The Economic Consequences of the Release (i.e., Brexit)

Much has been written on the recent decision by the UK to leave the European Union. Much of it is emotion-driven. But that is no way to assess such an important turn of events. The actual significance is, in significant degree, economic in nature. This calls for an economic analysis, to which we now turn.

The Organisation for Economic Co-operation and Development’s (OECD) Report published in April 2016, entitled The Economic Consequences of Brexit: A Taxing Decision[1], provides a competent summary of the disadvantages that might follow upon a British departure from the EU. We will use it as a reference for interaction.

Initial objections

The initial objections the Report registers are based on circumstantial evidence.

This holds for “Since EU membership in 1973, UK living standards have risen more than in peers” and “A multipolar world implies that the UK is economically stronger as an EU member, and in turn contributes to the EU strength.” (both on p. 9). Despite the graphs, such arguments, are, at best, suggestive rather than demonstrative. The same holds true for the objection that “Uncertainty has already begun to have a negative impact on the economy” (p. 10).

Exchange rates and the balance of trade

The Report then claims that “Uncertainty about Brexit has led to capital outflows and a weaker exchange rate” (p. 12). For a country running a perennial trade deficit, this is anything but objectionable. The graph below shows the development of the UK’s balance of trade since joining the EU (then the European Economic Community) in 1973.UK balance of trade

 

This shows a downward trend, and since the late 1990s, a persistent trade deficit. As such, a decline in the pound’s exchange rate will only help matters, by encouraging exports and discouraging imports.

This leads directly to the next objection, which is a weighty one. “Trade would be hit when the UK formally exits the EU.” If this is the case, it would be dire indeed. Let’s examine the substance.

“The EU remains the main trade partner of the UK and the financial sector benefits from direct access to the Single Market, which has strengthened the comparative advantage of the City” (p. 14). Absolutely true. And by way of elucidation: “Exports to EU countries account for about 12% of UK GDP and about 45% of total UK exports, and for imports the EU is even a more important partner.” This was already implied in the trade deficit data we looked at above.

The graphs below shows the breakdown. The first shows, by percentage, the UK’s export destinations, the second shows the UK’s imports by country of origin (source: The Observatory of Economic Complexity [http://atlas.media.mit.edu]).

UK exports

UK imports

The data is from 2014. As can be seen visually, Europe accounts for the lion’s share of both imports and exports.

The Report includes the following graph on page 15, showing the trade and current account situation between the UK and the EU:

UK current account2

Now then, all of this indicates mutual dependence. Even more than that, though, it indicates that the EU is more dependent upon the UK as a source of income than the other way around, given the fact that the UK runs a trade deficit with the EU. The EU has every reason to maintain existing trade relations with the UK. It would be to the EU’s disadvantage not to do so.

Renegotiating trade deals

The Report goes on to claim that “Negotiating a new trade agreement with the EU is likely to be complex” (p. 16). The various possibilities are laid out in a table, which we reproduce here:

brexit arrangementsThe claim is that negotiations will be complex and that the UK will be on the outside looking in, with the very real possibility of being relegated to “Most Favored Nation” status, in which trade with the EU will be “subject to the EU’s common external tariff.”

For one thing, negotiations need not be complex at all. The website Lawyers for Britain has put together comprehensive, detailed research papers on this issue, of which we gratefully make use. On Brexit and International Trade Treaties, it summarizes the issue both for the UK and for trading partners generally, with the following points (emphasis added to highlight key issues):

