President George W. Bush famously remarked in July 2008 that during the housing boom "Wall Street got drunk ... and now it has a hangover." It was the Federal Reserve that spiked the punchbowl. The Fed sowed the seeds for the bust of 2007-08 by overexpanding credit, keeping interest rates too low for too long. The Fed made these mistakes despite our having been assured that it had learned from past errors and that the art of central banking had been all but perfected. A commodity standard with free banking, and no central bank to distort the financial system, would have avoided such a boom-and-bust credit cycle.
To very briefly recap the cycle, the Fed in 2001-06 kept interest rates too low by injecting too much credit (White 2008, Taylor 2009). A disproportionate share of that credit flowed into housing, channeled there by federal subsidies and mandates for widening home ownership by relaxing mortgage creditworthiness standards. The dollar volume of real estate lending grew by 10-15 percent per year for several years--an unsustainable path. Rising real estate prices bred the illusion that creative mortgages to noncreditworthy borrowers were safer than previously thought. When prices leveled off, the truth was revealed. The reestablishment of sustainable housing prices has revealed scads of nonviable mortgages.
The boom-bust scenario could not have happened under a commodity standard with free banking. Under that regime any incipient housing boom would have been automatically and promptly dampened, before a severe bust became inevitable.
I specify "a commodity standard with free banking" because a commodity standard--or even a gold standard--does not fully describe the monetary regime. There are at least three varieties of gold-standard regimes: (1) a gold standard with a discretionary central bank; (2) a gold standard with a well-behaved central bank that "plays by the rules of the game"; and (3) a gold standard with free banking and a self-organized clearinghouse system.
A Discretionary Regime
A poorly constrained central bank on a gold standard--one that can act with discretion rather having to automatically follow the rules--could have replicated the Fed's recent policy mistakes. During the 1920s, the United States was officially on a gold standard, but the Federal Reserve held interest rates too low for too long and created too much credit. It did so partly in a vain attempt to help Britain rejoin the gold standard at its pre-WWI sterling-to-gold parity, despite a war-inflated sterling price level that remained well above its sustainable prewar level, by keeping New York's interest rates below London's. Another contributor was the Fed's adherence to the "commercial credit" or "real bills doctrine" that urged the Fed to satisfy the growing demand for credit at an unchanging interest rate. The Fed also was influenced by the view that credit creation could not be excessive if consumer price inflation was close to zero, even though an automatic gold standard in an economy of rising productivity would have had its consumer price level slightly declining. The U.S. economy boomed until June 1929, especially its interest-sensitive heavy industries (Phillips, McManus, and Nelson 1937), and asset prices rose until October 1929. The boom collapsed when the Fed used its discretion to reverse its easy money policies. The supposed gold-standard constraint on the Fed was too loose.
A poorly constrained central bank, with or without gold trappings, can cheapen credit when it thinks it expedient, or when it concedes to political pressure, to try to stimulate the economy. We are in such a period now. Expansion of the central bank balance sheet by open market asset purchases (or by purchases directly from banks or the Treasury, or by lending to banks) makes commercial bank reserves rise. If those reserves are lent out, the broad money stock will rise, pushing up nominal spending and the domestic price level. …