Representative money and the gold standard

Wonder

1. If a note is only a claim on gold, what stops the issuer from writing more claims than it holds?
2. Why did paper money appear in China centuries before Europe?
3. How could a gold standard keep prices aligned across countries without anyone managing it?

Explore

1. Paper money began as a receipt. In Tang China, merchants used “flying money,” drafts payable in another city, to avoid moving heavy strings of bronze coin. In early-eleventh-century Sichuan, deposit shops issued notes called jiaozi; around 1024 the Song state took over issue. The Yuan later made paper the main currency. Both dynasties eventually over-issued, and the notes lost value.
2. Europe repeated the pattern. Seventeenth-century London goldsmiths took deposits of coin and issued receipts that passed from hand to hand as money. Sweden’s Stockholms Banco issued Europe’s first banknotes in 1661 and failed within a few years after issuing more than it could redeem. The Bank of England, founded in 1694, became the model for a note-issuing bank tied to the state.
3. Representative money has one honest form: every note backed by metal in the vault and redeemable on demand. Its weakness is that holders cannot see the vault. Issuers learned that only a fraction of notes came back on any given day, so they could lend or spend against the rest. That is fractional-reserve banking: it works while confidence holds and invites a run when confidence breaks.
4. Britain tied the pound to gold by law in 1816 and restored convertibility in 1821, after suspending it during the Napoleonic Wars. Germany moved to gold in the early 1870s, the United States resumed convertibility in 1879, and by 1900 most major economies had joined. The classical gold standard ran from about the 1870s to 1914. Each currency was a fixed weight of gold, so exchange rates between them were effectively fixed.
5. David Hume described the self-correcting mechanism in 1752. A country that imports more than it exports pays out gold; its money supply shrinks, its prices fall, its goods become cheaper abroad, and gold flows back. Central banks nudged the process with interest rates, but no one had to plan it. The price level was stable over the long run, though recessions and banking panics remained frequent.
6. War broke the system. In 1914 the combatants suspended convertibility to pay for the fighting. Britain returned to gold in 1925 at the pre-war rate and left again in 1931. In 1933 the United States ordered citizens to hand in most gold coin, bullion and certificates (Executive Order 6102). The Gold Reserve Act of 1934 then raised the official price from $20.67 to $35 an ounce, devaluing the dollar by about 41%. Convertibility survived only between governments.

Key facts

Exercise nine, six, three, one

Fact check

Dates, figures and claims checked against the published sources listed below.

• R. von Glahn, Fountain of Fortune: Money and Monetary Policy in China (1996)
• D. Hume, "Of the Balance of Trade" (1752)
• B. Eichengreen, Golden Fetters (1992)
• US Executive Order 6102 (1933)
• Gold Reserve Act of 1934