  • “Because of the EU customs union and ‘common commercial policy’, the UK is not able to negotiate its own trade agreements with non-member countries — we can only do so as part of the EU. The UK will be able to participate in new trade agreements with non-member countries from the day after exit.  The process of negotiating new trade deals can be started during the 2-year notice period leading up to Brexit, with a view to bringing them into force on or soon after the date of exit.
  • “The EU has existing free trade agreements which currently apply to the UK as an EU member.  Most of these EU agreements are with micro-States or developing countries and only a small number represent significant export markets for the UK.  Both the EU and the member states (including the UK) are parties to these agreements. The UK could simply continue to apply the substantive terms of these agreements on a reciprocal basis after exit unless the counterparty State were actively to object. We can see no rational reason why the counterparty States would object to this course since that would subject their existing export trade into the UK market, which is currently tariff free, to new tariffs. There will be no need for complicated renegotiation of these existing agreements as was misleadingly claimed by pro-Remain propaganda.
  • “The UK was a founder member of EFTA but withdrew when we joined the EEC in 1973.  We could apply to re-join with effect from the day after Brexit. There is no reason why the four current EFTA countries would not welcome us back, given that the UK is one of EFTA’s largest export markets.  EFTA membership would allow us to continue uninterrupted free trade relations with the four EFTA countries, and also to participate in EFTA’s promotion of free trade deals with non-member countries around the world.
  • “The EU is seriously encumbered in trying to negotiate trade agreements by the large number of vociferous protectionist special interests within its borders.  After Brexit, the UK would be able to negotiate new trade deals unencumbered by these special interests much faster than the EU, and with a higher priority for faciliting access to markets for our own export industries including services.
  • “It is completely untrue that you need to be a member of a large bloc like the EU in order to strike trade deals.  The actual record of the EU compared to that (for example) of the EFTA countries demonstrates the direct opposite.
  • “The baseline of our trade relationship with the remaining EU states would be governed by WTO rules which provide for non-discrimination in tariffs, and outlaw discriminatory non-tariff measures. From this baseline, and as the remaining EU’s largest single export market,  we would be in a strong position to negotiate a mutually beneficial deal providing for the continued free flow of goods and services in both directions.  We explain what such a deal would look like in a later post, Brexit – doing a deal with the EU.”

All of this indicates that it will require no herculean effort for the UK to reestablish itself as an independent trading partner, neither vis-à-vis the EU, nor the world at large. After all, the other countries of the world are not members of the EU, and they are surviving. And it bears repeating that for the EU to impose a tariff on UK imports would make no sense at all, because the same kind of tariff would be imposed reciprocally on exports to the UK: all $420 billion of them (from all of Europe, 2014).

All in all, it would be in the EU’s best interest to simply maintain existing trade relations, as they are eminently in its interest.

Other near-term effects

Further near-term effects discussed in the Report, such as a putative “reduction in UK trade openness,” “imposition of tighter controls on inward migration,” leading to “a large negative shock to the UK economy, which would spillover to other European countries” (all p. 21), are either mere surmises or could serve to argue the exact opposite.

The argument that a decline in the exchange rate would have deleterious effects on the UK economy is an example of an argument that could just as well be used to argue the opposite. As discussed above, a decline in the exchange rate would bolster UK exports and inhibit imports, which would benefit the UK and disadvantage the EU. In other words, the neo-mercantilist export policy of the EU countries like German and the Netherlands would be brought more in line with equity.

Long-term effect on trade

The Report goes on to discuss possible long-term effects.

The first one discussed is the trade situation. “The UK is the most attractive destination for FDI in the EU, partly owing to access to the EU internal market” (p. 24). Foreign direct investment would be restricted by withdrawal from this internal market. But again, as noted above, access to the single market is unlikely to be restricted, as the EU derives more advantage from it than the UK. Furthermore, the major inhibitor to direct investment is currency risk. But it’s not like the UK is withdrawing from the euro; it is only rearranging its relation with the EU, with the relation between the pound and the euro (a free float) not changing at all.

Effect of reduced immigration

Secondly, “Immigrants, particularly from EU countries, have boosted GDP growth significantly in the UK” (p. 26). Apparently, immigrants are more productive than native-born Britons. This is obviously a contentious statement; whether it proves anything is another question. Then there is this contention: “Immigrants from the EU make a positive contribution to the public finances, despite relying on the UK welfare system, which is also the case of UK migrants elsewhere in the EU” (p. 27). This is another statement difficult to rhyme with realities. Even if immigrants are all net contributors in terms of social welfare revenues and payouts, the jobs they take, leave other labor market participants without jobs and thus, at least in part, adds to the social welfare rolls (unemployment and other forms of social assistance). In addition, “immigrants from new EU countries have comparatively lower wages…” (p. 27), which means they depress wages, which may be beneficial to employers, but not to employees, and additionally reduce consumption.

