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The Fall and Rise of the Gold Standard


Our revisionist theory of the gold standard takes the bill market and the discount rate into full account. Greater availability of gold is no cause for inflation. The new gold flows to the bill market lowering the discount rate, which quickly puts a greater variety of consumer goods on the shelves of retail shops preventing prices from rising. Nor is reduced availability of gold cause for deflation. The gold is withdrawn from the bill market raising the discount rate, which quickly eliminates marginal merchandise from the shelves, preventing prices from falling. Rising prices are never the result of an abundance of gold: they are always the result of scarcity of goods, such as that caused by misguided credit policies of banks discounting financial bills which are not backed by maturing consumer goods. Falling prices are never the result of a scarcity of gold: they are always the result of an overabundance of goods, such as that caused by misguided government policies creating unemployment.

Unevenly rotating economy

The gold standard can only be understood in the context of its clearing system, the bill market, trading real bills that move in a direction opposite to the flow of maturing goods to the final gold-paying consumer. Authors who are looking at the gold standard in isolation got the wrong perspective. They have to invoke the quantity theory of money. The trouble with it is that while it could explain linear changes, it is helpless to explain non-linear phenomena such as dynamic changes. Whenever Mises talked about an "evenly rotating economy," he had to rule out dynamics. To this extent his opus is unfinished and can only be completed by extending it to the "unevenly rotating" or dynamic economy, wherein the quantity theory of money no longer applies. The evenly rotating economy is strictly an abstraction that, by Mises' own admission, nowhere exists in reality, not even as a first approximation.

Classical theory of the gold standard

There is a natural tendency to minimize gold flows across international boundaries. Balances are settled, not through gold remittances, but through arbitrage in real bills. Arbitrageurs buy bills in a country running a deficit and sell an equivalent amount in a country running a surplus, to take advantage of the favorable spread in the discount rate. This arbitrage is particularly effective if one country acts as a clearing house, as England did prior to World War I.

This observation invites the following critique of the classical theory of the international gold standard, according to which gold flows from a deficit to a surplus country inducing changes in the relative price levels. In more details, as this theory would have it, prices fall in the deficit country and rise in the surplus country. Higher prices are supposed to have the effect of discouraging exports while encouraging imports, with the opposite effect for lower prices. This process purports to explain the adjustment mechanism of foreign trade. However, this pernicious theory has never worked in practice but caused a great deal of monetary mischief in the world after Milton Friedman persuaded governments to "float" their currencies in the early 1970's.

Revisionist theory of the gold standard

In reality, the price level hardly ever responds to trade imbalances. Economists have been at a loss to explain persistent trade deficits and blamed the gold standard for the anomaly. They should have blamed themselves and their flawed theories.

As our more sophisticated theory shows, if the supply of gold increases in one country, then the new gold first flows to the bill market where it will bid up the price of real bills. This makes the discount rate fall. Shopkeepers respond by filling their empty shelf-space with marginal merchandise. By the time the new gold trickles down to the rest of the economy in the form of higher wages and greater dividend income, the extra merchandise will be in place waiting for the increased consumer-spending to materialize. Social circulating capital expands and soaks up the extra demand for consumer goods. There is no inflation.

Conversely, if the supply of gold decreases in a country, then the gold is withdrawn from the bill market. Real bills are sold. That makes their prices fall. The discount rate jumps. Shopkeepers respond by eliminating marginal merchandise form their shelves. Neither gold outflow nor increased gold hoarding will squeeze prices. They cause the social circulating capital to contract as propensity to consume declines. Marginal merchandise is no longer available in every grocery store. The consumer who still wants it must search for it in speciality shops and be prepared to pay a higher price for it as moving these items can no longer be financed at the discount rate; it must be financed through a loan at the higher interest rate. There is no deflation.

Karl Marx talked about the "anarchy of the market" under the capitalist mode of production, suggesting that producers act blindly and they inevitably glut the market in expanding production. But as our analysis shows, assuming that the discount rate is not distorted by the banks and the government, producers and distributors have a sensitive inner communication system, the bill market. They know that by the time the new product reaches the shelves of the shopkeeper, the sovereign consumer will be looking for it. They get their signals, not from the rate of interest, but from the nimble discount rate. Its fall is signaling them the impending increase in consumer demand.

Fundamental principle of retail trade

This, then, is the fundamental principle of the retail trade: the adjustment mechanism which brings into balance the amount of gold in circulation with the supply of consumer goods works, not on prices but on the discount rate. The law of supply and demand is inoperative. An autonomous increase in demand has no inevitable effect on the prices of consumer goods but will, instead, lower the rate of marginal productivity of social circulating capital, i.e., the discount rate. The lower discount rate automatically makes the supply of consumer goods expand.

