Honest Money?

“Honest money” is a phrase bandied about as a self-evident truth. As the accompanying graph indicates, its incidence coincides with the heyday of the gold standard. As such, it is the pithy summary of a strongly-held view on the nature of money, which at the time of the gold standard had a highly political charge. The only honest money was gold.

Incidence of the usage of the phrase “honest money” in books, 1800-2000. Source: Google Books Ngram Viewer

As an example, Stanley Waterloo’s Honest Money: “Coin’s” Fallacies Exposed, published in 1895. Here, silver currency is made out to be a dishonest con game: “The Silverite Argument: 1/2=1.”

Modern defenders of “honest money” are not as fastidious. In this, they have forgotten, or at least laid to one side, the controversy of the 19th century as to gold versus silver. Nowadays, according to a leading proponent of this doctrine,[1] honest money is metallic money, preferably gold, but also silver; the only honest money is either a coinage of pure gold or silver composition, or a paper issue 100% backed by such money metal; banks that do not adhere to this are a fraud; the state has no role to play here except enforcement of contracts.

The role of the state is reduced, because honest money is commodity money. In the jargon of the economic historians, money is the “most marketable commodity.” It has developed from the give-and-take of trade as the commodity, or form of merchandise, that proved to be most liquid, i.e., most current, most acceptable to any market participant, not as something directly desired, but as something that could be held and used at a later time in a later exchange.

Hence, the market takes care of money as a sort of automatic by-product. And, according to this version of events, silver and gold constituted the most marketable commodities.

The standard is weights and measures, as befits a commodity. This explains the biblical insistence on honest scales. The shekel, mentioned in the Bible as a unit of currency, was a unit of weight.

Coinage came in later on, as a means of simplifying matters. Instead of weighing out the money commodity for each transaction, coinage was developed in terms of standardized units, in various denominations, unvarying in each denomination, presumably with the weight stamped on each exemplar by way of convenience.

Presumably – because in actual fact, there is no historical example of a coinage stamped with its weight, the way a modern ingot is. What’s more, this version of events is without basis in historical fact.

Not that money did not start out as commodity money. It did, only it did not function in the way the “honest money” proponents would have us believe. The earliest records show a functioning commodity system, but one entirely different from this. In ancient Mesopotamia, a commodity money system developed, but it was, primarily, barley that was the “most marketable commodity.” The barley standard seems to have developed out of the need to store and dispense barley by the cities of the Fertile Crescent, which were more or less autonomous and had to provide for their own citizens. This storage took place in the temples, and was centrally organized. Silver was the other mainstay in monetary transactions. It was used for more high-end and inter-local transactions, while barley was used for local, lower-end transactions.[2]

The important thing to note here is that these commodities were used as units of account. “The temples in Babylonia from the Ur III period through the Achaemenid period use barley like money, especially as a unit of account.”[3] A unit of account serves to facilitate transactions on paper, not actual hand-to-hand transactions. In other words, the commodity was stored away to serve as a basis for monetary transactions, while not actually changing hands. Here we see beginning to take shape before us the basis for the banking system that is the bane of the “honest money” proponents: fractional-reserve banking.

“These institutions were in a position to store grain. They needed it to feed their dependents, and it is clear that they could turn it rather easily into all sorts of other things they might need, ranging from labor-services to commodities.”[4] As Powell notes, the majority of the population was relatively poor and dependent upon these temples for work and sustenance. If payments were made in barley, these could be made on paper (actually, clay tablets) rather than in kind; and as such, they could be expanded far beyond the actual holdings. This in turn would feed indebtedness, which is what a fractional-reserve banking system generates.

