Gold as money
The use of gold as money can be traced back 6000 years to the Egyptians. Gold was used as money due to its unique combination of qualities – durability, portability, divisibility, consistency and intrinsic value. Its intrinsic value is derived from its scarcity. Silver has an equally long history as money, but it has the disadvantage that it tarnishes. In the UK, pounds sterling refers to the weight (lbs) of silver (sterling).
When gold was money, money had the following properties:
a. it could not be created by government – the amount of gold in circulation is constrained by its natural scarcity, which means that it has intrinsic value irrespective of the actions of government
b. it was not controlled by government – unlike property transactions and bank account transactions, gold transactions do not clear through a central registry or bank
So when gold was money, money was independent of government control.
Breaking the link between gold & money
Banknotes were originally receipts for gold
In the 16th century, banks started issuing banknotes as receipts for gold deposited at the bank. These receipts carried the words “I promise to pay the bearer on demand the sum of …”. This meant that the banknotes could be exchanged for the appropriate weight of gold by whoever presented the banknote to the bank – the bearer of the banknote. The fact that the bearer of the banknote could redeem the gold from the bank meant that banknotes could also be exchanged directly for goods or services and hence used as money. All the banknotes in circulation were backed by the gold held at the bank. The numerical value of a banknote represented the weight of the gold that it could be exchanged for.
Central banks and the gold standard
At the end of the 19th century and beginning of the 20th century, central banks (such as The Bank of England and The Federal Reserve) were granted monopolies on issuing a nation’s money by governments. The total amount of a nation’s money in circulation was backed by the total amount of gold held by the nation’s central bank. This concept is referred to as “the gold standard” and helped to facilitate booming international trade in the 19th century, as the money of many nations could be redeemed for gold.
Due to the 1st world war, many countries were taken off the gold standard by governments. This enabled governments to increase the amount of money in circulation to pay for the war, without increasing the amount of gold held at the central bank. This concept is known as “printing money”.
Although the UK tried to return to the gold standard after the war, it was eventually forced to abandon it in 1931 due to a large amount of money being exchanged for gold. This happened because the total value of the all the money in circulation was more than the total value of all the gold held by the central bank after printing money to pay for the war. Hence the pound was overvalued in terms of gold and people preferred to hold gold instead of pounds. This process is described as a “run on the bank”. People exchanged their money for gold, as nobody wanted to be the last person in the queue once the gold had run out.
In 1933 Roosevelt outlawed private ownership of gold, effectively ending the gold standard in the US.
After the 2nd world war, the US promised to exchange dollars for a fixed amount of gold. But Nixon abandoned this in 1971, due to large amounts of dollars being exchanged for gold and the need to print money for the Vietnam War.
Modern money
From this point in 1971 to the present day, “paper” money has been backed by nothing more than the faith of the payee that someone else will accept the money in the future.
Paper money has no intrinsic value, but derives its value from government decree that it will be used as money.
Since the advent of computers, money has also become virtual digits on a screen.
Breaking the link with gold has enabled the artificial “inflation” in the amount of money in circulation by governments, resulting in a decrease in its value.
“Paper money eventually returns to its intrinsic value – zero.”
Voltaire, 1694 – 1778
The implications of paper money
So why are house prices rising faster wages? The answer lies in the fact that the supply of money is not constrained by something like gold. The amount of money in circulation can be increased or decreased by the government. So, simplistically, if the government doubles the amount of money in circulation, then house prices will double because the number of houses will remain (roughly) the same and prices will be chased up by the newly created money. Or another way of looking at it is that the real value of money will have halved.
Incomes have not risen much in recent years, but people have still felt well off because house prices have been rising considerably for a long time. This is a sleight of hand, which masks the underlying problems with the economy and keeps the government in power by kicking the can down the road. Remember, governments are only in power for 5 years, so that is their timeframe when making decisions. Governments are focussed on staying in power.
Governments like low interest rates when economic times are tough, as it means that voters feel that they can afford to take on increasingly larger amounts of debt which drives the housing market up and keeps voters feeling well off and unlikely to vote them out of power.
“Politicians buy your votes with your money!”
It is also necessary to prop up house prices in order to keep the banks solvent so that they do not have to write down the value of their loans if house prices fall too much.
Governments also like low interest rates because it increases the amount of money in circulation, causing inflation which reduces the real value of the government’s debt.
If a government cannot pay back its debt, then the only two options are to default on it by declaring bankruptcy (unlikely to keep it in power) or inflate it away by increasing the amount of money in circulation and hence de-valuing the debt (more likely to keep it in power). The latter option equates to getting voters to pay for it, by de-valuing their money through inflation, which is really just another form of tax.
“The value of a sound money (gold) is that it prevents planners from redistributing the wealth and savings of the productive classes to the political classes in order to finance expensive unproductive agendas – or from depleting the savings of fixed income earners, or the wages of the poor”
Alan Greenspan wrote this many years before becoming a central banker (Federal Reserve Chairman, 1987 – 2006)