By the same token, an autonomous decrease in demand will raise the rate of marginal productivity of social circulating capital, i.e., the discount rate. A higher discount rate automatically makes the supply of consumer goods shrink. There is no such a thing as an autonomous change of supply in the retail trade. Supply is closely regulated by demand through the mechanism of the bill market and the discount rate.

The vulgar supply/demand equilibrium analysis cannot describe the process of supplying the consumer with urgently needed goods. It could not explain why prices were stable under the gold standard even in the face of changes in demand. In a previous article I have explained this phenomenon in terms of increasing economic entropy.

Coping with natural disasters

If a country is stricken with a bad harvest or by some other natural calamity destroying property and consumer goods, then there will be an immediate increase in the discount rate. Retail prices of consumer goods will not rise inevitably. The stricken country, thanks to its high discount rate, is an attractive place on which to draw bills. This translates into an immediate influx of short-term credit from abroad in the form of the most urgently needed consumer goods. Compare this with the present system of politically motivated foreign aid. By the time the amount and kind of aid is agreed upon by the negotiators, the need may well shift. The gold standard is by far the best system for the international division of labor in good times as well as in bad. Governments have exposed their subjects to unnecessary deprivations when they first sabotaged and then destroyed the gold standard and its clearing system, the international bill market. Peoples of various countries help one another to the fullest possible extent in case of calamities, provided that they are allowed to cooperate under the aegis of the international gold standard. Without its umbrella peoples are pitted against one another in a bitter competition which often drives them to war.

Coping with a gold avalanche

By the same token, the international gold standard and its clearing system the bill market allows nations to share the windfall or godsend that occasionally benefits one nation or another. Assume that the output of gold mines increases by leaps and bounds, or that foreign gold invades one country. It need not cause an increase in prices, as predicted by the vulgar theory. Instead, it will benefit all countries adhering to the international gold standard through a general lowering of the discount rate, which will first drop in the country hit by the gold avalanche. Suppliers will start drawing bills on foreign countries with a higher discount rate. The increase in imports will repel the invasion of foreign gold and expel excess domestic gold. Social circulating capital expands as a result of the lower discount rate. The spinoff from higher incomes due to the greater availability of gold will be met by an expanded offering on the shelves of the shopkeepers, who are able to display a great variety of goods thanks to the lower marginal productivity of social circulating capital. As excess gold is expelled, other countries will also start to benefit.

Now suppose that all countries except one close their Mints to gold, and all the monetary gold in the world descends upon that one country. Even in this extreme case there is no need for the prices to rise. The rate of marginal productivity of social circulating capital will be approaching zero. Retail stores will run out of shelf space and start using the side-walks to display marginal merchandise. The greater availability of gold will, in this case as in any other, call out an even greater abundance of merchandise. Price rises are always the result of a scarcity of goods, never of a greater availability of gold.

A bumper crop is often considered a disaster by producers who blame it for the collapse of prices. But it need not happen under a gold standard. The cash crop is part of the social circulating capital and when available in great abundance, marginal productivity will be lowered making the discount rate fall. This allows new products made of the same old ingredient to appear on the shelves. Furthermore, exporters take advantage of the low discount rate and draw bills on shipments of the bumper crop to foreign destinations. Instead of slashing prices, the gold standard will increase market share through slashing the discount rate. Everybody benefits.

Legal tender bank notes

It is true that scarcity is usually brought about by the banks and the government through their interference with the free flow of gold to the bill market, or with the free flow of merchandise across international boundaries. An example of this is the world-wide inflation of 1896-1914. World gold production increased at a prodigal rate after the opening of the gold mines in the Transvaal. This in itself would not have caused price increases if bill markets around the world had been allowed to absorb the new gold. They were not. The banks intercepted the new gold flowing to the bill market in order to construct a credit pyramid upon their newly expanded gold reserves.

The bank credit, however, was not healthy. It was not self-liquidating, as it would have if it had been based on real bills drawn on consumer goods moving fast to the gold-paying consumer. Furthermore, governments discouraged gold coin circulation instead of encouraging it. They drove the gold into the banks, and changed the laws that originally forbade the bank of issue to discount financial and treasury bills. The note issue of the Reichsbank of Germany was made legal tender in 1909. This event was the salvo that heralded the impending destruction of the bill market. Within five years, by the time the war broke out, the portfolio of most banks of issue consisted of financial and treasury bills, where previously only real bills were eligible for serving as reserves for the note issue. The bill market was paralysed and never since allowed to make a recovery.

A direct consequence of the unhealthy credit expansion was inflation world-wide, even before the war. It was conveniently explained away by the quantity theory of money, using gold as the whipping boy. Nobody pointed out that the expansion of credit far outstripped the increase in the stock of monetary gold. Still more serious was the undermining of the international bill market that could no longer prevent price rises through the discount rate mechanism after bank reserves were diluted through the addition of fiduciary bills. The fact remains that, in spite of government propaganda, it was not the inflow of new gold but the subversion of the bill market that caused the 1896-1914 inflation and price rises.

