The Problem of Saving

When Schumpeter writes, “Now to the question: what is a savings account?”,[1] he is not being facetious. There is more to savings than meets the eye. Of course, the bare fact of saving is simple enough to understand. Rather than spend all of our earnings, we take some and put it to one side. What could be more straightforward?

Actually, the problem is not so much understanding what savings, or a savings account, is, but what kind of effect it has. And that is anything but straightforward.

Essentially, what is accomplished with the act of saving is the removal of circulating medium from the cycle which is what an economy is.

An economy is a cycle or a circular flow: this is one of the first lessons of basic economics, encapsulated in the principle originally put forward by Jean-Baptiste Say, “supply creates its own demand.” All this means is that, at the end of the day, the producers are the consumer and the consumers, the producers. It is the same people producing who do the consuming, and vice versa.

At least, this is the basic picture, before things get complicated with things like foreign trade and fiscal policy. And things like savings. For what savings does is remove some of the circulating medium by which this economic cycle does its cycling. There are two aspects to the cycle: the circulation of goods and service, and the accompanying circulating medium by which the goods and services are accounted. When a shortfall of the circulating medium crops up, the result is deflation. And so, saving on the face of it has a deflating effect on wages and prices. And a deflationary environment is noxious to economic growth.

As a result, we have what economists have dubbed the “paradox of thrift” whereby saving, normally thought of as an act of economic virtue, or at least efficiency, actually depresses economic activity. The details as to how this occurs differ depending on the analyst, but the upshot is that saving, far from being the benign, even constructive act that it may well be on the personal level, actually has, or can have, a negative effect on the economy at large.

So which is it? Do we really have a paradox here along the lines of moral man, immoral society? Is personal saving something good for the individual or the household or other economic entity, but bad for the economy at large?

To figure this out, we have to take a look at what actually happens in the act of saving. First, of course, there is the proverbial mattress, or, especially in the days of coinage, the chest. In such a case, we have the circulating medium definitively removed from the economy for however much time the saver desires. (Or for much longer than that, as witness contemporary discoveries of hoards of coins from e.g. Roman times.) We can call this form of saving “hoarding.” It is peripheral to the main discussion.

What happens in the modern world is something different. When we save, our first resort is not the mattress but the bank. And when we do this, our money earns interest. What is interest? Let’s just say that is another of those phenomena that economists have a hard time figuring out. Perhaps we can address that subject in a future article. For now, we mention it in passing with the caveat that in the contemporary zero-interest-rate environment, it is not the incentive for saving that it normally might be.

So we put our money in banks. What happens then? Does it just sit there, like in the mattress? Not in the modern system. Instead, it enters into a second market, which runs independently of the market for goods and services with which we are already acquainted. We speak of the financial market. Banks (and non-bank financial institutions) are the gatekeepers of this market. We include a graphic taken from the accompanying course to indicate the structure of this second market.

Figure 3:  Two Markets, Two Monetary Circulations
Figure 1:  Two Markets, Two Monetary Circulations

Savings, then, go into this market, where they are “put to use” to earn income for the bank or other financial entity. The differential between what these latter entities earn and the interest they pay out is their profit.

What happens on this market? There are several submarkets which determine this. The bond market is where corporate and government borrowers go to get ahold of some of these savings. The stock market is where corporate interests go to sell stock in their companies – the money that goes here is not savings in the strict sense, as is money lodged with banks, but it does fall under the same category of earnings set aside to earn a separate income and to be available for future use, so we include it in our discussion.

“For future use” – this already indicates that the so-called paradox of thrift need not be so paradoxical. The writers on the problem of saving often seem to talk as if the money put into saving will never come back. In fact, the whole point of saving is to put earnings aside for “a rainy day,” or for the later purchase of big-ticket items, or for retirement – at any rate, not to eliminate it but to return it to circulation at some future time. And in a developed economy, over time the money put aside as savings will be counterbalanced by money previously set aside as savings and now returning to circulation. In addition, this money may have been supplemented by earnings on the financial market, which means that more money will be returning to circulation than left it. So on the face of it, this shouldn’t be a problem.

