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The Bullionist debates (guest post by Mike Sproul)

(Here is another guest post by Mike Sproul. I will finally write my second reply to Mike on the "backing theory" by next weekend.)

On February 26, 1797, the Bank of England suspended convertibility of the pound into gold. Up until then, anyone who held a deposit at the Bank of England, or a paper pound issued by the Bank of England, had been able to redeem a pound at the Bank for just over ¼ oz. of gold. But a run had reduced the Bank’s gold reserves to 1/7 of their former level, and if not for the suspension, the Bank’s gold reserves would have been gone in a few more days.

The effects of the suspension were surprisingly positive. Business revived, and the pound initially held its value. But from 1797 to 1810, the pound fell by 20% against gold. The depreciation of the pound ignited what became known as the Bullionist debates. On the Bullionist (Quantity Theory) side, David Ricardo blamed the Bank of England for issuing more paper money than the economy could absorb.

"The issues of paper not convertible are guided by the same principle, and will be attended with the same effects as if the Bank were the proprietor of the mine, and issued nothing but gold. However much gold may be increased, borrowers will in- crease to the same amount, in consequence of its depreciation and the same rule is equally true with respect to paper. If money be but depreciated sufficiently, there is no amount which may not be absorbed, and it would not make the slightest difference whether the Bank with their notes actually purchased the commodities themselves, or whether they discounted the bills of those who would so employ them." (Ricardo, 1810, p. 85)

On the Antibullionist (Real Bills) side, Charles Bosanquet denied that the Bank of England had caused the inflation.

"…(inflation will result whether) the issue be gold from a mine or paper from a government bank. All this I distinctly admit, but in all this statement, there is not a single point of analogy to the issues of the Bank of England."

The principle on which the Bank issues its notes is that of loan. Every note is issued at the requisition of some party, who becomes indebted to the Bank for its amount, and gives security to return this note, or another of equal value… (Bosanquet, 1810, p. 83.)

Economic historians have been very kind to Ricardo, and his Reply to Mr. Bosanquet has been described as “perhaps the best controversial essay that has ever appeared on any disputed question of Political Economy.” (McCulloch, John R., 1845). In contrast, “poor Bosanquet is left cutting a very sorry figure.” (Sayers, R.S., 1953).

The Bullionist debates provide an excellent example of what happens to a debate when both sides are making fundamental errors. Both Ricardo and Bosanquet failed to understand the differences between gold, government-issued paper money, and privately-issued paper money (bank notes). Ricardo could not see that gold produced from a mine was an asset to its producer, while paper money is a liability to its issuer. The discovery of 1 oz. of gold would raise the discoverer’s net worth by 1 oz, while the issuance of paper money would not affect the issuer’s net worth. Ricardo never understood that since paper money is normally issued in exchange for equal-valued assets, the assets of the issuer naturally keep pace with the quantity of paper money it has issued.

Bosanquet made the same mistake when he equated gold with “paper from a government bank”. Having seen the inflation of the Continental dollars in America, and Assignats in France, Bosanquet concluded that the issuance of government paper money was fundamentally the same as digging new gold from the ground. Bosanquet and Ricardo both failed to see that government-issued paper money, such as the Continentals and the Assignats, was the liability of the government that issued it, and was backed by the assets of that government. Only when the quantity of government paper money outran the government’s assets would inflation result.

Bosanquet correctly saw that bank notes were issued on loan, were the liability of the issuing bank, and thus were fundamentally different from gold. He failed to see that Assignats and Continentals were also issued on loan, were the liabilities of the issuing governments, and were fundamentally the same as bank notes (and different from gold). This put Bosanquet in an inconsistent position: If money that is “issued on loan” is not subject to inflation, then why did the Assignats and Continentals inflate? If money issued on loan does cause inflation, then he would be forced to admit his opponents’ contention that the Bank of England had caused inflation. This was a weakness that Ricardo was quick to exploit.

"Let us suppose all the countries of Europe to carry on their circulation by means of the precious metals, and that each were at the same moment to establish a Bank on the same principles as the Bank of England — Could they, or could they not, each add to the metallic circulation a certain portion of paper? and could or could they not permanently maintain that paper in circulation? If they could, the question is at an end, an addition might then be made to a circulation already sufficient, without occasioning the notes to return to the Bank in payment of bills due. If it is said they could not, then I appeal to experience, and ask for some explanation of the manner in which Bank notes were originally called into existence, and how they are permanently kept in circulation. (Ricardo, 1810, p. 87.)"

Ricardo failed to see any difference between gold and bank notes. He did not mention that adding a “certain portion of paper” to the circulation might cause an offsetting amount of coins or other moneys to be removed from circulation.  He never considered that inflation could have been caused by a drop in the value of the Bank of England’s assets, and so when confronted with the fact of 20% inflation, he considered it proof that the Bank of England must have over-issued its money. By his logic, the mere existence of bank notes proved that they were over-issued.

