I want to talk about, sort of the Theory of Monetary Institutions, that was the title of my book, but the missing word from that title is the Market Theory of Monetary Institutions. So, there are basically two approaches to monetary institutions that you´ll find in the literature, simplifying and condensing.
There´s a State Theory of Money and there´s a Market Theory of Money and the, sort of, statements that people who believe in the State Theory of Money will say, are things like:
Money cannot properly develop, unless the State becomes involved.And sometimes even more strong than that, sometimes, -money cannot possibly develop, or the origin of money relies on the imprimatur of the State; it´s not really money until the king says it is.-
But in many, many opinion pieces about monetary policy, you´ll find the statement: well, the monetary system cannot manage itself, we´all agree to that so now let´s discuss my plan for managing the monetary system.
But it´s taken for granted that money is somehow unlike other goods in the market, where market forces we rely upon to supply us with shoes, and it´s not too controversial to say that market for shoes can regulate itself.
But money is considered something different. And I want to offer an alternative perspective that money should be considered one of the products of the market, and a good that, although it is special, although it is different from shoes, it can regulate itself through market forces, if we would let it.
We begin at the very beginning and ask "can money emerge without the help of the state?" We find most famously Carl Menger´s attempt to explain this.
There had been earlier economists like Adam Smith, who understood that money was created by market forces, but didn´t really spell it out in a clear way.
And Menger is the first to spell it out, to provide a step-by-step account. Maybe I need to define what I mean by money; by money, I mean a commonly accepted medium of exchange.
A medium of exchange is a good that you acquire; not in order to consume it; not in order to plant it in the ground to make something grow from it; not to invest it, but purely, in order to trade it away later.
So it´s a medium thatas an intermediary step, an intermediate step between coming to market with a good that you´ve produced, and going home with a good you want to consume.
I was at a conference recently where we discussed the book The State Theory of Money, by Knapp, the German Historical School economist, and Knapp begins with a statement that money is a creature of the law, as though there would not be any money until some legal authority approved of it.
Turns out he had a different definition of money. He meant, it´s not... he defined money such that it was something that had to be legally recognized, otherwise it´s not really money.
Well, that´s not my definition of money. And I think a fairly standard definition of money is anything that plays this role of being a medium of exchange that is commonly accepted.
The question is, why does some good take on that role? If we start in a system of barter where people are coming to market and trying to trade directly; I come to market with asparagus and I want to go home with broccoli, then I have to find somebody who´s selling broccoli and is willing to swap it, trade it, directly for asparagus.
Why did people switch from that way of trading to using some medium of exchange, some intermediary good?
So Menger spells out why this social institution, really, would emerge. And it´s not something that was designed by anyone or imposed by anyone, and in Menger's account we don´t have to assume that some genius was surveying all of society and saying "well you don't have money, so let´s adopt this new way of behaving".
That, of course, would be rather bizarre, someone who never lived in a monetary economy, how would they know about this way of behaving and how would they convince everybody else to go along?
So that would be a rather heroic assumption about what someone knows and how persuasive that person is. But if we think about money as a social convention, it´s natural to think of it emerging, like a language emerges; because nobody invented English, nobody invented Spanish, we have plenty of evidence that they emerged gradually over the years.
So the common place of text books tell us that barter is difficult, direct exchange, we can also call it, because it´s hard to find someone who, not only has what you want but also wants what you have.
If you want broccoli you may find someone selling it, but they may not want your asparagus; and this is much like trying to get married, you may find someone who has what you want, but you may not want what they have, and vice versa. You may find someone who wants what you have, but...
So here´s the asparagus seller who wants broccoli, if the broccoli seller doesn´t want asparagus, it´s natural to ask: what do you want? What will you accept in exchange for your broccoli?
And if the broccoli seller says: I´ll accept cabbage. Then, it only takes a little bit of entrepreneurship on the part of the asparagus producer to say: "ah, if I can trade my asparagus for cabbage, then I can use the cabbage to acquire broccoli". And if that´s possible then cabbage becomes a medium of exchange.
So, a single individual can use a medium of exchange, when will it pay to do that? It´ll pay to do that if you can acquire something for your asparagus that´s more popular, that´s more likely to be wanted by whoever is selling the thing you want to consume.
So, in this picture you have a very unusual vase; very few people want that, if somebody is willing to pay you in salt for that, and salt is much more popular, much more widely demanded, then you have a better chance of going home with the thing you want to consume if you get hold of the salt. So that will make it easier to accomplish the trades you want to accomplish.
But there are other things you want to consider, which is how easy is it to carry around the salt, compared to how easy it is to carry around asparagus? The asparagus may be wilting while you´re carrying it around, so if you can trade for something that is more durable, that´s an advantage. If you can trade for something that is more portable, that´s not as bulky, that´s an advantage.
So that´s stage one, why people use indirect exchange; because it´s less frustrating than trying to trade directly. It may be very difficult to find that trading partner who, both, has what you want and wants what you have. So it´s easier many times to conduct these two trades rather than just holding out until you find the direct exchange that you want.
Stage two is then, "okay now we have people using different good as media of exchange, why should they all converge and use the same medium of exchange? why should one particular good become commonly accepted as a medium of exchange?"
And once you´ve discovered indirect exchange, you know that it pays to get hold of something more popular, more portable, etcetera. It pays you to keep an eye out for which good other people are using as a medium of exchange.
If you hear that a lot of people are using salt, then you´re more willing to accept salt because now you have a larger group that you can trade with. So that makes the popularity of some good as a medium of exchange, self-reinforcing.
Like a snowball rolling down a hill it will gather users. When I adopt salt as my medium of exchange or one of my media of exchange, then I increase the community of people who use salt, so it´s grown by one, that makes it more attractive to other people because now they can trade with me using salt.
