Overall Review
The traditional view of evolution of money states
that in the beginning there was barter. People used to exchange items they possessed with items that others had. When the requirements became
more complex a need was felt for a medium of exchange. And thus was born money.
Is this a correct understanding of the evolution of money? What is money anyway? How will we
measure it? Who will control it? How will we handle excesses and bubbles? What
are the challenges? How has these questions been answered over the course of civilization?
Over a span of 16 Chapters, author Felix Martin, in
his book 'Money - The Unauthorised Biography' takes the reader through more
than 2 millennia, from ancient Greece, through early Mesopotamia, ancient
China, medieval Europe, the island of Yap in the Pacific, finally ending
up with Modern economy as we know. Through this journey, the reader gets a glimpse
of how countries have handled money and many examples of the consequences of
its mismanagement.
Through this journey, the reader is exposed to a
variety of historical incidents that makes this book very interesting. Be it
the Irish Bank Crisis of the 70's, the Irish Famine, the demonetization of
Pound, the rise and fall of the brokerage firm Overend, Gurney and Co in
England etc. Each incident illustrates a concept related to money.
The book paints a broad canvas covering the
evolution and challenges of money and monetary policy. The challenge starts
with the definition of money itself. Historically there are two different broad
definitions of money. As per the traditional definition, money is unit of
economic value and the standard of measuring this value depends on the
confidence of the citizens over the sovereign. This view is countered by the
conventional 'Commodity View' of money that considers money as a commodity and
its value depends on the value of the underlying commodity. Hence the value of
money is a 'Natural Fact', away from the control of the sovereign.
Throughout the ages, people implicitly understood
money as a social technology. As per this understanding, there are three
aspects that define money. One, concept of Universal Economic Value, two, a
system of account keeping to measure the value and three, principle of
decentralized transfer whereby the value can be transferred from one entity to
another.
Through their custom of sharing the spoils of war
and sharing of the entrails of roasted oxen among its people, ancient Greeks
implicitly understood the concept of Universal Value. Numeracy, literacy and
accounting originated in ancient Mesopotamia. The interplay of Universal
Economic Value and the science of accounting led to the creation of money as we
know it.
One of the critical questions is who will control
money? Whether it should be controlled by Sovereign or by the society. The
Jinxia school of ancient China recommended that the money, its creation and
transaction, should be controlled by the Sovereign. As per this school, money
is a tool of sovereign, which can use this tool to redistribute wealth
between the sovereign and its citizens. This view had persisted over 15
centuries. However, the excesses of Sovereigns who manipulated this power for
personal gains led to resistance. One of the key ways in which Sovereigns
manipulated the system was by printing / minting more money and collecting
Seigniorage, which was nothing but redistribution of wealth from citizens to
Sovereign.
It was a matter of time before citizens resisted
the power of Sovereign to control money. Nicholas Orasme, a French
intellectual, posited that since the prime user of money is the wider
community, the control should lie with the community. Over time this argument
became theoretical due to the rise of mercantile class with trade becoming more
and more cross-border. This meant two things. One, lesser control by sovereign
of any one country on the transactions and two, money slowly morphing to
Transferable Credit and less dependent on coinage. As more and more trade
started happening through credit, the less they needed money in the form of
currency. This led to Sovereign gradually losing control over money.
The scale of influence of mercantile money was
limited. Sovereign's role could not be wished away. The clash between Sovereign
and Money Interest ended with the creation of a central bank with public
private participation. Bank of England, tasked with the creation of money and
maintenance of monetary policy was created based on this ‘Great Money
Settlement’. The money interest not only had control on its creation and
distribution, they also got the benefit of Seigniorage.
This led to the new problem of crony capitalism.
The reaction to this led to the design of the conventional approach to money.
As per this approach pioneered by John Locke, Adam Smith and all, money was
nothing but a commodity whose value was determined by the ‘facts of nature’.
This approach totally removed Sovereign control on monetary policy. The value
of money was fixed by natural forces. The disastrous consequence of this
approach was the Irish Famine which killed more than a million people !!!
