This guest post on the ramifications of the demise of the gold standard is by Rob Dix. A long-time Monevator reader, Rob is co-host of the popular Property Podcast and co-founder of Property Hub. Rob is also the author of the Penguin bestseller The Price of Money.
You may have been taught as a child the golden rule, ‘Do unto others as you’d have them do unto you.’ A more cynical golden rule was made famous in the movie Aladdin: ‘Whoever has the gold makes the rules.’
But a more accurate (if less pithy) formulation might be, ‘Whoever has the power makes the rules about the gold.’
The amount of money in the economy has been increasing dramatically over the last 50 years, and the pace is only getting faster.
How is that even possible? Well, for most of history, it wasn’t. It was only in the latter part of the twentieth century that the brakes came off and the creation of money became so unrestrained.
So what exactly changed towards the end of the twentieth century? To understand that we’ll start with a quick romp through the history of money up to that point.
The earliest money
People exchanged goods with each other long before the development of physical money. ‘Tally sticks’ were used at least 30,000 years ago to keep track of who owed what to whom. Eventually, these were replaced by clay tokens. But both seem to have been used simply as claims of ownership: the tokens themselves weren’t traded between people.
The first physical currency appears to have been the Mesopotamian shekel, dating back somewhere around 7,000 years. Metal coins are more recent still – seemingly originating independently in China around 1000 BC, and ancient Greece around 650 BC.
Eventually, these small pieces of metal would become the dominant way of organising an economy.
The UK is a good case study – and not just because it’s where I live! Records go back a long way, and Britain was a major global power during a period when critical innovations in the history of money were taking place.
We’ll link back up with other currencies later, when we reach the twentieth century.
Coining it
Coins started being used in England as early as the second century BC. But it wasn’t until the eighth century AD that their use became widespread and the coins themselves more standardised.
These later coins were made of silver, and the name ‘pound sterling’ derives from a pound weight of sterling silver. This was important, because the value of the coin was in the metal itself. Whether it was melted down or moulded into a convenient disc, it should be worth exactly the same.
A pound of silver was divided into 240 pennies. There were 12 pennies in a shilling and 20 shillings to a pound (12 x 20 = 240). Each penny was further subdivided into four farthings. We organised our coinage this way for about 1,300 years – until in 1971 someone finally came up with a less mentally-taxing structure. (“The British resisted decimalised currency for a long time,” as Neil Gaiman put it, “because they thought it was ‘too complicated’.”)
All those centuries ago, everything operated on a far more local basis – primarily owing to the time it took to convey messages across long distances. In the case of money, each town would produce its own coinage. There wasn’t one ‘Royal Mint’ as there is today.
The problem with this? It created ample opportunity for any individual ‘moneyer’ (the name for the trade that produced coins) to cheat the system by mixing in much cheaper tin with the silver that should have been used.
In other words, the unwary trader might think they were being given a valuable pound of sterling silver, but find they had nothing of the sort if they ever decided to melt it down.
Moneyers would come to regret giving in to this temptation. When Henry I became king in 1100 and discovered what was going on, he arranged for all the moneyers to be castrated and have their right hand cut off.
Royal flush
Seven Henrys and nearly 400 years later we find Henry VIII on the throne – coming to power in 1509.
Henry VIII wanted more centralised control of the currency. So he shut down all the local mints and decreed that the Royal Mint in London could be the only entity to create new coins.
This removed the opportunity for moneyers to meddle with the silver content of coins. But it introduced the opportunity for monarchs to do exactly the same thing centrally – without the risk of castration.
The effect was what you might expect from giving control to someone with a desire to accumulate as many goods as possible and no fear of retribution. About 30 years after the creation of the Royal Mint, the silver content of coins fell from over 90 per cent to just over one-third. The pound coin, originally named for its weight in silver, now very much wasn’t.
A similar pattern of increased centralisation has played out around the world.
In Germany, for example, the city of Hamburg had its own currency until 1873, until it adopted the mark upon German unification, then the euro in 2002.
In the US, although the dollar was established as the principal unit of currency in 1793, private local and regional banks were allowed to issue their own banknotes until 1861 – and approximately 1,600 of them did.
Some 244 separate clans issued their own forms of money in Japan until the yen was adopted in 1871.
In every case, this removed the ability for powerful local figures to manipulate money for their own benefit – and shifted that privilege to the central state.
The central bank is born
By about 1600, monarchs in much of the world had centralised their mints in this way. But another revolution was just around the corner: the development, in England, of the world’s first central bank.
By the 1600s, silver in England had become scarce because so much of it was being sent overseas as payment for foreign goods. In its place, gold started being used to define the value of the pound instead. (The change was overseen by one Mr. I. Newton – of ‘gravity’ fame.)
Around this same time, the country developed a serious requirement for state funds. England had lost a key naval battle in its ongoing wars with France. It needed to raise £1.2 million to rebuild the fleet.