And so we have this snowball effect or the technical term that economists like to use these days is, it´s a network good. It´s like a fax machine, the usefulness of it to you, depends on the number of other people who are using it.
Of course, I realize that fax machine has become a rather dated reference.
So the implication of this view or this theory, is that a commonly accepted medium of exchange can emerge without anybody intending it. When I accept salt, I´m not intending that everybody should use salt, but if other people act the way I do, then that´s the unintended outcome.
The first money that emerges in this way has to be something that was initially useful, because some people who are agreeing to be paid in salt, were going to consume it, were going to take it home and use it, so it has to be something useful.
But for policy purposes, the more important implication is, no collective decision is necessary, Menger emphasizes this in his famous article, on The New Origin of Money.
It doesn´t take a meeting of the Chamber of Commerce, to pass a resolution that we should all accept salt; it doesn´t take a meeting of the legislature, to decree that everyone should accept salt; it doesn´t take a judge from a bench, ruling that everyone should accept salt or silver, or whatever it is; no collective decision is necessary.
This is also true of the subsidiary role of money serving as a unit of account, that is, if I want to be paid in silver, then I will denominate the prices on the pricetags of the goods I´m selling, in units of silver.
Now, we know historically that it wasn´t salt, well there were instances of salt being used as a medium of exchange, of oxen being used as a medium of exchange; in ancient Greece people used oxen to buy and sell.
That may seem peculiar, but after all, they did walk themselves from market to market, so transportation was not a problem. As long as you kept them well-fed they were durable, the problem was when you tried to make change in an ox, it was a messy process, and after you had made change it was no longer so durable, no longer so portable.
So, if we think about silver versus oxen, versus barley, along these dimensions that have an effect on how convenient it is to use as a hand-to-hand medium of exchange, to carry it around from one exchange to another, silver does the best on these criteria.
Although, one of the criteria, which is how uniform is it, silver doesn´t do so well on, in its raw state, coming out of a silver mine. It´s not pure silver, it´s a grade of silver ore, which is mixed with other elements, and it´s not immediately obvious how pure it is, so you have to have some way of testing for purity which is inconvenient.
It´s not until coinage develops as a way of purifying and certifying the pureness and the weight of pieces of silver, that silver coins really dominate monetary exchange. Up until that point, other commodity monies, food stuffs, oxen, shells in many parts of the world, continued to be used. And it´s not until coinage is developed that silver drives these other monies out of circulation.
Silver is what historically emerged as the dominant commodity money around the world, and for higher valued payments gold, and eventually, gold standards displaced silver standards. But, was this the best choice? Some economists have asked. Is it the best commodity that tends to emerge as a commonly accepted medium of exchange?
If you ask what makes one commodity better than another as a medium of exchange, it has to be these kind of properties that were listed on the previous slide, portability and such, and the question is: could something that´s less convenient, nonetheless, emerge simply because the popularity of something becomes self reinforcing?
There is that tendency for something that gets ahead start to attract more users and thereby become even more popular.
But, I want to argue that along with this process, people who are deciding what to accept as a payment, will also be concerned about how suitable it is as a hand-to-hand medium of exchange, how portable is it? How durable is it? How divisible is it? and so on.
So, if you´re being offered payment in silver or wood, you´re going to ask yourself , well, I have to get this stuff to my next transaction, where I want someone to accept it from me; how portable is it? How durable is it? How uniform is it?
And in thinking about that, I´ll think which is going to be easier to spend at the other end of the transaction, so,which is going to be more popular with the person who accepts it for me.
So, I have to guess how they will evaluate the portability and durability and so on; so, in that way, since the money is something I want to trade with someone else, I have to take that other person's preferences into account.
And so other people's preferences for something that´s more portable and so on, will affect my choice of what to accept in the first place, because I want to trade it away to someone else, so there isn´t any market failure here of one trader, to incorporate the preferences of other traders.
Now, I said that the acceptance or the predominance of silver waited until coinage developed.
Coinage was not just a one-time invention, it was a series of technical advances; so, raw gold or raw silver is not so uniform, it imposes the hassle, the problem of weighing and testing its fineness at each transaction.
So what seems to have happened, as well as we can reconstruct it, is that people who were paid in pieces of precious metals, merchants, would mark their own pieces so they don´t have to weigh them a second time, when they are paying them out.
If other traders relied on them to mark the pieces honestly, then they don´t have to weigh them, they can rely on the mark provided by the merchant.
And merchants who became reputable for marking pieces honestly, people would actually bring them metal and say would you mark it for me, I will pay you a fee, because your mark is accepted as an honest evaluation of the metal, that would make it easier for me to spend.
The very earliest coins didn´t have any words or numbers on them because many of the people using them were illiterate and innumerate. But there was a problem with just marking one signal, one symbol, on one side of the coin, which was - clever operators figured out they could shave off the other side-, and the mark would still be there but there would be less metal than the mark claimed was there.
So they figured out that they needed to cover the entire piece with marks and put a reeded edge along the coin. And the techniques for doing this, punching out the coins, stamping them with powerful presses developed over the years.
But, basically the motive here is to improve the reliability of the certification of the pieces of metal, now if you buy a gold bullion today, whose certification do you rely on? The odds are it´s some Swiss company, like Engelhard Minerals. We rely today on private certification of gold bars, could we rely on private certification of coins? Sure, why not, and people did historically.
It´s perfectly feasible for private firms to undertake this minting service; people bring them the gold or the silver and pay them for the service of putting a stamp on it that certifies it. Here are some examples of private gold coins from the United States.
So, if private minting is feasible, why has it been so common that governments have monopolized the coinage industry? I don't know if you can read this it says: "The Royal Mint", so that´s the Royal Mint in London.
