Why the Value of Contemporary Money is Not Dependent on the Value of Gold


I note that there is oftentimes confusion today when the gold standard era is brought up. The reason for the confusion when discussing this era is because the monetary system functioned in an entirely different way. The confusion goes two ways; both from the past to the present and from the present to the past. Austrian-style economists and gold bugs tend to project the manner in which the 18th and 19th century monetary system functioned onto today’s world. While more modern theorists tend to project the way that the monetary system of today’s world works back onto the system of the 18th and 19th century.

I’m not going to lay out how the contemporary monetary system functions here. Sorry, Austrians, but you’re going to have to do your own work in this regard (try the Bank of England here). So, I will assume that readers are familiar with what might broadly be termed the theory of endogenous money creation and/or interest-rate targeting through Open Market Operations (OMOs) in a flexible exchange-rate system (or even, to some extent, in a pegged system). I will draw on a rather nice account that is laid out in Roy Harrod’s book Money. (Note that some of the discussion in this book is otherwise rather confused).

Under the gold (and silver) standard systems, as everyone knows, money was convertible into precious metal. The central authority set the official rate of conversion and the market adjusted to this. When the gold price, for example, fell in relation to money, gold would flood the public mint to be converted into money. The opposite happened when the gold price went above the value of money; i.e. money would return to the mint to be converted into gold.

In a gold standard system the effects of new money issuance will be primarily on the value of the currency vis-a-vis the value of other currencies. In a floating system, however, the issuance of new money has its effects, in the main, on the rate of interest. All other effects that it has are purely secondary.

This is not actually a question of theory. Rather it is a question of definition. In a gold standard system — that is, one in which all countries are in some ways linked to gold — all value is defined in terms of gold. Thus if your currency is unstable with reference to gold then it is unstable period. Gold is the central point of reference. But this is only due to a definition — or, more properly, an edict put in place by an agreement between members of a monetary system.

In this regard, an example from the so-called Bullion debates in instructive. These arose in response to the move by England, in 1797, to a temporary fiat system of money issuance in response to growing military spending. When the move to the fiat system was undertaken the value of the pound fell in relation to gold. The Bullionists, like Ricardo, claimed that this was due to too much money issuance. They said that because the Bank had increased the money supply this had led to a fall in the value of the currency. This is today known as the ‘quantity theory of money’. The Bank, however, protested. They said that the value of money had not fallen at all. They said that, rather, the price of gold had risen.

Let us stop here. The Bank were actually incorrect even on their own terms. I will not get into why this was here. Rather I want to sidestep this issue and discuss the fact that this entire debate was primarily about definitions. In this regard, Harrod wrote,

The contention [by the Bank] is clearly open to a terminological rebuttal. We might say that, in relation to a gold standard, we define a depreciation of notes as a fall in their value in terms of gold, so that a high price of gold bullion was conclusive evidence of a depreciation; this could be reinforced by reference to the fall of sterling in terms of other currencies in the foreign exchange markets, and by the fact that the price of gold had not risen in terms of other currencies still convertible. (pp28-29)

This is what is really at issue here. It is the very fact that we are talking in the frame of reference to the gold standard that the Bank is wrong in saying that the pound had not depreciated but rather that gold had appreciated. What gives us the right to talk in this specific frame of reference? Simply that most other countries were on a gold standard and that this is what facilitated trade. In such a system of reference, even if the pound ‘floated’, we can still gauge the value of the pound with reference to the value of gold.

Thus in this frame of reference the quantity theory of money is (if we broadly ignore the velocity of circulation and the question of inflation) in some sense true. Or, at the very least, it will be true in relation to question of foreign exchange. Why? Because if a country issues too much money then there will be insufficient gold reserves to back this money up. The country will then be forced off the gold standard and the currency will be worth less than the market value of gold. In turn, the money will be worth less than all the other international currencies as these will still be fixed to the value of gold. (Note that once the gold standard is abandoned this relationship is in no way mechanical or ‘linear’ and in that sense the quantity theory becomes misleading once more).

The problem today is that some — I think of the Austrians, but also some quantity theorists — are still thinking with this frame of reference in mind. In extreme form some claim that when the gold price rises this proves a fall in the value of money. But they are committing the same fallacy as the Bank of England in the Bullionist debates. Namely, they are discussing the value of the currency outside of the dominant framework of reference. Because the value of international currencies is no longer defined in terms of the value of gold — i.e. because by general agreement countries do not use gold as a reference point — when money devalues in relation to gold this only has bearing for those who hold gold. It has no general macroeconomic bearing on the actual value of the currency.

This is rather amusing because it is in their very insistence on disagreeing with modern conventions for moral or metaphysical reasons (i.e. they think that the current fiat system is ‘Bad’ by the criteria of their own metaphysical ruminations) that they end up making simple factual errors. Because money is a creature of convention and common agreement then it follows that if you disagree with the actual, objective system of reference in existence at any moment in time — that is, if you disagree with this because you ‘don’t like’ contemporary convention —  then you are simply factually wrong.

