Price of gold, value of paper money and currency board

Joseph Schumpeter coined the phrase “a credit theory of money” to classify the analysis of Smith and Thornton, according to which a banknote is a kind of paper credit. David Ricardo abandoned this approach during the bullionist controversy (1797-1821), whose main analytical issue was to explain the causes of the rising market prices of silver and gold bullion in the context of the inconvertibility of Bank of England notes.

According to Ricardo, the banknote is not a kind of paper credit, but a kind of token money. It is a token money that is printed on paper instead of cheap metal. However, although it has the same characteristics as government-issued paper money, it is not issued by the government, but by banks. It is not a legitimate form of issue in so far as the seigniorage - that is, a tax equal to the difference between the value of the money and its production cost - does not benefit the state, but the banks which make a profit by financing credit with banknotes. Ricardo did not trust the directors of the Bank of England, particularly when they claimed that it was never in their interest to over-issue notes, so that they did not have any responsibility for the high price of bullion and the low exchange rate.

The core of Ricardo’s bullionist argument - developed in The High Price of Bullion (1810) - is an analogy he establishes between inconvertible banknotes and debased coins.

Now, suppose that the quantity of money increases more than the quantity of goods to be traded, and that the exportation of all the outstanding undebased coins does not suffice to restore the previous value of money. In that case, the suspension of payments is unavoidable and there is no longer any form of mechanism to diminish the quantity of money. However, according to Ricardo, at this point, the value of gold bullion is higher outside England than inside, hence giving rise to an arbitrage opportunity. As a result of arbitrage, the London market price of bullion will rise above its mint price. Ricardo argues that the premium of the market price of bullion over the mint price occurs first, and then it makes the exchange rate fall, proving that the excess quantity of debased coins and inconvertible banknotes has brought about their depreciation. Ricardo wrote against Thornton’s analysis of the gold premium, according to which the premium of the market price of gold was the effect of a fall in the exchange rate.

At the end of this debate, in the Principles of Political Economy and Taxation (1817) and A Plan for the Establishment of a National Bank (1824), Ricardo argued that the quantity of paper money in circulation determines its value, which “may be considered as seigniorage” (Ricardo 1817 [1951]: 353) belonging to the state. Therefore, the banknote must be a form of legal tender whose issue must be monopolised by a state bank. This bank would not be authorised to grant credit, but to buy and sell gold bullion at a fixed price, as well as public debt. In so far as the quantity of banknotes determines both its purchasing power and the market price of gold, the bank would stabilise both by reduc­ing (increasing) this quantity when the market price of gold is above (below) the legal price. In this project, the convertibility of banknotes into legal tender coins becomes obsolete; convertibility into gold bullion is sufficient. This scheme relies on the idea that a fixed price for gold bullion is synonymous with stability of the purchasing power of money. Ricardo’s Plan influenced the Currency School.

The currency principle, developed by Robert Torrens in A Letter to the Right Honourable Lord Viscount Melbourne, on the Causes of the Recent Derangement in the Money Market and on the Bank Reform (1837) and Samuel Jones-Loyd, Lord Overstone in Thoughts on the Separation of the Department of the Bank of England, London, private edition (1844), is based on the quantity theory of money and the PSFM, and relies on an exogenous view of money. There is a causal link from money to credit. Every form of credit instrument is a “multiple” of money (narrowly defined as “currency”, which consists of notes and coins) previously deposited in a bank and loaned again (thus accel­erating the velocity of money). In 1837 Torrens improved and developed the bank credit multiplier. Banks launch this money, which would have remained unused had they not intervened, back into circulation.

Bank credit is based on currency, meaning “legal tender” money, that is, Bank of England notes and coins. For the currency principle - banknotes being strictly linked to the quantity of bank reserves in metal - credit is automatically regulated by variations in currency, which is a strategic variable. The currency has to contract and expand con­sequently to the state of the balance of payments, meaning the outflows and inflows of bullion. Bank crises are the result of the over-issue of notes, because the Bank of England does not enforce this strict link between its issues and the variation of its reserves in metal.

In delaying the implementation of this principle, the bank’s directors are thus obliged to “reign in” more severely later on. Therefore, it is necessary to make them restrict their issue immediately when they are losing metal.

This was the rationale of the 1844 Bank Charter Act, in favour of which the Currency School developed its argumentation and which divided the Bank of England into two separate departments (the Issue Department and the Banking Department). The activity of the Banking Department, which lends by discounting and is the source of the circula­tion of banknotes, is consequently controlled entirely by the quantity of banknotes it obtains from the Issue Department (in exchange for the gold it gives to this latter).

In fact, the currency principle proved itself capable of a degree of evolution. There is another cause of banking instability, which the Currency School identified from 1847 onward. They realised that the 1844 Act was incapable of regulating credit; it was only concerned with money. In 1858, Torrens stressed the “excessive and undue advances” by banks and their facilitating of an “undue diminution of their reserves” in notes, which could create panics. Nevertheless, he never advocated either a discretionary bank rate monetary policy or a relaxation of the 1844 Bank Charter Act.

Walter Bagehot, in Lombard Street: A Description of the Money Market (1873), intro­duced the concept of “lender of last resort” in an extension of the currency principle analysis, thus contributing to a renewal of its formulation that was to become British monetary orthodoxy, of which Bagehot was clearly a leading figure in 1870s. Bagehot developed this analysis by discussing the suspension of the reform in 1847, 1857 and 1866, stating that it was caused by the conduct of the Banking Department, when condi­tions were tight on the money market. According to him, the Bank of England’s Banking Department had to be the lender of last resort, not the Issue Department. The former

should increase its own capital, that is, its reserve so that it could lend to banks upon request. It would lend money exogenous to it - a loan of last resort did not equate to an issue of money. A liquidity crisis in the money market was a crisis of credit that should not be associated with a monetary crisis. The excess demand was for credit, not money.

The authors of the Free Banking School such as Henry Parnell, Observations on Paper Money, Banking and Overtrading (1827), and J.W. Gilbart, The Laws of the Currency, as exemplified in the Circulation of Country Bank Notes in England since 1844 (1854), wanted to return to Smith and had an influence on Bagehot. They advocated that free competition between banks in issuing notes convertible into specie would provide limits to the issue through interbank clearing with settlements in gold, because a reflux of excess notes from a bank could be deposited in a rival bank, which would return the notes to the issuing bank and bring an end to over-issue. They invoked the experience of Scotland and criticised the Bank of England, saying that it needed to be controlled and divided in several competing banks (Parnell 1827). G.P. Scrope in On Credit-Currency, and its Superiority to Coin, in Support of a Petition for the Establishment of a Cheap, Safe, and Sufficient Circulating Medium (1830) was in favour of the abrogation of the legal status of the Bank of England that gave it a monopoly position. Cyclical fluctuations were due to errors of the Bank and the absence of a self-regulating mechanism. However, they lost their case on this point in Parliament.