Gold Standards, the State, and Free Banking

By: Ed Bugos | Tue, Aug 5, 2003
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"The gold standard has been destroyed chiefly because it was an obstacle to inflation" - Friedrich Hayek, Can We Still Avoid Inflation? (From a 1970 lecture before the Trustees and guests of the Foundation for Economic Education at Tarrytown, New York)

"Proponents of the gold standard do not suffer from a mysterious "gold fetish." They simply recognize that gold has always been selected by the market as money throughout history" - Murray Rothbard, Mystery of Banking (1983); pp 11

Mises too had already told us why the gold standard failed. More accurately, he hinted at why it was going to fail.

In different wording, and with regard to the policy of hoarding gold in order to prevent commodity prices from rising (remember, the dollar was fixed to gold at the time, so this was really dollar policy) followed by the Federal Reserve System between 1914 and 1924 he said:

"we might even now without undue exaggeration say that gold has ceased to be a commodity the fluctuations in the price of which are independent of government influence. Fluctuations in the price of gold are nowadays substantially dependent on the behavior of one government, namely, that of the United States." (pp.431; Theory of Money and Credit, Chpt 20 on Money and Banking; Section 3.9 - Problems of Credit Policy in the Period Immediately After the War)

In the underlined part of the passage above he was effectively saying that gold no longer was a sound money, according to the Sound Money principle, because the Federal Reserve managed its fluctuations (uh, manipulation?).

The sound money principle does not mean the unattainable idea of stable money. It simply means the market decides on what money is, and what its worth. In this way, the Austrian School argues, money would be more stable than it is when inflation is allowed to expand unchecked. Sound money simply excludes government in both money and banking affairs.

At best, the gold standard can probably be no more than a pragmatic application of the sound money principle. At worst, it can be the wolf in shepherds clothing, or a Trojan horse; a deceitful compromise by the powerful.

Imagine it like a front in an illicit drug operation.

Only One Good Gold Standard, But Several Bad Ones
In a recent note to my subscribers I made the comment that the gold standard was abandoned in 1933/34 in the United States.

Understandably, many were puzzled. For they thought that President Nixon took America off the gold standard in 1971 (actually, the window officially closed in 1973, but with hindsight the case is frequently made that at the time most people knew the 1971 suspension was probably going to be permanent). But the gold standard that Richard Nixon abandoned was a "gold-exchange" standard.

The 1946-1971 Bretton Woods monetary system was modeled after the gold exchange standards that existed in Europe between the two World Wars. Under the typical gold exchange standard, the nation outlaws gold coinage, and restricts convertibility.

For instance, Britain in the 1920s allegedly returned to the gold standard it abandoned in 1914, but made the pound convertible only into bullion (as opposed to coins), so that only large traders had the privilege of convertibility. It was a debased form of a gold standard if you will.

Moreover, it returned to the gold standard at the prewar (overvalued) rate for the pound. Instead of solving the attendant problems with monetary deflation, or by applying sound money principles to increase the Pound's value:

"Great Britain persuaded the other European countries at the Genoa Conference of 1922 to go back, not to a genuine gold standard, but to a phony gold exchange standard. Instead of each nation issuing currency directly redeemable in gold, it was to keep its reserves in the form of sterling balances in London, which in turn would undertake to redeem sterling in gold. In that way, other countries would pyramid their currencies on top of pounds, and pounds themselves were being inflated throughout the 1920s. Britain could then print pounds without worrying about the accumulated sterling balances being redeemed in gold." (Rothbard; Mystery of Banking; pp.246)

Later, when the United States abandoned its government guaranteed gold standard, it adopted this model. The Bretton Woods monetary system was premised on just such a recycling (pyramiding) scheme, except with more members and the reserves this time were Federal Reserve Notes.

The world had their currencies pegged to the dollar, and the dollar was redeemable in gold. But what made the Bretton Woods system a gold-exchange standard was that gold coins weren't allowed in circulation; individuals in the United States were restricted in owning both bullion and coins (from 1934 until 1973/75).

