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Chapter 8. Promises
Do you understand money? Sure, you understand that people want to have money. You understand that more money is better than less money. But can you explain why? Oh, that’s easy, you might say: people want to have money because of the things that they can buy with it. True, but that doesn’t properly answer the question. Why are the people who sell those things happy to take your money in exchange? What is it that makes the money valuable? Take some money out of your purse and have a close look at it. What do you see? A bank note is a slightly odd but very detailed artwork printed on high quality paper. If it were a limited edition, it would certainly be worth a lot. The craftsmanship is extraordinary. But that’s not what makes it valuable: there are millions and millions of these notes. Almost everyone has a few; some people have lots.
So what’s going on? Most people can’t deliver a very convincing answer to this question. It’s even worse if you ask them to explain how banks work. There is a short answer to these questions, which I’ll give you now, though it will not mean very much until later in this chapter, when you understand the long answer. The short answer is that both money and banks are fundamentally a confidence trick. They rely on people having confidence in them for them to keep on working. Money is essentially a promise, usually from a government but sometimes from a corporation, a promise that in the future the money will be worth something real. A bank is a place to store promises and to keep them safe for the future, but more than that, it is a place where promises can be transformed and even invented out of nothing.
I expect you will agree with me that the short answer is not really very enlightening if you don’t already understand it. We need the long answer. We need some concrete examples. Let’s begin with a fairytale example, set in a rural landscape, maybe in the “dark ages” after the fall of the Roman Empire or maybe in some survivalist post-apocalyptic future. There are farms and villages, people have the basics of life, but there is no money. How does the “economy” work?
People can grow or make most stuff that they need for themselves. When they can’t make it for themselves, they can swap some of their stuff for whatever they need: they engage in barter. Even if they can make a particular thing for themselves, they might decide not to, they might barter instead. Suppose you need a basket. Rather than make it yourself, you know someone who is better at basket making than you, so you ask them to make one for you. You on the other hand have something they would like. Maybe you keep rabbits or chickens, so you can do a swap at what you both consider to be a fair rate, say one dozen eggs for a basket. Or it might work out that you get the basket today and what they get in return is a promise. Maybe you promise to help them repair the door of their barn, a two-person job that they can’t do on their own.
This promise, floating between the minds of two people, is like the spirit of money, almost condensing into reality, but not quite there. Since it has no material existence, it relies on individual memory and reputation. It’s difficult to pass a promise on to someone else. To see the difference that money makes, we need to introduce two technical inventions: the shop and token coinage.
Let’s suppose that some particularly well-endowed farm decides to open a farm shop, where people can come and get what they need “off the shelf.” Need a basket? Fine, we have just the thing here. How would you like to pay? Shall we say one dozen eggs? A shop like this has some advantages, provided it carries enough stock. You don’t have to search for other people to barter with, you can just go to the shop and find the thing you want. And there’s the added attraction that you can sit out of the rain and gossip with other shoppers.
It’s not entirely satisfactory though. Suppose you want something more substantial, some gizmo that’s worth half as much as a sheep. Maybe you even have to put in a special order and wait for the gizmo to be delivered next week by the craftsman from the other side of the woods. Why not go directly to the craftsman? Well, for one thing you’d have to walk to the other side of the woods, but the main reason is that the the craftsman has no interest in sheep. Sure, the gizmo is worth half a sheep, but the craftsman has enough sheep. He wants something else. You only have a sheep. So the shop provides both of you with a valuable service: you give the shop what you have and you get the gizmo, the shop gives the craftsman something else that he does want and in return gets the gizmo to pass on to you. This is great, but there’s a problem. The gizmo is only worth half a sheep. What does the shop give you for change? Chickens?
This is where the second technical invention comes in: token coinage. Let’s have the farm shop make some coins in its workshop. Maybe they have the stern face of the proprietor on one side, and on the reverse, the inscription “One Farm Dollar.” How much are they worth? The farm shop has a blackboard behind the counter, like the “specials” menu on a restaurant wall. It says something like this:
|1 doz. eggs||$1.00|
|… and so on …|
Now the answer to the question of what you get in change is quite simple. You get 25 Farm Dollars, which you can spend today in the shop, or you can keep them in your purse and come back another day. Or — and this is where it gets really exciting — you can use them to buy something outside the farm shop. Maybe you buy a basket from your neighbour, and in return you give them a Farm Dollar. Your neighbour is happy to accept this because they believe that they can go to the farm shop any time they like and redeem the Farm Dollar for something of real value. Something like a a dozen eggs. We have just invented money.
This token coinage is a promise made concrete, a promise that you can pass on to someone else. Ultimately, it’s a promise of real stuff from the farm shop. So long as people have confidence in the farm shop, the token coinage is worth something. Specifically, it is worth what the blackboard behind the counter of the farm shop says it is worth.
