by D.J. Webb
I don’t have time for a full blog on the gold standard, but I would like to address that subject in the New Year. However, the issue is so timely that I’m commenting briefly here, with some focus on Russia.
By far the best books explaining the gold standard are written by Nathan Lewis. His Gold: the Once and Future Money and his more recent Gold: the Monetary Polaris (available in PDF at http://newworldeconomics.com/GTMPpage.html) are unusual in that they explain the mechanisms—the actual central bank mechanisms—of the operation of the gold standard. I’m deep into the PDF, taking notes as I write, and I hope to upload a long blog article over the next couple of weeks on this subject. However, I strongly recommend all libertarians to download and start reading it, and upload your own blogs on this subject too. We need to get the discussion moving. I will focus on finishing the PDF first and not on answering comments here.
They key point Lewis makes is that “base money” is the only real money. Base money is notes and coins and reserves held by commercial banks at the central bank. If you buy a pint of milk with notes, you are using base money. If you pay for something electronically or by direct debit, that transaction is also ultimately accomplished using base money. You may think that the payment comes out of your personal bank account, but the bank doesn’t have notes and coins that represent your deposit in the bank held in a safe somewhere. Your “demand deposit” is strictly speaking a loan to the bank, a form of credit, and is just ones and noughts on a screen. What happens is that at the end of the day banks settle up all their transactions. If Barclays Bank receives 1 million transaction orders totalling £2bn to pay money into personal accounts held with NatWest, and NatWest receives 800,000 transaction orders totalling £1.5bn to pay money into personal accounts held with Barclays, those transactions are netted out at the end of the day, and £500m of Barclays Bank’s base money held with the Bank of England is transferred to NatWest. The ones and noughts on the screen in the individual bank accounts are all adjusted, but the real payment is in base money. If a business holds an account with Lloyds and pays £2000 to a worker who banks with Lloyds, then both accounts (the ones and noughts on the screen for both accounts) are adjusted, and in this case the net movement in base money is zero, because there is no net settlement required between banks at the end of the day.
Claims by some libertarians that in a gold standard system every penny of the broader definition of money supply would need to be backed by gold reserves are foolish. Lewis indicates in his book that most “gold bugs” don’t understand the gold standard either, or how it used to work before August 15th 1971. If such an approach were taken, it would indeed be the case that there would not be enough gold in the world to run a gold standard and that economic growth had become, by definition, impossible. In fact, it was never the case that the entire quantity of money in the economy, including base money and broader forms of money including demand deposits and loans, was limited by the amount of physical gold held by the central bank. Because “gold bugs” often take such a mulish view, they open themselves immediately to the accusation that their gold standard would be unworkable due to the insufficiency of gold supply.
In fact, Lewis shows that no gold is needed to run a gold standard, although it would be a more credible system to have some gold and to allow payments in specie. He explains that the gold standard can be run as a gold peg, with the quantity of base money being managed in such a way as to keep the currency stable against gold. This is workable because each country (apart from those who foolishly entered the euro) does control its own money supply: in the case of Russia, Russia does control the supply of rouble base money, so why wouldn’t they be able to keep the rouble stable? They can expand or contract base money at will.
Lewis also explains that many of the original principles of central banking have been forgotten, and that, for instance, in the 1997 Asian financial crisis, the Thai government defended the baht and ran down foreign-exchange reserves to do so—but did not shrink the monetary base. When the central bank sold gold or foreign exchange to buy baht, it should have removed those baht from circulation, thus eventually creating a scarcity of baht. Even in a severe run on the currency, only a certain amount of base money can ever be dumped—Lewis says 20% is an effective maximum—as base money cannot be run down to zero, and so by defending the baht at a certain parity and withdrawing the baht so purchased from circulation they would have eventually stabilised the baht.
In Russia’s case, they have sufficient gold to run a gold standard: Russia’s gold reserves already cover a much larger proportion of the monetary base than was usual in the pre-1971 period, and they have been buying gold all year, leading some to wonder if a gold-backed rouble is being planned. An alternative rumour on Bloomberg had it that Russia was so desperate it had been selling off the rouble—an absurd rumour as they have all year been buying gold, and they have recently confirmed they’ve increased their gold holdings yet again.
