The Unadulterated Gold Standard (History)

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November 19, 2012 1:39pm NYSE:IAU NYSE:SLV

Keith Weiner: The choice of the word “unadulterated” is not accidental.  There were many different kinds of gold standard, including what we now call the Classical Gold Standard, the Gold Bullion Standard, and the Gold Exchange Standard.  Each contained flaws; each was adulterated.


For example, in the Coinage Act of 1792, the government forced the price of one thing to be fixed in terms of another thing.  The mechanism was in Section 11:

And be it further enacted, That ”the proportional value of gold to silver in all coins which shall by law be current as money within the United States, shall be as fifteen to one …”[1]

Of course, people respond to such distortions.  When the government fixes the price of something too low, then people will hoard or export it.  If the price is fixed too high, then they will flood the market with it.

According to Craig K. Elwell, in his 2011 Congressional Research Service Report:

“Because world markets valued them [gold and silver] at a 15½ to 1 ratio, much of the gold left the country and silver was the de facto standard.”[2]

Subsequently, the government changed direction.  Elwell notes:

“In 1834, the gold content of the dollar was reduced to make the ratio 16 to 1.  As a result, silver left the country and gold became the de facto standard.”

If the law dictates the ratio between gold and silver, then only one metal—the one that is undervalued—will be used.  It would be extremely difficult for the government to get the ratio exactly right.  And even if so, as soon as the market value changed the ratio would be wrong and only one metal would circulate.

The government should not attempt to force a price onto the market.  In the unadulterated gold standard, the market is allowed to set the price of silver, copper, oil, wheat, a fine wool suit, and everything else.  It allows people to use gold, or silver, or seashells as money if they wish (the market has not chosen seashells in modern history).

Throughout the 19th century, there were various state laws to impose new kinds of restrictions on the banks.  One popular restriction was that in order to obtain a charter (permission to operate as a bank), the bank had to buy state government bonds.  This theme—forcing banks to buy government bonds—was to recur later.

This is a pernicious idea.  Banks must have an earning asset to match the liability of the deposit accounts.  Why not make them buy some government bonds as a condition for permission to operate?  Because this is obviously blackmail.  In a free country, one should not need to ask permission to be in business and one should not be forced to do something in exchange for that permission.

This policy has two economic effects.  First, it pushes the price of the government bond higher than it would otherwise be, which means it pushes down the rate of interest.  This distortion ripples throughout the entire economy.

Second, it exposes the state-chartered bank to the fiscal irresponsibility in the state capitol.  And of course the state capitol is encouraged to borrow and spend by this very perverse policy, because they know that there is always a market for their bonds.  This lasts until they default, of course.  And when they do, the state-chartered banks become insolvent.  This is not a failure of the gold standard, or of the free market.  It is a failure of a deficit spending policy and central planning.

There is another problem with this scheme.  The bank takes in deposits, especially demand deposits, and it buys bonds, especially longer-dated bonds.  This is called “borrowing short to lend long”, and it is dangerous because if the depositors want to redeem their gold or silver, the bank may be in a position where it has only an illiquid bond.  Obviously, the depositor does not want a government bond, and so the bank can be forced to default in a “run on the bank”.

All borrowing short to lend long schemes, also called “duration mismatch”, collapse sooner or later.  This is because the depositor, who is the ultimate issuer of the credit, is signaling that he only wishes to extend credit for short duration.  But the bank has expanded long-term credit.  This is not the bank’s decision to make, and by disrespecting its depositors’ intentions, it makes itself vulnerable to a run.[3]

In 1864, the National Banking Act imposed a tax of 10% on notes issued by state banks.  Needless to say, state-chartered banks responded to this threat of mass robbery.  There were 1466 state-chartered in 1863.  Five years later, 83% of them had either gone out of business or become nationally chartered.[4]

One of the provisions of this Act was to require nationally chartered banks to hold US government bonds in order to issue nationally standardized bank notes and other liabilities.[5]  One key reason for this was that the federal government was eager to finance the civil war (1861 – 1865).  In later years, when the federal government wanted to pay down its debt, this squeezed the banks and the result was deflation and panics.