The indebtedness is attested by the innumerable cuneiform tablets on which these transactions were recorded. And indebtedness led ineluctably to all manner of social oppression, up to and including debt slavery. This, in turn, led to “clean slate” legislation in which debts were cancelled, debtors were freed from slavery, confiscated lands were returned to the original owners. In fact, the first instance of the word “liberty” – the Sumerian amargi, used by Liberty Press as its logo – does not refer to liberty in the abstract, or to economic freedom, but to the very specific act of debt cancellation. “The term should not be translated vaguely as ‘liberty’ or ‘freedom’ in the abstract, but as an economic ‘Clean Slate.’”[5]

The point here is the one I made in my book Follow the Money: “This practice [of fractional-reserve banking] … follows in commodity-based banking’s wake” (p. 15). Commodities used as money do not circulate freely, at least not nearly as much as other commodities, and the more valuable they are, the less freely they circulate. In fact, they have a habit of disappearing from circulation. They wind up in temples or in chests or in vaults, and they circulate only among the very wealthy.  Abraham may have had 400 shekels of silver – “Abraham weighed to Ephron the silver, which he had named in the audience of the sons of Heth, four hundred shekels of silver, current money with the merchant” – but Abraham was a rich man, for a single shekel of silver was the equivalent of a laborer’s month’s wages.[6]

The biblical prohibition on interest needs to be understood in this context. North argues that the Old Testament does not outlaw the taking of interest. He does so by distinguishing between “usury” and “interest” as two different things. “The Hebrew word ‘usury’ was a term of criticism. Usury referred only to interest taken from a poor fellow believer, in other words, interest secured from a charitable loan. Such usury is prohibited by Biblical law. But interest as such isn’t prohibited.”[7] This suggests there are two words for the phenomenon of interest in the Old Testament, or that the word is used in two senses. This is not the case. There is only one word, and it used in only one sense: interest on loans, not just charitable loans but all loans. By the Law of Moses, any interest at all was illegal, at least to fellow Israelites.

How to understand this? The biblical prohibition on interest was part of a larger complex of institutions, such as the Jubilee, aimed at mitigating the effects of indebtedness. Abraham had been called from “Ur of the Chaldees,” one of the leading cities of “the Mesopotamian Way”; God called him to found a new nation, one that would be able to stand against these nefarious institutions and ward off their debilitating effects. The prohibition on interest was there to keep these institutions from gaining a foothold in Israel. Later on, the Phoenicians, through Jezebel, would introduce their land law into Israel and corrupt it from that end. But the prohibition on interest was intended to prevent Israel from falling under the sway of these foreign influences.

So the Old Testament, while not prohibiting commodity money, mitigated the effects of its use, for it is precisely this that the prohibition on interest provided. Honest money, indeed.

But one might object that this was an aberration. Commodity money as the basis of a fractional-reserve system is not at all what is intended (even though that is what the modern gold standard entailed); commodity money which circulates and/or which forms part of a warehouse-deposit banking system is.

This is problematic. For one thing, it flies in the face of recorded history. Coins valued at weight have hardly ever been able to sustain a circulation. They get removed from circulation precisely because there is no difference between the coin and the commodity. In order to keep coinage in circulation, the value of the coin has to be set at a level higher than its market (intrinsic) value, otherwise it will disappear. This is Gresham’s Law looked at from the other side: it is not that bad money drives out good, but that only “bad” money circulates at all. Which is why nearly all systems of coinage have been fiduciary. Contrary to popular belief, coinage was never a system established to make it easier for commodity money to function, with a coin’s weight stamped on it to simplify matters. Rather, it was established precisely to escape the system of commodity money with its accompanying inconveniences and injustices.[8]

There have been attempts to maintain an “intrinsic” value coinage. But what is clear from them is that their purpose was not to provide for a wide domestic circulation, but only for the upper levels of the economy, for high finance and international trade. During the Dutch Golden Age, for example, the Dutch produced what they called negotiepenningen, “trade pennies,” which were pure silver coins of a certain weight to facilitate trade. These were minted exclusively for international trade and were not meant for domestic circulation – hence the name. Similar examples are the Venetian ducat and the Florentine florin.

