Having seen the nature and causes of unsound money, what can we say about sound money?

It is money that can be trusted, by anyone and everyone who uses it. Trusted to do what? Trusted to retain its purchasing power.

what matters is what money can buy

After all, what matters is what money can buy, not the money itself. Sellers of goods and services expect payment for their products in a medium that can be used for making purchases. (Our old friend Say’s Law over again.)

At 3 per cent, the current rate of inflation, the purchasing power of your money will be halved in 23 years. It was not always so. The pound took 164 years, from 1750 to 1914, to halve in value. One dollar today is worth one cent of a century ago!

It could be worse: think of the poor Zimbabwean farmer who wants to export his crop of delicious oranges. Unlike a German exporter, happy to accept payment in his own currency, our farmer will accept payment in just about any currency except Zimbabwean dollars, because they fail the crucial purchasing power test.

In Zimbabwe, the 100-trillion-Z$ note bestows purchasing power equivalent to 40 US cents. With which you may be able to buy a cup of coffee! [I am not making these numbers up – you can check for yourself!]

This, of course, is what we call “hyperinflation”, with a vengeance. Even barter makes more sense!

But we must take care over terminology. To refer to these insane processes as “inflationary” is a statement of the obvious – indeed it is the very definition of inflation. Rising prices is one manifestation of inflation, rather than inflation itself. The term “inflation” should be used in its strict sense as referring to inflation of the money supply, or inflation of credit (the same thing).



What happens to all the new money?

The unrestricted credit creation called “quantitative easing” raises an obvious question: What happens to all the new money?

It is a mathematical certainty that if the quantity of money increases in relation to a given level of available goods, prices must rise. Not necessarily all prices, and not necessarily immediately. To see what its “first receivers” in financial institutions do with the money, you should simply identify the assets that have become dramatically more expensive after a few bouts of quantitative easing, coupled with cheap credit.

The initial impact is evident in the adverts for luxury cruises; extravagant town-houses with underground swimming pools and gyms in the most prestigious locations; £50,000 timepieces; gleaming sports cars; hand-crafted yachts; branded clothes and bejeweled baubles exclusive to Bond Street arcades; Chateau-bottled wines (or the chateaux themselves) – all at asset prices pushed sky-high by the new zillions! Much of it finds its way into new skyscrapers; speculation on stocks and shares; private clinics and health spas; and, inevitably, obscene levels of executive pay, disgracing the integrity of boardrooms everywhere.

This well-known phenomenon is called the “Cantillon effect”, named after the 18th Century economist Richard Cantillon, who noted that the consequences of an inflationary supply of new money occur gradually, and that they have a “localized” effect on prices. By this he meant that the original recipients of the new money (banks, financial houses and City institutions close to the Treasury and central bank) enjoy hugely greater sudden wealth at the expense of later recipients who, at first, don’t notice much price inflation.


but causes elude them altogether!


The next phase is a “filtering-down”, which dictates that the impact of new money on the price of foodstuffs, household goods and the basic ingredients in most people’s budgets takes longer to arrive,but its most noticeable effect is that prices are higher, having been pushed up by the earlier inflationary impact. [The same happens to ordinary domestic housing everywhere, making home ownership for the younger generation prohibitive. Uncomprehending politicians will scream about the need for “more affordable housing” – but causes elude them altogether!]

This process bites especially harshly in locations where shoppers, whose budgets are already stretched, are forced to seek out the lowest prices for essentials. The reduced “footfall” on the High Street causes many shops, already beleaguered by the competition of online shopping, to close. The insidious impact is transformative – just look at the changing composition of the typical High Street, where there used to be hardware stores, outfitters, hairdressers, decent restaurants, jewelers, fishmongers, professional offices, clinics, travel agencies, furniture stores, art and antique shops, bathroom showrooms. And now?

Apart from all the “to let” spaces where there used to be shops, there are charity shops, newspaper shops also selling cheap deli food and booze, cheaply appointed coffee-and-cake counters, kebab, burger and pizza bars, a couple of bank branches, estate agents advertising low-rent lettings, mini-cab call centres, mobile phone stores, clothing outlets with racks of cut-price clobber, traders in any rapid turnover enterprise.

[The impact of inflation can be more reliably observed over a period when measured against an essential commodity, such as oil.

Fifty-two years ago the price of a barrel of oil was $3.1. Today it hovers around $70 and rising. Although it appears as though the price of oil has gone up, hugely, that apparent rise is rather a measure of the loss in the dollar’s purchasing power over that period – over 95 per cent.

But what happens if you measure the price of that same barrel of oil against a stable commodity, such as gold, instead of the volatile dollar? Fifty-two years ago that barrel equated to 2.75 grams of gold. Now it equates to 1 gram of gold. Therefore the purchasing power of gold, measured in barrels of oil, has all but trebled.]

