Imagining the Gold Standard

The Marginal Revolution University has posted a nice little 10-minute video conversation between Scott Sumner and Larry about the gold standard and fiat money, Scott speaking up for fiat money and Larry weighing in on the side of the gold standard. I thought that both Scott and Larry acquitted themselves admirably, but several of the arguments made by Larry seemed to me to require either correction or elaboration. The necessary corrections or elaborations do not strengthen the defense of the gold standard that Larry presents so capably.

Larry begins with a defense of the gold standard against the charge that it caused the Great Depression. As I recently argued in my discussion of a post on the gold standard by Cecchetti and Schoenholtz, it is a bit of an overreach to argue that the Great Depression was the necessary consequence of trying to restore the international gold standard in the 1920s after its collapse at the start of World War I. Had the leading central banks at the time, the Federal Reserve, the Bank of England, and especially the Bank of France, behaved more intelligently, the catastrophe could have been averted, allowing the economic expansion of the 1920s to continue for many more years, thereby averting subsequent catastrophes that resulted from the Great Depression. But the perverse actions taken by those banks in 1928 and 1929 had catastrophic consequences, because of the essential properties of the gold-standard system. The gold standard was the mechanism that transformed stupidity into catastrophe. Not every monetary system would have been capable of accomplishing that hideous transformation.

So while it is altogether fitting and proper to remind everyone that the mistakes that led to catastrophe were the result of choices made by policy makers — choices not required by any binding rules of central-bank conduct imposed by the gold standard — the deflation caused by the gold accumulation of the Bank of France and the Federal Reserve occurred only because the gold standard makes deflation inevitable if there is a sufficiently large increase in the demand for gold. While Larry is correct that the gold standard per se did not require the Bank of France to embark on its insane policy of gold accumulation, it should at least give one pause that the most fervent defenders of that insane policy were people like Ludwig von Mises, F.A. Hayek, Lionel Robbins, and Charles Rist, who were also the most diehard proponents of maintaining the gold standard after the Great Depression started, even holding up the Bank of France as a role model for other central banks to emulate. (To be fair, I should acknowledge that Hayek and Robbins, to Mises’s consternation, later admitted their youthful errors.)

Of course, Larry would say that under the free-banking system that he favors, there would be no possibility that a central bank like the Bank of France could engage in the sort of ruinous policy that triggered the Great Depression. Larry may well be right, but there is also a non-trivial chance that he’s not. I prefer not to take a non-trivial chance of catastrophe.

Larry, I think, makes at least two other serious misjudgments. First, he argues that the instability of the interwar gold standard can be explained away as the result of central-bank errors – errors, don’t forget, that were endorsed by the most stalwart advocates of the gold standard at the time – and that the relative stability of the pre-World War I gold standard was the result of the absence of the central banks in the US and Canada and some other countries while the central banks in Britain, France and Germany were dutifully following the rules of the game.

As a factual matter, the so-called rules of the game, as I have observed elsewhere (also here), were largely imaginary, and certainly never explicitly agreed upon or considered binding by any monetary authority that ever existed. Moreover, the rules of the game were based on an incorrect theory of the gold standard reflecting the now discredited price-specie-flow mechanism, whereby differences in national price levels under the gold standard triggered gold movements that would be deflationary in countries losing gold and inflationary in countries gaining gold. That is a flatly incorrect understanding of how the international adjustment mechanism worked under the gold standard, because price-level differences large enough to trigger compensatory gold flows are inconsistent with arbitrage opportunities tending to equalize the prices of all tradable goods. And finally, as McCloskey and Zecher demonstrated 40 years ago, the empirical evidence clearly refutes the proposition that gold flows under the gold standard were in any way correlated with national price level differences. (See also this post.) So it is something of a stretch for Larry to attribute the stability of the world economy between 1880 and 1914 either to the absence of central banks in some countries or to the central banks that were then in existence having followed the rules of the game in contrast to the central banks of the interwar period that supposedly flouted those rules.

