Thursday, February 13, 2014

The Complications of Easy Money

The interview was first published by the Global Association for Risk Professionals on February 06th 2014

An Indian writer dives deep into the history of money and concludes that government interventions rarely end well

Although he is not by formal training an economist – and perhaps because he is not – Vivek Kaul has established a reputation as a provocative, clear-voiced economic commentator for Firstpost and other publications in India. One article about Kaul’s recently published history, “Easy Money: Evolution of Money from Robinson Crusoe to the First World War,” paid Kaul the compliment of being “readable.” In response, Kaul explained that he devotes considerable study to “break things down. If a child cannot understand what I am writing, it is pointless.”

Though perhaps understandable to the younger population, Kaul’s extensively researched, 300-page volume speaks to a very different, highly educated audience. He delves into the origins and evolution of monetary systems and finds in them pointed, cautionary lessons for the central bankers who manage the modern-day money supply and for policymakers concerned about the risks and stability of financial systems.

“One of the lessons from history is that money printing has never really ended well,” Kaul says in this recent interview conducted by Dr. Nupur Pavan Bang of the Insurance Information Bureau of India. “It has inevitably led to disaster. We don't seem to have learned that lesson at all.”

Why is “Easy Money” your title?
I use the term 'Easy Money' in the context of money being created out of thin air by kings, queens, rulers, dictators, general secretaries and politicians. The practice was regularly resorted to by kings of Rome and has been abused ever since. As the Roman Empire spread, it needed more and more money to keep its huge army all over the world going. But gold and silver could not be created out of thin air. Also, as Romans grew richer, luxury and showing off became an important part of their lives. This also increased the demand for precious metals. This meant more plunder of the territories Rome had captured in battle. But plunder could not generate gold and silver beyond a point. Hence, the Roman kings resorted to debasement.

How did debasement work?
A metal like copper was mixed with the gold or silver in coins, while keeping their face value the same. So let’s say a coin which had a face value of 100 cents had silver worth 100 cents in it. After it was debased, it only had 80 cents worth of silver in it. The remaining 20 cents was pocketed by the ruler debasing the currency. Once the Romans started this, the rulers who followed also debased various forms of money regularly. And that is a practice that has continued to this day. These days, governments print paper money and pump it into the financial system by buying government bonds. Actually, most of this money is created digitally and resides in bank accounts, but “printing paper money” is a simple way to explain this.

How and where has that history repeated?
Governments at various points in history have worked toward destroying money and the financial system. The Romans under Nero were the first to do it systematically by lowering the silver content in the Denarius coin. The Mongols, Chinese, Spaniards, French, Americans and Germans followed, at various points of time. When gold and silver were money, the governments destroyed money by debasing it, i.e., lowering the content of precious met­als in the coins they issued. When paper currency replaced precious metals as money, the governments destroyed it simply by printing more and more of it.

Today, in the U.K., for example, the government does not print money on its own. It sells securities to the central bank, which prints money to buy them. This started with the Bank of Eng­land being tricked into lending endless money to the government in the late 1790s by Prime Minister William Pitt. This al­lowed the government to borrow as much money from the Bank of England as it wanted to, without having to get clearance from the Parliament. Governments all over the world continue with this practice of borrowing unlimited amounts from their respective central banks. The practice has only increased over the last few years, since the advent of the financial crisis.

The first volume of your planned trilogy covers “from Robinson Crusoe to the First World War”. Do you think some earlier practices like barter were actually better?
Not at all. In fact, if barter was better, we would have probably stayed with it, and money and the financial system wouldn't have evolved. Barter had two fundamental problems. The first was the mutual coincidence of wants. I have some eggs and I want to exchange them for salt. So, I need to find someone who has salt and, at the same time, wants to exchange it for eggs. What if the person who has the salt does not want eggs, and wants sugar instead? To complete the transaction, I need to find someone who has sugar and is ready to exchange it for eggs. A simple, straightforward transaction could become fairly complicated.

In a barter system that has four goods to be exchanged, there are six ratios of exchange. But imagine a situation where there are 1,000 goods to be exchanged under a barter system. There will be 499,500 exchange rates.

And the second problem with barter?
Indivisibility. Let us say I have a potter’s wheel and want to exchange it for some basic necessities like eggs, salt and wheat. One way would be to find someone who has these three things and is ready to do an exchange. If I am unable to find such a person, then barter does not work for me.

That demonstrates the utility of money.
The evolution of the concept of money, where a standardized commodity could be used as a medium of exchange, did away with the problems of barter. Also, money allowed people to specialize in things they were good at. People can work in areas they feel they are most suited to without having to worry about how to go about getting the other things that they might require to live a decent life. This specialization, in turn, leads to discovery and invention. The concept of money is at the heart of human progress.

