The Power of Gold: The History of an Obsession

by Peter L. Bernstein

  Gold is not only the standard for the domestic currency: "Bullion is the true regulator both of the value of a local currency and of the rate of Foreign Exchange."" This statement is the core of the "true doctrine" to which Homer's letter refers. The "great evil growing out of the neglect of that doctrine" was the price inflation that was cutting so deeply into the purchasing power of money.

  To the Committee, following upon the analysis in Ricardo's letters to the Morning Chronicle, the whole problem was obvious and its solution was simple. The problem arose because "A general rise of all prices, a rise in the market price of Gold, and a fall of the Foreign Exchanges, will be the effect of an excessive quantity of circulating medium in a country which has adopted a currency not exportable to other countries, or not convertible at will into a Coin which is exportable."34 The "great evil" had developed from what Homer had characterized as "the neglect of that doctrine." The solution, therefore, was to restore convertibility of the currency into gold at the earliest possible mo:::ent.

  Meanwhile, the Committee took the position that the Directors of the Bank of England should act as though gold were still functioning as the true regulator despite the embargo on the free convertibility of paper currency into gold. That is, the Bank should ignore the reality of the pure paper currency system that had been forced upon the nation and respond instead to the unambiguous signals provided by increases in the price of gold and the weakness of the pound in the foreign exchanges. Upon the appearance of those signals, the Bank should curtail its credit activities, thereby restraining the growth in the money supply, just as it had done under identical conditions in 1783, 1793, and 1797. The Bank should manage its affairs under the restraints of a virtual gold standard, to put it in today's lingo. Ricardo would emphatically endorse this view in his 1816 tract on the high price of bullion. He asserted that "fIf the Directors] had acted up to the principle which they have avowed to have been that which regulated their issues when they were obliged to pay in specie ... we should not have been exposed to all the evils of a depreciated, and perpetually varying currency"35 (italics in original).

  The report angrily contradicts the evidence of several witnesses that the increase in the price of gold was merely the result of a scarcity, or excess demand, for gold. If that were the case, the report asks, why was the price of gold stable in France and the other continental countries? There was no scarcity of gold: "That guineas have disappeared from the circulation, there can be no question; but that does not prove a scarcity of Bullion, any more than the high price proves that scarcity." No, no, no! The authors cite the testimony of a dealer who acknowledged that "he found no difficulty in getting any quantity [of gold] he wanted, if he was willing to pay the price for it. 1116 The price of gold rose because of the "excessive quantity of circulating medium." The high price of gold was in fact proof that the supply of money was "excessive." No greater authority than that "very eminent Continental Merchant" agreed that the fall in the foreign exchange value of the pound would never have happened if paper money had been convertible into guineas: "I value everything by Bullion," he declared. He went on to inform the Committee that the whole problem had arisen simply because the Bank was "not allowing Bullion to perform those functions for which it seems to have been intended by nature."37

  The Committee then proceeded to interview the Directors of the Bank to determine whether they "held the same opinion and derived from it a practical rule for the control of their circulation. 1131 The flatout response from the Directors was that they held no such opinion. The controversy rages back and forth, but the Bank's position was succinctly set forth in the statement of Mr. Whitmore, the former Governor, who informed the Committee that "The present unfavorable state of the [foreign] Exchange has no influence upon the amount of [the Bank's] issues, the Bank having acted precisely as they did before.... The amount of our paper circulation has no reference at all to the state of the Exchange."39 The current Governor, Mr. Pease, agreed: "I cannot see how the amount of Bank notes issued can operate upon the price of Bullion, or the state of the Exchanges.... I never think it necessary to advert to the price of Gold, or the state of the Exchange, on the days on which we make our advances.""'

