hear a couple things about the "money supply" with a gold standard.
The first thing you hear is that it is determined by gold mining. The second thing
you hear is that it is limited to the amount of gold held "in
reserve," whatever that means. Sometimes you hear that it is determined
by the "current account balance." All of this is bunk.
Let's look at the United States. The U.S., during the 19th century, had the
most libertarian money and banking system you could imagine. Unlike Britain,
where the Bank of England had an effective monopoly on currency issuance, it
was pretty much a free-for-all in the United States. Anyone could issue
money. Of course, nobody would accept this money unless it had a credible
link to gold. The gold link was mandated by the Constitution of 1789, and
they stuck to it (with some lapses, notably during the Civil War) until 1933.
The point here is that the idea of a gold standard was that the currency's value
would be linked to gold. The amount of currency would expand or contract,
matching demand, such that the value remained stable. The actual amount of
money was a residual, the aftereffect of the mechanism which kept the value
The "dollar" was originally a European silver coin called the
"thaler" which originated in 1518. Our
"dollars" were basically the same value as those 16th century
European coins until 1933, when there was a one-time devaluation, and the
dollar was repegged at $35/oz. Today's floating
currency system dates from 1971.
The money supply of the United States in 1775 has been estimated at $12
million. This was mostly in the form of silver coins, mostly of foreign
origin. The most common coin was the Spanish silver dollar, one of the "thaler" coins that Europe had been using since 1518.
February 28, 2010: A Gold Standard
is a Value Peg
April 30, 2006: Value and Quantity
November 6, 2009: A Brief History
of the Dollar
January 3, 2010: The GLD Standard
April 15, 2006: Where the Rothbardians Went Wrong
I think we should start here with the notion of "what is money?" So
we know what we are talking about.
Money is what is today known as "base money." It is mostly paper
bills and coins, with some electronic bank reserves. Bank reserves are the "money"
that banks use to pay each other. In the past, these bank reserves were also
paper notes and coins. Because these were large transactions (between banks),
you needed really big bills.
1918 $10,000 bill, used for large transactions
Remeber, a dollar was worth about 1/20th of an
ounce of gold in those days. So, this bill was worth 500 ounces of gold, or
about $700,000 today.
Surprising at it may seem, all monetary transactions
today are done with base money (i.e. real money). You can't pay a bill
"with a credit card." What actually happens is that the bank pays
the bill with bank reserves (i.e. a bank to bank transaction), and then
records that you owe the bank for the funds transfered.
When you pay a bill "with a checking account," what actually
happens is that the bank pays the bill with bank reserves (base money), and
then reduces the amount of money that it owes you (your checking account).
All other "forms of money" are really forms of credit. You can tell
because there is a counterparty. Who is the
counterparty for a dollar bill? Theoretically, it is the Fed, but in fact the
Fed is not obligated to do anything, at any time, just because you have a $20
bill. As opposed to a credit contract, which is a legal agreement between
counterparties, money itself is something like a manufactured object. This is
easy to see with a gold or silver coin. You have to manufacture the thing.
Paper money is the same, but the costs of manufacturing are drastically
lowered because it is made of paper instead of gold. Just like your blender,
which is now made of plastic instead of stainless steel. However, if the
money serves the same purpose as a gold coin -- by having the same value as a
gold coin -- then it works just fine, even though it is made of paper instead
June 2, 2008: World Without Paper
April 21, 2007: Weights and
April 15, 2007: The Value of
Today's Dollars in 1854 Dollars
To get back to our story, the money supply in the United States in 1775 was
about $12 million, mostly of silver coin although there were already some
banknotes floating about, issued by private commercial banks.
There was a hyperinflation in the 1776-1789 period, but for our story we will
skip over that part. In 1809, a survey of the banking system recorded 92
reporting banks with total bank notes in circulation of $3.80 million. Plus
whatever bullion coins were out and about. These banks held $1.99 million of
gold (i.e. about 96,000 ounces at $20/oz.) as a "reserve" for their
banknote issuance. By 1818, this had expanded to $18.07 million banknotes,
with $5.47m of gold in reserve. The U.S. government itself had a bit of a
funny episode of money printing, issuing $15.46 million of Treasury Notes
during this time, but they were retired so that in 1818 the entire monetary
system of the U.S. consisted of coins and these $18.07m of banknotes issued
by private commerical banks.