Why were they given a monopoly in the production of most coins? Well, there are two possibilities; either there´s some market failure that the government is there to remedy, and in the case of coinage the first objection that´s often offered is "well if people trust a private mint then the private mint can cheat them".
It can stamp "one ounce of silver" on a coin, and only put in half an ounce of silver, and the rest can be tinned. Was that a problem? The historical record that we have of this privately minted coins indicates that it wasn´t a problem.
If people become suspicious of the product of a private mint, the mint´s business completely evaporates, because the whole rationale of the business is we bring you our gold or our silver because once you´ve stamped it, it becomes easier to spend because everyone trusts your certification.
If people no longer trust the certification, then why would you pay for the service? If you have the coins of a suspect mint, everyone is going to want to weigh them and test them for purity; there´s nothing there that is worth paying for.
The examples we have of the coins minted in California were more precise than the coins minted at the U.S. government´s mint. When the U.S. government set up an unofficial mint in San Francisco, they didn´t have any superior technical know-how or any better equipment; in fact, they bought their equipment from one of the private mints.
So how would it be that the government has some technical advantage in minting more precisely, are they going to be more scrupulous and more careful to operate the equipment? I think the question answers itself.
But the history of ancient and medieval government mints is a notorious history of the basement of coins, so they mint a coin and they claim it´s an ounce of silver, but it only has half an ounce of silver this year, and a quarter of an ounce of silver next year.
The silver coins in Spain became so debased they became known as the black money, because they were all tarnish and no silver. And they could continue to make a profit of this even after the public knew that the coins were underweight, because they could declare them legal tender, you must accept them at their face value, you must treat them as an ounce of silver even if you know that it´s less than an ounce.
And why would they do that? To raise revenue, because it´s more profitable to exploit the monopoly of the mint, not only by charging high fees to coin, gold, and silver.
And when I say monopoly I mean...for example, the Spanish mint made it illegal to take gold and silver to anyone else. All the silver that was coming from Potosí to Spain had to go to the Spanish Royal Mint; it couldn´t be taken anywhere else.
But this was a great source of revenue. So it´s for fiscal reasons that the coinage becomes monopolized, not because there was a market failure to produce reliable coins, quite the reverse.
Pretty early on, banks´ private firms, get into the business of issuing substitutes for coins and the first of these are bank deposits, so there are two things to explain here; why people would deposit their money with some private institution, and then, why these deposits, these claims on private firms would become a substitute for coin, how can you spend a claim on a depository?
In medieval Italy the earliest deposit takers, people who would accept small amounts of money from lots of customers, were people whose main business was changing coins.
Why did you need to change coins? Well, because there was so much debasement. There was a local mint monopoly in each city-state in Italy for example; the coins in Geneva are not the same as the coins in Milan, and are not the same as the coins in Venice.
So if you went from one city to another, they wouldn´t accept your coins from the other city, you had to trade them, you had to change them with a money changer. And by 1200 A.D., we have on the evidence of Raymond de Rouergue, money changers had moved into the business of creating deposits that were transferrable.
Why would people leave money with them? Well you can imagine a businessman who is doing business in a city which was not his home city, being paid in the local coins, but he wanted to take home the coins of his home city, saying to the money changer:
Look I´ve collected this much money during my business today, I don´t want to carry it around with me. I´ll leave it with you. I´ll come back at the end of the week and then we can trade it, you can pay me in the coins from my home city, which I can then take home. So they left money on account with money changers, and then these accounts began more permanent.
If I was traveling from Geneva to Milan every month, it would be convenient to have some money waiting for me in Milan, some local Milanese money. So they became the bankers, the deposit takers.
In England, the goldsmiths played this role of basically storing money for people, providing safe keeping for their money, and later moving into the business of making these deposits transferrable. Why would people want their deposits to be transferrable?
You don't need that strictly, if you want to make payments with coin, you go back to the depository, take your coins out. So, if Alice wants to pay Bob a hundred dollars, she can go to the bank, take out a hundred dollars in coin, put it in her wheel barrel there, take it across town and give it to Bob.
Bob says, thank you very much. He might count the coins, he might weight the coins if he´s not sure; he might test the coins to make sure there is really a hundred dollars worth of silver in them, and then, he´ll take them back to the bank; and let's assume they have accounts at the same bank, and put them back in the bank vault.
Well, there´s a lot of unnecessary toing and froing, there´s a lot of unnecessary transportation, and a lot of unnecessary weighing and measuring of the coins.
It doesn´t take too much genius for Alice and Bob to say: "hey, let´s meet at the banker´s office, then we don't need the wheel barrel, we don't incur the risk of walking through town with a wheel barrel full of coins, we don't have to go through the hassle of weighing them, let's just say to the banker: look, transfer a hundred dollars from Alice's account to Bob's account, and then we´re done.
We don´t even, well, there could be an intermediate step, they could say: well, let´s take out the coins and then put them right back in;but we don´t even need to take the coins out, because at the end of the day, Bob is trusting the banker to store the coins for him, and so, we can leave the coins in the vault, and just record the transaction on the bankers account book.
At the end of the day, Alice's account has gone down by a hundred dollars; Bob's has gone up by a hundred dollars. We don't need to take the coins out and look at them.
And so, when that stage is reached it´s much more convenient for Alice and Bob, but notice what´s happened, the payment has no longer been made in coins; it´s been made in claims to coins, it´s been made in bank liabilities. What´s changed hands is not coins but claims to coins.
IOUs issued by the banker and the subsequent history of payments through banks is simply one of developing more convenient ways, to signal to the banker, that you want to make a transfer from one account balance to another. So in making these transfers, not using the coins themselves, you´ve got lower transportation costs and you´ve got greater uniformity.
And one of the great services that medieval bankers performed in this world where the coins themselves were not trustworthy, was to denominate their accounts not in the names of coins, not in dockets and florins, but in pure weight units of silver.
