This summer marked the 40th anniversary of President Richard M. Nixon’s decision to sever the U.S. dollar’s official link to gold. On August 15, 1971, Nixon took to the airwaves in a national address from the Oval Office to declare that the U.S. Treasury would no longer honor foreigners’ demands to redeem dollars for gold. Because the United States was then the last country in the world with a currency defined by gold, it represented a complete and historic decoupling of the globe’s currencies—literally the money of the entire world—from the yellow metal.

For the first time in at least 2,700 years, dating to the Lydian coinage in what is now Turkey, gold was used as official money nowhere in the world. And for the first time ever the world’s monetary affairs were defined by a system of politically managed fiat currencies—that is, paper money run by governments or their central banks. The story behind Nixon’s catastrophic mistake, and the lessons it contains for today, suggest a framework for monetary policy and reforms that will induce strong and sustainable economic growth in the future.

It is important to understand what many current central bankers seem to have forgotten: the seminal importance of sound money—dependably valued, honest money whose value is not intentionally manipulated—as an institution in a modern exchange economy. Economies grow, and material wealth and welfare advance, through three interconnected phenomena, all of which are crucially supported by a well-functioning monetary unit: 1) efficient use of scarce resources via a system of prices and profit-and-loss, both of which encourage optimizing behavior on the part of all; 2) saving and the accumulation of capital for investment; and 3) the division of labor, specialization, and trade.

Regarding the last phenomenon, we would all be poor, and indeed most of us dead due to starvation, if we had to make and produce all our own food, housing, clothing, and other necessities and modern luxuries. As Adam Smith explained in his famous examination of a pin factory, dividing up the metal-straightening, wire-cutting, grinding, pin-head fashioning, and fastening and bundling operations into 18 separate steps increased the productivity of labor in the factory by at least 240-fold. (This of course dramatically increased productive output and raised workers’ real incomes.) And of course for society at large this specialization was not confined to single factories but spread across industries and agriculture: The baker, the butcher, the brewer, and the cobbler could all focus on their productive specialties and produce for a market wherein they could exchange with other specialists for desired goods.

Via economies of scale and scope, then, specialized production and exchange help to create a material horn of plenty for all in a society that’s felicitously based on peaceful, harmonious social cooperation. And here’s the key: None of this would be possible without a dependable monetary unit that serves as a medium for this exchange. Absent sound money, in fact, a division of labor, with all its specialized knowledge and skills, could hardly be exploited, because barter would mean that, say, a neurosurgeon would have to find a grocer who coincidentally needed brain surgery every time he wanted to obtain food. A barter society is by definition a primitive and poor one.

Similarly, the explosion in human progress in the last three centuries was propelled by the accumulation of capital, the tools, machinery, and other assets that increase per capita output and dramatically increase living standards. And here again, a well-functioning monetary unit facilitates the saving that allows for capital accumulation: Income need not be consumed immediately but can be transferred to others to invest productively in return for future payment streams. Sound money, in short, greatly enhances wealth-creating exchange and transfer of resources between present and future, and in doing so often assists in the development of higher output capacity in the future.

There is a third crucial way in which sound money serves to advance civilized human progress: By providing a common denominator for the expression of all exchange prices between goods, money greatly facilitates trade among all parties, thus extending the breadth of markets as far as money’s use itself, which in turn intensifies the division of labor that increases productive output and per capita incomes. Think about it: Without a monetary unit of account there would be an infinite array of prices for one good against all other goods; for example, the bread-price of shoes, the book-price of apples, and so on. In turn, calculation of profit and loss, on which effective use of scarce resources so critically depends, would be impossible.

In sum the institutional development and use of money has been an immense human achievement, every bit as important as language, property rights, the rule of law, and entrepreneurship in the advancement of human civilization. And it is important to note that while several commodities were tried as monetary exchange media over the centuries, from fish to cigarettes, the precious metals and especially gold were seen to be most effective, as they are valuable, highly divisible, durable, uniform in composition, easily assayable, transportable, and bear high value-to-bulk, along with being relatively stable in annual supply. In short, in an ever-changing world of imperfection, gold has been found to be a near-perfect, and certainly dependably valued, form of money.

Money, International Trade, and Economic Growth

To understand much about our current economic challenges and what to do to meet them, it is important to understand why gold, after several centuries of trial and error, came to be seen as sound money versus paper, other commodities, and even silver. The term sound money is especially important to grasp: It is meant to describe a reliable, dependably valued medium of exchange and account, not subject easily to manipulation, which can therefore effectively perform the three functions of money described above, all of which lead to prosperity and an advancing economy. This is critical for a civilized society whose economy is based on monetary exchange, because money is literally one-half of every transaction. So when the value of the monetary unit is volatile—when money becomes more or less unsound—it changes the intended terms of trade between parties, especially when that transaction involves exchange between present and future, as in capital investment. This in turn can cause such exchanges to break down or lead to distortions in trade that bring malinvestment of assets and waste of scarce resources.

No better illustration of this can be seen than in the German hyperinflation of 1923. German war reparations mandated by Versailles had so burdened the German economy that the German government took literally to printing the currency known as the papiermark in massive quantities. This rapidly depreciated the value of the currency until in the fall of 1923 workers were paid in wheelbarrows of cash twice daily. The velocity of spending skyrocketed, as workers immediately rushed to trade the quickly worthless paper money for anything of tangible value, buying commodities they often did not need. Saving and investment were stunted, price inflation soared out of control, and civil society lurched toward a complete breakdown by the end of 1923, when $1, which had bought 5.21 marks in 1918, now bought 4.2 trillion of them.

Seen another way, the German hyperinflation is an example of a “virus” infecting the economy, distorting prices in every transaction, every entrepreneurial investment decision, and the value of every bank account. Every calculation of profit and loss was changed in real terms as well, thus causing resources to be inefficiently used or traded—that is, wasted. While the harm caused by unsound money is usually less than what occurred in 1923 in Germany, it was no less real in a 1970s-style inflation, a 1930s-style deflation, or a 2000s-style housing bubble fueled by falsified interest rates thanks to the Fed’s over-creation of money.

