What is money?
Before we can understand money, we need to be able to answer the question. Perhaps a short history of Sterling, arguably the longest surviving currency, will help to clear our minds.
Sterling the first 1000 years – primarily a silver standard
While the name sterling is possibly derived from the name of an early Celtic coin called sterlings, the real history of Sterling, as a money unit, begins during the reign of King Offa (r757 – 796) with his creation of the “silver penny”.
The coin weighing approx 1.4 grams and, nominally at least, made of fine silver (99% pure). This creation was probably simply a means for making trade with the Charlemagne Empire, in continental Europe, and the Arab World easier as they were also using a silver coin of similar weight. The coin’s value closely approximated the value of the silver content.
The counting system with 240 units representing a Libra (Pound), owes it’s origin to Roman times, however no pound coin was minted until the 1400’s. To give some perspective for the delay in minting a pound … from David Sinclair’s “The Pound: A Biography”, we can interpolate that the purchasing power of a penny in 980 was the equivalent of around £75 of today’s money or that £1 then would buy the same as £18000 today!
As is fairly typical of monetary systems, it became debased from the original standards set during King Offa’s reign.
After the Norman conquest, King Henry 1 reinstituted the original standards after calling together 150 moneyers (the artisans who actually struck the coins at the Mints) to give account of themselves … 70 had their right hand chopped off and a testicle removed! It is alleged that the coins had become so debased, many had as little as 30% silver.
Debasement of the coins again became an issue, with some claiming that over time the silver was wearing away. In 1294 King Edward 1 reset the standard so that the coins were only 92.5% fine silver allegedly to allow for a much more durable coin, but in probability to give the crown a profit. To give confidence in the new coins he instituted what amounted to the world’s first quality control system, with the annual “Trial of the Pyx”.
This involves a trial in the legal sense, before a jury drawn from the goldsmiths, where samples of all the artisans work were stored in a box before being examined by the jury of experts. Quaint as it might seem it continues to this day! Each artisan was required to place his symbol on the reverse side of the coin. This 92.5% standard became known as the Sterling Silver standard and as said earlier probably deriving the name from an early Saxon coins called sterlings.
Debasement remained an issue, and to improve control over the quality of the coins the London Mint became the sole mint in the country during the 1500’s and was renamed The Royal Mint. Prior to this there were some 70 mints scattered around the country, each with their own artisans.
We become aware of the first signs of paper currency in Britain during the 1600’s, when in Samuel Pepys‘ diaries he records collecting his “notes” from a Goldsmith. These notes were in the form of receipts stating that gold was being held on behalf of the holder of the note.
In the early 1700’s Sir Isaac Newton in his role as Master of the Royal Mint formalised the ratio of Gold to Silver (the difference in the amount of effort required to produce a unit) in coinage of the day, effectively moving Britain onto a gold and silver standard, establishing a price for gold that was to endure for the next 200 years! This was most likely mainly to counter the rise of the Spanish gold coinage. I also find it interesting that this ratio endured for over 200 years.
The 1700’s also saw several Banks starting to produce their own notes. These notes as with the earlier Goldsmith notes were fully convertible into coinage and were not Legal tender in their own right simply a more convenient way of keeping your money safe.
During the 1790’s faced with a growing shortage of silver (as a result of increasing imports from China without corresponding exports, similar, in many ways, to the situation that exists today), and a need to finance the Napoleonic Wars the treasury took to issuing its notes, through the Bank of England (established during King William 111 reign, as a means for the crown to borrow from the wealthy). Convertibility into coin was suspended in 1797.
This silver currency had remained the UK monetary standard until 1797. It’s reputation for quality and purity had been forged through the actions of King Henry 1 and King Edward 1 and British coinage was highly regarded throughout the world. Over it’s 1000 years in existence there was hardly any inflation, barring the results of Mints debasing the coinage. If we average the inflation over the 1000 years it amounted to a small fraction of a percent.
Mining of silver in Britain had become the sole right of the Crown during the 1200’s, while the main source of gold, until the 1800’s, was by way of piracy carried out against the Spanish (who had established a gold coinage system in the 1500’s).
Up to this point we can say that money is the actual silver and gold in our coinage system, that paper notes were simply certificates for gold and silver being held on our behalf. In themselves neither gold nor silver had any intrinsic value outside of use as an adornment and because of their relative scarcity.
