Wednesday, May 18, 2011

Why Were There Boom/Bust Cycles in the 19th Century Gold Standard Era?

(Last month I gave a brief talk to a group of students at the University of Northern Iowa. The organizer, Mark, asked me an interesting question.)

Thanks for coming to UNI and discuss Austrian economics to a group of students. I was wondering if you could recap your argument on why the depressions occurred in the late 19th century and why they were not as severe.


Dear Mark,
My pleasure. Any time. The cause of all boom/bust cycles is the expansion of bank credit not financed by real savings. Fractional reserve banking allows banks to expand credit by manufacturing money out of thin air. This practice was challenged in England in the early 19th century, when some depositors asked the courts to force bankers to repay their deposits out of their personal funds. The depositors wanted the courts to treat deposit banking in the same legal manner as a bailment; that is, just as if a farmer deposited corn or wheat in a grain elevator. The elevator cannot speculate with this "deposit". But the courts ruled that the depositors had "lent" the banker the money rather than entrusted him with their money as a bailment. This is the legal side of the explanation to your question. The economic side is that when the bank loans money in a fractional reserve, rather than a one hundred percent reserve, system, the money supply increases without an increase in savings. Eventually reality reveals the problem, as prices start to rise in consumer goods, forcing resources back from more time consuming investments. These investments never were funded with real savings, only monetary expansion. This is what caused the several depressions of the late 19th century. But research has shown that these depressions were not nearly as onerous as those of the 20th and now 21st centuries, because the underlying reserves themselves--gold and silver--could not be inflated. This provided a limit to the expansion. But now the reserves themselves may be expanded by the Fed to infinite amounts. That is one source of the credit expansion. Then the fractional reserve banking system adds a second source of expansion.

For example, if reserves are 1 monetary unit (m.u.) and the reserve requirement is 100%, then the money supply is 1 m.u. Let's assume that we are under a gold standard and the banks keep only 10% reserves. Now the money supply can be inflated to 10 m.u.'s. But, if reserves are not gold and the Fed inflates them to 2 m.u.'s and the reserve requirement is lowered to 10%, the money supply can be inflated to 20 m.u.'s. So, under a gold standard with fractional reserve banking, the reserves themselves cannot be inflated, which limits the extent of money inflation. But when reserves themselves are nothing more than blips on a computer screen, the money supply can be inflated to infinite amounts. This is the worst of all monetary worlds, because there now is no institutional check on monetary expansion.


Patrick Barron

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