In those days, it was normal for monarchs to personally borrow the money needed to fund wars. Unfortunately, the recently deceased Charles II had defaulted on a huge amount of debt before his death. That put everyone off the idea of lending to his successors.
To give confidence to potential lenders, in 1694 William III agreed to the establishment of a new national ‘central’ bank: the Bank of England. Importantly, the Bank would be overseen by Parliament, rather than the king. Any money it borrowed would be the responsibility of the state as a whole rather than the reigning monarch.
The strategy worked: within 12 days, the new Bank had raised the £1.2 million that the war effort needed (from about 1,200 individuals).
And so the national debt – meaning the money owed by the government to those who’ve loaned it money, and a figure that’s in the trillions today – was born in 1694 with this loan of £1.2 million.
That loan was the start but certainly not the end. By 1815, at the end of the Napoleonic Wars, government debt had risen to around £800 million.
From bullion to banknotes
The creation of the Bank of England also led to the issuance of banknotes. Up until this point, the value of the pound had been in the silver or gold coins themselves. Now, for the first time, this value could also be represented by a piece of paper with no intrinsic value of its own.
Why would people start accepting worthless paper as a representation of valuable metal? Because these banknotes could be exchanged at the Bank of England for a fixed quantity of gold. The note was effectively a ‘receipt’ for real gold stored at the bank.
It was important for public confidence that the banknotes could be exchanged for gold on demand, but in practice they rarely were. People would happily accept banknotes in exchange for goods and services, safe in the knowledge that they were backed by something they trusted.
Of course, the Bank did actually have the gold it needed to repay everyone – just in case they all turned up at the same time bearing their paper banknotes and demanding the equivalent amount of gold… right?
Well, no, not really.
The Bank cottoned on to the fact that people were quite happy with the notes and rarely turned up to claim the gold, so it started issuing many more banknotes than it had the gold to back.
In the 1730s, the Bank almost collapsed when too many people turned up demanding gold at the same time. But it survived, and 50 years later it was still paying out gold on demand.
Money for nothing
In our quick whizz through financial history so far, we’ve seen a pattern. Whenever there’s an opportunity to create or obtain extra money, it’s enthusiastically seized:
- The local ‘moneyers’ of old had the opportunity to reduce the precious metal content of coins, so they did. And they had their bits chopped off as a consequence.
- Henry VIII had the chance to reduce the precious metal content of coins in a similar way once their production was centralised, so he did too. (His bits remained intact because, well, that’s a benefit of being in charge).
- The creation of the Bank of England gave the government the ability to borrow – and it racked up over £1 billion of debt in a little over a hundred years.
- The Bank also issued banknotes that could be converted to gold on demand… and issued more of these notes than it had the gold to back.
These specific actions – and this general tendency to game whatever system was in force at the time – meant that over the years, more and more money was being created.
Money, supply, demand, and inflation
The more money that is in circulation, the less each individual pound becomes worth.
In the next chart you can clearly see a collapse in buying power between 1750 (the furthest back I can find data, and about 50 years after the Bank of England’s founding) and 1815 (the end of the very expensive Napoleonic wars):
Buying power of £100 over time, 1750–1815
And it’s not just the pound. As we’ll see, the pattern of currencies being abused to benefit whoever is in power holds up across the world and throughout time.
The classical gold standard
As the chart above shows, the buying power of the pound actually picked up after 1815, and then stayed relatively steady all the way through to 1914.
One reason for this is a lack of war. Although there was war aplenty across Europe during the mid-nineteenth century, the UK largely stayed out of it and concentrated on building its empire. Less war means less need to print new money or pile up new debt.
But the other reason for the steady value of the pound was the implementation of the ‘gold standard’, which was introduced in the 1870s.
The gold standard was the solution to a problem that became apparent after Western countries decided to trade with one another rather than kill one another.
While increased international trade was far more prosperous and less gruesome than war, it came with one massive headache – the effort involved in constantly converting between national currencies.
To overcome this, most nations decided to join the United Kingdom in ‘pegging’ their currencies to an amount of gold.
The gold standard in practice
Every currency could be converted into gold at a set price, which had the effect of fixing exchange rates between different currencies too. (This is very different from today’s floating exchange rates.)
Effectively, this meant that gold would underpin international trade. The precious metal was literally shipped between each country’s central bank to settle payments. If a particular country bought more from other countries than it sold to them, its central bank’s gold reserves would diminish (and vice versa).
The gold standard, although it was only introduced as a way to facilitate international trade, also had the side effect of limiting the ability of the Bank of England to print endless quantities of banknotes. If those notes were used to buy goods from overseas, the Bank would have to ‘settle up’ by sending gold abroad – and eventually it would run out.
Nevertheless, although this meant the Bank had to be careful about the quantity of banknotes it issued (which stopped the money supply from growing as quickly as it had done before the international gold standard was introduced), nothing else within the UK had changed.
Banknotes continued to be notionally convertible into gold on demand, and there still wouldn’t be enough gold to go around if everyone turned up with their banknotes at once.
