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.