The greatest example of such a currency was the Byzantine solidus or bezant, a gold coin maintained for hundreds of years in Byzantium, minted at the rate originally set by Constantine: 72 coins per pound weight of gold. But this coin was part of an intricate system of coinage formed of three metals, copper, silver, and gold. The day-to-day economy ran on silver and copper; the upper reaches of the economy made use of gold. And the empire sacrificed prodigiously to maintain that gold coinage. The state strictly controlled trade to ensure that gold was not exported. It spent massive amounts of resources on gaining and maintaining gold mining regions. Tax rates were high to pay for all of these state activities, to control trade and maintain far-flung armies, all for the sake of maintaining the coinage. And economic development stagnated while economies in neighboring Islamic countries bounded forward: The Muslims, for their part, maintained a silver standard and reaped the benefits of it.

Now let’s suppose that we followed the hard money advocates’ advice and introduced a strictly commodity money based on the precious metals. And further, let’s suppose that we followed their advice and maintained this currency on a basis of strict 100% backing, i.e., without engaging in any fractional-reserve banking or making use of any sort of credit instruments that did not have a strict monetary backing. For one thing, this would call for a heavy dosage of state oversight to ensure that all transactions were conducted on the “up-and-up.” Credit would be eliminated, because credit intrinsically expands the money supply. No lending with the promise of money repayment could take place even on a personal basis, that did not have strict 100% monetary backing. For every such “credit transaction” would in essence expand the money supply. Even the corner grocer’s provision of groceries with a promise of repayment when the paycheck comes in, would be illegal and punishable.

So the state would be heavily involved in the administration of such a standard. But beyond that, it would mean an enduring and drastic deflation, with all the traumatic consequences of such a deflation. This is because the money supply, being limited to the amounts of precious metal that are available to be put into circulation, is by the nature of the case kept at a more or less constant level, while the broader economy, with its innovation, its new technologies, its expanding workforce, its expanding output and consumption, continually outstrips that circulation. With expanding goods and services and a constant money supply, the only direction for prices to go is down. And a deflationary environment is one in which spending collapses, consumption collapses, and everyone holds onto the money they have, to spend it only on things of pressing importance. That is the nature of a deflationary economy. The holders of precious metal would see their holdings appreciate in value daily, while those without such holdings would be left to the mercies of a contracting economy and the opportunities, or lack thereof, it affords.

The attraction of “honest,” i.e., market-based commodity money, is that it seems to be immune to the manipulations of dishonest actors, whether they be bankers, or merchants, or minters, or the state. But this is a mirage. Such an institution never has existed and probably never will. Money needs to be adaptable to the needs of the economy. The money supply needs to be capable of expansion. How that is to be achieved is another question, one which I answer in my oft-mentioned book Follow the Money, to which I refer the reader for further investigation.


 

[1] Gary North, Honest Money: The Biblical Blueprint for Money and Banking (Auburn, AL: The Ludwig von Mises Institute, 2011 [1986]).

[2] A helpful summary of Mesopotamian money can be found in Marvin A. Powell, “Money in Mesopotamia,” Journal of the Economic and Social History of the Orient, Vol. 39, No. 3 (1996), pp. 224-242.

[3] Powell, “Money in Mesopotamia,” p. 229.

[4] Powell, “Money in Mesopotamia,” p. 229.

[5] Michael Hudson, The Lost Tradition of Biblical Debt-Cancellation (New York: 1993), p. 16. Download here.

[6] Powell, “Money in Mesopotamia,” p. 229.

[7] North, Honest Money, pp. 81-82.

[8] My book Follow the Money contains much more on this topic.

Weighing the Gold Standard

Seeing as how the gold standard is a “money method”[1] by which all exchange value is made dependent upon the weight of a certain substance, viz., gold, it would seem appropriate to “weigh it up” to determine whether or not, “weighed in the balance,” it is “found wanting.”

Indeed, weight measurement was the standard of value during the period when the gold standard held sway, and that standard was gold by weight: the dollar was set at 23.22 grains of pure gold (a grain being 1/7000 of a pound), the pound sterling at 113 grains, the German mark at 6.146 grains, the French franc at 4.98 grains, etc. In this manner, all the currency systems of the countries that adhered to gold standard were bound together by gold. Gold served as the currencies of the world’s reserve currency. This is likewise the origin of the modern system of reserve currencies, but we reserve that discussion for another opportunity (I discuss reserve banking in more detail here).

