How the Pound Sterling Fell from Grace
The pound sterling has come a long way since its heyday back in the 19th and early-20th centuries. Since then, the dollar has taken its place and — potentially — is itself to be supplanted in the not-too-distant future. Here, I get to grips with the marginalization of the pound as the world’s favorite ‘reserve currency asset’.
Instead of bamboozling you with the jargon used by the typical student of money, I thought I’d outline a few rudimentary concepts first. There are two main reasons for doing this:
- To get a few things clear for people who aren’t well versed in the convoluted subject of money.
- To make sure that I’m speaking in no uncertain terms. Even people who are familiar with this subject tend to argue endlessly over what ultimately comes down to a disagreement over terminology!
Nevertheless, for those readers who are already accustomed to the terms in which we speak here at greshams-law.com (or anybody else for that matter), feel free to skip the next section or two to get to the main section of the article.
What is money?
Money does not have to be ordained into existence by the state, and it wasn’t ‘invented’ (as the propaganda producers at the ECB would have our children believe!). Rather, money is a good – indeed, any good – that people naturally come to choose as the medium of exchange. To overcome the difficulties inherent within a barter economy (for example, consider that the professor of economics who wants a haircut needs to find a hairdresser who wants lessons in economics!), people start to engage in indirect exchange. As Rothbard wrote in the excellent little book, What Has Government Done to Our Money? (available for free at the mises institute or at the greshams-law.com bookstore):
Under indirect exchange, you sell your product not for a good which you need directly, but for another good which you then, in turn, sell for the good you want.
Rothbard then goes on to explain how the intermediate good (i.e. the ‘another good’ in the quote above) might rise to the status of ‘money’:
If one good is more marketable than another – if everyone is confident that it will be more readily sold – then it will come into greater demand because it will be used as a medium of exchange. It will be the medium through which one specialist can exchange his product for the goods of other specialists.
Now just as in nature there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media of exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium which causes more marketability, etc. Eventually, one or two commodities are used as general media – in almost all exchanges – and these are called money.
So, what are currencies then?
My presumption is that few people would have substantial misgivings with the above discussion about money. However, they might when I separate the notions of money and currency.
For the purposes of the following discussion, I will use the term ‘currency’ to denote some kind of system of money (rather than simply money itself). So, for example, a banknote that is redeemable into gold would be a currency, but not necessarily a money (for example, consider whether or not a ‘greshams-law.com note’ would reach the status of a widely used medium of exchange!).
So, in this way, we can say that all currencies are functions of monies, but not all monies need be functions of currencies. For example, gold bullion might easily circulate as money alongside redeemable claims upon gold bullion, and yet the bullion wouldn’t be a ‘currency’.
If currencies are functions of monies, but monies needn’t be functions of currencies, then how did the world end up getting involved with all of these ‘reserve currency’ shenanigans?
Well, to get to grips with the concept of a ‘reserve currency’, we have to briefly review the progress of monetary matters over the past few hundred years. As Rothbard wrote:
We can look back upon the “classical” gold standard, the Western world of the nineteenth and early twentieth centuries, as the literal and metaphorical Golden Age. With the exception of the troublesome problem of silver, the world was on a gold standard, which meant that each national currency (the dollar, pound, franc, etc.) was merely a name for a certain definite weight of gold. The “dollar,” for example, was defined as 1/20 of a gold ounce, the pound sterling as slightly less than 1/4 of a gold ounce, and so on. This meant that the “exchange rates” between the various national currencies were fixed, not because they were arbitrarily controlled by government, but in the same way that one pound of weight is defined as being equal to sixteen ounces.