The claim is made that reduced immigration would lead to reduced skills, and “A loss of skills would reduce technical progress.” That may be true in the short term, but where there is demand for skills, there will be training and education to enable workers to acquire those skills, and there is no inherent reason why native-born Britons could not be trained up. It is in fact a curious prejudice and form of reverse discrimination to believe otherwise.

The upshot

As a result of these putative disadvantages, the claim is made for a “central scenario” in which “UK GDP is more than 5% below the baseline by 2030.” Just the opposite is at least as likely.

Objections in favor of withdrawal can also be made, of course, but the Report neglects to mention those. One is the fact that the UK is the second-largest net contributor to the EU’s budget, after Germany. Another is that the UK bears a major part of the costs of the EU’s common defense. Yet another is the costs of an inherently cumbersome and inefficient, far-off, relatively unaccountable bureaucracy regulating so much of the economic life of the nation.

But the biggest problem with the EU is tangential to this particular debate. It has to do with the single currency, the euro, in which the UK, of course, is not a participant. The euro forms a massive net drag on the world economy, and the debt overhang to which it has contributed, by having encouraged irresponsible, indeed unconscionable, North-South lending, is an toxic inheritance that not only stifles current economic growth, but also forms a burden that future generations will be hard-pressed to alleviate.

That, however, is stuff for another discussion. For now, it is enough to re-emphasize that, in line with the position outlined here (with an assist here), it is nations, not empires, that create wealth. And that should be kept uppermost in everyone’s mind.


 

  1. Kierzenkowski,R., et al.  (2016), “The Economic Consequences of Brexit: A Taxing Decision”, OECD Economic Policy Papers, No. 16, OECD Publishing, Paris.

Confessions of a Free Trade Advocate

Ever since I can remember I have been a proponent of free trade. It seemed the logical thing: why should the government restrict economic activity which in itself is legal and aboveboard? And when I began exploring economic theory, lo and behold, free trade was at the forefront of most every exposition. It was the natural, the logical position to hold, and arguments against it seemed forced and, in fact, unfair, as if a basic principle of justice was being violated.

My instincts received even more validation from historical, moral theology. Francisco Vitoria, the Spanish theologian who was the first to flesh out a recognizably modern theory of the international community and law of nations, made freedom of trade one of the pillars of such a world order. As I wrote in 1991, “Freedom of trade Vitoria also includes among these rights of natural communication. This is quite noteworthy: remember, these rights belong to the ‘primary’ law of nations and as such may never be denied! National governments may infringe the right of neither their own nor of foreign private citizens and subjects to freely engage in trade, so long as trade and business may be carried on without prejudicing the health and safety of the community.” Free trade seemed to be a categorical imperative.

I continued along these lines in a book I published in 1999 entitled A Common Law. There I articulated a twofold tradition in Western constitutional theory and practice, the common-law tradition and the civil-law tradition. Of these two, the common-law tradition espoused limited sovereignty and the primacy of private law over public law, while the civil-law tradition embraced absolute sovereignty and the subordination of private to public law. As an extension of this, I included freedom of trade versus restriction of trade as a dividing line between the two traditions. With regard to the unification of Germany’s disparate states in the 19th century, I wrote that “The roots of German unification lay firmly in the civil-law tradition. Customs union lay the basis for further political union: free trade was established within the customs union, tariff barriers between it and the rest of the world…. In the civil-law tradition, trade can only be securely established within an area controlled by the sovereign; the domestic economy is the only stable economy. In the common-law tradition, trade binds societies under law, a law which also binds sovereigns and commits them to enforce it. In the civil-law tradition, law is the servant of the sovereign; in the common-law tradition, the sovereign is the servant of law” (pp. 125-126). Here again, I made free trade a categorical imperative and one of the core elements of a “constitution of liberty.”