The gold standard and Word War One
The system wasn’t perfect, but it held well until the outbreak of World War One. At that point international co-operation (obviously) broke down and every country focused on doing whatever it took to fund the war effort.
In the UK, the Bank of England didn’t have anywhere near enough gold to prepare for war. This predicament was made even worse by individuals who, spooked by the rumours of war being declared, began doing the one thing the Bank didn’t want: queuing up to convert their notes into gold.
As a result, the day after war was declared on Germany, the Currency and Bank Notes Act of 1914 was signed into law. The Act gave the government the power to print millions of pounds worth of new banknotes. These had to be accepted as legal tender and, critically, could not be converted into gold.
This is why in the next chart you can see the buying power of a pound take a sharp leg downwards in 1914. The money supply suddenly increased, which naturally reduced its value:
Buying power of £100 over time, 1750–2020
This was a landmark moment. Although the banknotes that had been issued previously turned out not to be fully backed by gold (as became clear when people rushed to redeem them en masse), they were supposed to be. The Currency and Bank Notes Act of 1914 marked the first time the central bank issued money that had no notional link to gold at all.
These new pounds were pounds purely because they had ‘one pound’ printed on them, and because the authorities said that’s what they were worth.
The link with gold was briefly reinstated after World War One, but in 1931 the Bank of England permanently stopped offering to redeem banknotes for gold.
From that day on, the pound has been a ‘fiat’ currency – meaning it has value purely because the government says so, and has no link to anything tangible whatsoever.
The gold standard, rebooted
Once World War Two ended, there was a clear need for a new arrangement to rebuild trust and facilitate international trade.
Returning to basing everything on gold seemed to work pretty well in the pre-war years. But that wasn’t going to work this time – for the simple reason that the US now held three-quarters of the world’s gold supply.
How did it accumulate so much?
First, in 1933, President Franklin D. Roosevelt issued an order banning American citizens from owning gold. All gold had to be sold to the government in exchange for paper dollars. This was intended to boost the central bank’s supply, and it did.
Another factor was that before entering World War Two the US supplied the Allies with weapons and other resources, which they paid for with gold. And because it entered the conflict later than other countries, the war effort also drained US resources less.
Good as gold
Indeed the US’s post-war power – as well as its quantity of gold reserves and general trust in the strength of the dollar – meant that the dollar was seen to be ‘as good as gold’. So, in 1944, a new system was devised and signed up to by 44 countries.
The new system had three defining characteristics:
- The dollar was given a fixed value in terms of gold (1oz to $35).
- Every other currency fixed its exchange rate in relation to the dollar.
- Countries (but not individuals) could hand their dollars back to the US central bank (called the Federal Reserve) at any time, and receive the equivalent amount of gold.
This created a consistent and predictable basis for countries to trade with one another because everything was ultimately still based on gold. It established the dollar as a convenient, trusted currency that could be used for global trade
For example, the owners of a Japanese factory selling products to Greece might not want to receive drachmas in exchange for goods. But they’d be happy to receive dollars, knowing they could use those dollars in another international trade. Alternatively, they could convert them back into their home currency (the yen) at a pre-set exchange rate.
Goldilocks scenario
Under this system, currencies including the pound were effectively ‘backed by’ gold – just as they had been in the past – but with the dollar sitting in the middle to facilitate. And it worked: post-war stability was achieved and global trade was rebuilt.
For the system to continue functioning indefinitely, one thing was essential. Countries needed to believe that they would always be able to exchange dollars for a fixed amount of gold. In other words, they needed to believe that there really was enough gold to back up the dollars being issued.
All the US government had to do, therefore, was avoid creating millions of extra dollars without first accumulating more gold to back it up. Not too much to ask, in the scheme of things.
Oh. It was too much to ask. But – let’s be honest – not completely unexpected.
As we’ve already seen several times over, when leaders are given the power to create money and the full negative consequences will become some future leader’s problem, it often proves impossible for them to resist.
Under consecutive governments, the US ran massive social programmes, fought a lengthy war in Vietnam and raced Russia to the Moon. All of which required money the country didn’t actually have, so could only be achieved by creating more dollars.
When other countries realised what was going on, they started to lose faith that they’d be able to convert their dollars into gold in the future, because there couldn’t possibly be enough of it.
The upshot: many countries started exercising their right to hand back their dollars and demand gold.
Suspended animation
The US gold supply dwindled to the point where some kind of action was needed. So on 15 August 1971, President Nixon announced that the convertibility of the US dollar into gold would be ‘temporarily’ suspended.
In other words, on a temporary basis, $35 would stop equalling 1oz of gold – or any amount of gold. On a temporary basis, a US dollar would be backed by nothing – and therefore so would every currency with its exchange rate tied to the dollar.
That temporary basis has now been going on for 50 years and counting.
