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Democracy’s Journey Away from Gold

Central banks thus representing an exception to the democratic principle, the question arises how their artificial regulation of money came to displace the natural approach represented by gold. It is not as if the yellow metal has nothing democratic in its favor. The automatic character of the gold standard means that nobody needs to be invested with special powers to oversee the money supply. To the extent that the government would need to be involved via a central bank, this body would assume the significantly more modest function of ensuring the smooth operation of the gold standard whenever it runs into the occasional hiccup or comes under extraordinary stress. In performing these functions, the state would simply be ratifying the public’s choice of gold as the natural object best fitted to serve as money. The democratic will here registers its decision not through the ballot box but through the marketplace. what eventually reversed this ostensible placement of gold in democracy’s corner was two-fold. One was the strategic logic of electoral politics. The other was the values and habits of mind instilled by democracy.

The first test of liberal democracy’s original commitment to gold came in the nation of its birth, Britain. In the aftermath of the French Revolution, Britain became embroiled in a war with its neighbor across the English channel, which eventually involved the country in a protracted conflict with Napoleon. Britain had been on a de facto gold standard, though de jure a bimetallic standard including silver, since the early eighteenth century. But as the war with Napoleon became more protracted, a series of bank runs in 1796-1797 prompted the Bank of England to suspend the redeemability of its notes into gold. Inflation subsequently percolated upward and a debate was started on its causes.[1] Leading off for the bullionist side was Walter Boyd. He was a banker whose firm had recently gone into bankruptcy after the government stopped using it to market their loans. Though undoubtedly biased against the establishment as a result, his argument was nevertheless sound. In a 1801 pamphlet, Boyd maintained that the inflation was owing to the excess production of notes by the Bank of England to help finance the war with the French, an excess made possible by the suspension of convertibility.[2] To the central bank’s defense quickly came the anti-bullionist side, led by figures such as Nicholas Vansittart and Charles Bosanquet. They blamed higher prices on the combination of poor harvests, excessive note issuance by the country banks outside London, and the channeling of funds to Britain’s allies in the war. A key plank in their stance was their denial that the central bank could ever supply too much money, so long as it restricted itself to discounting sound commercial paper, that is, to buying short-term IOU’s (stands for “I owe you”, an acceptance of a debt) that merchants had contracted with others. The real bills doctrine, as this view is known, holds that this discounting activity will always keep the money supply in line with the needs of trade.

Taken to its logical extent, the anti-bullionist view leads to the conclusion that a permanently inconvertible paper money is viable. David Ricardo, who eventually joined the bullionist forces and became its most illustrious spokesman, was able to hinder that conclusion from being acted upon. With a deductive logic that would later be derided as the Ricardian vice, the great nineteenth-century English economist pressed the thesis that a superabundance of money was the culprit of Britain’s inflationary woes. He pointed out that the country banks, their notes being backed up by those of the Bank of England, could only issue additional currency on a base expanded by the central bank. Inveighing against the real bills doctrine, Ricardo observed that the quantity of money equivalent to the needs of trade could not be defined. “Commerce is insatiable in its demands”, he writes, “and the same portion of it may employ 10 millions or 100 millions of circulating media”.[3] In other words, the more money that is supplied, the more it depreciates. Eventually, its new value becomes proportionate to the existing quantity of goods. Any amount of money, then, can suffice for the requirements of commerce. It is only its purchasing power that changes.

Ricardo’s greatest stress, though, was on the injustice to which creditors would be vulnerable with fiat money. Their property rights would be violated. Upon repayment of the loan, they would end up with the ability to buy fewer goods than they originally had when making the loan. This is actually Ricardo’s closing point in his reply to the anti-bullionist Bosanquet. Elsewhere, in his On the Principles of Political Economy and Taxation., Ricardo underlines:

Experience, however, shews, that neither a State nor a Bank ever have had the unrestricted power of issuing paper money, without abusing that power: in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper for that purpose, as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or bullion.[4]

Ricardo’s thinking here was reflected in the 1810 Bullion Report calling for an immediate resumption of the gold standard. Produced by a British parliamentary committee, it was voted down when put before the entire House of Commons. Still, Britain’s legislative body did not categorically reject the idea of restoring convertibility. With the Napoleonic wars continuing to rage, Parliament thought it too early for a return to gold.[5] With the cessation of hostilities in 1815, Britain’s liberal democracy was put back on the road to the gold standard. The redeemability of notes into specie was reinstituted in 1821.

