Fool's Gold

By Jay Weiser

Eight centuries of Western monetary history show that bullion-based systems offer no benefits over paper-based systems.

The gold standard is a Holy Grail of otherworldly purity for which monetary knights perpetually quest. After all the stomach-churning, post-meltdown improvisations by central banks and governments worldwide—the Troubled Asset Relief Program, quantitative easing, and mortal entanglements with insolvent mega-debtors—it's natural to long for nobler days. Thus World Bank President Robert Zoellick argues for returning to gold as a monetary reference point. And in the credit market, guru James Grant yearns again to pull the Excalibur of the classical gold standard from the stone. While the current run-up in gold is a signal (whether of inflation expectations, credit problems, or lemming-like investor behavior remains to be determined), 800 years of Western monetary history shows that bullion-based systems offer no benefits over paper-based systems. Like all technocratic fixes, their rigidity can make things worse.

During the heyday of the classical gold standard, 1880-1914, claims Grant, "Central banks had the single public function of exchanging gold for paper or paper for gold." In theory, the monetary base smoothly adjusted, automatically contracting to protect the reserve when credit or inflation problems led to gold outflow, expanding when gold was turned in for central bank notes. In reality, central banks in bullion-based systems created money, engaged in open-market operations, and managed repeated crises as lenders of last resort—just as they do today. It is misleading to select a single stable 35-year period with no major wars and the giant boom of the Second Industrial Revolution—both the result of decades-long trends—and credit it to the classical gold standard.

Bullion-based systems have two major problems. First, supply is ordinarily fixed in the short term, creating deflationary pressure when economic activity expands: there is not enough coin to go around. As far back as the Middle Ages, bullion stocks were insufficient for commerce, not to mention costly to transport and safeguard. Before central banking, this led to currency debasement. As Carmen Reinhart and Kenneth Rogoff have documented, over centuries, the proportion of silver (the original European monetary base) in coinage inexorably dropped to a small fraction; by the 19th century it was quasi-fiat money._¹

Source: This Time is Different: Eight Centuries of Financial Folly (Princeton U. Press), Carmen M. Reinhart & Kenneth S. Rogoff, p. 178 (2009).

Given the limits of bullion, private bankers, such as the Medici, created money in the form of negotiable bills of exchange. In theory, these bills were convertible to bullion, creating an incentive for sufficient bank bullion reserves; in reality, they were backed by the quality of all the issuer's assets. Bills of exchange operated as cash and were rarely redeemed: as in any banking system, circulating currency was a small part of the monetary base, at least for major transactions. (Think M1 and M2 today, which include currency, demand deposits, and money market funds.) Then as now, no bank had enough reserves to immediately pay 100 percent of its obligations during a run. Major houses that wrecked their credit with bad sovereign loans, such as the Peruzzi and Bardi² banks, went bankrupt.

Bullion production was uneven, creating a second major problem: huge swings in the monetary base unrelated to the rate of economic growth and the size of economies. Large discoveries triggered massive expansion and inflation, but when mines played out, sudden production drop-offs caused contractions—the opposite of Milton Friedman's prescription for a constant rate of monetary base growth. Early modern Spain is the poster boy: after its conquest of South America, the giant Potosí silver mountain fuelled inflation and imperial overstretch in a series of Reformation-era wars, followed by multiple bankruptcies when production decelerated around 1590, then declined in the 17th century.³ Similarly, the silver supply surge created by the mid-19th century discovery of Nevada's Comstock Lode generated Japanese inflation that helped topple the Tokugawa Shogunate.⁴

Source: “Long-Term Silver Mining Trends in Spanish America: A Comparative Analysis of Peru and Mexico,” American Historical Review, Vol. 93 Issue 4, Richard L. Garner, p. 900, (October 1988).