If questioned, I imagine most people would have the vague notion that something is giving value to the pound, the dollar or any other national currency. Either because they remember a time when there was, or because it just seems logical that there must be.
Yet since that day in 1971, there isn’t even the pretence that a currency is backed by anything tangible.
In principle, this means there’s nothing to prevent governments from creating as much of their own currency as they want to.
And naturally, as they have throughout history when the opportunity presents itself, they do.
More money, more price rises
When government take advantage of their ability to create more of their own currency, what happens?
A three-step pattern which we’re now very familiar with:
- The amount of money in circulation goes up.
- Each unit of money therefore becomes worth less – meaning you can buy less with it. (It loses buying power).
- So prices – when denominated in pounds, or dollars, or whatever – go up.
Step 1 is why the amount of money in existence in the UK exploded in the late twentieth and early twenty-first centuries – to such an extent that everything before that point is barely visible, as you can see in the next chart:
Broad money (M4) in United Kingdom, 1900–2020, stated in millions of pounds sterling
The three-step pattern is also why, as this follow-up chart shows, the buying power of the pound has decreased so sharply (step 2 – and therefore also step 3):
Buying power of £100 over time, 1967–2021
And it isn’t just the pound. As you can see below, a whole host of major currencies have lost the vast majority of their buying power since the 1970s:
Buying power of 100 units of major currencies, 1967–2021. US dollar = black solid line, Australian dollar = black dashed line, German mark and euro = black dotted line, Japanese yen = grey solid line
Our new financial world
Ever since President Nixon made that announcement in 1971, we’ve been living in a completely new financial world. And that’s not hyperbole.
As we’ve seen, there have been times throughout history when the link between government-issued currency and an underlying ‘something’ (usually gold) has been weakened or broken. But the concept has always been there – in principle, at least.
Now though, for the first time, the only reason major global currencies have value is because governments say they do.
You could argue that this isn’t, in itself, a bad thing.
Clearly, a currency strictly backed by a fixed amount of gold isn’t dynamic enough to cope with extreme events. That’s why we’ve seen the normal rules abandoned during times of war. (However, you could also very reasonably argue that it’s only the overnight creation of large amounts of money that makes large-scale war possible – so it’d be better if governments were more restricted.)
A lack of restrictions also liberates the government to intervene in helpful ways in peacetime. For example, if an economic downturn causes widespread unemployment, the government can just create the money needed to provide jobs or welfare to prevent people from falling into destitution.
So flexibility can be positive, but it also has the disadvantage of introducing human nature.
Mo’ money, mo’ problems
If money had been created in tough times, then destroyed or repaid when conditions improved, that would be one thing.
Yet from the earliest moneyers to today’s governments, we’ve seen that once the value of money is diluted, it’s never reinstated. And since 1971, when the last practical constraint on money creation was suspended (‘temporarily’), we’ve witnessed a vastly higher amount of money creation than at any other point in history – with a corresponding effect on buying power.
As I explain in The Price Of Money, this certainly doesn’t affect everyone equally. Those closest to the source of the new money (or who have more of it to start with) often benefit, while everyone else suffers. I also explore the events of the years 2008 and 2020 in detail – both of which are on a par with 1971 in terms of how they’ve shaped the financial world we live in today.
To discover what happened next, grab a copy of Rob’s book The Price of Money: How to Prosper in a Financial World That’s Rigged Against You.
I had an emotional reaction to some of those graphs. A panic if you will…I nearly started looking up the websites of physical gold coin dealers.
I don’t trust our current government not to (further) cock up our currency and with it the country’s economy, and the panic rose while I was trying to work out where such a scenario would lead!
I have calmed myself slightly by noting that I own my home outright and the garden could be turned over to growing a fair bit of produce in a real pinch.
I think I will make myself a cuppa and calm down further. I doubt the article was intended to have people reaching for their foil hats and hoarding tins of beans, but that’s close to the irrational (?) response I just experienced.
Really interesting piece although somewhat depressing. Everytime I think about the actual concept of money the more depressed I get about the fact that it is clearly an edifice that could crumble at any time (and not before the most privileged get to take remedial action). At the same time it’s a confidence game that no one really has an interest in blowing the whistle on (well I guess a well armed despot might).
A superb and fascinating tour d’horizon Rob.
@Kame and @BBBobbins: the decline in the purchasing power of the pound looks panic inducing and depressing, but if there was no inflation at all then there would be no incentive to spend surplus capital and, arguably, perhaps slightly less incentive for productive investment, as newer and better plant and equipment would cost no more in the future than now.
Also, with a hard (gold backed) currency it is much more challenging to stimulate an economy after a demand shock, as the under reaction to the early (1929-32) stages of the Great Depression showed (i.e. at least until the stimulus of the New Deal etc. kicked in).
The problem (especially post-1971, although, as the piece illustrates, it was to an extent ever thus, as it’s human nature) is that whilst, with a fiat based currency, governments and central banks are willing to do what is necessary to stimulate demand when this falls below the productive potential of the economy, they are unfortunately much less willing and competent when it comes to reducing the money supply to reduce demand when there is as surplus of demand relative to that potential.
