9.7 — Gold, Paper and Central Banks

On 15 August 1971, in a televised address, President Nixon announced that the United States would no longer convert dollars into gold.

It was described as temporary. It has now lasted over fifty years.

Since that day, no currency anywhere in the world has been backed by anything physical. Every note in every pocket on Earth is a claim on nothing, valuable because a government says it is and everybody behaves accordingly (Chapter 9.1).

This chapter is about how money came to work that way, and about the institution that manages it.

The gold standard

Under a gold standard, a currency is defined as a fixed quantity of gold and the issuing bank will exchange notes for gold on demand.

Britain adopted it de facto in 1717 — reportedly through Isaac Newton's setting of the silver-to-gold ratio as Master of the Mint — and formally in 1821. Most major economies joined between the 1870s and 1900, producing the classical gold standard period of roughly 1870 to 1914.

What it did well.

Long-run price stability. Over decades, prices were roughly flat — the price level in Britain in 1900 was not far from 1800. The money supply could only grow as fast as gold was mined.

Fixed exchange rates, since every currency was defined in gold, which made international trade and lending predictable. The period was one of very high globalisation — trade and capital flows as a share of output reached levels not seen again until the late twentieth century.

And it constrained governments, which cannot print gold.

What it did badly, and the failures are severe.

It transmitted deflation. If the money supply is tied to the gold stock and the economy grows faster than gold is mined, prices must fall. Deflation is far more destructive than mild inflation, because debts are fixed in money terms: a farmer who borrows when wheat is at one price and repays when it has halved is repaying twice as much in real terms. The American agrarian protest of the 1880s and 90s was about exactly this, and William Jennings Bryan's 1896 speech — that you shall not crucify mankind upon a cross of gold — is the most famous statement of it.

It removed the ability to respond to a crisis. In a recession the correct policy is usually to expand the money supply and cut interest rates. Under a gold standard you cannot — you must raise rates to defend the gold reserve, which deepens the recession. Chapter 9.9 shows this doing enormous damage.

And the discipline was frequently suspended. Governments left gold in wars — Britain during the Napoleonic wars and both world wars — which tells you the constraint was binding only when convenient.

What a central bank actually is

Three functions, developed in that order historically.

Banker to the government — managing the state's accounts and its debt. The Bank of England was founded in 1694 for exactly this (Chapter 9.2).

Lender of last resort to the banking system — Bagehot's rule from Chapter 9.2.

And manager of the money supply and the price level, which is the modern primary function and the most recent.

How it works, mechanically.

The central bank sets a very short-term interest rate — the rate at which banks borrow reserves overnight, called the repo rate in India, the federal funds rate in the United States.

And that one number propagates. A bank that can borrow overnight more cheaply will lend more cheaply. Rates on home loans, business loans and deposits move. Cheaper credit means more borrowing, more investment and more spending, so demand rises; dearer credit does the reverse.

The transmission is slow and imprecise — the standard estimate is that a rate change affects inflation over four to eight quarters — and the central bank is therefore always acting on a forecast rather than on current data.

Other instruments: reserve requirements, which India uses actively through the cash reserve ratio; open market operations, buying and selling government bonds to add or drain reserves; and, since 2008, quantitative easing.

Quantitative easing, plainly. When the policy rate is already at or near zero, the central bank cannot cut further. So it creates reserves and uses them to buy longer-term assets — government bonds and sometimes others — from banks and financial institutions. The aim is to push down longer-term interest rates and to put cash into the system.

Two honest observations about it. It is not "printing money" in the hyperinflation sense — it swaps one asset for another and does not directly fund government spending. And its main measurable effect was to raise asset prices, which benefits people who own assets, which is a distributional consequence its designers did not emphasise.

Independence, and the argument about it

Most modern central banks are formally independent of the government of the day, and the reasoning is specific.

The problem it solves. A government facing an election has an incentive to cut rates and stimulate now, with the inflation arriving later. If everyone expects that, they build the expected inflation into wages and prices in advance, so the government gets the inflation without the stimulus. This is the time-inconsistency problem, and the answer is to hand the decision to someone who does not face the election.