While England was experimenting with conventional
approach, there were reformists in other parts of the world who were trying different
approaches. John Law in France identified the central problem as Sovereign
taking too much of debt, which entail fixed payments, backed by revenues which
were non-linear in nature. This skewed the risks in favour of lenders. The approach
followed by Law was to convert all the sovereign debt to equity.
Law also identified that economic growth can only
be achieved by circulation of money. When economy tends to be bad, people
become anxious and start hoarding money. This reduces the circulation of money
leading to a vicious cycle of ever lowering economic growth. The only way to
handle this is for the sovereign to pump in more currency so that money
circulation can be increased.
The key aspect is the trust and confidence of the
citizens in the stability of the economy. It is important for the sovereign to
have flexibility in monetary policy to issue currency. This cannot happen if
the currency is linked to a commodity. So one of the key reforms initiated by
Law was the issue of currency not linked to any commodity, the so called ‘Fiat’
money.
Meanwhile, England faced a series of economic
crises in the 19th Century. In about 1866, the then world’s largest
brokerage firm of Overend, Gurney and Company went bankrupt. This led to huge
economic crisis in the country. The editor of Economist, Walter Bagehot,
analysed the crisis and came up with some path-breaking suggestions. As per him
money is not a commodity since during times of crisis, while the demand for other
commodities go down, the demand for money increases. The key reason, as Law
understood it earlier in France, was the loss of confidence of the citizens in the entire
monetary system.
Bagehot understood that only Sovereign can bring
about this confidence. So he proposed flexibility for the sovereign to fix the
monetary standard. Especially at times of economic crisis, confidence is very
low. Bagehot proposed that at the time of economic crisis, the banking system
cannot meet the demands of the public. Bank of England (BoE) as a ‘Lender of
the last resort’ is duty bound to honour the bills presented to it. BoE should
honor all the bills presented to it without looking into the credit worthiness
of the presenter. This will boost the confidence of the public in the monetary
policy. To ensure that lenders do not misuse this facility, Bagehot recommended
that the loan to the public should be done at a very high interest rate.
Bagehot’s approach differed from conventional
approaches in three ways. When it comes to the role of monetary policy to
handle crisis, Bagehot encouraged the role of Sovereign in setting monetary standards
(since only Sovereign enjoyed political legitimacy) whereas classical
economists saw no role for sovereign. When it came to cause of and handling
recession, Bagehot maintained that recession is caused by the loss of demand of
money and the best way to handle is to aggressively increase the lending by the
central bank. As per classical economists, money has no role to play in
handling recession. The only way to handle recession is to increase supply of
commodities in the system.
Regarding the role of money, Bagehot believed in
the role of money to spur economic growth, while classical economists
considered money as incidental to the exchange of commodities.
The classical economics ultimately led to the
development of Orthodox Economics focusing on demand and supply of things in
the economy without any consideration of money. The principles of Bagehot led
to the development of modern theories of Banking and Finance without any
consideration for demand and supply of commodities.
And the twain did not meet.
In 2007, world faced a huge economic crisis, an outcome of this parallax. Across
the world banking system collapsed. The reason was the explosion of credit in
the system caused due to innovative new products developed by ingenious finance
experts. Since none of this impacted the demand and supply of commodities, the
economic world did not take notice. Only after the crisis hit that the world
realized the huge direct and indirect economic impact of the crisis mainly caused by excesses in the financial system.
Immediately after the crisis hit, the regulatory
authorities took a series of actions. One is to increase the capital
adequacy norms. However this is not sufficient. Martin recommends multiple
approaches including sharing the risk reward ratio between the sovereign and
the lenders. One approach will be to issue government bonds whose interest is
linked to GDP. Another approach is to curtail the role of sovereign in the
banking the system. This can be done by Sovereign backing only the retail activities
of the banks, leaving banks to take the risks of its market related activities.