Well, almost — there are subtleties here, aren’t there? For a start, the farmer sells at those prices, but he probably has another list, with slightly lower prices, when he’s buying. (Financial geeks call these the offer price and the bid price respectively.) It’s one of the ways that the farmer can extract value for himself, effectively charging a slight commission on each sale.
Another subtlety is that the farmer needs to set his prices at a level where he maintains some stock — if he has no stock, the Farm Dollars have no value. He can’t just pick prices out of the air. He needs to find prices where customers are happy to buy from him and suppliers are happy to sell to him.
Suppose, for example that there is a general glut of eggs. I’ll sell as many eggs as I can to the farm shop at their bid price. When they don’t want any more, I’ll sell the rest to other people at whatever I can get. Maybe I’ll offer you two dozen eggs for a Farm Dollar. Since they won’t keep, it’s better than feeding them to the pigs. If this goes on, the farm shop will have to lower the price on the blackboard, or else no one will buy eggs from them.
Similarly, if there is a shortage of eggs, and the farm shop keeps the same price, they will run out of stock. In that case, I’m not going to sell eggs to the farm shop, because I expect that you will come to me and be prepared to pay more, maybe one dozen eggs for two Farm Dollars. When they see that they can charge more for eggs, the farm shop will naturally raise their price, to reflect whatever “fair price” has been established in the community.
In a way, the community is doing the farm shop a favour. People buy and sell outside the shop and that way they come up with a fair price. The owner of the farm shop doesn’t have to work out a fair price from first principles, they only have to observe what the community has decided. (This is what is meant by Adam Smith’s “invisible hand,” guiding people to choose the right price for things, without ever needing to have kindly feelings toward one another.) In this way, the prices on the blackboard for different goods vary independently, depending on their scarcity.
But there’s another subtlety, one that affects all prices together. Before long, human nature being what it is, the farm shop will start to suffer from a problem that afflicts all money sooner or later: counterfeiting. Someone else with a workshop will carefully examine the Farm Dollars, quietly obtain the raw material and mint some look-alike counterfeit coins. It’s well worth understanding exactly what the crime is in this case. The Farm Dollars are a token coinage, which means that they have very little intrinsic value. (Just like the coins and notes in your pocket right now.) The value comes almost entirely from the fact that they represent promises: the promise of something real from the farm shop. It would be best if they were unforgeable, but in practice anything that can be made by one person can be forged by another, it’s just a matter of effort.
So what’s the crime? The crime is theft, initially from the farm shop and ultimately from all its customers. The counterfeiter gets to buy things from the shop at the current fair price written on the blackboard. If he walks in with 100 counterfeit Farm Dollars, and walks out with two sheep, then he has stolen the sheep from the farm shop just as as much as if he had walked in with a gang of thieves and taken them by force. Counterfeiting, like most scams, is just a low-violence form of mugging. The counterfeiter doesn’t even have to go to the shop himself. He can buy things directly from you or me. Eventually we will go to the shop. The same theft happens, just indirectly, provided that the price on the blackboard doesn’t change in the mean time.
Maybe this theft doesn’t seem so bad — after all, it’s the rich proprietor of the farm shop who suffers. He’s got so much stuff to start with, what difference does it make? Maybe you think the counterfeiter is an anti-capitalist freedom fighter. But wait. The counterfeiter has walked off with various real stuff in exchange for his fake Farm Dollars, so there’s less real stuff for everyone else. With enough counterfeit Farm Dollars, there will start to be shortages, and when there is a shortage, as before, the prices of things will go up in the community and on the blackboard at the shop. At that point the theft isn’t from the farm shop any more, it’s from the rest of us. We’ve got inflation.
The benefit of counterfeiting went to the first person who spent the fake coins, while the prices were still at their old level. The cost of the counterfeiting is spread over the whole community as prices rise. The people who suffer the most are the ones who spend the money in their purses last, paying the highest prices.
If the proprietor of the farm shop is unscrupulous, he will notice a clever variation on the counterfeiter’s crime, a way to steal from the community and enrich himself. The proprietor can “counterfeit” his own coins. Of course, he doesn’t really need to counterfeit them, he can just get his workshop to turn out more and more real coins. They don’t cost much to make — they are just tokens. He gets the benefit of spending them first at the old low prices. Maybe he builds up the stock of the shop. Maybe he lives in a grander style. Maybe he uses the money to pay for a new barn, or he buys another plot of land. The proprietor has to be careful not to over-do it. I think customers might be justifiably angry if they realised what was going on, if they worked out that the proprietor was inventing promises out of nothing, promises that could never be delivered at the old prices on the blackboard. They might turn up one night with pitchforks and flaming torches to help explain their point of view to the proprietor.
