Published in “GoldMoney Analysis” , 3rd June 2011
Modern central banks and the state: a coalition of interests
Money creation has long been synonymous with state power. In the dim-and-distant past, governments minted gold and silver coins, before eventually becoming the monopoly issuer of notes. In both cases they get a non-negligible profit – seignoriage – which is the difference between the face or exchange value of money and its intrinsic value. In the case of coins, the earning of a seignoriage is explained by the costs of minting and by the fact that the state (the seignior or lord) guaranteed the face value of the currency. As for paper money, seignoriage boomed with the increasing use of banks notes as substitutes for coins during the 19th century, as the face value of notes always massively exceeds the notes’ intrinsic value, thus boosting the earnings of the issuer. Unsurprisingly, governments – ever eager to find new sources of revenues – soon cottoned on to this fact.
As the law of basic economics dictates, an excessive supply of a good or service will push down its price. Regarding money, it means a deterioration of the purchasing power of the currency. Thus the massive inflow of precious metals into Spanish ports in the 16th and 17th centuries, as a result of the discovery of large gold and silver deposits in the Americas, was followed by rising prices across Europe (albeit at the modest rate – by modern standards – of around 2 per cent, according to the historian Niall Ferguson). Inflation is a monetary phenomenon that results from the growth of the money supply exceeding the growth in goods and services in an economy. If our income and wealth remain steady, but our money supply increases, then we will not be richer – we will simply pay more for existing goods.
The risk of inflation increases in purely fiat monetary systems in which there are no means of payment that retain any intrinsic value, and where only bank notes and other “bank money” media – such as various types of account deposits – are available for market transactions. In the absence of any limit on money creation in such a fiat system, the money supply grows at the whim of the monopoly issuer. This is why monetary rules are essential to protect the purchasing value of money. Such rules entail quantitative limits on the legal ability of monetary authorities (as well as the associated banking system) to create money.
The origins of central banks
Modern central banks are the result of the shared mutual interests of private banks and the state. In essence, the state granted the exclusive privilege to issue bank notes – for a certain amount of money – to a single bank, and received in exchange a credit by the bank of the same amount to cover its budget deficit.
This constituted true deficit monetisation as the deficit was paid for with newly printed money. As Vera Smith comments in her master work The Rationale of Central Banking and the Free Banking Alternative(1936), this exclusive privilege to issue notes was renewed and extended, both in relation to the area of influence of the bank notes and to the total amount of notes issued, every time the state needed further credit to finance increasing deficits. This monopoly of paper money was furthered by the imposition of legal tender clauses, while in many countries after the Second World War, the state took direct control of the central bank. This created an unstable monetary system that was heavily biased towards inflation.
Nevertheless, the monetary system – at least during the operation of the gold standard from the mid-19th century until 1914 – imposed effective limits on central banks’ proclivity towards money creation, as every single bank note had to be redeemable in gold on demand. As a result, money supply expansion was restricted, leading to a remarkable period of monetary and price stability.
These days, under fully fiat monetary systems, bank notes are no longer redeemable into gold and the acceptance of notes (as well as the stability of whole national economies) relies on central banks maintaining a disciplined approach to money issuance. But as the second half of the 20th century showed, central banks rarely stick to exacting standards. However, in our increasingly globalised world, people can often elude the effects of reckless monetary policies by buying sound currencies and gold and silver. In the face of this reaction, at the end of 20th century, states had no choice but to resume the independent status of the central banks and to let them conduct a monetary rule committed to maintaining low inflation. This, however, was not enough as central banks continued to issue excessive amounts of money – a key cause of the last financial crisis of 2007-08.
Maybe one day governments will again recognise the benefits of sound money.
the old lady of threadneedle street 