At these times of growing confusion over the future of currencies’ purchasing power, it is time to remove all doubt in the definitions of the differences between money, currency, and credit. This article traces the history and legal background to these relationships.
Despite the failure of the Bretton Woods agreement in 1971 and the state propaganda that followed, the position is clear. Both historically and legally money is and remains metallic coin — principally gold — and the rest is credit.
As a result of statist puffery of their fiat currencies, the public now wrongly believes it is fiat currencies that are money and that currencies have no price, except against each other. I show that this is factually incorrect. However, in financial markets legal money is always priced in legal tender, usually US dollar currency, when it should be the other way round. This inversion of the truth will turn out to be a costly error for those making this mistake.
In this article, I also show that the adverse consequences for prices from changes in the level of total commercial bank credit are significantly less than they are for changes in the level of central bank credit. Now that we are on the verge of a severe contraction of commercial bank credit, governments and their central banks are sure to respond by ramping up inflation of their currencies in a vain attempt to avoid deflation.
The consequences for fiat currencies are likely to be calamitous for them.
That will be the penalty we all face for ignoring the wisdom and findings of the Roman jurors, thinking that we know better with our economic models, macroeconomic policies, and statist control of markets.
Over two millennia of their careful deliberations, it was the Roman jurors who thoroughly examined and properly defined the difference between money and credit, upon which all economics and modern banking depend. Current monetary and economic fashions are mere ephemera in that context.
That metallic money had superseded barter from the dawn of history is outlined in the initial chapters of every economics primer. By weight, and then coin, it was the reliable money adopted by civilising humanity for trade. As commodities gold, silver, and copper were used as the best mediums of exchange.
It wasn’t for several millennia before organising Man put money onto a legal footing. It became important to do so to differentiate between money itself and promises to pay with it. These promises, or rights of action matched by duties to pay were credit which gave birth to banking. Both money and credit between them became circulating media. Money remained the same, always coin. But credit evolved along with banking into different forms: bank notes were a promise by an issuing bank to pay gold to the bearer on demand, and a deposit-taking bank’s duty is to pay a depositor on demand or to novate his deposit to his order. Additionally, merchants and businesses would issue discounted bills in lieu of payment, which had themselves tradable value.
In this article, I trace the legal history of the relationship between money and its credit substitutes from antiquity to the current day. It is now fifty-one years since the last vestiges of the link between the two were broken, when the Bretton Woods agreement was suspended by President Nixon. Today, the topic is becoming increasingly important because in western society the consequences of the split between legal money and legal tender in the form of credit is becoming a subject for wider public debate. Priced in the most desired of the three metallic monies, which is gold, the chart below illustrates the gulf that has opened between legal money and credit represented by the worlds’ four major fiat currencies since the ending of Bretton Woods.
The gap has widened to the extent that the currencies whose claim to be circulating media now depends solely on the legal tender status in their domestic economies, and the acceptance of the value of that status on the foreign exchanges. But the gap between legal tender and legal money has the former virtually valueless measured in terms of the latter. For the record, since August 1971, when US President Nixon suspended the agreement, the Japanese yen has lost 95% of its value in gold, the US dollar 98%, the euro 98.7% (contributing currency values are used before 2000), and sterling 99%.
In turn, the values of a wide range of commodities have soared measured in currencies but remained stable priced in gold. The next chart illustrates the difference between the US dollar and gold as the medium of exchange for acquiring a barrel of WTI oil since 1950.
Measured in dollars, the price of oil has multiplied 34 times since 1950. Not only that, but the price has been extremely volatile, relative to oil priced in gold. Since 1950, the price measured in gold has fallen 26%. And as the chart shows, it has been remarkably stable over the last seventy years.