Money is very complex topic. It has to be carefully
calibrated and constantly monitored. As per Martin, most of the crisis has
happened in the past due to wrong configuration of money. Only the right
configuration of money can take the world out of its troubles and bring about
the Freedom and Stability that money has been promising since the evolution of
the civilization.
This was a very difficult book to read, understand
and review. It took me five readings and copious note taking just to make sense
of the overall structure of this book. The challenge is that the author do not
maintain any chronological structure. For example, in Chapter 12, while talking
of structural reforms in France introduced by John Law, we go back to 6th
Century BC Greece to read about Solon’s views on democratization of monetary
policy. Also the points are explained in a tedious and roundabout fashion. Much
like needles in a haystack, key points are hidden in a verbal haystack and it
needs focused reading to get them out and present them in a synopsis that this
review attempts.
So, why should you read this book? The implications
of various money events are explained very nicely be it Irish Banking Crisis,
Irish Famine, Yap and their use of Fei, the debacle of OGC, the 2007
crisis....The reader experiences these crisis first hand as she reads them
explained in this book.
Being a book that deals with the complex and
controversial topic of money, there are many material out there that either
praises or pans this book. It is almost like the book appeals to some views and
do not appeal to others. In this polarized environment, my review aims to reach
a middle ground, I hope.
I will give this book a score of 3 /5 based on a
Layman’s perspective.
Given below is the Chapter Summary. I have reviewed only 15 Chapters below. The final chapter is the summary of the points covered in the book which I have summarized in the overall review above.
Chapter Summary
Chapter 1
In the first chapter of the
book, Martin provides three examples to prove that traditional view of
evolution of money was wrong. First example is from the Micronesian island of
Yap in the Pacific. Even as late as early 20th century this island was unknown
to the world. When discovered it was found tat the people of Yap were using
huge stones discs known as Fei as money. The size of the Fei denoted its value.
The Fei was placed in the city centre. The transaction between people was
represented by transfer of ownership of Fei.
The social status of people
in Yap was determined by their proportional ownership of Fei. The symbolism of
Fei as money is shown by the fact that the richest family in Yap did not even
possess a Fei. The Fei they were supposed to be having was hidden deep inside
the ocean having sunk in a shipwreck during its transfer to the island !!
The conventional view of
money is that it is a physical commodity. However the example from Yap shows
that money is nothing but a system of credit and clearing. Be that the case,
how did the view of money as a commodity survive for such a long time? One of
the reasons was the presence of coins that affirmed the view of money as a
commodity. While coins have survived the ravages of time, other symbols of
money, unfortunately, did not.
One such example is the
Exchequer tallies that existed in England from 12th Century to almost the
beginning of the 19th century. These tallies were used to manage the public finance
of England during this period. Tallies were wooden sticks on which were
inscribed with notches, the details of payment made to and from exchequer.
Once the details of the
payment was recorded in a tally stick, it was split in the middle from end to end
so that each party to the transaction could keep a record. The creditors half
was called 'Stock' and the debtors part was called the 'Foil'. The unique grain
of willow prevented a forgery while the portable nature of the tally meant that
it could move from the first party to the third party to close some unrelated
debt. This made them 'bearer securities' much like cheques that we issue in the
current day.
Sometime in the early 19th
century, England replaced Tally with proper notes. Once this was introduced,
huge stock of Tally sticks with government was considered to be a public
embarrassment and the entire stock of the sticks were set on fire inside the
house of lords.
With the loss of tally
sticks, world lost a recent evidence of use of money as an idea and a measure
of economic value. The surviving metal coins thus reinforced the idea of money
as a commodity.
Another reason why it is
difficult to analyze money is that impassive analysis is difficult. The very
nature of money, its integration with the day to day activities of each of us,
makes such analysis difficult. However opportunities for such analysis occurs
where extreme disorder happens in the monetary system. One such incident
happened in the Irish Banking system as recently as 1970. From May 1970, the
banks in Ireland were shut down for a period of about 6.5 months. Despite such
long shutdown the economy of Ireland proceeded briskly due to two reasons. One
was the cash withdrawals which business made before the closure that enabled
salary payment. However, more importantly, most of the business was run through
cheques, which moved from hand to hand in the form of IOUs.