So on the Bullionist side we have Ricardo, who wrongly lumped both bank notes and “government paper” together with gold. On the Antibullionist side we have Bosanquet, who correctly saw the difference between bank notes and gold, but still made the mistake of lumping government paper together with gold, rather than with bank notes. Neither side considered the Backing Theory. If they had, they might have seen that bank notes and government paper are both liabilities of their issuers, and are both valued according to their issuer’s assets. Thus, the 20% fall in the value of the paper pound could be attributed to a fall in the Bank of England’s ratio of assets to liabilities.

Since no one considered the Backing Theory, observers of the debate were left to choose between two flawed theories. Bosanquet’s errors were the more obvious of the two, since his assertion that issuing Bank of England notes on loan could not cause inflation left him unable to give a convincing explanation for the 20% inflation that had taken place.  Ricardo’s Bullionist theory, despite its flaws, at least yielded the simple (though misleading) result that inflation was caused by an increase in the quantity of money.

The victory of Ricardian Bullionism has left monetary theory in an unsettled state ever since.  The same mistaken ideas about the inflationary effects of gold, of government paper, and of bank notes, were a central part of the Currency School/Banking School debates of the 1840’s, the “Qualitative Credit Control” debates of the early twentieth century, James Tobin’s New View of the 1960’s, and most recently the Fiscal Theory of the Price Level.

The error that runs through all these debates is a failure to see that the value of gold, like all commodities, is determined by supply and demand, while the values of government paper and bank notes, like all financial securities, are determined by backing. People who have made otherwise valid criticisms of the Bullionist or Quantity Theory view have invariably fallen into the trap of thinking that government paper is valued like gold, while bank notes are valued according to their backing. This puts them in the indefensible position of claiming that paper money issued by governments is inflationary, while paper money issued by banks is not. Once we understand that backing determines the value of both bank notes and government paper, it becomes clear that the value of government paper is determined by the government’s assets, while the value of bank-created money is determined by the issuing bank’s assets.

  • Paul Marks

    I am certainly not uncritical of David Ricardo – for example his Labour Theory of Value (taken from some mistakes that Adam Smith made in his old age – but the development is really Ricardo not Smith) is a fallacy (as was pointed by Richard Whately, Samuel Bailey and others at the time) – and its pushing by James Mill and John Stuart Mill put economics on the wrong track for decades.

    However, Ricardo was right about the gold issue – the people (the people selling goods and services) wanted GOLD (that was money to them) they did not want Bank of England notes or commercial bank notes – so to talk of the latter (to talk of the paper) as "money" is accepting the use of FORCE (of the threat of VIOLENCE) in economic life. Legal tender laws and tax demands (and government courts backing the violation of contracts by commercial banks).

    As J.P. Morgan admitted a century later "gold is money – the rest is CREDIT".

    There is not such thing as a "costless" war – the wars against France could not be financed without real cost (although a HIDDEN cost) by the Bank of England printing notes.

    "Ah but it would have been different if they had been notes from commercial banks under free banking" – NO it would NOT have been different.

    The people (the selling the goods and services the government wanted to buy) still wanted gold – gold is what they wanted. Attempting to hide this basic fact by talk of "real bills" (or whatever) is no good.

  • Mike Sproul

    "gold is what they wanted. Attempting to hide this basic fact by talk of "real bills" (or whatever) is no good."

    People want GOODS, including gold. A real bill is a claim to goods, and so people value it. They might denominate the value of the bills in gold, dollars, etc, but it comes down to goods in general, not just gold.

  • Paul Marks

    Mike if the sellers of goods and services say they want gold in return for their goods and services who am I (and who are you) to say they "really" want something else?

    The sellers of goods and services should not have been forced to accept non gold when they wanted gold. Physical gold.

    And contracts (whether private contracts or government contracts) that said gold should have been honoured – not "legally" violated.

    By the way do we at least agree that the present situation (right now – not centuries ago) where the big players who (backed by the Federal Reserve and the other Central Banks such as the Bank of England) have been "selling gold" to depress the price, when this gold DOES NOT EXIST, is wrong?

    Is it not wrong to pretend to have gold (indeed to "sell gold") when one does not really have it? And if you doubt me – why is the government of Germany having such odd difficulty in getting its gold back from the New York Federal Reserve?

    The present system is based upon what an ordinary person would call FRAUD – and the fact that the regime declares it is not fraud (because they can make the law say anything they want it to) does not change that.

    • Mike Sproul


      Anyone, from a bank president to the town drunk, should be able to write out a piece of paper that says "IOU 1 oz, or 1 lottery ticket, or 1 strawberry, or whatever". There will be varying degrees of fraud involved, but if people choose to accept those IOU's, it's their business.

      Likewise, anyone, including the B of E, should be able to sell gold (or anything else) short. It's the customer's choice as to whether he wants to buy the thing being sold short.

      Don't know enough about the German situation to answer.

      • Paul Marks

        Mike – neither the Bank of England or the New York Federal Reserve have said they are playing the short selling (or naked short selling) game, according to them they have all the physical gold they say they have.

        Very well then – let them produce it by physically providing it to the "gold sellers" they have backed.

        I repeat what I have often said. Whatever commodity is used as money, ownership can be transferred electronically – so there is no need for "pieces of paper", unless (of course) the issuers of these pieces of paper do not really have the physical commodity they say they have. In which case we are in the world of Mr Ponzi and Mr Bernie Madoff.