We can see Sterling developed it’s reputation over a millenium, enhanced by the rather brutal punishment dished out by King Henry 1 for debasement by the moneyers, and the quality control over coins being opened to scrutiny by the Trial of the Pyx of King Edward 1.
Move to a gold standard – 1817 – 1914
Against an historical background of near zero inflation, the switch to unconvertible paper money in 1797 resulted in rapid increase in prices … prices increased by some 60% over the next 20 years.To break this inflation Lord Liverpool on the advise of Ricardo introduced a gold standard with the paper money becoming convertible into gold coinage from 1817.
The coinage struck after 1817 differed from previous coinage in that the face value of the coin was greater than the value of metal used in minting the coin. In this regard the coin started it’s journey toward becoming currency rather than money.
The golden era of the British economy had begun. The expanding Empire, provided a ready market for the increasing output of the growing British economy, fueled by the Industrial Revolution and major infrastructure projects.
The Bank of England Act of 1833 conferred sole legal tender status on the notes of The Bank of England, which was allowed to create notes subject to holding a corresponding value of gold. Banks already producing their own notes were allowed to continue subject to them holding gold and/or Bank of England notes to a corresponding value, no new Banks were allowed to print their own notes.
Improved manufacturing process resulted in a slightly deflationary environment with retail prices declining by around 30% over the 100 odd years to the outbreak of World War 1, when convertibility was once again suspended.
What is money?
At this stage, we can still say that we have an asset based money system, as the Bank of England was required to have gold holdings equal in value to the notes it printed, while other Banks printing money also had to hold either gold or BoE currency to like value.
Although the currency (notes and coins) are virtually equal to the reserves (Gold being held by the Bank of England), we should start drawing a distinction between the two. Currency is made up of the notes and coins, while money is the asset base or should we perhaps say reserves.
Trading within the local economy is done with currency (legal tender), while in the international markets with gold or shall we say money. In theory there could never have been more currency than reserves (money), The Bank of England Act of 1833 required the Bank of England to hold gold for any notes it produced, it was not required to print notes for all the gold it held.
1918 – 1945 only a quasi gold standard for a short while!
Perhaps the most difficult period in the worlds economic history
The rise of Trade Unions in Britain coupled with the loss of life during the first world war saw the first significant increase in wages in over a hundred years. Britain also started finding that it faced competition in it’s Empire as new sources of supply had begun developing, particularly during the war.
In 1925 Churchill, in the face of inflation caused by rising wages and general shortages and a mountain of debt incurred during the war, took Britain back onto a quasi gold standard. Against advise from Keynes he chose to value the pound at the same relationship to gold as at the commencement of the first world war (a value that had been set by Sir Issac Newton in 1717). The pound would not be convertible for the population, only for foreign trade.
While the relatively high valuation being placed on Sterling for international trade would appear to relieve some of the inflation … it was not sustainable.
The cost implications of wage increases made it increasingly difficult for British business to compete in world markets. The strain on the treasury gold reserves began to tell culminating in a run on sterling in 1931, and Britain finally left the Gold Standard resulting in a 24% devaluation against the dollar.
Although we can see all the reasons for this run on sterling and the mistake made by Churchill in effectively pretending that Sterling was still worth it’s weight in gold, the run is motivated because it can be seen that Britain is no longer competitive in the export markets, and that their reserves of gold must be dwindling.
Against a background of the Great Depression, the publication of Keynes’ General Theory (1935) was to have a major impact on our conception of money into the future. He decried the need to wait on the next shipment of gold from ‘the colonies’ before the amount of money could be increased. He makes a case for increasing the supply of money, to drive the economy toward full employment, through a deficit financed public works program.
What is money?
Even though conversion of the paper notes into gold, for citizens, had now been suspended our currency is still 100% backed by gold. We have, not yet, built a “Green Cheese” factory and persuaded the people that Green Cheese is as good as money to use Keynes’ words.
History has shown us that debasing our coinage (currency) resulted in inflation and in the same way during the Napoleonic Wars and the first World War when we adopted paper money without a corresponding increase in stocks of the asset backing the paper we had inflation!
Why should this be?
Gold has no intrinsic value … what makes it a basis for a stable monetary system?
1945 -1971 … Bretton Woods System
While the Bretton Woods Conference in 1944, between delegates from all the allied nations, was about establishing a framework for International trade, it had a major bearing on our internal money systems.
