Gold and International Trade Settlement (Part 2)

(A New Gold Supra-Theory – Post 2.)

Please Note: As a result of feedback on this post it became clear to me that I had to separate the explanation of Hume's mechanism from the discussion of international trade settlement. So I have created a post in two parts called "The ECB Targets 1752" that looks at the mechanism in the Eurozone.

I'm going to rework this post and discuss trade between currency zones here in order to keep to a 3 part limit. The original text will be archived and accessible. Warren James is helping me to put this together. My apologies if my learning curve is annoying anyone.

I'm determined that the build-out of this theory isn't going to become multi-layered. I don't want people to have to drill down through 5 layers of old posts to understand each component. Likewise if I commit to a maximum of 3 parts (as I have with this topic) I don't want it to become 4, 5 or 6 in the future. If updates are required then the existing parts may become longer posts but they will be reposted as "updates" to replace the original. The original text will continue to be accessible.


The challenge for the New Gold Supra-Theory is to predict how a new gold-based international monetary and financial system (IMFS) will operate. In part one I mentioned the ‘price-specie-flow mechanism’ originated by David Hume (1711-1776). An insight into international free trade that was further developed by classical economists such as David Ricardo. This mechanism may have influenced the design of the ECB Eurosystem’s Target 2 system.

The source I am drawing on for this post is a very dense, scholarly book published in 1937 called “Studies in the Theory of International Trade”. The writer was a Professor of Economics at the University of Chicago named Jacob Viner (Here’s a link to his bio.) It discusses the work of the classical economists on international free trade theory in great detail as well as the many debates they were involved in.

If anyone expects gold to correct international trade imbalances on its own via some mechanism like this the news isn’t good unless gold becomes a circulating currency again. However, if (as I do) you expect gold to tightly discipline currency issuers and to discover currency prices through international arbitrage then it’s no big deal. Currency exchange rates will get the job done that a flow of specie would have accomplished in the distant past. The description of this mechanism is usually presented (inadequately) like this short Wikipedia entry.

As I said in Part 1 this mechanism doesn’t require a gold standard to operate. It can and did operate under a mixed currency system. Classical economists were also able to observe the effect on this mechanism during periods when gold exchange was suspended by the Bank of England. Jacob Viner discusses a number of other factors, aside from prices, that influenced the operation of this mechanism including real costs, relative demand, velocities (that’s plural) and so on. I’m only referring to prices here for the sake of brevity. Here’s my summary of the features and limitations of this mechanism:

1. It requires the trading partners to be in the same currency "zone" i.e. using the same money (e.g. gold, silver, Pounds etc) So the Eurozone is readymade to benefit from this mechanism if the Euro is managed well. We should be able to see its influence at work in the numbers emerging from the Eurozone over time as it tends to equalize the prices of internationally traded goods to reflect one price plus transport and distribution costs and relative demand.

2. This mechanism worked both internationally and between regions within countries through deflation and inflation of the currency supply. This in turn influences prices and other factors that encouraged a constant flow of money. As prices etc adjust the flow responds until the amount of money in each country or region returns to its starting position. I imagine tidal forces when I try to picture this mechanism in operation.

3. This mechanism increased the diversity and volume of goods available in each region/country. There is an extract from Viner quoting Ricardo on this topic below.

4. It apparently exercised no influence over the amount of bank-created money. This was a regulatory and policy issue that was the subject of a long running controversy between the “currency school” and the “banking school”. Viner also reviews these debates in great detail.

5. The classical economists and Jacob Viner dismiss the possibility of any index being able to simulate the effect of this mechanism. This mechanism works but it’s impossible to prove it with statistics. In an interventionist world like ours today if something can’t be indexed or measured in some way it doesn’t matter or doesn’t exist for policy makers. That’s a huge impediment for the supporters of free trade even though the logic appears to be impeccable.

P. 342 Jacob Viner (my emphasis):
Free trade, therefore, always makes more commodities available, and, unless it results in an impairment of the distribution of real income substantial enough to offset the increase in quantity of goods available, free trade always operates, therefore, to increase the national real income. That the available gain is ordinarily substantial there is abundant reason to believe, but the extent of the gain cannot in practice be measured in any concrete way.

(From Page 339-40 of “Studies in the Theory of International Trade”)
... Ricardo went on to say that “it will very powerfully contribute to increase the mass of commodities, and therefore, the sum of enjoyments.” What was intended by Ricardo as the main proposition was, at least for our present purposes, of no importance. The incidental comment, on the other hand, was of great importance. It suggests two income tests of the existence, and perhaps also two income measures of the extent, of gain from trade, namely, an increase in the “mass of commodities” and an increase in the “sum of enjoyments.”