But temptation is difficult to resist. Is there any case in history where someone had the power to invent money out of nothing and resisted that temptation for long? Really, it would be better if there was some way to make it more difficult to invent money out of nothing. A good way to achieve that is to make coins out of something that’s intrinsically valuable, for example gold or silver. With gold or silver coins, neither outside counterfeiters nor the proprietor can easily make new coins in arbitrary numbers. First they need to get the metal, and if it takes a week’s effort to mine the gold to make a coin, that’s a huge disincentive to the counterfeiter. They might decide that it’s better to spend that week preparing for some other crime, or even to engage in honest work.
In practice, the value of coins made from precious metal often exceeds the value of their gold or silver content — they remain in part a token coinage. The reason for this is quite easy to see if we take the example of the Roman Republic. The silver denarius was about 85% silver, but its purchasing power fluctuated around twice the value of its silver content. Why? There were only so many denarii, but there were lots of things to buy. In particular there were lots of slaves, captives from the Republic’s many wars of conquest. In the slave markets of Rome, the prices “on the blackboard” were in denarii. The promise of the denarius was that the wars of conquest would continue, that the slave markets would always be full, that there would always be people to buy with your denarii. note 93
So, gold and silver coins have the advantage that their precious metal content acts as a brake on both counterfeiting and on outrageous production by the official mint. There is still a problem: the coins will not be pure metal. Both gold and silver are too soft in a pure form to make a robust coin. They need to be alloyed with other metals. But in what proportions? There remains an opportunity for counterfeiters, melting genuine coins and making fakes with a lower purity.
If there’s an opportunity for counterfeiters, there is even more for the official mint that makes the coins. The Romans didn’t invent banking, so they couldn’t use the modern tricks that you will learn about shortly. They thought money was just coins. But in the third century A.D., the Roman Empire suffered from the most devastating and persistent inflation. The Republic was history, the wars of conquest were long over, and with them the well-stocked slave markets. The Empire was merely trying to hold back throngs of envious barbarians behind its borders. The army protecting those borders had to be paid, and the soldiers expected an extra bonus on the accession of each new emperor. By the third century, these emperors were hopeful military dictators who lasted on average about three years before the next coup swept some other general into power. Taxes were extortionate, enough to put farmers out of business and drive them off the land. But still the state could not gather enough money to pay the troops and the government administrators.
So they debased the currency. The denarius had been 85% silver for hundreds of years, but now the silver content was steadily reduced until eventually the coins were nearly 100% bronze, quickly dipped in molten silver to give them the right colour. Even that was not enough, and coins were over-struck in the imperial mint with a stamp indicating that they were now of a higher value, like banknotes in Zimbabwe with more and more zeroes on them. The silver coins had been transformed into an empty token coinage, promising nothing. Since people needed currency for buying and selling they had to use it, but they suffered from the tremendous inflation. Cities also produced their own token coinages, even though this was illegal, so that local economies could function, and of course these suffered from inflation too.
At one point the Roman state even repudiated its own issue of gold coins — state-issued gold coins were no longer accepted for payment of taxes. Only pure gold bullion would do. (The fundamental reason for this was that some barbarian tribes were employed as “muscle” to guard the Empire’s frontiers, and they refused to be fobbed off with coins of uncertain metal content. They insisted on being paid in bullion.)
So, you can have inflation with a gold coinage if the purity of coins is not maintained. But you can also have inflation even when purity is maintained. Europe discovered this when the Spanish and Portuguese spent the gold and silver that they stole from South American empires following their discovery of the “New World.” This gold and silver was imported in huge quantities. It was suddenly very much easier to obtain — its previous owners, devastated by disease, were forced to surrender it to the Spanish. After that initial gold and silver was taken, the remaining inhabitants were put to work as slave labourers, mining new metal from the ground. Newly minted coins flooded out across Europe, bringing material goods to the Spanish and Portuguese, but in the end, inflation to everyone. The merchants were perhaps more fortunate than their customers, since when all the gold and silver was spent the customers had little to show for it, but their suppliers had the businesses, farms and workshops they had built to meet the demand. This lesson has not been lost on the Chinese in recent years.
In contrast, when we look at the the nineteenth century, despite an increased supply of gold, there was no general inflation. Prices in gold were stable or even falling during the century, despite the discovery of new gold and silver deposits around the world and the application of industrial technology to extract these metals from the ground. Why was there no inflation during the nineteenth century? Not, as some people suggest, because of the inherent virtue of gold currency. The true answer is that although there was more gold in the nineteenth century, there was also much more stuff to buy with the gold. In the sixteenth century there were only slightly more material goods to buy with the new gold, so prices rose. However, in the nineteenth century, the supply of material goods expanded exponentially. Rapid industrialisation, first in Britain, then around the the world, brought a bonanza of useful things to spend the new money on. The two effects more-or-less balanced out.
