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Free Banking and Gold

The type of free banking espoused by Ron Paul and Larry White has bank money convertible into gold.  In other words, gold is the base money.   Chris Colvin (a future colleague and reader of this blog) emailed me to ask whether a gold standard is essential for free banking.  Chris, like many other economic historians, has problems with the costs of the classical gold standard, particularly in the inter-war period.  The classical gold standard is often criticised for driving the business cycle and generating real income instability.  The economic decline suffered by economies after they came back unto gold after periods of conflict was particularly severe.

How would a free banker reply to this criticism?  Larry White argues that banking systems were "regulated in ways that almost surely contributed to monetary instability.  It would be necessary to disentangle these regulatory effects from any instability due to the gold standard itself" (Theory of Monetary Institutions, pp.49-50).
Other advocates of free banking, such as Hayek and Benjamin Klein  have suggested that banks in free banking systems could issue fiat-type money i.e., money which has no commodity backing it.  Others, such as Greenfield and Yeager (1983) suggest that a free banking system should have a multi-commodity standard (keeps price level more stable than gold) and a separation of the medium of exchange from the medium of redemption (i.e., bank money is denominated in the medium of account bundle, but redeemable for an indexed quantity of convenient and available commodities).

Larry White discusses these alternatives in his Theory of Monetary Institutions.  His main objection is that these alternatives are all untried entrepreneurial ideas, whereras a gold-standard free banking system has existed in the past.  As such, he is very much wed to the Mengerian view of the organic evolution of money.  

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