Ok, so the pound, dollar, franc etc. were originally redeemable for certain weights of gold. So how did pounds end up ‘backing’ all of those currencies? This – we contend – was attributable to the great temptation that has intrigued, haunted and coaxed bankers throughout the history of man: – the temptation to issue receipts for the stored items (in this case, gold) in excess of what is actually held. For each currency (the pound, dollar, franc and so on), there was a stock of issued notes (each supposedly redeemable into gold at a specific rate) and a stock of reserves backing the entire stock of issued notes. Governments, lacking the constraint of competition and benefiting from the protection of the gun, inevitably issued notes in excess of the stock of reserves backing their currencies. However, the market was not stupid! The aggregated convictions of alert speculators and traders were able to draw out the reality from the farce by subsequently bidding down currencies in relation to gold. But since different currency issuers did this at different rates, this could bring about a rather unfavorable situation for currency issuers…
Gold Export & Import Points:
Remember, Governments around the world were constantly engaged in printing currency, and yet nevertheless maintaining promises to redeem at specific rates (X notes for Y gold). Their great desire was to keep the illusion going (i.e. maintain a scenario where they could print currency), and their great fear was a market-induced revelation of their follies (i.e. a bank run / loss of reserves). The scenario where they could potentially be subject to their greatest fear (of an international bank-run) can be described by ‘Gold Export Points’ and ‘Gold Import Points’.
As was described by Rothbard above, currencies were just names for specific weights of gold, and so their ‘parity’ exchange ratios were really defined in the same way that ratios between different weights are defined. However, markets are smart and they would often discount certain exchange ratios to reflect the degree of monetary debauchery in the respective countries. For example, even though (for a long time) £1 = $4.866 at parity, the market might have easily moved the exchange ratio to reflect the degree to which either the pound or the dollar had been debauched. However, and this is very important, if the exchange ratio moved far enough beyond the so-called ‘Gold Export Point’, people would be pushed to redeem gold for their currency. Given that basically all currency issuers were unable to meet all of their currency liabilities, this was a scenario that struck profound fear in the hearts of the bureaucrats at the helms of those currencies! They were desperate for their currencies to not depreciate on the foreign exchange markets, lest they were to lose all of their gold (and thus lose the capacity to print currency)!
Here’s the intuitive explanation of the ‘Gold Export Point’: Imagine you’re in England and you’re going to buy something from a guy in America. Since the guy who you’re buying from is in America, you need to get some Dollars in order to pay him. So, intuitively and naturally, you go over to the foreign exchange markets to get some dollars with your pounds. Of course, given that dollars, pounds, francs, marks and so on are just names for different weights of gold, you fully expect the exchange rate to be £1 = $4.866 (i.e. parity). And if you find the rate at that level, you’d surely buy the dollars and pay the man. But what if the market is displaying an exchange ratio that differs from parity (perhaps to reflect the degree of money printing in recent weeks and months)? What if, say, £1 = $4.7 on the foreign exchange markets? Well, you (and everyone else) might easily say, ‘Screw that! I may as well redeem my pounds for gold, ship it over, buy some dollars and then pay the guy!’. After all, if you needed to pay $4.866 for the good that you’re buying, why pay more than £1? Your pounds are supposed to be just a name for a certain weight of gold, right?
Well, we first must take into account that shipping gold (etc) costs something, so maybe one wouldn’t say ‘Screw that!’ when one has to pay more than £1, but rather at £1.01 or £1.03 or whatever else depending on the cost of shipping, insurance etc. The point is that the ‘Screw that!’ point is exactly the ‘Gold Export Point’ – i.e. when it’s cheaper to redeem and ship the gold rather than buy the foreign currency on the foreign exchange markets. Since Governments around the world were engaged in printing currency (to one degree or another), this ‘Gold Export Point’ represented extreme danger for them. For it would mean that people might come to realize their follies. In other words, people might find out that they don’t have enough backing the currency to meet all of their promises. The Gold Export Point was the bane of their existence, the possible revealer of their follies, and thus – to government bureaucrats – the thing to be avoided at all costs!
The ‘Gold Import Point’ was just the inverse; if one was swapping a good for money to someone abroad, and receiving foreign exchange, one might find that the strength of one’s currency could invoke one to redeem the foreign currency and ship the gold back home.
Foreign Exchange Interventions:
[For those of you who are thinking; 'Umm... is this about the pound sterling or what?', allow me to explain: All of what has been said is relevant (and indeed a prerequisite) to a sound understanding of the pound's fall from grace. If you can wrap your mind around the above and the below you will have an understanding of this topic that is quite apart from the consensus. Moreover, it may even help you with your investments over the coming weeks, months and years.]