Conversely it was sound money, based on the international gold standard, that greatly impelled the fantastic rise in living standards across the nineteenth century in many parts of the globe. Gold as a common medium facilitated dramatic increases in trade and the international division of labor. With a dependably valued international medium of exchange and unit of account, long-term investment could be undertaken, and ever-increasing volumes of mutually profitable trading developed between nations, increasing jobs, output, and living standards dramatically. The century up to 1914 was a golden age of prosperity and harmony among nations, and while not devoid of all war, recessions, or panics, it was comparatively more peaceful and productive than any other period in human history.

The Rise of Central Banking

While the Bank of England was created in 1694, the United States did not get a central bank until the creation of the Federal Reserve System in 1913; by 1935, with the creation of the Bank of Canada, all modern nations had central banks. In theory a central bank, through monopoly banknote issue and effective control of a nation’s money supply, serves as a stabilizing influence in an economy by acting as a banker’s bank, a lender of last resort providing liquidity in panics, and a regulator of commercial banks and thus governor of their excesses. (However, in a recent exhaustive study, economists George Selgin and William Lastrapes of the University of Georgia and Lawrence White of George Mason University show that recessions were shorter and less severe, inflation and unemployment lower, and economic growth stronger and more durable in the century before 1913 than since the Fed’s creation). At the least, the central bank’s mandate included—and seemed to assure—maintenance of the value of the currency.

Beginning with World War I, and continuing through the Great Depression and World War II, the links to gold were for the most part effectively severed from most nations’ currencies, including the U.S. dollar. In the summer of 1944 economists (led by John Maynard Keynes and Harry Dexter White) met at Bretton Woods, New Hampshire, to design a postwar monetary system conducive to international trade. The resulting mechanism, known as the gold-exchange standard, tried to resurrect the beneficial aspects of the nineteenth century’s classical gold standard and lasted until Nixon scrapped it in 1971. In short the Bretton Woods agreement charged the U.S. government with defining the dollar in gold ($35 per ounce) and maintaining convertibility at this rate only with foreign governments and central banks. (Pointedly, there was no similar obligation to U.S. banks or citizens; gold had disappeared from circulation in the United States after Franklin Roosevelt’s 1933 decree.) In turn all foreign nations were to peg their currencies to the dollar, thereby preserving a regime (however illusory) of fixed exchange rates so as to promote certainty in international exchange and encourage cross-border trade and investment.

By the 1960s this system was beginning to break down on all sides. Foreign governments announced periodic devaluations against the gold-linked dollar to promote exports and allow for domestic government spending, and the United States ramped up “guns-and-butter” federal spending on both the Great Society and the Vietnam War. Inflation slowly crept into the U.S. economy, and gold-redemption requests spiked by the late 1960s at the U.S. Treasury’s gold window.

Nixon thus made his fateful decision in the summer of 1971, freeing the government from any redemption obligations. This had two immediate effects: It amounted to an automatic, if stealthy, repudiation of U.S. debt in real terms because it devalued all dollar-denominated assets and currency at once. It also allowed the U.S. government, in concert with a technically independent Federal Reserve, to manage the U.S. money supply for its own political ends indefinitely.

The Predictable Aftermath of 1971

In developing his theory of money and credit a century ago, the great economist Ludwig von Mises explained why a system of fiat currencies was bound to break down: The politicians’ urge to inflate the money supply in order to commandeer the resources of the real economy via expanded government spending would prove too great. Further, because the dollar was the de facto reserve currency of the globe post-Nixon (replacing gold itself), any U.S. inflation would encourage other nations’ monetary expansions and competitive devaluations in tandem. And indeed, an era of predictable instability has been the result: A trenchant stagflation in the 1970s was followed by banking and S&L crises in the 1980s; Russian, Asian, and Latin American banking crises in the 1980s–90s; overleveraged financial institutions and moral hazard-based bailouts of too-big-to-fail institutions in the 1990s–2000s; and in the last decade or so two Fed-induced bubbles and subsequent crashes. The second of those, based in the housing sector, “went viral” across the world thanks to the huge nominal amount of funds plus leverage of U.S.-based mortgage debt, coupled with the expectation on the part of investors that the U.S. government would guarantee any mortgage-bond losses.

This instability has starkly proven another tenet of Mises’s seminal work: Fiat currencies managed by central banks with a monopoly on note issue, rather than being a source of macro stability, are themselves the causal agents of repeated boom-and-bust business cycles. By increasing the money supply at zero effective cost, central banks encourage government spending and cause interest rates to fall below their natural rate, which induces private investment and a temporary boom. But this boom, usually in capital-equipment sectors or long-term durables, is not based on real individual and institutional savings. That is, the accumulation of capital is not “backed” by the real resources of society. By definition such a boom is inherently unsustainable and unstable, and must end in a bust and painful retrenchment. The greater and longer the creation of fiat money by the central bank, the harder and longer will be the ensuing recession.

A Path to Reform

The best solution to the myriad problems caused by the Fed’s post-Nixon fiat currency management is to return to sound money generated by private markets and intermediated by freely competing banks issuing their own notes. These notes could be backed by any commodity but most likely would involve a return to gold. Banks would compete for customer deposits and loan business on the basis of the soundness of their balance sheets and thus could not over-issue—or else they’d face redemption of their outstanding notes and a potential collapse from a bank-run. Such a system is far more stable than a monopoly central bank without constraints, subject to the inexorable pull of political designs (that is, malfeasance).

But there are many challenges to developing and implementing such a free-banking system with commodity money; this is the subject of work to be published in the future. Meanwhile a second-best solution would be for the Federal Reserve to cease and desist with any further fiat money creation—in essence, freeze the monetary base where it is, permanently. The Fed could then announce an intent to return to full gold convertibility, and any new notes it issued (and used by Fed member banks) would be 100 percent backed by gold. Any maturing securities held as assets on the Fed’s balance sheet would be used to purchase gold to build the Fed’s reserves. The permanent price of gold would be set over a period of months after the announcement of the new regime, as gold itself and competing currencies traded at new (lower) levels based on the U.S. government’s new commitment to dollar stability.

The results of this reform program would be electric and dramatic. Capital investment would soar in the United States, as America became a haven for high-productivity ventures once again. The entire U.S. economy would in effect be recapitalized. While an end to activist Fed monetary policy would raise the short end of the yield curve, over time real interest rates would revert to historic low levels due to dollar stability. Such monetary reform implies pro-growth fiscal reforms as well; the U.S. government’s profligacy would have to end because fiscal laxity would no longer be supported by an accommodating Fed. A new, sound dollar and a passive Fed would also engender other pro-growth reforms in banking, such as a reduction in or end to deposit insurance and a lower burden of regulations that stunt growth. The banking sector would at once be more competitive, better capitalized, less brittle, and on sounder footing itself.

