issue reserves too, but "reserves" are just the name we give to central bank currency held by commercial banks in electronic form rather than in paper form, and it makes no difference whether money is printed on paper, on plastic, or on computer disks.) Commercial banks issue deposits. (They used to issue notes too, but again it makes no difference whether money is printed on paper, plastic, or on computer disks.)

I think we need to distinguish two cases:

1. The "small country" assumption. Central bank stocks of gold are small relative to the total stock of gold.

2. The "large country" assumption. Central bank stocks of gold are large relative to the total stock of gold.

Implicitly, I was thinking in terms of the small country assumption. David's post uses the large country assumption. And Wikipedia tells me that even in 2011 central banks held about 17% of the total world stock of gold, which is not really that "small".

Most central banks today have replaced the gold standard with the CPI standard; they target 2% CPI inflation, rather than 0% gold price inflation. But central banks today hold extremely small stocks of those goods that make up the CPI. They own a few computers, and some furniture, but that's trivial compared to the total world stocks of computers and furniture. The "small country" assumption makes perfect sense for inflation targeting central banks today.

Under the gold standard, the "small country" assumption would still make good sense for the central bank of a small country like Canada. The Bank of Canada's stock of gold would be a very small percentage of the total world stock of gold.

But it would not make sense for a large country, and it would not make sense for a global analysis where the total stock of gold held by all central banks would be a large percentage of the total world stock of gold.

For a small country on the gold standard, we can treat gold as the super-alpha. Commercial banks follow the central bank, and the central bank follows gold.

For a large country on the gold standard, or for the world as a whole on the gold standard, we cannot treat gold as the super-alpha. Central banks can change the mix of assets on their balance sheets. They can hold more gold and less bonds; or less bonds and more gold. If central bank demand for gold is large, relative to the total stock of gold, the actions of central banks will affect the equilibrium real price of gold against all other goods.

If large central banks, or a large number of small central banks, buy gold and sell bonds (raising interest rates on bonds in the process and increasing the opportunity cost of holding hold so people sell gold to central banks and buy bonds from the central bank) that raises the equilibrium real price of gold against goods. And that raises the equilibrium price of central bank currency against goods. Which means the equilibrium price of goods falls against currency. It's a deflationary tightening of monetary policy, even though central banks keep exactly the same exchange rate of currency against gold.

Under the gold standard, gold is the super-alpha, but large central banks (or Departments of Finance) can lead it by the nose, by changing the percentage of gold in their portfolio mix. And David shows they were doing that in 1920-21, which is what caused the recession. And it would take a very long time for the gold miners to adjust the stock supply of gold in response to changes in the real price of gold caused by changes in central bank demand for gold.

Is that basically right, David?

[Update: see David's post in response, with a long quote from Dennis Robertson, the source of David's views on this.]