The problem was exacerbated when the federal government resumed the minting of coins.  The “Crime of 1873”[6] was the name many gave to the Coinage Act of 1873, which demonetized silver.  This was an enormous wealth transfer from the small saver such as the farmer who had silver stored at home into the hands of the wealthy who kept gold in the banks.

These problems occurred under the Classical Gold Standard.  Even before the Federal Reserve Act of 1913, we saw the following adulterations:

  1. A fixed gold:silver price ratio in a bimetallic monetary standard.  The unintended consequence was that first gold, and later silver, fled the country
  2. Laws forcing banks to seek permission to operate.  Big-spending governments, needing a market for their bonds, forced banks to buy their bonds in various schemes in exchange for permission to operate.  This exposed banks to bank runs and bankruptcy when the bonds defaulted, and created a new problem when the size of the banking system was restricted by the value of government bonds outstanding.
  3. Demonetizing one metal shifts wealth from one class of saver to another.
  4. Duration mismatch causes the business cycle.  The boom occurs due to credit expansion beyond the intent of the savers.  The bust begins when there are significant redemptions by depositors who need their money.  A full panic occurs when other depositors realize that the bank is not holding either money or short-duration assets such as Bills.  The bank holds illiquid long-term bonds and cannot pay depositor redemptions.  The run turns into bankruptcy.  The panic turns into a wide scale depression.

In Part II (Below), we will look at the Gold Bullion Standard and the Gold Exchange Standard.

In Part I (Above), we looked at the period prior to and during the time of what we now call the Classical Gold Standard.  It should be underscored that it worked pretty darned well.  Under this standard, the United States produced more wealth at a faster pace than any other country before, or since.  There were problems; such as laws to fix prices, and regulations to force banks to buy government bonds, but they were not an essential property of the gold standard.

The essential was that people had a right to own and trade gold coins.  They had the right to deposit them in a bank, if the bank offered attractive terms (especially the payment of interest).  Banks had a right to take deposits, to buy assets, and to pay interest.  Banks had a right to issue paper notes that were claims against gold.  Banks had a right to lend their deposits (fractional reserves).

Despite some government interference, the Classical Gold Standard enabled a Golden Age of prosperity and full employment that is totally out of reach today (not to be confused with the rapid development of technology).  This is not to say there were not business failures, bank failures and panics – what were later called depressions and now recessions.  A free market does not attempt to guarantee that no one can ever lose money.  It is merely an environment in which no one is forced to subsidize someone else’s risks or losses.

Unfortunately, by the early 20th Century, the tide had shifted.  Europe was inexorably moving towards war.  The US was abandoning the principles on which it had been founded, and exploring a different kind of government: an unlimited government that could centrally plan and manage the economy and the lives of the people.

In 1913, the US government created the Federal Reserve.  Much has been written about this now-hated organization.  At the time, the Fed was supposed to be the re-discounter of Real Bills.  Real Bills arose spontaneously in the market centuries before banks or central banks.  They are credit used for clearing.  When a wholesaler delivers goods to a retailer, the retailer accepts the goods and signs the bill.  Commercial terms were commonly Net 90.  It turned out that in the free market, these bills would circulate as a form of currency, with a value that was based on the discount rate and the time until maturity.  Real Bills were the highest quality earning asset, and the highest quality asset except only gold itself.

For many reasons, politicians felt that a quasi-government agency could make better credit decisions than the market.  To “discount” a Real Bill was to pay gold and take the Bill into one’s portfolio.  The Fed, as re-discounter, would offer the banks unlimited liquidity in exchange for their bills.  Almost immediately, the Fed also began to buy US government bonds.  What better way to expand credit than to push down the rate of interest?  The Fed could use much more leverage than if they were restricted to buying bills (which would all mature into gold in 90 days or less!)  This time, they thought, there was no limit to how far down they could push interest, nor for how long.