The gold standard is considered to be, well, the gold standard of money methods. Its great attraction lies in the discipline it lays on governments to conduct a strict and balanced fiscal policy. It does this because it ostensibly takes monetary policy out of the hands of the state. I say “ostensibly,” because the reality is a bit more complicated than that, as we shall see. Nevertheless, the gold standard system came also to be known as the “automatic mechanism” precisely because it functioned without government interference, indeed without any interference at all, guided by a veritable invisible hand. Again, this was not entirely the reality, but not entirely a departure from reality, either.

So the gold standard took currency management away from the state. Prior to it, the state did manage the currency. And that state-run currency system had its roots far back in history.

To be precise: with the advent of coinage in ancient Lydia (western Anatolia) around 700 B.C., the state became the manager of the monetary system.[2] Prior to this there were systems of commodity money – the Old Testament, for instance, speaks of silver as currency (a shekel being a weight measure of silver), and both silver and barley were used as commodity money in ancient Mesopotamia. These were not state-run but purely market affairs. Coinage was introduced, not as a form of commodity money, but precisely to counteract commodity money, which at that time was intimately tied up with the institution of debt slavery. It was introduced to insulate the domestic economy from foreign hegemony. It thus likewise accompanied the rise of the Western concept of freedom in the Greek city-states: coinage was one of the means which enabled the Greeks to wrestle their freedom from the Eastern (Persian) hegemonic empires.

Rome carried on the Greek tradition of coinage and introduced it throughout its empire (“Shew me a penny. Whose image and superscription hath it? They answered and said, Caesar’s. And he said unto them, Render therefore unto Caesar the things which be Caesar’s, and unto God the things which be God’s” (Luke 20: 24-25).) In so doing, it established for posterity the tradition of state management of the money supply. All of the Western European kingdoms took over this Roman institution and applied it as they waxed into independent sovereign states. But this system had its drawbacks. It required precious metals, mainly silver but also, secondarily, gold, to function. And during the entire period of medieval and early modern times, these metals were in short supply. The money supplies of these countries were subject to the vagaries of that supply – mines exhausted here, mines discovered there, new techniques opening new areas up for mining, the demand for silver from the East, in particular India and China – all of these factors played a role in the relative abundance or scarcity of the raw material needed to make the circulation go.

Add to this the practice of competitive devaluations conducted between currency regions, and one can understand the preoccupation for the provision of a supply of metallic currency; a preoccupation which later ages looked upon disparagingly. They even had a name for it: “mercantilism.” But this was no idle preoccupation, for the entire economic circulation depended on the existence of a metallic coinage; nothing else enjoyed the common consent and confidence necessary for a circulating medium.

Coinage was thus a state-run affair, and when the gold standard came around to supplant it, it actually supplanted the regime of coinage entirely. Where the gold standard became established, there coinage dried up. Gold coins never enjoyed the circulation the great silver pieces did, such as the Spanish pieces of eight, which in fact formed the bulk of colonial America’s circulation. No, the system of the gold standard was based on an entirely different “money method”: that of credit and banking.

This may come as a shock to those advocating a return to the gold standard. The common image is that of a rock-solid metallic currency that cannot be manipulated. But the reality of the gold standard was that, under its regime, credit exploded. This was not a bad thing; in fact, it was the way the Industrial Revolution was financed, and without it, that revolution probably would not have materialized. Still, the gold standard engendered a massive increase in banking and credit-derived bank money.

In this system, gold did not circulate in the sense of changing hands. Rather, it was locked up in bank vaults and served as the basis for the structure of credit. It was thus the reserve that every bank needed in order to issue credit. Theoretically, for every dollar of credit the bank issued, it could back in gold. Practice was different: reserve ratios were maintained depending on the likelihood of “cash,” i.e., specie, withdrawals. A ratio of 1/3 was common, at least initially. But with the practice of reserve banking, by which banks deposited their gold holdings with other “reserve” banks, the basis shrank.