The volatility measured in dollars commenced shortly after the Bretton Woods agreement was suspended. Until then, the price of oil had been very stable, consistent with a price relationship with gold. This was the case even with the highly tenuous link between gold and the dollar under the Bretton Woods agreement, and all purchases being conducted in dollars and other currencies. Only central banks on behalf of their governments and certain supranational organisations (such as the IMF) were permitted to swap dollars for gold bullion with the Federal Reserve Board. Yet, that vague linkage between gold and the leading international currency was sufficient to impart stability to the dollar, despite transacting businesses and individuals being excluded from the Bretton Woods arrangement.
We can even trace the stability of gold as money back to Diocletian’s edict, by the Roman Emperor when a debased denarius began to collapse. The table below shows how prices for selected items priced in gold have changed over the last 1,800 years.
Luxuries, such as alcoholic drinks are more expensive today, less so when taxes are allowed for and bearing in mind that in the cities they were substituted for water which was often undrinkable. But foodstuffs, which have benefitted from modern farming methods tend to be less expensive. While there are differences, measured in gold today overall prices are not substantially different from when the edict was issued.
Therefore, empirical evidence of the stability of gold as a medium of exchange cannot be convincingly challenged. As a metal, it is never consumed, so with some minor losses we know that the total of above ground stocks represents all the gold ever mined. Reasonable records of the accumulating quantities became available when imports from the New World into Europe began after its discovery in 1492. From these records, we know that the growth of above ground stock has been at a similar pace to that of the world’s population. In large part, that will have contributed to the stability of its purchasing power over time.
Since 1971 when the Bretton Woods agreement was suspended, the American government began a propaganda campaign to replace gold with the dollar. Consequently, after five decades the public in the western currency system no longer understands that gold is the only legal money, and the dollar is no more than a currency; that is to say a form of credit issued by the US Government which depends on the faith in its stewardship. But this is not the legal position. Governments might ban ownership and confiscate gold. It is hoarded by their central banks who prove reluctant to sell it, or to offer it in exchange for their currencies as originally promised. But so far as this author is aware, no government has passed laws countermanding the status of money and credit, originally determined by Roman jurors, and codified by the Emperor Justinian in the Pandects of 533AD.
The legal position and history of gold as money
As a medium of exchange, the function of money is to adjust the ratios of goods and services, one to another. Thus, the price expressed is always for the goods, money being entirely neutral. It is therefore an error to think of money as having a price. This should be borne in mind in the relationship between legal money, which is habitually given a price nowadays in fiat currencies, and the fiat currencies themselves which, given the status of legal tender, are erroneously assumed to have the status of money. The magnitude of this error becomes clear with understanding what legally is money, and what is currency. And this understanding starts with Roman law.
Roman law became the basis for legal systems throughout Europe, and by extension those of European settled regions, from North America, Latin America through Spanish and Portuguese influence, and the entire British Empire. In common with the Athenians, Rome held that laws were the means whereby individuals would protect themselves from each other and the state. But it was Rome which codified law into a practical and accessible body of reference.
The first records of Roman statutes and case law were the Twelve Tables of 450BC. These became the basis upon which individual jurors expounded, developed, and evolved their rulings over the next thousand years. The whole legal system was then consolidated into the Emperor Justinian’s Corpus Juris Civilis, otherwise known as the Pandects. When the empire relocated to Constantinople, the Corpus was translated into Greek and eventually reissued in the Basilica, at the time of the Basilian dynasty in the tenth century. It was that version which became the foundation for European law in the Middle Ages, except for England. As an eminent nineteenth century lawyer specialising in banking put it, the reason common law differed in England was that:
“The Romans abandoned Britain at the end of the fifth century and the common law of England on the subject of credit was exactly as it stood in Gaius which was the textbook of Roman law throughout the empire at the time when the Romans gave up Britain. But on the 1st of November 1875, the common law of England relating to credit was superseded by equity which is simply the law of the Pandects of Justinian.”[i]
In all, two thousand years of legal development had elapsed between the Twelve Tables and the reaffirmation of Justinian’s Pandects in Dionysius Gottfried’s version in Geneva of the Corpus Juris Civilis, translated back into Latin in 1583AD from the Greek Basilica.