As a final example, I wrote this in 1992: “Today the world is faced with the choice between two kinds of democracy. One, liberal democracy, is the descendant of the theocratic jus gentium, upholding freedom of trade, open borders, restricted national sovereignty, and the primacy of the private sector, considering that human society at the level of private association basically furthers the harmony of interests of its members, and that coercive authority is necessary only to ensure that violations in this harmony are punished. The other, social democracy, is the descendant of divine right absolutism, championing economic nationalism, closed borders, absolute national sovereignty (unless that sovereignty can be transferred to a supranational body), and the primacy of the public sector to rectify the inherent conflict of interests which exists in human society.”

So my free trade bona fides are fairly impeccable. But what I didn’t realize through all these expositions was something I only later began to uncover. It is a principle that already was elucidated by Friedrich List, one of the first post-classical economists to critique the doctrine of freedom of trade. The principle is this: trade between individuals and private entities is not the same as trade between nations, because it is nations that establish the framework within which trade can even take place. In the words of Karl Polanyi, markets are embedded. And this is of crucial importance. Nations establish currencies, laws, markets; they embody cultures and mores that impinge directly on economic performance; they embrace religions that, as Max Weber among others has shown, likewise are of crucial importance to economic activity. The public interest and the common-wealth are real factors that transcend private economy. They condition all economic activity and they cannot be abstracted away as if irrelevant to economics. This is the besetting sin of the free-trade theories of classical and neo-classical economics.

“How!” questions List. “The wisdom of private economy is then the wisdom of public economy! Is it in the nature of an individual to be preoccupied with the business and the wants of the future, as it is in the nature of a nation and of a government?” Leaving everything to individual action could not possibly ensure that collective interests will be taken care of. “Consider only the building of an American city; each man left to himself would think only of his own wants, or, at the utmost, of those of his immediate descendants; the mass of individuals as united in society are not unmindful of the interests and advantages even of the remotest coming generations; the living generation, with that view, submits calmly to privations and sacrifices which no sensible man could expect from individuals in reference to the interests of the present, or from any other motives than those of patriotism or national considerations” (National System of Political Economy, trans. G.A. Matile, Philadelphia: J.B. Lippincott & Co., 1856, pp. 245-246).

The absence of an understanding of the role of nations, and the focus on individuals, led classical economics to consider the entire world as one great commonwealth, with no distinctions of nationality and sovereignty. This is what led it astray. Its basic principles are valid within the framework of the nation, in their own sphere; but they run aground when trade between nations is considered. “In representing free competition of producers as the surest means for developing the prosperity of mankind,” List writes on p. 261, “the School is perfectly right, considering the point of view from which it regards the subject. In the hypothesis of universal association, every restriction upon honest trade between different countries would seem unreasonable and injurious. But as long as some nations will persist in regarding their special interests as of greater value to them than the collective interests of humanity, it must be folly to speak of unrestricted competition between individuals of different nations.” List here speaks only of national interests, but elsewhere he discusses the whole range of relevant criteria by which nations are distinguished. And so, “The arguments of the School in favor of such competition are then applicable only to the relations between inhabitants of the same country. A great nation must consequently endeavor to form a complete whole, which may maintain relations with other similar unities within the limits which its particular interest as a society may prescribe.” The social, public interests which obtain between nations are divergent; they differ from private interests and cannot be treated equally with them. “Now these social interests are known to differ immensely from the private interests of all the individuals of a nation, if each individual be taken separately and not as a member of the national association, if, as with Smith and Say, individuals are regarded merely as producers and consumers, and not as citizens of a nation” (p. 261).

So what does List propose as an alternative? Protectionism. This is his great failing. Because of this, his book has been neglected by those who realize the shortcomings of that doctrine, among whom I include myself. As I knew and still know, protectionism has its own set of problems.

Recall that “the School,” as List refers to the classical school of Adam Smith and Jean-Baptiste Say, advocated a commodity-money regime, which in effect harnessed the nations to a single currency. Because of this, if a nation wished to effectuate some sort of insulation of the domestic economy, it could only resort to protectionism as a fall-back.

The United States pursued a protectionist policy throughout the 19th and into the 20th century. The problems to which this led were given powerful expression at the crackup of the commodity-money regime in 1931, by James Harvey Rogers. Rogers placed a good deal of the blame for the bleak situation on the regime of tariffs obstructing trade.