Focusing on the difference between the supposedly rule-based behavior of central banks under the classical gold standard and the discretionary behavior of central banks in the interwar period, Larry misses the really critical difference between the two periods. The second half of the nineteenth century was a period of peace and stability after the end of the Civil War in America and the short, and one-sided, Franco-Prussian War of 1870. The rapid expansion of the domain of the gold standard between 1870 and 1880 was accomplished relatively easily, but not without significant deflationary pressures that lasted for almost two decades. A gold standard had been operating in Britain and those parts of the world under British control for half a century, and gold had long been, along with silver, one of the two main international monies and had maintained a roughly stable value for at least half a century. Once started, the shift from silver to gold caused a rapid depreciation of silver relative to gold, which itself led the powerful creditor classes in countries still on the silver standard to pressure their governments to shift to gold.

After three and a half decades of stability, the gold standard collapsed almost as soon as World War I started. A non-belligerent for three years, the US alone remained on the gold standard until it prohibited the export of gold upon entry into the war in 1917. But, having amassed an enormous gold hoard during World War I, the US was able to restore convertibility easily after the end of the War. However, gold could not be freely traded even after the war. Restrictions on the ownership and exchange of gold were not eliminated until the early 1920s, so the gold standard did not really function in the US until a free market for gold was restored. But prices had doubled between the start of the war and 1920, while 40% of the world’s gold reserves were held by the US. So it was not the value of gold that determined the value of the U.S. dollar; it was the value of the U.S. dollar — determined by the policy of the Federal Reserve — that determined the value of gold. The kind of system that was operating under the classical gold standard, when gold had a clear known value that had been roughly maintained for half a century or more, did not exist in the 1920s when the world was recreating, essentially from scratch, a new gold standard.

Recreating a gold standard after the enormous shock of World War I was not like flicking a switch. No one knew what the value of gold was or would be, because the value of gold itself depended on a whole range of policy choices that inevitably had to be made by governments and central banks. That was just the nature of the world that existed in the 1920s. You can’t just assume that historical reality away.

Larry would like to think and would like the rest of us to think that it would be easy to recreate a gold standard today. But it would be just as hard to recreate a gold standard today as it was in the 1920s — and just as perilous. As Thomas Aubrey pointed out in a comment on my recent post on the gold standard, Russia and China between them hold about 25% of the world’s gold reserves. Some people complain loudly about Chinese currency manipulation now. How would you like to empower the Chinese and the Russians to manipulate the value of gold under a gold standard?

The problem of recreating a gold standard was beautifully described in 1922 by Dennis Robertson in his short classic Money. I have previously posted this passage, but as Herbert Spencer is supposed to have said, “it is only by repeated and varied iteration that alien conceptions can be forced upon reluctant minds.” So, I will once again let Dennis Robertson have the final word on the gold standard.

We can now resume the main thread of our argument. In a gold standard country, whatever the exact device in force for facilitating the maintenance of the standard, the quantity of money is such that its value and that of a defined weight of gold are kept at an equality with one another. It looks therefore as if we could confidently take a step forward, and say that in such a country the quantity of money depends on the world value of gold. Before the war this would have been a true enough statement, and it may come to be true again in the lifetime of those now living: it is worthwhile therefore to consider what, if it be true, are its implications.

The value of gold in its turn depends on the world’s demand for it for all purposes, and on the quantity of it in existence in the world. Gold is demanded not only for use as money and in reserves, but for industrial and decorative purposes, and to be hoarded by the nations of the East : and the fact that it can be absorbed into or ejected from these alternative uses sets a limit to the possible changes in its value which may arise from a change in the demand for it for monetary uses, or from a change in its supply. But from the point of view of any single country, the most important alternative use for gold is its use as money or reserves in other countries; and this becomes on occasion a very important matter, for it means that a gold standard country is liable to be at the mercy of any change in fashion not merely in the methods of decoration or dentistry of its neighbours, but in their methods of paying their bills. For instance, the determination of Germany to acquire a standard money of gold in the [eighteen]’seventies materially restricted the increase of the quantity of money in England.