The medieval historians have a quite mysterious name for these pure weight units, that were not physically embodied in actual coins; they called them Ghost Monies. It sounds very mysterious and spooky.
But all it meant was a pure weight unit. And sob it was ounces of silver that were transferred, not dockets or florins or dollars. But that was a great advance and indicates that people want A more uniform money, and the bankers provided the service to denominate accounts in a perfectly uniform unit.
The problem of meeting at the banker´s office is that it may be inconvenient for both parties to meet at the same time, so if the banker will allow it, let´s just have Alice write out on a slip of paper: I authorize the transfer of a hundred dollars from my account to Bob's.
That´s known as a check; Alice gives it to Bob, Bob takes it to the banker, the banker checks the signature against Alice's signature on file, and only one person has to visit the bank.
In a giro transfer, Alice visits the bank instead of Bob, and Bob knows he´s been paid when it shows up in his account. In electronics funds transfer, again the person making the payment, signals to the banker but doesn´t even have to visit the banker, he can do it remotely.
And so, remote instantaneous deposit transfer becomes possible when the electric telegraph is invented, in fact, wiring money is one of the important applications for early telegraphs.
A lot of their business came from setting up telegraph machines inside bank offices so that money could be transferred instantaneously from place to place. And when I say money, I don't mean the coins went down the wire, I meant that claims on bankers were transferred.
So, the modern terminology is that we have digital money, well, we´ve had money represented by digits, since 1200 a.D.; there are digits on the bank's balance sheet. They´re kept in ink, but it doesn´t really matter whether they´re in ink or in pixels. It´s money that is not itself physical but is a claim on a financial institution.
Banks developed another kind of bank issued money, other than deposits, and that´s banknotes, or bank issued currency. Here are some examples that are currently circulating in Northern Ireland, but I could´ve put up pictures of nineteenth century banknotes; those were the predominant means of payment in the nineteenth century.
More than half of bank liabilities were in the form of currency rather than deposit balances. When people got paid, they got paid in envelops full of banknotes, and the great advantage of this kind of bank issued currency, was that you didn´t have to have a bank account to use it; and the transfer could take place without signaling the banker at all, completely outside the bankers knowledge the banknotes could change hands.
Alice simply hands them over to Bob, so nobody has to visit the bank; that´s convenient. And they became a very convenient substitute for handing over coin, because they´re more portable, and in a place where coins are not so trustworthy;
banknotes are more trustworthy, that they are backed by the amount of silver they claim to be backed by, when the coin you can´t really be sure that has the amount of silver that´s supposed to have in it.
In recent years, there´s been a narrow, very close replication of bank issued currency. In the smart cards that were developed by a firm called Mondex and later sold to NatWest.
A question that´s often raised if you think of a system in which you have two dozen banks and each bank is issuing its own brand of currency; here is an example from Scotland, these are currently, well actually a few years out of date; but there are still three banks that are allowed to issue currency in Scotland, the Bank of Scotland, The Royal Bank of Scotland, and Clydesdale Bank.
The question is often raised as if you have two dozen banks, issuing their own brands of currency, won´t that be a complete nightmare for the public, won´t that be a headache to keep track of the exchange rates between two dozen different banks? And the answer is: you won´t have to.
There was the case in the United States that banknotes would fall to discount when they left the immediate neighborhood of the bank that issued them, and that was a problem, but that´s not the natural market outcome.
That occurred only because the banks in the United States were very heavily restricted, they were not allowed to set up branches in other cities to redeem their own banknotes that had been issued in the first city.
It´s because it´s such a hassle for consumers to have banknotes that changed values depending on where you are, it´s bad for the bank's business. If a bank could come up with a way of making its money acceptable at par value throughout the economy,
they could get a lot more customers. So, banks were very keen to figure out how to do that. Just as American Express for its traveler's checks. That´s another ancient technology that you may´ve heard about from your grandparents. American express was very diligent iabout setting up offices throughout the world to make sure that its traveler's checks are accepted at face value.
So, commercial banks were there first, and they developed, they discovered sometimes indirectly, that it was in their interest to make sure that their notes were accepted and their checks were accepted at their face value.
That is, if there was a hundred dollar bank note, you could get a hundred dollars for it and not ninety-five dollars; you wouldn´t have to pay a fee or a discount to get it accepted by another bank.
The most direct way they did this, was they had a treaty from one bank to another, so bank A would say to bank B, I´ll accept your notes at face value, for your customers if you´ll accept notes from our customers at face value.
And why would I be doing you that favor? Because you´re doing me that favor and we can both increase the attractiveness of our notes in that way.It´s the same story that led to ATM networks, the Automatic Teller Machines, accepting cards from other banks.
There was no law that forced banks to give access to other banks´ customers, to their cash. They did it because, if my cards, if I´m a small bank and I only have three automatic teller machines, I´m going to have a hard time attracting customers.
If I can get another bank to agree to accept my customers´ cards,I can increase the attractiveness of putting your deposit in my bank. And so, banks form these networks as a way of increasing the attractiveness of their deposit accounts.
There were a couple of other way banks sort of stumbled into this. In Boston, there was this famous bank called the Suffolk Bank, which had the great idea when they say notes from out of town banks circulating at a discount in Boston.
They saw no changers buying them and earnings fees by purchasing them for ninety-five cents on the dollar, the Suffolk Bank said, well, we can do that, we can purchase them with our own notes and doing that will suck all the other notes out of circulation, replace them with our notes and we´ll soon have a much bigger share of the market for banknotes.
What they didn´t realize was that by buying out-of-town notes at closer to their par value, and competition eventually raised the price to no discount at all, hundred cents on the dollar, they made it more attractive for people to carry out-of- town banknotes into Boston, and so it was good for the out-of-town bank as well as for the Suffolk Bank.