The prominent part played by our high protective tariff in the present disastrous situation is beyond serious question. Aside from the political corruption which it has engendered in our national politics throughout more than a hundred years of our history, and aside, too, from the glaring domestic injustices which, since its inception, it has created and maintained; on it can now be laid the blame for a very important part in the extraordinary maldistribution of the money metal, in the recent drastic and rapid decline of prices, and therefore in the world-wide depression (America Weighs Her Gold, New Haven: Yale University Press, 1931, p. 193).

Of course this would have to be the case. Tariff walls short-circuit the functioning of a commodity-money regime. The attempt to eliminate trade imbalances through what effectively is a single currency run up against the shoals of that irreducible datum, the national economy. Domestic interests, in particular labor interests, simply will not pay the inflation/deflation whipsaw price to be paid to keep that system running. And so came the inevitable resort to trade barriers, and the eventual collapse of the system.

It is unfortunate that List’s exposition is known only for its advocacy of protectionism. Underneath that veneer lies a trenchant critique of the “cosmopolitan” system which is what unrestricted free trade embodies, which is valid now, as it was then. A common-law understanding of economics, which is what underlies List’s work, recognizes that nationhood and national sovereignty entail a framework of laws and institutions that delimit all economic activity and set up “natural” trade barriers that schemes like free trade and commodity money cannot overcome. A truly “natural” economic framework understands that currency is a function of sovereignty, and that floating exchange rates will provide the balancing mechanism that nations need to conduct trade relations with each other.

So how do we save freedom of trade? Not by eliminating nations, national sovereignty, national boundaries, and the like, but by embracing them within a framework that recognizes rather than undermines national sovereignty. Free-floating currencies are one crucial aspect of such a regime; after all, this is nothing else than free trade in currencies. Another is the adoption of domestic fiscal and monetary policies that do not promote the advantage of one nation over another. This is what happens when, for example, countries like Germany and China inflict forced-savings regimes on their own citizenry, punishing consumption and promoting production. What then in fact happens is that other countries are forced to take on board their excess production, as Michael Pettis has demonstrated in his book The Great Rebalancing. It is here that international efforts need to be conducted, not in imposing transnational regimes that undermine and displace national sovereignty altogether, and make a farce of even the pretense of democratic rule.

Weighing the Gold Standard

Seeing as how the gold standard is a “money method”[1] by which all exchange value is made dependent upon the weight of a certain substance, viz., gold, it would seem appropriate to “weigh it up” to determine whether or not, “weighed in the balance,” it is “found wanting.”

Indeed, weight measurement was the standard of value during the period when the gold standard held sway, and that standard was gold by weight: the dollar was set at 23.22 grains of pure gold (a grain being 1/7000 of a pound), the pound sterling at 113 grains, the German mark at 6.146 grains, the French franc at 4.98 grains, etc. In this manner, all the currency systems of the countries that adhered to gold standard were bound together by gold. Gold served as the currencies of the world’s reserve currency. This is likewise the origin of the modern system of reserve currencies, but we reserve that discussion for another opportunity (I discuss reserve banking in more detail here).

The gold standard is considered to be, well, the gold standard of money methods. Its great attraction lies in the discipline it lays on governments to conduct a strict and balanced fiscal policy. It does this because it ostensibly takes monetary policy out of the hands of the state. I say “ostensibly,” because the reality is a bit more complicated than that, as we shall see. Nevertheless, the gold standard system came also to be known as the “automatic mechanism” precisely because it functioned without government interference, indeed without any interference at all, guided by a veritable invisible hand. Again, this was not entirely the reality, but not entirely a departure from reality, either.

So the gold standard took currency management away from the state. Prior to it, the state did manage the currency. And that state-run currency system had its roots far back in history.

To be precise: with the advent of coinage in ancient Lydia (western Anatolia) around 700 B.C., the state became the manager of the monetary system.[2] Prior to this there were systems of commodity money – the Old Testament, for instance, speaks of silver as currency (a shekel being a weight measure of silver), and both silver and barley were used as commodity money in ancient Mesopotamia. These were not state-run but purely market affairs. Coinage was introduced, not as a form of commodity money, but precisely to counteract commodity money, which at that time was intimately tied up with the institution of debt slavery. It was introduced to insulate the domestic economy from foreign hegemony. It thus likewise accompanied the rise of the Western concept of freedom in the Greek city-states: coinage was one of the means which enabled the Greeks to wrestle their freedom from the Eastern (Persian) hegemonic empires.

