Page 1 of 5 CHINA'S DOLLAR MILLSTONE, Part 3 History of monetary imperialism
By Henry C K Liu
Over the course of the 19th century, enough gold was known to have been
accumulated by Britain to make it credible for the British Treasury to
introduce paper currency backed by its gold to force the demonetization of
silver in Europe to advance British monetary imperialism.
Many historians inaccurately ascribe to 19th century mercantilism as the policy
of accumulating gold for a country through export of merchandise. The fact is
that gold accumulation can only be achieved by a purposeful policy of monetary
imperialism. Mercantilism under bimetallism gave a trade surplus country both
silver and gold. Only monetary imperialism could cause an inflow of gold with
an outflow of silver.
In reality, Britain earned gold in the 19th century not from export
of merchandise because buyers of British goods had a choice of paying in silver
or gold under bimetallism. In reality, Britain accumulated gold by overvaluing
gold monetarily all through the 19th century. This allowed Britain to force the
world to demonetize silver and to replace bimetallism with the gold standard
after enough of the world's gold had flowed into Britain to enable the pound
sterling, a paper currency backed by gold, but essentially a fiat current
without bimetallism, to act as a reserve currency for world trade with which to
finance Britain's role of sole superpower after the fall of Napoleon.
With the pound sterling as reserve currency, British banks, operating on a
fractional reserve system backed by the Bank of England, the central bank, as
lender of last resort, could practice predatory lending all over the world,
sucking up wealth with boom and bust business cycles instigated by her
predatory monetary policy of fiat paper currency.
The strategy worked for more than a century until the end of World War I.
Between 1800 and 1914, the main British export was financial capital
denominated in fiat pound sterling disguised by the gold standard to be as good
as gold. The factor income from banking profits derived from pound sterling
hegemony paid for the wealth and luxury that Britain enjoyed as the world's
preeminent power in the century between the fall of Napoleon in 1815 and the
start of First World War in 1914.
The demonetization of silver stealthily turned the gold standard into a fiat
paper money regime through the officially gold-backed pound sterling because
the gold backing it was no longer priced in silver at a fixed rate, or any
other metal of intrinsic value for that matter. Gold and only gold became a
fiat unit of account set by the British Mint, a fact that made Britain the
monetary hegemon of the age.
No transactional meaning
An asset that is priced by or in itself has no transactional meaning, even if
it is gold. This is because a transaction must involve at least two assets of
different value, expressed with different prices in exchangeable currencies.
And there must be an agreed-upon exchange ratio at the time of the transaction
to effectuate a transactional outcome. Even in barter, an exchange ratio
between the two assets to be exchanged needs to be agreed upon. For example, an
ounce of gold can be exchanged for 15 ounces of silver. An ounce of gold that
can be exchanged for another ounce of gold carries no information of
transactional value.
Thus the pound sterling, even when backed by gold, was in fact a fiat paper
currency because the monetary value of gold is set by fiat devoid of any
relationship to any other thing of intrinsic value beside gold itself. Without
bimetallism, specie money cannot have any meaning of transactional worth.
Currency backed by gold turns into a fiat currency if it can be redeemed at its
face value only in gold. The monetary value of gold is not separate from the
commercial value of gold. Gold then can fluctuate in purchasing power due to
any number of factors, including government policy, but is not fixed to any
other metal of intrinsic value at a universally agreed upon ratio.
That a pound sterling is worth another pound sterling is no different than an
ounce of gold is worth another ounce of gold. And the market price of gold can
be manipulated by the government that is in possession of more gold than any
other market participant. This means that any unwelcome speculator can be
quickly ruined by the government. This is of course how central banks nowadays
intervene in the foreign exchange market for fiat currencies. Central banks
with sufficient dollar reserves, a fiat currency, can drive speculators against
their national currencies toward bankruptcy.
Before silver was demonetized, the silver/gold ratio was set monetarily at
15.5/1 in England and 15/1 in France, motivating speculators to buy silver with
gold in England and buy gold with silver in France for an arbitrage profit of
half an ounce of silver for each ounce of gold so transacted in the two
countries. This caused a continuous flow of gold to England independent of
international trade flows in other commodities. Even when Britain incurred a
trade deficit, gold continues to flow into Britain because of the monetary
hegemony of the pound sterling.
After silver was demonetized, gold could be exchanged at the British Treasury
only for pound sterling notes at the rate of 21 shillings, or one pound one
shilling, per ounce of gold fixed in 1717. The commercial price of gold in
England was set by the British Treasury on par with its monetary value because
the gold price was denominated in pound sterling. The commercial price of
silver or any other commodity in England was also denominated in pound
sterling, which had a monetary value in gold set by the British Treasury by
fiat.
After the demonetization of silver, no one knew how much silver was worth as
money because it was no longer used anywhere as money. Thus there could not be
any discrepancy between the commercial price of silver and its monetary value
because silver ceased to have a monetary value. Silver then became a commercial
commodity like any other commercial commodity, while only gold remained a
monetary unit of account accepted in the British Treasury and in other
treasuries of countries which observed the gold standard. Countries that
refused to join the gold standard saw their currency kept out of international
trade and had to pay a penalty of high interest rates on loans denominated in
their non-gold-backed currency.
