Mises Daily Articles
The Semantic Subversion of the Gold Standard and Free Banking
The recent Liberty Dollar raids raise the question: Why can't people use any currency they want?
The question goes deep into the heart of monetary policy. Two articles from the August 2005 issue of Econ Journal Watch point to confusion over even the terms that are used to describe ostensibly free-market policies, the "gold standard" and "free banking." The articles trace the history of these terms and how monetary policy changed their operational meaning. How these terms are defined plays a central role in economic analysis and how that analysis translates into actual public policy.
In "Gold Standards and the Real Bills Doctrine in U.S. Monetary Policy," Richard Timberlake (219–227) details how the gold standard has been blamed for the Great Depression and the liquidity crunch that preceded it. But, Timberlake argues that the "gold standard" that was in effect at the time bore little resemblance to the ideal of the gold standard. Economists conflate the effects of the regulatory apparatus with the gold base itself. "The profession is, therefore, working with fundamentally flawed historical analysis, and the general public is still misinformed and bewildered" (219).
Ben Bernanke contributed to the confusion. He wrote in a book review,
Eichengreen has made the case that the international gold standard, as reconstituted following World War I, played a central role in the initiation and propagation of the worldwide slump…[it is] a powerful indictment of the political and economic policy-makers who allowed themselves to be bound by golden fetters while the world economy collapsed. (223)
But, as Timberlake notes, Bernanke himself was puzzled by the fact that the pre–World War I gold standard was quite stable (224).
Timberlake (225) answers that the "interwar gold standard was not a gold standard. It was an entirely different system than the pre-1914 gold standard that had existed for 100 years. Timberlake brings in Leland Yeager to make the case: "The gold standard of the late 1920s was hardly more than a façade. It involved extreme measures to economise on gold… It involved neutralization or offsetting of international influences on domestic money supplies, incomes, and prices. Gold standard methods of balance-of-payments equilibrium were largely destroyed…"
In other words, it was Fed policy, not the gold standard that precipitated the Depression. By contrast, Timberlake (199) explains how a pure gold standard should function:
A true gold standard is a complete commodity-money system and, therefore, has an appeal not found in some other monetary arrangements. Under an authentic gold standard, the demand for, and supply of, money react simultaneously, through market prices for all goods and services and the monetary metal, to determine a given quantity of money. If prices of all goods and services and capital tend to fall, say, because of an increased demand for common money, the value of monetary gold being fixed in dollar terms rises in real terms, stimulating increases in the production and importation of gold, and the supply of gold to the mints. Since gold is the necessary base for currency and bank deposits, the quantity of common money also increases arresting the fall in market prices. Alternatively, when additional gold enters the monetary system from whatever source, it tends to raise money prices. Offsetting the potential price level increase are the nominal increases in goods, services, and capital that normally occur. In either case, successive approximations of goods production and money production through the market system generate an ongoing monetary equilibrium.
This is in contrast to the monetary policy embraced by the Fed, which did not allow the supply of money to find equilibrium with the market. Being clear about the definitions of the term "the gold standard" would allow economists (and the public) to properly discuss a complex subject like monetary policy. If it were recognized that "the gold standard" was not in effect in the buildup to the Great Depression, would policymakers and the public be so wary of the concept today?
Ignacio Briones and Hugh Rockoff investigate the larger question of free banking in their article, "Do Economists Reach a Conclusion on Free-Banking Episodes?" Like "the gold standard," they find that the term "free banking" has been used to describe monetary systems which had various levels of freedom from regulation, but none of which was totally free from government tinkering (315). None achieved the total free market in money envisioned by Hayek, which the authors (280) describe thusly:
Hayek imagined a system in which governments steered completely clear of money. The government would not define the basic legal tender or even the basic unit of account. Money would be completely "denationalized." Hayek imagined private firms issuing competing monies in units of their own choosing: Mengers, Ducats, Florins, Talents, and so on (1978, 53). In principle, these issuers could (and Hayek thought would) issue pure fiat monies — paper monies unbacked by any promise to pay in gold, silver, or other commodities. What would prevent them from overissuing, that is from simply adding zeros and collecting the seignorage? The reputation of the issuer would be enough, Hayek argued, to prevent overissue. If the government overissues a monopoly legal tender, the usual cause of inflation, there is little that the ordinary person can do. But in Hayek's world a brand of money that was depreciating in terms of commodities would be abandoned in favor of another brand that was not depreciating. Private competition, in other words, would solve the problem of inflation.
Briones and Rockoff (282) tell us that Adam Smith favored a more restricted "free banking" system, where the banks would be prevented from issuing small denomination bank notes, and, for the large denominations, they would be required to convert these bills into gold-backed currency on demand — effectively tying bank currency to the gold standard. But the banks would be otherwise free.
They survey "free banking" episodes in Scotland, the United States, Canada, Sweden, Switzerland, and Chile. Each occurrence of this relatively freer banking differed in several variables: freedom to issue bank notes, freedom to lend, freedom of entry, and freedom from regulation by (or help from) a central bank. Of their analysis, they write:
One would like to arrange cases of free banking on a continuum ranging from total freedom to total regulation. Any such arrangement, however, will be somewhat arbitrary. In the American case banks were highly restricted, for example, in terms of the assets they could hold, but they were free to issue shares with limited liability and were free of any oversight by a central bank. In the Scottish case, banks enjoyed far more freedom in terms of assets they could hold, but their liability was unlimited… Comparing these cases inevitably requires judgments about how important various restrictions were in practice (289).
While some academics have attempted to paint free-banking episodes as "wild cat" skullduggery, with fraudulent opportunists circulating worthless paper and avoiding the regulators, Briones and Rockoff (315) suggest that these cases were not the norm and that in fact the relatively "free banking" was also relatively good banking. They conclude:
It appears that wildcat banking, if it existed at all, was at most a very rare phenomenon. Some of the few cases of overissue and wildcat banking that have been reported resulted from legislation that undermined the ability of the public to distinguish among the notes issued by individual banks… A lot of very good banking was done in lightly regulated banking systems… Evidently, there were a variety of lightly regulated banking systems that could serve as models for sound banking systems… The story of free banking, moreover, provides a cautionary tale about judging the regulation of banking on the basis of anecdotes rather than evidence.
So, in both cases of the "gold standard" and "free banking" we find that much of the case against the free-market policy is based on misrepresentations of the policies and semantic subversion.
This sort of equivocation by economists (who should know better) extends well beyond the gold standard and free banking. In another EJW article, Kurt Schuler describes how American economists incorrectly labeled Argentina's monetary policy a "currency board" and how this led them to offer erroneous advice about how to fix the economic downturn in that country. He notes that journalists (and their editors) who spread these predictions can't be expected to catch the analytical mistakes and that this is essentially a charge for economists.
As we pursue more liberty-respecting government, we need to insist that our intellectual adversaries not get away with painting cartoon caricatures of central concepts. In the May issue of Cato Unbound, Econ Journal Watch editor Dan Klein, emphasized the importance of the meaning of words:
So, the next time someone says, "Oh, but that is just a semantic issue," kindly smack him upside the head for me (an instance of justifiable coercion).
But the quality of semantics does affect the quality of public policy. Confucius spoke of downward movements: "When words lose their meaning, people will lose their liberty." As for the upward movements, better semantics will mean less coercion.