Rome carried on the Greek tradition of coinage and introduced it throughout its empire (“Shew me a penny. Whose image and superscription hath it? They answered and said, Caesar’s. And he said unto them, Render therefore unto Caesar the things which be Caesar’s, and unto God the things which be God’s” (Luke 20: 24-25).) In so doing, it established for posterity the tradition of state management of the money supply. All of the Western European kingdoms took over this Roman institution and applied it as they waxed into independent sovereign states. But this system had its drawbacks. It required precious metals, mainly silver but also, secondarily, gold, to function. And during the entire period of medieval and early modern times, these metals were in short supply. The money supplies of these countries were subject to the vagaries of that supply – mines exhausted here, mines discovered there, new techniques opening new areas up for mining, the demand for silver from the East, in particular India and China – all of these factors played a role in the relative abundance or scarcity of the raw material needed to make the circulation go.

Add to this the practice of competitive devaluations conducted between currency regions, and one can understand the preoccupation for the provision of a supply of metallic currency; a preoccupation which later ages looked upon disparagingly. They even had a name for it: “mercantilism.” But this was no idle preoccupation, for the entire economic circulation depended on the existence of a metallic coinage; nothing else enjoyed the common consent and confidence necessary for a circulating medium.

Coinage was thus a state-run affair, and when the gold standard came around to supplant it, it actually supplanted the regime of coinage entirely. Where the gold standard became established, there coinage dried up. Gold coins never enjoyed the circulation the great silver pieces did, such as the Spanish pieces of eight, which in fact formed the bulk of colonial America’s circulation. No, the system of the gold standard was based on an entirely different “money method”: that of credit and banking.

This may come as a shock to those advocating a return to the gold standard. The common image is that of a rock-solid metallic currency that cannot be manipulated. But the reality of the gold standard was that, under its regime, credit exploded. This was not a bad thing; in fact, it was the way the Industrial Revolution was financed, and without it, that revolution probably would not have materialized. Still, the gold standard engendered a massive increase in banking and credit-derived bank money.

In this system, gold did not circulate in the sense of changing hands. Rather, it was locked up in bank vaults and served as the basis for the structure of credit. It was thus the reserve that every bank needed in order to issue credit. Theoretically, for every dollar of credit the bank issued, it could back in gold. Practice was different: reserve ratios were maintained depending on the likelihood of “cash,” i.e., specie, withdrawals. A ratio of 1/3 was common, at least initially. But with the practice of reserve banking, by which banks deposited their gold holdings with other “reserve” banks, the basis shrank.

So it was under the regime of the gold standard that we obtained an ever more “elastic” money supply. This was reflected in the explosion of credit. Macleod used the following example (from England) to show how the money supply there had changed under the gold standard.[3] He used the finances of the Slater house as representative of commerce in general. For year 1856, this is how its income statement looked:

macleod1

As Macleod noted, “Gold did not enter into their operations to even so much as 2 per cent. And this may furnish a clue by which we may obtain a rough estimate of the amount of Credit.” If this is representative, then credit amounted to 50 times the amount of gold. “This Credit produces exactly the same effects, and affects Prices exactly as so much Gold: and it is through the excessive creation of this kind of Property that all Commercial Crises are brought about.” It is a warning similar to the one Walter Bagehot made in his classic work Lombard Street: the entire edifice of credit was being erected on an ever slimmer basis.

Macleod avers that this lay at the heart of the commercial crises that repeatedly afflicted the economies under the gold standard. But it was the working of the gold standard during the times when it functioned automatically, the way it was supposed to work, that engendered the misery and resentment that led to the rise of the labor movement, political agitation, and the ultimate demise of the system.