The Bank of England could issue more pound sterling notes by fiat based on the
fractional reserve principle in banking. She only needed to keep enough gold to
prevent a run on pound sterling notes for gold at the Bank of England. And
since England was in possession of more gold than any other country at the
time, Britain under the gold standard became the monetary hegemon, with more
money at her disposal than justified by the amount of gold she actually held.
Other gold standard countries had to maintain a much higher fractional reserve
in gold than Britain and therefore had less money with which to participate in
international capital markets. The monetary hegemon could sustain a trade
deficit with an inflow of gold caused by monetary policy.
Without a fixed exchange-rate regime, each nation could adopt a gold standard
unrelated to other nations' gold standard. For example, the US at $20.67 per
ounce of gold and Britain at three pounds, 17 shillings and 10 pence per ounce
of gold would let the exchange rate between the dollar and the pound sterling
work itself out mathematically. This is what a fiat currency regime does,
except instead of being valued by a gold standard based on the amount of gold
held by the issuing government, the exchange rate of the currency is valued by
each country's monetary policy implications and financial conditions, such as
interest rates, balance of payments, domestic inflation rate, fiscal budgets,
trade deficits, and so forth.
The United States, though formally on a bimetallic (gold and silver) standard,
switched to gold de facto in 1834 and de jure in 1900. In 1834, the United
States fixed the price of gold at $20.67 per ounce, where it remained for a
century until 1933, when president Franklin D Roosevelt devalued the dollar to
$35 per ounce of gold, but made it illegal for US citizens to own gold in
amounts worth more than $100.
Before World War I, Britain had fixed the per ounce price of gold at three
pounds, 17 shillings and 10 pence, three times the original price of gold set
in 1717 which was at one guinea, or 21 shillings. The exchange rate between US
dollars and pounds sterling, the "par exchange rate", mathematically came to
$4.867 per pound during the period between 1834 and 1914. Between 1914 and
1933, the dollar/pound exchange rate mathematically rose to $2.214 per pound
sterling.
On August 25, 2008, a relatively uneventful trading day, the per-ounce market
price for silver was $13.45 and that of gold was $829, yielding a silver/gold
ratio of 61.6/1. This was four times the historic British Mint ratio of 15.5/1.
On that same day, the exchange rate between the dollar and the pound sterling,
both free floating fiat currencies, was $1.853 per pound sterling, determined
by monetary policies of their respective central banks. The exchange rate
between the dollar and the pound sterling on that day was less than one third
of the "par exchange rate" from 1834 through 1914.
The British pound had lost more than a third of its exchange value against the
dollar in 94 years while the dollar itself had also fallen against gold by
2,360%, from $20.67 to $829. The dollar had not become stronger, only the pound
had become weaker against the dollar. This is because the pound, like all other
fiat currencies in the world, has become a derivative currency of the dollar.
Quantity Theory of Money refined
John Locke (1632-1704) and David Hume (1711-76) provided considerable
refinement, elaboration and extension to the Quantity Theory of Money (QTM),
allowing it to be integrated into the mainstream of orthodox monetarist
tradition.
Locke developed the right of private property based on the labor theory of
value and the mechanics of political checks and balances that were incorporated
in the US Constitution. Locke, in 1661, asserted the proportionality postulate:
that a doubling of the quantity of money (M) would double the level of prices
(P) and half the value of the monetary unit.
Hume, in 1752, introduced the notion of causation by stating that variation in
M (money quantity) will cause proportionate changes in P (price level).
Concurrently with Irish banker Richard Cantillon (1680-1734), Hume applied to
the QTM two crucial distinctions: 1) between static (long-run stationary
equilibrium) and dynamic (short-run movement toward equilibrium); and 2)
between the long-run neutrality and the short-run non-neutrality of money. Hume
and Cantillon provided the first dynamic process analysis of how the impact of
a monetary change spread from one sector of the economy to another, altering
relative price and quantity in the process.
They pointed out that most monetary injections would involve non-neutral
distribution effects. New money would not be distributed among individuals in
proportion to their pre-existing share of money holdings. Those who receive
more will benefit at the expense of those receiving less than their
proportionate share, and they will exert more influence in determining the
composition of new output. Initial distribution effects temporarily alter the
pattern of expenditure and thus the structure of production and the allocation
of resources. This is how inflation causes income disparity.
Thus it is understandable that conservatives would be sympathetic to the QTM to
maintain the wealth distribution status quo, or if the QTM is skirted, to
ensure that the mal-distribution tilts toward those who are more likely to
engage in capital formation, namely the rich. This is precisely what happened
in the past two decades and caused sharp rises in income disparity. Thus
developing economies in need of capital formation would find logic in first
enriching the financial elite while advanced economies with production
overcapacity would need to increase aggregate demand by restricting income
disparity, which free-market fundamentalism has failed to do. This is the
problem of central banking in market capitalism: it delivers money to those who
need it least. This excess money is called capital.