So it was under the regime of the gold standard that we obtained an ever more “elastic” money supply. This was reflected in the explosion of credit. Macleod used the following example (from England) to show how the money supply there had changed under the gold standard.[3] He used the finances of the Slater house as representative of commerce in general. For year 1856, this is how its income statement looked:

macleod1

As Macleod noted, “Gold did not enter into their operations to even so much as 2 per cent. And this may furnish a clue by which we may obtain a rough estimate of the amount of Credit.” If this is representative, then credit amounted to 50 times the amount of gold. “This Credit produces exactly the same effects, and affects Prices exactly as so much Gold: and it is through the excessive creation of this kind of Property that all Commercial Crises are brought about.” It is a warning similar to the one Walter Bagehot made in his classic work Lombard Street: the entire edifice of credit was being erected on an ever slimmer basis.

Macleod avers that this lay at the heart of the commercial crises that repeatedly afflicted the economies under the gold standard. But it was the working of the gold standard during the times when it functioned automatically, the way it was supposed to work, that engendered the misery and resentment that led to the rise of the labor movement, political agitation, and the ultimate demise of the system.

This came about because of how the system affected wages and prices, enterprise, and employment. The automatic mechanism functioned through gold flows, and gold flows determined the money supply. Where gold flowed into the economy, the money supply could expand; where it flowed out of the economy, the money supply was forced to contract.

These flows occurred not only within countries but between them, given the international character of the gold standard. When economies, including national economies, ran trade surpluses or deficits, gold flowed to the surplus country, expanding its money supply and fomenting economic activity. By the same token, gold flowed out of the deficit country, restricting the money supply and depressing economic activity. The result was deflation in wages and prices.

So the gold standard worked by allowing inflationary and deflationary swings to redress trade imbalances. This resolved the underlying imbalance, but at what price? Severe bouts of unemployment, and consumption- (and thus production-) killing deflation. Schumpeter, perhaps the most thoughtful and nuanced defender of the gold standard, argued that deflation was not necessarily a bad thing, when all prices and wages moved in sync. Theoretically this might be true, but in practice, deflation has always been traumatic.

In fact, the only benefactors under a regime of regular deflation are creditors. This dynamic gave rise to the so-called social question and the various labor movements, socialism, and communism which characterized the later 19th century’s political landscape. The political unrest behind these movements found increasing recognition in the expansion of the suffrage, which brought the labor movement into the midst of the political arena, and put the interest of the workers on a line with those of the creditors. As a result, a new political calculus came to hold sway – called “stabilization” – consisting in the pursuit of price and wage stability. From this point on, governments pursued policies that could provide this kind of stability.

What then of the gold standard’s automatic mechanism? After all, it was based on the inflation/deflation model of rebalancing, and this new political agenda worked at obvious cross purposes to such rebalancing. The answer is, it was paid lip service as an ideal but was increasingly undermined in practice, first at the edges, later at its heart.

The first concessions to the new agenda were social programs and labor legislation. While they may have alleviated the working class’s lot, they did nothing to solve the underlying problem – the trade imbalance – and in fact hindered its resolution by devoting resources to perpetuating the status quo. Old-school conservatives recognized in this the first signs of state encroachment on the private sector, and they were right.

Along with this came central bank intervention. At first this was small-scale; but after World War I, it became de rigueur. Central banks came to master the art of “open-market operations” to control interest rates and, hopefully, changes in the money supply. But what really broke things open was the policy known as sterilization. By this policy, the automatic mechanism was entirely short-circuited. Sterilization entailed the removal of gold from circulation in the real economy to keep it from affecting prices and wages. This was done in the name of stabilization, but it effectively kept the gold standard from performing its rebalancing function. The countries from which gold flowed remained in a constrained economic situation, while the countries to which gold flowed were kept from expanding. Instead, that money went into the financial market. This precipitated the great bull run on the stock market in the late 1920s which ended in the Great Crash. After this, the gold standard system fell apart: some countries continued to adhere to it, allowing it to constrain their money supplies, while other countries went off of it and saw their money supplies expand and some degree of prosperity return. In addition, this period saw the advent of massive social programs administered by government, which required some degree of government influence on monetary policy in order to gain adequate financing. This dependence by government upon monetary policy, and the popularity this enjoyed among the electorate, sealed the fate of the gold standard.