Another monetary controversy erupted not too long afterward upon a sequence of financial crises in 1825, 1836-1837, and 1839. This time, it was a debate between the banking and currency schools.[6] Demonstrating how the question of the gold standard had now been settled, both parties agreed with the species redemption principle. Still, they differed on how best to implement it. The currency school maintained that the totality of money in circulation can be kept equivalent to what a purely metallic currency regime would entail by ensuring that all the notes issued are backed 100 % by gold reserves. By contrast, the banking school insisted that this was not enough, as money also consists of payment media such as bank deposits. They argued that a larger gold stock than that to support the notes was required if the central bank was going to have the wherewithal to supply liquidity to the financial system in a period of crisis. As it turned out, the currency school won the contest politically. Its convertibility rule was enshrined in the 1844 Peel Act. More importantly, too, that legislation established the Bank of England as the exclusive issuer of notes to implement the 100 % coverage rule.

Peel’s legislation shaped the framework of the classical gold standard. Forming a global monetary order, it can be said to have commenced in 1871 and reigned until 1914. Germany gave impetus to the international movement toward the yellow metal, when it moved away from a silver- based currency to one founded on gold. It was soon followed by Belgium, Switzerland, Italy, France, Netherlands, Denmark, Norway, and Sweden.[7] Gaining momentum, the adoption of gold spread to the rest of Europe and most of Asia, with China a notable exception. Not all of these nations were liberal democracies at the time, but the burgeoning republic of the USA would eventually join the gold system. It had to wait until 1879 to digest the tectonic shifts in American society and politics brought about by the Civil War. A number of the classical gold standard nations turned into democracies prior to 1914, such as New Zealand and Finland, while choosing to retain their link to the precious metal. Figure 3.2 depicts a rising trend for the number of democracies (as defined by the Polity IV scale)[8] as the classical gold standard proceeded from 1871 to 1913.

In retrospect, it is clear that this early relationship was doomed. It was not that the gold standard was an economic failure. In its classical version at least, it worked very well. With governments constrained from printing money at will, the system delivered on its main promise of preventing inflation. In 1913, on the eve of World War I precipitating the abandonment of gold convertibility, the consumer price level in the USA and Britain was actually lower than it was in 1873. As (Fig. 3.3)[9] indicates,

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Fig. 3.2 Number of democracies, 1871-1913. Source: Polity IV

US and UK retail prices, 1871-1913. Source

Fig. 3.3 US and UK retail prices, 1871-1913. Source: Measuring Worth

this performance can be broken down into two sub-periods—a deflationary tendency from the early 1870s to the mid-1890s, followed by a steady rise in prices through to 1913. This latter trend reflected additions to the gold supply, primarily from the discoveries in South Africa.

Current economic orthodoxy views deflation with horror. It is painted as a nefarious force that plunges economies into depression. The fear is that lower prices set a vicious circle into motion in which firms react to the attendant drop in revenues by laying off workers. Those left unemployed then buy fewer goods and services. So do those still employed, who have suddenly become more anxious about their job security. Sales fall again as a result, prompting this same process to repeat itself. Add to this that the drop in the price level increases the real burden of individual and corporate debt. This further reduces the demand for goods and services, as more resources are directed to meeting outstanding loan obligations. Meanwhile, some fail to pay these debts, and so bankruptcies rise.[10] Financial institutions that originally lent this money are then compelled to tighten credit availability to otherwise healthy firms, adding even more fuel to the economy’s slide.