The other story and this is the amusing story about Scottish bankers.
When the second bank in Scotland, the Royal Bank of Scotland, was founded, the first bank, the Bank of Scotland, which was the only bank in town said - we refuse to have anything to do with this upstart bank, we´re not going to accept its notes, if you want to make a deposit with us, you have to bring us our own notes or you have to bring us silver coin.-
The Royal Bank didn´t really have that choice and they said: - sure, we´ll accept deposits in the Bank of Scotland notes, or silver-and they did a very sneaky thing; when people made deposits in Bank of Scotland notes, they accumulated them, they let them pile up.
Maybe you can see where this is heading, they let them pile up, and they let them pile up for several weeks, then they borrowed Alices wheel barrel. They carried all the notes over to the Bank of Scotland, dumped them in a big pile on the counter, and said: - pay to the bearer on demand please.-
The Bank of Scotland had not seen this coming, they´d never had so many notes presented for redemption in one day, they ran out of silver.
They tried to delay the whole thing. They hired their most incompetent janitor to do the counting of the coin and they told him to knock over the pile of coins every so often, but eventually they ran out of coin, they were embarrassed, they had to put out a sign, No more silver today. Then, the Royal Bank could advertise - we are the only bank that pays silver,- so it worked.
But, once the Bank of Scotland saw this strategy being played against them, they said: - well, two can play at that game-,that´s when it became a duel. So, they collected Royal Bank of Scotland notes, they were happy to accept them at par, and they staged the rate on the Royal Bank every so often.
But when both banks know this is happening, it´s not going to work, all it does is force both banks to hold much bigger silver reserves, and eventually, they realize -we´re not driving the other guy out of business, we´re just making business more costly for both of us-, why don't we get together every day and swap the notes we´ve collected instead of trying to embarrass each other?
And that´s the origin of the clearing house in Edinburgh, but they continued to receive each others notes at par, so that they had something to bring to the next clearing session.
So, these kinds of gains from par acceptance aren´t exhausted until all the banks are members of the agreement. And that´s what you see in banking systems in the nineteenth century as, at least, as soon as railroads linked the entire country, you get nation-wide par acceptance, Canada being the biggest country where you see this.
But not in the United States, only because the United States does not allow branch banking across the nation, Canada does. And of course, ATM networks today are worldwide, so you no longer need to buy American Express Traveler's Checks, you just take your ATM card wherever you go and get currency that way.
So bank notes do circulate at par throughout the clearing networks, and the clearing networks extend as far as the law will allow. So, throughout Scotland, Canada, and Sweden are three good examples, and New England where the Suffolk Bank establishes a clearing system.
So, what I see is the naturally evolved banking system is one where the basic and definitive money is some unit of coin, silver or gold or specie, in the term pirates used to like to use. The unit of account is some amount of silver or gold, but people don't typically make retail payments in coins, it´s more convenient to use-bank issued currency, as long as you can trust the banks.
And I'll talk tomorrow about whether you can trust the banks, whether this is a safe system. The banks will not come up with their own units, they´ll denominate their monies in the coins to which they are claims.
And we can expect that the bank-issued money will be widely accepted at its face value, so no fluctuating exchange rates among banks, all the banks being linked into a clearing network, and that´s where we see where the law allowed.
Now, I want to say a little about how the monetary system regulates itself when it´s based on gold or silver, so the way, the thing an economist usually asks, is what determines the price level in this system.
If you measure the price level in ounces of gold, if you have some natural unit of gold; let´s say, as the unit in which people keep prices, then it´s very simple, it´s just how many ounces of gold does it take to buy a representative basket of goods. But often there´s some other unit that´s concocted.
A dollar was originally a silver coin issued in Germany, it was a particularly trustworthy mint that issued it, so it became a popular unit, in the New World the Spanish silver dollar as minted in Mexico, became the most widely accepted coin in North America.
So, if you´re measuring prices in dollars, then you need to translate that into units of silver or gold, so you need to know how many dollars per ounce of gold, if it´s a gold standard. So that´s R dollars per ounce of gold, and then multiply that by how many ounces of gold it takes to buy a basket of goods.
So the first ratio is not a price, although it´s sometimes called the official price of gold in dollars, it´s really just a definition. How are we defining the dollar, how many ounces of gold does a dollar contain?
The second ratio is a price, it´s the relative price of gold in terms of other goods. So the inverse of that, basket of goods per ounce of gold, you can call the purchasing power of gold. And that´s a useful concept because it gives us something to put on the vertical axis of the supply and demand diagrams.
So, that purchasing power of gold is determined by market forces, it´s a price, a relative price, it´s determined by the supply and demand for gold. So, supply and demand for gold is what ultimately determines the value of a monetary unit or, inversely, the price level.
So in a small open economy, it´s very simple, we can think of the supply curve for gold being flat if you are willing to pay more in goods for an ounce of gold, you can have all the gold you want in a world where arbitrage is operating perfectly.
Now, of course, in practice it is a little bit costly to ship gold and to ship goods in another direction. But in the limit we can think of a case where for the small economy for a city, say, they don't really have much leeway and the purchasing power of gold would be the same there as any surrounding economy.
But for the world as a whole, that can´t be true, the supply curve can´t be flat, because the world as a whole can´t import gold from anywhere, but has to produce it. So, for the world as a whole, we need an upward sloping supply curve. And, why have I got two diagrams? Because, there are two dimensions to the production and to the demand for money.
When we think about people demanding money, it´s money to hold. If you ask, what´s the quantity of money in the economy? It´s so many dollars or so many quetzales at a point in time, it´s not a flow, it´s a stock.
