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'Base Money' Under a Gold Standard

Counting 'legal tender' if gold were money again...

I THOUGHT that I would address some technical topics that come up from time to time, writes Nathan Lewis at New World Economics.

Here is a quote from a recent item, which will go unidentified for now, but which represents a common line of thinking:

"Actually, although irredeemable central bank notes are base money today, under a gold standard only coined gold and bullion reserves are base money. Notes in circulation are redeemable liabilities of the issuers and not part of actual or potential bank reserves. And although a currency board is less likely than a central bank to undermine the gold standard, there is no need for either.

"The most efficient form of a contemporary gold standard makes gold the base money – that is, the medium of redemption and unit of account-while currency and other common media of exchange are the fractionally backed gold-redeemable liabilities of commercial banks."

I find this confusing, which is another way of saying: incorrect.

You can define things however you want – I do not insist that others follow my conventions – but if you define them in a confusing manner, then problems ensue. For example, if I were to define an "apple" as: an apple, pear, peach or plum, that would be confusing – confusing in such a manner as to be what one might reasonably call: "incorrect".

I define "money" as: the universal item used in monetary transactions. Of course, this then requires a definition of a "monetary transaction", but I think we all have an idea of what this means, as opposed to a form of barter.

If I were to trade a sack of potatoes for a $20 Federal Reserve Note, I think everyone would agree that that is a "monetary transaction", because of the role that $20 bills play in our society, while if I were to exchange the same sack of potatoes for a socket wrench, we would call that "barter". Thus, $20 bills are a form of "money" because they are used as "money".

"Base money" today includes central-bank-issued notes and coins, and also deposits of banks at the central bank. I've described how these things – and only these things – are "money" today within the US Dollar system, because they are the only things acceptable in payment. Lawyers understand this well: a "legal tender" law codifies what satisfies the legal definition of a "payment". Thus, it is convention today that "money" and "base money" have basically the same meaning.

From this, we can see that a banknote that is redeemable in gold, and used in monetary transactions – for example, people regularly buy and sell things with it – is "money" and "base money" in just the same way that a banknote that is not redeemable in gold is, as long as either is used in a monetary fashion.

From this, we can also see that coin and bullion reserves are definitely not the only form of "money" in a system that uses redeemable banknotes. For one thing, bullion (ie, large bars) are only marginally a form of "money" at all. I think they would be generally accepted in transactions to a degree that could arguably be called "monetary", particularly in a society that also used gold coins and redeemable banknotes, but it would be a little non-standard to ask for or receive payment in bullion bars.

Also, coins or bullion held in reserve are actually not used in transactions, since they are sitting in a vault, rather than being used in transactions. During the 1890s, 1920s or the 1960s, central bank coin or bullion reserves were not counted as a form of money (base money), just as today US Treasury bonds or other assets of central banks are not counted as money.

Note that the author tacitly acknowledges this when he says that "base money" consists of "the medium of redemption and the unit of account." This list does not include a means of transaction, which I say is the defining characteristic of money. You can have a unit of account that is not money – for example, the French Livre Tournois, which was just an accounting notion. Actual payment, in France during that time, could be made in most any coin used in Europe, with its value translated into uniform livres tournois.

The equivalent today would be "a Dollar is equivalent to ten grams of gold." There is no ten-gram Dollar coin. You can make payment in any existing gold coin, or gold bullion, with its value translated into "Dollars" at a rate of one Dollar = 10 grams. In this case, the actual "money", the means of payment, the medium of transaction, the thing that changes ownership, is whatever gold coin you have – Krugerrands, Pandas, Maples, or any coin from any mint anywhere.

For example, let's say you had $10 million of banknotes in circulation, and $5 million of central bank deposits ("bank reserves"), with $3 million of gold coins and bullion as a reserve. I would say that the amount of "money" and "base money" was $15 million. This is different than calling "money" or "base money" only the $3 million of gold reserves.

Now, let's say that the central bank suspends gold conversion, like the Bank of England did in 1797. Does the amount of "money" then jump from $3 million to $15 million because conversion was suspended? If conversion is reinstated the next day, does "base money" then go from $15 million back down to $3 million? I say that the quantity of "money" or "base money" does not change. It was $15 million before and after conversion was suspended.

The notion that banknotes are not "money" might stem from some legalistic contortion arising from the fact that the US Constitution says that: "No State shall...make any Thing but gold and silver Coin a Tender in Payment of Debts."

This principle was violated right from the start, as many people were, from the beginning, buying and selling and paying debts in redeemable banknotes issued by independent commercial banks, including the banknotes of the First Bank of the United States. Probably Edwin Viera has a nice discussion of the various backflips of sophistry that were made over the years for people to make believe that the Constitution, still unamended, does not say what it most clearly says. But, I am more interested in reality than legalistic fantasy.

My "theory of money" must apply not only to the US but to any country with any legal history, and also, any form of "money", including Bitcoin or canned mackerel, which apparently serves today as a sort of money in some prisons.

Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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