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The Value of Money

By James H. Nolt

Last week I discussed some limitations of a gold standard monetary system. An additional problem on which I did not elaborate is that of misconceptions surrounding the value of money. Some advocates of a gold standard think that in its absence inflation becomes an intractable problem. This is wrong because inflation is influenced less by the monetary standard than by the private (and sometimes also governmental) financial interests that collectively determine the expansion and contraction of credit. As has been the case with major currencies in recent years, inflation can thus be very low or even negative notwithstanding the lack of a gold standard. Conversely, significant inflation is still possible even with a gold standard.

Throughout history there has been much mystery and misinformation about what determines the value of money. The problem is not as simple as many have assumed. When metallic standards were commonplace, people assumed the value of money was determined by the value of the metal incorporated in coins. Theoretically, this is true, but there are many exceptions that typically prevent the realization of this ideal. Furthermore, to say that the value of money is determined by the metal value of coins begs the question: What determines the value of that metal relative to everything else?

The most common answers to this question argue that it either depends on 1) the relative cost of production of the underlying metal, or 2) supply and demand. The first is the typical view using the labor theory of value from classical political economy, and the second is the neoclassical view. Both make the same flawed assumptions that 1) the value of money is determined by the price of the metal, and 2) this price is determined by competitive markets.

During the heyday of the classical gold standard from 1873 to 1914, the supply of monetary gold was influenced by the preeminent power of the leading investment banking network of the time: the five Rothschild family banks, especially those in London and Paris. The Rothschilds are well known as the leaders of most major bond syndicates during that era, exercising considerable influence on the credit supply. But they also played a prominent role in refining and lending monetary gold to the leading central banks, on whose boards they also sat (this story is told in Niall Ferguson’s two-volume history of the House of Rothschild and chapters eight and nine of my book, International Political Economy: The Business of War and Peace).

As creditors whose wealth was largely generated by and invested in bonds, the Rothschilds tended to be bullish on gold and bonds denominated in gold currencies, which is the same as saying they were typically bearish on the prices of almost everything else. An important thing to keep in mind is that price inflation indicates the falling value of money while price deflation is the opposite. Which is to say if the monetary metal—in this case, gold—becomes more valuable, the prices of other things go down, and vice versa. Between the 1870s and 1890s, the first quarter-century of the classical gold standard era, the world experienced the largest price deflation in history. This was great for creditors like the Rothschilds but bad for debtors, such as the many railroad and canal companies that went bankrupt during this period.

Purveyors of gold could thus increase the relative value of money quite apart from the cost of producing the underlying metal. The Rothschilds achieved this by exercising an effective monopoly over the supply to central banks and manipulating the conditions under which that supply was provided. Like most loans, the loans of monetary gold provided by the Rothschild banks were conditional on meeting certain credit terms. The times of greatest deflation coincided with increased monopoly power by the Rothschild banks. The value of money increased, consequently prices of most other things decreased, and debts became more valuable for their owners. Even when debtors went bankrupt, as many did during this period, their foreclosed assets would be reorganized by the banks into large conglomerates and trusts increasingly controlled by the great financiers.

It is perhaps slightly difficult to grasp the relations of private power that enable control over the value of monetary metal. However, it is even harder to understand how expansion and contraction of credit can influence the price level independent of the cost of producing the monetary metal.

Inflation can occur within a monetary standard system if the supply of the monetary metal is increasing faster than the overall growth of the economy. For example, during the 16th and 17th centuries a flood of new silver and gold from the Americas caused considerable price inflation of goods. But even without such an increase in the supply of the monetary metal, rapidly expanding private credit can cause inflation as well, as was the case with the financial revolutions of the 17th and 18th centuries.

Any increase in credit increases purchasing power. If production expands more slowly than the increase in purchasing power, price inflation will occur somewhere in the economic system, depending on where credit is most abundant. Often, rapid increases in credit inflate asset values such as real estate and shares of stock. Prices of luxury goods may also inflate. Obviously, access to credit is typically confined to rich property owners, so a rapid increase in credit often inflates the buying power of the rich and thus the prices of whatever they buy most. The price of ordinary consumer goods like beer, wheat, and cattle may be less affected.

The expansion of private credit has never been significantly restricted, regardless of whether currencies have been pegged to gold. In fact, insofar as a reliable monetary standard makes creditors more confident of the long-term value of debts, a gold standard may actually stimulate the growth of private credit and thus inflation. This effect may nevertheless be mitigated by the interest of creditors in preventing excessive inflation, since it tends to erode the long-term value of debts. Restricting credit bearishly at a point when the business cycle is overheated is the cure for the inflation disease, though this “cure” can be fatal for bankrupted bulls and many ordinary folks who become unemployed in the consequent downturn.

These countervailing tendencies of bears and bulls occur no less under a gold standard system then under the current system of flexible currency values. Under both systems, the relative value of money (and thus debts) fluctuates up and down over the course of the business cycle as bears and bulls contend. At stake is the value of money and debts denominated in money, and thus the relative fortunes of debtors and creditors, bulls and bears, are always in tension. There is no permanent equilibrium in this perpetual war within our polarized political economy.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo depicts portraits of Nathan Mayer Rothschild (1777-1836, left) and James de Rothschild (1792-1868). Artists unknown.]

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