Uneasy Money

In recent posts (here and here) I have mentioned both the gold standard and the gold-exchange standard, a dichotomy that suggests that the two are somehow distinct, and I noted that the Genoa Conference of 1922 produced a set of resolutions designed to ensure that the gold standard, whose restoration was the goal of the conference, would be a gold-exchange standard rather than the traditional pre-World War I gold standard. I also mentioned that the great American central banker Benjamin Strong had stated that he was not particularly fond of the gold-exchange standard favored by the Genoa Resolutions. So there seems to be some substantive difference between a gold standard (of the traditional type) and a gold-exchange standard. Wherein lies the difference? And what, if anything, can we infer from that difference about how the two standards operate?

Let’s begin with some basics. Suppose there’s a pure metallic (gold) currency. All coins that circulate are gold and their value reflects the weight and fineness of the gold, except that the coins are stamped so that they don’t have to be weighed or assayed; they trade at their face value. Inevitably under such systems, there’s a problem with the concurrent circulation of old and worn coins at par with newly minted coins. Because they have the same face value, it is old coins that remain in circulation, while the new coins are hoarded, leading to increasingly overvalued (underweight) coins in circulation. This observation gives rise to Gresham’s Law: bad (i.e., old and worn) money drives out the good (i.e., new full-weight) money. The full-weight coin is the standard, but it tends not to circulate.

When the currency consists entirely of full-weight gold coins, it is redundant to speak of a gold standard. The term “gold standard” has significance only if the coin represents a value greater than the value of its actual metallic content. When underweight coins can circulate at par, because they are easily exchangeable for coins of full weight, the coinage is up to standard. If coins don’t circulate at par, the coinage is debased; it is substandard.

Despite the circulation of gold coins for millenia, the formal idea of a gold standard did not come into being until the eighteenth century, when, because the English mint was consistently overvaluing gold at a ratio relative to silver of approximately 15.5 to 1, while on the Continent, the gold-silver ratio was about 15 to 1, inducing an influx of gold into England. The pound sterling had always been a silver coin, like the shilling (20 shillings in a pound), but by the end of the 17^th century, debasement of the silver coinage led to the hoarding and export of full weight silver coins. In the 17^th century, the British mint had begun coining a golden guinea, originally worth a pound, but, subsequently, reflecting the premium on gold, guineas traded in the market at a premium.

In 1717, the master of the mint — a guy named Isaac Newton who, in his youth, had made something of a name for himself as a Cambridge mathematician — began to mint a golden pound at a mint price of £3 17 shillings and 10.5 pence (12 pence in a shilling) for an ounce of gold. The mint stopped minting guineas, which continued to circulate, and had an official value of 21 shillings (£1 1s.). In theory the pound remained a weight of silver, but in practice the pound had become a golden coin whose value was determined by the mint price chosen by that Newton guy.

Meanwhile the Bank of England based in London and what were known as country banks (because they operated outside the London metro area) as well as the Scottish banks operating under the Scottish legal regime that was retained after the union of England with Scotland, were all issuing banknotes denominated in sterling, meaning that they were convertible into an equivalent value of metallic (now golden) pounds. So legally the banks were operating under a pound standard not a gold standard. The connection to gold was indirect, reflecting the price at which Isaac Newton had decided that the mint would coin gold into pounds, not a legal definition of the pound.

The pound did not become truly golden until Parliament passed legislation in 1819 (The Resumption Act) after the Napoleonic Wars. The obligation of banks to convert their notes into coinage was suspended in 1797, and Bank of England notes were made legal tender. With the indirect link between gold and paper broken, the value of gold in terms of inconvertible pounds rose above the old mint price. Anticipating the resumption of gold payments, David Ricardo in 1816 penned what he called Proposals for an Economical and Secure Currency in which he proposed making all banknotes convertible into a fixed weight of gold, while reducing the metallic content of the coinage to well below their face value. By abolishing the convertibility of banknotes into gold coin, but restricting the convertibility of bank notes to gold bullion, Ricardo was proposing what is called a gold-bullion standard, as opposed to a gold-specie standard when banknotes are convertible into coin. Ricardo reasoned that by saving the resources tied up in a gold coinage, his proposal would make the currency economical, and, by making banknotes convertible into gold, his proposals would ensure that the currency was secure. Evidently too radical for the times, Ricardo’s proposals did not gain acceptance, and a gold coinage was brought back into circulation at the Newtonian mint price.

But as Keynes observed in his first book on economics Indian Currency and Finance published in 1913 just before the gold standard collapsed at the start of World War I, gold coinage was not an important feature of the gold standard as it operated in its heday.

A gold standard is the rule now in all parts of the world; but a gold currency is the exception. The “sound currency” maxims of twenty or thirty years ago are still often repeated, but they have not been successful, nor ought they to have been, in actually influencing affairs. I think that I am right in saying that Egypt is now the only country in the world in which actual gold coins are the principle medium of exchange.

The reasons for this change are easily seen. It has been found that the expense of a gold circulation is insupportable, and that large economics can be safely effected by the use of some cheaper substitute; and it has been found further that gold in the pockets of the people is not in the least available at a time of crisis or to meet a foreign drain. For these purposes the gold resources of a country must be centralized.

This view has long been maintained by economists. Ricardo’s proposals for a sound and economical currency were based on the principle of keeping gold out of actual circulation. Mill argued that “gold wanted for exportation is almost invariably drawn from the reserves of banks, and is never likely to be taken from the outside circulation while the banks remain solvent.” . . .