However, Lewis’ book also shows that, even if you’re not aiming to keep the currency stable against gold, you can still use traditional central banking principles to keep it stable against other fiat currencies, namely, that the monetary base needs to be shrunk to defend the currency. Russia has blown more than US$100bn this year on defending the rouble, only to see the rouble fall sharply. Yet the irony is that the rouble monetary base is only equivalent to US$125bn at currency exchange rates. (The figures are given at http://www.cbr.ru/eng/statistics/credit_statistics/mb.asp.) This is for the reasons given above, that the monetary base (the real money with which all broader transactions are ultimately conducted) is much smaller than the so-called broad money supply, including credit and other things. Why wouldn’t they be able to stabilise the rouble when foreign-exchange reserves including gold are more than US$400bn? The monetary base is more than 300% backed by foreign-exchange reserves. Every single rouble note and coin could be handed in and exchanged at the parity defended by the government—and it wouldn’t come close to making a serious dent in the country’s foreign-exchange reserves. In fact, even the entire monetary base (including bank reserves) could be exchanged at the desired parity and still see Russia hold on to the vast bulk of its foreign-exchange reserves.
In practice, you could not have 100% of base money being dumped, as some base money is always required: people need a certain amount of notes and coins and commercial banks need a certain amount of bank reserves. So Lewis theorises only one-fifth of base money would ever be dumped: defend the existing parity with less than one-tenth of foreign-exchange reserves, and the crisis would be over.
However, it only works if the monetary base is then shrunk. Yet, as Lewis shows in his Forbes article at http://www.forbes.com/sites/nathanlewis/2014/12/19/its-official-elvira-nabiullina-wins-the-tall-pointy-hat-award-for-mismanagement-of-the-ruble/, US$100bn has been wasted by the Russian central bank this year to defend the exchange rate, but all the while the monetary base has been expanded, replicating the error of the Thais in 1997. (The monetary base is subject to some seaonality; year-on-year increases can be seen in the monetary base once the figures are compared to the same month in 2013.)
Think about it: it is said that capital flight from Russia may reach US$125bn next year (less than one-third of foreign-exchange reserves). But with the monetary base at US$125bn, this would be impossible if the Russian central bank followed a consistent policy of removing from circulation each rouble they bought to defend the currency. Instead, they are more likely to burn through in excess of US$100bn in foreign-exchange reserves to allow more than US$100bn to flow out of the country, leaving the monetary base unchanged, and the nation’s currency reserves much depleted.
There are no two ways about it: they have sufficient gold and currency reserves to defend the rouble. They need to dump the central bank governor, Elvira Nabiullina, as the first move in a fightback against Western attempts to destroy the rouble.
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There is enough supply of any practically divisible commodity to be money. In this case of gold all one would need to do would be to divide the gold holdings in weight by the total supply of pounds sterling then you could define each pound sterling at that amount of gold. Granted there’d be a huge appreciation of the currency and great price deflation but so what? People would be richer and the economy in the absence of price controls/ regulations will adjust quickly.
Also I think your argument about how everything is settled in base money seems to ignore the money multiplier (aka fractional reserves). In their absence bank runs would be a practical impossobility since they would have enough base money.
Note the function of the central bank is to cartellise, protect the banks from their own fraud (fractional reserves) and adverse risk taking; and to provide cheap credit to the state- it has no other purpose.
Unfortunately, like a lot of people on this site, you launch into commenting on something you don’t understand – you did not take the trouble to read the PDF. The idea that people in the UK would be “richer” if the government passed a law that one ounce of gold was now worth £1trn is absurd – such an absurd law would simply lead to a flourishing black market.
I pointed out a fact – not a theory, but a fact – that everything is ultimately settled in base money. Sure there is the money multiplier – but that reflects how base money is ultimately only a small fraction of the broad money supply. In the absence of this “multiplier”, no economic growth would be possible. The idea that every single pound in every personal account has to be backed by gold prevents economic growth – Lewis argues most gold bugs misunderstand the system they advocate – as do you.
