Am I Being Unfair to the Gold Standard? « Uneasy Money: A free-banking system based on a gold standard is thus likely to be subject to a shift in demand from holding bank money to holding gold, when it is least able to accommodate such a shift, making a free-banking system based on a gold standard potentially vulnerable to a the sort of vicious deflationary cycle that characterized the Great Depression. The only way out of such a cycle would be to suspend convertibility. Such suspensions might or might not be tolerated, but it is not at all clear whether or how a mechanism to trigger such a suspension could be created. Insofar as such suspensions were expected, the mere anticipation of a liquidity problem might be sufficient to trigger a shift in demand away from holding bank money toward holding gold, thereby forcing a suspension of convertibility. Chronic suspensions of convertibility would tend to undermine convertibility.
In short, there is a really serious problem inherent in any banking system in which the standard is itself a medium of exchange. The very fact that gold is money means that, in any fractional reserve system based on gold, there is an inherent tendency for the system to implode when there is a loss of confidence in bank money that causes a shift in demand from bank money to gold. In principle, what would be most desirable is a system in which the monetary standard is not itself money. Alternatively, the monetary standard could be an asset whose supply may be increased without limit to meet an increase in demand, an asset like, you guessed it, Federal Reserve notes and reserves. But that very defect is precisely what makes the Ron Pauls of this world think that the gold standard is such a wonderful idea. And that is a scary — as in terrifying — thought.