Money,
Gold and Inflation:
Some history and observations
by
A.L.M. Abdul Gafoor
Appropriate
Technology Foundation
Gold and money
From time immemorial gold was money. Valuable goods were priced in terms of gold:
this product is worth so many ounces of gold.
People paid the price in gold.
But assessing the fineness of the metal and weighing it each time a
transaction took place was a tedious and wasteful exercise. This led to the invention of the gold
coin. Mints, which produced the coins,
certified to its fineness and weight, and its accuracy was attested to in the
name of the ruling monarch. This made
the process of using gold as a medium of exchange in payment
for goods and services much easier. Although the values stamped on
the coins were generally taken at face value, if necessary, their real value
could still be easily ascertained.
Therefore a gold coin minted anywhere and issued in the name of any king
was acceptable everywhere in the world, for it had an intrinsic value as
well. It was universally accepted that
gold was money and gold coins were currency.
Silver and copper were also similarly used.
The reputation of a coin depended on the
integrity of the issuing monarch and the stability of his reign. Sometimes people chipped away a tiny piece of
the coin and passed it off for the face value.
Sometimes the mints themselves used less fine material or less weight –
often on the orders of the king – but stamped it otherwise. Yet verification of the true value was easy
and the debased coins quickly acquired the reputation they deserved. Each country determined the size, shape and
name of its own coin, but the real worth of the currency depended on the actual
gold content of the coin. This state of
affairs continued till the invention of the paper currency.
Paper currency and the
gold standard
Paper currency began its existence in Europe[1] when the
goldsmith issued a receipt for the gold coins deposited with him by a merchant
and this receipt began to be accepted by other merchants in the city as good as
the coins themselves. For the merchants
it eliminated the risk and trouble of carrying large amounts of coins, and they
were willing to pay a price for the service.
The goldsmith always honoured his receipts by redeeming them in
real gold coins, whenever and by whoever they were presented to him. This reputation of trust was the foundation
of his business.
In course of time, he discovered that only a
fraction of the gold coins deposited with him were reclaimed at any given time
and that a good portion always lay idle in his vaults. This realization prompted him to issue his
own “I-owe-you” notes (of course for a price) on the strength of the idle
coins.[2] These too acquired the same credibility among
the merchants as his deposit receipts.
This made him a moneylender as well.
When the goldsmith and moneylender became a
bank, the bank issued bank notes in convenient denominations (such as one,
five, ten, hundred, etc) instead of in specific amounts as in the goldsmith’s
receipts. These then became a more
convenient alternative form of currency and acquired credibility among the
general populace as well. Each bank
issued its own notes, and its popularity depended on the bank’s reputation as
to its credibility in redeeming its notes in real gold coins at all times. But a bank’s reputation did not extend much
beyond its own city and its environs. So
notes of several banks came into circulation.
Multiplicity of banks, bank failures (due to
excessive credit creation and failure to redeem bank notes in gold coins), and
fraud compelled the central government to step in and to declare itself the
sole authority to issue currency notes.
This was the beginning of the national paper currency and it began in
However, the paper currency was eventually
declared legal tender by law, meaning that refusal to accept it as a means of
payment was punishable by law. Since the
law held within the country, people held less and less gold coins in their
hands for use in domestic transactions.
For international transactions, however, gold bullion or gold coins
(readily exchanged for the paper currency) were used. Over time, the long-standing British practice
(since 1717), the strength of her economy, and the vastness of her colonial
rule augmented the “paper is as good as gold” mind-set throughout a good part
of the world.
By the end of the Napoleonic Wars (1815), many
currencies of the world were based on either gold or silver. By the end of the nineteenth century, gold
replaced silver as the basis of monetary arrangements in practically all of the
major trading nations. The readily
convertible, fixed-ratio gold-currency relationship, along with the private
citizen’s right to freely hold, export and import gold, came to be known as the gold standard. Between 1880 and 1914, the gold standard
prevailed on a global scale, and gave the impression that international gold standard was the normal state of affairs. The benefits included price and exchange-rate
stability, which in turn helped to conduct local and international trade and
investment with minimum risk of capital loss.
This further strengthened the trust in the paper currency and the gold
standard.
The metal content of the coins gave them a
readily verifiable amount of intrinsic value. The paper currency, however, was in fact only
an “I-owe-you” promissory note whose validity depended entirely on the issuing
bank’s promise to abide by the gold standard.