Let’s return once more to the subject of “sound money”, which cannot be separated from the question of interest rates, which we have now covered.

Under a bartering system there could be no inflation because there is no money supply to inflate. Prices of different products and services in relation to each other can still vary enormously due to changes in respective demand and supply caused by seasonal availability, the effect of drought causing scarcity – not only of materials and products, but labour too.

Money and gold

When money, as both a convenient medium of exchange and a reliable store of value, gradually superseded barter, the commodity used as a medium for settling domestic and international debts wasgold because it possesses the key attributes that serve so well as currency: relative rarity; durability; limited alternative utility; recognition and acceptance.

it is immune from the ravages of the government’s printing presses

Most important of all, it is immune from the ravages of the government’s printing presses and under the gold standard there can be no “inflation” as we know it today.

The only serious debasements to afflict gold are the practices (at which Henry VIII was expert) of “coin-clipping”, and the mingling of inferior alloys, often to pay for foreign wars.

Gold Standard

Under a gold standard a country’s unit of currency is defined by a specified quantity of gold held by its central bank, and into which its convertibility is guaranteed without restriction. Its unrestricted export and import makes it ideal for settling international obligations.

A country on the gold standard cannot increase the amount of money in circulation without also increasing its gold reserves. Because the global gold supply grows only slowly, being on the gold standard holds government spending and inflation in check.

[In 1844 the Bank Charter Act ruled that Bank of England notes were fully backed by gold, marking the establishment of a full gold standard for British money that lasted until 1931, when poor financial management led to rising trade and budgetary deficits, in turn causing the pound to be devalued on the foreign exchanges and hence a rise in import prices. The promise of convertibility into gold of pounds held abroad risked material depletion of Britain’s gold reserves – and so the gold standard was abandoned.]

In 1944 representatives of the allied nations and their central bankers met at Bretton Woods in New Hampshire, where it was agreed that (a) the US dollar would be accepted as the settlement currency for international trade; (b) that the US dollar would be redeemable in gold on presentation at the fixed rate of $35 to the ounce; and (c) the International Monetary Fund (IMF) would be formed to ensure that that the USA behaves itself fiscally and maintains the agreed ratio by controlling the supply of its dollars – a task which the IMF  spectacularly failed to achieve.

Redeeming those dollars

Throughout the 1950s and early 1960s the USA just kept on printing dollars regardless of whether they could redeem them in gold at $35 to the ounce. They were effectively paying for their imports with fake currency.

In 1958 General de Gaulle became President of France and over the next few years he noted with increasing alarm that the French Central Bank was stuffed full of US dollars, and French exports to the USA (wine, cheese, machinery, cars, clothes, etc) were being paid for, not in francs, but in still more dollars. In 1969 De Gaulle started to redeem the dollars France was holding against gold at the official rate of $35 to the ounce.

Other central bankers duly noted this redemption and soon began to follow suit. By 1971 America’s gold reserves had become seriously depleted, and President Nixon took the coward’s way out of the problem by simply declaring that debts denominated in dollars were no longer redeemable in gold – effectively taking America off the gold standard.

[Nixon could, of course, have faced up to the damage inflicted by the Federal Reserve’s systematic dollar destruction over decades. He could have devalued the dollar by restating its revised value in terms of gold, and then desisting from further debasement. It is reliably estimated that the true relationship between dollars and gold in 1971 was around $400 to the ounce.

This means the dollar lost almost 90 per cent of its purchasing power over the 27 years from 1944 to 1971. Reinstating the gold standard at that conversion rate could have arrested this slide – subject to acceptance of monetary discipline.

Today the “gold conversion price” (the price the Fed would have to set to redeem dollars for gold AND NOT RUN OUT OF GOLD) would be over $14,000 per ounce for base money, or, if savings and short-term bank liabilities are also to be covered, a staggering $53,000 per ounce!]

Economists who favour state control over the economy claim that the chief drawback of a gold standard is that it restricts government’s ability to control the money supply when, in their view, state intervention is warranted.

However, economists who consider that markets are preferred arbiters of what, if anything is needed, regard this restriction on monetary meddling as the gold standard’s greatest strength!

“Fiat” Money

In 1971 the gold standard was replaced by a system of “fiat” money under which the currency is not linked to the value of any commodity, but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.

The term “fiat” is derived from the Latin “fieri” – meaning arbitrary act or decree. In keeping with this etymology, fiat currencies are accepted only because they are defined as legal tender by government decree, not because they retain purchasing power, which they do not!

Finally, you will hear politicians opining on the effect of individual currencies: “If only the Italians ditched the euro and returned to the lira their exports would be more competitive…..” And the same sentiment is voiced over the Greek drachma, Spanish peseta, etc. This is all nonsense. It is not currencies that that need to be made more “competitive”, but production. German cars are not world-beaters because they are cheap, but because their production methods guarantee value for money – any money!
© Emile Woolf May 2018 (website)