Gold and Economic Freedom
by Alan Greenspan (1966)
An almost hysterical antagonism toward the gold
standard is one issue which unites statists of all persuasions. They seem
to sense - perhaps more clearly and subtly than many consistent defenders
of laissez-faire - that gold and economic freedom are inseparable, that
the gold standard is an instrument of laissez-faire and that each implies
and requires the other.
In order to understand the source of their antagonism,
it is necessary first to understand the specific role of gold in a free
society.
Money is the common denominator of all economic
transactions. It is that commodity which serves as a medium of exchange,
is universally acceptable to all participants in an exchange economy as
payment for their goods or services, and can, therefore, be used as a standard
of market value and as a store of value, i.e., as a means of saving.
The existence of such a commodity is a precondition
of a division of labor economy. If men did not have some commodity of objective
value which was generally acceptable as money, they would have to resort
to primitive barter or be forced to live on self-sufficient farms and forgo
the inestimable advantages of specialization. If men had no means to store
value, i.e., to save, neither long-range planning nor exchange would be
possible.
What medium of exchange will be acceptable to all
participants in an economy is not determined arbitrarily. First, the medium
of exchange should be durable. In a primitive society of meager wealth,
wheat might be sufficiently durable to serve as a medium, since all exchanges
would occur only during and immediately after the harvest, leaving no value-surplus
to store. But where store-of-value considerations are important, as they
are in richer, more civilized societies, the medium of exchange must be
a durable commodity, usually a metal. A metal is generally chosen because
it is homogeneous and divisible: every unit is the same as every other
and it can be blended or formed in any quantity. Precious jewels, for example,
are neither homogeneous nor divisible. More important, the commodity chosen
as a medium must be a luxury. Human desires for luxuries are unlimited
and, therefore, luxury goods are always in demand and will always be acceptable.
Wheat is a luxury in underfed civilizations, but not in a prosperous society.
Cigarettes ordinarily would not serve as money, but they did in post-World
War II Europe where they were considered a luxury. The term "luxury good"
implies scarcity and high unit value. Having a high unit value, such a
good is easily portable; for instance, an ounce of gold is worth a half-ton
of pig iron.
In the early stages of a developing money economy,
several media of exchange might be used, since a wide variety of commodities
would fulfill the foregoing conditions. However, one of the commodities
will gradually displace all others, by being more widely acceptable. Preferences
on what to hold as a store of value, will shift to the most widely acceptable
commodity, which, in turn, will make it still more acceptable. The shift
is progressive until that commodity becomes the sole medium of exchange.
The use of a single medium is highly advantageous for the same reasons
that a money economy is superior to a barter economy: it makes exchanges
possible on an incalculably wider scale.
Whether the single medium is gold, silver, seashells,
cattle, or tobacco is optional, depending on the context and development
of a given economy. In fact, all have been employed, at various times,
as media of exchange. Even in the present century, two major commodities,
gold and silver, have been used as international media of exchange, with
gold becoming the predominant one. Gold, having both artistic and functional
uses and being relatively scarce, has significant advantages over all other
media of exchange. Since the beginning of World War I, it has been virtually
the sole international standard of exchange. If all goods and services
were to be paid for in gold, large payments would be difficult to execute
and this would tend to limit the extent of a society's divisions of labor
and specialization. Thus a logical extension of the creation of a medium
of exchange is the development of a banking system and credit instruments
(bank notes and deposits) which act as a substitute for, but are convertible
into, gold.
A free banking system based on gold is able to extend
credit and thus to create bank notes (currency) and deposits, according
to the production requirements of the economy. Individual owners of gold
are induced, by payments of interest, to deposit their gold in a bank (against
which they can draw checks). But since it is rarely the case that all depositors
want to withdraw all their gold at the same time, the banker need keep
only a fraction of his total deposits in gold as reserves. This enables
the banker to loan out more than the amount of his gold deposits (which
means that he holds claims to gold rather than gold as security of his
deposits). But the amount of loans which he can afford to make is not arbitrary:
he has to gauge it in relation to his reserves and to the status of his
investments.
When banks loan money to finance productive and
profitable endeavors, the loans are paid off rapidly and bank credit continues
to be generally available. But when the business ventures financed by bank
credit are less profitable and slow to pay off, bankers soon find that
their loans outstanding are excessive relative to their gold reserves,
and they begin to curtail new lending, usually by charging higher interest
rates. This tends to restrict the financing of new ventures and requires
the existing borrowers to improve their profitability before they can obtain
credit for further expansion. Thus, under the gold standard, a free banking
system stands as the protector of an economy's stability and balanced growth.
When gold is accepted as the medium of exchange by most or all nations,
an unhampered free international gold standard serves to foster a world-wide
division of labor and the broadest international trade. Even though the
units of exchange (the dollar, the pound, the franc, etc.) differ from
country to country, when all are defined in terms of gold the economies
of the different countries act as one-so long as there are no restraints
on trade or on the movement of capital. Credit, interest rates, and prices
tend to follow similar patterns in all countries. For example, if banks
in one country extend credit too liberally, interest rates in that country
will tend to fall, inducing depositors to shift their gold to higher-interest
paying banks in other countries. This will immediately cause a shortage
of bank reserves in the "easy money" country, inducing tighter credit standards
and a return to competitively higher interest rates again.
A fully free banking system and fully consistent
gold standard have not as yet been achieved. But prior to World War I,
the banking system in the United States (and in most of the world) was
based on gold and even though governments intervened occasionally, banking
was more free than controlled. Periodically, as a result of overly rapid
credit expansion, banks became loaned up to the limit of their gold reserves,
interest rates rose sharply, new credit was cut off, and the economy went
into a sharp, but short-lived recession. (Compared with the depressions
of 1920 and 1932, the pre-World War I business declines were mild indeed.)
