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The Gold Standard

A third reason for price stability with a commodity money exists when that commodity is used by many other nations. When the price level in any one nation changes, the commodity will flow across borders to where it is most valuable. In fact, the quantity theory of money was developed to explain how the international payments mechanism worked. Prior to the First World War, most countries were usually on what was called the gold standard. This meant that gold was the official money and paper monies were redeemable in gold. In the 18th century some people, now called mercantilists, believed that the road to riches for a nation was to accumulate gold. They thought that just as an individual who had more gold was richer than one who had less, so a nation that had more gold in its vaults would be richer than a nation that had less.

A nation received gold from abroad when its exports exceeded its imports. When people bought from abroad—when they imported goods—they paid for the goods with their domestic money. This money would be returned when other nations bought from them. Only if foreigners bought more, or the nation's exports exceeded its imports, would it accumulate an excess of foreign money that could be redeemed for gold. It followed that mercantilists sought to curb imports and spur exports.

The quantity theory, however, suggested that this policy was self-defeating. Suppose a nation was accumulating gold. Either this gold would be used as money domestically or it would be used to support paper money. In either case M would rise, and the quantity theory predicted that this would raise the domestic price level. On the other hand, the loss of gold from foreign nations would reduce their money stock, causing foreign prices to drop. The higher prices (relative to prices in foreign nations) in the nation gaining gold would mean that imports would be more attractive because foreign products were now lower-priced. Thus exports would be harder to sell because they would have risen in price relative to foreign substitutes. This change in relative prices would work to stop the gold inflow. This was true even if the nation receiving gold sterilized its gold inflows, that is, did not allow additional gold to increase its money stock. Only if nations losing gold also sterilized their outflows could the flow of gold continue so that one nation could acquire the world's gold stock. But before this happened, the gold standard would collapse.

This story is simplistic, and complications in the adjustment process could significantly alter the plot.1 Thornton recognized a few of the complications already in 1802. The story does, however, illustrate the important point that what happens in one nation can have a significant impact in other nations, and that ignoring what happens in other nations may lead one to serious error. Economies are rarely closed, independent of what happens outside them.

Commodity monies have disappeared and money in modern economies is mostly bank debt. We may think cigarettes, seashells, or cattle make strange monies, but probably the oddest money ever is debt money.

If you make a bet with a friend about the outcome of a ball game and lose, you have created a debt. This debt is a liability to you because you owe it, and an asset to your friend because it is owed to him. The debt is real to you and your friend, but it has no physical existence. If you did not write out the terms of the debt, it exists only in your mind and in the mind of your friend. And debt is very easy to create.

Money in our economy is very similar to this debt that you created with your bet. Much of it has no physical existence other than as accounting entries that specify assets and liabilities. This bank-debt money is not subject to the same restraints that commodity monies have. For example, governments cannot readily alter the amount of a commodity money, but can easily alter the amount of bank debt money. The story of how debt money evolved from commodity monies and how the government can control the amount of this special form of debt is the topic of the next chapter.

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1 For example, goods that are identical regardless of where they are produced, such as grain, must have identical foreign and domestic prices, except for transport costs, or else large profits can be made through arbitrage. This idea is called the "law of one price."
Copyright Robert Schenk