  The Directors stubbornly refused to yield, to a point where their testimony sounds almost as though they could not even comprehend what the Committee members were driving at. Ricardo, in a letter to Malthus some years later, characterized them as "indeed a very ignorant set.";' Sixty-five years later, in reviewing these events, the great Victorian economist Stanley Jevons was just as impatient as Ricardo had been with the opponents to the Committee's arguments. Their refusal to get the point provoked him to write, "So unaccountable are the prejudices of men on the subject of currency that it is not well to leave anything to discretionary management. "4--

  Nevertheless, the Directors perceived themselves as merely doing what they were retained to do-meeting the demands of creditworthy borrowers. One could hardly accuse them of forcing Bank notes into circulation. As Mr. Whitmore explained to the Committee, "There will not remain a Note in circulation more than the immediate wants of the public require.... The Bank Notes would revert to us if there was a redundancy in circulation, as no one would pay interest for a Bank Note he did not want to make use of "a3 Another director, Mr. Harman, declared that by acting in that manner the Bank "cannot materially err. "44

  After the Committee's report refuses to accept any of these arguments, it expresses some second thoughts about the Bank. Despite "great practical errors," the report goes on to admit that the Directors had in fact shown "a degree of forbearance" and that the Bank should continue to merit the public's confidence in "the integrity with which its affairs are directed, as well as in the unshaken stability and ample funds of that great establishment. 114' The root of the problem lay in the failure of the Bank Directors to distinguish between what appears to be a legitimate loan to a deserving merchant and the impact of the resulting increase in money supply on the economy as a whole. But one can hardly blame the Directors, for the Restriction Bill itself imposed upon them an excessive amount of responsibility that had become tangled in massive conflicts of interest between private objectives and public needs.

  This line of reasoning leads to the Committee's most important conclusion. Their words here are worth quoting at some length. Echoing the principles about the role of gold originally set forth by David Hume and Adam Smith, the report provides the first and perhaps the most authoritative justification for the establishment of the gold standard as the superior system for managing an economy's money supply. The entire thrust of the statement is to throw up a sharp contrast to what can happen when money is not convertible into metal and such decisions are left to just plain human judgments.

  After pointing out the power over the economy that the suspension of cash payments transferred to the Directors of the Bank, the Committee goes on to contend:

  In the judgment of the Committee, that is a trust, which it is unreasonable to expect that the Directors of the Bank of England should ever be able to discharge. The most detailed knowledge of the actual trade of the Country, combined with the profound science of all the principles of Money and Circulation, would not enable any man or set of men to adjust, and keep always adjusted, the right proportion of circulating medium in a country to the wants of trade.

  When the currency consists entirely of the precious metals, or of paper convertible at will into the precious metals, the natural process of commerce, by establishing Exchanges among all the different countries of the world, adjusts, in every particular country, the proportion of circulating medium to its actual occasions.... If the natural system of currency and circulation be abandoned, and a discretionary issue of paper money substituted in its stead, it is vain to think that any rules can be advised for the exact exercise of such a discretion.46

  Ricardo, writing on the subject a year later, affirmed the superiority of the decisions of the markets over those of bankers with responsibility to
regulate the currency: "The exportation of the specie," he wrote, "may at all times be safely left to the discretion of individuals."47

  In short, the markets know best; their signals must determine policy. The Committee's logic leads them to a clear and unqualified recommendation: "That the system of the circulating medium of the Country ought to be brought back, with as much speed as is compatible with a wise and necessary caution, to the original principle of Cash payments at the option of the holder of Bank paper." Nothing else would provide "sufficient remedy for the present, or security for the future."" These words would continue to echo through the endless debates over money that lay ahead.

  The House of Commons did not provide an opportunity to debate the findings of the Bullion Conunittee until the spring of 1811. In the meantime, pamphlets on the subject appeared in great quantity, instructing the public on the fine points of the issues involved. This was also the moment for the appearance of Ricardo's The High Price of Bullion and the Depreciation of Bank Notes. The topic became so hot that one newspaper bribed a clerk at the Bank to steal a confidential copy of the names of the Bank's borrowers, which appeared the next day on the paper's pages.