It was limited gold reserves that stopped the unbalanced expansions of
business activity, before they could develop into the post-World Was I
type of disaster. The readjustment periods were short and the economies
quickly reestablished a sound basis to resume expansion.
But the process of cure was misdiagnosed as the
disease: if shortage of bank reserves was causing a business decline-argued
economic interventionists-why not find a way of supplying increased reserves
to the banks so they never need be short! If banks can continue to loan
money indefinitely-it was claimed-there need never be any slumps in business.
And so the Federal Reserve System was organized in 1913. It consisted of
twelve regional Federal Reserve banks nominally owned by private bankers,
but in fact government sponsored, controlled, and supported. Credit extended
by these banks is in practice (though not legally) backed by the taxing
power of the federal government. Technically, we remained on the gold standard;
individuals were still free to own gold, and gold continued to be used
as bank reserves. But now, in addition to gold, credit extended by the
Federal Reserve banks ("paper reserves") could serve as legal tender to
pay depositors.
When business in the United States underwent a mild
contraction in 1927, the Federal Reserve created more paper reserves in
the hope of forestalling any possible bank reserve shortage. More disastrous,
however, was the Federal Reserve's attempt to assist Great Britain who
had been losing gold to us because the Bank of England refused to allow
interest rates to rise when market forces dictated (it was politically
unpalatable). The reasoning of the authorities involved was as follows:
if the Federal Reserve pumped excessive paper reserves into American banks,
interest rates in the United States would fall to a level comparable with
those in Great Britain; this would act to stop Britain's gold loss and
avoid the political embarrassment of having to raise interest rates. The
"Fed" succeeded; it stopped the gold loss, but it nearly destroyed the
economies of the world, in the process. The excess credit which the Fed
pumped into the economy spilled over into the stock market-triggering a
fantastic speculative boom. Belatedly, Federal Reserve officials attempted
to sop up the excess reserves and finally succeeded in braking the boom.
But it was too late: by 1929 the speculative imbalances had become so overwhelming
that the attempt precipitated a sharp retrenching and a consequent demoralizing
of business confidence. As a result, the American economy collapsed. Great
Britain fared even worse, and rather than absorb the full consequences
of her previous folly, she abandoned the gold standard completely in 1931,
tearing asunder what remained of the fabric of confidence and inducing
a world-wide series of bank failures. The world economies plunged into
the Great Depression of the 1930's.
With a logic reminiscent of a generation earlier,
statists argued that the gold standard was largely to blame for the credit
debacle which led to the Great Depression. If the gold standard had not
existed, they argued, Britain's abandonment of gold payments in 1931 would
not have caused the failure of banks all over the world. (The irony was
that since 1913, we had been, not on a gold standard, but on what may be
termed "a mixed gold standard"; yet it is gold that took the blame.) But
the opposition to the gold standard in any form-from a growing number of
welfare-state advocates-was prompted by a much subtler insight: the realization
that the gold standard is incompatible with chronic deficit spending (the
hallmark of the welfare state). Stripped of its academic jargon, the welfare
state is nothing more than a mechanism by which governments confiscate
the wealth of the productive members of a society to support a wide variety
of welfare schemes. A substantial part of the confiscation is effected
by taxation. But the welfare statists were quick to recognize that if they
wished to retain political power, the amount of taxation had to be limited
and they had to resort to programs of massive deficit spending, i.e., they
had to borrow money, by issuing government bonds, to finance welfare expenditures
on a large scale.
Under a gold standard, the amount of credit that
an economy can support is determined by the economy's tangible assets,
since every credit instrument is ultimately a claim on some tangible asset.
But government bonds are not backed by tangible wealth, only by the government's
promise to pay out of future tax revenues, and cannot easily be absorbed
by the financial markets. A large volume of new government bonds can be
sold to the public only at progressively higher interest rates. Thus, government
deficit spending under a gold standard is severely limited. The abandonment
of the gold standard made it possible for the welfare statists to use the
banking system as a means to an unlimited expansion of credit. They have
created paper reserves in the form of government bonds which-through a
complex series of steps-the banks accept in place of tangible assets and
treat as if they were an actual deposit, i.e., as the equivalent of what
was formerly a deposit of gold. The holder of a government bond or of a
bank deposit created by paper reserves believes that he has a valid claim
on a real asset. But the fact is that there are now more claims outstanding
than real assets. The law of supply and demand is not to be conned. As
the supply of money (of claims) increases relative to the supply of tangible
assets in the economy, prices must eventually rise. Thus the earnings saved
by the productive members of the society lose value in terms of goods.
When the economy's books are finally balanced, one finds that this loss
in value represents the goods purchased by the government for welfare or
other purposes with the money proceeds of the government bonds financed
by bank credit expansion.
In the absence of the gold standard, there is no
way to protect savings from confiscation through inflation. There is no
safe store of value. If there were, the government would have to make its
holding illegal, as was done in the case of gold. If everyone decided,
for example, to convert all his bank deposits to silver or copper or any
other good, and thereafter declined to accept checks as payment for goods,
bank deposits would lose their purchasing power and government-created
bank credit would be worthless as a claim on goods. The financial policy
of the welfare state requires that there be no way for the owners of wealth
to protect themselves.
This is the shabby secret of the welfare statists'
tirades against gold. Deficit spending is simply a scheme for the confiscation
of wealth. Gold stands in the way of this insidious process. It stands
as a protector of property rights. If one grasps this, one has no difficulty
in understanding the statists' antagonism toward the gold standard.