It is the Digest section of the Corpus which is relevant to our subject. The Digest is an encyclopaedia of over nine thousand references of eminent jurors collected over time. Prominent in these references are those of Ulpian, who died in 228AD and was the juror who did most to cement the legal position of money and credit. The Digest defined property, contracts, and crimes. Our interest in money and credit is covered by rulings on property and contracts.
The regular deposit contract is defined by Ulpian in a section entitled Deposita vel contra (on depositing and withdrawing). He defined a regular deposit as follows:
“A deposit is something given another for safekeeping. It is so called because a good is posited (or placed). The preposition de intensifies the meaning, which reflects that all obligations corresponding to the custody of the good belongs to that person.”[ii]
Another jurist commonly cited in the Digest, Paul of Alfenus Varus, differentiated between the regular deposit contract defined by Ulpian above and an irregular deposit or mutuum. In this latter case, Paul held that:
“If a person deposits a certain amount of loose money, which he counts and does not hand over sealed or enclosed in something, then the only duty of the person receiving it is to return the same amount.”[iii]
So, a mutuum is taken into the possession of the receiver and in return for a right of action in favour of the depositor to be exercised by him at any time with the receiver having a matching duty to return the same amount, it becomes the receiver’s property to do with as he wishes. This is the legal foundation of modern banking.
Clearly, the precedent in the Digest is that money is always metallic. While anything can be deposited into another’s custody, it is the treatment of fungible goods, particularly money, which is the subject of these legal rulings. It is only through an irregular deposit that the depositor becomes a creditor. By laying down the difference between a regular and irregular deposit, the distinction is made between what has always been regarded as money from ancient times and a promise to repay the same amount, which we know today as credit and debt.
There is one issue to clarify, and that is to do with credit rather than money. As noted above, Justinian’s Pandects were compiled a century after the Romans had abandoned Britain. From what was subsequently unified as England and Wales out of diverse kingdoms, common law differed in that as property debts were not freely transferable. The transferee of a debt could only sue as attorney for the transferor. This placed debt as property in a different position from other forms of transferable property. Justinian took away this anomaly as a relic of old Roman law (the laws of Gaius, referred to above), allowing the transferee to sue the debtor in his own name.
The anomaly in English law was only regularised when the Court of Chancery merged with common law by Act of Parliament in November 1875. Since then, the status of money and credit in English law has conformed in every respect with Justinian’s Pandects.
While the legal position of money is clear, the economic position is technically different. Jean-Baptiste Say pointed out that money facilitates the division of labour. Technically, money is unspent labour, and is therefore a credit yet to be used. Various other classical economists made the same point. Adam Smith wrote that a guinea might be considered as a bill for a certain quantity of necessaries and conveniences upon all the tradesmen in the neighbourhood. Henry Thornton said that money of every kind [including credit] is an order for goods. Bastiat and Mill opined similarly.[iv]
But it is the legal difference, which is of overriding importance because it was founded on the principal that there is a clear distinction between metallic money and a duty to pay. Money is permanent while credit is not. Money has no counterparty risk, whereas credit does. By way of contrast with money, we can define credit: credit is anything which is of no direct use but is taken in exchange for something else in the belief or confidence in the right to exchange it away again.[v]
Principal forms of credit
Being subject to Gresham’s Law, money rarely circulates. It is the circulating medium of last resort. Instead, it is credit which greases the wheels of economies, the commercial relationships between humans. Deferred payment for the provision of goods and services is the most common form of credit in an economy. Guarantees of future payment, such as a parent commits to his children until they can strive for themselves is another example. Credit applies to the chain of production, where commodity suppliers, manufacturers, wholesalers, and finally retailers only get paid when the final product is sold. All parties in the production chain exist on credit until final payment is made. Corporate bills and bonds where debtors have a direct obligation to creditors are a form of organised credit. But here, we are primarily interested in credit which circulates within the banking system.
