Bank note convertibility into gold


It is reasonable to surmise that the slow rise in deposit money growth (deduced from the 1914 numbers mentioned previously) was a consequence of some factor that can be regarded as an intrinsic brake on excessive money creation at that time. What was this? Essentially it was that bank notes were convertible into gold coins.

Before we proceed with this significant issue it is important to elucidate the situation of bank deposits (as a later addition to money) in respect of money creation. The wonderfully rich literature on the history of money provides few clues as to what constituted the brake on the creation of deposit money in early history. We know that bank notes emerged from deposits of gold and silver coins, and that the volume of the latter therefore constituted an intrinsic brake (because of its natural scarcity).

However, bank deposits had a different history; so the question arises: what constituted an intrinsic brake on bank deposit creation? Historical texts are quiet on the issue, but there can be only one conclusion, and it is an obvious one: that bank deposits were convertible into bank notes (and still are), and bank notes were convertible into gold coins. Therefore, holders of bank deposits were in the same position as holders of bank notes: they could convert their bank notes and their bank deposits into gold coins.

To elucidate this significant issue (of the curbing of money growth), which also constitutes a part of the history of monetary policy, we need to delve back into history.

Convertibility: past and present

We know of the emergence in seventeenth century England of what can be called token money, that is, bank notes and bank deposits that have no intrinsic value (as opposed to coins which, made of precious metals and therefore having an intrinsic value, were real money). These token monies were convenient for payments, and they were accepted as such because they were also what can be called representative monies. This means they were representative tokens which were fully convertible into coin money that had an intrinsic value.

This is a significant issue because convertibility gave rise to the need by banks to hold a reserve of gold coins so that public demands for the conversion of bank notes into gold were always met. The banks of the earlier centuries knew that not all depositors would arrive at the same time and demand gold for notes. Therefore, they could make loans by the issue bank notes and credits to current accounts (that is create money) up to a point - determined by a "comfortable" reserve of gold. It will be apparent that the larger the reserve of gold coins the higher is the likelihood of meeting demands for gold. Given the natural limit imposed on the supply of gold by the limits of gold ore supply and gold mining technology, there was an intrinsic limit to money creation.

What about modern money? We know that modern money is intrinsically almost valueless. Deposit money (= computer-based accounting numbers) has no intrinsic value at all. We also know that bank notes (= paper money) has no value except the value of the paper on which it is printed, and that coin money has little intrinsic value [= the value of the non-precious (base) metals used to make them]. We also know that modern bank deposit and bank note money is convertible into coin money, and that there is no value benefit to be had in this conversion. And yet we all accept all these forms of money unconditionally as a means of payment. What happened between the era when bank deposits and bank notes were convertible into precious metals and now when they are not?

In a nutshell the answer is twofold. Firstly, money creation and the loss of confidence at times in token money led to utilization of the convertibility option, which led in turn to suspension of convertibility at times and eventually to permanent inconvertibility. Secondly, at the time of the introduction of permanent inconvertibility, the public had generally come to completely accept bank deposits, bank notes and coins by count, that is, by face value. Except for high-inflation countries, this is the case worldwide today. The three types of money (coins, notes and deposits) are money because they are generally accepted as a means of payment, and their underpinning is confidence. And herein lays a compelling responsibility: that of maintaining the value of the currency internally and externally. Because money can be created on demand by a borrower from a bank, a strict referee is required: the central bank in its role of implementation of monetary policy.

What led to the demise of bank deposit and bank note convertibility into gold? In order to answer this significant question we first need to cover the events that inter alia led to the formation of the Bank of England. This bank, which later morphed into a central bank, played a major role in the convertibility issue.

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