Should we have a hard dollar, backed by gold?

Summary: We’ll hear much from Republicans during Campaign 2016 about the glories of a gold-backed currency. Today’s post debunks that with history from 19th Century Britain, when both men and money were hard.   {1st of 2 posts today}

“Accursed thirst for gold! what dost thou not compel mortals to do?”
— Virgil’s Æneid (29-19 BC).

Belief in the superiority of a gold-based currency is a core element of their faux economics. They believe it provides a fixed foundation for the economy and prevents boom-bust cycles. It ignores not just modern economic theory but also two centuries of western history.

First, fixed is not always good. It’s usually better for interest rates and currency values to change rather than shocks flow through to national income and employment. To use a bad medical analogy, why don’t we all get pacemakers to stabilize our heart rate? Would a fixed pulse improve our health, especially during sex and other forms of vigorous exercise?

Second, a gold-based currency does not prevent financial bubbles or minimize boom-bust cycles. These occurred under the one of the most solid monetary systems, 19th C Britain, predating fiat currencies (and another of the Right’s bugaboos, fractional reserve banking; see Wikipedia for details). These cycles are an inherent aspect of free-market economies. They can occur even without credit, and can be reproduced in classroom exercises.

James Narron and Don Morgan at Fed of New York tell the story of one of the first great modern bubbles, it’s bursting, and the Bank of England’s successful response: “Crisis Chronicles: Railway Mania, the Hungry Forties, and the Commercial Crisis of 1847“. It’s a fascinating story and relevant to us today. Excerpt…

Railway Mania

British railway mania had a long fuse. The nation went through a lesser, “hypomanic” railway episode in the 1830s, but with the economy weak in the late 1830s and early 1840s, owing partly to the aftermath of the Panic of 1837, the spark did not catch. By 1843, however, the economy was recovering, interest rates were low, railroad construction costs were falling, and railway revenues were rising, thus setting the stage for a full-blown manic episode.

As is usually the case with technology booms, extravagant claims about the transformative powers of the new technology abounded: “Verily railways are the wonder of the world! Nothing during the last few years has created so marvelous a change as the great iron revolution of science” (Evans). Instead of “Internet speed,” as heard during the telecom bubble, the talk then was of “railroad speed.” The growing middle class in Britain, thanks to the industrial revolution, created a larger new cohort of eager investors wanting in on the action. With investors crowding, the number of railroad securities listed on the London exchange — and their prices — roughly tripled between 1843 and 1845.

… The mania, or “collective hallucination,” subsided in late 1845 as expectations seemed to turn, in part because of naysaying by the Economist (founded in 1843) and the London Times. On October 16 of that year, the Bank of England raised discount rates, and as credit tightened, railroad share prices began a long, steep decline, wiping out many fortunes along the way.

The Hungry Forties

With collapsing railroad prices as background, the proximate cause of the Commercial Crisis of 1847 was the shock to the agricultural sector and the subsequent financial and monetary fallout (Dornbusch and Frenkel). …

The Bank Charter Act and the Week of Terror

The Bank of England’s ability to contain the crisis as a lender of last resort was severely constrained by the Bank Charter Act of 1844 (Humphrey and Keleher). The Act gave the Bank of England a monopoly on new note (essentially money) issuance but required that all new notes be backed by gold or government debt. The intent, per Currency School doctrine, was to prevent financial crises and inflation by inhibiting currency creation. Adherents recognized that the Act might also limit the central bank’s discretion to manage crises, but they argued that limiting currency creation would prevent financial crises in the first place, thus obviating the need for a lender of last resort. But, of course, not all crises originate in the financial sector.

In the case of the Commercial Crisis, the perverse effect of the Act was to cause the Bank to tighten monetary conditions in both April and October as gold reserves drained from the Bank (Dornbusch and Frenkel). In July, a coalition of merchants, bankers, and traders issued a letter against the Bank Charter Act, blaming it for “an extent of monetary pressure, such as is without precedent” (Gregory 1929, quoted in Dornbusch and Frenkel).

The panic culminated in a “Week of Terror,” October 17-23, with multiple banks failing or suspending payments to depositors in the midst of runs. The Royal Bank of Liverpool shuttered its doors on Tuesday, followed by three other banks, and by the end of the week the Bank of England held less than two million pounds in reserve, down from eight million in January. Systemic collapse seemed imminent.

On Saturday of that week, London bankers petitioned the prime minister to suspend the Bank Act, and by midday Monday, the Bank of England had received a letter from the prime minister and the chancellor of the exchequer authorizing the Bank to issue new notes without gold backing and to “enlarge the amount of their discounts and advances upon approved security,” effectively suspending the Bank Act.

The ability to expand fiat note issuance increased liquidity and helped the Bank restore confidence, and the high discount rate the Bank was charging attracted gold reserves back to its vaults (hence the maxim “seven percent will draw gold from the moon”). By December, interest rates were down substantially from their panic levels.

Lessons for Modern Times?

In contrast to the Bank of England in 1847, the Federal Reserve during the Panic of 2007-2008 was authorized to act as lender of last resort, and, in fact, the Fed acted aggressively to provide liquidity to the financial system in unprecedented ways. Through a variety of newly created facilities, the Fed expanded the types of institutions it would lend to, including nonbanks, and the types of collateral it would lend against, including asset-backed securities.

——————  End excerpt  ——————

For More Information

The gold standard worked for the UK because its leaders allowed the Bank of England to break its bonds during emergencies. Brad Delong (Prof Economics, Berkeley) explains…

1. “The ECB’s Battle Against Central Banking“.
2. “Central Banks Have the Power to Do Things They Have No Power to Do Department“.

To learn more about the great 19th C railroad bubbles start with see Wikipedia. For detailed analysis see these articles by the brilliant Andrew Odlyzko (Prof Mathematics, U MN; his bio here). Odlyzko shows how bubbles look sensible at the time, until their underlying assumptions prove wrong over the short-term — even if they prove to be correct over the long-term.

• “The collapse of the Railway Mania, the development of capital markets, and the forgotten role of Robert Lucas Nash (a forgotten pioneer of accounting & financial analysis)”, Accounting History Review — See an extended preprint PDF.
• “The Railway Mania: Fraud, disappointed expectations, and the modern economy”, Journal of the Railway & Canal Historical Society — See a preprint PDF.
• “Charles Mackay’s own extraordinary popular delusions and the Railway Mania”.

If you liked this post, like us on Facebook and follow us on Twitter. See all posts about gold, about central banks, and especially these…

• Government policy errors as a cause of the Great Depression.
• Explaining the gold standard, the Euro, Default, Deflation, and Hyperinflation.
• What every American needs to know about the Federal Reserve System.
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