This credit comes in two forms. There is currency in the form of bank notes, which today is only issued by central banks. Currency represents a right of action against the issuer in bearer form to pay in gold coin. Today, it is the matching duty to pay which has been reneged upon by central banks as agents for the state. Clearly, bank notes are credit matched by a debt obligation, as any examination of central bank balance sheets will show. Then there is commercial bank credit in the form of customer deposits. Banks are dealers in credit, and again, there is no doubt that customer deposits are a credit in favour of the customer, and a debt to the bank.
That is the long-standing position. But today we need to clarify the status of an additional form of credit emanating from central banks but not in public circulation, and that is credit provided by central banks to commercial banks. The accounting treatment of quantitative easing comes into this category. QE adds to a central bank’s liabilities to commercial banks (described as reserves). These appear as assets in the commercial bank balance sheets matched by deposit liabilities in favour of non-bank customers, typically insurance companies and pension funds.
That is the accounting trail. But from a central bank’s perspective the policy is to look through accounting identities and inject liquidity into the public credit system. Nevertheless, it leaves an additional credit relationship between the central bank and the commercial banking network, which is not circulating credit.
Furthermore, there are today financial institutions which deal in credit without a banking licence. These are termed shadow banks. More correctly, they are arbitrageurs of credit rather than originators, so we can generally disregard their suspected contribution to the quantity of circulating media.
Relative to money, the quantity of currency and bank credit in circulation is always far larger in quantity. And of the two, bank credit dwarfs the quantity of bank notes. It is the availability of credit, particularly bank credit, which drives economic progress. This progress was the distinguishing feature of human advancement through the industrial revolution compared with earlier feudal and mercantile economies when transactions were settled in coined money and very little economic progress was made.
An interesting example highlighting the difference credit makes to economic progress was to be found in Scotland. The Royal Bank of Scotland was founded in 1727 in competition with the pre-existing Bank of Scotland. But there were insufficient commercial bills in circulation to support the business of both banks. The Scottish economy was predominantly subsistence farming under a feudal system of land ownership, and circulating media were silver coin and Bank of Scotland banknotes. To create new markets for credit, the Royal Bank invented a cash credit system, whereby anyone could borrow from it without collateral so long as sufficient guarantees were available from at least two respected persons. These cautioners, as they were termed, had continual access to the borrower’s account and could stop it at any time.
The availability of this credit allowed Scotland’s economy to progress rapidly from its impoverished feudal state. It was enormously successful, and there can be no doubt that the wealth created within a few decades facilitated the Scottish Enlightenment, giving us Burns, Hume and Smith along with a host of other thinkers and philosophers. And that was despite the interruption of the Jacobite uprising in 1745, which briefly occupied the whole of Scotland.
The key to a successful system of credit is in its foundation. It must be credibly linked to money if depositors are not to be defrauded and the certainties of price stability to be maintained. If depositors are confident that possessing credit is similar to possessing money, then the record shows that the purchasing power of credit is broadly secured and is not dependent on the quantity of credit in circulation, so long as credit expansion is not sufficient to destabilise its relationship with money.
The link between money and credit
The ills in today’s credit system are easily traced to the lack of any sheet anchor provided by a credible link to money. Anyone who fails to see this merely expresses a denial of the evidence. Modern mainstream economic beliefs can be divided into two camps: the neo-Keynesians who tell us that macroeconomics is a separate science from microeconomics, microeconomics being the old, discarded Says law version; and the monetarists, who can only imagine a mechanical relationship between the quantity of money (by which they mean credit) and its purchasing power.
Today, central banks are dominated by neo-Keynesians, though monetarists may be making a comeback. Both camps dislike the uncertainties of markets, which they seek to suppress or manage through the agency of the state. The neo-Keynesians have failed in their policies utterly, which is why monetarism is likely to be in the ascendent. But the empirical evidence only offers partial support to the monetarists’ mechanical observations. Accordingly, official monetary policies are currently at a crossroads leading to nowhere.