  On May 6, 1811, by which time the note issue had risen by another L2 million and the price of gold had extended its climb, Francis Homer finally transformed words into action by submitting to the House sixteen resolutions designed to implement the proposals contained in the Bullion Committee's report. Homer begins by tracing the sequence of events in the crisis that led to the formation of the Committee, after which he carefully defines the legal definition of a pound sterling in terms of its weight in gold and declares that Bank notes are promises to pay in such money.

  His resolutions end with two specific recommendations. First, that for as long as the suspension of convertibility continues, "it is the duty of the Directors of the Bank of England to advert to the state of the Foreign Exchanges, as well as to the price of Bullion, with a view to regulate the amount of their Issues.""y The second proposal urges all possible haste in returning to convertibility by moving the end of the suspension of cash payments from "Six Months after the Ratification of a Definite Treaty of Peace," as originally stipulated in the Restriction Bill, to "Two Years from the present Time. "'"

  Henry Thornton then added an extended analysis of runaway inflations in Sweden, France, Russia, and America. He went on to explain that the longer the depreciation in the value of the paper pound persisted, the more difficult it would be to reestablish the old standard. This was a point of primary importance, similar in its substance to the dispute in 1717 between Locke and Lowndes. "If the inflation provoked by the paper pound were to continue for eight, ten, or even fifteen or twenty years," Thornton declared, "then it may be deemed unfair to restore the ancient value of the circulating medium, for bargains will have been made and loans supplied under an expectation of the continuance of the existing depreciation."-"

  That is, when a rising price of gold significantly reduces the amount of gold that a pound can buy, all who owe money would be badly hurt if they were forced to pay the equivalent of the amount of gold that a pound would have bought when they had originally signed their contracts. Such misgivings reappear on every occasion when the authorities have been faced with the painful choice of snuffing out depreciation of their money or allowing it to continue.

  Homer's resolutions were debated in the House for four days. The first fifteen resolutions were defeated by a vote of 150 to 75; the final resolution to change the cutoff date went down by 181 to 47.

  What happened? Despite all its eloquent arguments, the Bullion Committee had simply ignored the brutal reality that Britain was engaged in the greatest war in history up to that time-a true precursor to the total wars of the first half of the twentieth century. The most important financial objective for the government was to encourage the highest possible level of production of food, coal, ships, guns and ammunition, and uniforms. Consequently, the leadership of the government was reluctant to put any brakes on the money supply as long as the war continued and the government was spending more money than it was receiving in tax revenues. Although the Bank had increased its holdings of government debt by very little up to 1810, its position in government securities would more than double between 1810 and the end of the war in 1815.52 The Chancellor of the Exchequer was vehement on the subject, announcing that the Committee's recommendations were equivalent to "a declaration that we must submit to any terms of peace rather than continue the war."5'

  Other members of the House, concerned about precisely the problem that agitated Thornton, were reluctant to return to the old relationship between the pound and gold when prices were already so much higher than they had been when the rupture took place-the very issue that would nearly tear Britain apart in the 1920s. A third group resented the attack on the management of the Bank and rose to their defense. It is amazing that the most vocal part of the opposition came from sheer incredulity that the Bullion Committee could have figured out matters properly and that the Bank's notes were actually "depreciating."

  The most dramatic response to all of the extended debate, and the defeat of Homer's sixteen resolutions, was provided by a young nobleman named Peter King. Because he was a nobleman, he was known by the delightful name of Lord King. As a member of the House of Lords, Lord King had been denied the opportunity to participate in the debate, and so he decided to drop his own private bombshell to underscore the validity of the Bullion Committee's analysis and Henry Thornton's worries about the impact of changing monetary values on contracts drawn in fixed sums.

