The value of gold and the high price of bullion
Ricardo’s explanation of the high price of bullion is based on two distinct arbitrages. The first, described in The Price of Gold (1809), concerns the domestic arbitrage between the face value of banknotes and the mint and market prices of gold.
At first sight, Ricardo’s approach is similar to Thornton’s: under convertibility, if any difference appears between the mint and market price of gold, there will be an arbitrage which will close this gap. If the market price is higher than the mint price, the agents will find it profitable to sell gold bullion on the market and, with the banknotes received, buy guineas at the Bank of England at the mint price, melt the guineas, and then sell the bullion again, thus making a profit. The opposite will happen if the market price of bullion is lower than the mint price. These arbitrage processes continue until the market price reaches the level of the mint price. This conclusion is the same as that proposed by Thornton, although we must emphasize that Ricardo’s explanation of the process is different. According to Thornton, it is the increase in the supply (demand) of bullion on the market that produces the decrease (increase) in its price. According to Ricardo, the bank brings the market price to the level of the mint price by withdrawing “the superfluous quantity of their notes from circulation”. He uses the quantity principle to explain the variation in the market price of gold: “No efforts of the Bank could keep more than a certain quantity of notes in circulation, and if that quantity was exceeded, its effects on the price of gold always brought the excess back to the Bank for specie” (1809 [1962]: 16). A high price of bullion reflects a low value of money, resulting from a high quantity of banknotes.The second arbitrage, described in The High Price of Bullion (1810 [1962]), operates at the international level.
Ricardo assumed an open economy without banknotes, therefore without a currency market, and without international capital flows. Money is gold. Ricardo considered Hume’s price-specie flow mechanism, and established that a country in which a gold mine is discovered will experience an increase in the quantity of money in circulation. Its value decreases, and in so far as its value abroad remains at the same level, an arbitrage opportunity appears. Because it is “cheap”, the gold, “whether in coin or in bullion... leave[s] the country... for those countries where [it is] dear” (Ricardo 1810 [1962]: 54). Exportation of gold results from the arbitrage between the domestic and foreign values of the metal. Consequently, the quantity of gold diminishes in the country, and its value therefore increases, removing the arbitrage opportunity. Ricardo explained that the creation of a bank with the right to issue convertible notes has the same effect as the discovery of a gold mine on the value of money (gold and banknotes) and on the export of gold to other countries. Furthermore, in the domestic circulation, the banknotes take the place left by the exported gold coins. Under the suspension of specie payments, the adjustments will be the same as long as there are gold coins in circulation to be sent abroad. However, if gold disappears from circulation and notes can no longer buy it, then because banknotes have no intrinsic value so that they are not exportable, the adjustment mechanism between the quantity of money and its value ceases to function. There is no way to remedy the depreciation of banknotes when they are the only money in circulation. Then, an arbitrage opportunity appears: as a consequence of the legal fixed price of coins, the internal value of gold coin has decreased along with the depreciation of the banknotes, whereas the international value of gold bullion still remains the same. This situation creates the opportunity to melt the coins and export the bullion. Ricardo did not describe this arbitrage, but concluded that the existence of an equilibrium with no arbitrage opportunities requires an increase in the internal market price of gold that reflects the depreciation of banknotes: “An increase of paper currency... lowers the value of gold bullion but rises its money price” (Ricardo 1810 [1962]: 64). This conclusion is used as the keystone for the analysis of exchange rates.