The gold standard: the cause of the Great Depression?
Despite gold rising to over $530 at the end of last week, there is a lot of dumb stuff written about the gold standard and the Great Depression these days. I opened the paper the other day and I read a column by Robert Samuelson in The Washington Post, entitled '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.'
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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.
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Such a view is not uncommon. America's own newly appointed Fed chief, Ben Bernanke, also holds such views. Bernanke is a Great Depression buff, just as some people are Civil War buffs. It fascinates him. He studies it as a man might pick over the remains of some archaeological dig. He even began a book about it.
In the Wall Street Journal, Greg Ip summarises some of Bernanke's views on the Great Depression. On top of the list: 'Beware of outdated orthodoxies such as the gold standard.' You see, 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. 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.
So 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 the US backed the creation of the Federal Reserve. They appreciated the value of a good cartel.
Whereas gold is a bit like a cash-only bar. People with little money who like to drink tend not to like cash bars.
Thus the problem with the gold standard and the Great Depression, Mr Samuelson, is not that there was not enough gold. The problem was too many dollars, pounds, reichmarks and francs. When Roosevelt ordered Americans to surrender their gold coins in the spring of '33, he was not saving capitalism. He was burying it.
The gold standard: a broken promise?
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 harbour.
Just because governments frequently broke these rules does not mean the gold standard itself is at fault. (The rules were broken with finality in 1971, 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 scallywag. Usually, the preferred term is 'liar'. Today we call such people politicians and 'saviours 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.
The gold standard: better than paper money?
Why should paper money create unsustainable booms? I'll attempt an answer in brief, at the risk of over- simplifying 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 - ether 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 are more savings in the economy than there really are. 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, thus 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 re-establishes 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.
Of course, 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.
Secondly, 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.
By Chris Mayer for The Daily Reckoning
Recommended further reading:
You may like to read more on the gold standard, the Great Depression and whether gold is set to replace paper money. Or, for a full list of articles on gold and other precious metals, go to our section on investing in gold.
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr Mayer's essays have appeared in a wide variety of publications, including the Mises.org Daily Article. He is also the editor of 'Crisis & Capital', formerly the US Fleet Street Letter.