The same kind of centralized pyramiding of Federal Reserve Notes goes on today, except there isn't even a phony gold standard in place to deceive people. It isn't necessary. For, inflation is indeed the true opium of the people...

It's only necessary if the people are opposed to inflation. Then you've got to fool them somehow if you want to keep it going. Ludwig von Mises said this about the gold-exchange standard:

"The gold-exchange standard, whatever argument may be advanced in its favor, is vitiated by an incurable defect. It offers to governments an easy opportunity to embark upon inflation unbeknown to the nation. With the exception of a few specialists, nobody becomes aware in time of the fact that a radical change in monetary matters has occurred. Laymen, that is 9,999 out of 10,000 citizens, do not realize that it is not commodities that are becoming dearer but their tender that is becoming cheaper." (Mises in the Theory of Money & Credit; pp. 494 on the Return to Sound Money)

We call such gold standards clunky government rig jobs. Or I like to call them the Trojan Horses. Awarding the government the ability to regulate money and to award banking monopolies is as Gary North (popular contemporary Austrian economist) recently put it:

"a government-guaranteed gold standard is to money what government-guaranteed health inspection is to prostitution. Both guarantees are subsidies to the providers. Both guarantees create the illusion of decreased risk. Finally, the operations of both systems are best described by the same verb" - Gary North; Two Kinds of Gold Standard - July 25th, 2003

In his essay, however, North didn't differentiate between the classical gold standard (which existed in the US between 1896 and 1933) and the gold exchange standard (which the Bretton Woods system effectively was).

He differentiated between a market determined gold standard and a government guaranteed gold standard. If I may be so bold, the world has rarely, if ever, been witness to the former.

The classical gold standard in the United States was a government guaranteed (or traditional) gold standard. It differed from the gold-exchange standard, but it also differed from the ideal free market established gold standard.

Consider Gary North's conclusion:

"The State's gold standard is a preliminary to eventual confiscation or debasement. The State's promise of redemption on demand should not be trusted.

A gold coin standard by profit-seeking storage organizations can be trusted with less risk, but not if the storage is offered for free. There are no free lunches. Someone will eventually pay for free services. When it comes to fractional reserve banking, that someone is always the late-coming depositor.

This is why any call by conservatives for the State to adopt a gold standard is futile. No one will listen. Even if voters understood the case for a limited State, they would not be able to limit the State by a State-run gold standard. A State-run monetary system, with the exception only of Byzantium, becomes a debased standard.

This is why the free market is the only reliable source for the re-establishment of a gold standard. Honest money begins with these steps: (1) the revocation of legal tender laws that require people to accept the State's money; (2) the enforcement of contracts; (3) laws against fraud, which fractional reserve banking is. The free market can do the rest."


Thus, while I often refer to the traditional gold standard in America (1896-1933) as the last gold standard, I only mean to differentiate between the traditional gold standard and the gold-exchange standards. By no means do I mean to imply that particular gold standard was sound.

On the contrary, as North says, and as history has shown: "The State's gold standard is a preliminary to eventual confiscation or debasement. The State's promise of redemption on demand should not be trusted."

Legal Tender Laws, Central Banking are Obstacles to Sound Money
To understand how a market would determine the gold standard (and how it determines money) one needs only to understand how a market works free from intervention.

But to understand why the State's gold standard fails Sound Money doctrine and leads to confiscation/debasement, I think the reader needs to understand that the real conflict is between free decentralized banking and monopoly / centralized banking, as both Mises and Rothbard showed, rather than simply a matter of discipline. The State, through granting legal tender privileges (i.e. the government decides what constitutes a legal unit of account, which means that all creditors and merchants are legally forced to accept a specific fiat currency in exchange for their labor, goods, and/or in settlement of all debts), always endorses the latter. And the latter is inflationary.

Mises argued that:

"The real obstacle in the way of an unlimited extension of the issue of fiduciary media is not constituted by legislative restrictions of the note issue, which after all, only affects a certain kind of fiduciary medium, but the lack of a centralized world bank or of uniform procedure on the part of all credit-issuing banks." (on Peel's Act - Chpt 20: Money and Banking; pp. 411, Section 2.2 in the Theory of Money and Credit)

Murray Rothbard, a Mises student, went on to write several books on the subject of money and banking. He discussed this conflict (centralized versus decentralized) at great lengths. He built on what Mises discovered.