But the pre-World War I experience shows that deflation is not necessarily evil. In a growing economy, where the money supply is kept constant, deflation is precisely what is to be naturally expected. Prosperity is about a progressively larger quantity of goods being produced over time. There can be no doubt that the economy grew impressively during the classical gold standard period. From 1871 to 1913, British real GDP more than doubled, rising 112 %. During the post-Civil War period that the USA was on gold extending from 1879 to 1913, its real GDP more than tripled, up 260 %.[11] Britain had already been on the gold standard since 1821 and, over the ensuing 50 years, its real GDP nearly tripled. As if that were not proof enough, compare that pre-World War I American experience to a similarly sized time frame when the gold standard ceased to be in operation. So as not to bias the comparison, let us remove the period of lackluster growth witnessed after the recent financial crisis. Consider 1974-2008: real GDP went up 169 % during this period versus 261 % from 1879 to 1913 (Fig. 3.4).

True enough, prior to World War I, the USA was what we would today call an emerging market economy. As such, it could be expected to

US and UK real GDP growth, with and without gold. Source

Fig. 3.4 US and UK real GDP growth, with and without gold. Source: Angus Maddison

enjoy higher growth rates than the developed nation it has since become. But even if we partially adjust for that by factoring the difference in the amount of human labor input, and thus consider GDP per capita, the USA saw that figure increase 89 % from 1974 to 2008, not much different from the 82 % ascent during the deflationary era of 1879-1913. Keep in mind that economic data prior to World War I is not as reliable as that recorded since the 1920s. Also, the constructed numbers have embedded within them the assumption that deflation is always correlated with diminishing economic activity. It is plausible, then, that the level of economic activity during the classical gold standard era has been underestimated. Broadening the analysis to more countries, a study looking at 17 of them over more than a century found that depression did not follow a deflationary phase 90 % of the time.[12] Economists, it seems, have been misled by the Great Depression into overgeneralizing the dangers of deflation.

That danger, to be sure, is real. But we must distinguish between good and bad deflations. In the context of an advancing economy, deflation is good. This is because the demand for money, emanating from companies looking to turn their produced goods into cash, rises only steadily. Economic actors have sufficient time to calmly adjust to the price changes. But in the context of a sharp and sudden increase in the demand for money, deflation is bad. Such surges in the demand for money are most liable to occur in crisis situations. Whenever a mass of individuals and firms are short of funds, there is a rush to sell goods and financial assets for money. Even those not short of funds are tempted to seek refuge from the maelstrom and raise their cash position. The widespread fright thereby triggered becomes such that most decide the wiser course is to hunker down by reducing consumption and investment. To relax everyone’s nerves here, it is necessary that the money supply increase to cushion the demand shock.

Opponents of the gold standard maintain that it prevents this very response from taking place. The government is stripped of any discretionary sanction to inflate the money stock. Following Barry Eichengreen, it is commonly alleged that the monetary link to gold deepened—if it did not outright cause—the Great Depression.[13] Without getting too enmeshed in the history of the period, leading up to the early 1930s, the USA had long been a net recipient of gold flows. From 1914 to 1930, US gold reserves had nearly tripled.[14] So despite a temporary surge of outflows in late 1931, in reaction to Britain’s abandonment of the gold standard, the Fed had ample room to feed liquidity into the system.[15] It certainly had enough to prevent solvent financial institutions from being forced into bankruptcy and the public from subsequently losing confidence in banks and withdrawing their money en masse—both those circumstances precipitating a catastrophic tumble in the money supply that turned a recession into a depression.[16]

Moreover, a gold standard does not have to be structured in such a way as to require the entire money supply be backstopped. As the classical version based on the 1844 Peel Act was limited to notes outstanding, it left bank deposits free to fluctuate.[17] As such, the central bank can act as a lender of last resort by adjusting the reserves-to-deposits ratio. This is a prime example of that prudence discussed before fully consistent with the implementation of a natural measure like the gold standard. It cannot be forgotten either that this lender of last resort function was originally set forth by Walter Bagehot in his Lombard Street: A Description of the Money Market. This book was published in 1873 when Britain was operating under the classical gold system.[18] Clearly, he did not view that role as being irreconcilable with the convertibility of money into gold.