You write that gold, which historically backed the value of coins or currency, “is valuable, because it is useless". Can you explain this oxymoron?
That may sound oxymoronic, but it is not. Gold is highly malleable (it can be beaten into sheets), ductile (can be easily drawn into wires), and the best conductor of electricity. Despite these qualities, gold does not have many industrial uses like other metals have. This is primarily because there is very little of it around. Also, pure gold is as soft as putty, making it practically useless for all purposes that need metal.

Now, why am I making this point? It is important to understand that when commodities are used as money, they are taken away from their primary use. If rice or wheat is used as money for daily transactions and to preserve wealth, then there are lesser amounts of rice and wheat in the market for people to buy and eat. This, in turn, would mean higher prices of grains, which are staple food in large portions of the world. If a metal like iron is used as money, it is not available for its primary use.

Why is gold different?
Given the fact that it is extremely expensive, and that it does not have many industrial uses, the mere act of hoarding gold does not hurt anyone or infringe their rights. That “uselessness” also helps it to retain value.

Silver has lots of industrial uses. If one owns silver during a recession, chances are that the price of silver, and thus its purchasing power, would fall, because there would be less demand for silver for its industrial uses. The same would be true for metals like platinum and palladium which are also used for industrial purposes. Gold would not be impacted. As analyst Dylan Grice wrote in “A Minskian Roadmap to the Next Gold Mania“ (2009), “The price of gold will be unaffected by any decline in industrial de­mand because there is no industrial demand!” Hence, gold is useful because it is useless. This is paradoxical, but true.

What determines currency values now, and what causes them to crash, as was the case in the South East Asian crisis of 1997?
Paper currencies inherently do not have any value. What makes them money is the backing by the government that has issued them. Hence their designation as fiat currencies. One paper currency’s value vis-à-vis another to a very large extent depends on the economic strength of the issuing country. Before the South East Asian crisis, the Thai baht was pegged against the U.S. dollar: one dollar was worth 25 baht. Thailand’s central bank ensured that this rate did not vary. Hence, it sold dollars and bought baht when there was a surfeit of baht in the market and vice versa.

Once economic trouble broke out in Thailand’s and other regional currencies, investors exited them en masse. They exchanged baht for dollars to repatriate their money. In the normal scheme of things, with a surfeit of baht in the market, the value of the baht would have fallen. But the baht was pegged to the dollar. The Thai central bank kept intervening by selling dollars and buying baht. But it could not create dollars out of thin air. It ran out of dollars, and the peg snapped.

The baht was a piece of paper before the crisis. And it continued to be a piece of paper after the crisis. What changed was the economic perception people had of Thailand. As a result, the baht rapidly depreciated in value against the dollar.

What is the relevance today?
Central banks around the world have been on a money-printing spree since the late 2008. Between then and early February 2013, the U.S. Federal Reserve System expanded its balance sheet by 220%. The Bank of England did even better, at 350%. The European Central Bank came to the money-printing party a little late and expanded its balance sheet by around 98%. The Bank of Japan has been relatively subdued, increasing its balance sheet by 30% over the four-year period. But it is now printing a lot of money, planning to inject nearly $1.5 trillion into the Japanese money market by April 2015. This is huge, given that the size of the Japanese economy is $5 trillion.

One of the lessons from history is that money printing has never really ended well. It has inevitably led to disaster. But we don't seem to have learned that lesson at all.

In a past interview, Dr. Ishrat Husain, former governor of the Central Bank of Pakistan, pointed out that if shareholders' equity in a bank amounts to 8% of deposits, then 92% belongs to depositors, ang although excessive risks are taken with the depositors' money, the upside gains are captured by the shareholders and managers. But, if they lose money, taxpayers have to bail them out. This “asymmetric relationship in incurring risk and appropriation of reward makes the financial sector more vulnerable to exogenous shocks.”
I totally agree with Dr Husain. I talk about this in some detail in “Easy Money.” Walter Bagehot, the great editor of The Economist, wrote in Lombard Street, “The main source of profitableness of established banking is the smallness of requisite capital.” This book was published in 1873. So things haven't changed for more than a century. The low shareholders' equity of banks makes the entire financial system very risky.

What would it take to mitigate that riskiness?
Anant Admati and Martin Hellwig explain this point beautifully in “The Bankers' New Clothes” (2013). Let us say a bank has shareholders' equity of 2%, as some had between 2007 and 2009. If the value of the assets falls by 1%, half of its equity is wiped out. The bank cannot issue any new equity. So what does the bank need to do, if it wants to move its shareholders' equity back to 2%? If the bank has assets worth $100, its shareholders' equity earlier stood at $2. If the value of these assets fell by 1%, the bank's assets are now worth $99. Its equity is also down to $1. To increase shareholders' equity back to 2%, assets must fall to $50 – meaning $49 worth of assets must be sold.

In times of trouble, a lot of banks need to do this, leading to a rapid fall in the value of their assets. This tells us that if banks have a little more equity, then they will need to sell a smaller amount of assets, which will make for a more stable financial system during times of trouble.

Therefore, shareholders' equity in banks needs to go up. This is a no-brainer, the influence of Wall Street notwithstanding. 
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