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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...
¹http://nesara.org/files/coinage_act_1792.pdf,
accessed Oct 2012
²http://www.fas.org/sgp/crs/misc/R41887.pdf, accessed Oct 2012
³http://keithweiner.posterous.com/duration-mismatch-necessarily-fails
⁴http://en.wikipedia.org/wiki/National_Bank_Act
⁵http://www.let.rug.nl/usa/essays/general/a-brief-history-of-central-banking/national-banking-acts-of-1863-and-1864.php
⁶http://en.wikipedia.org/wiki/Coinage_Act_of_1873
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