Paper and Promise, Part 1
by James Turk,
The Daily Reckoning
Date: October 17, 2006
Pick up any introductory economics text, and you'll see money definned as something that performs three functions:
- A standard of value - that is, a generally agreed-upon measurement used to express the price of goods and services.
- A store of value, which holds its purchasing power over long periods of time, to allow people to save and thereby defer their spending until some future date.
- A medium of exchange, which is easily transferred from one person to another in return for goods and services.
This is an acceptable definition, as far as it goes. But a deeper understanding of money is possible when you think of it as a communications medium....
Just as a given word means the same thing over years and centuries, allowing language to convey ideas from one generation to the next, money communicates the measurement of wealth. A gram of gold is an unchanging unit of account, like an inch or a meter. It conveys meaningful knowledge by how much it has purchased over time. A gram of gold has bought roughly the same amount of wheat since the Middle Ages, for instance.
When a unit of account is unchanging (again, think of inches or meters, which refer to the same lengths from one year to the next), the money based on it is "sound." That is, it effectively communicates wealth over time. As you'll see in the next couple of chapters, for 200 years the British pound was sound because each unit of currency was, throughout this period, defined as 0.2354 troy ounces of gold. And the U.S. dollar was sound from 1900 to 1933 when it was defined as 23.22 grains of fine gold. These currencies were simply names for given weights of gold.
Today's dollar, on the other hand, is emphatically not sound, because it isn't defined in any unchanging way. A dollar isn't a weight of gold, sliver, or anything else. It's simply a bookkeeping entry, an IOU of the banks that are permitted by the U.S. government to create dollars....
Currency, meanwhile, is the physical representation of money, the item that passes from hand to hand in return for goods and services. When it takes the form of society's standard of value, as with gold and silver coins (or, as you'll learn shortly, older forms of money like goats and slaves), currency is also money. When it takes the form of, say, paper notes, currency is not money but a "money substitute." And if a currency is not defined in terms of money, but is created and controlled by a national government, it is a "fiat" currency, so called because it exists by government fiat, or decree....
Why does gold - or any other successful money - hold its value?... It is money, which is accumulated, not consumed like other commodities. As such, its value depends on our belief in its ability to function as money. We trust sound money because it exists in limited supply and is, by definition, not subject to government manipulation.
Fiat currencies, in contrast, are controlled by governments, which are, as you now know, fundamentally incapable of managing their monetary affairs....
Once established as humanity's money of choice, gold came to be synonymous with wealth and power,...
Eventually, however, the imperfections of gold and silver money became a problem. Metal coins were too noisy and bulky to be practical in large denominations. They also wore out over time, eroding a small but significant part of an economy's wealth. So in the 1690s, the founders of the Bank of England - destined to become the world's dominant bank over the next two centuries - had an epiphany: Instead of letting gold and silver coins circulate, why not lock them in a vault and issue paper notes to be used in the coins' place? The bank began issuing paper "pounds" with the promise that they could be redeemed at any time for pound coins composed of gold or silver....
The result was a conceptual breakthrough: the first widely circulated money substitute.... Soon, much of England's money, in the form of gold and silver, sat in the Bank of England's vault, while its currency, now a liability (or IOU) of the Bank, circulated as bits of paper.
The honeymoon lasted for about three years, during which time the citizenry was happy to carry around light, quiet pound notes. But it soon became clear - in a process destined to be repeated many times in later centuries - that the monetary authorities were issuing more paper than was backed by the gold and silver in their vaults. In one of history's first bank runs, holders of pounds rushed to convert paper into metal, and the system careened toward failure. In desperation, King William III appointed his resident genius, Sir Isaac Newton, Master of the Mint in 1699.... He recognized that paper currency was an important innovation, but also that it wasn’t money. Putting bureaucrats in charge of the printing presses would therefore lead to disaster.
To be viable, paper currency needed an external standard by which it could be measured and controlled. So Newton defined the pound as a precise weight of gold and linked the amount of paper money outstanding to the weight of gold in the Bank of England's vault (in the process dislodging silver, which until that time had been England's dominant form of money). Paper currency circulated as a substitute for money (i.e., gold), while gold provided the standard by which the value of paper currency was measured. Linking gold to bank-issued currency came to be known as the classical gold standard. And notwithstanding the occasional war-related interruption, it would serve the British Empire well for two centuries.
The above information has been redacted from the article as it originally appeared on TheDailyReckoning.com on October 17, 2006.
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