But alas for the best made pigeon-holes! If we assert that at the present day the quantity of money in every gold standard country, and therefore its value, depends on the world value of gold, we shall be in grave danger of falling once more into Alice’s trouble about the thunder and the lightning. For the world’s demand for gold includes the demand of the particular country which we are considering; and if that country be very large and rich and powerful, the value of gold is not something which she must take as given and settled by forces outside her control, but something which up to a point at least she can affect at will. It is open to such a country to maintain what is in effect an arbitrary standard, and to make the value of gold conform to the value of her money instead of making the value of her money conform to the value of gold. And this she can do while still preserving intact the full trappings of a gold circulation or gold bullion system. For as we have hinted, even where such a system exists it does not by itself constitute an infallible and automatic machine for the preservation of a gold standard. In lesser countries it is still necessary for the monetary authority, by refraining from abuse of the elements of ‘play’ still left in the monetary system, to make the supply of money conform to the gold position: in such a country as we are now considering it is open to the monetary authority, by making full use of these same elements of ‘play,’ to make the supply of money dance to its own sweet pipings.

Now for a number of years, for reasons connected partly with the war and partly with its own inherent strength, the United States has been in such a position as has just been described. More than one-third of the world’s monetary gold is still concentrated in her shores; and she possesses two big elements of ‘play’ in her system — the power of varying considerably in practice the proportion of gold reserves which the Federal Reserve Banks hold against their notes and deposits (p. 47), and the power of substituting for one another two kinds of common money, against one of which the law requires a gold reserve of 100 per cent and against the other only one of 40 per cent (p. 51). Exactly what her monetary aim has been and how far she has attained it, is a difficult question of which more later. At present it is enough for us that she has been deliberately trying to treat gold as a servant and not as a master.

It was for this reason, and for fear that the Red Queen might catch us out, that the definition of a gold standard in the first section of this chapter had to be so carefully framed. For it would be misleading to say that in America the value of money is being kept equal to the value of a defined weight of gold: but it is true even there that the value of money and the value of a defined weight of gold are being kept equal to one another. We are not therefore forced into the inconveniently paradoxical statement that America is not on a gold standard. Nevertheless it is arguable that a truer impression of the state of the world’s monetary affairs would be given by saying that America is on an arbitrary standard, while the rest of the world has climbed back painfully on to a dollar standard.

HT: J. P. Koning

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7 Responses to “Imagining the Gold Standard”


  1. 1 Henry January 3, 2017 at 3:20 pm

    David,

    You said:

    “As Thomas Aubrey pointed out in a comment on my recent post on the gold standard, Russia and China between them hold about 25% of the world’s gold reserves. Some people complain loudly about Chinese currency manipulation now. How would you like to empower the Chinese and the Russians to manipulate the value of gold under a gold standard?”

    So what is the difference? Chinese manipulation of a gold reserve system or Chinese manipulation of a US $ reserve system? You are arguing against yourself. I don’t think this is a very powerful argument for not having a gold reserve system. (And I am not arguing for a gold reserve system.)

    I have not read Robertson’s “Money”, so I don’t know what precedes or proceeds the passage quoted. However, it fails to mention one thing and that is what is required for a sound return to gold is the appropriate pricing of gold in terms of currencies. You have essentially argued that the problem with the interwar gold standard was that there was a shortage of monetary gold reserves (essentially Cassel’s position). I would argue that the problem was not a shortage of gold reserves (and remember that international reserves at the time not only included gold but also Sterling and increasingly the US dollar) but the mispricing of gold, in particular of the overvaluing of Sterling on the return of the UK to a gold standard and the undervaluing of the Franc.

    This mispricing expressed itself in the relative BOPs performance of these two countries. The UK lost international reserves and the French gained international reserves (mainly in the form of Sterling balances which they sought to convert to gold).

    So the problem was not a shortage of monetary gold but mispriced currencies in a fixed exchange rate system, and of course, how the respective countries went about dealing with this mispricing and the ensuing pressures on their respective BOPs.

    You also pillory the French for their accumulation of gold from 1926 onwards forgetting the huge accumulation of monetary gold by the US from the early 1920s.

    On top of managing a mispriced gold reserve system, the world had to deal with the investment and ensuing speculative boom that was raging in the US. The US’s export performance during this period was strong, resulting in burgeoning international reserves. This disparate export performance began to weigh on the international system as well as creating concerns in the US, the US eventually endeavouring to reign in the boom. This with the weakened state of the world economy drove the world into the slump and deflation of 1929-1930. In the US, the deflation was caused by the disappearance of 30% of the banks and deposits, not the lack of monetary gold reserves.

