Gold standards and the real bills doctrine in U.S. monetary policy.

AuthorTimberlake, Jr., Richard H.
PositionViewpoint essay

[The English gold standard after Waterloo] was a perfectly "free" or "automatic" gold standard that allowed for no kind of management other than is implied in the regulatory power of any central bank that is a "lender of last resort." ... [Despite much opposition] the gold-standard policy was never in real danger politically, and if it was not, until much later, adopted by all other countries, [their delay] was not a matter of their choice: in spite of all counterarguments, the "automatic" gold standard remained almost everywhere the ideal to strive for and pray for, in season and out of season.

--Joseph A. Schumpeter, History of Economic Analysis

In recent decades, several journal articles and some mainline books have blamed what the authors label as "the gold standard" for the failure of the Federal Reserve System (the Fed) to pursue a countercyclical monetary policy that would have prevented the Great Contraction of 1929-33 and the subsequent Great Depression of 1933-41. Although the authors of these publications note differences between the classical pre-World War I gold standard and the post-World War I gold-exchange standard, they nonetheless claim that the latter "gold standard" was operational during the 1920s and early 1930s. They insist that significant changes in the quantity of money or the lack of such changes were dictated by fixed values of gold for the units of account and that this restriction was responsible for the misconduct of monetary policy during the period. They seem unaware that if central bankers are managing a "gold standard" in order to control monetary policy, whatever it is they are managing is not really a gold standard.

These authors also seem to understate the extent to which the Fed and other central banks' deliberate management of the gold-exchange standard prevented monetary adjustment in the period 1929-33 from resembling the pattern of equilibrium typical of the classical gold standard. Indeed, none of the "gold standard" critics specifies the attributes of a true--classical--gold standard. Nor does any of them make any reference to the legal provisions in the Federal Reserve Act that the Federal Reserve Board (Fed Board) could have used to abrogate the gold-reserve requirements for Federal Reserve Banks (Fed Banks) or to the fact that all Fedheld gold was on the table in a crisis. Most important, none of these publications includes any reference to the real culprit in the monetary machinery of that era--the real bills doctrine, which was then the working blueprint of the primary policymakers in the Fed.

In this article, I seek to rectify these errors of commission and omission for the sake of historical accuracy. I do not lobby for any particular monetary policy or system. However, until the policy history of such an important episode as this one is properly analyzed and understood, the general public and its representatives in Congress are being misled and therefore are understandably confused. Policymakers are forever in danger of repeating past mistakes or inventing new ones.

The Constitutional Gold Standard

Joseph Schumpeter's observation about the gold standard that the English Crown restored between 1819 and 1822 reflects the high esteem in which "the world" held the operational, automatic gold standard. Somewhat relaxed lending policies by the Bank of England, after Parliament ordered the restriction of gold payments in 1797, had allowed the market price of gold to rise above its mint price, but after the travail brought about by the Napoleonic Wars, Parliament prescribed policies that eventually restored the prewar gold parity of the pound sterling.

A few years earlier the U.S. Constitution declared that Congress should have the power "[t]o coin money, regulate the Value thereof.., and fix the Standards of Weights and Measures." (1) It further stipulated, in Section 10 that "[n]o state shall ... coin Money; emit Bills of Credit; [or] make any Thing but gold and silver Coin a Tender in Payment of Debts." These few sections provided for a bimetallic monetary standard in the United States. (2)

To make a metallic standard operational, a legislature must follow certain principles and procedures. First, it must specify the value of the unit of account in terms of a weight of gold (or silver). It does so by prescribing a gold coin of a convenient denomination. For the United States, Congress defined the gold dollar as 24.74 grains of pure gold. The basic gold coin it authorized was a $10 gold Eagle that contained 247.4 grains of gold with an additional 10 percent base metal to make the coin suitable for practical use (Bordo 1997, 264; Officer 2001). Other gold coins were proportioned by weight in the appropriate denominations. These coins were legal tender for all debts private and public, and by the proscription declared in Section 10 nothing else except silver would be so privileged.