Ricardo did not expand these suggestions, but in his Notes on Malthus he repeated them: if two regions engage in trade with each other “the advantage ... to both places is not [that] they have any increase of value, but with the same amount of value they are both able to consume and enjoy an increased quantity of commodities,” adding, however, that “if they should have no inclination to indulge themselves in the purchase of an additional quantity, they will have an increased means of making savings from their expenditure.”

I would like to leave you with a question to ponder. If all currencies are fully convertible (freely exchangeable [1] with each other) and there is no intervention inhibiting the flow (such as capital controls) then all of the world's currencies would be like one single fungible money supply. Of course there is constant intervention in many currencies. So if you wanted to promote international free trade it would be helpful if you could create an international reserve currency that no one could mess with, would it not? 
In the third and final part of this series I’ll present an issue that I think has brought those of us who anticipate a new gold-based IMFS to an impasse -  a stalemate. I think it needs to be addressed so we can move on.

[1] Another hat tip to DP. I added 'with each other' in order to try to make it clearer that this is purely an exchange of currencies and not a reference to a gold exchange standard.


DP said...

I look forward to the concluding part of the series, which I presume will bring it all together and reveal the whole that you intend us for the first time to see.

I'm not going to pass comment on what you have said in part 2, except to say "fully convertible (freely exchangeable)" may benefit from being more explicit about what you mean exactly by the terms I have highlighted in bold(?).


DP :-)

costata said...

Hi DP,

.."fully convertible (freely exchangeable)" may benefit from being more explicit..

One fund, one money supply, one pool. Happy to talk about it,

DP said...

I believe what you mean by this is that they would be exchangeable for each other (or anything else) in the market, at market-determined exchange rates.

Rather than what some may assume you to have meant (many of them vociferously disagreeing and instantly choosing to abandon further consideration of your theory, since to them it is now clearly hogwash) … namely, that the currencies would each be exchangeable for gold from the Central Bank. Which is something you may even go on to assert would ultimately be the case, but only indirectly and not at a mandated fixed price as in the gold standards of yore.

You may yet even expand upon how this would be a significant improvement on past gold standards, but who knows until I allow you to finish? ;-)

costata said...

Hi DP,

"..they would be (freely) exchangeable for each other.."

That's what I was trying to say. At any exchange rate the market dictates.

"..that the currencies would each be exchangeable for gold from the Central Bank.."

Where did they get that from? I can't see any words in either post that could be interpreted as making that assertion.

I'm definitely asserting that gold will price currencies. And yes, I think the new IMFS will be called a gold standard. Perhaps described as a new, improved gold standard to overcome objections from some quarters.

"...but only indirectly and not at a mandated fixed price as in the gold standards of yore.."

I don't think any currency issuer will be able to mandate an exchange rate under this new system. And in what "gold standards of yore" was anyone able to mandate a "fixed price" for gold.

Recall that post of FOFOA's discussing the gold royalty payments demanded from Aramco by Ibn Saud in the 1940s. The gold medallions were shipped off to Mumbai where they were selling for around US$70 an ounce according to the numismatist who described those events.

What was the "fixed" price of gold in the late 1940s?

What prompted Ibn Saud's demand to be paid in gold at the fixed rate in US dollars? In retrospect we should have connected the dots more clearly in that post.

Here's a preview of some of the other topics I intend to address:

1. How a dual currency system works.

2. Why "black" markets are usually just a free market response to bad policy and ill-advised intervention by governments.

3. Currency management in a gold-based system.

4. The argument about the relationship between the BBs and GLD that I flagged in my imaginatively titled "First Post".

Part three isn't going to complete the whole picture. And feedback along the way may change that picture. If anyone can show in a concrete way that anything I put forward is completely wrong then I'll acknowledge that in a post too.

I also have unanswered questions. Or at least questions without clear answers e.g. in relation to Target 2. Did Germany's trade surplus result in flows to the peripheral countries because of the prices+-specie-flow mechanism?

Clearly the flows resulted in malinvestment but that doesn't change the fact that money flowed. This mechanism predicts such flows. And despite the dire predictions from IFA it seems to have handled the adjustment perfectly from a money flow perspective.

DP said...

Where did they get that from?

Not from what you said, but what they assume you meant.

