Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Central banks across the globe use a common set of policy tools to achieve their inflation and employment goals – regulating the money supply and interest rates, and occasionally implementing measures such as quantitative easing. That toolkit can trace its origins to the intellectual contributions of David Ricardo, one of the earliest opponents of a gold standard.
“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”1. Readers of Advisor Perspectives will recognize this most famous of all quotations about the influence of academic ideas on actual economic events. Much more difficult to find are the opposite circumstances: when sound ideas are excluded from economic theory because they have practical rather than academic origins.
David Ricardo is the best example of a counterfactual to Keynes’ witticism. He is a “defunct economist” of note, whose thoughts on the labor theory of value, comparative advantage, and the law of diminishing returns can be found in references in the academic literature. What goes largely unnoted (and completely absent from his Wikipedia page) are Ricardo’s practical conclusions about what works best as a currency system.
Ricardo began working in the City of London in 1786 at the age of 14 as a clerk and runner for his father’s brokerage firm. By age 21 he was an established bill broker – a trader in the exchanges of Bank of England notes, trade bills, gold guineas and silver sterling. He then took what was, in retrospect, the largest single gamble of his life. He and Priscilla Anne Wilkinson eloped and married. Each of them was immediately and permanently disowned when their families learned the news: Ricardo for marrying anyone other than a Jew, Wilkinson for marrying anyone not a Quaker. From that day forward, neither of their families spoke or wrote to them again.
After being banished, Ricardo was able to join a firm run by John Lubbock, a speculator. Lubbock and his partners were busy using Newton’s calculus to make their bets on the spreads between bank paper, sovereign debt, and gold and silver coin and bullion. Within a generation the Lubbocks and others in the City were regularly incorporating academically-trained mathematicians in their operations.
Ricardo never attended university, but he thought mathematics was the key to understanding political economy. John Louis Mallett complained about Ricardo’s conduct as a member of Parliament, “He meets you upon every subject that he has studied with a mind made up, and opinions in the nature of mathematical truths.”
This was not yet a common practice in political economy. In the debates over whether the Bank of England should return to the gold standard, there is very little that can be described as “quantitative” argument. The two sides’ disagreement was almost entirely over the question of “value.” The supporters of the gold standard – the “Bullionists” - believed that gold’s unique physical properties and scarcity gave it inherently stability. Gold’s value fixed its price. By ordering the Bank of England to resume exchange of gold coin for its notes, Parliament could effectively end the inflation that had troubled Britain during its two decades of war against France.
On the other side were the members of the “True Bills” or “Quantity” school. The second label can be confusing because both the Bullionists and the True Bills schools accepted the monetarist premise that the quantity of money determined the price of the currency. Where the members of the True Bills disagreed was over the performance of gold; it was, they argued, not “storehouse of value.”
Even when Britain had been on a gold standard, the price of money had been unstable. In 1717 the shilling had been established in 1717 as 6.16 grains of 22-carat gold; the Bank of England had received the privilege of a near monopoly on note issue. Yet, during the next 80 years, measured by what they would buy, guineas had gone up and down by as much as 50%. New discoveries of gold could lead to the kind of inflation that Europe had experienced with the Spanish seizure of the riches of America and the Philippines; a shortage of gold could produce a collapse in prices.
To regulate the money supply and prices, there had to be a direct control of the quantity of money by the Bank of England. The Bank should regulate its volume of note issues by only discounting the “true” bills of merchants. By paying strict attention to the needs of commerce, the Bank of England could ensure that its notes would act as a stable measure of value.
As a practical matter, Ricardo wanted the Bank of England to be obligated to exchange of paper money for coin. But, as a matter of economic theory, Ricardo had come to disagree with the Bullionists. Gold had no intrinsic quality that made it a unique “storehouse of value.” Its price – the quantity and quality of what it could be exchanged for – fluctuated in exactly the same manner as other items in active commerce. How could it do otherwise?
Gold as money and what it bought were always a paired trade.
Ricardo also thought the advantages of symbolic money (paper notes and checks in Ricardo’s age, digital debits and credits in ours) were too obvious to require defending; that, too, seemed mere common sense. The True Bills school was wrong to think that the discounting of merchant IOUs could somehow produce the ultimate asset – legal tender money. What would limit the central bank’s ability to discount? A system whose design converted debt into cash was a monetary alchemy that literally turned lead into gold, without limit.
How could the country have a flexible currency whose supply was governable? In the age of the steam engine, that was a theoretical question that had genuine practical overtones. Symbolic currency was useful and necessary; but there had to be a method that would restrain its over-issue other than 100% reserve banking. If every bank note and check had to be “backed” by stored coin, then the country and the world’s money supply would be limited to the output of its mines and smelters.