But there is a problem, and it is this. In normal situations this flow of funds back and forth between the ordinary and the financial markets is not problematic. But in the contemporary situation, it is.

One reason is because the ordinary market is being hit from various directions, making it unproductive and therefore unattractive. Firstly there are what Jane Jacobs (see this post for more on her) called “transactions of decline,” in which government removes money from productive activities, precisely because they are productive, and redistributes it to non-productive activities, precisely because they are unproductive. This can have a Keynesian motivation, whereby Say’s Law is turned on its head: demand then creates its own supply, and all government has to do is distribute money around to consumers (breaking the link between production and consumption) to generate productivity. According to Keynesians, this should in and of itself bring about prosperity, but as Jacobs points out, it only undermines productive activity and the human capital that underlies that productive activity, and so becomes a self-generating downward spiral.

Other things government engages in that undermine productivity are excessive taxation and regulation. All of this makes the ordinary market an unproductive affair, in which risks exceed rewards. The upshot is that savers put their money, not in ordinary investment, but in the financial market, which essentially is a zero-sum game, but in which at least the prospect of a decent return beckons.

And so more funds flow into the financial market than flow out, creating a dearth of liquidity in the ordinary market, which manifests itself in low interest rates combined with difficulty in borrowing (despite those low interest rates).

The flip side of the dearth of liquidity in the ordinary market is a glut of liquidity in the financial market. As funds pile into the market, returns there diminish and the quest for “alpha” (market-beating returns) becomes a frenzy. This is what happened during the 2000s in the run-up to the credit crisis. With the excess liquidity in the financial market, funds were available for lending that never would have been lent in a normal risk/reward analysis, often under political duress. An example is the subprime lending that took place. Michael Lewis (see this post for more on him) wrote about this in two of his most important books, The Big Short and Boomerang (the latter in particular gives a dramatic picture of the workings of the liquidity glut).

This was exacerbated by the trillions of dollars kept in the financial market by exporting countries like Japan and China (see this post this post for more on this), in their attempts to hold down the values of their domestic currencies. That in itself added substantially to the glut. But the very fact that what these countries were doing– looked at globally – was further undermining productivity by destroying productive capacity in rich countries while misdirecting investment in their own countries, only meant that another nail was being driven in the coffin of the ordinary market. Such “global value chains,” when established and maintained through currency manipulation and other fiscal and monetary policies designed to create unfair advantage for exporters at everyone else’s expense, only make the ordinary market even less attractive, which is another reason for the flight to financial markets, and even to inert investments like gold and other luxury items such as works of art.

A lot of work has to be done to restore ordinary markets to decent functionality. One of these is a return to an emphasis on the national economy as opposed to the lopsided emphasis on global-value-chain globalism such as obtains today. And within the national economy, a return to emphasizing the production side of the economy. Consumption does not magically engender productive activity; in particular, deficit spending to fund consumption is as pernicious a fiscal policy as can be devised. Various forms of capital are needed for that, various forms of infrastructure, from legal to educational (virtue versus entitlement) to religious. All of this is fodder for new discussions, so we’ll leave it at that for now.

This topic and more are dealt with more fully in the accompanying course.

[1] Treatise on Money, p. 147.

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.

National Economy?

At first glance the notion of a national economy would seem to be self-evident. After all, the lion’s share of economic data comes in the form of “national accounts,” which treat the nation as a self-contained economic entity, like a business. And the talk, when it comes to the economy, is always of how the nation is doing, or how other nations or countries are doing. Likewise, history revolves around the nations and their economic progress, as with the US and its “manifest destiny.”

