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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.