What’s so Bad about the Gold Standard?

Last week Paul Krugman argued that Ted Cruz is more dangerous than Donald Trump, because Trump is merely a protectionist while Cruz wants to restore the gold standard. I’m not going to weigh in on the relative merits of Cruz and Trump, but I have previously suggested that Krugman may be too dismissive of the possibility that the Smoot-Hawley tariff did indeed play a significant, though certainly secondary, role in the Great Depression. In warning about the danger of a return to the gold standard, Krugman is certainly right that the gold standard was and could again be profoundly destabilizing to the world economy, but I don’t think he did such a good job of explaining why, largely because, like Ben Bernanke and, I am afraid, most other economists, Krugman isn’t totally clear on how the gold standard really worked.

Here’s what Krugman says:

[P]rotectionism didn’t cause the Great Depression. It was a consequence, not a cause – and much less severe in countries that had the good sense to leave the gold standard.

That’s basically right. But I note for the record, to spell out the my point made in the post I alluded to in the opening paragraph that protectionism might indeed have played a role in exacerbating the Great Depression, making it harder for Germany and other indebted countries to pay off their debts by making it more difficult for them to exports required to discharge their obligations, thereby making their IOUs, widely held by European and American banks, worthless or nearly so, undermining the solvency of many of those banks. It also increased the demand for the gold required to discharge debts, adding to the deflationary forces that had been unleashed by the Bank of France and the Fed, thereby triggering the debt-deflation mechanism described by Irving Fisher in his famous article.

Which brings us to Cruz, who is enthusiastic about the gold standard – which did play a major role in spreading the Depression.

Well, that’s half — or maybe a quarter — right. The gold standard did play a major role in spreading the Depression. But the role was not just major; it was dominant. And the role of the gold standard in the Great Depression was not just to spread it; the role was, as Hawtrey and Cassel warned a decade before it happened, to cause it. The causal mechanism was that in restoring the gold standard, the various central banks linking their currencies to gold would increase their demands for gold reserves so substantially that the value of gold would rise back to its value before World War I, which was about double what it was after the war. It was to avoid such a catastrophic increase in the value of gold that Hawtrey drafted the resolutions adopted at the 1922 Genoa monetary conference calling for central-bank cooperation to minimize the increase in the monetary demand for gold associated with restoring the gold standard. Unfortunately, when France officially restored the gold standard in 1928, it went on a gold-buying spree, joined in by the Fed in 1929 when it raised interest rates to suppress Wall Street stock speculation. The huge accumulation of gold by France and the US in 1929 led directly to the deflation that started in the second half of 1929, which continued unabated till 1933. The Great Depression was caused by a 50% increase in the value of gold that was the direct result of the restoration of the gold standard. In principle, if the Genoa Resolutions had been followed, the restoration of the gold standard could have been accomplished with no increase in the value of gold. But, obviously, the gold standard was a catastrophe waiting to happen.

The problem with gold is, first of all, that it removes flexibility. Given an adverse shock to demand, it rules out any offsetting loosening of monetary policy.

That’s not quite right; the problem with gold is, first of all, that it does not guarantee that value of gold will be stable. The problem is exacerbated when central banks hold substantial gold reserves, which means that significant changes in the demand of central banks for gold reserves can have dramatic repercussions on the value of gold. Far from being a guarantee of price stability, the gold standard can be the source of price-level instability, depending on the policies adopted by individual central banks. The Great Depression was not caused by an adverse shock to demand; it was caused by a policy-induced shock to the value of gold. There was nothing inherent in the gold standard that would have prevented a loosening of monetary policy – a decline in the gold reserves held by central banks – to reverse the deflationary effects of the rapid accumulation of gold reserves, but, the insane Bank of France was not inclined to reverse its policy, perversely viewing the increase in its gold reserves as evidence of the success of its catastrophic policy. However, once some central banks are accumulating gold reserves, other central banks inevitably feel that they must take steps to at least maintain their current levels of reserves, lest markets begin to lose confidence that convertibility into gold will be preserved. Bad policy tends to spread. Krugman seems to have this possibility in mind when he continues:

Worse, relying on gold can easily have the effect of forcing a tightening of monetary policy at precisely the wrong moment. In a crisis, people get worried about banks and seek cash, increasing the demand for the monetary base – but you can’t expand the monetary base to meet this demand, because it’s tied to gold.