        • Mike Sproul


          Selling short means selling something you do not have, so what did you mean when you said in one place that it's wrong for the BOE to sell gold it doesn't have, and then turn around and say that the BOE says they are not short-selling?

          If a dollar specifically says that its issuer holds 100% gold reserves, then its issuer should hold 100% gold reserves. But if a dollar specifically says that its issuer operates on fractional reserves, and if people use those dollars for centuries, then I'm OK with that.

          • Paul Marks


            I know what "short selling" and "naked short selling" mean.

            But the whole point is that the big players on the London gold market say that the Central Banks are backing them and the Central Banks (such as the New York Federal Reserve) say they have the gold. That they are NOT engaged in what you describe.

            O.K. New York Federal Reserve – let us see the gold you say you have.

            It is very simple – they either have the gold or they do not have it.

            So no more tap dancing.

  • MichaelM

    Mike, you need to do a post on exactly what you mean by 'determined' here because, if you want to mean 'determined' in a temporally sequential, cause-and-effect sense, I don't see how valuation of government paper money based on the government's assets is possible when most government issuers of paper money do not publish extensive listings of their asset holdings and even those that do aren't necessarily going to have accurate valuations of all those assets. Then there is the uncertainty that surrounds the concept of an 'asset' when we're talking about a governing body — is the taxing power an asset? Is the power of eminent domain an asset?

    I'm not seeing exactly described a mechanism for how this valuation process occurs. You can say something about expectations and demand for cash balances in a particular form of money (ie. people pay attention to a bank's asset holdings as a way of knowing whether they will be able to keep up redeemability, and this heavily influences their demand to hold balances of this bank's liabilities), but this is something that makes perfect sense from a quantity-theoretic point of view.

    Ultimately, it seems to me like the 'backing theory' is just a truism running back to accounting identities and practices, rather than a useful theory that tells us truths that are applicable in an economic system.

    • Mike Sproul


      Money is normally valued more like a bond than like a share of stock. (Think of the payoff to a written put option.) The value of a bond issued by a solvent firm is invariant to the firm's assets. Only when the firm becomes insolvent does the value of the bond vary with the issuer's assets (like a share of stock).

      This is easiest to see in the case of convertibility. If the money issuer pegs a dollar to 1 oz of silver, then as long as the issuer is solvent, $1=1 oz. If the issuer becomes insolvent, then the value of a dollar will reflect the issuer's assets and liabilities. Only in this case do people have to check with those "extensive listings" to estimate the true value of the dollar.

      Once the convertible case is understood, the next step is to recognize that the rules for valuing inconvertible dollars are barely any different from the rules for valuing convertible dollars. Convertibility can mean many things, after all. It can be instant or delayed, certain or uncertain, based on gold, taxes, bonds, etc.

  • Rob Rawlings

    "The error that runs through all these debates is a failure to see that the value of gold, like all commodities, is determined by supply and demand, while the values of government paper and bank notes, like all financial securities, are determined by backing"

    Would it not be more correct to say that the demand for financial securities is also determined by supply and demand , but a large determinate on the demand side is the level of backing ?

    • Paul Marks

      The value of government (or private) paper money is also determined (in part) by supply and demand.

      Increase the amount of paper money and, eventually, its value will start to drop – although this may be seen in asset price inflation (such as the stock market or the real estate market) rather than "prices in the shops".

      As for "backing" – the whole concept is weird. Either the commodity (whether it is gold or silver or whatever) is the money or it is not – if it is the money then it is not "backing" (the money is simply a certain weight and purity of the commodity – and ownership can be transferred electronically between sellers and buyers), and if the commodity is not the money then there is no need for "backing".

      The whole idea of "backing" seems to be about giving people the impression that the money is a certain commodity (say gold or silver) whereas, in reality, it is not. But we are not allowed to call this "fraud" even though the intent is to deceive for financial gain.

      • Mike Sproul


        1) If the new dollars were always issued for 1 oz worth of goods, then $1=1 oz no matter how many dollars are issued. Of course banks will normally not push the issuance of dollars to the limit like that. If excessive dollars are issued, they will reflux to the bank, and the bank will stop issuing.

        2) If a dollar coin contains 1 oz of silver then the coin is itself a commodity and there's nothing to explain. But a dollar can also be a piece of paper convertible into 1 oz, and that dollar can buy things at the store the same as a coin, whether it is called money or not.

        3) Sometimes paper money is issued fraudulently and sometimes not. Stores issue $1 gift cards all the time, generally without any fraud involved.

    • Mike Sproul


      People often speak of the value of bonds and stocks being determined by supply and demand, and the idea looks reasonable on its face, but if, for example, a paper dollar is a claim to 1 oz of silver, then $1=1 oz, regardless of supply and demand. If we wanted to speak of the supply and demand for paper dollars, the only reasonable way to draw both the supply and demand curves is a a horizontal line with a height of 1 oz/$. We might imagine that the supply of dollars was suddenly restricted, and as a result $1=1.01 oz, but this would create arbitrage opportunities. Same if the demand for dollars suddenly fell and $1=.99 oz.