Looking forward to the remainder… Cheers! :-)

costata said...

mortymer eat your heart out. Just joking mate, I'm picking through this stuff like you go through IMF and BIS documents.

I'm going to amend this post to include some material I picked up from reviewing information on the ECB's "Harmonized Index of Consumer Prices" (HICP) that dovetails with a money supply management strategy based on HICP and the prices+>specie>flow mechanism.

The ECB's HICP only uses final consumption prices in the index. In their words:

“household final monetary consumption expenditure"

Viner's preferred measure of velocity is the “final purchases velocity of money”. Reasoning that "It is not purchases, or transactions, in general which are significant for the mechanism of adjustment, but only purchases of certain kinds."

Another area where the approach to HICP dovetails with this mechanism is that housing is currently excluded from the index. Apparently Eurostats hasn't figured out a statistical approach to allow housing to be included in the inflation index.

The velocity of money is one of the drivers of the mechanism. And not just any velocity measurement. (So that needs correction in the posts as well.) Viner actually uses housing to illustrate why he excludes certain purchases from the calculation of the velocity of money:

"If, for instance, a particular house has changed ownership as between dealers through purchase and sale three times in one year, and not at all in the next year, neither the transactions in one year nor their absence in the next year have any direct significance
for the international mechanism."

So looking at the HICP in combination with prices+>specie>flow if HICP is telling the ECB that the prices of commodities and services are rising or falling and velocity is confirming that then there is a money supply issue that needs to be addressed if it isn't auto-correcting for some reason. And a system like Target 2 would be the most conducive to auto-correction.

Extending the logic of the prices+>specie>flow mechanism and the HICP approach a little further. It could explain why you could have, say, a real estate boom in full swing without moving prices in your HICP consumer goods and services basket. Which would be a neat and tidy explanation of the reason why you can have no apparent "inflation" in the general price level when asset prices are going nuts.

I suspect it also lends support to VtC's disaggregated credit approach. Only one kind of money is driving this (h/t DP) - base money only for HICP. Spent on the stuff people pay cash for - consumption goods. Goods generally purchased on credit are in a different circuit.

Lastly it could also explain why the ECB could safely pump billions of Euro into Ireland when the SHTF. Velocity could have been telling them that the money was being hoarded rather than being spent.

(And yes, I know Uncle costata should get a life instead of messing about with this stuff.)


DP said...

Glad to see you're making solid progress towards a New Gold Supra-Theory, mate. ;-) Public writing, knowing you will receive feedback and your credibility will be on the line, does tend to be quite effective in focusing the mind and from there new insights tend to spring.

The problem with houses, is they are not consumed over short periods. People tend to treat them as assets as much (more than?) as consumer goods. (BTW does this also apply to a certain extent in the case of other durable goods, say, cars?)

Apparently Eurostats hasn't figured out a statistical approach to allow housing to be included in the inflation index.

So maybe they are deliberately ignored for the purposes of inflation targeting?

Is it for much the same reason that Central Banks don't appear to concern themselves too much with targeting stock/bond market values? Although it seems to me busts there will inevitably impact the demand for… specie. So maybe that explains why they don't want to allow them to fall, even if they don't mind them rising strongly?

As you indicated, these high priced, part-consumption part-financial assets also tend to be bought on credit rather than outright. There's probably more than a couple of reasons they're (…over a long enough timeline…) increasingly high priced. But most people thinking they only have to put the margin down prolly helps. And the matter of them being considered financial assets (that, like stocks, can only go up in price!! ;) ) prolly doesn't put much of a brake on things either.

From the point of view of a Central Bank, the good thing about irrational exuberance (whether it shows up in the market for stocks, housing, or any other asset class) is that it diverts demand from cash — a great way of avoiding liquidity issues in the monetary system, which inevitably lead to dreaded consumer price deflation.

costata said...

Hi DP,

quite effective in focusing the mind and from there new insights tend to spring

100% agree. Posting IS different. It's too easy to get off-topic in a thread. I'm hoping to pull some great stuff out of the comments and elevate them into the posts.

I think the ECB may be forced to exclude assets such as houses for the reason Viner did. The oddity here is that houses are exluded from a consumer inflation index. Every CPI I have ever come across has housing in it except HICP

It's also odd that Eurostats has had years to come up with something for housing. Presumably they have rejected everything they could have just cloned from other countries. Why?

Two more thoughts then I'll shut up. Target 2 was conceived as a "payments system" primarily for banks but not solely for banks. It can handle retail as well. Consider what sort of overview the ECB is going to have once the banking union is in place.

