The Myth Of The Free-Market Gold Standard

An interesting perspective. Aivars Lode


Forbes Magazine, 4/20/2012, Timothy B. Lee

I suggested that a fall in the value of the dollar due to money creation by a central bank is little different, morally speaking, from an oil company pushing down the price of oil by increasing production. Commenters raised a number of objections; here I want to focus on the oft-mentioned argument that money is different than oil because the government has a monopoly on money, while no one has a monopoly on oil.

On the surface, these seem like totally distinct questions. It’s been a very long time since we’ve had a genuine free market in currency, and so it’s hard to predict what such a market would look like. In principle, there’s no reason to assume that a private issuer of currency would produce a stable price level.

I think the reason so many people see a link between free markets and stable prices is that they see a gold standard as the alternative to central banking. And it’s true that the gold-backed currencies of the 19th Century held their value better than modern-day fiat currencies do. But the 19th Century gold standard was instituted by an 1873 act of Congress, it was hardly the result of market forces.

Moreover, it’s easy to overstate the extent to which gold- and silver-backed currency standards limited the government’s control over inflation rates. While the 1896 presidential campaign was nominally about whether to allow silver to be used as currency, the actual policy question was whether to expand or contract the money supply. The “free coinage of silver” advocated by Williams Jennings Bryan was the quantitative easing of its day. Bryan’s easy money views were no more or less free-market than the hard-money policies of his opponent William McKinley.

Even assuming that the free market would have produced gold-backed currencies in the 19th century, that by no means implies that it would do so today. During the 20th Century, we went from a world in which most people dealt in cash to one in which most people pay by check and (increasingly) credit card. In a world dominated by electronic methods of payment, interoperability is extremely important. And this means that as a practical matter, the incumbent banks that control the nation’s major payment networks would have a tremendous amount of influence over the choice of currency standard. And it’s hard to see why they’d go with a commodity-backed currency. After all, the ability to create money is extremely profitable.

Supporters of a gold standard believe that consumers would reject private fiat currencies in favor of commodity-backed currencies because the latter is likely to have a lower inflation rate over the long run. But observing consumers’ actual behavior tells another story.

Consider the case of credit cards. Credit card companies charge fees of around two percent for every transaction. Merchants and their customers can avoid paying those fees by dealing in cash. Yet most merchants find the convenience of accepting plastic to be worth the cost, and few customers go out of their way to patronize cash-only establishments because their prices are 2 percent lower.

The same point would likely apply to competing currencies. Obviously, consumers would eschew currencies with extremely high inflation rates. But given a choice between a convenient currency with a four percent inflation rate or an inconvenient currency with a zero percent inflation rate, most consumers are going to pick the more convenient currency. And that means that the market-leading currencies would have some room to expand the money supply (making large profits for themselves in the process) without much risk of lost market share.

So it’s far from obvious that a free market in currency would produce an inflation rate of zero. To the contrary, a free market in currency would likely result in a consortium of large banks controlling the money supply. This consortium would have a strong incentive to maximize real economic output, since doing so would maximize the profitability of its money-supply franchise in the long run. And so if, as many economists believe, the output-maximizing inflation rate is around 2 percent, that’s likely the inflation rate private issuers of currency would target.