      It's an easy distinction to make: The value of GOODS is determined by supply and demand, and the value of financial securities is determined by backing.

      • No. The value of financial securities relative to silver, gold or other assets is fixed. But that's not what people mean when they talk about value. They mean the value of the financial security relative to consumer goods and services. A silver certificate issued for one ounce of silver will always and everywhere equal one ounce of silver. But the number of apples that silver certificate can buy may vary widely due 1) to the supply of silver certificates and/or 2) the supply of silver.

        • Paul Marks

          "A silver certificate issues for one once of silver will always and everyone equal one ounce of silver" – no Mr McKinney it will not.

          Both the silver market and the gold market are rigged (systematically rigged with the full support of the authorities – so it is pointless to call the police) the physical gold and silver is simply not there – which is why customers in the Far East are already demanding a premium to accept "certificates" rather than physical metal.

          When this corrupt system will collapse I can not tell you (even Jim Rogers can not give a specific date), but collapse it will.

          • Mike Sproul


            Yes, a 1 oz. IOU written by the town drunk will sell for less than 1 oz. But a 1 oz IOU written by the local bank president will sell for 1 oz.

        • Mike Sproul


          Agreed. But nothing about this contradicts my assertion that goods are valued according to supply and demand, while securities (like so-called credit money) are valued according to their backing.

          • Paul Marks

            Mike you really trust Bank Presidents more than the town drunk? Even after everything that has happened?

            I do not know the town drunk in your town – but I can tell you that the people (the banking people and so on) involved in the gold market are crooks (they really are).

            So your faith is utterly misplaced.

  • "… inflation could have been caused by a drop in the value of the Bank of England’s assets, and so when confronted with the fact of 20% inflation…"

    Of course, the next question is why did the BoE's asset's decline in value? Assets don't just lose value; they lose value relative to something else. For example, in a barter economy an apple may trade for a potato at one point. If suddenly people in the market demand two apples for each potato, then we would never say that apples have lost value. We would say they have lost value relative to potatoes.

    Gold can lose value because of a surge in production, as it did in CA during the gold rush when a glass of milk might cost $10. Gold lost value relative to milk and other consumer goods.

    " The error that runs through all these debates is a failure to see that the value of gold, like all commodities, is determined by supply and demand, while the values of government paper and bank notes, like all financial securities, are determined by backing."

    Mike repeats his assertion that the value of financial securities are determined by their backing and not by supply and demand. Yet he never shows why supply and demand apply to everything in life but financial securities. Or why the theory of value applies to everything in life but securities. Very strange that securities seem to have something unique that none of the basic principles of economics apply to them.

    Yes, securities are different from gold. But commodities have more differences among them, and services are very different from commodities, yet services follow the principles of value and supply/demand just as commodities do. Mike's challenge is to so why financial securities, which are very much likes services, aren’t subject to the principle of value and supply/demand.

    If bankers follow the strictest principles of the banking or real bills school, very little inflation would happen because the newly created credit money would quickly disappear as the short term loans were paid off. The problem of inflation only arises when bankers lend on longer term securities and do their normal borrow short and lend long thing. Then the new money doesn't disappear for a long time.

    If banks borrow short and lend long, a violation of the banking principles, but if banks didn't do it then insurance companies or other institutions would do it because it's too lucrative. Someone has to lend long term because consumers need long term lending to buy assets such as housing and cars and businesses need it to build plants and buy equipment. Demanding that all lending institutions lend only for the short term is unrealistic.

    When banks do that, then businesses spend the new money on hiring labor. The new money in the pockets of the workers increases their demand for consumer goods and the increased demand causes prices to rise. Mike can argue that increased demand and not the money issue caused inflation, but the increased demand would never have happened without the loans. He can say that the value of collateral fell, but that's just semantics. We can say prices rise or the value of money falls but they are the same thing.

    • Paul Marks

      As both Ludwig Von Mises and F.A. Hayek (at least Hayek before extreme old age – when his opinions may have changed) pointed out, the arguments of the early 19th century "Banking School" were a series of fallacies, the idea that credit-money expansion (rather than just REAL SAVINGS) is needed for the "needs of trade" is wrong – flat wrong.

      However, the "Currency School" who were "right about the problem" were "wrong about the solution" (the Banking Act of 1844). Limiting note issue by banks ignores the basic problem that they can engage in credit expansion (i.e. the creation of credit BUBBLES – boom-BUST) in many other ways.

      If someone is to get a loan (either for consumption or for investment) someone else must MAKE A SACRIFICE OF CONSUMPTION (which is what REAL saving actually is). If there is not an equal (or greater) sacrifice of consumption to the loans then a credit expansion (a credit BUBBLE) has been created.

      As for gold and silver – no great expansion of production has taken place, it simply has not.

      Nor has then been any decline in the demand for physical gold – indeed demand has gone up.

      Supply – no great increase (of either gold or silver}.

      Demand – no decline.

      Yet a 20% "decline in the gold price" in 2013.

      The solution to this paradox is clear – THE MARKET IS RIGGED.

      It is that brutally simple.

