Economists Say the Darndest Things, Gold Standard Edition

I often hear economists say things like “look, the vast majority of economists think the gold standard is terrible.” I have no idea if this is true (many economists outside of macro likely have no opinion on the gold standard), but it is incredibly misleading even if we believe the quote to be true. The reason I say that this quote is misleading is that whether or not the gold standard is a good or bad institutional regime depends on the precise institutional characteristics of the gold standard. In other words, which gold standard are we talking about? Are we talking about a free banking regime in which banks issue their own notes that are redeemable in gold? Are we talking about a system in which there is a central bank that has a monopoly over currency issuance that redeems its notes in terms of gold? Or are we talking about a Bretton Woods-type system? The institutional characteristics matter when we are evaluating the benefits and costs of the system. In general I find that the “consensus view” in economics is not that the gold standard is bad, but that particular experiences with the gold standard were bad. In other words, there is a difference between saying that the gold standard is inherently bad and saying that our experience with the gold standard is bad. Allow me to elaborate.

When I hear economists say that the majority of their colleagues oppose the gold standard, what they are typically referencing is a critique of the international gold standard that existed during the interwar period. In fact, in my experience, I have found that there are few economists outside of the field of monetary economics who actually know much about the gold standard beyond the interwar experience. This is problematic. If I ask an economist if the gold standard is bad, I would expect them to answer based on carefully thinking through the costs and benefits of the gold standard relative to alternative monetary institutions. One should not expect that they simply point to a very negative experience and conclude that it was bad. This is not good economics. One must consider the counterfactual.

With regards to the interwar experience, people often point to the role that the gold standard played in the Great Depression and conclude that the gold standard is bad. For example, Earl Thompson and Scott Sumner have argued that the Great Depression can be explained by fluctuations in the real price of gold. Barry Eichengreen (and others) have discussed how the recovery of a particular country from the Great Depression can be predicted by the timing of their decision to leave the gold standard. Milton Friedman and Anna Schwartz argued that China avoided the worst of the Great Depression because it was on a silver standard.

If this is all you knew about the gold standard, you might naturally conclude that it was a terrible monetary system. However, it is important to understand the particular details of the monetary system during the interwar period. For example, an important characteristic of the interwar period was the fact that the gold standard was managed by central banks. Why is this important? Well, one reason is that the functioning of any monetary system depends on participants following particular rules of the game. As Doug Irwin has shown, the Bank of France did not follow the rules of the game for the gold standard. Instead the French hoarded gold, creating an artificial shortage of gold reserves that, in turn, created significant, exogenous deflationary pressure amongst those countries on the gold standard.

So, if one wanted to judge the gold standard based on the interwar experience, the correct conclusion would be that the gold standard can produce massive costs when mismanaged by central banks. Based on the magnitude of the costs it would therefore not be unreasonable to say that “the gold standard can be terrible when managed by central banks.” In fact, I have made this argument many times! However, note that I have qualified the statement that the gold standard is terrible by placing it in a particular institutional context. This is a much weaker statement than concluding that the gold standard is always and everywhere bad.

The qualification that I outlined in the previous paragraph is important. A number of economists, such as Larry White, George Selgin, and others have written about competitive note issuance under a commodity standard. If one is to conclude that the gold standard is always and everywhere terrible, then one must not only assess the performance of the gold standard in the presence of central banks, but also in the absence of central banks. Larry White’s pioneering work demonstrated that a free banking system actually worked quite well.

Another problem is that economists often compare the actual performance of the gold standard to the theoretical possibilities of central banking under a fiat standard. If a country maintains the gold standard, then fluctuations in the real price of gold can have real effects on economic activity. Thus, dispensing with the gold standard eliminates these sorts of effects. Not only that, but in theory a central bank under a fiat standard can adjust the money supply to maintain relative price stability while also potentially minimizing fluctuations in real economic activity. However, it is unfair to compare the experience of the gold standard with the theoretical possibilities of central banking. For example, Jurg Niehans (1979: 140) writes:

Commodity money does not exist today. It is also not ideal in the sense that it is relatively easy to imagine noncommodity systems that are intellectually more satisfying than commodity money. In fact, a noncommodity system, since it gives monetary policy more freedom, can, if it is ideally managed, always do at least as well as any commodity money system and probably better.