So, we need to keep track of the stock supply and the stock demand to hold that money, but money being produced by the mining industry is in ounces per year; it´s a flow. So we´ve got a flow dimension and a stock dimension that makes it a little bit complicated. We can start the whole reason for drawing supply and demand diagrams is to shift them to see what happens.
But we want to start in an equilibrium where both markets are clearing at the same purchasing power of gold and what that means is that you can take gold out of you mine, and take it to a mint and have it coined. And conversely, if you want to use gold for industrial purposes, you can melt down your coins.
And so, the same prices should prevail in the flow market where the supply curve represents gold coming out of the mines, more gold will be mined at a higher purchasing power per ounce, and the demand curve downward sloping is for industrial uses of gold.
And at a higher purchasing power, people will use substitutes for gold to make jewelry, to make electric circuits, candlesticks, whatever gold is being used for. So there´s some purchasing power of gold that equates the amount of gold being produced to the amount of gold being taken up for industrial purposes.
At the same time, in the market for monetary gold, there´s an upward sloping supply because at any point in time we can convert some jewelry into money, if people want to.
And at a higher purchasing power of gold, it becomes more expensive to hang on to gold candlesticks. Some people will melt them down to convert them to money. And the demand curve is downward sloping, because if each unit of money buys more, you don´t need so many units to accomplish your transactions.
So in fact, I´ve given it this curvature, which represents that what people care about is the purchasing power ofr their money balances, not how many units are in them.
So, if that´s our staring point, what happens if there´s an increase in the demand to hold money? So, that might happen if suddenly a large country joins the gold standard.
So this country now wants to replace all its silver coins with gold coins; they need to buy a lot of gold in the world market, so the demand curve for monetary gold shifts to the right, so we go from curve one to curve two,
the equilibrium goes from here to here. The purchasing power of gold is going to rise as a result of this increased demand but what I´m going to show you is that this is not a permanent effect.
Eventually, the increase in demand will be satisfied by an increase in the quantity of gold, and the purchasing power of gold will return to its old value. So, the second stage, is that the purchasing power of gold rises to equilibrium point two, but now when we go over to the flow market, we no longer have all the gold being mined, being taken up for industrial purposes.
Now, there´s an increased flow of gold coming out of the mines, it pays to dig a little deeper when the purchasing power is higher, but a reduced quantity being demanded for industrial purposes, it pays to switch to substitutes, to use other metals.
And so, there´s a gap there, that I´ve labeled GM. That´s the flow of gold out of the mines, that´s not being used up for industrial purposes, where can it go?
It can be taken to the mint. It can be turned into coins. But that can´t be the end of the story because if it´s being turned into coins, that´s going to make the stock supply of gold shift.
So, this supply curve is going to start shifting to the right as coins are accumulating, out of the excess mine production, how far is it going to shift? Well, it´s going to keep shifting as long as there´s a gap here, but as it shifts, the purchasing power of gold is going to start to fall, the gap remains until the purchasing power of gold falls back to the original starting point.
So the final equilibrium is at point three, where the entire increase in the demand to hold gold has been satisfied by increase production of gold, and the purchasing power of gold returns to its original level.
So that´s kind of remarkable what it illustrates is that there´s a self stabilizing property to a commodity money, that an increase in demand will not permanently affect the purchasing power of money, but the purchasing power of money has a long-run stable path.
And this of course is something that was often touted by the proponents of a gold standard. It has an anchor built into it. The purchasing power of gold does not drift all over the place because it´s determined by the economics of mining.
So, the initial change in the purchasing power of gold is reversed in the long-run by the increase supply produced by mining. And so that´s the price level stabilizing property of a gold standard.
Now, the same is not true, if there´s a shift in the flow market, because what pulled us back to the initial purchasing power of gold, was that the flow supply and demand curved had not shifted, but what if they shift?
This is the worry, traditional worry of opponents of the gold standard. You´re leaving the purchasing power of money to the accidents of the gold mining industry. So suppose there is a shock, suppose we discover a new less expensive place to produce gold.
Suppose we discover gold in California, which we hadn´t known about before. That can have a permanent impact on the purchasing power of gold, so there is potentially a vulnerability of the price level to supply shocks and that´ been a traditional argument of critics.
Now it becomes a historical question: how big were these shocks? how big would we expect them to be in the future? Well, the biggest supply shift in history was the California Gold Rush, when it first was recognized, a French economist named Chevalier
said: "wow, this is going to cut down the value of money in half; the purchasing power of gold is going to drop by half when all this new gold accumulates".
So, he had seen the flow rate at which it was being produced. Just a few years later, the famous economist William Stanley Jevons, -he had to develop price indexes for this purpose, this was the first purpose for which price indexes were developed-, said well let's measure what actually happened to the purchasing power of gold.
And his estimate was that in the 15years since 1849, or I guess 14 years by 1863, the value had only dropped about somewhere between 9 and 15%; so, about 1% a year was the inflation due to the biggest gold supply shock in history.
Not such a big deal. You may go back and say well, we can go further back into history to the discovery of the New World; and there too, the effect on prices in the Old World, from the gold and silver being produced and looted from the New World, was a little less than 1% percent a year so by modern standards, hardly noticeable.
By the standards of a world that was accustomed to absolutely stable prices, a price level that doubles in a century, is a revolution; and some economic historians call it the Price Revolution.
But, by the standards of modern fiat monies it was a very mild inflation and that´s the way Jevons described the California discovery, a few years after that. Jevons predicted that the accumulated drop would be 30%, even that turned out to be an overestimate.
Bajet, a few years later, found that the fall in the value of gold had actually bottomed-out just a year after Jevons made his prediction and at that point, growing demand in the world economy caught up with and began to outgrown the supply of gold coming from California; so, it wasn´t very long before the purchasing power of gold began to reverse itself.
