The Gold Standard Gets No Respect

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There
is a lot of dumb stuff written about the gold standard and the Great
Depression these days. I opened the paper yesterday and I read a
column by Robert Samuelson in The Washington Post, "Gold's
Enduring Mystery."

Samuelson
goes on to say some things about gold's role as money for much of
recorded history. Then he gets to the Great Depression and he enters
the realm of the absurd. He writes: "But the gold standard's
very rigidity led to its collapse in the Great Depression. Too little
gold fostered banking and currency crises."

Tsk,
tsk. Poor gold! Now the blame for the Great Depression lies at your
feet. Truly, the victors write history. For here is history from
the view of a paper money enthusiast.

Such
a view is not uncommon. Our own newly appointed Fed chief, Ben Bernanke,
also holds such views. Bernanke is a Great Depression buff, just
as people are Civil War buffs. It fascinates him. He studies it
as a man might pick over the remains of some archeological dig.
He even began a book about it.

Greg
Ip's piece in the Wall Street Journal summarizes some of
Bernanke's views on the Great Depression. On the top of the list:
"Beware of outdated orthodoxies such as the gold standard."

To
the world-improver set, confident they can push the right buttons
and pull the right levers, the gold standard is nothing more than
a straitjacket. To those who see gold's charms, that is precisely
its chief merit. You see, the gold standard checks the creation
of new money.

If
every dollar must be backed by a certain amount of gold, then you
cannot create money out of thin air. The gold standard says you
must have the gold first. Governments find it harder to wage war,
dole out entitlements and build public works with a gold standard
tying them down. Banks can't lend as much money; hence they can't
make as much money. This is why the banking interests of this country
backed the creation of the Federal Reserve. They appreciated the
value of a good cartel.

It's
a bit like a cash-only bar. People with little money who like to
drink tend not like cash bars.

The
problem, Mr. Samuelson, is not that there was not enough gold. The
problem was too many dollars. When Roosevelt ordered Americans to
surrender their gold coins in the spring of '33, he was not saving
capitalism. He was burying it.

Capitalism – or free markets – depends on contracts. Contracts are nothing
but promises. When contracts cannot be enforced, then you join the
world of banana republics and post-Soviet style looting. The system
breaks down. So it was whenever the country reneged on its promise
to back its own currency with gold.

Those
who gave their gold in exchange for dollars – backed by a promise
to redeem in gold – were simply left with dollars. Their own government
essentially stole their gold from them. Dollars, I should note,
that have lost a lot of value in the ensuing seventy years.

But
there's more than this. Money unfettered by specie is the main fuel
for the unsustainable booms that later turn into the panics, crashes
and depressions that pock the landscape of financial history. Gold
was what reigned in such excesses. It was the anchor that kept the
ship in the harbor.

Just
because the government frequently broke these rules does not mean
the gold standard itself is at fault. (The rules were broken with
finality in 1972, when President Nixon quashed the last vestige
of the gold standard). A man who cannot keep his promises cannot
reasonably lay the blame on the promises. Such a routine breaker
of promises may be a rogue, a thief, and a scalawag. Usually, the
preferred term is "liar." Today we call such people politicians
and "saviors of capitalism."

Bernanke
may have studied the Great Depression, but he has read the wrong
books. He should give a look at Murray Rothbard's America's
Great Depression
. Rothbard's examination is clear and logical,
without the trappings of mathematics that otherwise pollute economic
texts today.

Why
should paper money create unsustainable booms? I'll attempt an answer
in brief, at the risk of oversimplifying something that's taken
centuries to get right and that is still being explored and elaborated
upon by economists today. (The best thing to do is read the book.
Read only the first three chapters and you'll know more about business
cycles than most professional economists.)

Basically,
in a free market, individuals decide how much they want to save.
These savings are invested in the market – either by the saver
or through an intermediary (like a bank). The price of savings is
the "natural rate" or "pure interest rate."
Just think of it as a natural market price, the result of supply
and demand.

So,
when you create money out of thin air you give the impression there
is more savings in the economy than there really is. You distort
interest rates and the natural rate does not function so well. The
market's signals are emitted through a monetary fog.

All
this excess money leads to new investments and spending creating
the "boom." As Rothbard says, "the boom, then, is
actually a period of wasteful misinvestment. It is when errors are
made, due to bank credit's tampering with the free market."

At
some point, the misinvestments are exposed as unprofitable, the
growth unsustainable. "The depression is actually the process
by which the economy adjusts to the wastes and errors of the boom,
and reestablishes efficient service of consumer desires." In
other words, the jig is up, reality sets in and the pull of the
market price – the "natural rate" – start to assert itself.

It's
just like any other price controls. Set it too high or too low and
there are consequences. It is unsustainable. This is why we have
markets, to discover the "right" price.

There's
a lot more to this idea than I can delve into here. But the main
point I want to make is this: The gold standard is not to blame
for the crises of the past. They were caused by our inability to
keep the promise to redeem in gold. And, secondly, that far from
causing crises, the gold standard kept in check the growth in money.
As a result, the gold standard served to stem unsustainable booms
and avoid the necessary busts that follow.

December
10, 2005

Chris
Mayer is the editor of Capital and Crisis. This article first appeared
in The Daily Reckoning.

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