The major effect of the Bretton Woods agreement was that instead of countries pegging their currencies to gold they would be pegged to the Dollar, which in turn would be pegged to gold at $35 to a troy ounce. The Dollar would be fully convertible and backed by gold holdings of at least 25%.
At a slight stretch of imagination we can still say that gold underpins the currency.
However partially freed from the need to have gold (trade surplus) before creating new money and influenced by Keynes’ General Theory, which suggested printing money as a route to full employment, governments began printing money.
In Britain this led to the 1967 devaluation by the Wilson Government and an IMF bailout.
In 1971 under Nixon the USA suspended convertibility of the Dollar into Gold.
From now on we can no longer even imagine that gold underpins our money. However, as gold has no intrinsic value, can it make any difference?
1971 -2014 Free floating currencies.
The changes implied by the suspension of the Dollar convertibility into gold by Nixon, implied a major change in the world monetary system. To understand what the change meant let us consider gold and gold holdings.
If we consider how gold holdings arise.
Fundamentally the gold holdings are the result of surpluses in the balance of trade and investment income flows. If we go back to the pre 1914 system where imports and exports were settled in gold, this is obvious. The mechanics of settlement are carried out on behalf of the State by the Central Bank (Bank of England). When we export goods the person on the other side through the banking system will ‘buy’ Sterling in order to pay. The effect of this was to deliver Gold bullion to the treasury. The exporter would receive notes from the Bank of England. In terms of the 1833 Bank of England Act notes could only be issued against gold holdings.
In the period starting with the First World War, BoE was released from the need to hold gold before printing notes. Mainly to cope with the fall in exports during the war. Our banking system moved from a 100% reserve backed system to a partial reserve. With Bretton Woods gold was no longer the form of settlement for International trade, being replaced by the Dollar (theoretically at least) the dollars were purely a certificate of gold holdings, until the suspension of convertibility by Nixon.
During the 1930’s partially as a response to the Great Depression our banks were allowed to ‘create money’ without having a 100% reserve of either gold or government bonds. Initially we required them to hold 25% reserves against deposits on their books, after 1945 we reduced this to 20% following the USA. During the Wilson Government this was reduced to 15%, while the Thatcher Government in preparation for Big Bang reduced this to 5%. Under John Major this was allowed to slide to 3%. Moving the banking system closer to Basle1, a standard that set the minimum solvency levels for banks to be part of a wider International Banking framework.
Gordon Brown effectively did away them requiring any, by removing the regulation from BoE and granting a government guarantee on deposits up to £50000, finally completing the conversion to Keynes’ “Green Cheese”. To quote Keynes “We will just have to persuade them that Green Cheese is as good as money, and build a Green Cheese factory”.
Classical theory as espoused by Hume, Say, Ricardo and others suggest that increasing the quantity of money within the economy would impact mainly on prices, while Keynes in his General Theory considered this to be secondary with the main impact being on investment and output.
Contrary to Keynes’ predictions the biggest impact has been on prices.
If we consider the following table:
|1717 to 1914
|Gold Standard set by Sir Isaac Newton
|Total Retail Price increase
|1914 to 1945
|Gold convertibility suspended
|Total Retail Price increase
|1945 to 1971
|Dollar Standard … 25% gold backed
|Total Retail Price increase
|1971 to 2014
|Total Retail Price increase
In the first period of nearly 200 years we see that retail prices rose by only 65%, the bulk of this rise occured during the Napoleonic War (1797 -1815) while production of coins was suspended and we used paper money.
The next 30 years during which convertibility was largely suspended, retail prices rose by 220%, we can however ascribe the bulk of this rise to the two world wars which were deficit financed.
The post world war two inflation averaging around 4.7%, while cause for some concern was nothing like followed the final removal of gold from the backing to currency.
The average inflation rate has increased to around 6%, in spite of it having hovered around 3% for the last 15 or so years! The last 15 years have seen inflation appearing in asset prices rather than consumer goods which is what we report.
From this table we can see that the outcome of increased printing of money has been closer to the perception of the classical economists than Keynes, although there is also no doubt that employment levels have also been far higher.
It is perhaps easiest to understand money by looking at the diagram “Classical Central Bank Model”. Although our current model is a little different in that the division between the Central Bank and the Banking sector is no longer quite so clear.