“Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.”
—Barry Eichengreen, Golden Fetters (1992), p. 4
Berkeley Professor Barry Eichengreen has fueled the flames of anti-gold in his recent historical work, Golden Fetters: The Gold Standard and the Great Depression, 1919-1939 (Oxford University Press, 1992). Essentially, the author argues that (1) the international gold standard caused the Great Depression and (2) only after abandoning gold did the world economy recover. The book has been praised by colleagues, further dampening enthusiasm for the precious metal as an ideal monetary system.
It should be noted at the outset that Eichengreen, a Keynesian, is extremely biased against gold. In 1985, while teaching at Harvard, he edited a collection of essays entitled The Gold Standard in Theory and History (New York: Methuen, 1985), which pretends to offer a “complete picture” of how an international gold standard would operate, with pros and cons. Yet he failed to include a single article by a gold supporter! His last chapter, “Further reading,” makes no reference to Mises, Hayek, Röpke, Rothbard, Sennholz, Laffer, and other noted defenders of gold. So much for objectivity and what MIT professor Peter Temin calls “the best collection of readings on the gold standard available today.”
Despite his extensive research and history, Eichengreen cannot crucify mankind upon a cross of gold. In reality, the blame for the Great Depression must be laid at the feet of Western leaders who blundered repeatedly in re-establishing an international monetary system following the First World War. Their mistake was establishing a fatally flawed mixture of gold, flat money, and central banking, known as the “gold exchange standard,” instead of returning to the “classical gold standard” that existed prior to the Great War.
Eichengreen rightly points out that the mischief began during the First World War, when the European nations went off the gold standard and resorted to massive inflation to pay for the war. Following the Armistice, European nations desired to return to gold-convertible currencies, but they created a weak monetary system known as the “gold exchange standard,” where currencies were pegged primarily to the British pound and the American dollar rather than to gold itself. The gold exchange standard created a pyramid of paper claims upon other paper claims, with gold playing a far lesser role.
Austrian economists, such as Ludwig von Mises and F. A. Hayek, and the American sound-money school, led by Benjamin Anderson and H. Parker Willis, recognized that the fractional-reserve, fixed-exchange gold standard was a recipe for disaster. They predicted an eventual economic crisis under the gold exchange standard.
Monetary troubles worsened when, in 1925, Britain made the fateful error of pegging the pound at the exchange rate that prevailed before World War I at $4.86, clearly an artificially high rate. As a result, Britain suffered a deflationary depression for the rest of the 1920s. Moreover, to help Britain return to gold at the prewar exchange level, the Federal Reserve pushed down interest rates in 1924 and 1927, igniting a fateful inflationary boom in the U.S.
Eichengreen blames the gold standard, but the real fault lies in Britain’s nationalistic zeal to return to gold at an artificially high rate. A more sensible solution would have been for all European nations, including Britain, to return to gold at a redefined rate that recognized the increased supply of money and price levels following the war. In Britain’s case, this would have meant a new exchange rate of approximately $3.50.
Eichengreen also blames the gold standard for the monetary crises of the 1920s and 1930s, but it was really a gradual movement away from a genuine gold standard that caused the economic debacle of the 1930s.
Eichengreen even admits that the prewar classical gold standard worked well. He writes, “For more than a quarter of a century before World War I … the gold standard had been a remarkably efficient mechanism for organizing financial affairs.” (p. 3) Eichengreen attributes exchange-rate stability and prosperity to international cooperation, but the underlying reason was that industrial nations largely avoided inflation and strictly linked their monetary policy to gold flows during this period.
The classical gold standard required issuers of money to hold sufficient gold reserves to handle the demands of anyone who wished to redeem their currencies into lawful money. National banknotes and bank reserves were redeemable in gold coins or bullion at any time. For example, each gold certificate issued by the U.S. Treasury contained the following declaration: “This certifies that there has been deposited in the Treasury of the United States of America TWENTY DOLLARS IN GOLD COIN payable to the bearer on demand.” Although the U.S. Treasury did not maintain 100 percent specie reserves for all its legal obligations under the classical gold standard, it did hold more than 100 percent reserves to cover its gold certificates.
Auburn University economist Leland Yeager explains the virtues of a fully-backed commodity standard: “Under a 100 percent hard-money international gold standard … the government and its agencies would not have to worry about any drain on their reserves…. There would be no danger of gold deserting some countries and piling up excessively in others . . .” Because of monetary stability under the prewar gold standard, Milton Friedman and Anna J. Schwartz conclude, “The blind, undesigned, and quasi-automatic working of the gold standard turned out to produce a greater measure of predictability and regularity—perhaps because its discipline was impersonal and inescapable—than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability.”
Was the Depression Inevitable Under Gold?
Eichengreen and other gold critics have pointed out that in a crucial time period, 1931-33, the Federal Reserve raised the discount rate for fear of a run on its gold deposits. If only the U.S. had not been on a gold standard, the critics say, the Fed could have avoided this reckless credit squeeze that pushed the country into depression and a banking crisis. However, Friedman and Schwartz demur, pointing out that the U.S. gold stock rose during the first two years of the contraction. But the Fed reacted ineptly. “We did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up.”
In short, even under the defective gold exchange standard, there may have been room to avoid a devastating worldwide depression and monetary crisis.
How should we solve our continuing monetary problems? After recounting the chaotic events between the world wars, Eichengreen opposes the strict discipline of gold. Amazingly, he calls for more international cooperation between central banks, which even he admits is “weak soup for dinner at the end of a bitter cold day.” (p. 398) A much better solution would be to return the classical gold standard.