The Great Depression, too, tells nothing against a precious metal reserve precisely because such a framework no longer truly existed. After World War I, the world moved to a gold exchange standard. Under this regime, only one or a few currencies are directly backed by gold. The remaining currencies revolve around these, fixed in value against them on the FX market.[19] Heading into the 1930s’ Depression, the US dollar and British pound served as the anchors for the gold exchange system. Favored at the time for the greater elasticity it offered to nations in managing their respective money supplies, the gold exchange system has the problem of providing too much elasticity. Rather than the general public holding their respective states to account, the system shifts the responsibility to other states. More precisely, it falls to those states running the non-anchor currencies.

The convertibility check thus becomes a matter of political negotiation. Initially possessing the greater leverage are the anchor countries. They are in control of the currency most widely used to settle international transactions. Yet they are under the temptation of exploiting their leverage by issuing more money than they can actually back up. This temptation is all the more alluring due to the non-anchor countries’ willingness to accumulate holdings of anchor currencies. The greater their reserves of these

and Sons, 1999), 64-65.

anchor currencies, the more easily the non-anchors can support their own money supply. Inevitably, as this buildup of reserves continues apace, the leverage will transfer to the non-anchor group. They now can wield the threat of converting their holdings of the anchor currencies into specie and depleting the gold held by the anchor group.

As it turned out, during the 1920s, the USA took advantage of its anchor status to run an easy money policy. In no small part, this was to help Britain deal with an overvalued currency brought about by the country’s regrettable decision in 1925 to return to gold at the pre-war conversion rate. The enormous inflation caused by all the money printing to pay for World War I turned this move into a recipe for a huge and painful decline in prices.[20] The Fed, then led by Benjamin Strong, was already experimenting to stabilize prices and was encouraged in its loose money stance by the fact that consumer prices were steady. But it neglected to consider asset prices. These were accelerating upward in the stock market. The Fed also ignored that significant improvements in productivity during the 1920s were hiding the inflation that was actually taking place. Without the excess liquidity being provided, consumer prices would have gone down as a result of the greater quantity of goods being produced. The upshot of the Fed’s monetary discretion within the gold exchange standard was an unsustainable boom. That set up the stock market bust of 1929 along with the economic downturn of the early 1930s that led numerous countries, including Britain in 1931, to delink their currencies to gold.

The Bretton Woods system set up after World War II was also a gold exchange standard. In this reincarnation of the interwar scheme, the US dollar was made the sole anchor, reflecting the country’s status as the world’s largest creditor and the currency’s position as the leading monetary unit in international trade. It was fixed at $35 per ounce, though only central banks could request to convert their dollars into gold. Bretton Woods proved a sturdier gold exchange standard than its interwar precursor. Yet it too eventually foundered on the inability of the anchor to resist the lure of exploiting its superior position. As more and more dollars were issued than could be redeemed by all the gold stored in Fort Knox and the vaults at the New York Federal Reserve, the situation came to a head in the 1960s during the Johnson and Nixon administrations. The need to fund both the Vietnam War and the Great Society imposed enormous budgetary stresses. Pressure was on the Fed to finance the expenditures, pressure to which it relented. A wave of dollar redemptions for gold hit the US treasury, in a campaign orchestrated by the Charles De Gaulle government in France. He was actually hoping to instigate the return of the classical gold standard. Instead, President Nixon announced the closing of the gold window in August 1971, a momentous decision oddly finalized during a rushed series of meetings at Camp David over a weekend.[21] The Western democracies have been on a fiat money standard ever since.