The entire system of credit
clearing and economic activity in one of the world’s top 20 economies ran
smoothly for an indeterminable time period.
How did this happen?
This happened because most of
economic activity in Ireland was local in nature and the system was based on
people knowing each other. This was facilitated by the availability of local
pubs where people used to assemble for drinks.
One final example to show
that the idea of money as a commodity is wrong is the Siege of Valletta by the
Turks in 1565. As the Ottoman embargo dragged on, the supply of gold and silver
ran short. To overcome this the knights of Malta minted coins in copper. The
motto they printed on the coin read ‘Non Aes sed Fides’ (Not the metal but
trust)
The fundamental theme of
first chapter is to address the question ‘What is money?’. Conventional view is
that money is nothing but a commodity medium of exchange. It is nothing but the
‘Gold Standard’. As this book argues, money is not a commodity. It is a social
technology comprised of three fundamental elements – an abstract unit of value,
a system of accounts that keep the individual or institution credit / debit
balances as they engage in trade with one another, and the ability to transfer
the value from one to another. The ‘Transferability’ is what converts credit to
money. In other words, money is a ‘transferable credit’. As the example of
Tallies in England or the IOUs written in Ireland show, it is not the idea of
money as a commodity that matter, it is the transferability of credit that
determines the money. The transferability of credit depend on the trust that
the society places on the debtor’s ability to deliver. In addition the third
parties must also be willing to accept debtors IOU in lieu of payment.
Chapter 2
Across the history, different
items has been used by people as a medium of exchange with coins being the most
visible currency. What this proves (paradoxically !) is that money is not a
thing. It is a social technology; a set of ideas and practices which organize
the way we live together.
To illustrate the evolution
of money, Martin takes that reader through three different eras in this chapter.
In the age of ancient Greeks - the age of Iliad and Odyssey, there was no
money. The society was hierarchical and was designed for war. So how did Greeks
Organize and manage without money? For one, the needs were basic. Food, water
and clothing. And it was an economy of self-sufficient households in which
individual tribes man subsisted on his own produce. In addition, there were
three social institutions that played important roles in organizing the
community. One was the distribution of spoils of war. Two was the system of
reciprocal gift exchange between chieftains and three was the sacrifice of oxen
to the gods and the distribution of roast beef in equal parts to the
congregation. These three worked to ensure order among a warrior society.
While ancient Greece was a
warrior society, they Mesopotamia was primarily an agrarian society. Due to
this sedentary style of living, they developed the first known city state. To
handle the needs of a large population, they developed world's first known bureaucracy.
The power was shared between king and the temples. To manage the social order
and the complex needs of the public and multiplicity of transaction, they
invented three most important social technology of human civilization, vis.
literacy, numeracy and accounting.
Traditional view of emergence
of scripts is that the scripts developed out of images of everyday
objects. However, the cuneiform scripts of ancient Mesopotamia are almost
similar to the present day scripts. Literacy helped the city states to develop
bureaucracy to handle the complexity.
Ancient Mesopotamia was a
treasure trove for archaeologists. In between lots of rich artifacts, they also
discovered clay artifacts of different sized and shapes. While initially
thought to be children's play things, later they were found to be sophisticated
tools used for what came to be known as 'Correspondence Counting'. Each
artifact identified different type and quantity of things. So a transaction
involving the sale of five cows, for example, was denoted by the use of five
artifacts that represented the cow.
From use of physical
artifacts to the use of pictures of artifacts was the next step. The idea of
correspondence counting was the early precursor to accounting.
Even with the use of
pictures, one had to draw 5 pictures of the artifact to show transaction
involving 5 units of an item. Over a period of time, symbols were invented to
represent numbers. So, now, instead of pictures of five artifacts, you needed
to draw only two symbols, one to represent the item and the other to represent
the number transacted.
It must be noted that nowhere
in Mesopotamia, despite the numerous and complex transactions, the concept of
money as we know it, was used.