      And if I am wrong…..

      Let the "gold sellers" (and the Central Banks who stand behind them – as they are really the creatures of the Federal Reserve and the Bank of England and so on) show the physical gold they are selling.

      They can not show the physical gold.

      Because IT DOES NOT EXIST.

      • Mike Sproul


        Mises and Hayek, for all their excellent work on libertarianism and free markets, were wrong about money. That's why their followers tend to advocate some very unlibertarian restrictions on free banking, such as gold standards, restrictions on fractional reserve banking, and artificial restrictions on the quantity of money.

        Do you object to people making bets? Like, for example, for every $1 rise in the price of gold, A pays B $1, while for every $1 fall in gold, B pays A $1. That's all that people are doing when they trade gold that they don't have. Nothing wrong with it as long as both parties have their eyes open.

        • Paul Marks

          Firstly both Hayek and Mises were SUPPORTERS of Free Banking.

          As for "wrong on money" – just stop this, please just stop it.

          If you have not got the gold you say you have (or whatever commodity you have agreed to in a private contract) then just be a man about it, do not do a tap dance and try to "redefine" what you agreed to.

          As for money the main work on this was done by Carl Menger (not that he contradicted anything that had been understood before him).

          Money is primarily a STORE OF VALUE (the fact that economic value is subjective does not mean that it can not be stored – indeed such commodities as gold and silver have served this function for thousands of years) money is also a medium of exchange – but if something is just a medium of exchange without being a store of value there are big problems with it (Bitcoin people please note).

          As for money lending – the word "banking" does not add anything useful.

          A money lender should have the money that he or she is lending – either their own REAL SAVINGS or the REAL SAVINGS of other people (entrusted to them to be lended out).

          If the money lender does not really have the money they claim to have then they are engaged in a SCAM – a credit BUBBLE.

          And eventually the bubble will burst – boom turns to BUST.

          When people come for the CASH and the banker does not have it, he should admit the truth and go BANRUPT – not demand that the state (or its courts) "suspend cash payments" or bail him our in some other way.

          This is FREE BANKING Mike.

          It is when a money lender does NOT call upon the state to save him from the private contracts he voluntarily signed.

          If you lend out "savings" that DO NOT EXIST you have created a BUBBLE and that bubble will BURST.

          When it bursts you should not go crying to the state (or its courts)

          Better yet……

          Do not create the bubble in the first place – lend out money that actually does exist (not book keeping tricks and other jive and double talk).

    • Mike Sproul


      1) The BOE's assets fell in value because it was the period of the Napoleonic wars.
      2) The distinction between goods and securities is pretty clear, and when people explain the value of securities, they only rarely (and mistakenly) speak of supply and demand as determining value. For example, the Black Scholes model has no parameter for the supply of calls or the demand for calls. Securities pricing always hinges on arbitrage relations, not supply and demand. For example, if a dollar that is convertible into 1 oz ever sells for 1.01 oz, then that's an arbitrage opportunity.
      3) It's not a question of money disappearing. As long as every dollar is issued in exchange for 1 oz worth of goods or securities, then $1=1 oz, regardless of whether dollars were issued for short or long term bills.
      4) New money that is issued for equal-valued assets does not change the net worth of either the issuer or the receiver of the money, so it does not change the demand for goods and does not cause inflation. When we do see inflation, it is caused by money outrunning the issuer's assets, not by its effect on demand for goods.

      • Paul Marks

        Mike the real assets of the Bank of England did NOT "fall in value" because of the wars with France or any other reason.

        The gold and silver in their vaults was not destroyed by war (no one came and used an anti matter bomb on it) the NOTES the Bank of England produced fell in value – and they fell in value because they PRINTED MORE OF THEM.

        Yes they printed more of them to finance the war – but had there been NO WAR and they printed more of them, the notes would still have fallen in value.

        And please stop talking about "gold and services" – that is "index money" (Irving Fisher to the, very late, F.A. Hayek).

        Bank of England did NOT say "I promise to pay you one once of goods and services".

        You know perfectly well what was what promised – and as the Bank of England printed a lot more notes (without having more metal in its vaults) it could no longer honour its promises.

        Some index of "goods and services" had nothing to do with the matter.

        And Frank Fetter refuted Irving Fisher on "stable price index" stuff the best part of a century ago.

  • I think it would clarify things to understand that we are using the term "value" in two different ways. When you say goods are valued by supply/demand, you're using the exchange definition of value. When you say securities are valued according to their backing, you're using it to mean the contract value. It's like the difference between the coupon rate of a bond and the actual rate one will earn in the market place when you buy it. The two rates are usually different. Of course the coupon rate, the contract rate, will always be that stated on the bond, but the exchange rate will vary widely.

    So when the security contract specifies that the owner can exchange a security for a fixed amount of silver/gold specified in the contract, most of the time the owner can exchange the two at the contract rate.

    But during bank runs it won't. Since banks always and everywhere issue notes the some of which is greater than the total backing, when people figure that out and a bank run starts then the bank will find it physically impossible to keep the contract rate of exchange.