I don’t expect you will get round to reading the PDF – but you disqualify yourself from the discussion if you don’t understand its parameters.
DJ,
You have written some excellent stuff in the past but this is not one of them. You sound like a Marxist saying I cannot discuss Marxist economics without first reading Das Kapital. I frankly have better things to do than read a 240 page pdf. I have read more than enough on monetary history and monetary theory to find errors in what you write which was the sole purpose of my response.
Firstly, I am no gold bug. In the absence of the government control of money (legal tender et al) I’d expect different metallic coins some containing gold, others silver and for low value transactions copper with no fixed exchange rate between them; paper wouldn’t circulate with a banks holding 100% reserves as they couldn’t track who owned the money in the warehouse and thus who to charge for it as Larry White points out. In the modern day a lot of this could go to electronic transactions with the banking sector doing the legwork.
I think the distinction to between base money and broad money is somewhat semantic. Money is the general medium of exchange and final payment for goods and services. Note the Rothbard’s essay Austrian Definition of the Money Supply. Others would include a paper by Joe Salerno and article by Michael Polllaro.
Your error is assuming that the money multiplier helps anything. All it does is artificially inflate the level of true savings leading to businesses engaging in projects which physical cannot be finished; note Hulsmann’s “Time Preferences and Investment Expenditure”. Only saving and investment can lead to growth, nothing more nothing less. In fact the money multiplier reduces the value of individuals’ wealth reducing saving and increasing consumption thus impoverishing us relative to the situation that would otherwise pertain.
You completely misunderstand my suggestion for monetary reform (which is effectively Rothbard’s as Paul Mark’s notes below). When Britain left the gold standard for the final time it effectively expropriated individual’s gold, leaving them just with paper. Such a change would redistribute the gold from the central bank (who stole it) and return it who original owned it, thus making most people richer at the expense of the criminal central bank. It is not an arbitrary price control, it is merely the mechanism of devaluation of the currency following inflation during a period of hiatus of the gold standard.
Finally, you have ignore my main point regarding gold that any supply of a practically divisible commodity can serve as money. All that would happen if there was a relatively small supply would be price deflation. Therefore there is always enough, gold, silver and copper to serve as currency, your base, factually incorrect assertion notwithstanding.
(it’s dobbothegreat, having problems posting under my original name)
The trouble with “backing” or a “standard” is that it is often an open door to fraud – as in the late 1920s when countries were “on the gold standard” but a full credit expansion boom-bust happened anyway (the Benjamin Strong New York Federal Reserve credit money expansion).
The late Murray Rothbard was correct on money.
For example, if the Russian government want a gold “Rouble” they should publically show exactly how much physical gold they actually have and then divide this gold by the number of “roubles” – that would be the level of he “rouble”, neither more or less.
Exactly the same is true for the Pound or the Dollar.
Accept that I suspect we could show a lot less physical gold than Mr Putin could. Yes I am one of those paranoid people who think a lot of the gold is not physically there (in the New York Fed) any more.
Of course then there is no need for the special names “Rouble”, “Pound”, “Dollar” (and so on). One would just express the weight and purity of the gold (or silver – or whatever) that one was talking about – and that would be it.
No need for special names.
Thank you for the article. My question is, given the thoroughly authoritarian nature of the Putin regime, why would he consider something such as gold backing for the rouble?
No reason at all Mr Mayfield – unless it was a last gasp effort to save his dictatorship.
And I repeat my point about “backing” – either gold is the money or it is not, talk of “backing” or “standards” confuses the issue.
I’m on p129 of the 290-p PDF. The part I’m hoping to get it to is how the central bank withdraws base money to stabilise the currency and the impact on the economy that has. I would like to know Lewis’ argument to the idea this would cause a liquidity crunch in the banking system. So that is the reason I wanted to read the book first. I note that none of the comments here raised any interesting issues – such as the one I just raised – which was disappointing in terms of the quality of debate. I will eventually finish the PDF and upload a more detailed article on the gold standard. I’m taking copious notes as I go.