The Bottom-Up Gold Standard

Fifty years ago, on the evening of August 15, 1971, President Richard Nixon addressed the American people to announce several measures to address a trinity of economic problems engulfing the United States: specifically, mounting unemployment, rising inflation, and growing disequilibrium in the balance of payments.

Perhaps the most consequential change was President Nixon’s suspension of the U.S. dollar’s convertibility into gold. No longer would foreign governments be able to exchange their U.S. dollars for gold as per the Bretton Woods system. Though the Nixon Administration presented this suspension as a temporary measure, it became permanent—primarily, it turns out, because of Nixon’s choice of policy advisors and his own preferences for open capital flows and stimulative monetary policy. What had been an international monetary system based on a dollar-exchange standard was turned into one based on fiat money, thereby cutting the world’s last remaining association with the classical gold standard: the international monetary system that had been based on the principle that money issued by nation-states was freely convertible into gold at a fixed price.

The classical gold standard had disintegrated almost sixty years earlier when the Great Powers deployed inflationary measures to finance military expenditures throughout World War I. Its successor, the gold exchange standard, likewise fell apart in 1931 as governments struggled to contain unemployment in the midst of the Great Depression. Nevertheless, often-heated arguments about the gold standard’s strengths and weaknesses continue today. This tells us that something more is a stake in these debates than just the conduct of monetary policy.

Economics leads to Politics

Advocates of the gold standard typically stress its impressive record in promoting long-term price stability. Lewis E. Lehrman and John D. Mueller point out, for instance, that when the classical gold standard was at its zenith (roughly 1879-1914) “average annual CPI inflation [in America] was 0.2 percent, with average annual volatility (up or down) of only 2.2 percent.” “No other standard,” they add, “comes close in combining low average inflation with low volatility.” In a similar vein, Lawrence H. White observes that “historical comparison shows that [the gold standard] has provided more moderate and steadier money growth in practice than the present‐​day alternative, politically empowering a central banking committee to determine growth in the stock of fiat money.” A second oft-cited benefit was that the classical gold standard reduced uncertainty in international trade by fixing international exchange rates between those countries which participated in it.

Gold standard skeptics, by contrast, underscore an association between intermittent surges in the world’s gold stock and high-levels of short-run price volatility. The same critics maintain that the gold standard can unduly slow down growth. The money supply, they argue, should increase as an economy’s productivity grows. Given that the essence of the gold standard is the insistence that money must be backed by gold, gold’s natural scarcity hinders the economy’s ability to produce more of the capital it requires to continue expanding.

The gold standard’s defenders would respond that this was how it helped to smooth the boom-bust cycle over the long-term and inhibited inflationary breakouts. Moreover, they would add, by reducing the uncertainty and risk associated with fluctuations in the value of money which had nothing to do with the relative valuation of different goods and services, the gold standard incentivized productivity and investment precisely because of the confidence that prices would remain relatively constant over time.

When you look at the writings of many gold standard critics, you soon discover that their main objection is less about economics than politics. A common complaint is that the gold standard limited the ability of state institutions to manage the economy. For if the money supply is determined by the gold supply, monetary policy no longer exists as a tool which state officials believe they can use to proactively stimulate or slow down economic growth. Debates about the gold standard thus play into long-standing disagreements about the state’s proper economic role, how much faith should be placed in governments to manage economies, and the economic goals that state officials should prioritize in the short and long-term in a world in which trade-offs are inevitable.

Ruled-Based Money versus Political Money

“We have gold because we cannot trust governments,” Herbert Hoover famously said in 1933. Hoover was referring to the well-documented ways in which governments from time immemorial have manipulated the currency to achieve various ends. Back in the late sixteenth-century, for example, the Jesuit moral theologian Juan de Mariana railed against the Spanish monarchy for engaging in currency debasements as it tried unsuccessfully to stave off state bankruptcy and fund what seemed to be endless wars across the globe.

From this perspective, the gold standard’s most obvious political effect was the limitation which it placed upon modern governments to behave in similar ways. When nations embraced the gold standard, they were accepting a set of rules which enforced the priority of long-term price stability and implied a willingness to resist pressures to manipulate the currency to realize other goals.

In grave national emergencies, it wasn’t unusual for nations to suspend convertibility. Britain did this, for example, during its long struggle with France in the 1790s and 1800s. The operating assumption, however, was that convertibility at the original rate would be restored once the emergency was over. The fact that Britain returned to convertibility in 1821 had the effect of reinforcing its commitment to gold parity and the restraints associated with this.