A preference for a tangible gold currency is no longer more than a relic of a time when Governments were less trustworthy in these matters than they are now, and when it was the fashion to imitate uncritically the system which had been established in England and had seemed to work so well during the second quarter of the nineteenth century. (pp. 71-73)

Besides arguing against the wastefulness of a gold coinage, Keynes made a further argument about the holding of gold reserves as a feature of the gold standard, namely that, as a matter of course, there are economic incentives (already recognized by Ricardo almost a century earlier) for banks to economize on their holdings of gold reserves with which to discharge their foreign obligations by holding foreign debt instruments which also serve to satisfy foreign claims upon themselves while also generating a pecuniary return. A decentralized informal clearinghouse evolved over the course of the nineteenth century, in which banks held increasing amounts of foreign instruments with which to settle mutual claims upon each other, thereby minimizing the need for actual gold shipments to settle claims. Thus, for purposes of discharging foreign indebtedness, the need for banks to hold gold reserves became less urgent. The holding of foreign-exchange reserves and the use of those reserves to discharge foreign obligations as they came due is the defining characteristic of what was known as the gold-exchange standard.

To say that the Gold-Exchange Standard merely carries somewhat further the currency arrangements which several European countries have evolved during the last quarter of a century is not, of course, to justify it. But if we see that the Gold-Exchange Standard is not, in the currency world of to-day, anomalous, and that it is in the main stream of currency evolution, we shall have a wider experience, on which to draw in criticising it, and may be in a better position to judge of its details wisely. Much nonsense is talked about a gold standard’s properly carrying a gold currency with it. If we mean by a gold currency a state of affairs in which gold is the principal or even, in the aggregate, a very important medium of exchange, no country in the world has such a thing. [fn. Unless it be Egypt.] Gold is an international, but not a local currency. The currency problem of each country is to ensure that they shall run no risk of being unable to put their hands on international currency when they need it, and to waste as small a proportion of their resources on holdings of actual gold as is compatible with this. The proper solution for each country must be governed by the nature of its position in the international money market and of its relations to the chief financial centres, and by those national customs in matters of currency which it may be unwise to disturb. It is as an attempt to solve this problem that the Gold Exchange Standard ought to be judged. . . .

The Gold-Exchange Standard arises out of the discovery that, so long as gold is available for payments of international indebtedness at an approximately constant rate in terms of the national currency, it is a matter of comparative indifference whether it actually forms the national currency.

The Gold-Exchange Standard may be said to exist when gold does not circulate in a country to an appreciable extent, when the local currency is not necessarily redeemable in gold, but when the Government or Central Bank makes arrangements for the provision of foreign remittances in gold at a fix, ed maximum rate in terms of the local currency, the reserves necessary to provide these remittances being kept to a considerable extent abroad. . . .

Its theoretical advantages were first set forth by Ricardo at the time of the Bullionist Controversy. He laid it down that a currency is in its most perfect state when it consists of a cheap material, but having an equal value with the gold it professes to represent; and he suggested that convertibility for the purposes of the foreign exchanges should be ensured by the tendering on demand of gold bars (not coin) in exchange for notes, — so that gold might be available for purposes of export only, and would be prevented from entering into the internal circulation of the country. (pp. 29-31)

The Gold-Exchange Standard in the form in which it has been adopted in India is justly known as the Lindsay scheme. It was proposed and advocated from the earliest discussions, when the Indian currency problem first became prominent, by Mr. A. M. Lindsay, Deputy-Secretary of the Bank of Bengal, who always maintained that “they must adopt my scheme despite themselves.” His first proposals were made in 1876 and 1878. They were repeated in 1885 and again in 1892, when he published a pamphlet entitled Ricardo’s Exchange Remedy. Finally he explained his views in detail to the Committee of 1898.

Lindsay’s scheme was severely criticized both by Government officials and leading financiers. Lord Farrer described it as “far too clever for the ordinary English mind with its ineradicable prejudice for an immediately tangible gold backing of all currencies.” Lord Rothschild, Sir John Lubbock (Lord Avebury), Sir Samuel Montagu (the late Lord Swythling) all gave evidence before the Committee that any system without a visible gold currency would be looked on with distrust. Mr. Alfred de Rothschild went so far as to say that “in fact a gold standard without a gold currency seemed to him an utter impossibility.” Financiers of this type will not admit the feasibility of anything until it has been demonstrated to them by practical experience. (pp. 34-35)

Finally, as to the question of what difference, aside from convenience, does it make whether a country operates on a full-fledged honest to goodness gold standard or a cheap imitation gold-exchange standard, I conclude with another splendid quotation from Keynes.

But before we pass to these several features of the Indian system, it will be worth while to emphasise two respects in which this system is not peculiar. In the first place a system, in which the rupee is maintained at 1s. 4d. by regulation, does not affect the level of prices differently from the way in which it would be affected by a system in which the rupee was a gold coin worth 1s 4d., except in a very indirect and unimportant way to be explained in a moment. So long as the rupee is worth 1s. 4d. in gold, no merchant or manufacturer considers of what material it is made when he fixes the price of his product. The indirect effect on prices, due to the rupee’s being silver, is similar to the effect of the use of any medium of exchange, such as cheques or notes, which economises the use of gold. If the use of gold is economised in any country, gold throughout the world is less valuable – gold prices, that is to say, are higher. But as this effect is shared by the whole world, the effect on prices in any country of economies in the use of gold made by that country is likely to be relatively slight. In short, a policy which led to a greater use of gold in India would tend, by increasing the demand for gold in the world’s markets, somewhat to lower the level of world prices as measured in gold; but it would not cause any alteration worth considering in the relative rates of exchange of Indian and non-Indian commodities.

In the second place, although it is true that the maintenance of the rupee at or near 1s. 4d. is due to regulation, it is not true, when once 1s. 4d. rather than some other gold value has been determined, that the volume of currency in circulation depends in the least upon the policy of the Government or the caprice of an official. This part of the system is as perfectly automatic as in any other country. (pp. 11-13)