Chapter 3
What is a dollar?
Is it something physical or
is it a unit of measure. If it is the latter, what does it measure?
A dollar or a rupee measures
economic value. Which means that economic value has to have universality.
In the early days of
evolution of money, the idea itself was local. Each transaction was measured on
its value, the so called Barter System. This chapter examines the evolution of
a concept of universal economic value that revolutionized the idea of money.
The idea of economic value is already universal. For example an ‘Archana’ in an
Indian Temple (Spiritual Value) costs Rs.10 (economic value). Or for that
matter, insurers calculate the economic value human beings to determine the
policy premium.
Considering the universal
applicability of the idea of economic value, can it be standardized? Here one
faces challenges. Economic value is a social construct and is closely linked to
the societal norms and constructs. Getting into the social realm, economic
value is more political in nature. So for example, Indian food, while
inexpensive in India, becomes ‘exotic’ and costs a lot in other countries. In
this case, while there is an economic value for Indian food, the value is
different in different contexts (non-standardized)...
Even though Mesopotamia
invented the concept of accounting and numeracy, the excessive bureaucracy
ensured that the other requirement of money, vis. The concept of universal
value was not available. However, the ancient Greece had the concept of
universal economic value but did not possess knowledge of accounting. So when
this knowledge was transferred to Greeks, it is no wonder that the concept of
money as we know it originated there. All pieces of jigsaw fell in place as it
were !!. There are evidences that as early as the 6th century BC, Greeks
were using ‘Drachma’, a currency, for transactions.
The spread of coinage
accelerated the usage of money. One of the key uses of money is decentralized
negotiability. The new idea of universal economic value made possible
offsetting of obligations without reference to a centralized authority.
With the spread of money
societies were turning into ‘monetary societies’. The age of centralized
authority was ending and was being replaced by money. Social status was being
measured by the amount of money one possessed. Money provided social mobility.
What about political
stability? Without centralized control, won't the society collapse? Surprisingly
no. Since the basis of universal economic value was the concept of universal
social value, as shown by sharing of the spoils of oxen sacrifice in ancient
Greece, money promised political stability, as against the chaos as predicted
by vested interest.
Next question is, who will
control money? This question is addressed in chapter 4.
Chapter 4
Who should control money? In
other words, who should print it? Who will ensure that universal economic
value?
Fascinating questions raised
in chapter 4. It starts off with the example of Argentina, where in the late
90s and early 2000, the sovereign control on the currency almost failed and
parallel currency called ‘Creditos’ existed, prompting stern warning from IMF.
Chapter also talks about Russia of 90s where parallel economy was the norm.
Ideally Sovereign should
control money supply primarily due to two reasons. One, it is the largest payer
and two, it has the political authority. Political experts have long realized
the predominance of sovereign in matters relating to money. Constitution of
almost all countries vest the power to print currency on the sovereign
This raises some interesting
questions. The role of money is to ensure freedom and stability for the
‘Society’. What if the interest of sovereign diverge from that of the society?
How to ensure that the interest are aligned?
While some of these questions
are being debated even today, some of these question were answered in China in
4th Century AD. Duke Huan of Qi dynasty enlisted a group of scholars
(known as Jinxia school) to come up with ideas to help sovereign become
powerful. The ideas on money that this group discussed were collected in a work
known as Guenzi. The findings of this group is remarkable for their
universal applicability even in modern times. As per them money is a tool of
the sovereign, part of the machinery of the government.
If money is a tool of
sovereign, two question arise. One, how did it work? And two, to what
objectives should the sovereign deploy it? Jinxia scholars developed the
theory. First of all, the value of money was unrelated to the intrinsic value
of the token used. Instead, money’s value was directly proportional to how much
of it is in circulation, compared to the quantity of goods available. Role of
sovereign was to modulate the money available in order to vary the value of the
monetary standard in terms of these goods. Sovereign could pursue a
deflationary policy by sucking in all the currency so that the prices of goods
will fall. Or it could be inflationary, by transferring money to subjects while
accumulating goods, thus causing the prices of goods to increase manifold.