But the idea of a national economy does not extend to the level of theoretical category. Economic theory does not take it into consideration. It comes into play because of political, not economic, considerations. The fact of the matter is, because politics is concentrated at the national level, so also is fiscal and monetary policy. And this factual state of affairs determines the subject matter. It is at the national level that both fiscal and monetary policy takes place; it is the level at which results from these policies are expected.

Economic theory, however, is not discussed in terms of the nation but in terms of abstractions: the “market,” “business,” “consumers,” etc. This is, or at least it used to be, referred to as “microeconomics.” Then we have “macroeconomics,” which is essentially the economic role of the state with its aforementioned fiscal and monetary policies; in this way we smuggle the nation in through the back door, as it were.

But the nation never functions as a subject of economic theory in its own right. Economic practice, of course, cannot avoid it – the sovereign democratic state is the way things are, it delimits the subject matter at the “macro” level.

The unexamined presupposition in all of this is, what is the locus of the economy? It is actually a question of the utmost importance, because only in this way can we come to grips with crucially important notions – and realities that, like it or not, we have to deal with – like the “global” economy.

One person who, thankfully, did not leave this presupposition unexamined is Jane Jacobs. In her book Cities and the Wealth of Nations,[1] she puts the notion of a national economy, which she takes to be the reigning doctrine, squarely in the cross-hairs. In her view, such an economy is an artificial imposition: the real economy is city-oriented. Cities, not nations, form the watersheds of an economy. Which is to say, cities are the focus of integrated, mixed economies, involving all major sectors from agriculture to industry to finance. Within the city and its supply regions, a stable and integral economy is maintained.[2]

Therefore exporting and importing takes place between cities, not nations. By extension, cities perform the vital economic function of import-replacing: the replacement of imported goods with goods of their own making. In Jacobs’ model, it is this import-replacing function that is the basic motor of economic growth.[3]

Jacobs adds to this import/export functionality the logical corollary: currencies. Currencies function as feedback mechanisms: they provide economies with information with respect to their productivity vis-a-vis other economies. A rise in an economy’s currency indicates that it is more productive than other economies the currencies of which are falling in relative terms, while a fall indicates the reverse condition.

So then Jacobs draws the obvious conclusion. Since cities are the basic units of import and export, currencies, in order to best perform their function, should be geared to the city economy itself; their rise and fall would thus trigger the appropriate response in the city economy, because this currency fluctuation acts as both tariff barrier and export subsidy (a falling currency acts as an export subsidy, a rising currency as a tariff barrier). Cities should maintain their own currencies.[4]

This also indicates a problem with this entity known as the national economy. A larger political unit such as a nation-state, when it imposes a common currency on a multiplicity of cities, short-circuits this feedback function of currencies. It favors the economies of some cities at the expense of others. Since cities not only import and export to foreign nations but also to sister cities in the same nation,[5] the automatic feedback information provided by the currency does nothing to allow cities within the range of the currency to adjust their economies to each other. They receive none of the feedback information that a city-based currency would provide them. Therefore, the cities whose economic position is favored by the national currency continue to grow, while the others stagnate.[6]

Clearly Jacobs is no friend of the nation-state. “Virtually all national governments, it seems fair to say, and most citizens would sooner decline and decay unified, true to the sacrifices by which their unity was won, than prosper and develop in division.”[7] And she takes classical economics, especially as exemplified in Adam Smith’s tellingly titled Inquiry into the Nature and Causes of the Wealth of Nations, to task for this. Smith “accepted without comment the mercantilist tautology that nations are the salient entities for understanding the structure of economic life. As far as one can tell from his writings, he gave that point no thought but took it so much for granted that he used it as his point of departure.”[8] Smith’s unthinking assumption of this assumption was subsequently passed from generation to generation without any further thought on the matter. “Ever since, that same notion has continued to be taken for granted. How strange; surely no other body of scholars or scientists in the modern world has remained as credulous as economists, for so long a time, about the merit of their subject matter’s most formative and venerable assumption.”[9]

So Jacobs agrees with us that the locus of the economy is an unexamined proposition. Nevertheless, her thesis that the nation was the focal point of classical economic theory is debatable. In fact, it is contradicted by an early proponent of “The National System of Political Economy,” Friedrich List.[10] List certainly does not figure as an unthinking follower of Adam Smith. His description of Smith’s school is telling: he calls it “the Cosmopolitical System.” By which he means that, pace Jacobs, it is the antithesis of a “national system” of economics.

