“Fool’s Gold” Standards

In a recent Mises Daily, “A Golden Opportunity“, Patrick Barron and Godfrey Bloom make the case for Germany to withdraw from the monetary union combined with a strong argument that “a golden Deutsche Mark is possible and desirable”. This recommendation may be a step in the right direction, but it leaves Germany with a central bank and a discretionary monetary policy: “The Bundesbank would be responsible for monetary policy just as it was before Germany joined the EMU”. They conclude,

A prerequisite to market acceptance of any gold money would be confidence in the integrity of the sponsoring institution. Not only is the Bundesbank known for its integrity and reverence for stable money; Germany itself has a worldwide reputation for the rule of law, advanced financial architecture, and a stable political system. For these reasons, Germany would prove to the world that a gold-backed money is not only possible but desirable. (emphasis added)

Joe Salerno, in “Gold Standards: True and False“, provides some sound guidance on discussion of a return to gold. What is ultimately desired is a return to a market-chosen money, which has historically been a commodity — gold or silver money, not a gold- or silver-“backed” money. Salerno’s caution continues to be relevant. He argues,

A significant development in the current controversy over the role of gold in the U.S. monetary system, which has potentially important implications for both monetary theory and policy, has gone largely unnoticed by commentators on both sides of the debate. I am referring to the emergence of a new defense of gold that differs fundamentally from the traditional case for the gold standard. This development has been obscured by the diversity of plans for monetary reform coming out of the pro-gold camp. A close examination of these proposals, however, reveals that they are of two distinct types; they differ not only in the reasons they offer for considering a gold standard desirable, but also in their conception of what monetary arrangements constitute a “gold standard.”

First, there are the proposals that embody the traditional “hard money” arguments for the gold standard. These arguments focus on the desirability of a free-market commodity money vis-à-vis a government-monopolized paper fiat money. The basic thrust of the hard money proposals is to render government monetary policy superfluous by restoring a genuine gold standard under which the quantity and value of money is determined solely by market forces. The second group of pro-gold writers, whose proposals have received the most publicity, have eschewed the traditional hard-money case for gold and in its stead constructed a quite novel case purporting to demonstrate that gold can provide government monetary authorities with an effective instrument for managing the money-supply process within the established fiat-money framework. For this group, the raison d’être of a gold-based monetary regime is that it facilitates the achievement of government monetary policy objectives. Needless to say, the gold standard envisioned by these policy-oriented advocates differs quite radically from the ideal of the hard-money group. The gold “price rule,” which is the monetary reform favored by most policy-oriented gold advocates, bears only a superficial resemblance to the traditional conception of the gold standard. (emphasis added)

Given Professor Salerno’s careful differentiation of proposed gold standards as either true or false standards, one must be careful when evaluating any proposal for a return to gold. Questions of concern:

  1. Will the proposal, in the short run, be a better monetary system with better monetary policy than the current system of nationalized (or “continentalized,” in the case of the euro) fiat moneys?
  2. Is the proposal one that will move the system over time to a true gold standard — a gold-coin standard?
  3. Will the proposal become like the interwar gold-exchange standard, a false standard that will likely lead to economic results that will discredit gold (and/or silver) as money?

Salerno’s comments are equally applicable to other current discussions concerning gold that have recently appeared in the Wall Street JournalSeth Lipsky, in “The Gold Standard Goes Mainstream“, points out that, as a result of Ron Paul’s influence, “In the ferment within today’s Republican Party, there’s a growing realization that America’s system of fiat money is part of the economic problem.” He concludes,

It is no small thing that Mr. Romney’s platform calls for a gold commission and an audit of the Fed. The last Republican to run on a platform calling for a dollar “on a fully convertible gold basis” was Dwight Eisenhower, who cast the promise aside once in office. That’s a strategic misstep for Mr. Romney, should he win in November. (emphasis added)

In a critique of a return to gold, John H. Cochrane of the University of Chicago concludes, “No monetary system can absolve a nation of its fiscal sins.”

Ron Paul, in “Why Monetary Freedom Matters,” reinforces Salerno’s caution on true reform, a market determined money, versus reforms, that while perhaps better than a “false trust in fiat money” will leave too many opportunities for monetary mischief. Paul states, “As far back as the Gold Commission (1982), I’ve made the case for gold.” But he wouldn’t close down the central bank: he would legalize competition in currencies, repeal legal-tender laws, and eliminate all taxes on silver or gold purchases, and allow private mints. In essence, his proposal is

similar to what F. A. Hayek (1976, 1978) had talked about. Why don’t we denationalize money, legalize competition, allow free markets to work, and allow free-market banking to work?

Armed with Salerno’s strong case for a true gold standard, you be the judge. In my judgment, Ron Paul is on the right track; Cochrane is misdirected by false gold standards; and Barron and Bloom’s proposal, while attractive in the short run, is (if not accompanied by Paul’s suggested reforms in the United States and elsewhere) most likely a step in the wrong direction.

Advocates of sound money should be heartened by the interest currently being generated for monetary reform. Discussion should be guided with a few things in mind:
  1. Gerald P. O’Driscoll Jr.’s concerns about abolishing central banks,[1]
  2. Salerno’s gold standard: true or false, and
  3. Paul’s caveat that

Others are thinking about it [monetary reform], but some of them would like to internationalize something different than the dollar reserve standard. They would like to have another fiat currency and a pretend alliance with gold — and they want to move control over a new global currency into the IMF and the World Bank. I think that would be a disaster. (emphasis added)

Let’s hope Lipsky’s optimism concerning a gold commission becomes a reality where a “well-conceived and well-staffed gold commission” (preferably one dominated by Austrian-influenced economists) actually sorts out the issues in favor of competition in currency and an evolution toward a gold-coin standard à la the outline provided by Paul.[2]


[1] See “Central Banks: Abolish or Reform.” HT to Kurt Schuler at Free Banking.