However, the gold standard’s fundamental conditions, i.e. (1) fixed-ratio gold-currency relationship, (2) the ready convertibility
and (3) a private citizen’s right to freely hold, export and import gold, were
not always fulfilled. There were devaluations,
restrictions and suspensions. For
example,
First,
Second, the
In March 1933 President Roosevelt restricted foreign-exchange dealings and gold and currency movements, and in April he issued an executive order requiring individuals to deliver their gold coin, bullion and gold certificates to Federal Reserve Banks. By setting progressively higher dollar prices for gold, the Administration engineered a series of devaluations, leaving the dollar with 59 percent of its former gold content.[4]
Third,
By 1936, when
Things changed drastically between the two
World Wars, especially since the depression of the thirties. By 1936, nearly all countries had broken the
link between gold and currency, and all currencies were on a free-float. This broke the international exchange-rate
stability and, together with the restrictions on the free flow of gold between
countries, the basic conditions of the gold standard ceased to exist. Consequently, international trade and
balance-of-payments experienced unprecedented difficulties. This led to some serious concerns and to the
Bretton Woods Conference, held in the
The Bretton Woods
Agreement
In 1944, the Bretton Woods Agreement was
negotiated and in 1945, forty countries – that is, practically all the
countries then in existence – signed the Agreement. Its main sponsors were the
Previous to this each currency was directly
anchored to gold – every currency was equivalent to a certain weight of gold –
but now only the US dollar was directly anchored to gold. And, all other currencies only through the US
dollar. It was sometimes called the
gold-dollar standard. This was the
second major shift in the gold-currency relationship.
Under the Bretton Woods Agreement, the US
dollar was fixed as equivalent to 1/35 fine ounces of gold (i.e. one ounce of
gold was set equivalent to 35 US dollars) and the US Government guaranteed to
maintain this ratio, and to exchange every US dollar presented to it (at the
“gold window”) into the equivalent weight of gold at anytime. All other countries promised to peg their own
currencies at a fixed ratio to the dollar.
The International Monetary Fund was established to maintain this
regime. From now on no national currency
could be presented to the issuing central bank for conversion into gold. While gold was still held as reserve, the US
dollar became the major reserve currency at the central banks, and almost all
foreign exchange dealings took place through the US dollar. Only central banks (and some industrial users
of gold) could present their US dollar holdings at the
But the US Government financed its growing
budget deficits by printing dollars, without regard to its gold reserves
(especially in the 1960’s), and began to use exchange controls and moral
suasion[6] to
discourage central-bank conversion of American financial assets into gold. By the end of 1970, official US dollar claims
of foreigners had mounted to more than twice the US gold reserves. Fearing an imminent run on her gold reserves,[7] the US
Government made a decision that changed the course of history. Suddenly, on
Post-1971 currencies
The currency is still a promissory note, but
all issuing authorities have absolved themselves of any obligation (legal or
otherwise) of redeeming it in gold (or any other thing of value), nor even in
another currency.[8] Now it is the citizen’s expectation that
other citizens will honour the printed paper he holds in his hands that
keeps the currency afloat. The moment
one citizen refuses to honour the promise that nobody promised anybody, it
will trigger a complete collapse of the currency system. But that right of refusal is denied by law,
because the paper note is designated as “legal tender”. Money has become an illusion – a very rare
kind of illusion that is imposed, legalized and enforced.
In 2002, Europe replaced one illusion with
another illusion – the currencies of 12 European nations were replaced with a
single currency, the Euro. Literally
overnight, 31 December 2001 / 1 January 2002, one of the world’s most valued
“hard currency” – the German Mark – along with its counterparts from France,
the Netherlands, Belgium, Italy and others, became mere used paper worth
nothing; while another mere printed paper that was worth nothing the previous
day suddenly became “legal tender”. It
was done “legally” and “democratically”.
The world watched on its television screens
truck-loads of the old currencies being shredded and made into pulp, to be
turned later into toilet paper! The
coins were also melted for re-use, but their metallic value remained intact.
The US dollar is officially designated as
“Federal Reserve Note” and has printed on it (1985 series) the name of the
country (The United States of America), name of the currency (Dollar),
denomination (one, ten, etc), a serial number, a statement (This note is legal
tender for all debts, public and private), and the signatures of the Treasurer
of the United States and the Secretary of State.
The Canadian dollar is issued in the name of
the Bank of Canada, signed in
The British Pound is issued in the name of the
Bank of England, signed in
The Indian Rupee is issued by the Reserve Bank
of India, signed by the Governor, guaranteed by the Central Government, and
carries the promise, “I promise to pay the bearer the sum of … rupees”. What is a rupee? Another kind of “circular argument”?