But Krugman is being a little sloppy here. If the demand for the monetary base – meaning, presumably, currency plus reserves at the central bank — is increasing, then the public simply wants to increase their holdings of currency, not spend the added holdings. So what stops the the central bank accommodate that demand? Krugman says that “it” – meaning, presumably, the monetary base – is tied to gold. What does it mean for the monetary base to be “tied” to gold? Under the gold standard, the “tie” to gold is a promise to convert the monetary base, on demand, at a specified conversion rate.

Question: why would that promise to convert have prevented the central bank from increasing the monetary base? Answer: it would not and did not. Since, by assumption, the public is demanding more currency to hold, there is no reason why the central bank could not safely accommodate that demand. Of course, there would be a problem if the public feared that the central bank might not continue to honor its convertibility commitment and that the price of gold would rise. Then there would be an internal drain on the central bank’s gold reserves. But that is not — or doesn’t seem to be — the case that Krugman has in mind. Rather, what he seems to mean is that the quantity of base money is limited by a reserve ratio between the gold reserves held by the central bank and the monetary base. But if the tie between the monetary base and gold that Krugman is referring to is a legal reserve requirement, then he is confusing the legal reserve requirement with the gold standard, and the two are simply not the same, it being entirely possible, and actually desirable, for the gold standard to function with no legal reserve requirement – certainly not a marginal reserve requirement.

On top of that, a slump drives interest rates down, increasing the demand for real assets perceived as safe — like gold — which is why gold prices rose after the 2008 crisis. But if you’re on a gold standard, nominal gold prices can’t rise; the only way real prices can rise is a fall in the prices of everything else. Hello, deflation!

Note the implicit assumption here: that the slump just happens for some unknown reason. I don’t deny that such events are possible, but in the context of this discussion about the gold standard and its destabilizing properties, the historically relevant scenario is when the slump occurred because of a deliberate decision to raise interest rates, as the Fed did in 1929 to suppress stock-market speculation and as the Bank of England did for most of the 1920s, to restore and maintain the prewar sterling parity against the dollar. Under those circumstances, it was the increase in the interest rate set by the central bank that amounted to an increase in the monetary demand for gold which is what caused gold appreciation and deflation.


17 Responses to “What’s so Bad about the Gold Standard?”

  1. 1 Lord April 13, 2016 at 3:44 pm

    Has the gold standard ever operated without a reserve requirement? Have they ever operated without a reserve ratio target or altered one when they did?


  2. 2 Henry April 13, 2016 at 6:40 pm

    “……it was the increase in the interest rate set by the central bank that amounted to an increase in the monetary demand for gold…………..”


    Can you explain how that works? It doesn’t seem likely.


  3. 3 Frank Restly April 13, 2016 at 8:25 pm


    “Can you explain how that works? It doesn’t seem likely.”

    Prior to the Great Depression, many debt contracts were written to be payable in gold (including a lot of sovereign debt – U. S. included).



    “All three cases were announced on February 18, 1935, and all in favor of the government’s position by a 5–4 majority. Chief Justice Charles Evans Hughes wrote the opinion for each case, finding the government’s power to regulate money a plenary power. As such, the abrogation of contractual gold clauses, both public and private, were within the reach of congressional authority when such clauses presented a threat to Congress’s control of the monetary system.”

    You have to remember that there were no mutual funds or IRAs or Pension Funds back then. Debt and bonds were held primarily by the banking system and so interest rate increases (with those interest payments made in gold) act as a form of monetary contraction.