The denial of legal money’s existence and its distinction from credit is a product of fifty years of post-Bretton-Woods propaganda. The coming test will not be whether gold is still money, but whether the credit system survives. But we must look through today’s economic fashions to understand what needs to be done to stabilise credit to the point where it is accepted by the public again as credible substitutes for money.
The old mechanism was to link bank notes to gold and require commercial banks to offer to discharge their debt obligations to depositors by exchanging them for bank notes or coined money. And the note issuer would be required to maintain liquidity reserves of coined money to meet any public demands for the encashment of its banknote obligations into money.
The ratio of a note-issuing bank’s obligations to its money reserves was set by Sir Isaac Newton at 40%. While we may describe that as the ultimate standard, the success of the Bretton Woods system which even denied public access to central bank reserves suggests that a successful link between money and credit need not be as rigorous as Newton insisted. Admittedly, from the past the dollar inherited stronger links with gold which will have contributed a continuing element of confidence in its exchange value.
However, the expansion of dollar credit over the course of Bretton Woods was significant. According to Freidman and Schwartz, in 1945 broad money supply M3 was $143.9 billion. By August 1971, when Bretton Woods was suspended, it had increased to $685.5bn, according to the St Louis Fed. Yet prices, particularly those of commodities, were remarkably stable despite a near fourfold expansion of dollar credit. But as time progressed, the link between money and dollars became increasingly stretched, requiring international cooperation to maintain the link in the London gold pool which failed before the link was abandoned altogether in August 1971.
The Bretton Woods experience disproves the mechanical monetarist theory of the equation of exchange. We can all accept that an expansion in the quantity of credit tends to raise prices through its dilution. But the incorrect monetarist assumption is based on credit expansion feeding directly into spending, leading to proportionate price changes. But as we have seen with post-war Japan, in an economy where there is a propensity to save consumers meet the expansion of credit with an increase in their saving. Instead of driving up Japan’s consumer prices, excess credit simply increases the availability of capital for businesses and funds the state’s spending deficits. Elsewhere, in today’s economic environment, which is dominated by a top-heavy financial system, not all of the credit expansion filters through to the non-financial economy.
In the early nineteenth century, the cycle of bank credit expansion and contraction had some effect on prices at the wholesale level. However, later in the century these fluctuations diminished, not because credit fluctuations moderated, but it appears that businessmen and their customers had increased their propensity to save. A savings culture emerged, typified by Dickens’s aphorism about spending in David Copperfield, serialised in 1849: “Annual income twenty pounds, annual expenditure nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Furthermore, improvements in the banking system evolved over time. The joint stock banks joined the London clearing system in 1854, followed by the Bank of England in 1864. This served to improve the banking system’s efficiency and by the daily netting off of transactions between them there was a reduction perceptions of counterparty risk. Our next chart shows how the swings between estimated wholesale price inflation and deflation subsided over the course of Britain’s gold coin standard under these influences.
This was an economy driven almost entirely by bank currency and credit, with relatively few minor transactions conducted in coin, and those only at the final retail level nearly all in silver and copper. The situation today is vastly different because credit is no longer tied in any way to money. And of the seventy or so recorded collapses in purchasing power in mediums of exchange, they have all involved fiat currencies.
The lesson for us is that while fluctuations in the quantity of bank credit do affect prices, the consequences are almost certainly less when compared with those arising from equivalent changes in the level of central bank currency in a fiat system. Furthermore, with sound money there is an increase in the propensity to save which stabilises prices when credit expands. And that is why bank credit has continued to be at the heart of economic progress from Roman times, while fiat currencies come and go. If the policy objective is economic progress, it can only be achieved by credibly linking credit to money.