To bring this about monetary policy must again become a big political issue—the dominating political issue—in a way it has not been since the presidential election of 1896, when William Jennings Bryan railed against a “cross of gold.” Indeed this can happen if people come to understand that the main culprit of U.S. booms and busts since 1971, and indeed the primary progenitor of the global disaster of 2008—from which we have yet to recover—is the political management of money by the Federal Reserve. Sound money, honest money, besides being a necessary cause of sustainable economic growth itself, is the antidote to the tragically unnecessary torpor of our modern world.

Money of any sort, commodity-based or not, derives its value in large part from what economists call a “network effect.” Like a fax machine, whose value depends largely on how many other people have fax machines, we value money because other people value it. We feel confident our money will buy us what we need tomorrow. A strong network effect means that something drastic has to happen before people will give up their familiar form of money.

Something drastic was happening when U.S. Rep. Ron Paul’s Gold Commission was set up in 1979. By the time the commission’s report was issued in 1980, inflation had reached alarming levels: The consumer price index was at 14 percent and rising. The prime rate was over 20 percent, and in 1980 silver exploded to $50 an ounce and gold surpassed $800 (about $2,300 in today’s dollars). Bestselling books urged people to buy gold, silver, diamonds, firearms, and rural hideouts.

We now know that inflation was peaking and that the silver price spike was a fluke caused by a failed attempt to corner the silver market. But none of this was apparent at the time, so it was reasonable to wonder whether our monetary system would survive. What did happen, of course, was that the new Fed chairman, Paul Volcker, stepped on the monetary brakes hard enough to break the back of inflation. Two back-to-back recessions resulted but were followed by a long period of recovery in which both inflation and interest rates dropped steadily. The Gold Commission was largely forgotten, though the U.S. Mint did get into the business of producing gold coins in a big way.

We have a crisis of a different sort at present, featuring unprecedented levels of public and private debt rather than inflation. In addition, global trade has advanced significantly and worldwide financial markets are tightly linked. Many new financial innovations have emerged since 1980, not just the sophisticated derivatives that were at the center of the 2008 crisis, but also innovations such as exchange-traded funds (ETFs) that are available to everyone. The euro is in trouble, and there is a real possibility that a Chinese property bubble is about to burst. Gold is above $1,400 an ounce, up from $250 a decade ago, while silver has advanced from about $5 to over $30 an ounce.

Ron Paul is no longer a lone voice calling for a return to gold. Robert Zoellick, president of the World Bank, astonished everybody recently when he wondered out loud whether gold should again play a monetary role. Although he drew praise from some quarters, most comments were dismissive. Berkeley economist Brad DeLong, for example, nominated Zoellick for the “Stupidest Man Alive.” One is reminded of Gandhi’s four steps to victory: First they ignore you, then they ridicule you, then they fight you, then you win.

In 2010 the Central Bank of China imported over 200 tons of gold, more than offsetting recent IMF sales. This is in addition to the 350 tons that are mined in that country annually. Wealthier Chinese citizens are adding it to their portfolios. While substantial, Chinese gold holdings are still dwarfed by their holdings of U.S. Treasury securities. The gold purchases may be intended mainly as a signal of its displeasure with dollar hegemony. Other central banks are acquiring gold in smaller amounts.

Monetary Links to Gold

Within just a few years ETFs have attained a prominent place in the investment world. None has been more amazing than the SPDR Gold Trust (GLD), which purchases and stores gold bullion for the benefit of its shareholders. This fund was launched in 2002 by the World Gold Council, an industry group, as a means of stimulating demand. The results have exceeded their wildest dreams. GLD now holds about 1,300 tons of gold bullion, a hoard larger than that of any central bank save four. (A metric ton of gold would fill a large suitcase and have a market value of about $45 million.) Competing funds of the same sort now offer silver, platinum, and palladium in addition to gold.

Gold coins are also selling at a brisk pace. The U.S. Mint offers Gold Eagles along with an array of silver and platinum coins. But it’s difficult to get one-ounce Eagles at present, and the smaller sizes have been discontinued entirely because the Mint has run short of bullion inventory. Presumably this is bureaucratic ineptness, because the bullion markets are highly liquid. Canadian Maple Leafs, South African Krugerrands, and others that compete with the U.S. coins are readily available. These are all “bullion coins,” so-called because their value is only marginally above their gold content.

The one-ounce Gold Eagle and the Maple Leaf have an interesting feature: They are legal tender, the Eagle for $50 and the Maple Leaf for C$100. While the gold price will surely never again see such low levels, it is interesting that the authorities saw fit to establish this modest link between gold and money.

Soaring prices for precious metals and unprecedented demand for bullion gold and silver coins are an obvious sign that investors are worried. Anyone who buys bullion or coins has to be concerned enough to forgo interest income and pay, directly or indirectly, storage and insurance costs. If and when confidence in the world’s monetary and banking institutions returns, we can expect a rush out of precious metals and into productive assets.

Now to the central question: Will gold again be money?

Don’t Call It a Comeback. Yet.

Gold is too volatile, say some. If, for example, the Fed were to adopt a stable gold price as its monetary target, it would be hitching the U.S. economy to a wild horse. If the Fed had tried to track gold’s recent rise, it would have had to engage in massive quantitative “dis-easing.” Monetary deflation added to falling aggregate demand would have been a disaster.

The problem with this argument is that it takes the gold price as given. Had the Fed hitched its wagon to gold some years ago, it would have added significant inertia to the “wild horse” and it is likely that the run-up would have been milder or nonexistent.

Still, gold targeting by the Fed is probably not a good idea. The Fed has lost a great deal of credibility of late, thanks in part to Chairman Ben Bernanke’s recent declaration on 60 Minutes that the Fed would not “print money” to carry out the next round of quantitative easing. The chairman’s life will only get more complicated now that Ron Paul has become chairman of the House Subcommittee on Domestic Monetary Policy. Should the Fed adopt gold targeting, markets would need to be shown over a long period that it was serious about hewing to gold in the face of political pressures to the contrary.