This will give them a totally unprecedented data view of prices in an economy as large as the EU.

DP said...

A new TV show concept?

People Put The Stupidest Things In Their CPI!

… OK, perhaps not then…

But, Indonesia putting gold in theirs? I mean, COME ON!!

Presumably they have rejected everything they could have just cloned from other countries. Why?

I think I've already bored you enough with my thoughts on this earlier, so I'll STFU now and wait patiently for you to dole out my next meal!

Cheers! ;-)

costata said...


I know I said I would shut up and this is definitely the last one for the evening (here) but something just clicked.

Viner maintains that you have to exclude all goods that are in the hands of someone who is going to onsell them. Intermediate goods in the terminology I'm used to.

So including housing would be a huge statistical issue in a system that utilized the prices+>specie>flow mechanism to supply liquidity to a payments system.

costata said...

I like the concept. Good night.

DP said...


Oh, and I neglected to mention that I had some thoughts on TARGET2 that may prove relevant (or bullshit?) too.

Thank you and good night! ;-)

DP said...

"Intermediate goods" seems like it applies to stuff in the production chain(?).

I would say houses are finished goods, but are considered largely a financial asset by the consumer — unlike, say, the contents of their kitchen cupboards, they would include them in the asset side of their personal balance sheet. (If they ever bothered to draw one up of course! But who's got time for that shit?)

victorthecleaner said...


I suspect it also lends support to VtC's disaggregated credit approach. Only one kind of money is driving this (h/t DP) - base money only for HICP.

Thanks for the twitter hint. I agree about disaggregate credit, but I do have a disagreement at the technical level.

On disaggregate credit. I am quite sure the founders of the Euro knew pretty exactly how this works in practice, and Richard Werner's work basically confirms it post-hoc.

The disagreement is here: The sort of "money supply" that's responsible for consumer prices is all the "currency" that circulates in the market for goods and services. Before WWI this was basically physical cash (being transported by the mail coach service). Yes, you could write cheques at that time, but they were drawn on a local bank and clearing was by mail/shipment of cash as well. Therefore, credit money played little role.

In the modern economy, what circulates in the market for goods and services is

1) A part of the monetary base. For example, by cash payment. But some other part of the monetary base is held as long term savings. With Fisher/Freedman, you would consider the entire money supply and notice that the velocity drops the more base money people hoard. Unfortunately, now you have two unknowns in the equation, velocity and price level, and there go your predictions...

victorthecleaner said...

Alternatively, following Werner, you would try to distinguish how much is hoarded and how much circulates, and then it turns out that the velocity of the circulating amount is approximately constant (empirical result), and so your equation has only one unknown, the price level, and you are in business for predictions.

2) But also credit money circulates in the market for goods and services. For example, I can take out a car loan, get some $ credited to my account and then pay the car dealer by wire transfer. That's credit money only, not involving any base money. Even more obviously, I can pay for my new stereo system by credit card. Again, the relevant money is credit money.

It turns out that what counts for consumer prices is the amount of credit created in the banking system that's used for consumption (as opposed to investment in businesses and as opposed to speculation on margin). In some cases, it is very easy to figure out whether some credit money is used for consumption. In other cases, you need to guess.

What are second mortgages used for? Probably largely consumption (people running out of cash, and this is the cheapest source of credit). But it might be speculation, too. What is a loan to government used for (or, alternatively, what happens when a commercial bank posts a government bond as collateral when they borrow reserves from the CB)? Government expenditures are largely salaries, and so the share that's consumption is probably similar to the consumption part of national income.

costata said...

Hi VtC,

Thanks for responding. I'll press on with this and see where it takes me.


victorthecleaner said...

In summary, yes, it is pretty clear that the ECB is targeting their HICP rather than house prices or the stock market.

You see, it all comes down to free fiat. Once gold functions (and this is the world for which the ECB has been set up), the value of their fiat money relative to the real economy is free and the ECB can choose how to manage it.

What would you try to keep constant in terms of your fiat?
a) the price of gold
b) the HICP
c) the median house price
d) the oil price
e) a basket of commodities
f) some producer price index
g) the S&P 500 stock index
h) some index of wages and salaries
i) any one of the above, but your fiat money depreciating by 2% annually compared with that

I think it is pretty obvious that you want to go for (b) or perhaps (h) or (i). The others are more or less ruled out. [Note that (a) is ruled out because your system would fail in the same fashion as the gold exchange standard failed]

Now you think about how the flow of gold equilibrates international trade and capital flows. What do you peg your fiat money to?