So, if we look at the practice, if we look at level of the gold standard, the historical record of the gold standard in practice, we see much smaller variations in the price level, this is for the United States, up to Roosevelt's abandonment of the gold standard in 1933. After the dotted line the price level takes off, so it´s pretty clear that price level was much more stable under the gold standard, than it has been under what replaced it; under fiat money standards.
So, the great benefit of a commodity money standard, of a gold standard in particular, is that expected inflation is very close to zero. In a paper by Roenick and Weber, they tried to average over many countries and many decades what was the average rate of inflation under gold and silver standards, and they came up with minus half a percent a year.
So gold tended to appreciate very slowly, probably because gold mines tend to be depleted over time. So, it becomes a little bit more costly each year to dig it out.
They compared it to fiat money episodes and came up with six and half percent a year, but that´s a very conservative estimate because they had to exclude cases of very high inflation, hyperinflation.
And if you have several episodes of 6 and a-half percent inflation and toss in one episode of 10,000% inflation, it excuses the whole average.
So, excluding those, fiat money inflation rates were higher. Now, they have since come down, central banks have been a little less inflationary than 6 and a half percent per year in recent years.
But it´s clear that looking at the long historical record, the cost of holding money to the money holder, was much lower under silver and gold standards.
If you ask, under which is the predictability of the price level greater? That turns out hard to measure in any direct way, depends on how you think people are forming their expectations, but one indirect measure, which I think is quite persuasive, is that under the gold standard, companies could issue 50-year bonds, even 100-year bonds.
The government of Great Britain famously issued perpetual bonds to refinance its debt; bonds which would only be paid the interest every year and never be retired.
The traditional objection to the gold standard has been that it´s costly. Why dig money out of the ground when you can use paper? Milton Friedman, famously made this argument, said "yes we like low inflation, but we can do it with paper money if we will manage it properly".
He later became a little more skeptical about whether if you gave a central bank the right to issue money it would obey any kind of limit you tried to place on it. But back in the 50s he produced this estimate of the resource cost.
He said we want to know how much the change in the gold stock, that´s Delta G, the growth in gold, the mining every year, will consume of national income, that´s Y.
And he had a very clever way of estimating it, he said: let's figure out the ratio of new gold to money growth, let's figure out the implied rate of money growth, if we think the purchasing power of money is going to remain constant, and let's figure how much money we need relative to national income or how much money people demand to hold.
Plug in numbers for those and we can estimate the cost.Now, I´ve changed Friedman's estimate a little bit because he, for some reason, assumed that the ratio of gold to M2 was 100%.
Which I think produces an over estimate. If you look at the reserve ratios, banks have historically been able to hold, it´s closer to 2% against the broad measures of bank liabilities, so if we plug that in, we get a monetary gold production each year amounting to five one hundredths of one percent of national product.
So, there is a resource cost, but it´s pretty small. Compared to what? What you would like to compare it to is the resource cost of a fiat money standard and the resource cost there, is not the paper and ink, it´s the inflation.
So, if we try to estimate the resource cost of holding money when it´s inflating at 6 and a-half percent a year, and compare it to the resource cost, the burden imposed on money holders by this tax of their money melting away, the standard way of doing that, we get a figure much bigger than the resource cost of a gold standard.
So, just from a very utilitarian stand point, a commodity money system can be rationalized, can be justified, as a less costly monetary system.
Or to put it in other way, there´s some threshold in which fiat money isn´t worth it, and the threshold may be somewhere, depending on how you estimate the resource cost, somewhere around 4% inflation.
So, if you are not confident that you can hold your central bank to 4% inflation, then you might want to adopt some external currency and this explains why countries that have had a poor track record, have found it worthwhile to adopt official dollarization; it´s less costly.
The value of any goods or service is measured as a function of its marginal utility to its users, and there is a nice example of that, that I want you to comment on; in the year 106 before Christ, the Roman Republic decided for the first time to pay their citizens, the voluntary army of Romans, some money for their services in battle.
So, the Roman army became suddenly a professional army, had been a volunteer army. And, at that time, the Romans had been for centuries minting coins of gold, silver, and copper.
So, we can assume that anybody at that time, if they were offered to be paid for some service or value, would prefer gold or silver, let´s say; but the Roman soldiers did not want gold or silver, they wanted bags of salt.
Because in remote battlefields, a bag of salt was far more useful than any other amount of silver or gold they had at their disposal at the moment. So, it means that the so-called intrinsic value of a commodity like gold or silver is not that intrinsic, it´s extrinsic.
It´s for a solider in the battlefield, gold and silver are of very little use, but salt is very important. From that word, by the way, sal comes the word salary. So, are there any intrinsic values then, in any money?
No, I completely agree with you and this example is one reason I use salt as my example of a medium of exchange, early on. But, the only place I used the word intrinsic was with regard to to the properties of money, not the value of money; and, if you look carefully, you´ll notice I put it in quotation marks; by which I meant, so-called intrinsic properties.
There are physical properties, to a commodity, and we can call those intrinsic. The fact that absolutely pure refined gold is uniform is an intrinsic property because it´s an element.
Every piece of pure gold is like every other piece of pure gold. But portability, which was one of my qualities, is not even intrinsic because it´s a ratio of value to bulk, and value is not intrinsic, it´s the estimation of the market place.
So, even these properties that contribute to the convenience of using particular commodities are not all chemical properties, not intrinsic in that way, in some respects they´re market based.
So, I completely agree with you in regard to value, value ias a result of valuation by people in the market place, is not any direct result of the chemical properties of the good under consideration.
When people talk of intrinsic value of a monetary commodity, they mean that it has a non-monetary use; that apart from its monetary value it has a practical use that is nonmonetary.