So, if the above has been understood, it should be clear that governments and their central banks would have a strong incentive to accumulate foreign exchange reserves of some kind (I’m yet to show why those reserves happened to consist of the pound sterling in the 19th Century). Governments and central banks were desperate to pursue the historic folly of currency printing, and yet they didn’t want to suffer the vicious consequences of an international bank run on their reserves. So, in attempts to have their cakes and eat them too, they sought to intervene in the foreign exchange markets. Whenever a currency’s exchange ratio approached the ‘Gold Export Point’ (or the ‘Screw that!’ point), they sought to intervene to avoid the achievement of that perilous price. Governments and their central banks would do this by buying or selling their own exchanges to push them back to parity (extension for the purposes of pretension).
Given that the foreign exchange markets were a prime arena for the financial speculator, and that the movements of exchanges away from parity were probably their doing, one can imagine why this silly method of denial would work for some time. The financial speculator trades with his own precious capital, and consequently he might only seek to trade foreign exchange away from parity if he’s pretty sure that it will work out. You can understand – then – how the temporary accumulation of large foreign exchange reserves would allow governments and their central banks to get away with monetary debauchery for some time. After all, even if – say – the franc were only 30% backed by gold, the speculator might fear the consequences of speculating against a large quantity of foreign exchange reserves ready to be used against him. Only at the extremes highs in monetary profligacy and extreme lows in a country’s foreign exchange reserves might the speculator then ‘position himself against parity’ with any gusto.
But which type of Foreign Exchange to Keep in Reserve?
So, here we get to the crux of the matter; why was the pound sterling chosen as the ‘go to’ foreign exchange reserve to hold? Indeed, why was holding pounds the ‘go to’ method of attempting to have your cake and eat it too?
Well, given all that has been said above, I’m guessing that you might be a bit more confident about approaching the above question. The key question that governments and central banks would have been asking was; where does the greatest threat to the status quo in monetary affairs lie? Given the understanding of ‘Screw that!’ or ‘Gold Export/Import Points’ above, there would have been two main attributes to watch out for:
- Quantitatively large trading partners. That is, those guys that could induce a drain of the gold reserves.
- Those currencies that tend to be “hard”. Or, in other words, those currencies that tend to undergo less monetary debasement.
In short, those currencies that belonged to large trading partners could potentially cause a problem, in particular if they were relatively strong anyway!
Britain wasn’t always the statist mess that it is today:
Despite Britain’s current statist leanings, it was the originating point of the classical liberal tradition. Unsurprisingly, then, Britain had a “hard currency” attitude, a relatively good hold on the benefits of upholding private property rights and – in consequence – an eagerness to trade freely with foreign nations. Combine this with the usual stuff about Britain’s status as the dominant world power, its control over foreign countries and their currencies (in the colonies), and its general dominance as a hard currency centre of the world, and you have some extremely compelling reasons for foreign governments and central banks to keep significant pound sterling reserves.
The Monetary & Intellectual Decline of Britain:
The souring of Britain’s intellectual leadership and the concomitant decline in the degree to which it upheld a sound money inevitably took away the reasons for foreign governments and central banks to own significant holdings of the pound sterling. As Carroll Quigley wrote in Tragedy & Hope: A History of the World in Our Time, this souring of British intellectualism seems to have been part of a general tide towards cynicism about man as such:
The nineteenth century was marked by (1) belief in the innate goodness of man; (2) secular- ism; (3) belief in progress; (4) liberalism; (5) capitalism; (6) faith in science; (7) democracy; (8) nationalism. In general, these eight factors went along together in the nineteenth century. They were generally regarded as being compatible with one another; the friends of one were generally the friends of the others; and the enemies of one were generally the enemies of the rest. Metternich and De Alaistre were generally opposed to all eight; Thomas Jefferson and John Stuart Mill were generally in favor of all eight…
…To the nineteenth century mind, evil, or sin, was a negative conception. It merely indicated a lack or, at most, a distortion of good. Any idea of sin or evil as a malignant positive force opposed to good, and capable of existing by its own nature, was completely lacking in the typical nineteenth-century mind. To such a mind the only evil was frustration and the only sin, repression.