Why should sovereign pursue
any of these policies?
First, it would provide a
powerful tool for income redistribution among sovereign’s subjects. An
inflationary policy will erode the claims of creditors and eased the burden of
debtors and a deflationary policy had the opposite effect. Another important
redistribution was from the subjects to the Sovereign. By minting new money and
putting into circulation virtually at no cost, sovereign was asking subjects to
pay more for eh same amount of goods. (This is called ‘Seigniorage’ in modern
economic parlance). Second, it would regulate economic activity by making the
primary instrument of organization and settlement of trade more readily
available.
As per Jinxia scholars, for
sovereign’s power to be effective, sovereign must retain exclusive control over
money.
Meanwhile, when monetary
thought evolved in Europe, it was in a different direction. This is discussed
in Chapter 5
Chapter 5
Ancient Roman empire had a
thriving monetary economy. It was surprising to read that Rome had its own
‘Subprime crisis’ as early as 33 AD. Credit became excessive, real estate
prices became very high and when Emperor implemented capital adequacy norms,
the economy collapsed. The sovereign had to bail out the bankrupt lenders !
How history repeats. Again
and again.
From the collapse of Roman
empire in 4th century AD, the monetary economics slowly faded in
Europe. However, the idea of universal economic value still persisted. In 8th
Century AD, England introduced Pounds, Shillings and Pence as monetary units.
However, the usage of these units stabilized in 12th Century AD. The
usage of coinage was complicated by the fact that kings authority was limited.
This meant that while pounds, shillings and pence remained as the coin, their
value varied locally and was not standardized.
The coins were made of
Silver, but did not specify any value. This gave sovereign an advantage of
lowering the value of coin to impose a one-off wealth tax on the holders of the
coined money. The coin would be ‘Cried Down’ and the existing coin would be
presented to the mint to re-coin the cried down issue. Sovereign can, in
addition, levy a charge on the re-minting operation. The sovereign could also
lower the value of Silver in the coins, so called ‘Debasement’ and levy ‘one
off’ tax on people. The potential for mischief was enormous. If the
need arose, Sovereign could raise enormous sums by ‘crying down’ or even
demonetizing altogether the current issue of coinage and calling it in for
re-minting off a debased footing.
The remonetization of Europe
over the ‘Long 13th Century’ (late 12th to mid 14th)
generated two conflicting phenomena. One was the emergence of ‘money interest’,
a group of individuals and institutions whose wealth was held in money and the
other was the Sovereign that increasingly addicted to Seigniorage. The more
activities were monetized, and the more people in the money economy, the mover
was the tax base on which to levy Seigniorage. Clash was bound to ensue.
In the mid 14th Century,
a French scholar, Nicholas Orasme wrote ‘A treatise on origin, nature, law and
alteration of money’. In that, he tried to address two questions. One, was it
right that sovereign should manipulate the monetary standards? And two, in
whose interest he should do it, if at all?
As per Orasme, money was not
a property of the Sovereign, but that of the entire community that use it
(which was the ‘Wealthy Class’ at that time). Money was an essential service,
to be operated in the interest of public at large. Since money was to serve
people, money should be controlled by the public and not by the sovereign. In
case any ‘debasement’ is required, that would be decided by the public, not by
the sovereign.
So what was the role of the
sovereign? It was to try and discover new sources of precious metal so
that new coins can be minted.
The innovative idea
introduced by Oresme was the in considering monetary policy’s ability to
redistribute wealth and incomes and its ability to stimulate or stifle trade,
the wider community's well-being should take priority.,
All these innovative ideas
remained short lived as industrial revolution and accompanying commercial
class, too roots in Europe. They invented the idea of banks, an invention that
upended the entire monetary thought.
This is covered in Chapter 6.
Chapter
6
The early 14th
Century in Europe was characterized by the arrival of the mercantile class.