They shy away from removing the punch bowl even as rising inflation (e.g. over 2.5% p.a.) empirically demonstrates that demand is no longer in shortfall, and has become excessive relative to supply.
No politician or central banker likes to be seen to raise taxes or interest rates, even when it becomes obviously necessary to restore equilibrium (by reducing the supply of money, and therefore demand).
Rather politicians and central bankers always want to be seen to be tax and interest rate cutters.
Unfortunately, you can’t run an economy on a fiat system unless you are prepared to do both as and when required, just as you can’t drive unless you are ready to use both the break as well as the accelerator.
The article suggests a straight causal relationship between money supply and inflation. Clearly, matters are more complicated. In the decade after the GFP central banks tried hard and failed to create real-world inflation (though they did produce asset price inflation). Even according to economic theory, which is notoriously over-simplistic, there are two terms in the equation: money supply and velocity.
*GFC, of course
Every system of assigning a value to money is, in the end, a decision that money is worth something because we say it is. That includes the gold standard. (Why gold? Silver was used for much longer than gold, the shekel was a “barley standard”, lots of Pacific-rim cultures used cowry shells…)
Here are the important things to know:
1. Every system of assigning a value to money has its strengths and weaknesses.
2. Because every money system has weaknesses, circumstances will eventually arise where the current money system is either making it difficult to solve a problem or is itself causing a problem.
3. At this point, a new money system with strengths that are better suited to solving the current problem will be introduced.
4. Because every money system has weaknesses as well as strengths, circumstances will eventually arise where the new money system is either making it difficult to solve a problem or is itself causing a problem.
I’m sure everyone can see where this is going.
We could go back to the gold standard, or the silver standard, or the [insert commodity name here] standard. A commodity-based money system might be better than the current system at this point in time, or it might not. It certainly wouldn’t be a permanent solution to all of our money problems because… see point 1.
Short summary: All money systems are arbitrary, and all have strengths and weaknesses. There is nothing special about the gold standard.
Dave.
Got 101 gold sovs buried somewhere. Any gain CGT tax free. Why a 101? I wanted a 100 and miscalculated how many. Worth just under £160k.
Real return historically is close to zero, inflation hedge is very arguable, hugely volatile etc etc but hey it’s a nice insurance policy…..Very partial and imperfect hedge against the wheels falling off.
What a great article & testament to Monevator that it’s published here rather than a ‘fancy’ print publication, where it would easily sit. Thank you.
(Tiny headline typo: The Gold Standard and WORD War One).
Well written.
BTW the USA did not race “Russia” to the moon, but rather the whole USSR.
Also the USSR did not sign the end-of-WW2 Bretton Woods agreement which pegged currencies to gold via the dollar. So major parts of the world (the USSR and all the communist controlled Eastern Europe) were outside this system. China also left the system in 1949 when communists took over.
Alas the people in those places suffered terrible economic hardships.
I would like to verify Rob’s chart 1 (that can be seen in the Kindle preview of the book almost at the 100% of sample end) that seems to indicate a relative invariance of UK house prices relative to gold 1970-202o, compared with pounds. I am surprised, if gold is a serviceable hedge against house price inflation we should know more. I’d like to see the source data.
Rob has a tendency to favour a linear y-axis in his book, which tends to be misleading when gauging price changes over time, though it makes for a more impressive shock-horror story for the uninitiated. That’s not inherently bad, but perhaps sensationalist 😉
@Time like infinity
@ermine
..both adding great comments which enhance the article – thank you.
@tom_grlla
100% agreed!
A fascinating read, just placed a reservation for the book at the local library.
Nice article, though my takeaway is that any monetary system (fiat, pegged to gold or hybrid) is susceptible to being ‘exploited’ by the powers that be (and by extension the electorate that elects them in democracies).
I used to be an admirer of the Robs and The Property Podcast, primarily because in their early days they were a lone source of honest comment in an industry (property investment) that was (and is!) teeming with charlatans.
However, I lost a bit of respect for them since they came out with their REIT, initially vanilla and now wrapped up in a gimmicky ‘fintech’ form (it’s called ‘Portfolio’, a ‘multi million pound property investment app’) and started getting more stringent about how property was the only way, high leverage was essential to success when building a portfolio, etc. Their REIT is an appalling investment proposition that’s only ever likely to come good if it grows by many multiples to absorb the currently large proportion of fixed costs.
As it’s the Monevator, I’ll put up this review of Portfolio Property Hub REIT for anyone interested. Hopefully that doesn’t break any rules!
https://medium.com/@InvestorReview/property-hub-reit-portfolio-review-buyers-beware-d3e17d72506d
Interesting article, and tempts me to look at the book (unfortunately not yet in our local bookshop). Also some good discussion points above.
