In the Gold Standard, How Are Interest Rates Set?

The answer is profoundly important as we debate what sort of role gold ought to play and evaluate the various gold standards being proposed.

If people are free to own gold coins directly, then the mechanics of setting the rate of interest are simple. Let’s define a term. The marginal saver is the saver who could go either way, either holding a bond or a gold coin. If the rate of interest ticks downward, he will sell the bond, or withdraw his money from the bank, thus forcing the bank to sell the bond. He would rather hold the gold than commit to the time and risk for such a low interest rate. If the rate of interest ticks upward, he will buy the bond, or deposit his coin in the bank.

The marginal saver sets the floor under the rate of interest. It cannot fall below his preference or else he will vote with his gold. His preference has real teeth (unlike today where savers are totally disenfranchised).

Let’s define one more term. The marginal entrepreneur is the entrepreneur with the lowest rate of profit. If his profit falls for any reason, such as due to a rise in costs, he will shut down his enterprise. One cost is the cost of capital, i.e. the rate of interest. No entrepreneur can borrow at a rate higher than his rate of profit, and the marginal entrepreneur is the first to buy the bond and sell his capital stock at an uptick in the rate of interest.

The marginal entrepreneur sets the ceiling over the rate of interest. It cannot rise above his ability to pay, or else he will vote by selling his capital stock and buying a bond issued by a more productive enterprise. He also has teeth.

Under the gold standard, the rate of interest is kept in a narrow and stable band. This is the principle virtue of the gold standard. It does not fix the level of prices, which would be neither possible nor desirable. It keeps the rate of interest consistent, which serves the interests of wage earners, pensioners, and other savers, and of entrepreneurs whose work provides the goods, services, jobs, and interest payments on which everyone else depends.

When evaluating any proposed gold standard, one should ask the question: how will it determine the rate of interest?