Plunder as the cause of inflation

Going further back in time we may observe that the great historic tides of prices, blamed on the dispersal of gold, were really caused by military conquest and plunder, making goods scarce. This was true of the sack of Persepolis by Alexander the Great in 331 B.C., as well as the sack of Cuzco by Pizzaro in 1533 A.D. The fact that looted gold was the instrument whereby goods were made scarce in other parts of the world does not change the validity of this observation. The important thing is that it was not the greater availability of gold per se that made prices to rise, but the scarcity of goods due to plunder.

Fall of the gold standard

The fall of the gold standard can only be understood in the context of the fall of the bill market. After World War I the victorious governments that redrew international boundaries would not allow the free circulation of real bills and consumer goods to resume. They also wanted to deny the gold coin to "man's greedy little palms", to use the phrase of Lord Keynes. The bill market was scuttled, and governments assumed control of foreign trade in consumer goods which was thereafter animated by political rather than economic considerations.

This turned out to be the most disastrous public decision in peacetime. In an earlier article of this series I related how it led to the collapse of the gold standard followed by unprecedented unemployment world-wide, as predicted by Professor Heinrich Rittershausen of Germany in 1930. It is a shameless lie that the gold standard collapsed due to its inner contradictions, after spreading unemployment in the world. The fact is that it was sabotaged, before the war by Germany in making bank notes legal tender (an act that was duly aped by France as well as other countries), and after the war by the victorious governments in destroying the clearing system of the gold standard, the bill market. The theory and history of the gold standard has been distorted by governments and their hand-picked mouth-pieces at the universities. It is time to set the record straight and state the truth: mass unemployment in the 1930's was caused by the governments themselves in destroying the wage fund, however inadvertently, along with the bill market.

Detractors of real bills must logically applaud the government hatchet job that destroyed the bill market while making preparations for the war in 1909. They conveniently look at it as a needed "purification", purging the gold standard as it were from its imperfections. Advocates of the 100 percent gold standard are intellectual accomplices of the greatest job destruction of history. They approve the abolition of the wage fund in the consumer goods sector, a corollary of the destruction of the bill market. You cannot have it both ways. If you deny self-liquidating credit, then you also deny jobs financed thereby.

In praise of gold hoarding

The most serious charge against the gold standard, made by Lord Keynes, is that it is "contractionist" in that it encourages gold hoarding and, through the contraction of the money supply, it creates unemployment. The truth, however, is that gold hoarding in the early 1930's was maliciously instigated by the enemies of the gold standard, first and foremost among them Lord Keynes himself. They started a whispering campaign that the national currency should be devalued to help the export industry. This was nothing short of advocating sabotage.

In so far as gold hoarding/dishoarding as an economic phenomenon are concerned, they are healthy and natural. In fact, gold hoarding is an organic part of the mechanism that regulates the (floor of the) rate of interest: it is the only way the public can stop the banks from expanding credit by withdrawing bank reserves. Gold hoarding of the marginal bondholder sets a limit to falling interest rates. If the government tries to stop gold hoarding by confiscating it, then the propensity to hoard, instead of working through a natural conduit, gold, would find outlet in the hoarding of other marketable merchandise, an unnatural conduit, which is fraught with the greatest dangers, namely, that of generating a runaway vibrator through resonance between price fluctuations and interest-rate fluctuations, such as Kondratiev's long-wave inflation/deflation cycle.

Rise of the gold standard

The gold standard shall, like the mythological bird Phoenix, rise from its ashes when the regime of irredeemable currency forced on the peoples of the world will self-destruct, as the time-bomb of ever-increasing unpayable debt, having reached critical mass, goes off. The born-again international gold standard will be complete with its natural clearing system, the international bill market. Advocates of the so-called 100 percent gold standard display a most profound ignorance of monetary science when they naively think that the clearing system of the new gold standard will consist of fleets of cargo planes flying gold around the world to satisfy their taste for purity.

There is a great urgency to have a national debate on the burning questions how to prepare for the cataclysmic collapse of the regime of irredeemable currency that is now threatening the world. It is inexcusable that some people are trying to smuggle in their own petty agenda and derail the orderly discussion of the main issue, the study of the operation of the gold standard in depth, including its clearing system the bill market, and its signaling system the discount rate (as distinct from the rate of interest).

The second coming of the gold standard and the bill market is inevitable, despite the charlatanism of the opponents of real bills. Their 100 percent gold standard will be rejected 100 percent by events as they unfold.

Antal E. Fekete, Where Mises Went Wrong, SafeHaven, September 15, 2005
Antal E. Fekete, Unemployment: Human Sacrifice on the Altar of Mammon, SafeHaven, September 30, 2005
Antal E. Fekete, Economic Entropy, SafeHaven, October 9, 2005


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