Balance of payments and the price of gold: the gold points mechanism

Thornton’s explanation of the high price of bullion through the functioning of the cur­rency market and gold points mechanism (GPM) was Thornton’s second main contribu­tion to monetary theory.

According to Thornton, international trade lies at the origin of debts. If imports to England are higher than its exports, then the supply of English bank debt exceeds demand on the currency market, and the exchange rate falls. An arbitrage opportunity appears when the fall in the exchange rate reaches the point at which it is profitable for gold dealers to demand English bank debt in order to buy gold on the British market at the market price, or to request their reimbursement in coins at the mint price. The arbi­trage between market and mint prices induces the draining of the banks’ gold reserves. The level of exchange rate that causes an external drain of gold is called the “gold export point”. Through this mechanism, by seeking “like [other commodities] that country in which it is the dearest” (Thornton 1802 [1939]: 145), gold fulfils the function of interna­tional means of payment. Here, gold outflows are the effect of the low exchange rate. This can occur as a consequence of a trade deficit caused by British inflation, but it can also happen if the trade deficit is caused by bad harvests, which lead to more imports, irrespective of any inflation in the prices of British exports. The excess supply of bank debts on the currency market may also occur when capitalists export capital in order to invest in foreign countries, or when the government supports foreign governments by sending them important sums of money in time of war. In this case, the exchange rate can fall to the level of the “gold export point” even though there is no trade deficit in goods. The conclusion is that gold flows are not linked to the balance of trade, but to the balance of payments.

Now, what happens when the obligation for the Bank of England to pay its notes in gold is suspended? Then, if the exchange rate falls below the gold export point, the inter­national arbitrageurs continue to buy bank debt on the currency market with a view to transforming it into gold in London. However, under the suspension of specie payments, they can only buy the metal on the gold market, creating an excess demand that pushes up the market price of gold. Consequently, because the bank no longer supplies gold at the mint price, the price of bullion reaches a level far above its mint price. This level is proportional to the fall in the exchange rate. Neither Boyd, nor King, nor Wheatley envisioned this causality mechanism between exchange rate and high price of bullion. The originality and main contribution of Ricardo was that he contradicted Thornton by reversing the causality between exchange rate and price of bullion:

Here, and in many other parts of the same article, the fall in the exchange, or the unfavourable balance of trade, is stated to be the cause of the excess of the market above the mint price of gold, but to me it appears to be the effect of such excess. (Ricardo 1810, vol. III: 64, original emphases)