    But even without a bank run, securities backed by gold/silver will lose exchange value regardless of the backing. Because of the expansion of the volume of securities in the market above the total backing, the securities will lose value in exchange with goods/services even if the gold/silver backing does not. That becomes visible as price increases for goods/services. You would say the increase in demand causes the rise in prices, but the demand would not increase without an increase in the supply of securities.

    Of course, I'm talking about a general rise in prices, not just the rise in a few commodities. With a fixed quantity of money, an increase in the price of oil, for example, through increased demand would force a reduction in other prices and no general rise in prices. Mathematically, it's impossible for all prices to rise without an increase in the quantity of money.

    In sum, you're right that securities retain their coupon, or contract value except in the rare cases of bank runs. But their exchange value, their power to purchase goods/services, can change dramatically depending upon the volume issued.

    • Paul Marks

      An honest bank would have no problem with bank runs – for the following reason.

      People who entrusted their savings to the bank to be lent out, would know that their savings were NOT THERE (they had been lent out) and thus would not line up demanding that money be given to them – money that was not there.

      People who wanted the bank to just look after their savings (not lend them out) would PAY the bank to do so – and the money would be there (physically there – in the vaults) to be withdrawn whenever they wanted it.

      The problem of bank runs is due to the dishonest (misleading with the intent to financially benefit) practice of calling money that is lent out a "deposit".

      Money that is to be lent out is NOT a "deposit" – it is not deposited(it is lent out).

      If this was all made clear in advance there would be no such thing as a "bank run".

      As people who just wanted their money protected ("deposited" in the vault) would pay the bank for this service, and those people who were prepared to RISK their savings (in return for interest) would not line up trying to "withdraw" money they knew (in advance) was not there.

      The problem lies in pretending that different parties can have the same money at the SAME TIME (a false idea reflected in banking accounting where loans are "money credited to the account" and people who hand over their savings to the bank, to be lent out at interest, are told [insanely] that they still have the money).

      If my savings are lent out I do NOT have them any more (so it is pointless trying to withdraw them – they are not there) – not till when and IF the loans are repaid.

      If I do not like this – then I should not ask for interest, indeed I should PAY THE BANK (for storing my savings for me – and so on).

      • Mike Sproul


        So if fractional reserve banks stopped using the word "deposit", and substituted a phrase like "fractional reserve lodgement", then you'd be OK with that? It seems to me that we're all OK with fractional reserve banking as long as both parties have their eyes open.

        BTW: Any bank is vulnerable to being robbed, or to its assets (like bonds) falling in value, and if an insolvent bank maintains convertibility of its money at a fixed rate, then a run will result. The only way to be safe from runs is for banks to be able to suspend convertibility of their money.

        • Paul Marks


          What I would be O.K. with is for the banks (or any money lender) to lend out the REAL SAVINGS of savers who had agreed to this (savers who did not want to agree would have to PAY THE BANK if they wanted it to look after their money – not lend it out).

          Bankers (or anyone) who tries to lend out money that DOES NOT REALLY EXIST (a "fraction" of 30 tenths, or 100 tenths or a 1000 tenths) via book keeping tricks, create credit bubble – a boom-BUST.

          They wind up begging the government courts to void their contracts – by "suspending cash payments" and other tricks (and the bust happens anyway).

          Whether lending out more money than actually exists should be "illegal" is a legal question – not a question of economics.

          Under old Roman law it was illegal – under the law of the United States (and the United Kingdom) it is NOT illegal.

          From the point of view of economics all that can be said is that creating a credit bubble (lending out "money" that DOES NOT ACTUALLY EXIST) creates a boom-BUST.

          Remember saving must be a SACRIFICE OF CONSUMPTION – if there is no sacrifice there is saving.

          Just calling book keeping tricks "savings as real as any other" (as Lord Keynes did – for a detailed examination of this see Hunter Lewis "Where Keynes Went Wrong") does not make book keeping tricks real savings – and does not prevent the boom-BUST.

  • Mike Sproul


    "But during bank runs it won't. Since banks always and everywhere issue notes the some of which is greater than the total backing, when people figure that out and a bank run starts then the bank will find it physically impossible to keep the contract rate of exchange."

    We also need to clarify the difference between "assets" and "reserves". Say a bank issues 100 bank notes ("dollars") to people who deposited 100 oz of silver. Note issue=assets=reserves. But then the bank spends 80 oz buying land (or bonds, or whatever) worth 80 oz. Now, assets=note issue=100, and reserves=20. This bank is solvent, and can handle a run by first selling its 80 oz of land and buying back $80 of its notes. Then it can use the 20 oz of reserves to buy back the remaining $20 of notes, and everyone is paid in full. At no point does the value of $1 fall below 1 oz.

    But suppose the bank's land drops in value from 80 oz to 70 oz. Now the bank is insolvent, and a run can't be stopped. The best depositors could hope for is that their $100 of notes will be redeemed for the bank's 90 oz worth of assets.

    • Paul Marks

      Why should the bank bother to issue notes at all?

      The ownership of the silver (or gold) can be transferred electronically (there is no need for notes).