Starting from handling the credits and debits related to the local trade, this
class was also facing challenges related to cross border trade. While Orasme
and his ilk were trying to change laws related to Seigniorage in France, the
mercantile class bypassed the sovereign money altogether by creating their own
‘money’
While the banking process
itself was very rudimentary, restricting to handling of credit, the scale of
transactions themselves was huge involving ‘millions of pounds transacted in a
day without any use of sovereign money’. The way it worked was as follows.
Some of the big business
house in Europe issue ‘Bill of Exchange’, which was basically IOUs, guaranteed
by the business houses. A buyer of a good in one country will but these Bills
to settle his purchases with a seller. The seller of the good will in turn use
this bill to settle his purchases in another country.
Every once in a while, the
various buyers and sellers of these bills will use the Sales fairs at various
European Cities to settle the books and carry forward the balances. To handle
the ‘Exchange rates’ a new notional currency, named ‘Ecu de Marc’ was
introduced. Fixing of exchange rates between sovereign currencies and the
notional currency was one of the key aspects of the periodic settlement
process.
One of the critical aspects
of the banking system is the handling of credit risk, the so called ‘Asset
Liability Mismatch’. How did these banks handle credit risk? In the early
days this risk was handled easily since both the assets and liabilities were
local and short term in nature. So they automatically matched. Liquidity
risk was handled through frequent settlements.
The task of a judicious
exchange banker was to transact in the first few days of the central fair so
that on the day of settlement, he could perfectly offset his debit and credit
balances and turn a profit. Through this self-regulated network and hierarchy
of credit, they had created a viable private money on a Pan European scale.
The sovereign was not happy.
It tried to impose control on the system by imposing severe penalties, but
despite that the system continued.
While the banking system
created huge private wealth, it also created significant political changes.
This is addressed in Chapter 7
Chapter 7
One of the implications of
the points discussed in the previous chapter was that the great merchant houses
had discovered means of producing, international money beyond any one
sovereign's control. Moreover, without any collateral to back it, this money
was invisible, intangible and solely based on trust
This money had the potential
of impacting the valuation of sovereign’s money. In fact, from a ‘Value 26
Flemish shillings’ in 1544, the British pound had depreciated almost 50% to 13
Flemish shillings. This got the sovereigns worried. One of the ways in which
they tried to counter the shadow money influence was through direct market
intervention. Through a special fund. When this did not work, sovereign
resorted to coercion by mandating that the foreign currency reserves of English
merchants in Antwerp be converted into a forced loan to the crown.
These were all temporary
measures and an uneasy calm remained between merchants and sovereign for over
four centuries. One advantage of this was that the arbitrary hold of sovereign
on the money was eliminated. The existence of shadow money ensure that the
sovereign control over money had lost its effectiveness.
From the Jinxia academy of 4t
century which postulated money as a tool of sovereign to money as a tool to put
control on the excesses of the sovereign, monetary theories had completed one
full cycle.
While private money may look
good on paper, practically there are challenges. One is the size which is
limited to a group of people who transact based on trust. Two, private issuers
could default, leaving their creditors worthless. Or, there could be unexpected
events that could dent the confidence on the system. Due to all these reasons,
sovereign money will continue to be the default.
While this inequillibrium
continued, the sovereign needed money to fight wars. Identifying new sources of
money became the challenge. The King of England tried many ways, including
Lottery, to fund the war. Nothing worked.
There were two simple
questions to be answered. One, how to fund the current wars by using the future
income? Two, how to get private money to partner with Sovereign to fund the war
chest.?
One of the suggestions was to
set up a bank funded by public – private partnership. This bank will print
currency, mint coins and lend to the sovereign. The money group was excited
since this helped them share the Seigniorage. Government could get money to
fund expenses. This bank, will, thereby help create a ‘Grand Settlement’
between money interest of the mercantile class and the interest of the
sovereign.
Bank of England was born.
What is the implication to
monetary thought? From Jinxia academy, where money is a tool of Sovereign and
be controlled by it, to money being used as a tool to control the excesses of
the sovereign, monetary thought had come a full circle. Money was social
technology to help redistribute the wealth. This role of money remained
constant thru ages. Another constant was the political role of money.
