The Rules of the Gold Standard Game

The academic and investment community has intellectually bought into theories of interest rate manipulation based upon signals gleaned from the quicksand of near-term economic statistics.

Although proven by the scientific methods of economics, somehow the chain of desired short-term outcomes generated through this central planning has a side effect of producing long waves of debt accumulation.

While we were still in the long wave of debt accumulation relative to national income that stretched from the early 1950s to 2008, it was impossible for anyone to refute the case for such a system. Academic studies reinforced the view that inflationary money growth was beneficial and optimal, and importantly, they did not anticipate a financial meltdown.

But the collapse of the stock market in September–October 2008, triggered by the fall of Lehman Brothers, would put academic theory to the test, for the media and politicians would invoke the dreaded analogy to the Great Depression.

Economists will never cease to debate what forces pulled the world into that lost decade of the 1930s, what lifted it out, and what improved policy making might have done. A great deal of academic literature exists, and the tone of the discussion has shifted ever since contemporaneous commentators began the debate over the causes and remedies.

A brief review follows, but in advance two areas in particular might deserve increased attention going forward, forcing accepted explanations to be revised. One is the tendency of credit to grow excessively under a regulated centralized bank that targets inflation through interest rate setting. Another is why modern day floating exchange rates were unable to prevent the buildup of destabilizing trade and capital imbalances.

Economists have gained notoriety in recent decades for linking gold to the Depression’s downturn and then crediting the revival of the late 1930s with the lessening of its use as a currency reserve, not necessarily by outright accusation but through its ability to transmit deflation globally.

This being the case, the inability of today’s floating exchange rates to block the transmission of credit contraction and the deflation of asset prices (and prospectively wages and consumer prices) is a glaring counterpoint to singling out adherence to gold as a cause of poor economic performance of certain nations during that era.

The plethora of academic research published to date advocates the transmission thesis, yet upon careful examination these papers have established only a weak statistical case for it. Uniquely, new research that demonstrates a more convincing correlation that the countries which experienced recovery of industrial production by 1935 had central banks which refrained from extreme efforts to violate the rules of the game necessary for the gold standard.


Bill Baker,
for The Daily Reckoning

[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy here.]

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