One hundred years ago it was common to link contracts such as railroad bonds to gold. I have in my possession such a bond, issued in 1893 (it’s a beautifully engraved document, incidentally), which promises to pay at maturity “one thousand dollars in gold coin of the present standard of weight and fineness.” Borrowers probably didn’t expect to be paid with a stack of 50 gold coins, which would have been inconvenient. Rather, the phrase was meant to protect the borrower from future government debasement of money. But sanctity of contract went out the window in 1933, when Franklin Roosevelt abrogated all such private contracts at a stroke. Predictably, 50 one-ounce gold coins now fetch nearly $70,000.

Gold Clauses

A comeback of gold clauses in business contracts is a realistic possibility, provided they could survive legal challenges based on legal tender laws. Imaginative clauses could be created that guaranteed a return in dollars at least partially linked to the gold price. Such things already exist, in fact. Everbank, an online bank, currently offers, among other innovative products, a five-year certificate of deposit whose return is tied to the price of a basket of precious metals. At worst, investors get their principal back. At best, their five-year return is capped at 50 percent. Everbank is not, of course, issuing gold-backed money, but it is coupling gold to money’s role as a store of value.

Another possibility is that shares of GLD could assume an informal monetary role. Those shares currently trade for about $135 each. Originally they represented one-tenth of an ounce but have lost some value as administrative charges have been deducted. New sub-shares, perhaps representing one gram each, would equate to $45. Getting such sub-shares into circulation would be much easier via the Internet than getting paper shares into circulation. Such schemes would of course require government forbearance backed by political pressure. That pressure would not likely arise until and unless the current financial crisis grew to alarming proportions.

In 2003 e-gold.com was established as an online gold-payment service, growing to five million accounts in 2008, according to its owners. That year the company pleaded guilty to conspiracy to engage in money laundering and conspiracy to operate an unlicensed money-transmitting business. The company’s problems seem to have had more to do with security than with gold per se. Still, the e-gold case serves as a reminder that innovators in gold payments may face legal problems.

Recently J.P. Morgan Chase announced that in addition to Treasury securities, it would begin accepting gold as collateral for certain loans. “Many clients are holding gold on their balance sheets . . . and are looking to make these assets work for them as collateral,” said a company spokesman. “It gives another use to gold as a cash instrument,” added a commodities analyst, exaggerating only slightly. Indeed, Treasury securities are considered very close to money itself in terms of safety and liquidity, so it is rather remarkable to see gold accepted as substitute collateral even in this minor sector of the financial markets. It suggests a gradual movement of gold toward monetary status.

New Currencies

What about a new currency backed by the Fort Knox holdings? There would be practical difficulties, assuming most of the gold is in 400-ounce bars, each with a dollar value exceeding a half-million. It would be expensive to convert all this to coin, and besides, the smallest practical coin, perhaps five grams, would still represent over $200. A $10 gold note would fetch a mere speck of gold. More realistic than gold notes would be a spinoff of a new gold exchange-traded fund. Shares of that fund might gain gradual acceptance as money, especially if a dollar crisis were in progress.

U.S. public or private institutions aren’t the only possible sources of a return to gold. Though globalization has been fostered by declining trade barriers and transportation costs, we still lack the considerable advantages of a uniform worldwide currency or rigidly linked currencies. In the late nineteenth century, when all major currencies were tied to gold, the dollar/pound exchange rate was no more worrisome than the inch/centimeter exchange rate. As things stand now, firms doing business in different currencies must divert significant resources away from satisfying customers and into managing exchange-rate risk. Currency fluctuations have not been minor, as Milton Friedman expected when he first proposed floating exchange rates. During 2010, for example, the euro ranged between $1.19 and $1.45—a variation wide enough to turn a multinational firm’s yearly profit into a loss or vice versa. The need for a new global currency may be an opportunity for some enterprising central bank—China’s perhaps—or some private firm to establish a new international form of gold-linked money or near-money.

There are those who defend the gold standard on ideological grounds, claiming near perfection for it. This is unrealistic. For example, price inflation can happen under a gold standard. Ironically, as confidence increases in a fractional-reserve gold standard, people are less inclined to hold monetary gold. The multiplier increases, and there is price inflation—mild, gradual, and predictable. Increasing prosperity and the consequent increasing demands for nonmonetary applications of gold such as jewelry or technology would work in the opposite direction: The supply of monetary gold would drop, causing deflation. New gold discoveries or better mining techniques dilute gold’s purchasing power—another inflationary development likely to be mild and gradual. But it is conceivable that someone could invent an economical process for converting base metals into gold—the alchemists’ dream. This very unlikely development could be a major disruption to an economy using gold-backed money. The most likely situation under a gold standard would be gradual, mild deflation as happened in the late nineteenth century. In short, a totally stable price level, if such could be defined, is not something to expect from a gold standard.

Resource Costs and Stability

We cannot overlook the resource cost of gold locked away as backing for money. Monetary gold cannot be used for jewelry or electronics. Friedman once dismissed a return to gold on the grounds that the resource cost would amount to 2 percent of GDP. But his estimate was predicated on 100 percent backing of the wider M2 money supply. Under a fractional reserve system, the cost would be much lower.

Of course, monetary gold lying “idle” in a vault is only idle in a naive physical sense. A gold bar sitting undisturbed in a vault is producing security for holders and users of money day in and day out. The irony here is that while the amount of monetary gold would likely decrease as a fractional-reserve gold system gained confidence, our present system seems to require the retention of 8,000 tons at Fort Knox, while leaving the control of money under the increasingly politicized Federal Reserve—the worst of both worlds.

It is possible that stability will return to our current monetary and banking systems. We could have a repeat of 1980 and a couple of decades of stability and growth. If not, there is good reason to believe that gold will make a return in some form.

Propositions About Gold

Gold has intrinsic value. Actually, nothing has intrinsic value. The value of any good or service resides in the minds of individuals contemplating the benefits they might derive from it. What gold does have is some rather remarkable physical properties that make it very likely that people will continue to value it highly: luster, corrosion resistance, divisibility, malleability, high thermal and electrical conductivity, and a high degree of scarcity. All the gold ever mined would only fill one large swimming pool, and most of that gold is still recoverable.

Only gold is money. Although gold was once used as money, that is no longer the case. Money is whatever is generally accepted as a medium of exchange in a particular historical setting. Right now, government-issued fiat money, unbacked by any commodity, is the only kind of money we find anywhere in the world, with some possible obscure exceptions.