Rothbard argued that central banking began in England in the 17th century as a "crooked deal between a near-bankrupt government and a corrupt clique of financial promoters," and specifically that it wasn't the product of a natural market evolution.

In the Mystery of Banking, he says, "On the contrary, it was the result, as Bagehot put it, 'of an accumulation of legal privileges on a single bank.'"

Rothbard too focussed on Peel's Act as a pivotal moment in the conflict.

Peel's Act was a controversial restrictionist measure; controversial because Sir Robert Peel and his clique were from the leading opposition to Inflationism, yet the act simply awarded the Bank of England more legal power over note issue.

As Rothbard said:

"In a praiseworthy attempt to end fractional reserve banking and institute 100% money, the Peelites unfortunately decided to put absolute monetary power in the hands of the very central bank whose pernicious influence they had done so much to expose. In attempting to eliminate fractional reserve banking, the Peelites ironically and tragically put the fox in charge of the proverbial chicken coop." (pp188 -- Mystery of Banking)

The other main Rothbard-Misesean criticism of Peel's Act was that the British Currency school (dominated by Peel at the time) stubbornly refused to acknowledge demand deposits, or anything but the central bank's notes as money. So banks were able to issue demand deposits beyond the restrictions, and inflation reigned.

The sound money principle was upended.

The failure of Peel's Act became the academic world's example of why a man made restrictionist policy can't work to check inflation, and in the more extreme interpretation, why central banking can't work. But in reality it became the pivotal point inducing the unbridled growth of central banking, and the abandonment of sound money doctrine, which as many Austrian School economists argue occurred in the late 19th century.

The reason restrictionist measures can't work in the context of a centralized banking system is, "a monopoly bank privileged by the State could not, in practice, be held to a restrictive 100% rule. Monopoly power, once created and sustained by the State, will be used and therefore abused." Forget about theory. That's the reality of it all.

Several times after Peel's Act was enacted, the Bank of England suspended it (1847, 1857, 1866, and 1914) when the inflation induced booms busted, and its banks didn't have enough cash reserves to settle redemption demands.

What this means in lay terms is that any claims by a central bank that it could restrict the growth of money has been proven absurd by the failure of one of the strictest attempts in recent history, let alone events of the recent past. A central bank's reputation as a regulator of a free banking system is ironically limp, or outright deceptive at worst. Its independence from the government is not even theoretically valid so long as it is the government which grants it its monopoly.

Yet there are those who argue that a central bank is the product of the natural evolution of a free banking system. For, everywhere there was free banking, there is now a central bank!

Rothbard pointed out two things in the "Mystery of Banking."

First, banking in Scotland was free between 1727 and 1845 - until it ended when the British Government ratified Peel's Act in 1845. Second, he made the controversial contention that banking in the United States even before the Civil War was never really free (i.e. decentralized).

Since we're not discussing the Fed's origins we'll put aside the second point except to the extent the reader understands my main point here: the Federal Reserve was not the creation of a free decentralized banking system. On the contrary, Rothbard showed it was a State system, which led to the National Bank Acts after the Civil War, which resulted in the centralized banking structure that in the end required a lender of last resort.

Free Banking in Scotland, however, was free in the sense that it was decentralized, and each bank checked the other by calling on it to redeem in each others notes. Rothbard found:

In contrast to the English banking system, the Scottish, in its 120 years of freedom from regulation, never evolved into a central banking structure marked by a pyramiding of commercial banks on top of a single repository of cash and bank reserves. On the contrary, each bank maintained its own specie reserves, and was responsible for its own solvency. The English "one-reserve system," in contrast, was not the product of natural market evolution. On the contrary, it was the result, as Bagehot put it, "of an accumulation of legal privileges on a single bank." Bagehot concluded that "the natural system—that which would have sprung up if Government had left banking alone—is that of many banks of equal or not altogether unequal size." Bagehot, writing in the midnineteenth century, [p. 187] cited Scotland as an example of freedom of banking where there was "no single bank with any sort of predominance."

