Why Credit Needs a Golden Anchor
This article examines the relationship between credit and its anchor in value. Today, that anchor is fiat currency, which is both parochial and unstable. Historically, and in law it has always been gold.
It is a common error to think of credit in a narrow sense, without realising that officially recorded credit in the form of banknotes and deposit accounts with the commercial banks are only a minor part of the total credit in an economy. This article takes a holistic view of credit.
The relationship between credit and whatever provides an anchor to its value is a far larger topic from that commonly discussed in economic journals. It involves an understanding of the relationships between currency credit and commercial bank credit, the consequences of which rarely occur to economic commentators.
There is evidence that changes in central bank credit have a greater impact on prices than an equivalent change in commercial bank credit — a new and important topic for our consideration.
This article draws on the history of law as it applies to banking, money, and credit. For both contemporary economists and the layman, it involves some concepts that may be novel to them. But given that they concern the very survival of contemporary currencies, they are worth making the effort to understand.
Introduction
The purpose of this article is to explain why gold anchors credit values, an anchor which is absent in the fiat currencies that seek to replace it. It is a topic over which there is considerable confusion, not least from the two dominant schools of economic thought: Keynesian and monetarist. And while Ludwig von Mises, who was more responsible than anyone else for promoting the Austrian school of economics in the US explained and denounced inflationism, his work predominantly dealt with the inflation of fiat currencies, without much examination of the second level tier of credit issued by commercial banks, other than establishing its relationship with the business cycle.
It became a short step for many followers of von Mises in America and Hayek in Britain to conclude that the cycle of bank credit is an economic evil and that if banks were forced to become banks of deposit, acting as custodians while other institutions would act as arrangers of finance, then we would abolish the credit cycle.
Clearly, the expansion of credit tends to undermine its purchasing power. But the relationship between the changes in the volume of credit and its purchasing power is not straightforward. And then there is the difference between central bank credit and commercial bank credit to consider: does one undermine purchasing power more than the other? So far as I’m aware there is no economic literature examining this possibility.
The current situation of currencies with no relationship to gold has only been in place for fifty-two years. Before that, the link was gradually eroded from Roosevelt’s ban on ownership by American citizens in 1933, its revaluation in dollar terms the following year, and the Bretton Woods agreement in 1944. In has been a journey away from sound money lasting ninety years. Despite this progressive attrition, prices, particularly of commodities and raw materials were relatively stable before the ending of all links between gold and currencies. Now we should turn to empirical evidence of price behaviour under a proper gold standard, as shown in the chart below.
This is the only long run of statistical evidence of price stability under a gold standard and is of wholesale prices in the UK following the Napoleonic Wars. As usually happens, there was a post war slump as war spending ceased, reversing war-time inflation, and leading to lower prices. The gold sovereign coin standard was introduced in 1817, which continued to be exchangeable for Bank of England banknotes until the First World War. And as the new gold coin standard bedded in, the cyclical changes in price levels gradually diminished, partly due to improvements in the banking system, such as in the clearing system set up by the London banks, which was joined by the Bank of England in 1864.
Before 1914, the British government paid down most of its record high levels of Napoleonic War debt. Through industrial development, the British economy improved the living standards of the people substantially. And despite its diminutive size, Britain became the wealthiest nation in the world. As can be seen from the chart, after a shaky start producer prices became remarkably stable, barely changing in aggregate over almost a century.
The Bank of England’s banknote issue, which was encashable into gold sovereigns on demand, stood at £22,082,909 in 1820. The 1844 Bank Charter Act eliminated the note issues of the other London banks, but despite their removal from circulation and after a mid-century dip the BoE’s note issue only increased to £28,437,985 by 1900. Between 1844 and 1900, broad money supply is estimated to have increased by nearly eleven times and there was a substantial increase in commercial bills as well, which being credit should not be neglected.[i]
Despite this expansion of the quantity of credit, there was little net effect on producer price levels. In 1844, the composite price index stood at 8.9, and in 2000 it was 9.2. This suggests that an expansion of commercial bank credit has less impact on prices than an expansion of the note issue, and that not all forms of credit are equal in their effect on prices.
It is worth pausing for a moment to let that sink in. In terms of its effect on purchasing power, it has been demonstrated that changes in the quantities of bank and other wider forms of credit have significantly less impact on the general level of prices than changes in the quantity of central bank credit.
But we must introduce a caveat: the expansion of bank credit and commercial bills in nineteenth century Britain did not generally provide finance for consumption, thereby inflating prices. Today, instead of gold we are all on a loose dollar standard with respect to its role as the principal reserve currency and its function for pricing commodities and international transactions. And without gold’s steadying influence, the principal factor in the relationship between gold, a currency, and subordinate bank credit is how peoples’ perceptions change when credit expands. This is particularly true when credit expansion funds consumer spending.
If consumers spend the additional credit, they will tend to drive up the general price level measured in the currency. If they save it, they will tend to drive up the level of capital available for investment, benefiting manufacturing methods and thereby introducing a contrary factor which should restrict rising consumer prices. Furthermore, changes in the application of credit between purely financial activities and the non-financial GDP economy contribute to making long runs of price data misleading for assessing the impact of increases in the quantity of credit on the purchasing power of a circulating media.
In determining how the circulating media is valued with respect to the goods and services being exchanged, we cannot ignore their application to the ancient classifications of wealth. Aristotle made the connection thus: “We call wealth all things whose value can be measured in money” (Nicomachean Ethics Book V). The true meaning of wealth is exchangeable rights. And economics, or commerce, is basically the science of exchangeable rights.
There are three types of exchangeable rights which might be bought, sold, or exchanged:
- Material property or the right to it, being a specific material substance, which in law is referred to as corporeal property, alternatively referred to as material wealth.
- Immaterial property, being an individual’s intellectual and labour capacity to render any sort of service. Corporate goodwill falls into this category.
- Incorporeal property which is neither material nor immaterial. It is in the broadest sense represented by debt, which is synonymous with credit, obligations which are exchangeable and are therefore wealth. It may be in an individual’s possession, not yet in an individual’s possession, or may only exist at a future date, such as the right to an income stream. But the right to it when it does come into existence is present and may be bought and sold just as if it was a material property. In Roman and English law, incorporeal property is a right separated from any specific corpus.
It can be immediately observed that gold coin in possession is material, or corporeal property, while credit, being a promise or obligation, is incorporeal. But the value of items, either being personal or collective wealth, in all three categories must be expressed in a medium of exchange. If that medium is a material property, it is a completely different thing from being incorporeal.
Under a gold standard, incorporeal property took its value from a material property. Under today’s fiat dollar standard, all forms of incorporeal property take their value from another incorporeal property, banknotes, which are a central bank’s liability. Credit is only valued in another credit, an arrangement which is inherently unstable, irrespective of changes in its quantity. Picking all this apart is the essence of the riddle we face.
Understanding gold — real money
Since the ending of barter, various corporeal properties have been used as media of exchange, but ultimately, various communities trading with each other and other completely independent communities settled on three metals as the best stores of value: gold, silver, and
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