The evidence broadly supports it — independent central banks have on average delivered lower inflation without worse growth.

And the criticisms are serious. Unelected officials making decisions with enormous distributional consequences — a rate rise protects savers and hurts borrowers, and the two are different people. Independence is always partial: governors are appointed by governments, and pressure is applied. India's central bank has had public disagreements with its government over reserve transfers, rate policy and regulatory autonomy, and two governors have left in circumstances widely read as involving such conflict.

Inflation targeting

The dominant framework since the 1990s. New Zealand adopted it first in 1990; India adopted a formal target in 2016 — 4 percent consumer price inflation with a band of plus or minus 2 percentage points, set by the government in consultation with the Reserve Bank and implemented by a Monetary Policy Committee.

Why a positive target rather than zero. Deflation is more dangerous than mild inflation, for the debt reason above and because falling prices encourage people to postpone purchases, which reduces demand further. A small positive target keeps a buffer. It also allows real wages to fall without nominal wage cuts, which workers resist strongly.

Why India's target is higher than the 2 percent typical in rich countries. A fast-growing developing economy has faster productivity growth in some sectors than others, which pushes measured inflation up structurally, and food is a large share of the Indian consumption basket and is volatile for the reasons in Chapter 2.5.

And the limitation that the last few years exposed. A central bank raising rates cannot do anything about a supply shock. When inflation is caused by a war interrupting energy supply or by a monsoon failure, raising rates suppresses demand across the whole economy to offset a shortage in one part of it. It works and it is a blunt instrument.

The Indian system, specifically

The Reserve Bank of India was established in 1935, nationalised in 1949.

Its instruments: the repo rate, the cash reserve ratio, and the statutory liquidity ratio requiring banks to hold a portion of deposits in government securities. The SLR is unusual by international standards and it has the effect of creating a captive market for government debt, which is convenient for the government and is a constraint on bank lending.

And it manages the exchange rate, unlike central banks that let their currencies float freely. India runs a managed float: the rupee moves, and the RBI intervenes in the foreign exchange market to smooth it, holding large foreign exchange reserves — currently among the largest in the world — for the purpose.

Why reserves matter so much to India is Chapter 6.28's story: 1991 happened because reserves ran out. No Indian government since has been willing to be in that position, and the reserve accumulation is the direct consequence.

Where the danger actually lies

Fiat money is safe as long as the central bank does not finance the government's deficit directly, and dangerous when it does.

Monetisation of the deficit — the central bank creating money to hand to the treasury to spend — is the mechanism behind every hyperinflation in Chapter 9.8. Most modern central banks are legally barred from it, and India ended the automatic monetisation of deficits in 1997.

The distinction from quantitative easing is real and is genuinely subtle. QE buys government bonds in the secondary market, from investors, with the stated aim of lowering interest rates. Monetisation buys them directly from the government to fund spending. Critics argue the economic difference is smaller than the legal one, and the counter-argument is that QE is reversible and is undertaken to hit an inflation target rather than to fund a deficit. The distinction held during the 2010s and 2020s, and it depends on the central bank's willingness to reverse course, which is a question about institutions and not about mechanics.

Where this shows up in your life

Your home loan rate moves when the Monetary Policy Committee meets, six times a year, and publishes a decision.

Your savings lose value at the inflation rate, which is why a fixed deposit paying 6 percent when inflation is 6 percent has a real return of zero.

And the price of imported goods, including oil, moves with the rupee, which moves with interest rate differentials, capital flows and the RBI's intervention.

The single most useful idea in this chapter is the distinction between nominal and real. A nominal figure is in rupees; a real figure is adjusted for inflation. A salary that rises 5 percent when prices rise 6 percent has fallen. Almost every misleading economic claim in public argument works by quoting a nominal number, and converting it to real terms is the check.

What the next page covers

In November 1923 a loaf of bread in Berlin cost 200 billion marks. Chapter 9.8 covers inflation and the great hyperinflations — what inflation actually is and the three distinct ways it starts, what happened in Weimar Germany and why, Hungary's 1946 record, Zimbabwe and Venezuela, why hyperinflations all end the same way, and the political consequences, which in the German case are not a footnote to the twentieth century but a cause of it.