In a footnote he added:

Walter Bagehot, Lombard Street (Homewood, Ill.: Irwin, 1962), pp. 3233; White, "Free Banking," pp. 42-43. Furthermore, Scottish free banking was never plagued by any problem of counterfeiting. Counterfeiting is generally a function of the length of time any given note remains in circulation, and the average Scottish bank note lasted a very brief time until a competing bank would return it to the issuing bank through the clearinghouse for redemption. Emmanual Coppieters, English Bank Note Circulation 1694-1954 (The Hague: Martinus Nijhoff, 1955), pp. 64-65; White, "Free Banking," pp. 43-44.

Scottish bank notes became so prominent that they were frequently used in the North of Britain in the early 19th century, while the British notes never made it into circulation in Scotland.

The structure of the Scottish banking system wasn't centralized.

So what happened. How did they fall prey to this debauchery? Or are the central bankers right? Is central banking simply the natural progression of a free banking system?

Rothbard said of the Bank of England's new powers in Scotland at the time:

"One interesting point is the lack of any protests by the Scottish banks at this abrogation of their prerogatives. The reason is that Peels 1845 Act suppressed all new entrants into Scottish note banking, thereby cartelizing the Scottish banking system, and winning the applause of the existing banks who would no longer have to battle new competitors for market shares." (Mystery of Banking)

When people become rich and successful, I suppose it's just human instinct for them to want to protect their livelihoods. That's what seemed to happen here. The Scottish bankers that survived the discipline of the market no longer wanted to compete. They were seduced by the Bank of England. They were offered a cartel.

It's the same in any industry. Few people want market discipline today, yet that's our only real challenge in society. To serve the market!

There can be no discipline in banking so long as there is a central bank, awarded the power to issue notes at will. And there can be no free banking so long as governments can enforce legal tender laws (which support the centralized structure).

Free banking means every bank has to keep appropriate quantities of "specie reserves," and is subject to "calls for redemption in specie by other, competing banks as well as by the general public." It is a decentralized form of banking, as opposed to today's "centralized banking system, able to inflate the supply of money and credit in a uniform manner."

Smarter people than me say so. The problem today is the modern financial man refuses to believe that the subject of money is as simple as disciplining banks and governments through a market determined gold standard.

Indeed, the traditional gold standard is no more viable than Peel's Act was in its aim, so long as the banking system retains its monopoly over money; so long as it remains centralized.

Thus, legal tender laws are the main barrier to a viable gold standard because they are responsible for creating the need for a centralized structure to begin with. A centralized structure is needed to ensure the inflation is controlled.

In this regard, Rothbard noted that the Federal Reserve System was not simply a lender of last resort, but a powerful, proactive engine of inflation, as its creation was the last piece of the centralized structure in America's banking system put in place:

"The new Federal Reserve System was deliberately designed as an engine of inflation, the inflation to be controlled and kept uniform by the central bank." (Mystery of Banking)

Controlled and uniform.

It is the key advantage of a centralizing banking system. Not to prevent inflation. But to "inflate the currency in a smooth, controlled, and uniform manner throughout the nation."

That might help you understand what they mean today when they say "inflation is under control." They realize they can't say there isn't any inflation, so they say things like that, or that deflation risks are larger than inflation risks, or they discuss inflation expectations, or they redefine inflation as the rate of change in certain prices.

But they never say there is no inflation in money and credit. At least I've never heard them say it that way. The main point is that the repeal of legal tender laws would in all likelihood lead to a decentralized free banking system, one which a gold standard could more easily check.

Will They Confiscate Gold This Time?
Diane Francis wrote an article for the Financial Post, and she ended it asking, if gold threatens to rise, and in doing so threatens our economic system, why wouldn't the government confiscate it again as it did in 1934?

The answer to this question is simple: they can't blame the gold standard this time around.

You see, gold isn't the problem. Inflation is. When gold is going up, it simply means the public is losing confidence in the State's money.