Perhaps people who say this mean that gold is the only form of money that can ensure stability. That’s what future Federal Reserve Chairman Alan Greenspan thought in 1967, when he wrote “Gold and Economic Freedom” for Ayn Rand’s newsletter. “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation,” he said. When later asked by U.S. Rep. Ron Paul whether he stood by that article, Greenspan said he did. But he weaseled out by saying a return to gold was unnecessary because central banks had learned to produce the same results gold would produce.

The gold standard is too rigid. The gold standard makes it impossible for a government central bank to conduct monetary policy—hooray! Under the Fed’s watch the dollar has lost more than 95 percent of its purchasing power and the economy was convulsed by the Great Depression of the 1930s, the stagflation of the 1970s, and the crash of 2008. Milton Friedman long ago explained the long and variable lags that follow monetary interventions and at one point called for replacing the Fed with a computer. The end of government economic manipulations in the form of monetary policy is a major potential benefit of a gold standard.

Gold is supposedly too rigid to accommodate increased demand for money at certain times of the year—historically harvest time and Christmas time—or in wartime. Falling prices are one way an economy can adjust to an increase in the demand for money, but this accommodation works best over a longer period. A short-term accommodation is possible when banks hold fractional reserves. On short notice and without any increase in monetary gold, fractional-reserve banks could simply issue more bank notes or their electronic equivalent during periods of high demand and retire them when demand subsided.

Inflation is impossible under a gold standard. Between 1897 and 1914 the gold stock rose at about 3.5 percent a year due to new discoveries and inflows from abroad. As a result, prices rose about 26 percent over this span, or about 1.4 percent per year. This was not a disruptive level of price inflation—but it was inflation.

The gold standard was tried and failed. This is a plausible proposition, not to be dismissed out of hand. Nor may we simply note that because we never had a pure gold standard, the concept was never really tested. We must do better than that.

During much of our history, money was linked to gold in some degree, and there were some serious monetary problems during that time. The record of gold is bound up with the institutional arrangements that prevailed at various times in our history. Snapshots from that history should help illuminate this claim.

Before proceeding, we need a definition. Under a gold standard either private banks or a monopoly central bank issues notes (or their electronic equivalent) redeemable in gold. Gold coins may circulate as well. Notes may be fully or fractionally backed, meaning a note issuer may not have sufficient gold to redeem all outstanding notes at one time. In passing I assert, contrary to some “hard money” advocates, that fractional-reserve banking is an institution that is entirely compatible with free markets and the rule of law.

The period between the War of 1812 and the Civil War is commonly called the “free banking era.” It is also called the era of “wildcat banks” because many banks were poorly capitalized, poorly if not fraudulently managed, and prone to failure. Conventional wisdom says that this era demonstrates conclusively the need for strict government regulation of money and banking. Like other free-market institutions, free banking rests on the sanctity of property rights, with no government involvement other than prosecution of theft or fraud. But there was substantial government involvement all along, so the “free banking” label is only accurate in relative terms.

The most egregious departure from free-banking principles was the frequent suspension of specie payments: banks’ refusal to honor their obligation to redeem their banknotes for gold. These breaches of contract, which should have triggered liquidation and perhaps criminal prosecution, were in many instances tolerated or even encouraged by government authorities, especially during times of war or economic contraction.

Second, the free-banking paradigm does not include a monopoly central bank. The Second Bank of the United States—roughly speaking, the U.S. central bank of its time—closed its doors in 1836. Its defeat, engineered by populist President Andrew Jackson, came with wide support from a public that had been generally suspicious of banks since the founding of the Republic. But the end of the Second Bank was by no means the end of federal government involvement in banking. With the Second Bank gone, the federal government still needed depositories for its funds. Certain private banks, which came to be known as “pet banks,” were selected for this privilege. This was one way in which the federal government continued to influence the banking system.

A third intervention, practiced by federal and state governments, was prohibition of branch banking. No banks were allowed to cross state lines to open branches, and there were significant restrictions within most states as well. The strictest state laws forbade any branching whatever, while others allowed branching within their states on a limited basis. The result was that many communities could only be served by small, poorly capitalized, and often poorly managed local banks. Stronger city banks might have established branches in areas where early banks had failed or where none had emerged, particularly with the spread of the telegraph and railroads. But they were not allowed to do so. For confirmation of the ill effects of branch prohibition, we need only look as far as Canada, which has always had a few strong nationwide banks. During the Great Depression, when some 9,000 U.S. banks failed, not a single Canadian bank went under.

Fourth, many state governments required banks to hold their bonds as part of their reserves. This of course provided a captive market for such bonds. The National Banking System, established after the Civil War, imposed a requirement to hold federal Treasury securities. Thus the five-dollar gold note (see photo), issued by the Farmers Gold Bank of San Jose, California, in 1874 promises to “pay the bearer on demand five dollars in gold coin.” But it also says the note is “secured by bonds of the United States deposited with the U.S. Treasurer at Washington.” In other words, the government gave the banks incentive to substitute bonds for some of the gold they might have held as reserves.

The gold standard is to blame for severe downturns in 1893 and 1907. The panic of 1893 was quite severe. That year saw numerous railroad bankruptcies, bank failures, and declining stock prices. Among the causes were general overbuilding of railroads, the Silver Purchase Act of 1890, and the protectionist McKinley tariff of 1890. Perhaps a modern central bank, with unlimited money-creation power, could have mitigated some of the immediate pain. But as we have seen, the record of the Federal Reserve, which acquired that power in the following century, suggests a failed institution. As it was, the panic was over in fairly short order and economic growth resumed.

The Panic of 1907 was marked by bank runs, numerous bankruptcies, and sharp drops in stock prices. A trigger for the Panic was a failed attempt to corner the stock of United Copper using borrowed money. Other factors included the San Francisco earthquake and the Hepburn Act, which gave the Interstate Commerce Commission power to set maximum railroad rates, suppressing the shares of those companies.

The Panic was ended largely through the efforts of J. P. Morgan. Again, things turned around in fairly short order and growth resumed.

