If you have ever taken the time to look at a banknote issued by the Bank of England, you may have noticed that it carries the words “I promise to pay the bearer on demand”… Pay the bearer what, exactly? Twenty pounds for a twenty-pound note? Feels a bit like a circular conversation might be coming up.
For most of its history, the wording had a more tangible meaning because a banknote was a claim on something else. Present it at the Bank and, in principle, it could be exchanged for gold. It saved people hulking around great bags of gold coins. So whilst gold was still the money, the paper was the convenient medium by which citizens and businesses could transfer ownership. The metal was the settlement.
That arrangement is long gone, but the question behind it has returned in an unexpectedly modern form. The Bank of England has announced that it will retain £120 billion of long-dated government bonds to support present and future banknote issuance. There are currently around £99 billion of Bank of England notes on its balance sheet, including those used to support Scottish and Northern Irish banknotes. As quantitative easing is unwound, the Bank must decide what assets will stand behind this physical money.
The Fed Hiked. Gold Fell. Now The Real Test Begins.
The answer is gilts, UK government bonds. British banknotes will be backed primarily by British government debt, nothing new. This is common central-bank practice and is considered to be perfectly sensible accounting. However, when viewed from the perspective of sound money, philosophically it is rather more interesting.
Humour me a moment or two whilst I take you back to 1844, when Sir Robert Peel’s government passed the Bank Charter Act after a succession of banking panics. It separated the Bank’s note-issuing operation from its other activities and imposed rules on what could support the currency. A fixed amount of notes could be backed by government securities, and anything beyond that had to be backed by physical gold.
At the time, it was widely understood by the Victorian nation that confidence in paper required a boundary. Whilst a bank might find it useful to create more notes, and a government might of course find that useful too, there was always gold sitting in the background to supply the inconvenient discipline. No bar of gold could be produced by parliamentary enthusiasm or improved economic forecasts, and this gave the system a level of confidence, trust and respectability.
The rules were suspended during several crises, and Britain eventually abandoned gold convertibility. But the words on the banknotes remained, and the principle was still held: the promise printed on a note should lead somewhere beyond the institution making it.
Today, it leads into the state’s own balance sheet, definitely not gold or pound coins. A banknote is a liability of the Bank of England, and the ‘asset’ supporting it is principally a promise by the Government to pay interest and repay borrowed money. Modern money is not backed by nothing, per se. But rather than being backed by a tangible, finite resource, it is backed by something very intangible indeed: the credibility, productive capacity and taxing authority of the country issuing it.
This is a stronger foundation than critics of fiat currency sometimes allow because Britain has deep capital markets, functioning institutions and a long record of honouring its debts. People accept pounds because they expect everybody else to accept them tomorrow, just as those people expect the same of everybody else, and so the system rolls on. Money has always depended, at least in part, on this collective confidence.
Buried within the arrangement, however, is a pretty clear circularity: the Government issues bonds, the central bank holds those bonds as assets, and the central bank then issues money against them. That money is accepted by the public because it trusts the Government and the Bank standing behind it, which means the entire structure is solid for precisely as long as confidence in those institutions remains solid. It is a circle that can support an advanced economy, but a circle nonetheless.
This week’s announcement makes that relationship unusually visible because, alongside retaining £120 billion of gilts to support banknotes, the Bank is considering selling a further £146 billion of bonds acquired through quantitative easing gradually back to the Government as the portfolio is unwound. These would be market-price transactions between legally separate parts of the state, rather than an accounting trick through which the debt simply disappears, but the image is still striking: one public institution selling the Government’s promises back to the Government, whilst retaining other government promises to support the currency.
All of this complexity is a legacy of the financial crisis and the policies introduced in its wake. Quantitative easing began as an emergency measure, one intended to support the economy when interest rates could do little more, and eventually produced an £895 billion portfolio of gilts and eligible corporate bonds. Now the authorities must reverse it without unsettling the very bond market on which the Government depends for its considerable borrowing. The emergency may have passed, but, as is so often the case with emergency policy, its balance sheet has proved rather more durable.
This is where gold earns its place in the story, although not because sterling is about to fail, nor because every banknote requires a bar beneath Threadneedle Street. It does not. Gold is relevant because it sits outside the circle, owing nothing to the credibility of the Bank of England, the borrowing requirements of the Treasury or the willingness of tomorrow’s taxpayer to honour yesterday’s debts.
A gilt, however safe and useful it is perceived to be, is somebody else’s obligation; a bank deposit is a commercial bank’s liability; and a banknote is a central bank’s liability. Each can be valuable, dependable and entirely appropriate to hold, but each relies upon an issuer keeping its promises, whereas physical gold is not a promise to pay at all. It is the asset itself.
For years at a time this difference can appear largely academic and, in a well-run monetary system, it probably should. Yet wealth is accumulated over periods far longer than most policy frameworks, central-bank experiments or political promises tend to last. The Victorians attempted to account for that uncomfortable fact by placing gold at the end of the monetary chain; we have replaced their metal with government credit and institutional confidence, both of which can be formidable, but neither of which is finite.
Perhaps that is progress, and it is certainly more flexible, but flexibility is usually another word for discretion, while discretion is only ever as sound as the people exercising it. The promise written on a banknote has not disappeared so much as changed: it no longer promises gold, it promises that the system which issued the note will remain worthy of belief.
Gold makes no such promise and, of course, that is rather the point.
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