      And even before the invention of electronic means the gold or silver coins could have been handed out at the bank (when savers agreed for their savings to be lent out, i.e. agreed to RISK them, in return for interest). All this stuff about "have notes because gold or sliver coins might damage your clothing" or "you might fall in a river and drown" was just jive (double talk – cant) to hide a SCAM.

    • Yeah, something similar happened to cause the latest crisis. Investment banks borrowed money using MBSs as security, which were derivatives based on real estate. Those banks became insolvent when the value of the MBSs collapsed. But the value of the MBSs collapsed because real estate prices fell. Real estate prices fell because the money supply plateaued after increasing for a decade. Rising real estate prices had accompanied credit expansion, but when the Fed slowed the growth in money by raising interest rates, the price of real estate collapsed due to collapsing demand. Since the asset behind the MBSs had collapsed, so did the value of the MBSs. The whole process is described in the Austrian business cycle theory.

  • Mike Sproul

    Paul and McKinney:

    You're right to think that one person's borrowing must be matched by another's lending. You are also right that things have to add up. Borrowed goods can't come out of thin air. But you're wrong to think that fractional reserve banking violates these principles. Sane lenders only lend to people who have enough wealth of their own to pay back the loan, so every dollar created by lending is backed by someone's property, whether or not the lender operates on fractional reserves. (I'm deliberately speaking of lending, not saving. Irving Fisher's intertemporal choice model identifies them as two different things.)

  • Paul Marks


    It depends what you mean by a "fraction".

    If you mean less than ten tenths of the cash savings (the real savings – the sacrifice of consumption) then you are correct.

    If total cash savings are one billion Dollars and total lending is 900 million Dollars (90% – or nine tenths) then no credit bubble has been created and no boom-bust will occur.

    However, that was not even the case in the time of the first Mr J.P. Morgan – he used to lend out (in various complex ways interconnecting with other banks) 30 Dollars for every 10 Dollars (cash – in those days gold) he really had. Not nine tenths – 30 tenths.

    Today one is talking in terms of hundreds or thousands of tenths.

    The vast majority of "money" is not money at all – it is a credit bubble.

    But even in the time of Mr Morgan (a time of RELEATIVE sanity) Fractional Reserve Banking did break the rule that all lending should be from real savings – because it simply was not.

    Today there is hardly any connection at all between real saving and lending.

    The financial and monetary system is no longer distorted (as it was in the days of Mr Morgan), it has become an insane nightmare.

    • Mike Sproul


      If the loans you are describing were made without collateral, then you'd be right, but loans are made with collateral. If I have a $100,000 house, the most I can borrow against it is about $80,000. Once that's done, there is an $80,000 lien on my house, and I can't borrow any more against it. The loan has coined my house into money, but the money was not created out of thin air.

      • Paul Marks


        Stuff is still "awaiting moderation", but I will reply to this point.

        "collateral" is not relevant to this point.

        I can not lend what I do not have, and a third party acting on my behalf (called a "bank" or whatever) can not lend what it does not have.

        Someone may have wonderful "collateral" (for example a mountain entirely made of rubies), but if I have no money to lend them, I have no money to lend them.

        Their "collateral" is not relevant to this logical matter.

        If someone wants a loan they should go to someone who actually has cash-money (REAL SAVINGS) and pay the interest they request for lending (risking) their money, not to someone who does not have the money.

        And no amount of clever book keeping tricks changes this.

        • Mike Sproul


          Suppose I have 100 turkeys, and you have 400 chickens. Chickens trade in the market for 1 oz of silver each, and turkeys for 4 oz, but chickens are more liquid, since they are consumed year-round, rather than mostly during holidays.

          You could easily buy your groceries by writing chicken IOU’s, since everyone knows you have the chickens to cover them. So suppose you’ve written 150 IOU’s, that each IOU is worth 1 oz (or 1 chicken), and that people use your IOU’s as money.

          One day I ask you for a loan of 30 of your chicken IOU’s, and I offer my turkeys as collateral. The supply of IOU’s rises by 30, but they are fully backed by at least 180 oz worth of chickens and turkeys. None of the IOU’s is backed specifically by silver, and the last 30 IOU’s are backed by turkeys rather than chickens, but they are all adequately backed, even though they were issued on fractional reserve principles.

          • Paul Marks


            If you do not have something you can not lend it.

            It does not matter if it is a chicken or a piece of silver.

            If you do not have a chicken you can not lend me a chicken. And if you only have five chickens you can not lend me ten chickens.

            If you do not have any silver you can not lend me silver. And if you only have five ounces of silver you can not lend me ten ounces of silver.

            A "fraction" of 100 ounces of silver is less than 100 ounces of silver – for example 90 ounces of silver (this would be a fraction of 9 tenths).

            You can not lend out 110 ounces of silver if you only have 100 ounces of silver – you can not lend out a "fraction" of 11 tenths.

          • Mike Sproul


            You are not lending me chickens that you don't have. You are just lending me a chicken IOU but keeping physical possession of the chickens.

