The Unadulterated Gold Standard
The choice of the word "unadulterated" is not accidental. There were many different kinds of gold standard, including what we now call the Classical Gold Standard, the Gold Bullion Standard, and the Gold Exchange Standard. Each contained flaws; each was adulterated.
For example, in the Coinage Act of 1792, the government forced the price of one thing to be fixed in terms of another thing. The mechanism was in Section 11:
"And be it further enacted, That "the proportional value of gold to silver in all coins which shall by law be current as money within the United States, shall be as fifteen to one..."¹
Of course, people respond to such distortions. When the government fixes the price of something too low, then people will hoard or export it. If the price is fixed too high, then they will flood the market with it.
According to Craig K. Elwell, in his 2011 Congressional Research Service Report:
"Because world markets valued them [gold and silver] at a 15½ to 1 ratio, much of the gold left the country and silver was the de facto standard."²
Subsequently, the government changed direction. Elwell notes:
"In 1834, the gold content of the dollar was reduced to make the ratio 16 to 1. As a result, silver left the country and gold became the de facto standard."
If the law dictates the ratio between gold and silver, then only one metal--the one that is undervalued--will be used. It would be extremely difficult for the government to get the ratio exactly right. And even if so, as soon as the market value changed the ratio would be wrong and only one metal would circulate.
The government should not attempt to force a price onto the market. In the unadulterated gold standard, the market is allowed to set the price of silver, copper, oil, wheat, a fine wool suit, and everything else. It allows people to use gold, or silver, or seashells as money if they wish (the market has not chosen seashells in modern history).
Throughout the 19th century, there were various state laws to impose new kinds of restrictions on the banks. One popular restriction was that in order to obtain a charter (permission to operate as a bank), the bank had to buy state government bonds. This theme--forcing banks to buy government bonds--was to recur later.
This is a pernicious idea. Banks must have an earning asset to match the liability of the deposit accounts. Why not make them buy some government bonds as a condition for permission to operate? Because this is obviously blackmail. In a free country, one should not need to ask permission to be in business and one should not be forced to do something in exchange for that permission.
This policy has two economic effects. First, it pushes the price of the government bond higher than it would otherwise be, which means it pushes down the rate of interest. This distortion ripples throughout the entire economy.
Second, it exposes the state-chartered bank to the fiscal irresponsibility in the state capitol. And of course the state capitol is encouraged to borrow and spend by this very perverse policy, because they know that there is always a market for their bonds. This lasts until they default, of course. And when they do, the state-chartered banks become insolvent. This is not a failure of the gold standard, or of the free market. It is a failure of a deficit spending policy and central planning.
There is another problem with this scheme. The bank takes in deposits, especially demand deposits, and it buys bonds, especially longer-dated bonds. This is called "borrowing short to lend long", and it is dangerous because if the depositors want to redeem their gold or silver, the bank may be in a position where it has only an illiquid bond. Obviously, the depositor does not want a government bond, and so the bank can be forced to default in a "run on the bank".
All borrowing short to lend long schemes, also called "duration mismatch", collapse sooner or later. This is because the depositor, who is the ultimate issuer of the credit, is signaling that he only wishes to extend credit for short duration. But the bank has expanded long-term credit. This is not the bank's decision to make, and by disrespecting its depositors' intentions, it makes itself vulnerable to a run.³
In 1864, the National Banking Act imposed a tax of 10% on notes issued by state banks. Needless to say, state-chartered banks responded to this threat of mass robbery. There were 1466 state-chartered in 1863. Five years later, 83% of them had either gone out of business or become nationally chartered.⁴
One of the provisions of this Act was to require nationally chartered banks to hold US government bonds in order to issue nationally standardized bank notes and other liabilities.⁵ One key reason for this was that the federal government was eager to finance the civil war (1861 - 1865). In later years, when the federal government wanted to pay down its debt, this squeezed the banks and the result was deflation and panics.
The problem was exacerbated when the federal government resumed the minting of coins. The "Crime of 1873"⁶ was the name many gave to the Coinage Act of 1873, which demonetized silver. This was an enormous wealth transfer from the small saver such as the farmer who had silver stored at home into the hands of the wealthy who kept gold in the banks.
These problems occurred under the Classical Gold Standard. Even before the Federal Reserve Act of 1913, we saw the following adulterations:
A fixed gold:silver price ratio in a bimetallic monetary standard. The unintended consequence was that first gold, and later silver, fled the country
Laws forcing banks to seek permission to operate. Big-spending governments, needing a market for their bonds, forced banks to buy their bonds in various schemes in exchange for permission to operate. This exposed banks to bank runs and bankruptcy when the bonds defaulted, and created a new problem when the size of the banking system was restricted by the value of government bonds outstanding.
Demonetizing one metal shifts wealth from one class of saver to another.
Duration mismatch causes the business cycle. The boom occurs due to credit expansion beyond the intent of the savers. The bust begins when there are significant redemptions by depositors who need their money. A full panic occurs when other depositors realize that the bank is not holding either money or short-duration assets such as Bills. The bank holds illiquid long-term bonds and cannot pay depositor redemptions. The run turns into bankruptcy. The panic turns into a wide scale depression.
In Part II, we will look at the Gold Bullion Standard and the Gold Exchange Standard...
²http://www.fas.org/sgp/crs/misc/R41887.pdf, accessed Oct 2012