  • [1] I owe my account of the bullionist debate given here to David Laidler, “Highlights of theBullionist Controversy”, Research Report Nol. 13, Stockholm School of Economics:Institute for Economic History Research, 2000; also, Jacob Viner, Studies in the Theory ofInternational Trade, (New York: Harper and Brothers, 1965), 119-217.
  • [2] Walter Boyd, A Letter to the Right Honorable William Pitt on the Influence of the Stoppageof Issues in Specie (London: J. Wright, Piccadilly, and J. Mawman Poultry, 1801),
  • [3] David Ricardo, The Works of David Ricardo: With a Notice of the Life and Writings of theAuthor (London: John Murray, Albermale Street, 1888), 341.
  • [4] David Ricardo, On the Principles ofPoliticalEconomy and Taxation (London: John Murray,Albermale Street, 1821), 426.
  • [5] David Laidler, “Highlights of the Bullionist Controversy”, 16-17.
  • [6] On this controversy and its legislative aftermath, see Jacob Viner, Studies in the Theory ofInternational Trade, (New York: Harper and Brothers, 1965), 220-224 & 229-234; GlynDavies, A History of Money, 310-313; David Laidler, “Highlights of the BullionistControversy”, 23-25; Murray Rothbard, Classical Economics: An Austrian Perspective on theHistory of Economic Thought, Vol. 2 (Auburn: Ludwig von Mises Institute, 2006), 227-270.
  • [7] Jeffry Frieden, “The Dynamics of International Monetary Systems: International andDomestic Factors in the Rise, Reign, and Demise of the Classical Gold Standard” in The GoldStandard in Theory and History., 2nd ed., eds. Barry J. Eichengreen and Marc Flandreau,207-228. (New York: Methuen, 1995).
  • [8] The Polity IV scale evaluates governments on a continuum from -10 to +10, with theextremes representing an entrenched autocracy and a consolidated democracy, respectively.In assigning a score, considerations include the level of political competition and constraintson executive power. See The Polity IV Project at,
  • [9] Measuring Worth,
  • [10] Irving Fisher, “The Debt Deflation Theory of Depression”, Econometrica, 1, no. 4 (1933),337-357.
  • [11] The growth data presented in this paragraph is derived from the Angus Maddison databaseof historical economic statistics. The relevant data file entitled, “Statistics on WorldPopulation, GDP and Per Capita GDP, 1-2008 AD” can be downloaded at,
  • [12] Andrew Atkeson and Patrick J. Kehoe, “Deflation and Depression: Is there an ImportantLink?” AEA Papers and Proceedings, 94, no. 2 (2004), 99-103.
  • [13] Barry Eichengreen, Golden Fetters’. The Gold Standard and the Great Depression, 1919-1939(New York’ Oxford University Press, 1992).
  • [14] See World Gold Council, “Historical Data - Annual Time Series on World Official GoldReserves since 1845”, (August 10, 2011),
  • [15] Data on US gold inflows and outflows during the 1930s is provided by Price Fishback,“US Monetary and Fiscal Policy in the 1930’s”, Oxford Review of Economic Policy, 26, no. 3((2010), Table 1 at 388-389.
  • [16] Milton Friedman and Anna J. Schwartz, A Monetary History of the United States,1867-1960. (Princeton: Princeton University Press, 1971), 299-419. Between 1929 and1933, the money supply dropped by an astounding one-third—as measured by M2, whichincludes currency held by the public as well as checking and savings deposits.
  • [17] Benn Steil and Manuel Hinds, Money, Markets, and Sovereignty (New Haven: YaleUniversity Press, 2009), 158-159.
  • [18] Walter Bagehot, Lombard Street. A Description of the Money Market (New York: John Wiley
  • [19] Murray Rothbard, “The Gold Exchange Standard in the Interwar Years”, in Money and theNation State: The Financial Revolution, Government, and the World Monetary System, eds.Kevin Dowd and Richard Timberlake, Jr. (Oakland: Independent Institute, 1998), 125-132.
  • [20] Ben Steil and Manuel Hinds, Money, Markets, and Sovereignty, 175.
  • [21] Francis J. Gavin, Gold, Dollars, and the Politics of International Monetary Relations (ChapelHill: University of North Carolina Press, 2004), 120-121 & 129.
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