The dollar-gold link established by the 1944 Bretton Woods agreement didn’t work. Indeed it didn’t, at least not for long. Under Bretton Woods the United States and its currency were accorded a special role. The United States was obliged to redeem dollars for gold, but only dollars tendered by foreign central banks. No one else could get gold for dollars, and no other currencies were directly redeemable. There was a tacit agreement that foreign governments would not “abuse” their redemption privilege, but the French under Charles de Gaulle and his gold-oriented finance minister, Jacques Rueff, saw things differently and insisted on redemption—which, oddly enough, entailed moving gold bars from one part of the New York Fed’s vault to another, since the Fed was storing gold as a service to the French. By 1971 it had become clear that far more dollars were likely to be tendered than could be covered by gold, and President Nixon unilaterally ended gold redemptions. This cut the last (very indirect) link between the dollar and gold. By then silver had disappeared from U.S. coins as well.

De Gaulle cannot be blamed for the failure of Bretton Woods. All he did was to point out the emperor’s lack of clothing. As the Federal Reserve created more and more fiat money, some of which made its way overseas, the redemption promise rang more and more hollow. By the time Nixon took action there was no other choice but to slam the gold window shut.

Milton Friedman was one of the first to propose floating exchange rates. The notion seemed radical and unworkable at the time (around 1960). That of course is the system we have now, and while it has eliminated sudden devaluations, currency markets are much more volatile than Friedman anticipated. Nor did he anticipate the degree to which governments would enter the markets to manipulate their own currencies, as when the Chinese authorities sell their currency to keep it from rising too fast against the dollar. And he would have been appalled at the “race to the bottom” that threatens to break out as governments seek to boost their domestic economies by driving down their currencies to make their exports more competitive.

In his wonderful little book Money Mischief, Friedman asked himself whether the pure fiat standard, which has been in force only since 1971, could endure. He didn’t give a definite answer but expressed grave doubts. The possibility of a general loss of confidence in fiat money is reason to believe that gold could once again play a monetary role, as I will argue in the second part of this series.

The gold that was once locked up at Fort Knox is gone. It has been 40 years since the last indirect link between the dollar and gold was severed, and yet the government continues to hold some 8,000 metric tons of gold bullion—the world’s largest single stash. Oddly enough it is valued at $42 per ounce, the last official price before it was set free to be established in free trading. At today’s market price of around $1,300 per ounce, the hoard would be valued in the hundreds of billions of dollars, although that much gold could not be dumped precipitously without suppressing the price.

James Picerno, writing in a recent issue of The Atlantic, asked why the hoard remains. Three hundred billion dollars may not be a huge sum in this new era of trillions, but it’s not chump change either. His conclusion: A selloff would be seen as a sign of weakness or even desperation and might trigger a loss of confidence in the government’s money and/or its debt. He also cites a poll which indicates that 87 percent of Americans believe the government shouldn’t sell its gold reserves. We can only conclude that gold still plays a very indirect role in maintaining confidence in the government.

But is the gold still there? Yes, almost certainly, though we hear occasional calls for an outside audit. A more plausible accusation is that some of it has been leased to short sellers. This is a common practice among central banks that offers distinct benefits to the government. First, it earns a bit of interest income. More important, it can covertly suppress the gold price. Rising gold prices annoy Treasury secretaries and central bankers because the rise implies falling confidence in their currency. Leased gold remains in the vault and on the balance sheet even though it (or rather a paper claim on it) has been sold to someone else. Although one can find rumors on the Internet, there is no way, short of a thorough audit, to know the extent of gold leasing by the U.S. government, if any.

With the global economic downturn continuing and the prospect of currency wars looming, scattered voices are again suggesting a role for gold in our money. One of those voices belongs to Robert Zoellick, president of the World Bank. Could gold stage a comeback in some form? In Part 2 we will examine those prospects.

Today FEE and The FreemanOnline.org hosted an hour-long Idea Room live chat with Professor Steven Horwitz. In a lively discussion about contemporary economic problems, Professor Horwitz answered questions on inflation, government spending, budget deficits, the gold standard, and many other subjects.

Click here to visit the Idea Room and read his answers. Also stay tuned for the next edition of the Idea Room next month.

And yet the Fed enjoys almost sacred-cow status. Most Americans have been led to believe that modern nations absolutely must have some government institution to “manage” the economy, provide money and credit, and control interest rates. Blinded by that notion, they assume that if we didn’t have the Fed, we’d be stuck in the horse-and-buggy age, plagued by terrible boom-and-bust cycles.

Over the near-century since Congress established the Fed (in 1913), it has had many critics, but never one with the moral and political stature of Representative Ron Paul. The congressman from Texas is not a political hack who takes positions just to please constituents and get reelected. He has made a lengthy, serious study of economics, especially our monetary institutions, and his book End the Fed puts his knowledge on display. But it’s more than just a display of knowledge. The book shows Paul’s passionate commitment to the cause of establishing the honest, dependable monetary system the United States was supposed to have.

That’s why Paul wants to end the Fed. It gives us a dishonest and easily manipulated monetary system that we can only depend on for constant inflation. Abolishing the Fed, he writes, “would be the single greatest step we could take to restore American prosperity and freedom and guarantee that they have a future.”

The financial turmoil and prodigious deficits of recent years have people wondering about the future. For them, this book will be like finding an oasis when you’re desperate for water in the desert.

Paul begins by explaining how the Fed came to be. The United States survived without it for more than a century, although the nation suffered from periodic recessions and “panics.” Those episodes, Paul makes clear, weren’t due to any flaw in the free market, but were caused by bad government monetary policy and banking regulation. The Panic of 1907, however, was seized on by banking interests to push for the cartel they had long desired. Congress obligingly created the National Monetary Commission in 1908. It was dominated by big bankers who said that the country needed an “elastic” currency and a “lender of last resort” to backstop banks that got themselves into deep trouble. The legislation was drafted in 1910 at a secret meeting on Jekyll Island, Georgia, at a resort owned by the biggest banker of all, J. Pierpont Morgan. Congress passed it in 1913.

One thing most people have heard is that it is the Fed’s job to give us price stability. Paul shatters the idea that it does so by noting that goods costing one dollar in 1913 now cost $21. Nor does the Fed give us economic stability. Paul points to the numerous recessions we’ve had since it was established.

Drawing on his study of Austrian economic theory, Paul demonstrates that the boom-and-bust cycle is generated by the Fed’s penchant for tampering with interest rates. When it drives them artificially low, it stimulates a temporary boom that must eventually end in recession or depression, with high unemployment and many bankruptcies among overstretched firms.