Ricardo’s answer was arbitrage. Symbolic money – and all forms of debt – required the discipline of unrelenting discounting against gold.2 In Hansard’s record of his speeches from 1819 to 1823, Ricardo returned again and again to detailed criticisms of how the directors of the Bank of England were failing to manage the discount between gold and “the pound” – i.e. the Bank’s own notes. The Bank’s notes had to return to par so the price fluctuations in the economy at large could be freed from the distortions that resulted from the Bank’s manipulations as the sovereign government’s credit manager and the nation’s issuer of monopoly currency.
In insisting that the Bank of England call in some of its notes to eliminate the persistent discount, Ricardo made no claim that this would produce future price “stability.” In a war or other emergency, the sovereign government, either directly or through its central bank, would again print money. Abolishing symbolic money would be no more successful. In panics, where people were deprived of currency, they would create their own credit paper as substitutes for coin, whether or not the law allowed it. There was no escaping the need for or the likely abuse of symbolic money.
The purpose of a gold standard was to have a monetary measure against which symbolic money could be priced. As a man who made his fortune brokering, trading and underwriting money and debt during the period when specie convertibility had been suspended, Ricardo would not argue that a “paper” system of money and credit was unworkable. He would and did repeatedly argue that there had to be, in law, a permanent check and balance of arbitrage between coin and symbolic currency. Ownership of gold could not be abolished; contracting for exchange in gold had to be part of citizens’ right to contract.
In his last essay, The Plan for the Establishment of a National Bank, Ricardo argued that the right to issue paper legal tender should be taken away from the Bank of England. The Bank of England and other banks could continue to issue their own notes just as they issued letters of credit and other promises to pay; but the country’s only money should be coin and the legal tender paper issued by a national bank. The sole obligation of the national bank should be to maintain the price of its paper legal tender at par with gold. The duty of its board of directors would be to issue pounds and buy gold and to sell gold and buy in pounds so that money’s paper and gold prices matched their relative utilities. The national bank would not lend or borrow money; it would simply be the supplier of the paper currency in the amounts that matched what gold said the price of money was.
Money’s only usefulness was to be a unit of account that neither commerce nor government could amend, abolish or regulate. The supply of money was not be regulated by the national bank according to the needs of “the economy.” The national bank’s maintaining the price of symbolic money in reference to a weight and measure of gold would not guarantee that banks and treasuries and exchequers would always have sufficient reserves to meet the demands of exchange. As a system of lending, “free” banking was not more inherently risky than the activities of regulated reserve banks. In both circumstances, the confidence of depositors was based entirely on their belief that the bank’s own drafts, checks and notes would be negotiable at par for money. Once that confidence was forfeited, whether the reserves were 2%, as with the Scottish banks, or 6-8%, as with the Bank of England, it would be of little consequence. Depositors, note holders and counterparties would conduct a “run” that would only end when the reserves were exhausted.
But, under a national bank system, if businesses, individuals and governments were unable to satisfy their creditors’ demands for payment in money (whether gold or symbolic), they must resolve the default through discounting, not through adjustments in the money supply. If savers of money wanted the rewards of thrift and absolute caution, they could place their money in trust companies or other depositories that guaranteed 100% currency reserves and pay for the convenience of such relative certainty. If, on the other hand, the wanted the rewards of interest or speculative profit – the rewards that come from dealing in credit, they must accept the risk of loss. Where the Bank of England and other bank’s structures were hopelessly flawed was in their pretense that they could keep “money” on deposit and at the same time lend it out.
David Ricardo’s plan for a national bank was not adopted. The Bank of England – and all central banks since then – have continued to be both issuers of symbolic money and lenders of first and last resort. No country or currency bloc central bank or official international lender allows its currency to be subject to any direct obligation of exchange for gold (or silver).
In my next article, I will explain why Ricardo thought the central bank had to choose between (1) managing the discount between symbolic and specie money and (2) auctioning and actively buying the exchequer's debt. Both tasks were the responsibility of government, but the same authorities could not do both; and their accounts had to be completely separated.
Stefan Jovanovich manages the portfolio for The NJT Company, Inc., a family office based in Nevada.
1 Concluding notes in Keynes’ The General Theory of Employment, Interest and Money
2 Or silver. The precious metal to be used was a matter of history and convention. In India and China “money” was silver; in Europe it had been both. In order to avoid the arbitrage between the two metals that had nearly killed the Bank of England at its birth, one of the two metals would have to be a secondary token coinage. That made gold the logical choice for Britain.
More Active Management Topics >
