Convertible Paper Money and Gold Standard - dummies

Convertible Paper Money and Gold Standard

By Ayse Evrensel

Beyond a bartering system, another type of money appeared toward the end of the Middle Ages (about the 15th century), coinciding with expeditions to distant regions of the world that monarchs financed. These expeditions led to a significant increase in international trade at that time.

Along with international trade, the flow of money among countries, which would today be called international capital flows was also increasing, contributing to globalization starting in the 15th century.

To handle the increasing international trade, banks and bankers appeared on the scene. Double-entry bookkeeping also was introduced in medieval times, which made it easier to keep track of bank balances. Some meticulously kept business documents from mostly Italian businessmen have survived to our time and show sophisticated business practices and financial schemes.

This increase in the volume of economic activity required a different type of money to increase the efficiency of goods- and money-related transactions. Convertible bank money appeared around the 15th century and slowly replaced commodity money.

Suppose you were a merchant in 15th-century Venice. You deposited your 50 gold coins with a banker, and he gave you a certificate that you could use in your transactions as money. Therefore, at the beginning, convertible bank money was based on precious metal coins.

At the time when convertible paper money appeared, there was no monetary authority. Bankers created deposits that were convertible to gold. While the Bank of England is the oldest central bank and has been around since the 17th century, many central banks started in the 19th and 20th centuries. Convertible bank money went through some changes after its introduction in the 15th century.

In the earlier periods of convertible paper money, banks promised to pay precious metals but generally held fractional reserves of precious metals, lending out some of the precious metals. On occasion, more depositors would want to withdraw metal than the actual stock of precious metals held by banks, which led to bank runs. Major countries used silver, gold, or both to back their money.

Despite its variations, convertible paper money lasted until 1973. Therefore, you may think that a metallic standard in some shape or form was the only type of money until 1973. This thinking isn’t entirely correct. A metallic standard does not allow monetary policy to be used to address a country’s economic problems or create additional funds. Therefore, the metallic standard didn’t continuously last until 1973.

During the world wars in the 20th century, many other wars, civil wars, and revolutions, countries went off the metallic standard, printed money without backing, created inflation, and paid for the expense of armed conflicts.

The history is full of examples where countries dropped the metallic standard during wars and revolutions to be able to raise revenues. Examples of the suspension of the gold parity include France during the French Revolution (1789), Great Britain during the Napoleonic wars (1803–1815), the U.S. during the Civil War (1861–1865), and many countries during WWI (1914–1918) and WWII (1939–1945).