  4. 4 Jose Poncela April 14, 2016 at 1:05 am

    At the time there was a crisis waiting to be unchained. A construction bubble in Florida in hurricane prone areas, overindebted Midwest farmers and too much speculation in NYSE. Whether it was the Banque de France or HMT bonds or something else that lighted the pyre is anecdotal as is also anecdotal if the initial spark was linked to the gold standard or to a hurricane or to the first global movement of capitals across the Atlantic. It could have been any of them. The important issue is that, whether the initial spark was there or not, the gold standard would always have made the crisis worst,


  5. 5 Nanikore April 14, 2016 at 1:53 am

    ” “……it was the increase in the interest rate set by the central bank that amounted to an increase in the monetary demand for gold…………..”


    Can you explain how that works? It doesn’t seem likely.”

    My understanding is that interest rates were raised to attract capital (gold) flows into a certain country. So it is relative international interest rates that is driving the demand for gold and therefore the increase the increase in interest rates as countries try to stock up on their reserves.

    Anyway, look forward to David’s explanation. DG, this is a great piece. I find the Gold Standard a very elusive thing to try and understand, but this is very clear. You are also doing us a favour as it is so important we get the historical record right; there has been too much distortion of the historical record or a lack of proper interest in it due to the domination of model-led analysis in modern economics.



  6. 6 JKH April 14, 2016 at 3:42 am

    You’ve made the interesting point a number of times in various posts on gold that it’s not the stock of gold reserves that makes the gold reserve standard work. Although this is the first one where I recall you taking that to the limit in the sense that the standard could work at least in theory with zero reserves.

    I just wanted to draw attention to what I think is an interesting parallel in a “fiat” system, one level down in the banking hierarchy, which is that commercial banks do not require a pre-existing stock of central bank reserves to make loans, a la the usual “heterodox” story (and based on the facts as observed by some who have actually done the job). This is also obvious from the Canadian case at least, where there is now no legal reserve requirement for banks. And it is the basis of course for the debunking of the textbook money multiplier myth (i.e. the directional causality).

    In both cases, it’s the flow rather than the stock that the central bank must manage – more specifically, the pricing of the flow. It does it by ensuring convertibility at a fixed price in the case of the pure gold standard; it does it in the case of fiat bank reserve management (e.g. pre-2008 Fed) by controlling the supply of reserves such that supply and demand steers the interest rate toward the Fed funds target.

    The effective need (rather than the mandated need) for reserves in both cases is driven by the operational limits to synchronization of flows required to balance the liquidity position. Solvent commercial banks practice active liability management in order to minimize the need for excess reserves on a daily basis (pre-2008). And central banks on a gold standard could do something similar, although the flows could likely be choppier and the effective usefulness of excess/required reserves greater.

    The Bank of France contributed to global deflationary tightening by accumulating gold reserves. In a more benign analogous way, central banks can tighten monetary policy in effect (although marginally) by boosting uncompensated commercial bank reserve requirements, which requires banks to widen their interest rate spreads in response in order to preserve net interest margins.


  7. 7 David Glasner April 14, 2016 at 9:51 am

    Lord, Before passage of the Bank Act of 1844, I don’t believe that there were any legal reserve requirements in Great Britain, but I am just guessing. In any event the legal reserve requirements applied only to notes issued by the Bank of England. I don’t believe that there were legal reserve requirements on bank deposits. Again I am not an expert on the institutional details. At any rate, the existence of reserve requirements were obviously independent of the statutory definition of the pound sterling as a fixed weight of gold. You said:

    “Have they ever operated without a reserve ratio target or altered one when they did?”

    What is the antecedent of “they?”

    Henry, Whenever a central bank under the gold standard felt that its holdings of gold were less than they wanted, the response was to raise the interest rate. Doing so caused a reduction in borrowing from the bank causing more loans to be repaid than new loans issued, causing a net inflow of assets into the bank which the bank could use to increase its holdings of gold.

    Jose, We disagree about what was central and what was peripheral. At any moment in an economy, there is always a spectrum of assets of greater and lesser quality and safety. So, if there is a crash, you can ex post always point to the least safe assets and say: “oh if it handn’t been for those unsafe assets and the reckless speculators that bid up their prices, there would have been no crash.” There was a powerful deflation that caused the collapse and under the gold standard, the primary cause of deflation is the value of gold.

