Ray/Mike,
Maybe this can help
Gold and Economic Freedom
by Alan Greenspan
Published in Ayn Rand's "Objectivist" newsletter in 1966, and reprinted
in her book, Capitalism: The Unknown Ideal, in 1967.
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 War 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.