In a sense this was a lucky coincidence — it certainly wasn’t planned by anyone. The quantity of gold tended to grow at a rate similar to other industrial production because if there was a shortage of gold, people would be able to make more profit by using their technology to mine gold, rather than coal, iron ore or something else. Investment would follow the best returns, a feedback loop keeping the growth of gold currency more or less in line with the increased production of other industrial products.
You now know quite enough about the basic properties of money. It’s time to introduce that distinctly mixed blessing, the bank. Let’s return to our fairy-tale world with the farm shop, but turn forward the hands of history by many decades. Life has been kind to people. The countryside is productive. Towns have developed, with workshops and guilds. Local quasi-states gather taxes and issue gold and silver coins from their mints. Counterfeiting happens, but it’s punished severely, for example by castration or death, so it’s not a serious problem.
Let’s suppose that you live a prosperous life in one of these towns, and you have a small stash of gold coins. You could keep them under your mattress, or in a strong box, but there’s always the danger of theft. It must be possible to do something better with them. You could put them in a bank, and in this world there are two kinds of bank: the “money scrivener” and the “goldsmith.” Let’s look at each of these in turn.
The money scrivener is a kind of financial match-maker. When you go to a money scrivener, he will take your cash and give you in return a bond, which is just a fancy name for an “IOU” with a “not before” date. This document promises that the money scrivener will return your original money plus a specified amount of interest on some particular day in the future. For example, you might invest 100 dollars, at 10% interest and the bond will promise you 110 dollars when you present it back to the money scrivener one year from today. You can’t get the money back in the mean time because the money scrivener is going to loan it out to some businessman.
The money scrivener makes a mirror-image deal with that businessman. Say the businessman is a cobbler who has taken on an apprentice. With the extra help, he can now make and sell more shoes, but first he needs to buy more leather, and he doesn’t have enough spare cash in his business. So he goes to the money scrivener, who gives him 100 dollars right now, and in return he signs an IOU, promising to pay back 120 dollars on that day in one year’s time. On the birthday of the bond, the money scrivener will then be able pay the 110 dollars he owes you, and he will have 10 dollars profit for himself.
Sometimes a deal will go sour and the businessman won’t be able to pay back all or even any of the debt. If the money scrivener thinks there’s a risk of this, he can ask for security when he makes his loan — he can make sure that the businessman forfeits something valuable if he can’t come up with all the money. But none of this is your concern. The money scrivener has personally promised to deliver your investment back to you with interest, regardless of what might go wrong. It’s his problem to sort out the details with the businessman.
Notice that you can’t get your money back before the maturity date on the bond: the money scrivener doesn’t have it, and doesn’t claim to have it. Some businessman has it, or more likely several businessmen have part of it. You might, if it is a bearer bond, be able to sell the bond to someone else before the maturity date, but there’s no guarantee of that, or what price they might pay. If you do sell it, whoever buys it will still have to wait until the maturity date to get their payout from the money scrivener.
A bond needn’t be for a year, it could be for any fixed period, but the interest on short-term loans will be small. (If it takes six months for a business to transform your money into real goods and sell those goods, few businessmen will be interested in short-term loans.) What if you don’t want to lock your money up for a fixed period with a money scrivener? Maybe you want to be able to get your money back the day you need it, on demand. If that’s the case, you need the other sort of banker, someone with a good strongroom and guards to keep it safe for you until that day. In our fairy-tale world, that someone is called a “goldsmith,” because they are a goldsmith. Their main business is making and repairing gold jewelry, but because they have a good strongroom and guards, they can make a business on the side looking after other people’s valuables.
Unlike the money scrivener, the goldsmith charges you to keep your gold in his strongroom. This is just like having a safe-deposit box in the modern world, or like a self-storage facility. When you make a deposit, the goldsmith gives you a ticket, which is essentially a warehouse receipt for your cash. Often, these tickets don’t have the depositor’s name on them, so anyone can redeem them for cash. This has the interesting consequence that goldsmith’s tickets can be used as money: rather than paying for something with gold coins, just give them some goldsmith’s tickets for the right amount. They can redeem the tickets later, or spend them in turn. (Modern British bank notes still have written on them the phrase “I promise to pay the bearer on demand the sum of … .” This is a remnant of their original function as goldsmith’s tickets.)
