In part 1 of this series we saw how the Gold Standard became established as the monetary system in large parts of the world during the 19th and early 20th Centuries, but that placed great power into the hands of a small number of very wealthy banking families. We’ll now take a closer look at how that happened, and what strategies were tried in order to escape their influence.
The ties that bind, and enrich
Throughout history governments have found the need to borrow money; even before mass democracy, every population’s demand for services has exceeded their willingness to pay taxes. This is even more the case in times of war. For a country on the gold standard, borrowing money meant borrowing gold, and the people who had gold were the banks. In an era when, even more than today, personal relationships counted for a great deal, those who had trusted networks – especially networks of family or a shared religion – were at an advantage in the banking world. Many people may read ‘religion’ there and think “ah, Jews”, but it would be entirely wrong to single them out: in the UK, both the Barclays and the Lloyds families (the latter originating in Dolobran, just outside Welshpool) were Quakers, while the Morgans (whom we met in the previous article) were Anglicans, very much a minority in the US.
The point was that if you were part of a community of people whom you could trust implicitly, and who were known to outsiders also as being trustworthy and responsible, then you were at a huge advantage to anyone else. In modern terms we’d say that there were high entry barriers into the banking world. As banking families spread out over larger and larger areas, so their wealth grew exponentially. Their close family networks became channels of information just as much as of money, placing them in prime position to take advantage of the best investment opportunities as industrialisation took hold across the Western world. “It’s not what you know, but who you know” has never been truer, before or since.
Banking on the people
To escape from their power and influence, governments developed two strategies. The first was the creation of Central Banks, firstly in Sweden in 1668 and, not long afterwards in 1694, the Bank of England. These were conceived as independent companies into which individuals could invest money to be lent to the government in exchange for a modest but reliable rate of interest. The initial shareholders in the Bank of England consisted of over 1500 people who invested amounts as low as £25 or as much as £10,000 (the King’s personal contribution).
The usual mechanism for governments to raise money through a central bank was to use it as a channel for selling bonds: essentially, pieces of paper from the government promising to pay the bearer a regular sum of interest, sometimes for a fixed period or sometimes in perpetuity. Such bonds, because they were guaranteed by the government and ultimately backed by its tax revenues, were regarded as a very safe investment; as the certificates were sometimes edged in gold leaf, they also became known as ‘gilts’. Like any bond, including the type issued today, they could be relied upon to provide a regular income but their actual resale value could vary significantly. Suppose you held bonds, for which you’d paid £100, and on which the government paid regular interest at 2%. You can sell your bonds to anyone else who might fancy having a predictable £2 a year for a £100 outlay. The next year, needing to raise more money on more attractive terms, the government issues new bonds paying 3%. Anyone wanting an income of £2 a year only has to buy £67 of the new bonds, and so the resale value of your bonds has just fallen to that amount and you’re suddenly £33 out of pocket.
Despite this risk, government bonds issued by central banks were a popular investment for people and companies who needed a regular income but were prepared to lose some – but hardly ever all – of their capital. Pensioners, and insurance companies, for example. The same is just as true today, as we’ll see in the next part of this series.
The other, far more risky approach was simply to print more paper money than there was gold to back it up, effectively creating new money out of thin air. Of course this undermined the principle that paper money was redeemable for gold. There is a story of a conversation between Abraham Lincoln and his Treasury Secretary, Salmon P. Chase, at the time in 1861 when they were contemplating the issue of ‘Greenbacks’ – paper dollars – to avoid the interest rates of up to 36% being demanded by New York banks to finance the American Civil War. Chase had recently started the practice of stamping “In God We Trust” on American coins. The idea came up that the Greenback notes should bear a Bible verse on them, and Lincoln suggested Acts 3:6, “Silver and gold I do not have, but what I do have I give to you.”
Ultimately, this approach relied on the twin assumptions that the government was going to show some restraint in the amount that it printed, and that not everybody who held the paper money would rush to the bank to redeem it at the same time. Sometimes this worked out reasonably well – the ‘Greenbacks’ fluctuated in value but stabilised after the war at the same price as gold-backed dollars, while the Bradbury Pounds issued by Lloyd George to finance the First World War also held their own. The Assignats issued by the post-revolutionary French government in the 1790s fared less well, losing around 20% of their value almost overnight and becoming worthless within about five years.
Returning to the Gold Standard
If leaving the gold standard was risky, returning to it afterwards was riskier still. Greenbacks and Bradbury pounds avoided the fate of Assignats by being issued on the understanding that they were a temporary measure, to be withdrawn or converted into gold-backed money as soon as conditions allowed. In the case of the Greenbacks, their value fluctuated wildly during the Civil War according to the fortunes of the Union cause, dropping to under 40% of their original value in July 1864 as General Ulysses S. Grant repeatedly failed to break Robert E. Lee’s hold on the Confederate capital in Richmond. After the war, though, their value bounced back until by 1878 they were back on a par with gold-backed dollars. After that, the US having sufficient gold available to back them as well, they became regular US currency.
The Bradbury pounds had a different fate: they were legally regarded as having the same value as gold-backed pounds throughout their existence, but after the War the government followed through on its promise to bring them out of circulation and return to “sound money”. This took until 1928, during which time the contraction of the money supply contributed to the deflation which was characteristic of the era. Combined with the glut of cheap German coal which was flooding the British market as a result of the wartime reparations that Lloyd George had negotiated at Versailles, this led directly to the deep industrial depression of the 1920s and 30s which brought so much hardship to the South Wales valleys and other parts of the UK.
Modern Central Banking
During and after the Second World War, a type of gold standard was introduced under the “Bretton Woods system” whereby the value of the US dollar was anchored to gold while other countries defined exchange rates relative to the US dollar. Under normal circumstances these exchange rates were fixed, but governments had the freedom to vary them when necessary – as Harold Wilson did in 1967 when the UK unilaterally devalued the pound from $2.80 to $2.40 (a discussion on why a government might choose to do this will have to wait until Part IV of this series).
By 1971 however, as the US economy flagged under the burden of the Vietnam war, the link between the dollar and gold was formally broken by Richard Nixon and the modern era of “fiat currencies” (‘fiat’ from the Latin ‘let there be…’) can be said to have begun.
In the next part of this series, we’ll take a look at the mechanics of how fiat currencies operate, how central banks use interest rates to manage their value, and why even countries who have so much wealth that there is no need for their governments ever to borrow money – and could therefore easily enforce a Gold Standard if they wanted to – nevertheless choose to use them.