Gold and Economic Freedom
by Alan Greenspan
[written in 1966]
This article originally appeared in a newsletter: The Objectivist
published in 1966 and was reprinted in Ayn Rand's Capitalism:
The Unknown Ideal
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 Was 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.
Alan Greenspan
[written in 1966]