It’s a bit like inventing your own numerical system because you ‘don’t like’ the existing one and then debating with someone who adheres to the decimal system. You are wrong by default simply due to the fact that the decimal system is the one that the vast majority of people use today. Thus in adhering to some sort of moral or metaphysical view of money rather than a pragmatic one, such thinkers and theorists are simply engaged in a sort of self-enforced social isolation. And as society continues to ignore their fringe moral and metaphysical views they find that their theories do not fit a world in which dominant conventions rule the day.


About pilkingtonphil

Philip Pilkington is a London-based economist and member of the Political Economy Research Group (PERG) at Kingston University. You can follow him on Twitter at @pilkingtonphil.
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7 Responses to Why the Value of Contemporary Money is Not Dependent on the Value of Gold

  1. Dan Sullivan says:

    Debunking the gold standard was central to Irving Fisher’s Chicago Plan.

    And some pertinent quotes from the actual proposal:

    [page 5]
    The Gold Standard
    (1) During the last ten years the world has largely given up the gold standard. Gold is still, and may always remain, an important part of the machinery of foreign trade and exchange. But it is no longer, and probably never again will be, the sole reliance for determining the “internal value” of monetary units. Even those who advocate some degree of return toward the former gold standard are, as a rule, now convinced that it must be “managed” and never again left to work automatically”.

    [page 6]
    A grandiose ideology has been built up on this so-called “stability” of gold-standard currencies. The public has been confused and frightened by the cry, “the dollar is falling” or “the French franc is falling”, which simply means falling with reference to gold; whereas it may well have been that the real trouble was that the value of gold was rising with reference to commodities. Indeed such was often the case. Yet the uninformed public never realized that the so-called “stability” of the golden money had little to do with any stability of buying power over goods and services. In fact, the buying power of so-called “stable” gold currencies fluctuated quite violently, because the value of gold itself was changing. Perhaps the most vicious feature of the gold standard was that, so long as exchange rates – the price of gold in terms of gold – remained unchanged, the public had a false sense of security. In order to maintain this misleading “stability” of gold and exchange rates, the “gold bloc” nations periodically made terrific sacrifices which nor only destroyed their prosperity, and indeed brought them to the brink of bankruptcy, but ultimately destroyed the gold standard itself.

    [page 7]
    The depression experience of all countries under the gold standard has shown that it is scarcely worthy of being called a “standard” at all. It has shown that the so-called “stability” of gold and of foreign exchange destroyed the stability of the buying power of money and thereby the stability of economic conditions generally. In fact, the effort to retain gold as a “standard” has had such disastrous results all over the world that, for the time being, international trade has been deprived of some of the useful services which gold might still render it.

    [page 8]
    At present healthy domestic economic conditions are generally given precedence over the maintenance of a fixed money value of gold. This is a great step forward. The countries which have consistently followed this new line have more nearly solved their depression problems than have those that have sought to compromise by permitting considerations other than domestic welfare to determine their monetary policies. And for the United States stability in the domestic purchasing power of the dollar is certainly of far more importance than stability in its exchange value in terms of foreign monetary units.


  2. Be A Debaser says:

    This is a great post.
    I wish it existed two years ago when every single “wealth manager” I met tried (metaphorically) to ram bullion down my throat.

  3. Bruce Wilder says:

    Your use of the example of the Bank of England suspending specie payments during the Napoleonic Wars reminded me a bit of the legendary headline from a London newspaper:

    “Storm in Channel – Continent Cut Off”

    At the time — 1797 — the immediate issue was the interaction of the system of circulating coins (specie), made with precious metals, with the system of “public credit” and bank notes, which had evolved to support most merchant transactions.

    Promising to pay in specie upon demand creates the potential for a de-stabilizing run on the bank, limiting the ability of the Bank to provide liquidity in the form of currency, and by extension, the ability of banks and merchants together to provide a system of mercantile credit. Moving to a pure fiat currency solved that problem, saving the system of “public credit” from collapse.

    The quantity theory is wrong, because it misses that money as credit functions as a kind of bridging insurance, facilitating a pace of transactions, which no quantity of coin could manage, because coin does not have this insurance feature, which a system of banking and credit does.

    In 1797, I would say that the Bank was essentially right, because convention had declared “public credit” the dominant form of money, and gold specie, a mere accessory.

    • Dan Sullivan says:

      While there is a tenuous argument for a small amount of bank-created credit, it is clear that bank-issued money has been a device for transferring wealth from producers (labor and genuine capital) to banking interests.

      Moreover, that argument assumes, not only that government is incapable of issuing currency properly, but that people are incapable of adjusting their spending and saving habits. It assumes that people will keep spending at their normal pace when prices rise, even if they know that government will adjust the money supply to bring prices back in line.

      Essentially, the argument against government creating all money takes a molehill of a problem and makes a mountain of it, while ignoring the fundamental injustice of letting private parties create our money and lend it to us.

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