The classical gold standard worked

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From the American Institute for Economic Research:

Government Abuse of Money and the Benefits of Market-Based Money

It is worth recalling that money did not originate in the laws or decrees of kings and princes. Money, as the generally accepted medium of exchange, emerged out of the market transactions of a growing number of buyers and sellers in an expanding arena of trade. Commodities such as gold and silver were selected over generations of market participants as the monies of free choice because of their useful characteristics to better facilitate the exchange of goods in the marketplace.

For almost all of recorded history, governments have attempted to gain control of the production of money to serve their seemingly insatiable desire to extract more and more of the wealth produced by the ordinary members of society. Ancient rulers would clip and debase the gold and silver coins of their subjects. More modern rulers, whether despotically self-appointed through force or democratically elected by voting majorities, have taken advantage of the monetary printing press to churn out paper money to fund their expenditures and redistributive largess in excess of the taxes they impose on the citizenry. Today the process has become even easier through the mere click of a mouse on a computer screen, which in the blink of an eye can create tens of billions of dollars out of thin air.

Thus, monetary debasement and the price inflation that normally accompanies it have served as a method for imposing a hidden taxation on the wealth of the citizenry. As John Maynard Keynes insightfully observed in 1919 (before he became a Keynesian):

By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The process engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose.

The Benefit of a Gold Standard to Limit Government Abuse

It was the corrosive, distortive, and destructive effects from monetary manipulation by governments in the early part of the 19th century that led virtually all of the leading economists of that time to endorse the anchoring of the monetary system in a commodity such as gold to prevent governments from using their powers over the creation of paper monies to cover their budgetary extravagance. John Stuart Mill’s words from the middle of the 19th century are worth recalling:

No doctrine in political economy rests on more obvious grounds than the mischief of a paper currency not maintained at the same value with a metallic, either by convertibility, or by some principle of limitation equivalent to it… All variations in the value of the circulating medium are mischievous; they disturb existing contracts and expectations, and the liability to such changes renders every pecuniary engagement of long date entirely precarious…

Great as this evil would be if it [the supply of money] depended on [the] accident [of gold production], it is still greater when placed at the arbitrary disposal of an individual or a body of individuals; who may have any kind or degree of interest to be served by an artificial fluctuation in fortunes; and who have at any rate a strong interest in issuing as much [inconvertible paper money] as possible, each issue being itself a source of profit. Not to add, that the issuers have, and in the case of government paper, always have, a direct interest in lowering the value of the currency because it is the medium in which their own debts are computed… Such power, in whomsoever vested, is an intolerable evil.

Under a gold standard, it was gold that was the actual money. Paper currency and various forms of checking and other deposit accounts that may be used in market transactions in exchange for goods and services were money substitutes, representing a fixed quantity of the gold-money on deposit with a banking or other financial institution that was redeemable on demand.

Any net increases in the quantity of currency and checking and related deposits were, in principle, dependent upon increases in the quantity of gold that depositors with banking and financial institutions added to their individual accounts. Any withdrawal of gold from their accounts through redemption required that the quantity of currency notes and checking and related accounts in circulation be reduced by the same amount. Under a gold standard, a central bank was, in principle, relieved of all authority and power to arbitrarily “manage” the monetary order.

In reality, central banks anchored in gold standards used their authority in various ways, at various times not consistent with the rules of the game as just outlined. Nonetheless, gold standards did serve as a practical check and limit on unrestrained monetary expansion and abuse for a good part of the 19th and early 20th centuries. (See my article “The Gold Standard as Government-Managed Money.”)

The Gold Standard’s Supposed Inflexibility Was Its Strength

Many critics of the gold standard have considered these formal rules to be rigid and inflexible about how the monetary system and the quantity of money in the society is to be determined and constrained. Yet, the advocates of the gold standard long argued that this relative inflexibility was essential to discipline governments within the confines of a hard budget.

Without the escape hatch of the monetary printing press, governments must either tax the citizenry or borrow a part of the savings of the private sector to cover their expenditures. Those proposing government spending must either justify it by explaining where the tax dollars will come from and upon whom the taxes will fall, or make the case for borrowing a part of the savings of the society to cover those expenditures at market rates of interest that tell the truth about what it will cost to attract lenders to lend that sum to the government rather than to private sector borrowers, and therefore the truth about the social cost of private sector investment and future growth that will have to be forgone.

In other words, the gold standard helped to prevent government from monetizing the debt to cover all or part of its budget deficits. The government, under a gold standard, no longer could create the illusion that something can be had for nothing. (See my article “Why Government Deficits and Debt Do Matter.”)

This was why Austrian economist Ludwig von Mises felt reasonable in arguing:

Why have a monetary system based on gold? Because, as conditions are today and for the time that can be foreseen today, the gold standard alone makes the determination of money’s purchasing power independent of the ambitions and machinations of governments, of dictators, and political parties, and pressure groups. The gold standard alone is what the nineteenth-century freedom-loving leaders (who championed representative government, civil liberties, and prosperity for all) called “sound money.”

The Classical Gold Standard Worked — as Long as Guided by Liberal Ideas

Of course, the gold standard, during its heyday in the years before the First World War, succeeded in fulfilling its role in notably limiting government deficit spending and restraining the dangers from price inflation only so long as those in charge of managing the government-established central banks were guided by ideas and policy views inspired by a political philosophy of classical liberalism and limited government.

Once the political philosophy and the policy views changed during and following the First World War in far more interventionist and welfare-statist directions, central banks became engines of monetary and general economic disruption and instability. Indeed, once the control of money and credit is in the hands of government, little is really secure in terms of the reach of political control in the society. It depends almost completely on the politics and purposes of those in government and those appointed to manage the central banks.

The German free market economist Gustav Stolper, while an exile in the United States during the Second World War, wrote in his book This Age of Fable: The Political and Economic World We Live In (1942):

Hardly ever do the advocates of free capitalism realize how utterly their ideal was frustrated at the moment that the state assumed control of the monetary system.… A ‘free’ capitalism with governmental responsibility for money and credit has lost its innocence. From that point on it is no longer a matter of principle but one of expediency how far one wishes or permits government intervention to go. Money control is the supreme and most comprehensive of all governmental controls short of expropriation.

Separating Money From the State, the Ultimate Policy Reform

Stolper’s insight, I would suggest, points in the direction of a reform of the monetary and banking system that does not stop with restrictions on Federal Reserve discretionary policy over money or interest rates, such as under the classical or traditional government-managed gold standard. It points in the direction of an end goal of separating the monetary and banking system from government control and oversight, and in its place putting a system of private, competitive free banking — a truly market-based money and banking system. (See my article “Free Banking and the Case Against Central Banking.”)

Continue reading at the American Institute for Economic Research…

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