This came about because of how the system affected wages and prices, enterprise, and employment. The automatic mechanism functioned through gold flows, and gold flows determined the money supply. Where gold flowed into the economy, the money supply could expand; where it flowed out of the economy, the money supply was forced to contract.

These flows occurred not only within countries but between them, given the international character of the gold standard. When economies, including national economies, ran trade surpluses or deficits, gold flowed to the surplus country, expanding its money supply and fomenting economic activity. By the same token, gold flowed out of the deficit country, restricting the money supply and depressing economic activity. The result was deflation in wages and prices.

So the gold standard worked by allowing inflationary and deflationary swings to redress trade imbalances. This resolved the underlying imbalance, but at what price? Severe bouts of unemployment, and consumption- (and thus production-) killing deflation. Schumpeter, perhaps the most thoughtful and nuanced defender of the gold standard, argued that deflation was not necessarily a bad thing, when all prices and wages moved in sync. Theoretically this might be true, but in practice, deflation has always been traumatic.

In fact, the only benefactors under a regime of regular deflation are creditors. This dynamic gave rise to the so-called social question and the various labor movements, socialism, and communism which characterized the later 19th century’s political landscape. The political unrest behind these movements found increasing recognition in the expansion of the suffrage, which brought the labor movement into the midst of the political arena, and put the interest of the workers on a line with those of the creditors. As a result, a new political calculus came to hold sway – called “stabilization” – consisting in the pursuit of price and wage stability. From this point on, governments pursued policies that could provide this kind of stability.

What then of the gold standard’s automatic mechanism? After all, it was based on the inflation/deflation model of rebalancing, and this new political agenda worked at obvious cross purposes to such rebalancing. The answer is, it was paid lip service as an ideal but was increasingly undermined in practice, first at the edges, later at its heart.

The first concessions to the new agenda were social programs and labor legislation. While they may have alleviated the working class’s lot, they did nothing to solve the underlying problem – the trade imbalance – and in fact hindered its resolution by devoting resources to perpetuating the status quo. Old-school conservatives recognized in this the first signs of state encroachment on the private sector, and they were right.

Along with this came central bank intervention. At first this was small-scale; but after World War I, it became de rigueur. Central banks came to master the art of “open-market operations” to control interest rates and, hopefully, changes in the money supply. But what really broke things open was the policy known as sterilization. By this policy, the automatic mechanism was entirely short-circuited. Sterilization entailed the removal of gold from circulation in the real economy to keep it from affecting prices and wages. This was done in the name of stabilization, but it effectively kept the gold standard from performing its rebalancing function. The countries from which gold flowed remained in a constrained economic situation, while the countries to which gold flowed were kept from expanding. Instead, that money went into the financial market. This precipitated the great bull run on the stock market in the late 1920s which ended in the Great Crash. After this, the gold standard system fell apart: some countries continued to adhere to it, allowing it to constrain their money supplies, while other countries went off of it and saw their money supplies expand and some degree of prosperity return. In addition, this period saw the advent of massive social programs administered by government, which required some degree of government influence on monetary policy in order to gain adequate financing. This dependence by government upon monetary policy, and the popularity this enjoyed among the electorate, sealed the fate of the gold standard.

What are the lessons to be learned from this history?

  1. The gold standard in its historic form as “automatic mechanism” will never be introduced as long as the electorate is democratic, i.e., as long as universal suffrage is the rule;
  2. The gold standard is not a coinage-based but a bank- and credit-based system;
  3. If it is a hard-money, coinage-based system that people are after, then a silver rather than a gold standard would be more feasible. For centuries, silver formed the backbone of the currency system, and for good reason: it is available in sufficient quantities to form an everyday circulation. When the gold standard was introduced, it displaced coinage, which brought great hardship on common people, who suffered from the lack of a circulating medium fitted to their needs.

 


 

[1] The term is Joseph Schumpeter’s: see his Treatise on Money (here and here).

[2] For the historical background to the following discussion, see my book Follow the Money. For more on this entire discussion, one may also consult the accompanying introductory course in economics, which goes into more detail.

[3] The following is taken from Henry Dunning Macleod, The Elements of Economics (New York: D. Appleton and Co., 1881), vol. I, pp. 324-325.