What are the lessons to be learned from this history?

  1. The gold standard in its historic form as “automatic mechanism” will never be introduced as long as the electorate is democratic, i.e., as long as universal suffrage is the rule;
  2. The gold standard is not a coinage-based but a bank- and credit-based system;
  3. If it is a hard-money, coinage-based system that people are after, then a silver rather than a gold standard would be more feasible. For centuries, silver formed the backbone of the currency system, and for good reason: it is available in sufficient quantities to form an everyday circulation. When the gold standard was introduced, it displaced coinage, which brought great hardship on common people, who suffered from the lack of a circulating medium fitted to their needs.

 


 

[1] The term is Joseph Schumpeter’s: see his Treatise on Money (here and here).

[2] For the historical background to the following discussion, see my book Follow the Money. For more on this entire discussion, one may also consult the accompanying introductory course in economics, which goes into more detail.

[3] The following is taken from Henry Dunning Macleod, The Elements of Economics (New York: D. Appleton and Co., 1881), vol. I, pp. 324-325.

Another Look at Quantitative Easing

In a previous post (“Quantitative Easing and Substitutionary Atonement”), I discussed some of the underlying philosophy of quantitative easing, the latest of the Fed’s attempts to “stimulate” the economy.

Quantitative easing, to recap, is the term for central bank purchases of assets on the open market.

The difference with traditional “open-market operations” is twofold.

Firstly, the purpose: open-market operations normally have interest-rate manipulation as their goal. The Fed maintains what is called the federal funds rate, which is the interest rate (yield) the Fed targets in buying and selling short-term treasury paper, the most liquid asset on the money market. This sets a floor for interest rates generally. Quantitative easing, on the other hand, is not conducted to manipulate interest rates. Rather, it is conducted to amplify the money supply in the financial market, and in this manner to affect asset prices.

Quantitative easing comes into play when interest-rate manipulation has run its course — such as when interest rates have already been lowered to zero or near-zero, in which case those efforts come to resemble pushing on a string.

Secondly, and in line with the purpose, the quantity involved: as can be seen on the accompanying graph, quantitative easing involves a massive increase in asset purchases as compared with standard open-market operations. The latter were in operation prior to the credit crisis of 2008, and the asset level was stable at around $900 billion, reflecting the fact that buying and selling were conducted interchangeably. The former was initiated soon thereafter, as can be seen from the explosion in asset holdings. In the meantime, it has stabilized at $4.5 trillion (!).

fed balance sheet 2007-2016
Fed balance sheet, 2007-2016. Data obtained from the Federal Reserve Board.

What has been the effect of this? Well, as my previous post explained, it has simply increased the money circulating within the financial market. By contrast, it has done nothing to stimulate the ordinary market. This disconnect between the two markets is explained further in our course in economics, which outlines the relationship between these markets.

Now let’s juxtapose the Fed’s balance sheet with the Dow Jones Industrial Average, this time updated to March 2016:

Correlation of the Fed's balance sheet with the Dow Jones Industrial Average, 2007-2016
Correlation of the Fed’s balance sheet with the Dow Jones Industrial Average, 2007-2016. Data obtained from the Federal Reserve Board and S&P Dow Jones Indices LLC.

The correlation still seems to hold true. The Fed has not added to its holdings since late 2014, and the DJIA has been unable to break through the ceiling that inaction has formed. Whether or not the correlation is a direct one, or whether there is any real relationship between the two, is more a matter of theoretical plausibility than practical proof, but it would certainly seem that there is some causal relationship.

Assuming that there is such a relation, this would also indicate where the stock market is headed once the assets start being reduced, either by being sold or by being retired. This will take money out of the financial market, causing prices to drop. This in turn might lead investors to take out their own money, precipitating what could become a rout.