GOLD AND ECONOMIC FREEDOM by Alan Greenspan
Written in 1966, this essay is taken from “The Liberty Dollar Solution,” edited by Bernard von NotHaus.
GOLD AND ECONOMIC FREEDOM
by Alan Greenspan
Since the beginning of World War I, gold has been virtually the sole international standard of
exchange.
Gold, having both artistic and functional uses and being relatively scarce, has always been considered
a luxury good. It is durable, portable, homogeneous, divisible and, therefore, has significant
advantages over all other media of exchange.
But 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 division 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) that act as a substitute for, but are convertible into, gold.
A free banking system based on gold is able to extend and thus to create bank notes (currency) and
deposits, according to the production 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 for 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 worldwide 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 re-established 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 12 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 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 worldwide series of bank
failures. The world economies plunged into the Great Depression of the 1930’s.
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 “hidden” 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.
Regards,
Alan Greenspan
for The Daily Reckoning
Editor’s Note: Alan Greenspan is chairman of the Federal Reserve and conductor of the world’s greatest
experiment in paper money.