Imagine the United States in 1809. It stretched from Georgia to Maine. There
were no telephones or telegraphs in those days. This survey of 92 banks was the
best they could do at the time. However, there may have been other banks
issuing banknotes, not to mention coins being carried in from overseas and so
forth. So what was the real money supply of 1809? The fact is that we
don't know. They didn't know either. Did any of those 92 banks have any
idea how many banknotes were being issued by the other 91? Of course not. It
didn't matter! The only thing that was important was that the value of the
banknotes remained at its specified gold parity. This was done by the
adjustment of supply. If the value of the banknotes was sagging compared to
its bullion parity (i.e. people were bringing them in to be traded for
bullion), then the issuance of banknotes was reduced. If the value was above
the parity, more banknotes were issued.
Admittedly, this was a time of some turmoil, since it contained the War of
1812, some excess note issuance by banks in the South, issuance and
redemption of Treasury Notes, and other turmoil. We're just looking at the
operations of commercial banks here.
For one thing, we see that the amount of gold in reserve has almost no
relation to the amount of banknotes in circulation. The reserve coverage
varies wildly. Second, we see that the amount of banknotes in circulation has
no relation to the amount of gold at banks, the amount of gold in the world,
the production of gold miners, or some such thing. The important thing for a
gold standard is only that the supply matches the demand, producing a
currency whose value is linked to gold. (The purple line and right axis shows
the ratio of banknotes outstanding to bullion held.)
Now let's move along to the 1817-1840 period. Here we have a similar graph,
but for just one bank, the Second Bank of the United States. This was just
one of many commercial, note-issuing banks, but it was the largest and most
Here we see that the Second Bank of the United States had wildly varying
banknote issuance, and wildly varying gold reserve coverage. There was no
"steady expansion of the money supply due to mining." There was no
"100% reserve," or even some stable reserve/issuance ratio. The
total aggregate money supply of the United States was a lot more stable, of
course. But they didn't know that. They had no idea what all the other banks
were doing, at least not in real time. The only thing that was important for
them is that the value of their banknotes be maintained at their proper
gold parity via the adjustment of supply.
Here we have some statistics for all commercial banks from 1833-1859. We end
in 1859 because in 1860, the U.S. government began issuing
"greenback" currency not-linked to gold, and the U.S. went off the
gold standard until 1879. These statistics are from the Historical
Statistics of the United States 1789-1945.
So once again, we see that banknotes in circulation is all over the map, and
bullion reserves at commercial banks have fallen to under 20% in most
situations. (The wild variations are due to a banking crisis that began in
1837. If your bank goes bust, then the banknotes issued by that bank were
Beginning in 1860, the free-for-all libertarian banking system was reformed.
The U.S. government organized the "National Bank Notes" system,
whereby banknotes would only be issued by certain chartered banks. This was
to assure people that their banknotes came from a reasonably respectable
institution. There were lots of National Banks, however, not just a handful.
After the removal of the "greenbacks," the entire U.S. monetary
system consisted of these National Bank Notes issued by private commercial
banks. There was no government or Federal Reserve-issued money. Of course,
all these National Bank Notes were linked to gold, via the mechanism of supply
adjustment, with supply adjustment still performed on a bank-by-bank basis.
However, the gold reserve for the National Banks was aggregated at the
Treasury. The banks themselves held Treasury obligations (debt).
Typical National Bank Note, from the Annville National Bank of Annville,
Let's continue our story from 1880, when the dollar was returned to the gold
standard at $20.67/oz. after the Civil War devaluation. By this time, silver
has been demonetized, so we are effectively on a gold-only standard
(monometallic) although this was not made official until 1900. The Treasury
ended up holding a lot of silver in those days. Bullion reserves are given in
gold-only terms and also in gold+silver terms, with
the silver accounted for at market prices. This is the first time we have
reliable system-wide statistics.