The first modern central bank, the Bank of Amsterdam (founded 1609, early in the Dutch Republic's Golden Age of economic dominance), devised proto-modern solutions for stabilizing its silver monetary base. As 17th-century Latin American silver production dropped, debtors flooded the Dutch economy with debased foreign silver coinage, creating a stagflation risk. The Bank experimented with a bullion standard, converting different coins to paper at fixed exchange rates, but it could never get the rates right for long, triggering Gresham’s Law events where bad money drove out good. The Bank eventually adopted the Bretton Woods-like solution of ending silver convertibility for its reserves in significant commercial transactions, issuing publicly traded notes, and regulating the supply of silver and interest rates through open-market operations. The Dutch florin became Europe’s stable reserve currency from about 1680-1780.⁵

The Bank of England (founded in 1694 to fund the world war against France’s absolutist Louis XIV) moved to a gold standard in 1717 when Master of the Mint Sir Isaac Newton drove silver off the market by accidentally overvaluing gold.⁶ Although nominally on a bullion standard, the Bank suspended it during the world war crises of 1696 and 1797 (anticipating the suspension of the classical gold standard with the onset of World War I in 1914). In some of the eight crises in between the early suspensions, the bank's merchant and trader creditors voluntarily agreed to take paper instead of bullion.⁷ The first print reference to The Old Lady of Threadneedle Street, a 1797 post-suspension cartoon, shows her in a dress made of banknotes, crying rape as the handsome Prime Minister, William Pitt the Younger, seduces her while shaking gold guineas out of her pockets.

Source: James Gillray, "Political Ravishment, or The Old Lady of Threadneedle St. in Danger!" (Hannah Humphrey, May 22, 1797), reproduced by New York Public Library.⁸

The late stages of the Napoleonic Wars triggered severe inflation.⁹ In response, politicians fetishized the gold standard. The Bank resisted a return, fearing deflation and an inability to provide liquidity in crises. Subsequent events showed that the Bank was right, with parallels to both Britain's catastrophic post-World War I gold standard resumption of 1926, which helped trigger the Great Depression, and to post-2008 improvisations.

Parliament, spurred by economist David Ricardo, passed a gold standard resumption bill in 1819. In response, prices dropped by 36 percent over the next three years. This triggered worker unrest, which the government quelled with the Peterloo Massacre in Manchester (1819), killing 11 and injuring hundreds.¹⁰ (Like many brilliant economists to come, Ricardo insisted that the problem was not with his plan, but with the incompetents executing it. He was rumored to have recanted on his deathbed in 1823.¹¹) By 1822, the Prime Minister, Lord Liverpool, who had backed the 1819 resumption bill, was threatening legislation to force the Bank to pump money into the system so that the government could fund proto-Keynesian poor relief payments.¹²

The economy recovered by 1824, thanks to an emerging markets boom in newly independent South American nations—and the Bank's gold reserves fell by 74 percent, starting a new crisis. In 1825, the Bank abruptly tightened credit to defend the gold standard, causing 64 banks to fail, but the run continued, even as the government demanded that the Bank "pay out to the last penny." (One government member helpfully suggested that if the Bank's "gold was exhausted, they should place a paper against their door stating that they had not gold to pay with, but might expect to have gold to recommence payment in a short period." ¹³) In the end, Nathan Rothschild arranged a last-minute gold facility from France.¹⁴ Although Grant’s flinty lender of last resort restricts itself to “emergency lending against good collateral at a high rate of interest,” in 1825, the Bank of England worked overtime to print new notes, then literally turned its agents into traveling salesmen of liquidity, flooding the country with paper in exchange for a wild agglomeration of assets. It tripled its discounts in a few weeks from ₤5 to ₤15 million. "[W]e were not on some occasions over nice," Bank Director Jeremiah Harman told Parliament,¹⁵ channeling Federal Reserve Chairman Ben Bernanke.