The problem is that capitalism can't work well when the inflation alters the economy's price structure. In the thirties, the banks and government could have blamed the gold standard because it failed to check the inflation. But they probably realized that it really failed because they didn't want the market's discipline. So instead, they blamed the gold standard for restricting their ability to stimulate the economy.

Today, there is only central banking to blame. Diane Francis might be more correct to ask, why wouldn't we abandon central banking?

The Demise of Private Property and America's "Potential" Decline
It should be clear to the student of money that Legal Tender laws are the main impediment to honest money and social progress. It's through such laws that history's most notorious central bankers have been able to sanction their banking and money monopolies, and thus to perpetrate the crimes of inflation - as against capitalism, of morality, and social justice.

I believe when way future historians look back on mankind's current struggles they'll say something like this:

For millenniums mankind struggled to overcome tyrannical rule by other men, but failed to see how easy it really was. They needed only to understand how such despotic inroads into their individual freedoms would never be possible had they subjected their kings, governments, and banks to the same kind of market discipline most all other businessmen were. In other words, they only needed to understand how inflation undermines the institution of private property. With inflation gone and out of our lives forever now, we have ingeniously eradicated the one factor most responsible for social injustices, capital depravation/decumulation, moral decay, unemployment, growing taxes, too much government, financial volatility, and even war. There's been peace for over 2000 years since the great...

I know, my optimism knows no bounds.

Congressman Paul is an optimist too (press release below). But he's also a true warrior for liberty. His aim is correct: to repeal the legal tender laws. His timing may be premature. But if only there were more like him, America could one day recover its powerful economic position in the world, rather than succumb to the decline marked by all other empires through history.

See, gold bugs aren't pessimists. We would be if we believed the world will be subject to inflation forever. Maybe then gold would be dead. The thing is, I left the concluding futuristic remark above open because it seems that throughout history, progress was only made after great tragedies... after a crisis materialized.

So where will the Inflationists take us exactly this time?

Congressman Ron Paul introduces new legislation: "The Honest Money Act, HR 2779". From last week's press release:

Absent government intervention through legal tender laws, individuals acting through the market decide what they will use as money. Historically, the free market has chosen some combination of gold and silver whenever they were available. As Dr. Edwin Vieira, the nation's top expert on constitutional money, stated: "A free market functions most efficiently and most fairly when the market determines the quality and the quantity of money that's being used." When government creates fiat money out of thin air, the purchasing power of existing dollars falls. Fiat money erodes the value of savings, and is especially harmful to those living on fixed incomes. Paul believes centralized planning in monetary affairs is as harmful as centralized planning in economic affairs.

"Fiat money is widely accepted only because of legal tender laws," Paul stated. "Throughout the 20th century, the legal tender power enabled politicians to fool the American public into believing the dollar no longer meant a weight of gold or silver. Instead, the government told the people that the dollar now meant a piece of government-issued paper backed up by nothing except the promises of the government to maintain a stable value of currency. Of course, history shows that the word of the government (to protect the value of the dollar) is literally not worth the paper it is printed on."

Obviously, our lesson hasn't been learned despite the many wars such polices have arguaby caused over the past 200 years alone.

When historians write the rise and fall of the American Empire (I sincerely hope they never do; I'm just roughing readers up a little), I hope they get it right: that people didn't realize how the sound money principle was the most effective way to protect their property from confiscation, and their freedom from tyrants.

Maybe America won't ever end up with a tyrant. Maybe the bureaucracy will just keep growing, like it has in Canada, or Japan. Socialism surely will grow.

But then, the Austrian School has shown how socialism has often led to fascism in the modern progressive era. I don't want to make that argument though. Indeed, my main point is that it could very well be different this time, but it probably won't be good.

If the institution of private property is at root the best explanation for America's relative prosperity, the demise of the sound money principle is the best explanation for its fall. And it began more than 100 years ago.

Either our generation is going to make the sacrifice voluntarily, or the next generation, our children, or theirs, will live our legacy of moral turpitude. Certainly, there is great cost involved in going to a gold standard today. But the cost of rejecting one grows as each decade passes.

Please don't mistake me for an expert or guru. I'm merely a passionate student of money.


Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

The editor is not a registered advisory and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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