The Two Markets

gold flows and the automatic mechanism

In the days of the gold standard, all the economies of the Western world functioned along the lines of the import/export model shown above. They were interconnected as one, via the mechanism of gold-based money and fractional reserve banking. Since each country’s currency was tied to gold, these countries were locked into what essentially was a single currency. The age of the gold standard was therefore also the great age of internationalism and far-reaching globalism.

The specific mechanism by which prices and wages were made to adjust was by gold flows, in what was called the “automatic mechanism.” In the system of gold-based currency, banks play a key role. Gold serves as a reserve upon which banks erect a monetary circulation via credit: “gold substitutes” or “money substitutes.” These money substitutes are created through the mechanism of credit, by lending. Lending is restricted to a multiple of the bank’s gold holdings; during the 19th century, a reserve ratio of 1/3 was common.

Among other things, this means that gold holdings determine the size the money supply might attain. Now take the situation of the import and export economies depicted above, and imagine that they are two countries, not two regions, thus, two national economies with their own currencies. The imbalance between the two, in the time of the gold standard, would be redressed by gold flowing toward the country with greater production and thus a larger money supply. But that gold would be drawn away from the underperforming economy. And that would restrict the money supply there, reduce credit and loans, and induce a decline in wages and prices. Thus, by way of this automatic mechanism, the same adjustment is at work as within a national economy, between two regional economies, at least as far as wages and prices are concerned. But during the era of the gold standard, there were also few restrictions on immigration, so that migration also functioned as a rebalancing mechanism. But the major adjustment mechanism was gold flows.

The situation is sketched in figure 6.

Figure 6: Gold Standard: Imbalance covered by gold payments
Figure 6: Gold Standard: Imbalance covered by gold payments

The flow of gold would cause wages and prices to go up in the exporting country and down in the importing country. This would trigger the same kind of adjustments in prices, wages, investment, and labor that were outlined above with regard to interregional trade.

Now then, during this period there likewise came about major changes in social and political conditions, strongly influenced precisely by the operation of this “automatic mechanism.” There being no social welfare mechanisms to cushion the blows, these adjustments went hard on the working class (and the producing class as well). And in times of deflation, the creditor class made money off of this, as their gold holdings only became more and more valuable.

The upshot was the “social question,” the clamor for expansion of the suffrage, the rise of the labor movement, and thus political pressure to alleviate the workings of this rebalancing mechanism. One of the instruments devised to this end was, beginning with Bismarck, social security programs. Another was the rise of central bank technique to manipulate gold flows so as to short-circuit the gold-based feedback mechanism. This brings us back to the “two markets”: for the field of activity required to carry out that technique was the financial market.

The central bank needed the financial market to gain control of – indeed, subvert – the, in that case, no longer automatic mechanism. The newfound goal was “stabilization” – stable prices and wages. Such a goal could not but work against the constitution of the system, gold-flow-induced expansions and contractions of the money supply, with resultant rises and falls in prices and wages. This contradiction led to the massive dysfunctionalities of two world wars and the Great Depression.