Furthermore, the Fed makes it easy for the federal government to finance its extravagant (and usually unconstitutional) spending. It can purchase government bonds through “open market operations” and magically turn federal debt into new money. What a scam. Politicians get to spend without explicitly raising taxes and then blame the resulting depreciation of money on others.

So the Fed is a bad institution, but what alternative is there? We can’t go back to some antiquated system like gold, can we? Paul shows that a monetary system based on precious metal is both feasible and much to be desired, precisely because, unlike paper, government can’t manipulate gold.

The book ends with an excellent list of suggested readings. I predict that End the Fed will lead to quite a few knowledgeable and zealous opponents of government economic intervention, and not just regarding money.

Ron Paul’s book is a timely cry of the heart. With our economy in tatters, opportunistic scoundrels in Washington are calling for vast, freedom-killing expansions of government power. Paul stands athwart their plans. This brave book is a rallying point for Americans who know that we’re on a path to ruin.

Bruce Ramsey, an editorial writer for the Seattle Times, has already edited three collections of Garrett’s journalism. But Garrett’s own papers were mostly destroyed except for one year’s worth of a journal; just one small book had been written about him in the 1960s by an author who had access to many people who knew Garrett directly. Ramsey had to go to such unobvious sources as biographical works by or about the likes of journalist Gay Talese, newspaper magnate Randolph Hearst, and financier Bernard Baruch to get much useful secondary information.

What Ramsey had access to, and condenses and explains with skill and affection, is a lifetime of printed journalism and commentary on his times from Garrett, a clear writer and interesting thinker. From that, Ramsey paints a fascinating and complicated man who championed classic American political (and other) virtues.

Garrett is remembered by modern libertarians as one of their forefathers in the prewar “Old Right.” Garrett was a fellow traveler, friend, or mentor to many figures important in the early growth of the modern American libertarian movement, from FEE founder Leonard Read to novelist and polemicist Rose Wilder Lane to Richard Cornuelle, early functionary of the libertarian support organization the Volker Fund.

As Ramsey demonstrates, Garrett was too individual a thinker and writer to be slotted in as simply an early modern libertarian. He’s best seen as an eclectic constitutionalist, for “an America-first foreign policy, economic laissez-faire and a gold-backed dollar.” But Garrett was not categorically for free trade and had a soft spot for national autarky, which he saw as both an economic and foreign-policy good. He was against legal gambling, free banking, and free immigration (and not just prospectively—he believed the American spirit of individualism had been sullied by the pre-World War I immigration of a European proletariat).

Garrett was born in Illinois in 1878, and by age 18 (at most) had launched a lifelong career as a journalist and editorialist in the Midwest and later Washington, D.C., and New York. He got an early start studying the worlds of twentieth-century business and finance, and had a gift for winning the respect of highly placed men and difficult interview subjects such as Bernard Baruch and Henry Ford.

The most educational part of Ramsey’s book to those who only know Garrett by his later political essays on the death of a free America (kept in print through much of the past 50 years by various libertarian and conservative publishers) consists of discussions of the series of novels Garrett wrote in the 1920s. All are set in the world of business and industry. His belief in the virtue and efficacy of individual effort was at the core of his social philosophy. He once wrote, “I have never seen a good farmer with a good wife in a state of failure,” which sums up his attitude toward how one succeeds.

Garrett’s intellectual approach differed from the systemic rationalism of such libertarian founders as Ayn Rand and Ludwig Von Mises. He once wrote to his friend the socialist Lincoln Steffens that “there is not one damned thing I am sure of . . . it is much more important to believe something than that what you believe should be right.” His shock at how quickly the individualist America he thought he knew from pre-New Deal days embraced creeping socialism led him to declare, “I am too humiliated to have an opinion about anything. Everything I believed about my own people was wrong.”

He came to think that Americans of the postwar era were, sadly, getting exactly the type of government they wanted and that the original Americans belonged to a different breed entirely. This sense of loss led to the grim mood of the early libertarian movement—the realization that believers in limited government and free markets were fighting to reverse a defeat, not preserve a system. As the title of Garrett’s most famous essay put it, “The Revolution Was.”

A major theme of Garrett’s intellectual life was especially prescient: an understanding of the importance of gold as a monetary standard, that bankers and government “must be limited by something they cannot control . . . the gold standard.”

Ramsey sums up why American, and certainly libertarian, historians should remember Garrett: “Because he stood against state dominance at home and state intervention abroad, and showed that the two are connected.” Alas for Garrett’s cause, his relevance is as strong as ever.

How bad does inflation have to be before ‘Facebook currency’ becomes accepted tender?

FEE Timely Classic:
“The Great German Inflation” by Bruce Bartlett

But, alas, in the end Krugman resorts to the arguments of the great economic cranks of history, from Silvio Gesell to John Maynard Keynes. He’s like the mechanic who expertly describes a problem with your fuel pump—then insists your car needs more gas. If the tank is full, he tells you to attach an auxiliary tank.

In other words, Krugman is still the one-trick pony featured in the Times. Whatever the problem, his solution is always the same: inflation. It shows up in the example he uses throughout the book, a 1970s babysitting co-op on Capitol Hill.

The baby-sitting “economy” is a co-op in which the couples agree to babysit one another’s children for coupons (babysitting credits) instead of dollars. But Krugman says this scheme ran into problems during the winter. The couples hoarded their coupons (that is, they refused to hire babysitters) while trying to get more coupons (sell babysitting services) so they would be able to go out more often in the summer.

Unfortunately, with everyone pursuing the same strategy at once—trying to sell without buying—Krugman writes, the co-op went “into a recession.” But never fear: This babysitting “liquidity trap” ended when the directors of the co-op printed and distributed more coupons and everyone lived happily ever after.

The problem with drawing general lessons from this situation should be obvious. A babysitting co-op in which a few people with similar preferences produce one good cannot be a model for a complex economy. But since Krugman—like other Keynesians—believes an economy is a crude, simple mechanism controlled by “aggregate demand,” this is the best he can do.

Writing about this “fix” for the co-op, Krugman says, “Recessions, in other words, can be fought simply by printing money—and can sometimes (usually) be cured with surprising ease.”

Even though I have read many of Krugman’s columns and was not surprised by this answer, it is nonetheless shocking to read that a Nobel laureate actually believes that we can “cure” almost any economic downturn by cranking up the printing presses.