Most currency notes have similar formulations,
have intricate designs and often carry the portrait of the present head of
government or an important personality or symbol of the nation.
But the newest of all currencies – the Euro –
has the most economical formulation. It
has a serial number, denomination, a copyright line, “© BCE ECB EZB EKT EKP
2002”, and nothing else! There is
apparently a signature, but whose and on whose behalf? What is this intricately designed piece of
modern art, what does it signify, and what is it to be used for? It does not even promise to be legal
tender! Is it then possible to refuse to
accept it in settlement of a debt, without legal consequences?
Price of gold
From 1945 to 1971, every currency had a fixed
relationship to the US dollar and the US dollar, in turn, to gold at the rate
of 35 dollars per ounce of fine gold.
Consequently, every product anywhere in the world had a unique ultimate
price in terms gold. But gold itself did
not have a price in any currency. For
gold was money, currency. It was
measured by weight. An ounce of gold was
an ounce of gold; any number of units of gold was that number of units of
gold. 35 US dollars was equivalent to one ounce of gold, not
that the price of gold was 35 US dollars.
However, gold was no longer legal tender
(currency), the dollar was. No gold
coins were minted anymore. If you are in
the US and your tax bill was 350 dollars, you could not pay 10 ounces of gold
at the counters of the tax department; you have to pay in dollar bills. Neither was gold acceptable at the
supermarket cash counter for the goods in your trolley. But until 1971 you could still (in theory)
exchange gold for US dollar and US dollar for gold at the US “gold window”, at
the fixed ratio of 35 dollars per ounce of gold. However, since no one transacted business in
terms of gold any longer and everyone used the dollar (because it was the only
legal tender) gold could be obtained commercially only by paying for it in
dollars. This amount of dollars paid per
ounce of gold became the price of gold.
Even though its official rate was still 35 dollars per ounce, for
ordinary purposes, gold was bought and sold at commercial outlets, and on
account of their expenses such as handling charges, trading costs and business
profit, it was sold at a different “price”.
Gold has now acquired a price and has become
just another commodity. People got used
to thinking of it as a commodity, and it had a price just like any other
commodity. Yet, it did not vary much
from the official rate. The real break came in 1971, when the official rate was
ended with the stroke of a pen. From
then on there was no holding back. Now
we talk about the price of gold!
Currently (January 2008), it is over 900 US dollars per ounce.
Was it gold going up in price or the dollar
going down in value? This question is
rarely asked. The price goes up because
of high demand for gold (or its short supply), or is it the currency
depreciating? Is anybody in
control? Obviously not any government or
central bank; neither the IMF. If it is laissez-faire, then freedom from
government control for whose benefit?
A simile
The question of gold going up in price or the
dollar going down in value can be expressed by a simile. Suppose we are at a railway station, and
there is a train standing at the station.
Suppose there are two observers, P and T, one on the platform (P) and
the other on the train (T). Since the
train is not moving, whether one stands on the platform or sits in the train he
is at rest. Now, suppose there is a car
moving on a road parallel to the track.
Whether you measure its speed from the platform or from the train, the
car will have the same speed. If P and T
made the observations, both their observations of the speed of the car will be
identical, because they are both fixed relative to the ground. Now, suppose P also got into the train and
both made their separate observations.
Their measurements will still be identical – whether they stood on the
platform or sat in the train their observations showed the same results. Seeing this, say, they decide to sit together
in the train and make their observations.
Now, suppose, unnoticed by our observers, a
driver got into the train and moved it. What will happen to the measurements of
our observers? Their observations of the
speed of the car moving along the road will be identical, and they will believe
that it was the true speed. But, is
it? It will not tally with the observations
of another observer on the ground or on the platform. The difference will be the speed of the
train. P and T may still argue that
their observations gave the true speed of the car; they might even genuinely
believe that the station was suddenly moving away from them! If there was no one on the platform and all
the people were on the train, everyone will believe so too. The station and the platform are moving away
from us! Our saying that the price of gold is going up is exactly the same.
When the driver reverses the train, the station
and the platform will move towards us.
Gold price is going down! The
earlier we get off the train and get out of this illusion the better.
But somehow people seem to have been mesmerized
into forgetting that standing on the platform (i.e. gold is the standard by
which everything is measured) is the normal state of affairs. On the platform you have the ability to move
whichever way you liked and at whatever speed you wished. But when you sit in a moving train with all
the doors locked it is the driver who decides the speed and direction of your
movement.
