How to Run a Central Bank with a Gold Standard
September 15, 2011
(This item originally appeared in Forbes.com on September 15, 2011.)
The Keynesians are usually quick to insist that “central banking” is not possible with a gold standard system. They think that they invented it.
The Bank of England is normally credited with creating the processes known today as “central banking.” This took place over a long period of time, but the Bank’s first great success as a “lender of last resort” is generally considered to be during a crisis in 1866, during which the Bank made loans from its discount window at a penalty rate of 10%, thus defusing the crisis.
John Maynard Keynes was born in 1883.
During the 19th century, the Bank of England was also the world’s leading gold-standard institution, and served as the center of a monetary system that not only encompassed Britain but much of the world. The Bank served these two roles – maintaining the British pound’s gold link and also serving as a central bank – up until 1914. You could call this “19th century central banking.”
The Federal Reserve was created in 1913, to serve a role somewhat like the Bank of England had in Britain. The Fed indeed served this role, alongside the gold standard, for another 58 years until the U.S. left the gold standard in 1971. It’s true that the reason the U.S. gold standard failed in 1971 was in large part due to the Fed’s mismanagement and adoption of Keynesian ideology. However, it was also due to a personnel change – William McChesney Martin, who had led the Fed since 1951 and was, in 1969, defending the gold standard, was replaced in 1970 by Arthur Burns, hand-picked by Nixon to rev up the economy with “easy money.”
The Bank of England too was overrun by Keynes’ followers. In the late 1940s, it attempted to keep short-term lending rates at 0.5%. This led to a devaluation of the pound in September 1949, and the end of any remaining stature the British pound had as an international currency.
Central banks became the avenue by which the Keynesians could operate one of their two big tricks: “easy money” as a solution to virtually every sort of economic difficulty. (Their other trick is government spending.) You could call this “20th century central banking.” This was completely antithetical to the principles of a gold standard, which is to create stable, reliable, secure and predictable money free of willful human intervention. The consequence of this “easy money” ideology is the floating currency system we have today, which dates from 1971.
The Keynesian economists will also insist that gold standard systems tend to have intermittent financial crises. This was true – these were the “liquidity shortage crises” that the Bank of England eventually figured out how to solve. After 1866, Britain never suffered another liquidity shortage crisis. However, the United States did not have an institution that served the role of the Bank of England in Britain. The U.S. continued to suffer liquidity-shortage crises, including a bad one in 1907 that provided the political impetus for the creation of the Federal Reserve system.
The crisis in 1907 was the last such liquidity shortage crisis in the United States. The U.S. remained on a gold standard for another 64 years, until 1971.
The purpose of a gold standard is to create stable money – money that is stable in value. No economic crisis has ever been caused by stable money. The liquidity-shortage crises that emerged during the 19th century were eventually solved, within the context of the gold standard system.
What the Keynesians are really complaining about is the fact that a gold standard system prevents them from engaging in their favorite pastime, jiggering the currency. In other words, “20th century central banking.” And what has been the result of that? The U.S. census just declared that the median annual earnings of males employed full time was $47,715 in 2010. This is practically the same as the inflation-adjusted $44,455 of 1969 – just before the gold standard system ended in 1971. We’ve gone nowhere in forty years.
Those figures are subject to the government’s official inflation statistics, which might make things look better than they really are. Let’s look at this a different way. In 1969, a dollar was worth 1/35th of an ounce of gold. So, the median full-time male income, of $8,668 nominal, was 248 ounces of gold. In 2010, the dollar was worth an average of 1/1224th of an ounce of gold, and the full-time male worker was making only 39 ounces of gold. This figure is somewhat exaggerated by the rapid decline in the dollar in recent years, but describes, I would say, the economic reality of the situation.
Today, the Keynesians continue to believe that they can fix the economy’s problems with an “easy money” policy. The result is that the value of the dollar declines. If the value of the dollar declines, then the value of wages paid in dollars declines. People become poorer. This looks like it is going to go on for quite a while longer.
Eventually, people may decide that they are a little tired of having their wages devalued by the funny-money magicians. They may demand that their currency is once again linked to gold, the eternal money. This is entirely compatible with “19th century central banking,” It’s the “20th century central banking” that we want to get rid of.