Alan Greenspan 1.4 – Contradictory

In “Gold and Economic Freedom”,  Alan Greenspanⁱ wishes to show that “… under the gold standard , a free banking system stands as the protector of an economy’s stability and balanced growth”. However, Alan Greenspan’s examples of unregulated banking based on gold are contradictory.

Greenspan starts with banks generating money to make loans: “A free banking system based on gold is able to extend credit and thus create bank notes (currency) and deposits, according to the production requirements of the economy”.

When the economy is slow, “… when the business ventures financed by bank credit are less profitable and slow to pay off”; the banks: “curtail new lending,…usually by charging higher interest rates.”

When the economy is good, “when banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly”. The loans have lower interest, “and bank credit continues to be generally available.”

His next paragraph creates contradiction. It presents the situation where different countries have the gold standard in common, and “there are no restraints… on the movement of capital”.

If a country has a liberal credit market, “interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries” and “immediately cause a shortage of bank reserves in the easy credit country… tighter credit standards and a return to competitively higher interest rates.”

As a result, “the economies of the different countries act as one… Credit, interest rates, and prices tend to follow similar patterns in all countries”.

Greenspan’s contradictions are:

1. Banks cannot act according to the production requirements of their economy, as in his first example ; but must act according to the interest rates of the banks in his second example, in other gold standard economies.
2. The banks in his first example could never have started or participated in their expansion with low interest, because the gold deposits would have fled to the countries in the second example.
3. If the interest in all the countries started at parity; when the banks of the first example started charging higher interest, the gold would leave other countries and cause those economies to contract. To prevent loss of their gold deposits, the banks of the other countries would also raise their interest rates – causing their economies to contract. Either way, all the countries must contract their economies whenever one country raises interest rates.
4. Wherever business starts to get better, banks cannot return to the previous low interest rates or they will lose their deposits to other banks. Economic growth will stop as soon as it starts.

 Greenspan fails to show how expansion or growth can begin. His first example of the creation of money starts with the economy already in full swing. When Greenspan’s gold standard economy contracts, the banks have no means to counter that. Instead, the banks wait for businesses to solve the problem, “and require… existing borrowers to improve profitability” without funds. They also “.. restrict the financing of new ventures…”. Both Greenspan’s examples of the individual bank and the multinational situation end with high interest rates and economic contraction.

In Greenspan’s ideal system, there is incentive to set high interest rates. Once high interest rates are in place, there is no way to lower them. Once in a contraction, Greenspan’s gold standard banks do not have the tools to begin expansion. They only have tools to slow the economy down. The contraction must continue. The ratchet only works in one direction.

Here is Greenspan’s statements in full:

“When banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly and bank credit continues to be generally available. But when the business ventures financed by bank credit are less profitable and slow to pay off, bankers soon find that their loans outstanding are excessive relative to their gold reserves, and they begin to curtail new lending, usually by charging higher interest rates. This tends to restrict the financing of new ventures and requires the existing borrowers to improve their profitability before they can obtain credit for further expansion. Thus under the gold standard , a free banking system stands as the protector of an economy’s stability and balanced growth.

When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. Even though the units of exchange (the dollar, the pound, the franc, etc.) differ from country to country, when all are defined in terms of gold the economies of the different countries act as one-sol long as there are no restraints on trade or on the movement of capital. Credit interest rates, and prices tend to follow similar patterns in all countries. For example, if banks in one country extend credit too liberally, interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries. This will immediately cause a shortage of bank reserves in the “easy money” country, inducing tighter credit standards and a return to competitively higher interest rates again.”