    In fact, Hawtrey himself (p. 137 of his “The Gold Standard…”) said:

    “The catastrophic fall in the world price level that occurred was the cause of the breakdown of the gold standard”

    and not the other way round.

    The problem in the 1920s and early 1930s was an international monetary system based on mispriced fixed exchange rates, not a shortage of gold reserves. This was the overlay to the eventual bust of the US investment/speculative boom of the late 1920s, which in turn brought on the depression.

  2. 2 David Glasner January 3, 2017 at 5:10 pm

    Henry, You quoted me:

    “As Thomas Aubrey pointed out in a comment on my recent post on the gold standard, Russia and China between them hold about 25% of the world’s gold reserves. Some people complain loudly about Chinese currency manipulation now. How would you like to empower the Chinese and the Russians to manipulate the value of gold under a gold standard?”

    And you asked:

    “So what is the difference? Chinese manipulation of a gold reserve system or Chinese manipulation of a US $ reserve system? You are arguing against yourself. I don’t think this is a very powerful argument for not having a gold reserve system. (And I am not arguing for a gold reserve system.)”

    You misunderstood. The point was not that the gold standard is bad because it is subject to manipulation. The point is that the claim that the gold standard is somehow invulnerable to manipulation is not valid.

    You said:

    “I have not read Robertson’s “Money”, so I don’t know what precedes or proceeds the passage quoted. However, it fails to mention one thing and that is what is required for a sound return to gold is the appropriate pricing of gold in terms of currencies.”

    Setting the appropriate exchange rates between currencies is certainly a problem. But that is a problem separate from the problem of stabilizing the real value of gold. Now the real value of gold. After World War I the real value of gold was half of what it was before World War I, but the dollar price of gold which was the only country with a currency convertible into gold after World War I was the same as it had been at the start of World War I. Given that the dollar price of gold was not going to change, and there was nobody that I know of who was advocating changing the dollar price of gold, either the demand for gold had to be reduced compared to what it had been before World War I or there was going to be deflation in terms of dollars and gold that would restore the real value of gold to something close to its prewar value.

    You said:

    “You have essentially argued that the problem with the interwar gold standard was that there was a shortage of monetary gold reserves (essentially Cassel’s position).”

    You made this assertion in a comment on my recent post “Golden Misconceptions,” and I just don’t know how you came up with this idea. Perhaps you are focusing on Cassel’s argument that there would be a deflationary trend because gold output was unlikely to increase as rapidly as gold demand so that the real value of gold would be rising over time. That was a different argument from his his argument about the cause of the Great Depression. What I have said, and what Cassel and Hawtrey said, is that the sudden and sharp increase in gold demand by central banks starting in 1928 precipitated the onset of the Great Depression in late 1929 when deflation, caused by the increase in gold demand, accelerated sharply.

    You said:

    “I would argue that the problem was not a shortage of gold reserves (and remember that international reserves at the time not only included gold but also Sterling and increasingly the US dollar) but the mispricing of gold, in particular of the overvaluing of Sterling on the return of the UK to a gold standard and the undervaluing of the Franc.”

    According to you, the mispricing of sterling began in March 1925 when Britain restored convertibility at the prewar parity against the dollar and the mispricing of the franc began in 1926 when Poincare stabilized the franc at a rate of about 25 francs to the dollar. Those events took place three or four years before the Great Depression started at the end of 1929 and in your comment on my other post on the gold standard you accused me of conveniently using a lag to account for “the time difference between the increase in French and US reserves and the 1929 and onwards deflation.” But you don’t seem have any problem with a lag of three or four years.

    You said:

    “This mispricing expressed itself in the relative BOPs performance of these two countries. The UK lost international reserves and the French gained international reserves (mainly in the form of Sterling balances which they sought to convert to gold).”

    Actually the UK’s balance of payments was quite steady, thanks to a 5% bank rate until 1929. The French balance of payments was positive because the economy grew rapidly based on an improving economy thanks to an undervalued currency. But the inflow of gold was the result of a very high gold reserve requirement on banknotes so that an increasing demand for money could only be accommodated through an export surplus and the importation of gold. In addition to the importation of gold as cover for the increased quantity of banknotes, the Bank of France cashed in its dollar and sterling denominated foreign exchange for gold and would only accept gold as settlement of its claims on foreign debtors.