Another interesting aspect of the goldsmith’s business is that people presenting tickets don’t care whether they get their original coins back in return. (If it was originally someone else’s ticket, you certainly don’t care.) Provided the coins are authentic, with the correct gold or silver content, that’s all that matters. And in fact, who would be better placed to check the quality of the coins than a goldsmith? People might actually be happier to be paid with a goldsmith’s ticket than with coins, because the coins represented by the ticket would be of guaranteed quality.
At this point, you are probably about to say, “Yes, but …” How do you know that a goldsmith’s ticket is itself authentic? Isn’t this just like the farm shop all over again, isn’t there going to be a problem with counterfeiters? Yes, there is. Goldsmiths can’t employ the best countermeasure, which is to make their tickets out of precious metal — that’s what they are warehousing! Instead, they make their tickets out of special-quality watermarked paper, with very high quality printing. They are numbered and signed. It may even be customary for people to sign the ticket on the back when they spend it, so that counterfeit notes can be traced back to their origin. (This practice persisted with Bank of England white five pound notes until only a few decades ago.) The goldsmiths can also get help from the law-courts, if forging their tickets is officially classified as counterfeiting. Forging a goldsmith’s ticket would then be just as risky as counterfeiting the official gold and silver coins, with the penalty of castration or death.
Now, I’ve deliberately brought you in at crucial turning point in the fairy-tale world. We are about to step off into the abyss which is traditional banking. Some goldsmiths have started to warehouse gold coins for free. Others are even paying a small amount of interest on deposits. They can do this because they have decided to loan out some of the gold in their strongroom for interest, just like a money scrivener. The customers holding goldsmith’s tickets know this, but for now they are happy, because they can still take their cash out on demand. Since they can take it out any time, they mostly want to leave it where it is, especially since it is now earning interest. What could possibly go wrong?
If you have seen newsreels from the 1930s, or if you were in one of the queues outside the British bank Northern Rock in September 2007, you will know exactly what can go wrong. The goldsmiths’ clever new scheme is in fact a scam, a confidence trick. Provided everyone has confidence in the goldsmith’s tickets, things continue just as before. But when people think “maybe there isn’t enough gold in the strongroom to pay back my ticket,” then the game is up. Everyone with a ticket turns up at the same time, and now there isn’t enough gold to pay everyone. The goldsmith goes bankrupt, and any remaining tickets are more-or-less worthless. We say that there has been a run on the bank.
Can you put your finger on exactly what went wrong? An accountant would say that the problem was with the time-structure of the goldsmith’s assets and liabilities. The goldsmith’s assets are the gold in his strongroom, plus the IOUs from businessmen promising to pay back loans with interest in maybe a year’s time. The goldsmith’s liabilities are all those tickets, each promising to pay the bearer a certain amount of gold on demand. Right now, not a year from now. When there is a run on the bank, the goldsmith can make good on the first few tickets, but there comes a point when the strongroom is empty. To make good on the next ticket, he needs to get money back from one of his loans, but that is locked up for a year. Perhaps he can sell the IOUs for those loans, but that takes time, and he probably won’t get their full value anyway. In modern British law, there are two ways to be bankrupt, and the goldsmith has just illustrated one of them: he is unable to pay his debts as they fall due. It was all a problem of timing. In a way, the goldsmith was always bankrupt by this definition, because he was always liable to pay out on the tickets before he had the money back from his loans. The goldsmith was pretending that money could be in two places at once.
There is a positive side to this. The goldsmith engages in this confidence trick because he makes more profit, but the scam also helps other businessmen, and perhaps indirectly the whole community. People always had the choice of putting their money into a bond with the money scriveners. Some of them thought that they might need their cash back at short notice, so they took it to a goldsmith instead. But money in a goldsmith’s strongroom just sat there, unlike money scrivener’s loans which were used to help make more real stuff in the world, the stuff that is the fundamental reason why money is worth anything in the first place. The goldsmith’s confidence trick takes this idle money and puts it to work. The goldsmith’s depositors have become half-willing investors in local businesses. But only half-willing. Like most scams, they are happy to go along with it while they seem to be getting something for nothing.
But the goldsmiths face another temptation, rather worse than loaning out their gold. Since goldsmith’s tickets are being used as money, rather than loaning out gold, why not just print some new goldsmith’s tickets and loan those out instead? From the goldsmith’s point of view, this is better because there’s an obvious limit to how much gold they can loan out: the limit is all the gold they had in their strongroom. There is no such limit on the number of tickets they can issue. They could issue five or ten times more tickets than their stock of gold. This is known as fractional-reserve banking. The goldsmith only has a fraction of the cash reserves needed to make good on all the tickets.