Just as the negative idea of the nature of evil flowed from the belief that human nature was good, so the idea of liberalism flowed from the belief that society was bad. For, if society was bad, the state, which was the organized coercive power of society, was doubly bad, and if man was good, he should be freed, above all, from the coercive power or the state. Liberalism was the crop which emerged from this soil…
…These characteristics of the nineteenth century have been so largely modified in the twentieth century that it might appear, at first glance, as if the latter were nothing more than the opposite of the former. This is not completely accurate, but there can be no doubt that most of these characteristics have been drastically modified in the twentieth century. This change has arisen from a series of shattering experiences which have profoundly disturbed patterns of behavior and of belief, of social organizations and human hopes. Of these shattering experiences the chief were the trauma of the First World War, the long-drawn-out agony of the world depression, and the unprecedented violence of destruction of the Second World War. Of these three, the First World War was undoubtedly the most important. To a people who believed in the innate goodness of man, in inevitable progress, in the community of interests, and in evil as merely the absence of good, the First World War, with its millions of persons dead and its billions of dollars wasted, was a blow so terrible as to be beyond human ability to comprehend. As a matter of fact, no real success was achieved in comprehending it. The people of the day regarded it as a temporary and inexplicable aberration to be ended as soon as possible and forgotten as soon as ended. Accordingly, men were almost unanimous, in 1919, in their determination to restore the world of 1913. This effort was a failure. After ten years of effort to conceal the new reality of social life by a facade painted to look like 1913, the facts burst through the pretense, and men were forced, willingly or not, to face the grim reality of the twentieth century. The events which destroyed the pretty dream world of 1919-1929 were the stock-market crash, the world depression, the world financial crisis, and ultimately the martial clamor of rearmament and aggression. Thus depression and war forced men to realize that the old world of the nineteenth century had passed forever, and made them seek to create a new world in accordance with the facts of present-day conditions. This new world, the child of the period of 1914-1945, assumed its recognizable form only as the first half of the century drew to a close.
As this sourness crept in, one of the most extreme periods of bitterness and anti-liberalistic actions came to pass – WWI. As Rothbard wrote:
To wage the catastrophic war of World War I, each government had to inflate its own supply of paper and bank currency. So severe was this inflation that it was impossible for the warring governments to keep their pledges, and so they went “off the gold standard,” i.e., declared their own bankruptcy, shortly after entering the war. All except the United States, which entered the war late, and did not inflate the supply of dollars enough to endanger redeemability. But apart from the United States, the world suffered what some economists now hail as the Nirvana of freely-fluctuating exchange rates…
As Britain sunk intellectually, and hence monetarily and economically, the key conditions named above became less pronounced and hence the incentives to own pounds as a reserve also diminished. Indeed, this happened precisely because there was a replacement: the United States dollar. The United States, which embraced the liberal tradition to a relatively greater extent (which is still evident today) and kept up redeemability, then began to fulfill the criterion that Britain previously fulfilled:
- A quantitatively large trading partner,
- A relatively “hard” currency.
- Prominent as a ‘super power’ etc.
The Trend Continued…
In an attempt to regain its status as the “hard currency” centre of the world, Britain attempted to return to the gold standard at a rate of £1 = $4.86. Perhaps this was a noble attempt to reestablish the principles of the nineteenth century, but something was missing – the intellectual and social convictions of the nineteenth century. Such a move would only have been possible if the intellectual and emotional mood of the country was compliant with the ideas of the nineteenth century. The profound deflation that ensued following this pseudo-return to a pseudo-gold standard (the gold exchange standard) proved too onerous for the people of Britain. As Carroll Quigley wrote:
The decisive event that caused the end of financial capitalism in Britain was the revolt of the British fleet at Invergordon on September 15, 1931, and not the abandonment of gold six days later. The mutiny made it clear that the policy of deflation must be ended. As a result, no real effort was made to defend the gold standard.
So, in this way, it became progressively less attractive for foreign governments and central banks to own the pound sterling as a ‘reserve currency’. As the United States sunk into civilizational decline at a slower pace than Britain, the attention that the pound previously attracted moved towards the dollar.
[NOTE: I'll be writing extensively about the dollar's reserve currency status soon. Given that the central banks of the world are now - in a sense - 'money producers' rather than currency issuers, the story and dynamics are somewhat different.]
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012