The debasement of credit debases wealth
It may come as a surprise to most people, but debt is wealth. The more debt there is in an economy, the greater the wealth of a nation. To illustrate the point, financial assets, ranging from government bonds to equities, and even derivative values are all forms of debt though their characteristics may differ. These are debt obligations to be discharged by debtors in favour of creditors. All portfolio investments are comprised of credits, which are rights of action against debtors with a matching obligation to the creditors. A company has an obligation to deliver an income stream to its shareholders, or the value of it, in perpetuity. A bond issuer has a duty to discharge its obligations to its creditors under the terms of the bond’s prospectus.
Besides its exchangeability, the key to the value of this wealth being maintained lies partly with individual obligations, but also with a general stability of the entire credit system. We have seen from the evidence of a currency which is readily exchangeable for coined money that the accumulation of wealth over time was remarkable. As a measure of its national wealth, before the First World War over 80% of the world’s shipping had been built in British shipyards. In the matter of a few decades, the living standards of the poor had improved immeasurably from bare subsistence, and fortunes were made by entrepreneurs providing wanted goods and services; just rewards for improving the living standards of everyone.
The contrast with conditions today could hardly be greater. Once the debasement of credit is considered, most of the apparent wealth in the economy is just that: apparent and also a delusion. We have shown that since the Bretton Woods agreement was suspended, the dollar has lost 98% of its purchasing power measured in money, and sterling 99%. But in common with other currencies, priced in them financial and property assets have soared.
The delusions extend to physical assets. It is well known that property prices in populous centres, such as London, have risen beyond anyone’s expectations. But that is priced in legal tender sterling, which only since 1971 has lost 99% of its value relative to legal money — which is gold. Our next chart shows how London residential property prices have performed in sterling and real money.
While an index measured in sterling legal tender based on 1968 has risen 114 times, in legal money the rise has been 29%. The difference between the two is the illusion of wealth under a fiat currency system. This is not an argument against home ownership. Rather, it is an attempt to put supposed wealth, numbers merely inflated by the debasement of legal tender, into context. This exercise can be repeated for all other appreciating assets with similar results.
The global credit system is imploding
With bank balance sheets now highly leveraged, the urgent imperative for bank directors is to reduce the ratio of balance sheet assets to their bank’s own capital. The larger banks being public companies, their directors have an obligation to protect their shareholders’ interests. And with interest rates now rising, there is a growing threat of falling financial asset values undermining both balance sheet investments and loan collateral.
Depositors rely for their protection on the duty of a central bank to ensure that the banking system does not fail. Failing that, there are deposit protection schemes to protect smaller deposits. But since central banks inflated their balance sheets with bonds acquired through quantitative easing, rising interest rates are now leading to substantial mark-to-market losses, driving the central banks themselves into insolvency. In the financial systems of the major economies, we now face the prospect of insolvent commercial banks having to be backstopped by insolvent central banks. The scope for loss of public confidence in the entire credit system is becoming more threatening by the day.
This is not the only threat to currency values. As we have seen, nearly all transactions in the economy are settled in commercial bank credit which is now contracting at an accelerating rate. With all eyes on GDP, the impact will be seen by governments as highly deflationary. Government revenue receipts will be threatened with collapse, and mandated welfare obligations will soar.
The Keynesian approach is to double down on failed policies and replace the contraction of private sector credit with an expansion of public sector debt, for fear of deflationary conditions. But for the public and the foreign exchanges, the additional debasement of the major currencies becomes suddenly more obvious than the contraction of bank credit which is the proximate cause for the GDP crisis. It will be a miracle if confidence in the currencies and the entire credit system does not fail completely.
The lesson we should learn from the relationship between the two principal forms of bank credit is that the impact of central bank credit debasement on a fiat currency’s purchasing power undermines faith in it to a far greater extent that an equivalent change in commercial bank credit. And that if credit was bound properly to money, the crisis would have been avoided.
[i] See HD Macleod’s The Elements of Banking, Longmans Green & Co, 1877
[ii] See de Soto’s Money, Bank Credit, and Economic Cycles, Chapter 1.
[iv] Listed in HD Macleod’s The Elements of Banking.