Currency and price
Money or currency is expected to serve three
basic purposes: unit of account, medium of exchange, and store of value. The unit of account function allowed every
product to be priced in terms of the currency.
This was an important step in the development of commerce. Now every product can be given a unique price
and, since the currency unit was common to the whole country, the price of any
given product could be compared across the country or the worth of any product
could be compared with that of any other.
The medium of exchange function allowed products to be easily bought and
sold for money at competitively determined prices, rather than bartered with
the attendant cumbersome search for matching products. The store of value function enabled the money
earned by selling a product or service to be kept in store until another
product or service was actually needed.
This also enabled delayed payments for goods and services and the taking
and returning of loans with a time delay, without any loss to either
party.
Every product has a price in terms of the
currency of the country. This chair is 5
dollars, this book is 10 riyals, this shirt is 15 rupees, etc. What is the price of currency? What is the price of a dollar, a riyal, a rupee? It is one dollar, one riyal, one rupee. The difference is: the price of a chair may
vary from day to day, depending on supply and demand, but the price of one
dollar remains one dollar at all times.
So is the value of every currency, in its own terms. Price change – inflation or deflation –
affects the price of products, but it has no effect on the value of currency,
because it is measured in its own units.
Why? Because that is how we have defined money. One dollar
(riyal or rupee) is always one dollar (riyal or rupee); that is our common unit
in which we have decided to measure all our prices.
It may look absurd, but consider the following
scenario. Say, the price of the chair
went up from 5 dollars to 10 dollars.
Now, suppose we decided to make the chair our currency. Then, we will have a price for the dollar in
terms of chairs! And, the price of the
dollar in the above scenario would be 1/5 of a chair! Consequently, when the price changed,
instead of the chair going up in price it would be the dollar going down in
price – the value of dollar goes down from 1/5 of a chair to 1/10 of a chair,
from 0.20 ch to 0.10 ch.
Currency – dollar or chair – so long as we
unambiguously define and identify it and agree on what constitutes one unit of
it, will serve the purposes of unit of account and medium of exchange. Present-day paper currencies, whatever their
names, serve these purposes very well.
There is no dispute over it. So
the paper currency is still useful, viable, valuable and indispensable.
Inflation and currency
depreciation
However, it is in its third function – that of
store of value – that modern paper currency fails miserably. It does not keep its value from year to year,
sometimes even from month to month. The
same dollar (or any other currency) that bought a loaf of bread last year does
not buy a similar loaf of bread this year.
We can say the dollar has depreciated in value. But others would say the price has increased
(due to inflation).[9] Since there are tools to measure inflation
(e.g. the consumer price index),[10] and
none to measure currency depreciation (depreciation against what?),[11] the
failure of modern paper currency to store value remains a well hidden
secret.
Inflation was defined as positive change in
price, and this change was assumed to be brought about by supply/demand
interaction. A negative change was
called deflation. When inflation/deflation
was defined, money was still anchored to gold, and there was currency
stability. And, prices changed
positively and negatively. But, today’s
price change includes currency depreciation (of monetary value) as well.
To illustrate, suppose the price of a loaf of
bread was 50 cents last year and has changed to 60 cents this year. This is a 20 percent price increase which is
defined as 20 percent inflation. This
can be expressed as: current price = old price + currency depreciation (i.e. 60
= 50 +10). To put it another way, one cent which bought 1/50 of a loaf of bread
last year buys only 1/60 of it today.
That is why your 50 cents now buys only 50/60 of the loaf and you must
pay 10 cents extra to obtain the full loaf.
If we assume the quality and quantity of the bread as well as the demand
and supply remained the same, then it must be the currency that has changed its
character. In other words, the currency
has depreciated by 1/6 or 16.7 percent.
This requires extra money to be paid for the same bread, and this is
reflected in the new price. We have no
tools to measure currency depreciation but have an index to measure the price
change. Therefore, we talk about the
latter and call it inflation.
Since currency depreciation is the major part
of today’s (post-1971) price change, it has become a one-way street – always
positive, i.e. inflation. Any deflation
– due to excess supply, low demand, or increased efficiency – is masked by
currency depreciation.
Currency depreciation could be brought about in
many ways, but the major enduring cause could be traced to deficit financing.[12] Other sources of currency fluctuation (and
depreciation) include government expediency, currency trading raids, bank
credit creation, gold price fixing, and interest rate manipulations. Since the main players in all these actions
are a powerful few, currency depreciation is a manipulated affair. And, since currency depreciation is the major
component in the recorded price change, today’s observed inflation has little
to do with free-market competition. The
people, in whose name most of today’s governments are run – of the people, for
the people, by the people – have no say in the matter, except to bear the consequences.