    NK, I don’t see why you are having a problem with the statement you quote, you seem to be affirming it in the paragraph beginning with “my understanding.”

    JKH, You are right that I have discussed this all before in various posts. I am not sure why you think that I have gone further in this post than in any of my previous ones. We certainly agree in rejecting the money multiplier account of money creation by the banking system, and I don’t see anything to disagree with in your explanation of how central banks manage the reserve position of banks in a fiat system.


  8. 8 Nanikore April 14, 2016 at 12:55 pm

    DG, no problem with your explanation, and your answer to Henry’s question explaining the mechanism linking interest rates and the stock of gold is very helpful.


  9. 9 richardhserlin April 14, 2016 at 4:10 pm

    “a decline in the gold reserves held by central banks – to reverse the deflationary effects of the rapid accumulation of gold reserves…”

    I think when the right talks about the gold standard they mean a really fixed gold standard, like $1,000 always can be converted into exactly 1 oz. of gold, and this never changes. Anyone can always go to the government, give them $1,000, and leave with an ounce of gold, just like in the good ol’ days, you know when the 99% were dirt poor, and the average lifespan was in the 30’s… If only the right could take us back to that, sigh…


  10. 10 Frank Restly April 14, 2016 at 6:18 pm


    “I think when the right talks about the gold standard they mean a really fixed gold standard, like $1,000 always can be converted into exactly 1 oz. of gold, and this never changes.”

    Basically an impossibility under fractional reserve banking.


  11. 11 Henry April 15, 2016 at 3:55 am

    “Whenever a central bank under the gold standard felt that its holdings of gold were less than they wanted, the response was to raise the interest rate.”

    OK. I was thinking of private demand, not central bank demand.


  12. 12 Rachel Falco April 15, 2016 at 3:05 pm

    Brilliant… Thank you!


  13. 13 Ron Bennett April 15, 2016 at 5:25 pm

    Asset backed currency: or
    How to fix the private Fractional Federal Reserve System:
    Our Fractional Federal Reserve and fiat currency is the cause of the disastrous steady economic decline in this country over the last 100 years.
    A stable currency, one that does not cause inflation or deflation boon and busts will eliminate most of the problem.
    A stable asset backed currency is much simpler to achieve than most people realize. It also has many advantages over a gold or partial gold backed currency. In fact it only takes three simple rules to implement a stable asset backed currency. I will list these rules in order of importance starting with the most important.
    1. Outlaw derivatives and naked shorts.
    2. Change the fractional reserve requirement from 1/10 to 1/1
    3. Require collateral on all loans.

    When the FED prints money out of thin air and lends it to purchase an asset with the asset used as collateral, then the money is backed by a hard asset with real value. I learned this from C. Edward Griffin. When I first heard it I was shocked then I realized that it was obviously true.

    Changing the fractional reserve requirement from 1/10 to 1/1 will prevent the banks from creating money that is not backed by hard assets. Currently the national debt is 18 Trillion dollars. When the government borrows 18 trillion dollars and deposits it in the national bank. The banks can now loan out 10 times that amount or 180 Trillion Dollars. The banks get 10 dollars for every dollar for the government. If the fractional reserve requirement is changed to 1 to 1 then the banks can create 0 dollars that are not backed by hard assets. The money that the government borrows is backed by the hard assets of the government.

    Derivatives also create money out of thin air that is not backed by anything.
    The current derivatives market is 1.2 Quadrillian or 20 times world GDP or 80 times US GDP or 66 times US government debt. The fractional reserver creates money at 10 time the debt, but the derivatives market creats money at 20 to 100 times debt. This is why the absolute most important immediate reform to our monitory system is to Outlaw Derivatives which were illegle up untill 1995.


  14. 14 Henry April 18, 2016 at 2:46 pm


    Throughout your post you talk of the value of gold or the price of gold. I presume when you use this phrase you don’t mean the conversion rate of gold into local currency. You must mean it in terms of the value of other goods. Is that correct?


  1. 1 www.mattian.co.uk Trackback on April 30, 2016 at 7:55 am
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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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