While @Time like Infinity makes some good points his final point about supply and demand only really applies in an idealised textbook situation where both supply and demand are elastic. That doesn’t really apply to the current inflation. When forces external to the national economy reduce supply of a fundamental utility (thinking of the Russian invasion of Ukraine and energy supplies) raising interest rates isn’t going to help the resultant inflation much – people still need energy to heat and light their homes and power their appliances, so all reducing their spending power does is reduce discretionary spending and harm the totally different segment of the economy that relies on that. The Russians aren’t going to change their plans because the Bank of England raises their base rate.
The belief that the pound “has value purely because the government says so, and has no link to anything tangible whatsoever” is completely false and basically a conspiracy theory. The national currency enables the economy to function. It is used to pay taxes, goods, property, services, salaries, trade etc. It is backed by the entire economy – government, consumer, business, national and international.
Interesting comment @Nigel Owen because it is both right and wrong.
Wrong because it is clearly the case that the pound is not tied to any commodity – it would mean that commodity has a constant price regardless of whatever else is going on, and there is no commodity with that property.
But at the same time right because the pound is intrinsic to the economy and given its value by it. There is an argument that the key feature of the pound is that it is used to pay taxes, and indeed nothing else will substitute. Thus quite apart from those in government employment who are inevitably paid in the government currency, everyone else needs pounds to pay their taxes and as a direct consequence they accept pounds as payment for goods, services, etc. Cowrie shells simply won’t do.
But as I think you imply, it means the government do need to rule in ways that don’t undermine trust in the pound for all transactions within the economy.
No conspiracy theories needed!
@PipMcInt (#11): thank you for the appreciation. Although I’ve had access to the internet since 1994, and have been reading Monevator since 2008, it’s only in the last month, since subscribing to this blog (the first and only website I’ve ever subscribed to), that I’ve ever commented on anything online. So the appreciation means a lot.
@Jonathan & @Nigel Owen (#14-16):
Fiat currency is as backed up as any other necessary fiction for modern civilization to operate.
The nation state is a necessary fiction. It exists because we believe it to do so and act accordingly. But it is not physically real like a mountain or a fundamental particle is real. That lack of physical reality is irrelevant where the idea – here that of money – has a shared psychology existence.
Money represents the idea of the state, which is accepted generally as:
– the arbiter of disputes,
– the source and enforcer of legal rules and norms,
– the entity with the right to tax and issue currency,
– the directing mind for social and economic policy,
– the normal source of funding for education,
-the provider of social protections and health care,
– the territorial possessor of the nation’s human, financial and physical capital, and,
– subject to public international law, the sovereign authority in that territory, normally with standing armed forces.
So, there’s actually quite a lot backing up a typical fiat currency.
Given a choice between those attributes, and the backing of a lump of gold metal, all else being equal I’d tend to prefer the backing of the long list above, rather than the shiny stuff.
Agree with Jonathan that I’ve given a stylised example for inflation re: supply and demand curves, and that the reality for the UK will be much more complicated in practice than what I’d described.
Also agree with Jonathan that a very sizeable proportion of recent UK inflation has been imported.
This was first due to pandemic related global supply chain disruption in 2021, arising both from the backlogs at ports and in international shipping and also from COVID related production disruption, in particular issues with Chinese factories.
Since 2022 it has been exacerbated, or outright caused, by the disruption of the Russo-Ukraine war, which has very significantly adversely affected both energy and food costs.
The externalities of inflation since 2021 also resembles the price shocks of the summer of 2008 (oil at $140/barrel), of 1979-80 (following the Iranian revolution) and of 1973-74 (following the OPEC embargo).
Whilst there are, I think, good reasons to accept the basic premise of commentators on the US economy, like Barry Ritholtz (Big Picture Macro blog) that inflation in the US is overwhelming imported (e.g. https://ritholtz.com/category/inflation/), such that further rises in the FOMC rate would only damage demand without addressing the underlying (external to US) causes of inflation; I don’t myself think that the UK is in the same space (analysis wise) on this.
Empirically in the UK we’ve got a high and rising (6.8% p.a. last reading) rate of core inflation, which is supposed to strip out all the external to UK imported elements which otherwise appear within the RPI, RPIX, HICP and CPI measures of inflation.
Looking at it more systemically:
Yes, on the one hand our economy is very much import led, even more so than the US. So, we’d expect much of the power of interest rate rises to curb inflationary pressures to be muted when inflation is obviously imported.
But, on the other hand:
1. Here in the UK, unlike for the US, we don’t have the benefit of what the French Gaullists in the 1960s called the exorbitant privilege of the dollar. Sterling behaves since 2016 increasingly like a Emerging Market currency. It’s risky thing to own internationally. Not any longer a currency of first resort. The Euro, Dollar and Renminbi (and possibly the Yen) are the currencies of choice and of international trade. Not anymore the pound.