  • Mike, Your description of the role of backing sounds to me basically the same as the description I or other quantity theorists give to the workings of a currency board. If you used the word redeemability rather than backing we would be saying the same thing. If started de novo, a currency board is necessarily fully backed because currency is only issued for the redemption asset at a fixed price and over issue is redeemed at the fixed price of the asset backing the currency. You say reflux, which is the same thing I think. So is there any difference between your backing theory and the quantity theory? Maybe not if backing is a devise for regulating the quantity of money. In real life the issue has been raise whether full backing is necessary, when an existing central bank becomes a currency board (i.e. adopts currency board rules) and only has some of the foreign exchange needed for backing (it has other assets, of course so unless it has negative capital its assets exceed its currency liabilities even if its redemption assets don't). We have argued (and in practice this has worked as long as the rules were followed) that full backing was not important (as long as there was enough of the redemption asset that the market never lost confidence in the central bank's ability to honor its redemption commitment. So here is a test of whether the quantity theory and backing theory are the same or not. I would argue that a currency not fully backed but fixed in price to an asset the central bank had a lot of but less than its currency liabilities would work just as well with the same inflation behavior as a fully backed one. It is fully backed at the margin only. Backing theory would seem to say that it would not. But further up there some where in this discussion, you said, correctly in my view, that the value of the currency issuers assets only matter in bankruptcy. That is the quantity theory view, i.e. the role of redemption/backing is to regulate the quantity of money to keep it consistent with its fixed price visa vise the redemption asset (or valuation basket ect). If your backing is not a quantity theory explanation, how does it work?

  • Mike Sproul


    I think we'd both say that the quantity theory does not apply to a currency board. Whether a currency board held $100 as backing for 100 astrals, or $200 as backing for 200 astrals, 1 astral=$1 either way. I think we'd also agree that if a currency board tried to maintain a peg of $1=1 astral, and if that board held only $99 against 100 astrals issued, then there would be a run on the board, with the first 99 astrals getting $1 each, and the last getting nothing. Now change just one thing: Let the assets consist of $100WORTH of various assets, rather than actual dollars.

  • Mike Sproul


    Sorry for the partial post above. For some reason, accidentally hitting the tab key makes the comment post.

    Anyway, whether we have a board holding $100 against 100 astrals, or a (fractional reserve) bank holding $100 of various assets against 100 astrals, both of the results from the first paragraph still apply: (1) If you double assets while doubling money issue, the value of money is unaffected, and (2) Keeping anything less than full backing results in a run and collapse. Both of these results are inconsistent with the quantity theory, but consistent with the backing theory.

    Two areas where we are far apart: (1) I'd say that a partially backed currency will not work. (2) Backing is a device for regulating money's value, but not its quantity.

    • Paul Marks

      To think in terms of "backing" is not good.

      Money lending should be exactly that – the lending of money (not something that, supposedly, represents something else).

      Real savers should agree to lend (to risk) their savings in return for interest – either directly lend their savings (as in peer to peer lending) or via a trusted third party (called a "banker" if you wish – as long as it is understand that calling someone a "banker" does NOT give them magical powers to create money from nothing).

      The idea that money can be lent out and (at the same time) still be in the account of the saver is a fundamental error – and no amount of book keeping tricks (or the use of complex language) can make it not an error.

      As for what people use as money – what commodity is used as money should be up to buyers and sellers. However, if the money is (for example) silver (of a certain purity) then lending must be the transfer of the silver (not something "backed by silver" – that just leads to a mess) from the saver to the borrower, no pretence that the savers somehow still have the money after it has been transferred to the borrowers.

      For those who do not wish to carry physical commodities electronic transfers of ownership are available.

      And for those who do not wish to lend (risk) their savings – enterprises will look after them (true "deposit" holders), but only if they are paid (by the savers) to do so.

  • Paul Marks


    If you are lending a chicken you had better have a chicken to lend.

    I am not interested in your IOU.

    An IOU is from the borrower – not the lender.

    It is like going to a shop – the customer might say "I do not have any cash right now – will you let me have a chicken, I will pay you tomorrow". Then it is up to the shop keeper to decide whether or not to trust the customer

    But if the shop keeper tries to sell a chicken that DOES NOT EXIST – that is just nuts. The customer can not eat it, and it will not lay eggs.

    You can not lend what you do have.

    If you do not have the money (the real savings) you can not be a money lender.

    A bubble blower is not the same thing as a money lender.

    • Mike Sproul


      A turkey farmer can issue an IOU for 1 chicken. You wouldn't buy it, but I would, since I know that he has enough turkeys to cover the chicken IOU. He's willing to issue it, and I'm willing to buy it. It would be very anti-free-banking of you to interfere and forbid our exchange.

      • Paul Marks


        I am not trying to "forbid" anything – this is not a blog on legal matters, it is a blog on economics.

        All I am saying is that WHEN you go bankrupt because you do not have the turkeys you have promised, you should be allowed to go bankrupt (no bailouts).

        Ditto those people and institutions (including the Federal Reserve) who have promised people and institutions (such as the German Central Bank) gold they do not have.

        I repeat I am not interested in your IOUs – and, in the end, no one is interested in IOUs. If you do not have the actual stuff you claim you have, then you go bankrupt.

        Whether or not you should also go to jail (for fraud) is another question – and I have expressed no opinion about that.

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