    “This mispricing expressed itself in the relative BOPs performance of these two countries. The UK lost international reserves and the French gained international reserves (mainly in the form of Sterling balances which they sought to convert to gold).”

    The mispricing, as you put it, did not require France to accumulate gold by converting sterling and dollar claims into gold and by imposing exceptionally high gold reserve ratios on banknotes, which in France, unlike the US and the UK with highly developed deposit banking system, were the predominant medium of exchange.

    “This mispricing expressed itself in the relative BOPs performance of these two countries. The UK lost international reserves and the French gained international reserves (mainly in the form of Sterling balances which they sought to convert to gold).”

    Apparently you just can’t help channeling Austrian Business Cycle Theory.

    You said:

    In fact, Hawtrey himself (p. 137 of his “The Gold Standard…”) said:

    ‘The catastrophic fall in the world price level that occurred was the cause of the breakdown of the gold standard’

    and not the other way round.”

    Please try to understand Hawtrey before you quote him. His point was that, having precipitated the deflation that caused the Great Depression, the gold standard could not survive, because countries had to leave the gold standard or remain caught in a deflationary downward spiral.

    “The problem in the 1920s and early 1930s was an international monetary system based on mispriced fixed exchange rates, not a shortage of gold reserves. This was the overlay to the eventual bust of the US investment/speculative boom of the late 1920s, which in turn brought on the depression.”

    Please, enough of your “shortage of gold reserves” red herring and the Austrian myth that the Great Depression was caused by an unsustainable investment/speculative boom in the late 1920s.

  3. 3 Henry January 4, 2017 at 5:43 am

    David,

    “But you don’t seem have any problem with a lag of three or four years.”

    I said the mispricing of currencies in terms of gold was an overlay. It contributed to the weakening of the international economy as governments/central banks attempted to compensate for the mispricing. I wasn’t arguing that the mispricing of currencies caused the Depression – it set the scene.

    “Actually the UK’s balance of payments was quite steady, thanks to a 5% bank rate until 1929. ”

    Apologies. I should have been more specific. The overvalued pound left UK’s BOT in an unhealthy state. Its BOPs was shored up by capital flows engendered by a relatively high bank rate, as you say. The overvalued Sterling left the UK not competitive in the traded goods sector – forcing it to depress its internal price level.

    “Please try to understand Hawtrey before you quote him.”

    I take your point on that one. Reconsidering, I did misquote him.

    “Please, enough of ……….. the Austrian myth that the Great Depression was caused by an unsustainable investment/speculative boom in the late 1920s.”

    I have not read much of the Austrian economic literature. However, I see it from a Keynesian perspective. I think someone like J. K. Galbraith would probably see it that way also.

  4. 4 David Glasner January 5, 2017 at 12:01 pm

    Henry, An overvalued pound may have been a problem for Britain, and especially for those unable to find work, but the 1925 to 1929 period was actually a period of steady economic growth and modestly falling unemployment. There was no reason why Britain could not have continued on a path of steady growth and declining unemployment if Britain had not been caught up in an international deflation imposed on it by outside forces. You said:

    “The overvalued Sterling left the UK not competitive in the traded goods sector – forcing it to depress its internal price level.”

    Under a gold standard, Britain could control its price level in only two ways: 1) changing the dollar/currency peg, or 2) altering the real value of gold. There was no specific policy choice to deflate.

    I don’t think that Galbraith qualifies as being anywhere near an authoritative representative of Keynesian doctrine. He was an excellent writer and an interesting and insightful commentator, but he was out of his depth as an economic theorist.

  5. 5 Nick Rowe January 22, 2017 at 2:43 am

    Why did I miss this very good and convincing post? Must be because it was New Year and I was otherwise engaged.

    One very minor disagreement: I think you have a false dichotomy between the Price-specie flow and other equilibrating mechanisms — we need both. “Arbitrage” is just another name for a very fast and powerful price-specie flow mechanism.

  6. 6 Nick Rowe January 22, 2017 at 2:54 am

    But I remember David Laidler teaching Hume and saying the same as you on the Price specie flow mechanism. So I’m clearly outgunned!


  1. 1 prostaff 550 Trackback on January 22, 2017 at 7:42 pm

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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.

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