Embracing the gold standard’s rules does not, however, sit well with those who believe in high degrees of government economic activism. If you hold, for example, that the state can and should soften the impact of recessions by increasing the money supply during economic downturns, or that the government’s economic priority must be full employment, or that central banks should have considerable discretion to use monetary policy to address economic crises, the gold standard is not your friend. For the gold standard imposed a discipline on state institutions that limited them from proactively using monetary policy to pursue such objectives.

That same discipline also meant that if governments really wanted to tackle major problems like long-term unemployment or persistently low-growth rates, they would have to take highly unpopular measures like liberalizing sclerotic labor markets dominated by over-mighty unions or opening the economy up to more domestic and foreign competition. Not surprisingly, many political leaders prefer tinkering with monetary policy to provide short-term relief and avoid making difficult decisions—just as it’s easier for drug-addicts to find short-term relief from their pain by getting high again rather than making the hard choice to confront the challenges at the core of their dysfunctional behavior.

In other words, the classical gold standard’s development as a universal basis for monetary stability and as a global payment community was not planned, let alone implemented by a supranational institution. It’s not coincidental that the classical gold standard emerged at a time in which capital, labor and goods moved with relative ease across national boundaries. Its appearance and workings reflected the late-19th century’s greater faith in human liberty than that which prevails today.

There is, however, something else about the logic underlying the gold standard that generates negative responses in some quarters. It is that the gold standard’s rules reflected a tacit acknowledgement that state institutions really can’t know things like what the optimal discount rate will be today, tomorrow, next Easter, or 15 months from now. For to know such things would require monetary policymakers to be able to assimilate ever-increasing and ever-changing amounts of data that they can’t possibly master in real time, let alone draw definitive conclusions from. At best, they are making informed guesses. The situation is worsened by the fact that the data upon which they are reflecting upon is invariably months-old by the time it is considered by the monetary policy decision-makers, as well as the reality that the same information has been filtered and processed by the people working for them.

Once we accept all this, our willingness to take monetary policymakers’ prognostications seriously should become heavily qualified. By contrast, the gold standard didn’t aspire to overcome the knowledge problem which manifests itself as much in monetary policy as in any other area of economic life. It simply embodied rules that created a standard for comparing the monetary value of everything. In this regard, the gold standard’s objectives were clear, specific and more modest than, for example, trying to guarantee perpetual full employment. Yet it delivered on its basic promise and didn’t encourage people to view state officials as quasi-divine Masters of the Universe.

Monetary Order from the Bottom-Up

That points to another aspect of the gold standard with political implications. As the ordo-liberal economist Wilhelm Röpke emphasized, the classical gold standard rested upon different monetary authorities of various nations voluntarily agreeing, and without recourse to formal treaties, “to behave in matters of monetary and credit policy in such a way that this fixed and free coupling remained an undisputed permanent institution.” A respect for national sovereignty was thus combined with the idea that civilized nations will keep promises to each other and freely conform to particular norms, even in the face of immense pressures to break the rules.

To this extent, the classical gold standard was an international monetary system that emerged from the bottom-up instead of being imposed from the top-down by some type of world central bank like that proposed by Lord Keynes at Bretton Woods. In other words, the classical gold standard’s development as a universal basis for monetary stability and as a global payment community was not planned, let alone implemented by a supranational institution. It’s not coincidental that the classical gold standard emerged at a time in which capital, labor and goods moved with relative ease across national boundaries. Its appearance and workings reflected the late-19th century’s greater faith in human liberty than that which prevails today.

What were the period’s equivalent of central banks certainly had a role insofar as they were responsible for controlling the discount rate in order to alter the gold inflow. We also know that the heads of institutions like the Bank of England were informally in touch with each other throughout adjustment periods. The point, however, is that they freely bound themselves to rules. Though there were occasions when the rules were departed from—most notably when some countries permitted exchange rates to diverge from par—the monetary authorities generally declined to tinker with the gold standard to try and address specific domestic economic challenges.

In this sense, as Röpke was fond of stating, the classical gold standard contained the essential components of an international monetary standard—unity, stability, and freedom—and integrated nations into an international payments system unparalleled in history, but without any of these countries subordinating themselves to a supranational authority. That stands in vivid contrast to contemporary proposals for monetary reform that argue for some type of global monetary authority which operates much as the European Central Bank does for nations who are members of the euro-zone.

The classical gold standard certainly had its fair share of weaknesses, but arguably no more and perhaps even far less than the monetary systems with which the world is presently lumbered. While the prospects for its revival are presently dim, the gold standard’s history reminds us that not every economic challenge demands a centralized political solution. In many cases, it turns out, bottom-up is better.