  "For the defence of his property," Lord King informed his tenants that he would no longer accept Bank notes at face value in payment of their rents. He maintained that there was no reason why he should suffer just because prices had risen so much since they signed their various leases. Consequently, he proposed to give each of his tenants a choice of two options. They could pay him their rent in an amount in gold equal to the amount of gold that could have been purchased with Bank notes at the time their lease was signed, or they could pay him a sufficient amount of Bank notes to purchase that amount of gold at its present price. He even went so far as to declare his preparedness to pay his own creditors in similar fashion and to reduce the rent payments from his tenants if prices were to decline and the purchasing power of Bank notes improved. He then published his speech in a pamphlet that incorporated tables to help his tenants and any other interested parties to figure out what the adjusted payments would be.54 Lord King's announcement caused such a furor that Parliament passed special legislation declaring that the face value of contracts was inviolate and could not be so revised.

  There were more crises, more hearings, more public debates, more inflation, and even deflation before Parliament finally restored the convertibility of Bank notes into gold in 1821. By that time, the usual period of deflation that has followed major wars had driven the price level all the way back down to its level in 1797. The distortion that bothered Lord King in 1810 had been washed out of the system. Full cash payments in gold were restored and a new coin was issued, the sovereign, equal to twenty shillings and 21,Y21 of the amount of gold in a guinea; in preparation for this moment, the Mint produced a total of 35 million sovereigns in 1821.5' The gold standard was now an acknowledged reality, enshrined in official legislation. The British arrangements became the model for the rest of the world to follow for nearly one hundred years.

  The system put metal above man in managing the nation's money supply. Nobody ever thought that it would be easy to figure out how much money is the right amount. Most people want more money than they happen to possess, but easy money can lead to inflation in which all the extra money loses value. Consequently, managing a money system is a task mired in ambiguity, which is why today's central bankers are better at double-talk than plain English. Baron Rothschild is rumored to have said on one occasion that he knew of only three people who understood money, and none of them had very much of it.<
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  The act of faith underlying the gold standard was in the ability of free markets, expressed by changes in the price of gold, to do a better job than policymakers at this complex task. In this structure, gold was expected to support a system of checks and balances so that the supply of moneylike Goldilocks's chair-would never be too large or too small.

  But what happens when the quantity of the ultimate standard of value itself begins to grow? What, in essence, is the difference between the Bank of England creating paper money by generously accommodating their commercial customers in the early 1800s and the cornucopia of gold that the rash and daring prospectors of the nineteenth-century gold rushes contributed to the supply of cash in the United States, Australia, and South Africa? If Francis Horner had been alive when Francis Drake poured a flood of gold into the English economy in the late 1500s, would he have complained?

  Gold is a product of the earth, not some construct dreamed up by economists and financiers. Although the sober members of the Bullion Committee acknowledged that new supplies of gold might be discovered, they never contemplated anything to match the enormous gold strikes around the world between 1848 and the end of the century. The golden nuggets in the stream at Sutter's Mill in California made Croesus look like a piker, and Australia, the Klondike, and South Africa were yet to come.

  The excitement generated by the gold rushes was a vivid reminder of the central role that gold has played in our civilization. It is time to take a closer look at precisely how that happened.

  he yarns of the nineteenth-century gold rushes in California, Australia, the Klondike, and South Africa have been told over and over, in books, movies, and on television. Every library devotes yards of its shelves to the subject. All these accounts of adventure and personal drama are gripping, but they reduce a great story to too small a scale. The scope of the nineteenth-century discoveries dwarfed everything that had happened up to that point in the history of gold. Gold production in the United States surpassed both iron ore and petroleum in value until after World War I. Seen from that perspective, the gold of Croesus, Pizarro, and the caravans of the Sahara shrinks to tiny pinpoints. Furthermore, although the huge increase in gold supplies made possible the establishment of the international gold standard, the economic impact of the discoveries was radically different from the Price Revolution of the Sixteenth Century and quite the opposite of what most experts confidently expected to happen.