The crisis abated, but an automatic, smoothly adjusting gold standard failed to take hold. An 1839 crisis required another emergency French gold facility. With the enactment of Robert Peel's Bank Charter Act of 1844, Parliament mandated a statutory exchange rate and what turned out to be excessive reserves. The Act forced the Bank, operating on a "thin film of gold,"¹⁶ into a giant pro-cyclical credit contraction in the agricultural/railway crisis of 1847. Asked about providing emergency liquidity, Bank Governor James Morris effectively said "it's not my job": "[W]hether Her Majesty's Government might have any political Reasons, such as Fear of Mills being stopped, or Riots in the Country, was a Question for them to decide, and one which we could not answer."¹⁷

The Government finally caved in, suspending the Act in 1847 (Peel, like Ricardo, blamed the incompetent Bank rather than his law) and during subsequent crises in 1857 and 1866;¹⁸ the 1890 Barings crisis was resolved with a third French gold facility.¹⁹ Despite the 1844 Act's attempt to create a statutory straitjacket, Walter Bagehot in Lombard Street (1873) dismissed it as "only a subordinate matter in the money market."²⁰

The 1866 crisis was followed by a deflationary expansion in the UK, as the Second Industrial Revolution took off and the post-Civil War American South returned to world cotton markets. The adoption of the post-1880 classical gold standard—59 countries hewed to convertibility by the start of World War I ²¹—followed rather than caused these structural changes. Much of the classical gold standard's success came from increased supply: deflation increased the real price of gold, which over a period of decades triggered additional exploration and technological innovation.²² Huge gold discoveries in California and Australia surged into the world monetary system in the decade after 1849, then diminished. The ensuing post-1870 deflation raised the real price of gold, ultimately incentivizing the huge discoveries in South Africa's Witwatersrand in 1886 and Canada's Klondike in 1896 and triggering another round of reflation. (The Klondike gold strike abruptly ended the debtor currency agitation that had roiled the rapidly growing, chronically bullion-short United States from the 1870s Greenback Party through William Jennings Bryan's 1896 Cross of Gold speech.)

Far from creating smooth, automatic adjustments, the huge new gold supply led to money market manipulations. Britain fought the 1899-1902 Boer War, in part, to keep South African gold supplies under British control. South African gold ore was shipped exclusively to the United Kingdom for refining in regular quantities, and the Bank of England bought any unsold gold at the official price.²³ (During World War I, when one South African mining company wanted to sell in the United States to take advantage of higher prices, the government stopped it.²⁴) Fearing excessive expansion from the increased gold flow, the Bank of England added to its gold reserves and set an above-market Bank Rate.²⁵

The following chart illustrates that from 1821 (after the passage of the resumption bill, though before resumption itself) through 1913,²⁶ decade-over-decade gold production growth of less than 50 percent was associated with deflation, while gold supply production growth in excess of roughly 100 percent was associated with reflation.²⁷ (Because it took time for changes in gold production to work their way into the economy, changes in gold production are lagged by ten years, so that the 1811-1820 change is graphed under 1821-1830. Price levels are reported in a ten-year moving average.)

Sources: "Some Evidence on the Real Price of Gold, Its Costs of Production, and Commodity Prices," by Hugh Rockoff, in A Retrospective on the Classical Gold Standard, 1821-1831 (1984), Michael D. Bordo & Anna J. Schwartz, eds. (U. of Chicago Press 1984), p. 624, Table 14.2. CDKO: Long term indicator of prices of consumer g&s (Jan. 1974=100), Table 3.6, Composite Price Index and annual change 1800 to 2008, UK Office for National Statistics.

Bullion-based standards never produced a seamless, automatically adjusting mechanism—only a series of crises. Central bankers constantly manipulated to balance exchange-rate stability, price stability, and economic growth. Sometimes they failed: Reinhart and Rogoff show that the free capital flows of the classical gold standard era were associated with an increase in banking crises.²⁸

Source: This Time is Different: Eight Centuries of Financial Folly (Princeton U. Press), Carmen M. Reinhart & Kenneth S. Rogoff, p. 156 (2009).

In more recent times, the "Greenspan-Bernanke Put" promised a similar technocratic fix. The godlike Greenspan had supposedly replaced the business cycle with a "Great Moderation"—until it blew up. Since the 17th century, whether under the silver standard, gold standard, or fiat money, central banks have imperfectly improvised in the financial markets as they are, not as gold standard theory wishes they were.