Is this legal? Isn’t it a kind of counterfeiting? There never was any cash to pay out on one of these invented tickets. At the very least surely it is fraud? The honest answer to these questions is to say, yes, this is like counterfeiting, it is a kind of fraud. And yet this is exactly how traditional banking works. We have now entered the abyss. Essentially all banks are fractional-reserve banks. Why don’t the bankers go to jail? Because the law is written specially for them, to say that it isn’t counterfeiting, that it isn’t fraud, if they do it. Other businesses can’t do it, you and I can’t do it, but a bank can.
This is interesting, but perhaps even more interesting is the fact that you are now part of that very small minority of people who understand how it really works. You probably have a slightly queasy feeling that this can’t really be how banks work. Surely they take some people’s cash and loan it to other people, like money scriveners, or at least like those unambitious goldsmiths who loaned out their gold? But no, banks really do invent money out of nothing, just as goldsmiths invented tickets out of nothing and loaned those tickets out for interest. The only difference is that in our world the goldsmith’s tickets are called banknotes.
This is the central scam of banking, but there are many extra subtleties. One is that the goldsmith need not issue tickets, but he can still play the same tricks. Suppose that instead of issuing tickets, the goldsmith keeps track of deposits in a big accounts book, one page per customer. Customers can transfer money to other people by using a bill of exchange, also known as a cheque. This is an instruction to the goldsmith to move money from my account to yours, something like this:
To Mr G. Smith, One Goldsmith Lane, London.
Please move one hundred pounds from my account
to the account of Mr A. N. Other.
So, rather than a goldsmith’s ticket moving from my purse to yours in the outside world, a clerk executing this bill of exchange subtracts a number from my account book page and adds it to your account book page inside the goldsmith’s building. The goldsmith can still invent money out of nothing simply by adding a number to your account book page, in return for your IOU which he keeps in the strongroom until its maturity date. On that day, you pay back the IOU by telling him to subtract the money you owe from your account book page. Invented goldsmiths tickets and invented numbers on an account book page are exactly equivalent. (Though it took economists most of the nineteenth century to work this out. When laws were passed regulating the issue of banknotes, the bankers simply moved on to another technology and ran their scam with account books.)
Another subtlety is how best to prevent a bank run. A key piece of theatre is to make the building containing the bank as imposing and monumental as possible. It should either look so solid that it would comfortably out-last the pyramids, or else it should show conspicuous disregard for expense, a temple of glass, chrome and marble. The employees should be sober and serious. The directors should be pillars of society, beyond reproach. As with all scams, a proper disguise is vital.
To prevent a bank run gaining momentum, it is vital to have enough cash on hand to always pay out promptly. How much is enough? Through the centuries, experience has shown that it is prudent to keep one dollar of cash on hand for every five banknotes which promise to deliver one dollar “on demand,” a reserve ratio of 20%. Now, prudence is not compulsory, so from time to time governments have imposed particular reserve requirements by law. The fraction of reserves to banknotes demanded during the twentieth century has generally ranged from the prudent 20% to the rather lax 5%. This last figure is only really practical with government connivance and the help of a central bank.
A central bank is a bank which has a special relationship with the government. Sometimes it is entirely controlled by the government. (As is the Bank of England nowadays, though it was for centuries privately owned.) Sometimes it is regarded as part of the government, even when it isn’t. (This is the case with the United States central bank, the Federal Reserve.) Sometimes it is independent of government, but has special privileges not given even to other banks. (This is the case with the European Central Bank.)
A central bank is expected primarily to do things which benefit its government, for example creating money out of nothing and lending it to the government. Secondly, it is expected to act as an overseer and lender of last resort for other banks. The idea of this is that when an ordinary bank suffers from a bank run, it can get a short-term cash loan from the central bank which saves the day. This is the government connivance which allows other banks to survive with the otherwise suicidal reserve ratio of 5%.
In return for these services, the government writes special laws to protect the central bank. For example, central bank notes may be declared legal tender, so people cannot write contracts specifying payment only in cash. People have to accept payment in the central bank’s notes. The government can temporarily “suspend specie payment” on the central bank’s notes, so people cannot redeem the notes for gold or silver coins, but still have to accept the notes as legal tender. It should be obvious how useful this is to the central bank. (Today, around the whole world, specie payment is suspended, and has been for around 60 or 70 years. This is a long time, but it’s still best to regard this as a temporary measure, since it’s historically unusual, and in the long-run unstable.) The government can even suspend the usual requirement that each year a business must have its accounts audited. The US Federal Reserve has not been audited for decades. Oh, and of course as a central bank you still get to do what all other banks can do, namely to invent money out of nothing. When you are a goldsmith it’s nice to have the government on your side, isn’t it?