In line with the influential vision of “Perpetual Peace” put forward in the late 18th century by the celebrated Abbé St. Pierre, this “cosmopolitical system” of economics presupposes harmony and peace between the nations. In such a situation, nations per se have no interests; the human race is joined together as one; and for this reason, “for the most part the measures of governments for the promotion of public prosperity are useless; and that to raise a State from the lowest degree of barbarism to the highest state of opulence, three things only are necessary, moderate taxation, a good administration of justice, and peace.[11] Free trade is then the norm, and indeed, can only truly be implemented under the auspices of such a universal peace. But, argues List, this is to confuse a hypothetical goal toward which the nations should work, with a standing condition already attained.

The [classical] School has admitted as realized[,] a state of things to come. It presupposes the existence of universal association and perpetual peace, and from it infers the great benefits of free trade. It confounds thus the effect and the cause. A perpetual peace exists among provinces and states already associated; it is from that association that their commercial union is derived : they owe to perpetual peace in the place they occupy, the benefits which it has procured them. History proves that political union always precedes commercial union. It does not furnish an instance where the latter has had the precedence. In the actual state of the world, free trade would bring forth, instead of a community of nations, the universal subjection of nations to the supremacy of the greater powers in manufactures, commerce, and navigation. [12]

While Smith and the other proponents of the classical school did recognize the existence of nations and national interests, List correctly assesses the basic orientation of the system. Much of this was inchoate; Lists’s strictures served to stir up debate, generate criticism, and give rise to critical schools of economic theory, such as the so-called Historical School.

This is evident not only in the advocacy of free trade generally as panacea for all economic ills, but also, importantly, in the advocacy of free trade in the area of currency. As we explored in this earlier post, leaving currency to the free market is a key element in a cosmopolitan system that deemphasizes nations as economic actors and subjugates sovereignty, in order to establish a “center-periphery” system of exploitation. And Adam Smith’s classical system established commodity money as a cornerstone of its economic order. As such, in its essentials List’s construct holds true.

List is correct to point out that mercantilism, the target of the classical school’s vituperation, took the nation to be the focus of economics. The system of commodity money, established to overcome mercantilism, is thus a product of the cosmopolitan system. Indeed, the latter found its justification in the fact that it overcame mercantilism, with its supposed framework of conflict of interests and the struggle between nations.

The system of commodity money came to be embodied in the gold standard. As I have argued elsewhere (Follow the Money, ch. 14: “The Great Transformation”), that system ended up in the shipwreck of two world wars and a great depression. As such, it is forever a thing of the past.

Since then, we have had national currencies; and since 1971, ostensibly free-floating national currencies. Jacobs’ polemic against the current system of national currencies has this to say for it, that it understands the role of currencies as feedback mechanisms. Furthermore, the understanding of economies as things that are city-oriented and city-generated. Where Jacobs goes astray is in her exclusive focus on currencies as the only way imbalances are rectified.

As I outline in the accompanying course, economic regions within national boundaries, which thus share the same currency, adapt to each other and resolve imbalances between each other by changes in wages and prices. These changes trigger flows between the economic regions, which are called factor flows: flows of mobile factors of production. Two such factors are labor and capital. They flow back and forth between economic regions, depending on such things as wage levels, price levels, and interest rates.

In the cosmopolitan system, these flows take place not only within countries but between countries. The world is then viewed as a unified, universal jurisdiction of provinces, with the free flow of mobile factors of production settling up regional imbalances.

