A major argument against the gold standard is “the slowness with which its supply adjusts itself to genuine changes in demand.”1 (This is a major reason for Hayek’s opposition to the classical gold standard.) As this argument goes, an increased supply of gold often becomes available after it is no longer needed. Nevertheless, this increase in the stock of gold remains permanent and provides a basis for excessive expansion of credit even when the demand for credit falls.
First, although newly mined gold entering the market varies and can vary significantly, it is generally around 2 percent of the existing gold stock available for monetary use. Such a large stock tends to stabilize general prices. Whenever more gold is needed for monetary uses, it flows from the gold stock available for nonmonetary uses. Conversely, whenever gold is no longer needed for monetary uses, it flows back to the gold stock available for nonmonetary uses. (When gold flow is a problem, the cause is usually a poorly run credit system or governmental intervention.)
Second, if the government does not intervene to prevent prices from changing, prices and wages will adjust to match the available quantity of monetary gold. (When production rises faster than the money supply, prices generally fall as happened during the last quarter of the nineteenth century. Typically, manufacturers do not like to see their prices fall in nominal terms, so they pressure the government to intervene to prevent the decline. Most governments are only too eager to oblige because intervention increases the power and prestige of the rulers.
Likewise, wage earners do not like their wages to decline in nominal terms even if their purchasing power is increasing.
Perhaps the most common argument against falling prices, especially for farmers, who are usually in debt, is that previously acquired debt does not also decline with declining prices. Thus, an undue burden is created for the debtor. He borrowed money of less value, buying power, and must now repay with money of more value. However, if the purchasing power of the monetary unit is rising faster than farmer’s income is declining, then the undue burden vanishes. The farmer still comes out ahead; he can buy more with what he earns though his income has declined. The same is true for the wage earners and manufacturers who are debtors.)
Third, and most important, this problem of supply adjustment is greatly alleviated when the gold standard is accompanied by the real bills doctrine and local banks are not restricted in expanding and contracting their bank notes and checkbook money used to buy real bills of exchange. When a financial panic or the need for more cash occurs, banks can issue more bank notes and checkbook money so long as a demand for money exists. When the supply of gold begins to increase, banks can begin contracting their bank notes and checkbook money to bring the supply of and demand for money into equilibrium.
Furthermore, flexible credit money can smooth out seasonal monetary demands and changes in interest rates. Moreover, it greatly reduces the movement of monetary gold from one region to another.
When properly used, bank credit money prevents prices from falling without causing them to rise. Local banks should increase bank notes and checkbook money as the demand for money increases and contract them as demand declines. Gold serves as a check. If too many bank notes or too much checkbook money is issued, they will be redeemed for gold. If too few are issued, people will deposit less gold in banks.
When the real bills doctrine is allowed to operate freely, it greatly alleviates, if not eliminates, the perceived problem caused by the slowness with which the gold supply adjusts to changes in demand. The problem with the supply of gold adjusting to the demand for money occurs primarily when governments interfere with the expansion and contraction of bank credit money under the real bills doctrine. Governmental intervention caused most of the monetary problems in the United States and Great Britain during the latter part of the nineteenth century and in the world following World War I.