The relationship between government money and bank money is especially confusing, particularly when central banks are involved. Throughout history, governments have minted gold and silver currency, and they have also minted token coinage and printed paper money. Really, there is no difference between government paper money and token coinage. Governments resort to such fiat currency in times of existential crisis, from the Roman Empire’s not-really-silver denarii, to “Continental” government notes in the American War of Independence, or the “greenback” government notes of the American Civil War. These were all really just token coinage, created in unlimited quantities, with essentially the same result: tremendous inflation.
So people prefer government coins with a substantial content of gold or silver. That way a government can’t continually create more coins out of thin air. They have to go to some effort to obtain the precious metal, which acts as a natural brake on the production of coins. And yet governments need more money. Perhaps it is now clear why central banks are so useful to governments. They let governments have some of the advantages of a token coinage without the usual consequences. The central bank looks respectable, and it isn’t the government, so people are more inclined to trust its banknotes. The central bank doesn’t indefinitely print more and more banknotes, it keeps to some plausible reserve ratio, so this is genuinely an advance on government token coinage. With government protection the central bank is largely immune to bank runs.
It’s worth thinking about why a central bank bothers to maintain some particular reserve ratio. Since it’s protected from bank runs, why doesn’t it just keep the printing presses going and churn out more and more banknotes? If there was only one state and only one central bank, then this is almost certainly what would happen. There would in fact be no difference between government paper money and central bank paper money. Before the twentieth century, the world-wide gold standard ensured that the check on each central bank came from outside, from other states and their banks.
Although each state could make a law that their own central bank’s notes were legal tender, and could even suspend specie payment, these laws obviously didn’t apply to foreign countries and their banks. When merchants in one country imported goods from a foreign country, how did they pay? If they used central bank notes from their home country, these notes would pass from bank to bank in the foreign country until eventually some bank (usually the foreign central bank) presented them back to the central bank in the merchant’s home country. Even if specie payment had been suspended for ordinary citizens at home, the central bank in the merchant’s home country had to redeem its notes for gold when foreign banks presented them — that was what the gold standard guaranteed. Otherwise why would anyone ever accept a foreign banknote? Notes which were not backed by gold were regarded quite rightly as empty promises, easily made and easily broken.
Now, when there was trade both ways between two countries, the central bank in each country would accumulate a stack of foreign central bank notes. If the value of trade in both directions was equal, there was no need to transfer gold — the central banks could just swap their stacks of banknotes. But if there was more trade in one direction than the other, then the reserves of one central bank would run down. Eventually, the reserves might run out completely. Economic life might continue inside the “bankrupt” country, but external trade would come to a halt when the country found itself no longer able to pay for imports. This is how the gold standard effectively restricted the ability of central banks to create money without limit.
Faced with the prospect of exhausting their reserves under the gold standard, a central bank or its government might take one of a number of compensating steps. The government might pass laws to encourage the export of goods, hoping to collect in return a bigger stack of foreign banknotes so that the swap of notes would be more even. The government might pass laws to discourage the import of some goods, either by taxing them, setting quotas or making them illegal. Or the government could pass laws restricting the export of banknotes themselves — so-called “exchange controls.” More dramatically, the government could launch a war, with the intention of seizing control of some resources of value to foreign countries, and balance imports and exports that way. The problem with all these measures is that they tend either to be unpopular with foreign countries, and provoke tit-for-tat retaliation, or to be unpopular with with the merchants at home, who often form a significant portion of the government’s supporters.
So, under the gold standard, governments usually preferred that central banks solve the problem themselves. The central bank might declare that its banknotes were devalued, or in other words, would be redeemed for less gold than it had previously promised. However, this was considered dangerous because foreigners might wonder if one devaluation would be followed by another, and another. This lack of confidence could be self-fulfilling, and the banknotes might end up being worth a lot less than intended.
A more reliable solution was to build up the reserves of the central bank by offering a higher rate of interest on deposits. That would tend to bring in gold from abroad, and so the reserve ratio would return to a more prudent level. As a side effect, it would also tend to curb general bank lending in that country, because other banks would be forced to increase their interest rates too. (If any bank can benefit from the central bank rate just by making a deposit there, why would they lend out to businesses at less than that rate?)
Central banks and governments don’t always agree about what to do in such circumstances, or even tell each other the truth. For example, in the 1920s, the head of Britain’s central bank, Montagu Norman, persistently lied to the government about the amount of its gold reserves. Britain had suspended payment in gold during the First World War, even to other central banks. In 1925, Britain returned to the gold standard, and the Bank of England quickly began to build up gold reserves. It should have reduced its interest rates, to be less attractive to foreign gold. Under the high interest rates, businesses struggled and ordinary people lost their jobs. But Norman liked the high interest rates, because they caused deflation (the opposite of inflation). The main asset of a bank is money, and that money is worth more when there is deflation. Norman decided to hide the excess gold with some accounting tricks, the connivance of banking friends in New York, and outright lies. note 94
Here is an example of what Quigley meant by the sovereign power of “money control.” At that time, the Bank of England was a privately owned bank, and Norman was a private citizen. Everything the Bank of England did as a central bank was governed by the deal it cut with the government, as set out in legislation. Norman broke that deal and seized money control for himself. Only a handful of people knew the truth. The Bank’s “Court,” its board of directors, were just as much in the dark as the government. There is no doubt that if Norman’s actions had been known at the time he would have been sacked or worse. (What he did was essentially treason.)