A legal-tender specification for a weight of gold initiates a gold standard. Having taken that action, the government need do nothing more than subject itself to the dictates of the standard. It may produce legal-tender gold coins, or it may leave the coinage of money entirely to private coin smiths. (3)

Once a metallic standard is in place, the institution becomes self-regulating. Individuals, banks and other financial institutions, business firms, foreign-exchange dealers, and the world's gold industries unwittingly cooperate to make the system work. Other conditions are also necessary or desirable: the supply of common money that banks and individuals generate on the gold base must be responsive to the quantity of monetary gold; market prices must be sensitive to changes in the quantity of money; and gold must be allowed to flow freely in and out of the economy in response to private initiatives (Hepburn 1924, 482-86; Timberlake 1993, 24; Officer 2001).

A true gold standard is a complete commodity-money system and therefore has an appeal not found in some other monetary arrangements. Under an authentic gold standard, the demand for and supply of money react simultaneously, through market prices for all goods and services and for the monetary metal, to determine a given quantity of money. If prices of all goods and services and capital tend to fall, say, because of an increased demand for common money, the value of monetary gold being fixed in dollar terms rises in real terms, stimulating increases in the production and importation of gold and in the supply of gold to the mints. Because gold is the necessary base for currency and bank deposits, the quantity of common money also increases, arresting the fall in market prices. Alternatively, when additional gold enters the monetary system from whatever source, it tends to raise money prices.

Offsetting the potential price-level increase are the nominal increases in goods, services, and capital that normally occur. In either case, successive approximations of goods production and money production through the market system generate an ongoing monetary equilibrium. (4)

Frederick Soddy, a chemical engineer interested in applying scientific principles to monetary phenomena, observed in the early 1930s that under an ideal gold-standard system the "proportionate increment of the [economy's real] revenue ... [is] always as great as the proportionate increment of its aggregate quantity of gold" (1933, 179). Although the world's gold mines could not be counted on to satisfy this norm precisely, gold prices of commodities over the centuries have been extraordinarily stable (Jastram 1981, chart 1, 9f.).

A true gold standard provides an economy with a set of rules prescribing the conditions for the supply of common money. Once the rules are in place, the system works on the principles of a spontaneous order. Human design is limited to the framework for the standard and must refrain from meddling with the ultimate product--the quantities of both base and common money.

Fractional-reserve commercial banks, operating within a gold-standard system, create nongold notes and deposits as a by-product of their lending operations. They knowingly accept the fact that they must be able to redeem the common money they create with the gold reserves they retain. As cost-recovering competitive enterprises seeking to stay in business, they must judge accurately the proper quantity of gold reserves necessary to support their demand obligations if they hope to maintain the convertibility of their notes and deposits into gold.

Departures from true gold standards tended to occur when governments that had initiated such standards began to issue paper moneys. A government's money, unlike that of a competitive commercial banking system, attempts to mimic or rival gold. If its paper currency becomes irredeemable and its metallic currency is underweight, a government using its power of flat ("Let there be") declares its money to be legal tender. People then must accept it, willy-nilly.

The U.S. Treasury Gold Standard

Congress revoked the operational gold standard for an indefinite period on December 30, 1861. It then passed the Legal Tender Acts in 1862 and 1863, authorizing the U.S. Treasury Department to issue $400 million of U.S. notes--"greenbacks"--and some other flat currency. By 1870, outstanding Treasury currencies were five times the amount of bank-held specie in 1860. Currency and bank deposits over the same period increased to about $1,300 million, or roughly two and one-half times their total in 1860 (Friedman and Schwartz 1963, 704; Timberlake 1993, 90, 105).

Prices, including the market price of gold, also increased substantially during the war. However, by 1870 the federal government's postwar monetary policies had brought the price level back down to 145 percent of its 1860 level, and the price of gold was down to 120 percent of its prewar parity (Hepburn 1924, 225-27; Timberlake 1993, 111). The gold standard, however, was still in remission...

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