The problem with this system is, of course, that it does not take nations into account as inescapable realities with inescapable, differentiated, often conflicting characteristics. Nations have different cultures, languages, religions, mores, values, levels of material development, and certainly different approaches to and attitudes towards getting and spending. This leads to evident differentials in things like rates of economic growth.

There is more. Nations have an unsettling penchant: inner drive to establish sovereignty. This was one of the great insights of the German Calvinist statesman and political philosopher Johannes Althusius (1563-1638). At the time, the doctrine of sovereignty was for the first time being fully developed in its modern form as the power that cannot be gainsaid, the power that stands above all other human institutions and authorities and “speaks the law” to them in a final manner. The Frenchman Jean Bodin (1530-1596), coincidentally one of the forerunners of the theory of commodity money, was also the developer of this new theory of sovereignty, which he located squarely in the ruler, whether king or national assembly of whatever sort.

Althusius accepted Bodin’s doctrine of sovereignty but turned it on its head, as it were. It was not the ruler, but the nation as a whole which was the bearer and locus of sovereignty. The ruler was simply the administrator thereof, who exercised its power in the name of and in trust to the true sovereign, the people or nation.

I have attributed the rights of sovereignty, as they are called, not to the supreme magistrate, but to the commonwealth or universal association. Many jurists and political scientists assign them as proper only to the prince and supreme magistrate to the extent that if these rights are granted and communicated to the people or commonwealth, they thereby perish and are no more. A few others and I hold to the contrary, namely, that they are proper to the symbiotic body of the universal association to such an extent that they give it spirit, soul, and heart. And this body, as I have said, perishes if they are taken away from it. I recognize the prince as the administrator, overseer, and governor of these rights of sovereignty. But the owner and usufructuary of sovereignty is none other than the total people associated in one symbiotic body from many smaller associations. These rights of sovereignty are so proper to this association, in my judgment, that even if it wishes to renounce them, to transfer them to another, and to alienate them, it would by no means be able to do so, any more than a man is able to give the life he enjoys to another. For these rights of sovereignty constitute and conserve the universal association.[13]

This key consideration is something that Jacobs and economists in general overlook. Sovereignty is a legal and political doctrine that fixes economic reality in a determinate and conclusive manner. It transcends economics while also acting as a basic datum that real-world economics must take into consideration. And it is nations that exercise sovereignty. As such, it is nations that establish and maintain a common law, the determiner of economic reality: hence, common-law economics. Currency, for one thing, is a function of this common law. No nations, no sovereignty; and no sovereignty, no common law. As this piece is already long enough, I will spare the reader any further elucidations. But this on-site article can serve to fill the gap.

[1] Jane Jacobs, Cities and the Wealth of Nations: Principles of Economic Life (New York: Random House, 1984).

[2] Ibid., ch. 2.

[3] “Whenever a city replaces imports with its own production, other settlements, mostly other cities, lose sales accordingly. However, these other settlements – either the same ones which have lost export sales or different ones – gain an equivalent value of new export work. This is because an import-replacing city does not, upon replacing former imports, import less than it otherwise would, but shifts to other purchases in lieu of what it no longer needs from outside. Economic life as a whole has expanded to the extent that the import-replacing city has everything it formerly had, plus its complement of new and different imports. Indeed, as far as I can see, city import-replacing is in this way at the root of all economic expansion.” Ibid., p. 42.

[4] Ibid., ch. 11.

[5] Ibid., p. 43.

[6] Ibid., ch. 11.

[7] ch. 13; the quotes are from pp. 212, 215-16.

[8] Ibid., p. 30.

[9] Ibid., p. 31.

[10] As elaborated in his book The National System of Political Economy,  first published in German in 1841. The English translation was first published in 1856.

[11] National System of Political Economy (1856 ed.), p. 191.

[12] Ibid., p. 200.

[13] Frederick S. Carney (trans. and ed.), The Politics of Johannes Althusius (London: Eyre & Spottiswoode, 1965), p. 10. Emphasis added.

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:


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.