2. Having left the EU, and having neither kept membership of the single market nor joining EFTA as an alternative to it, the UK is now outside of any major trading block. The US through NAFTA and its successors, and the EU27 through the Common Market, each have huge structural advantages over the UK, which better enables them to weather supply and price shocks without resorting to interest rate rises.
3. The UK’s lack of economic growth both:
a). coming out of the GFC in the decade after 2009; and,
b). after the pandemic;
(esp. relative to the US, whose economy is now substantially larger in real terms than in 2019 and, of course, as compared to 2008, whereas ours is likely smaller than in 2019, and not much bigger in real terms than in 2008); suggests that we have a serious shortfall of productive capacity in the UK as compared to what we enjoyed up to 2008. This in turn is likely to have significantly impaired the UK’s non-inflationary rate of growth, meaning that we have less scope, as compared to the US or to our position in earlier years, to use supply side measures to curb price increases, leaving us more reliant on raising interest rates (notwithstanding the imported origins of much, but not all, of our inflation).
4. Unlike the US, in the UK we don’t have either a huge internal market for our own national outputs of goods and services, nor do we have huge internal reserves of any of the four factors of production, e.g.:
– (for land) we don’t have massive agricultural surpluses (unlike the mid Western states),
– (for physical capital) we don’t have huge reserves of oil and gas (we’ve nearly tapped out the North Sea, whilst the US still has highly productive shale oil and gas fields and conventional oil resources from the Gulf of Mexico and Texas),
– (for labour) the US remains a more attractive destination for labour (the coveted green card), and,
– (for entrepreneurship) the US leads in many areas of innovation worldwide, whereas it is hard to think of any really convincing ones for the UK. We don’t really have a fully fledged version of Silicon Valley here. Since Brexit London plays second fiddle to New York in the financial markets. As a country we’re rather ineffective at commercialisation, often inventing strikingly useful products which then go on to be developed and exploited by our competitors.
Therefore, because of that relative lack of self sufficiency and our weaker position now (structurally speaking) as compared to that of the US and the EU27, we can’t as readily insulate ourselves from inflationary pressures, whatever their causes, as perhaps they can.
Based upon this, my best guess is that, going forward, the UK is more likely than before to have to accept one or more of higher inflation, higher interest rates, or a weaker currency.
A thought provoking post and great comments. I admit that I struggle to get my head around it all so wondering what it means practically for a UK investor. Does the apparently weak position of the UK and the pound mean that a portfolio which overweights UK equity and bonds (e.g. lifestrategy funds) is actually more risky than straightforward global equity and bond trackers?
@Rahul thanks for the link to the deconstruction, much appreciated. I can’t complain about the £9.99 for Rob’s Kindle book, it was a diverting read.
Unlike every other Brit, I have an extreme and intense dislike of residential property as an investment because it stiffed my younger self something rotten, but even without that, Rob’s conclusion that the only way to resist financial repression is leveraged residential property stuck in my craw. I paraphrase slightly, he did recommend VWRL and commodities and did offer the requisite disclaimers, but the feeling was that residential property was the One True Way. I agree with him, in the specific case or try and own the house you live in. That’s because the experience of renting is spectacularly evil in the UK. The value of the expensive asset is in the usufruct but mainly in keeping landlords out of your life.
@Time like infinity, an interesting and comprehensive account. You may need a blog of your own!
I find the concept of “core inflation” rather difficult, while I can see that it is useful to strip energy costs (etc) out of an inflation index, I can’t see how it can exclude the continuing impact of those costs on everything else. Pretty much every other sector is a user of energy, and has transport costs (affected by fuel prices) as an input. Inflation in those will have gone up lagging the rise in energy/fuel prices, and there will be a similar lag in their fall.
@ermine. Thanks for taking one for the team. I did suspect that anyone who sub-titled their book “”How to Prosper in a Financial World That’s Rigged Against You” would at some point scream that the only way to prosper would be “real assets”. Given he runs a property podcast, a decent guess for that real asset would be property. No surprise.
I really liked the early history of currencies and did not know the origin of the name of our currency “Pound Sterling”. Checking the etymology on wikipedia I find that Sterling likely meant little star from the pattern on early coinage. I had assumed it was something to do with the city of Stirling in Scotland.
The price of silver today is around £0.62 per gram. 454g grams to the pound in weight, so a pound of (Sterling) silver today is worth £0.62 x 454 = £281.48.
On the other hand when Pound Sterling first came in, I imagine there weren’t a lot of different things you could buy for it by today’s standards and some things have become a lot cheaper due to mass production etc.
@Jonathan B. Central bank monetary policy can do nothing about supply-side spot inflation shocks (or for that matter velocity shocks). It takes 12-24m for the impact of monetary policy to be fully felt. What it can do is manage forward inflation expectations since the key issue is managing second round effects. Inflation begets inflation. Long-term forward inflation expectations are driven more by core inflation than headline inflation (mainly wage inflation to be honest). Hence the focus on core.