The Fed almost certainly enabled the government to borrow at lower rates than would otherwise have prevailed, but even so the rate of interest rose during World War I.  This is because the government was borrowing unprecedented amounts of money.  The interest rate peaked in 1919.  Then it began to fall, not bottoming until after World War II.

The net effect of the Fed was to totally destabilize the rate of interest.  In looking at this graph of the 10-year US Treasury bond from 1790 to 2009, one thing is obvious.  There were spikes due to wars and other threats to the stability of the government.  But for long periods of time, the rate of interest moved in a narrow range.  For example, from 1879 until 1913 (i.e. the period of the Classical Gold Standard), the rate of interest was bound to a range of 3% to 3.5%.  During World War I, the rate spiked up to 5.5% and then began to fall to well under 2% after World War II.  Then the rate began its ascent to over 17% in 1981.  After 1981, the rate has been falling and is currently under 1.7%.  It will continue to fall, but that is a discussion for another paper.

The US, unlike Europe, did not suspend redeemability of the currency into gold coin.  In Europe, the toll of the war in terms of money, property, and of course lives, was much higher.  The governments felt it necessary to force their citizens to deal in paper money only.  After the war, they had problems returning to gold.  For example, Germany was prohibited from freely trading with anyone.  One consequence of this was that the Real Bills market never reemerged.

In 1925, Britain initiated a short-lived experiment: the Gold Bullion Standard.  The idea was that paper money would be backed by gold, but the gold would be kept in the banking system in the form of 400-ounce bars.  Technically, the paper was redeemable, but the bars were so large that, for all practical purposes, the money may as well have been irredeemable to ordinary people.  Britain abandoned this regime in 1931, in part due to gold flows to the US.

In 1933, the President Roosevelt told American citizens that they must turn in their gold for approximately $20 per ounce.  Once the government got all the gold they could, Roosevelt revalued gold at $35 per ounce.  The dollar was never again to be redeemable to Americans.

After World War II, Europe was physically and financially devastated.  European gold had largely moved to the US either because of the coming war, or to pay for munitions.  The Allied powers knew by 1944 that they would be victorious, and so met at Bretton Woods to agree on the next monetary system.  They agreed to what could be called the Gold Exchange Standard.

In this new standard, the US dollar would be the reserve asset of the central banks and commercial banks of the world.  They would end up with dollars on both sides of their balance sheets, and pyramid credit in their local currencies on top of this reserve.  The dollar would continue to be redeemable to foreign central banks (but not to US citizens).

This regime was unstable, as economists such as Jacques Rueff and Robert Triffin realized.  Triffin proposed that there is a dilemma for the world and the US.  As the world demanded more money, this meant that the US had to run a trade deficit to provide the currency.  But a chronic trade deficit would cause the value of the dollar to fall, with wealth being transferred from foreign creditors to domestic (US) consumers.

Throughout the 1960’s, European central banks, and most visibly France, redeemed dollars.  By 1971, the gold was flowing out of the US at a rate of over 100 tons per day.[1]  President Nixon had to do something.  What he did was end the Gold Exchange Standard and plunge us into the worldwide regime of irredeemable paper money.

Since then, it has become obvious that without the anchor of gold, the monetary system is un-tethered, unbounded, and unhinged.  Capital is being destroyed at an exponentially accelerating rate, and this can be seen by exponentially rising debt that can never be repaid, a falling interest rate, and numerous other phenomena.

In Part III, we will look at the key characteristics of the Unadulterated Gold Standard.

Keith Weiner is the founder DiamondWare, a VoIP software company, and has a PhD from Antal Fekete’s New Austrian School of Economics in Munich. He is now a trader and market analyst in precious metals and commodities. He is also president of the Gold Standard Institute USA.

Related: SPDR Gold Trust (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV), iShares Gold Trust (NYSEARCA:IAU).


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