Interest and inflation
In Christendom, till 1545, usury was
prohibited. In that year the British
parliament was persuaded to pass the Usury Law.
This law introduced an innocuous word called interest, and usury was
defined as high rate of interest. Usury
was still prohibited, in deference to the Church, but “reasonable” interest was
made permissible. What is reasonable and
what is high was to be determined by the Parliament, and in 1545 it was decided
to fix it at ten percent per annum.
Eventually interest was accepted in all countries of
Now that interest was legal, money was
available only at a price. Those who had
savings and were unwilling to take risks deposited their money in the bank and
demanded interest. The bank, in turn,
lent it to those who needed money and charged them at a higher rate. A good portion of the nation’s savings filled
the vaults of the bank and the owners made money out of other peoples’
money. They grew rich and powerful –
sometimes even more powerful than their government.
The law recognizes interest but not
inflation. When currency depreciation
was engineered and passed off as inflation the bank got its second chance. It adjusted its interest rates to accommodate
inflation and compensate for value loss of capital. The new rate was called nominal interest rate
and was set equal to the real interest rate plus the inflation rate. Inflation began to eat into the value of
currency, and it ate even while the money was held in one’s own hands. People panicked and sought to protect their
savings. The bank’s new offer seemed a
good option and they went for it. If you
cannot be induced by interest to surrender your wealth to the bank, you will be
driven to it through inflation!
More money filled the bank’s vaults and the
owners became richer and richer, and globally powerful. That seems to be the end result of moving
from gold to paper and dumping the gold standard. The old owl said, “I used to see you carrying
sacks of gold, now you have bundles of paper.
Where has all the gold gone?”
The bank is the stronger party in any
lending/borrowing transactions, and it used inflation rate projections too to
its advantage. Savings deposits and
loans are by nature future commitments, and forecasts of inflation rates will
have a range. The bank used the lower
rate when paying interest to the depositors and the higher rate when charging
the borrowers, profiting both ways. What
a bonanza!
Muslim dilemma
The bank’s offer was a good option to those who
had no qualms about paying or receiving interest. But Muslims are prohibited by their religion
to deal in interest in any manner. That
lands them in a dilemma. If they hold
their savings or wealth in the form of currency its value is slowly eroded by
inflation, and if they go to the bank for protection against it they will be
dealing in the prohibited interest. This
is a specifically Muslim problem and therefore they alone have to find a
solution. Others are not so affected by
it and therefore cannot be expected to seek one.
A solution may become available if the real
interest rate and the inflation rate combined in the nominal rate could be separated
from each other. Here too what needs to
be computed is the realised inflation rate and not the speculative one used
by the bank. It is no easy task, but
what we are really after is not the inflation rate but the currency
depreciation that brought it about. So,
one has to begin by inventing a tool to measure currency depreciation. Such an approach has been employed and a
solution offered in Gafoor (1999 and 2006).
Interested readers are referred to the literature.
References:
1.
Eichengreen, Bary, The
Gold Standard in theory and history.
New York: Methuen, Inc. 1985.
2.
Gafoor, A.L.M.Abdul, Commercial Banking in the presence of Inflation,
3.
………….,
Attacking inflation on capital. Islamic Banking and Finance magazine (
4.
Kurtzman, Joel, The
Death of Money.
*******
© A.L.M.
Abdul Gafoor, 2002.
Revised February 2008
10/m
Note: An edited version published, under the title
“The Nature of Paper Money: Some history and observations”, in Islamic Finance Today, February 2008,
[1] The Chinese are reported to have used paper currency since 800 AD.
[2] This process would later become known as “credit creation”.
[3] Eichengreen (1985), p.4.
[4] ibid., p24-25.
[5] ibid., p25.
[6] Bankspeak for quiet persuasion.
[7] “The straw
that supposedly broke the camel’s back was a British request in August 1971
that the Federal Reserve swap a portion of the Bank of England’s dollar
holdings for sterling, which was perceived in the
[8] “The dollar has become a circular argument. It is still a promise to pay. But to pay what to whom?” R.David Ranson, quoted in Kurtzman (1993), p.61.
[9] The claim that prices increase because of inflation while inflation is measured by price increase is another kind of circular argument.
[10] See for example, Gafoor (1999) for how price indexes are constructed and computed.
[11] See Gafoor (1999) for a new measure of capital (currency) depreciation.
[12] Why governments got into deficit in the first place and why the gap keeps widening every year are altogether different issues.