[2] For legislation embodying Paul’s suggestions see “Free Competition in Currency Act of 2011″ (H.R. 1098).

This article was previously published at


The Importance of Debate on Banking Freedom

A recent QJAE paper by Bagus and Howden has reignited the controversy over Fractional Reserve Free Banking versus Full (100%) Reserve Banking. Per Toby Baxendale, “two very clear conceptions of money (have been) developed by Austrian School theorists past and present”. One is a Monetary Equilibrium Theory (MET) branch, favouring Fractional Reserve Free Banking, with “the rest of the Austrians favouring Full Reserve Banking.”

There are, however, some Austrians in neither camp; what I would call agnostic (Cochran 2010, p. 121-22) relative to free banking. As a long time contributor to developments of Austrian Business Cycle Theory (ABCT) with this view, I recognize the potential for a 100% banking system to eliminate the credit creation at the heart of the ABCT boom-bust process. However, I recognize the complexity of the saving-investment process in a capitalistic system with well-developed financial markets (including banks) which are heavily dependent on financial intermediation to funnel savings from ultimate savers to ultimate investors through what is often simplistically represented as a loanable funds market.

As hinted at by Baxendale, at the heart of many, if not most, of the controversies surrounding the role of money and banking in an advanced economy is the careful differentiation of dual services provided by banks: transaction services and intermediation. The issue is made more complicated by the possibility that the public may willingly and knowingly hold financial instruments that can be viewed by the holder as a transaction asset while, simultaneously, at least some of these funds may be a source of loanable funds; funds for which the bank intermediates between ultimate lender (depositor) and an ultimate borrower.

The ‘free bankers’ make an effective case that under proper conditions banking freedom is an institutional framework that would, given the great uncertainty and risk involved in any time-related planning, allow the voluntary interaction of agents to channel funds from savers to investors while minimizing trading at false prices, in this context deviations of interest rates from the natural rate(s).

In an earlier attempt to examine this issue rigorously, Cochran and Call (2000) concluded in favor of banking freedom:

A definition of commodity credit provided by Mises (On the Manipulation of Money and Credit 1978, p. 119), however, leaves the door open for a compromise. Commodity credit is “credit which a bank grants by lending its own funds or funds placed at its disposal by depositors.” Under what conditions are funds placed at the disposal of the bank by depositors? The problem is that the short run merges into the long run in gradations that are, as Marshall suggested, imperceptible. Money can be, and often is, both a present good and a future good, depending, in part, on the subjective evaluation of the depositor. As Friedman (“The Quantity of Money: A Restatement” 1956, p. 14) pointed out, economic agents hold cash balances because they derive utility from both sources and the same unit of money may provide both services. Where cash holdings are a form of saving, the holder may actually be willing to temporarily surrender the present for the future. Such funds (and the resources made available by the saving) can be made available for loans.

Here, the market, as it often does, provides a solution. Free banking is a process where the market makes the ultimate judgment on where to draw the line between money as a present good and money as a future good. Bankers must make a judgment on the proportion of their deposits that represent saving and the proportion that are currently serving as present money for the holders of the deposits. Only funds held as savings may be safely “invested” or loaned. Consumers of banking services make judgments about the safety and soundness of the banking institutions with which they deal. Successful banks will provide the mix of services that meet the needs of their clients. The market test makes it qualitatively difficult to distinguish the Mises from the Selgin outcome. While Mises expected the discipline of the market to move banks closer to the 100-percent-reserve position, Selgin anticipates lower levels of reserves and hence more intermediation and lending. Just as Marshall’s short run blends into the long run, the practical aspects of Mises’s theory of money, credit, and banking blend into the theory of free banking provided by Selgin.

A footnote provided the following caveat:

The above argument depends on the caveat that free banking means banks operate in an environment in which banks are subject to the general rules of commercial and civil law and are not the recipients of special privileges and protections granted by the state. As expressed by Mises (1998, p. 440 [Human Action: A Treatise on Economics. Scholar’s Edition]),

What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.

In simpler words, those criticizing free banking, properly understood, on cycle grounds need to look elsewhere to justify a 100% reserve system.

Bagus and Howden represent the latest challenge and others (Selgin and Evans and Horwitz) have adequately responded. While applauding Bagus’s and Howden’s “abstaining from a discussion of legal and ethical issues”, both critiques expose the weakness of the arguments presented by Bagus and Howden. Evans and Horwitz then “attempt to specify how debate between the two sides might proceed more productively.”

Since my above-quoted article was penned, other touted challenges to the free banking argument have arisen particularly from De Soto (Money, Bank Credit, and Economic Cycles, 2009) and from Jörg Guido Hülsmann (“Has Fractional-Reserve Banking Really Passed the Market Test?”, The Independent Review, Winter 2003).

In correspondence with Larry Sechrest right before his untimely death, we agreed that we both had hoped these contributions would move forward the discussion and perhaps, especially for me, provide acceptable arguments in support of the 100% reserve position. We both were disappointed with the arguments presented, for reasons very similar to the criticisms by Selgin of the Bagus and Howden paper. Since Larry put his thoughts in writing, I’ll refer interested readers to the new preface in the Mises Institute reprint of his Free Banking.

The discussion generated both on the web and in academic writings by Bagus and Howden should be welcome in light of the recent crisis and its aftermath. It is more important than ever that “the question of banking freedom must … be discussed again and again, on basic principles” (Mises, On the Manipulation of Money and Credit 1978 p. 45).