September 12, 2010: the Gold:Silver
Once again, we see that banknote issuance by no means stays in some stable 2%
per year trend defined by gold mining, nor does it maintain any stable ratio
with bullion reserves. Bullion reserves vary from 30% to 60% during this
period. Counting gold alone (as you should, because this was really a
monometallic standard), we see that they drop as low as 12% or so. What
stayed stable during this time was of course the value of banknotes,
as defined by their $20.67/oz. gold peg.
We have come to the end of our first century. We began in 1775, with the
dollar pegged to gold near $20/oz., and we ended in 1900, 125 years later,
with the dollar still pegged to gold near $20/oz. (in actuality there was a
little bit of variation, but let's just call it even point-to-point).
Remember that we began our show with $12 million of money, mostly in the form
of foreign silver coins. In 1900, including gold and silver coins, we have
$1,954 million of notes and coins, an increase of 163 times over 125 years.
So we see that a gold standard does not at all limit the money supply to some
fixed quantity. The money supply increased by 163 times! However, the value
of money was stable, at $20.67 per ounce of gold.
As it turms out, we have some statistics on world
gold production going back to 1493. Let's start our story in 1780:
From this we can see that the total amount of aboveground gold increased by
about 3.4x. Not 163x. Three point four times. So explain to me again how it
is that "money supply" is determined by "gold
production"? Of course it's baloney.
Why did the total currency in circulation expand by 163 times? Because the
United States was an expanding economy. The population of the U.S. was 5.24
million in 1800 and 76.21 million in 1900. Plus, each of those people got a
lot more wealthy during that time as well, due to the Industrial Revolution.
Also, financial systems became a lot more complicated, so there were a lot
more monetary transactions. With a different country, which didn't enjoy such
an amazing expansion during that time -- China perhaps -- you would have a
totally different result, even with a gold standard. A gold standard is a
system where supply is expanded (or contracted) to meet the demand for money,
such that the value of money remains stable, i.e., pegged to gold. There was
a lot of demand for money in the U.S., maybe not so much in China.
As I argued earlier, it's a lot like today's gold-linked ETFs:
January 3, 2010: The GLD Standard
An ETF is a lot like a paper currency in some ways. Both are
"paper," although an ETF is not even that. ETFs are supposed to
have 100% bullion coverage, but in fact that is probably a bit of a fib. The
point is, why does GLD have the "money supply" (shares outstanding)
that it does today? GLD issues shares in response to market demand. If the
market threatens to push the value of GLD above its gold bullion peg, more
shares are issued. If people demand less GLD -- they're selling -- then
shares are purchased and removed from circulation to support the value, once
again keeping it pegged to gold bullion. This is the exact mechanism that
paper currency issuers used in the 19th century. It has nothing to do with
mine supply, or gold reserve holdings. GLD does not go out and buy gold
bullion, on a whim or something like that, and then issue shares in
proportion to the bullion purchased. No no no. It's all driven by market supply and demand. For
example, what if we decided that GLD was bogus, and the Julius Baer gold ETF
was our preferred gold ETF of choice? Then we would sell GLD and buy the Baer
fund. The "money supply" (shares outstanding) of GLD would contract
and the "money supply" of the Baer ETF would increase. Both would
remain pegged to gold (ideally).
That is pretty much how a gold standard system works. It is a system that
links a paper currency to gold via a mechanism of supply adjustment. This
situation of "multiple ETFs linked to gold" is very much like
"multiple world currencies linked to gold." Would the base money
supply of France or Britain grow or contract at the same rate as the U.S.,
even if all the currencies were linked to gold? Of course not. They would
vary depending on the demand for francs, pounds, and dollars, just as the
shares outstanding of various ETFs vary depending on how much people want to
own one ETF instead of another.
By now, you may have figured out that most everyone, the mainstream academics
and Nobel-Prize-winning newspaper columnists, the Rothbard
amen corner and other "goldbug" types,
mostly have no idea what a gold standard is.
December 15, 2010: The Biggest
But there needs to be more than me and a couple obscure academics (and a
handful of "supply siders") who understand this stuff. Now, there
is me and you. Really, that's all there is. You can look for some other group
that has been able to figure this stuff out, but you will never find it. It
doesn't exist. Just me and you. We have to start somewhere.