Okay, there´s a better way to express that idea, it´s... call it a commodity. The commodity means that it has some use, apart from its use as money. But the value, of course, is determined by the value that people place on that use of that commodity.
What would happen with the volatility of the price of gold, because the gold is a price too, so we adopt the volatility of the price of the gold as the price of our currency?
A second question is: the gold standard has to be adopted by all the world to function well, what would induce the Bank of Japan, Bank of England, Bank of Canada, that have relatively low inflation rates in the last twenty years, to adopt that gold standard.
Then what would happen with an oil shock in the gold standard? We will have higher prices because we have oil shock, is that right? It is a question.
You´ve pointed to a very important issue, which is now that we have demonetized gold; gold has become very volatile in price.
When gold was the monetary standard throughout the world, it was not volatile in purchasing power because it was a very deep and broad reservoir of demand to use it for monetary purposes.
Now, when people speculate about the inflation rate on the dollar, they buy and sell gold and so create that volatility in the value of gold.
But, given that that´s the situation we´re now in, it is more difficult to resume the gold standard because any one country that went first, in adopting the gold standard, would not have a very big stabilizing effect on its value and so it would be subject to this kind of volatility.
I wrote a piece for the Cato Institute, about a year and a half ago, which they gave the title: Is the gold standard still the gold standard among monetary institutions?
We have this expression, the gold standard meaning the highest quality,and so they wanted to give the title to this essay: Is the gold standard still the gold standard? I thought that was just a little bit too obscure.
Gold standard among monetary systems and there I tried to deal with all the objections people have offered to the gold standard; but, I saved for last the objection you´ve raised which I think it´s considerable, which is there is a re-entry problem, we wouldn´t get all the advantages unless everybody rejoined the gold standadrd.
Or to put it in other way; the benefits would be greater, the more countries sign on. So, how we´re going to do that, I´m not sure. I don't have any great faith that the United Nations or the OECD is going to decide thet they´d rather give up their monetary powers or that the individual central banks are going to give up their monetary powers.
One possibility is that a parallel gold standard will develop, so that people... in a way, I hope this doesn´t happen, because it´s only plausible that it will happen in fiat currencies become really unstable.
People will abandon the currency they´re accustomed to if it becomes unstable enough. We see spontaneous dollarization in countries with high inflation, but there is that possibility.
And so to make it as painless as possible, we should repeal any legal restrictions that prevent people in dealing in gold or silver or foreign currencies, so the transition can be as smooth as possible.
But, as far as they´re being sort of worldwide conventions to return to the gold standard, I can only imagine that a situation in which the current system completely breaks down into really raging inflation, it´s not impossible.
I hope it doesn't happen, but there is no... the only thing that prevents is the wisdom of central bankers, and you can decide for yourself how much faith to place in the wisdom of central bankers.
Most of the money now is private, in the world...
-it always has been-
...and the multiplication of the money before the crisis increased the prices in the real estate and other goods, so the gold standard is not a guarantee about low inflation, if most of the money can be multiplied by financial institutions, am I right?
There are strict limits imposed on financial institutions, imposed on banks, as to how much money they can create, on a given base of gold reserves, and so that´s what will restrain inflation.
And we look at the historical record of the gold standard, there was private issue of money back then, and banks were under much less regulation than they are now.
Banks had no reserve requirements; and yet, you didn't have explosions of hyperinflation in banking systems where banks were completely free to issue money. And the reason is, they were restrained by their obligation to redeem their liabilities in gold.
And the legal system would enforce those obligations. So, they had to be very circumspect in how much money they created. And that restrained the over issue of money.
You show a graphic that has a dot in the middle and marks the inflation and then how it went up, my question is this; does the fiat money you talk, that it is used now in the United States is violating the rights of the United States´ people?
So, does fiat money violate the rights of the people? Well, in the transition from gold to fiat money people´s rights were certainly violated.
People had written, had contracts with their bankers that said they were entitled to be paid back in gold and the government stepped in and said to the banks: " you may not fulfill that contract".
People had bonds that entitled them to repayment in dollars in an amount equivalent in purchasing power to the gold, at the time they wrote the contract, the so-called Gold Clauses, so the repayment was indexed if the government devalued the dollar against gold you had to repay more dollars, and the U.S government simply abrogated those contracts. So, people´s rights were certainly violated in that transition.
I don't know if it is a violation of rights beyond that, but certainly it´s a tax that when inflation is created by issuing more money, that means the money in your pocket is worth less and less each year; so, if taxes are a violation of rights, then that´s a violation of rights. Is there something else you had in mind?
Yeah, if that change in the system was unconstitutional?
It was definitely unconstitutional according to the U.S. Constitution. The U.S. Constitution recognizes only a gold and silver standard. And my former colleague Richard Timberlake has a very interesting short monograph called Gold-greenbacks in the Constitution, in which he details how the Supreme Court, during the civil, war when it was called upon to make the constitutionality of the green backs.
The on-backed money issue during the war, simply made up rationale excuses for declaring this money constitutional when it was clearly unconstitutional. Thank you.
In this conference, Lawrence H. White thoroughly examines the evolution of money and monetary institutions. He also explains how the monetary system regulates itself when it is based on gold or silver.
During the lecture, White looks at the increasingly efficient ways of exchanging goods that evolved throughout history until eventually precious metals became a commonly accepted medium of exchange. He then traces the history of coinage and bank deposits and describes how banking systems with networks of facilities to ensure secure transactions around the globe developed. The implications of government versus privately issued currency are also analyzed. White examines gold, in particular the use of the gold standard. Finally, he looks at the benefits of adopting the gold standard once again.
Versión en español La evolución de las instituciones monetarias
Nuestra misión es la enseñanza y difusión de los principios éticos, jurídicos y económicos de una sociedad de personas libres y responsables.
Universidad Francisco Marroquín