The author seems overly concerned about ever increasing money supply. The quantity theory of money was proposed in 1517 by Copernicus so it’s not exactly a new thing to any of us! The cross-spectral coherence between either narrow or broad money growth and inflation over the long-term has exhibited little variation–being, most of the time, close to one. What matters, at least over shorter timeframes such a decade, are velocity and inflation shocks since this impacts the cross-spectral gain. Evidence suggests that monetary regimes characterized by low and stable core inflation exhibit low gain and high coherence in under shocks. They are more resilient.
The BoE was rather late in acting. EM central banks started hiking from mid 2021 and the BoE should have moved with them. Like the ECB, it waited for the Fed but that was too late. Starting a tightening cycle late means hiking more and for longer. Often until something breaks.
Very helpful @ZX. I couldn’t make sense of why the BoE is still wanting to raise interest rates when they know they won’t affect inflation for at least 12 months – and inflation is on the way down (albeit slowly) anyway. But from what you say it is doing the rise they should have done a year ago, to make sure the market expectation is that matters are in hand.
And I hadn’t known Copernicus dabbled in economics!
Property was / is my thing, although I am diversifying now thanks to the education I have been getting here for some years, thanks Monevator team.
I have been aware of the Rob’s and their podcast for many years, but for the last few years I have had my doubts about them, it started when they launched their REIT.
I agree with @Rahul (thank you for the links), they are very much hard sell now and their advice/analysis on the podcast is not balanced, IMHO, which is likely to not end well for anyone who blindly follows it.
Property is not the investment opportunity it once was, by quite a margin, but it appears this does not fit the narrative that their business model is dependent on.
It’s a shame, I used to enjoy listening to their podcast.
@ZXSpectrum48k (#24) & @Jonathan B (#20 & #23): reports today from ING (research note), KMPG (Yael Sekfin), HSBC (Ian Stuart) and Jonathan Haskel on the MPC that the BoE Base Rate (BEBR) may either have to go higher than previously expected or not be reduced for much longer than previously anticipated.
I wrongly initially thought that the current (2021 onwards) inflation wave in the UK was transitory (like the BoE did),
and that it would pass when the post COVID supply chain normalised.
I was also generally inclined towards being an inflation dove (i.e. do more QE, consider negative rates, BoE should lend to businesses directly) during 2009-2020.
The current momentum in core inflation has me spooked though, and veering into the sense that we’ve done too little, too late in terms of rate rises.
Am I going from one pole of opinion to the other on this unnecessarily, or is it different this time (i.e. into a new higher & sustained inflation regime unless BEBR gets yanked quite a bit higher for some time)?
Conventional economics generally held, pre 2008, that market rates needed to be higher than inflation (or at least above core inflation) in order to destroy enough demand in an economy to align demand with production and curb price rises.
From 1985-2008 BEBR averaged 2.5% over core inflation. Currently BEBR is over 2% below core inflation (4.5% v 6.8%).
Is the MPC likely to be right to think that it does not need to actually get BEBR above the rate of core inflation in this cycle? If not, then are we looking at a prolonged (multi year) period of core inflation exceeding 2.5% p.a.?
I am very surprised that Monevator published those scaremongering charts. No sources and decades go by without a penny in interest.
The interest earned on cash allowed it to maintain its purchasing power for the past 120+ years. Contrary to what you may think based on the article, returns on cash have been unusually good since the US cut the link to gold in the 70s.
UK inflation-adjusted returns on cash (treasury bills) from the Credit Suisse Investment returns yearbook 2023 (p41):
1900-2022: 0.9% p.a.
1973-2022: 1.5% p.a.
2000-2022: -0.9% p.a.
@rho — I agree the charts are clearly designed to amplify a point, but we’re discussing here the declining spending power of particular fiat currencies due to inflation, not what return you would have happened to get in from holding that currency as cash in a bank account (and ignoring tax, incidentally, in your cited returns).
Of course in practice inflation is exactly why you need to do *something* with your cash, as you suggest, and as I covered back in my very first investing 101 article:
https://monevator.com/investing-for-beginners-why-do-we-invest
In contrast, investing would be less urgent if spending power didn’t decline over time… 🙂
@TI & @rho (#27+28) & my post #26: re: interest rates, inflation & value of money and those returns on cash in nominal v real terms: Ed Conway on Twitter yesterday (14/6/2023): “But now let’s adjust for the fact that these days people have bigger mortgages and lower incomes vs their monthly payments. @resi_analyst has done the sums on this. It results in a line like this. This is a genuinely comparable measure of the burden of mortgage repayments” https://t.co/GDbLKr2n9P” / Twitter
Scary that 5.75% BoE BR now like the 14% of 1991 (which @ermine rightly reminds and warns us of).
But if home equity is higher now than then, the higher nominal rates might not be as equivalent in its effects for borrowers as in the past, and may not translate as effectively to higher real returns on cash. (E.g. higher borrowing rates not affecting as many people (relatively) as before = perhaps less scope compared to the past to curb inflation). Just a conjecture of course.