If you peg it to the prices of goods and services, you have a clean separation of two concepts.

1) The gold price in terms of the prices of the imported/exported goods and services fluctuates in order to balance trade flows. If you peg your fiat to goods and services, the natural flow of gold adjusts the trade flows.

2) Any flow of non-tangible capital (currency or debt instruments) is then "artificial" in this picture and has to be sterilized by gold open market operations.

This way of separating between "trade" (goods and services) and "capital" (currency instruments) makes your new financial system as complementary to the old gold standard as possible:

Gold versus goods and services are at opposite ends of the lever.


victorthecleaner said...

Note that I put "capital" in quotation marks in the last sentence. It refers only to currency denominated capital, i.e. credit balances, bonds and other debt instruments. This is the "currency part" of the capital account. Foreign direct investment or purchases of foreign shares are nor inccluded.

costata said...

Hi VtC,

The tyranny of time zones dictates that I can't contribute to the discussion for a few hours. If you want to think out loud here in the meantime please do so. I have a gut feeling that there is something important in this topic that we have yet to crystallize.

victorthecleaner said...

Apologies to Milton Friedman for some gross misspelling.

PS: Apologies to the head of PIMCO for not capitalizing.

costata said...

Hi DP,

Oh, and I neglected to mention that I had some thoughts on TARGET2 that may prove relevant

That link is dead. I would like to hear your thoughts on this.

I just reread your comments to get up to speed. I'm going to go through VtC's comments next.


costata said...

Hi VtC turns out that the velocity of the circulating amount is approximately constant (empirical result), and so your equation has only one unknown, the price level, and you are in business for predictions..

I wanted to start with a basic description like the old specie-based system and then layer in more complexity. Viner didn't just look at the classical economists era he also reviewed the work in this area right up to 1937. So banks and debt of various types are in his analysis. I'll try to summarize his approach to see if it is similar to Werner

Basically I see this mechanism as a liquidity management tool. It only factors into the currency price if a shortfall in the money supply or and excess is allowed to persist.

This way of separating between "trade" (goods and services) and "capital" (currency instruments) makes your new financial system as complementary to the old gold standard as possible:

Gold versus goods and services are at opposite ends of the lever.

This comment was the most succinct description of the gold-will-flow argument that I have seen to date.

Once I have fully incorporated the flow mechanism, Target 2 and HICP in this series I would like to use this in a compare and contrast of the will-flow and won't-flow arguments.

Thanks for responding.


DP said...

Strange - link works for me. #Bygones

Here is a Special Edition URL, customised just for you:


costata said...

I think I should write a separate post discussing the theory that the ECB's Target 2 and HICP are designed according to the principals of the prices+>specie>flow mechanism. This way I can merely discuss its operation within the EMU and leave out the international aspects of the mechanism.

I'll explain that the classical economists asserted that this mechanism would work intra-region and between nations. Then I can rework this post to focus solely on the international trade implications of this mechanism.

In fact a title just occurred to me for the separate post "The ECB Targets 1752". Odds on the obsessive gold price watchers will think it's a gold price target instead of the year David Hume described the mechanism in "On the balance of trade".

DP said...

That would be an ecumenical matter.

But it would probably help attract traffic, as you imply. :)

DP said...

BTW I am very much in favour of a series of short, tight, highly-focused articles, which link in to each other to build a whole that is larger than the sum of its parts.

costata said...

Hi DP,

I think I clicked on the wrong link or something. I'm dog tired, half of the town has hayfever like I do and it was around 35 degrees today.

That's a good overview. I can use this ABC post to highlight a difference between the Federal Reserve system's primary mission and the ECB's where Target 2 is primarily an integrated payments system.

...a series of short, tight, highly-focused articles, which link in to each other to build a whole that is larger than the sum of its parts.

Again 100% agree. I think this would be a very useful thing to create. Have you ever had a look at Pearltrees?

DP said...

Yes, Victor!

Gold versus goods and services are at opposite ends of the lever.


There is financial capital.
There are capital goods.
There are consumer goods.
And then there is gold.
It is to say "gold moves thru paper currencies"from consumer to producer.

costata said...

I have to log off now. It's good night from me and it's ......

DP said...

I hadn't come across pearltrees - I'll check it out. Thank you, and good night!

victorthecleaner said...


Yes, Victor!

Congrats on your recent progress towards freefiat! #FFFTW


DP said...

I hadn't come across freefiat - I'll check out the wiki. Thank you, and good night! ;D