The emphasis is my own. It is easy to argue that, in theory, a fiat money managed by a central bank is preferable to the gold standard. However, the question is whether central banking in a fiat regime actually produces better outcomes than a gold standard. This is a much more complicated question than people think. We cannot look to the interwar period and conclude that the gold standard is bad any more than we can look at the 1970s in the U.S. or the hyperinflation in Zimbabwe and conclude that fiat regimes are bad — yet this is precisely what people on both sides of this debate often do! Similarly, we cannot look at idealized versions of the gold standard or central banking under a fiat regime to draw our conclusions.

To assess whether the gold standard, or any monetary system, is “good” or “bad” requires careful consideration of the institutional characteristics of the system. A gold standard can work quite well within the right institutional structure. But the same could be said for a fiat regime. To argue that one or the other is inherently bad — or worse, claim that everyone agrees with you — is to do a disservice to those who want to learn about monetary economics.

Free Banking and the Friedman Rule

Imagine that there are two types of people in the world — recognizable and unrecognizable. Recognizable people can develop reputations, which can have either positive or negative effects. If a recognizable person develops a reputation for being trustworthy, then he or she will likely be able to issue debt to finance the purchase of goods and services. If the person is not trustworthy, but is easily recognized, then he or she will not be able to issue debt. All else equal, people who are recognizable will have an incentive to be trustworthy so that they can issue IOUs to pay for stuff. People who are not recognizable don’t have the same incentives. Since nobody can recognize them, they will never be able to issue IOUs.

Let’s think about this in the context of general equilibrium theory (without a Walrasian auctioneer and without any exogenously specified thing called “money”). In the absence of some auctioneer to price and distribute goods and in the absence of money, people must meet with every other person in the market to determine whether trade is possible. Recognizable people will be able to issue IOUs in order to trade as long as they are trustworthy and there is a mechanism to punish them if they do not repay their debts (e.g., exclude them to a world of autarky if they don’t repay their debts). But how can the non-recognizable people trade? Well, they could sell their goods to recognizable people in exchange for an IOU, but then all they have is an IOU. And what exactly does the IOU provide?

Assuming that each recognizable person can produce some good, the IOU would represent a promise to produce some quantity of the good in the future. A non-recognizable person could then present the IOU for this good at some future date or the person could turn around and use this IOU to purchase some other good. The seller in this circumstance would be willing to accept a third party IOU if (a) they want the good that IOU promises, or (b) they think they can pass on the IOU to someone else. Whether or not condition (b) is satisfied depends on the good the IOU-issuer is promising. Ultimately, what happens in this scenario is that certain goods will be found to satisfy condition (b) and those IOUs will start to circulate as a medium of exchange.

What this example resembles is a sort of free banking regime. People with good reputations are able to issue IOUs that can end up circulating like bank notes — these are banks. Eventually an IOU can be redeemed by whoever is holding it for some fixed quantity of a good that the IOU-issuer promised.

This implies that there is a key feature of free banking regimes. In actual free banking regimes, bank notes could be redeemed for one particular good, gold. The value of one bank note, consistent with our example, was defined as a particular quantity of gold. This implies that the price of gold in terms of bank notes is necessarily fixed. However, the relative price of gold to an index of all other prices is not fixed. In a growing economy, under these conditions, prices would decline on average with increases in productivity. As a result, the promise to pay a fixed amount of gold at a future date would actually entail a positive rate of return.

Thus, under a free banking regime, if (1) productivity is growing, (2) the decline in prices due to rising productivity completely offset the real interest rate, then a free banking regime naturally reproduces the Friedman rule.