Hume describes how different degrees of money illusion among income recipients,
coupled with time natural and artificial delays in the adjustment process,
could cause costs to lag behind prices, thus creating abnormal profits and
stimulating optimistic profit expectations that would spur business
overexpansion and employment during the transition period. These non-neutral
effects are not denied by the adherents of QTM, who nevertheless assert that
they are bound to dissipate in the long run, albeit often with great damage if
the optimism is unjustified. The latest evidence of the non-neutral effects of
money is observable in expansion of the so-called New Economy from easy money
in the past decades and the recurring collapse of its serial bubbles.
The QTM formed the central core of 19th-century classical monetary analysis,
provided the dominant conceptual framework for interpreting contemporary
financial events and formed the intellectual foundation of orthodox policy
prescription designed to preserve the gold standard. The economic structure in
19th-century Europe led analysts to acknowledge additional non-neutral effects,
such as the lag of money wages behind the rise of prices, which temporarily
reduces real wages; the stimulus to output occasioned by inflation-induced
reduction in real debt burdens, which shifts real income from productive
debtor-entrepreneurs to unproductive creditor-rentiers; the so-called "forced
saving" effect occasioned by price-induced redistribution of income among
socio-economic classes having structurally different propensity to save and
invest; and the stimulus to investment imparted by a temporary reduction in the
rate of interest below the anticipated rate of return on new capital.
Yet classical quantity theorists tended persistently to minimize the importance
of non-neutral effects as merely transitional. Whereas Hume tended to stress
lengthy dynamic disequilibrium periods in which money matters much, classical
analysts focused on long-run equilibrium in which money is merely a veil.
Ricardo, the most influential of the classical economists, thought such
disequilibrium effects ephemeral and unimportant in long-run equilibrium
analysis. Gods, of course, enjoy longer perspectives than most mortals, as do
the rich over the poor. As John Maynard Keynes famously said: "In the long run,
we will all be dead."
As leader of the Bullionists, who advocated immediate and full-par resumption
of convertibility of notes in gold, Ricardo charged that inflation in Britain
was solely the result of the Bank of England's irresponsible over-issue of
money, when in 1797, under financial stress from the Napoleonic Wars, Britain
left the gold standard for inconvertible paper.
At that time, the Bank of England was still operating as a national bank, not a
central bank in the modern sense of the term. In other words, it operated to
improve the English economy rather than to strengthen the sanctity of
international finance by protecting the value of money against inflation.
Ricardo, by focusing on long-term equilibrium, discouraged discussions on the
possible beneficial output and employment effects of monetary injection on the
national level. Like modern-day monetarists, Bullionists laid the source of
inflation, considered a decidedly evil force in international finance, squarely
at the door of the national bank.
Milton Friedman declared some two centuries after Ricardo: "inflation is
everywhere a monetary phenomenon". Friedman's concept of "money matters" is the
diametrical opposite of Hume's view of money that most monetary injection would
involve non-neutral distribution effects. This has been the result of
Greenspan's abusive use of liquidity to moderate the business cycle by creating
price bubbles.
The historical evolution in 18th-century Europe from a predominantly full-metal
money to a mixed metal-paper money forced advances in the understanding of the
monetary transmission mechanism. After gold coins had given way to banknotes,
Hume's direct mechanism of price adjustment was found lacking in explaining how
banknotes are injected into the system.
Quantity Theory of Money and government policy
Henry Thornton (1760-1815), in his classic The Paper Credit of Great Britain
(1802), provided the first description of the indirect mechanism by observing
that new money created by banks enters financial markets initially via an
expansion of bank loans, by increasing the supply of lend-able funds,
temporarily reducing the interest rate below the rate of return on new capital,
thus stimulating additional investment and loan demand. This in turn pushes
prices up, including capital good prices, drives up loan demands and eventually
interest rates, bringing the system back into equilibrium indirectly.
The central issue of the doctrines of the British classical school that
dominated the first half of the 19th century was focused around the application
of the QTM to government policy, which manifested itself in the maintenance of
external equilibrium and the restoration and defense of the gold standard.
Consequently, the QTM tended to be directed toward the analysis of
international price levels, gold flow, exchange-rate fluctuations and trade
balance. It formed the foundation of mercantilism, which underpinned the
economic structure of the British Empire via colonialism, which reached
institutional maturity in the same period. But it was the British who
discovered that gold flow was guided by Gresham's Law of bad money driving out
good, and caused gold to flow into Britain by purposefully overvaluing its
monetary ratio to silver.
Bullionists developed the idea that the stock of money, or its currency
component, could be effectively regulated by controlling a narrowly defined
monetary base, that the control of "high-power money" (bank reserves) in a
fractional reserve banking regime implies virtual control of the money supply.
High-power money is the totality of bank reserves that would be multiplied many
times through the money-creation power of commercial bank lending, depending on
the velocity of circulation. Under the gold standard, bank reserve can take the
form of gold or bank notes.
In the three decades after Britain returned to the gold standard in 1821, the
policy objective focused on the maintenance of fixed exchange rates and the
automatic gold convertibility of the pound. But the Currency School (CS) versus
Banking School (BS)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