That’s bad enough, but Krugman also likes to rewrite economic history.

He says our present economic and financial troubles are due to free markets and financial deregulation. He argues that the cartelized financial system created during the New Deal should have remained unchanged, even though it was actually in crisis back in 1980. The alleged “deregulation,” however, did not create free markets but expanded moral hazard by increasing deposit insurance and empowering the Fed to “backstop” financial market losses, which invited reckless behavior on Wall Street. All this federal interference with both free markets and an authentic profit-and-loss system resulted, predictably if sadly, in the current financial meltdown.

From blaming the Great Depression in part on the gold standard to caricaturing free markets, Krugman places himself squarely in the socialist-interventionist camp. He writes: “Some people say that our economic problems are structural, with no quick cure available; but I believe that the only important structural obstacles to world prosperity are the obsolete doctrines that clutter the minds of men.” Unfortunately Krugman counts freedom among them.

But the truth is that Hayes was a strong and principled leader of firm character, who, during a critical time in history, shored up the country’s finances. His contributions to restoring American credit are worth noting today.

Hayes was a small-town Ohio lawyer until his Civil War exploits earned him a promotion to brigadier general and won him a congressional seat after the war. After one term in Congress, Hayes was elected three times as governor of Ohio. In 1876 he won the Republican nomination for president, and during the campaign that followed he defeated Governor Samuel Tilden of New York in a controversial election. Tilden won the popular vote, but Hayes won the electoral vote after a special commission awarded him the disputed states of Florida, South Carolina, and Louisiana.

Severe Inflation

Once in the White House, Hayes withdrew northern troops from the South and thus ended Reconstruction. But the enormous financial debts from the Civil War still lingered. That war had been so costly that the Union could not secure the cash (that is, specie) to fight it. Congress and President Lincoln covered expenses by issuing over $400 million in greenbacks, which would not be redeemable in gold until some future date. The flood of greenbacks caused inflation and chaos—merchants wanted specie, not paper that someday might be redeemed.

Many Americans, especially debtors who liked the idea of repaying loans in inflated currency, welcomed the greenbacks and wanted more to be printed. The problem with that, apart from serious inflation, was that foreigners were refusing to buy American debt, which raised the interest costs on the almost $2 billion that the Union borrowed to fight the war.

In 1875 Congress had promised to redeem the greenbacks for gold in four years and Hayes ran his campaign on a pledge to fulfill that promise. “Low rates of interest on the vast indebtedness we must carry for many years,” Hayes said, “is the important end to be kept in view.”

As president, therefore, Hayes prepared to retire the greenbacks. He had budget surpluses every year in office, and he used these extra funds to help build up a gold reserve to pay off the greenbacks. So effective was Hayes at this task that when the official government redemption date (January 2, 1879) came around, few people stepped forward to get gold for their greenbacks. Confidence in U.S. credit was such that most people traded greenbacks at face value with confidence that gold would be in the Treasury if they ever wanted it.

Having solved the greenback problem, Hayes also faced a crisis with silver. From the beginning of U.S. history, gold and silver coins (and bullion) had circulated to pay debts, to conduct trade, and to transact business. Silver of course is more plentiful than gold, and the ratio had been 15 or 16 ounces of silver to 1 ounce of gold. The U.S. Treasury in fact minted coins and traded the metals at 16 to 1 during much of the 1800s. But that all stopped after the Civil War.

The problem was that active mining in the American West was yielding much more silver than gold.

Also, the demand for silver was down because the rest of the world was beating a path to a monometallic gold standard. By the end of the 1800s, with silver prices down, it took about 32 ounces to buy one ounce of gold. The silver miners believed this devaluation of their metal was unfair. Those who favored inflation were happy to agree: If the government would stabilize the ratio at 16 to 1, debtors could repay in inflated silver dollars instead of gold. Flooding the market with silver (fixed at 16 to 1) would have the same effect as running greenbacks off the printing press.

Hayes was appalled at the persistent efforts of inflationists to tamper with the currency. “Expediency and justice both demand honest coinage,” Hayes insisted. Sound currency and sound character were one and the same to Hayes. “A currency worth less than it purports to be worth,” Hayes observed, “will in the end defraud not only creditors, but all who are engaged in legitimate business, and none more surely than those who are dependent on their daily labor for their daily bread.”

Free Silver

The inflationists lobbied hard with their politicians for what was called “free silver,” which was short for the free and unlimited coinage at the fixed ratio. They couldn’t muster the votes, but they did support the Bland-Allison Act in 1878.

Under that bill Congress would be obligated to buy at least $2 million (and up to $4 million) worth of silver and mint it into special dollars of almost one ounce. Such “dollars” in 1878 contained only about 90–92 cents worth of silver, and Hayes was dismayed that Congress would even consider tampering with U.S. coins that way. He promised to veto any “measure which stains our credit.” When Congress passed the act anyway, Hayes vetoed it. Congress, however, overrode Hayes with a two-thirds vote, and the Bland-Allison bill became law.

The presence of these new silver dollars bothered Hayes, but American credit remained strong throughout the world. The greenback problem was under control and the government continued to retire the Civil War debt through annual budget surpluses. In 1880, for example, federal revenue was $333.5 million, which was $65.9 million—almost 20 percent—more than expenses. The biggest item in the federal budget was $95.8 million for interest on the debt. With diligence, Hayes had renegotiated much of this debt from 6 to 5 and sometimes 4 percent.

In an effort to slash future expenses, Hayes began efforts to make government bureaucrats work more honestly and efficiently. In the New York Customs House, for example, some officials were extorting payments from importers and other officials were drawing salaries but doing almost no work. Since President Grant, Hayes’s predecessor, had suffered greatly from the shenanigans of dishonest government officials, Hayes tried extra hard to reform the civil service and make sure government graft was kept to a minimum.

Finally, Hayes showed balance in his administration. When, during a massive railroad strike in 1877, a state governor asked him to send in federal troops to preserve order, Hayes obliged. But he would not use federal troops to break the strike.

Hayes was a constitutional president. He believed in an executive strong enough to veto bad legislation, but he did not want to expand executive powers beyond what the Constitution specified. Congress was where laws needed to originate and where most political debate needed to take place.

Politics to Hayes was not a career. After serving one term as president, he happily stepped down and returned to private life.