So, the gold standard was not a solution to all problems with money, not proof against all deception by bankers, but it did impose some worthwhile limits on the capacity of central banks to invent money out of nothing. But you will notice that I am speaking in the past tense. The gold standard is no more. What happened?
The gold standard, which formed the backbone of international trade in the nineteenth century, stuttered in and out of existence in the first decades of the twentieth century. Most people agreed that it was a good thing, but the pressures of war or economic depression meant that it was sometimes a good thing that would have to wait for better times. After the Second World War, the United States held the majority of the world’s official reserves of gold, and the victorious Allied nations agreed on a new system of money which was not quite the old gold standard. The United States defined its dollar to be 1/35 of an ounce of gold, and other countries defined their currencies in terms of the dollar. (However, inside the United States, people were not allowed to own gold bullion or coins. All the circulating gold coins had been confiscated by the government during the 1930s banking crisis, after which they were melted down into ingots and stored in Fort Knox.)
For a while this new system seemed to work, but by the late 1950s things were clearly going wrong. In 1958 the total dollar holdings outside the United States were around $20 billion, up from $10 billion, ten years earlier. Over the same period, the United States’ gold reserves had dropped from $25 billion to $20 billion, at the official rate. Clearly the United States as a whole was spending abroad more than it was receiving, but neither the government nor the central bank took effective steps to change this. Under the new system of money, foreign central banks could still ask for gold in return for their dollars, and seeing that there was only just enough gold to make good on all the dollars they held, this is exactly what they did. It was like a very slow bank-run. note 95
Eventually, on 15 August 1971, President Richard Nixon “closed the gold window.” The United States defaulted on its promise to redeem dollars for gold. About half of the 1958 gold reserves had been spent attempting to preserve the value of the dollar, but now the charade was over. This left significant questions about what the dollar was now worth. Surely the result must eventually be inflation and ruin?
In 1973, the Kuwaiti oil minister put the issue quite succinctly when he asked: “What’s the point of producing more oil and selling it for an unguaranteed paper currency? … Why produce the oil which is my bread and butter and strength and exchange it for a sum of money whose value will fall next year by such-and-such a percent?” A very good question, and a question which must have had a very convincing answer, because of what happened next. note 96
The oil-producing nations, including Kuwait, arranged to be paid much more for their oil, but they also arranged to be paid exclusively in dollars, despite the fact that it was an “unguaranteed paper currency.” This is an arrangement which persists to the present day. We do not know exactly what convinced the oil-producing nations to make this choice or why they have stuck fast to their choice despite the dramatic inflation which the dollar has suffered in the meantime. (Depending on who you believe, the dollar lost at least 80% of its value, maybe even 95% of its value, between 1973 and 2011.) For the United States, the benefit was clear: the dollar, although not backed by gold, was now effectively backed by oil. The prices on the blackboard were in dollars and if you wanted to buy oil you needed to come to the shop with dollars in your pocket. note 97
Because of this odd arrangement, the United States dollar continues, as I write, to be the world’s reserve currency, and the United States central bank has been able to create dollars without limit. Since the 1970s, these invented dollars have puffed up one financial bubble after another, not only in the United States but all over the world. So far, as each bubble has burst it has been replaced with another, bigger bubble. Each time, the bubble machine itself has survived the crash, because that suits the narrow interests of the American establishment as they play their infinite game of wealth. As I write these words in 2011, the situation appears to be getting more and more precarious, but seeing into the future is always uncertain. It’s hard to say when the bubble machine will finally stop forever. Maybe when you read these words, it will have already stopped.
What then? Would it be a good idea to establish something like the gold standard again? Looking back at history, whenever governments have tried to base their currency on something other than gold or silver this has always been unstable and temporary. It’s surprising that the United States has managed for so long. However, despite the enthusiasm of some people for currency based on gold and silver, it’s not clear that we could ever really have a gold standard again. To explain why, I need to tell you a story. It’s a story that also pulls together most of the ideas that we have met so far, a story of blood and gold.
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Version: DRAFT Beta 3. Copyright © Stuart Wray, 29 December 2011.