This was about to change with
the advent of the science of economics. The key question that economics asked
and which changed the paradigm was the following.
What is the standard based on
which money should be issued?
This is addressed in the next
chapter.
Chapter 8
While the equilibrium
established between the money interests and sovereign seemed to have
stabilized, it caused a lot of concern among the supports of constitutional
monarchy. They felt that the combination of a powerful sovereign and wealth
money interests could use this authority to overturn the hard fought property
rights of common man.
They were looking for ways to
undermine the power of the grand settlement. The key concern was that the
standards were not fixed behind the issue of currency by Bank of England. In
theory, Bank could print excess or less currency, thereby leading to
redistribution of wealth between citizens and powers that be.
One such opportunity
presented itself when Bank decided to tackle the problem of silver coins.
The problem was simple as
much as it was age old. The value of silver in the coin was greater than the
value of the coin itself. The result was that the coins were sold off to
bullion traders at the value of silver content. Whatever coins that remained in
circulation were also badly mutilated to strip off as much silver content as
was possible. The end result was that the silver coins which were in
circulation had almost 50 percent less silver that the value of the coin
itself.
This problem had been faced
multiple times in history. At each point the sovereign either depreciated the
currency (so called Crying Up) or reduced the quantity of silver in the coin
(Debasement).
British parliament invited
Mr.William Lowndes, a lifelong veteran of treasury to suggest solution to the
problem. Mr.Lowndes recommended a one-time debasement of the Pound by 20%,
which meant that the content of silver in the coin will be reduced by 20%
bringing the value of the coin same as the value of silver content in the coin.
This was a time tested
practice to handle currency stability. British parliament asked Mr.John Locke,
leading intellect of the age, for his views.
Mr.Locke opposed the
debasement entirely. He posited that there is no difference between the
value of ‘Pound’, the coin and the value of silver content in the coin. As per
him, the Pound coin was losing value not because of inflation, but because of
the loss of silver content in the coin. Locke proposed recall of existing
coins and issuance of new coins with the full silver content and a fixed value.
In 1696, the parliament
decreed that existing, clipped silver coins will no longer be a legal
tender and proposed replacement over a six month period. The Old coins were
replaced with new coins with full silver content. As soon as it was issued, the
new coins were taken out of circulation by vested interests and the same was
exported as bullion. This resulted in a crippling coin shortage which
ultimately led to deflation and contract in trade. Many people committed
suicide.
Why did Locke insist on such
a position? It is possible that as a constitution liberal, whose guiding
principles were individual freedom and liberty, he was worried about giving
excessive power to sovereign to determine the value of money. He probably
wanted the decision to be based on natural facts.
After initial hiccups, the
new currency system seemed to have attained some form of stability. However,
none had predicted the arrival of new transactions.
The commercial class invented
debt. The implications are covered in the next chapter.
Chapter 9
Let us summarize our understanding
so far. Traditionally money was considered to be a social technology and had
political ramifications. Sovereign had the flexibility to adjust the value of
money, ideally in the ‘interest of society’, thereby creating a wealth
redistribution between the lenders, the borrowers and the sovereign.
Then came Lock with his idea
of money as a ‘fact of nature’ and whose value has to be fixed based on
‘natural Facts’. Sovereign had no control on its value and had no flexibility
to adjust based on requirements. Money as a tool to handle crises, both natural
and man-made, was off limits.
One of the most common and
regular crisis that occur in a monetary society is what is known as ‘asset
bubble’. The values of various assets are driven up to extra ordinary levels
through use of excessive debt. In many cases, the institutional oversight is
week (either by omission or commission) and loans are taken against collateral,
which exist only on paper. Eventually one of the parties in this bubble will
default on their payments and the bubble will burst. This will quickly explode
into a full-fledged crisis, which if not handled quickly and effectively, can
cause significant economic slowdown for years. It is the responsibility
of sovereign to handle this crisis.
Another type of crisis is
natural calamity like famine. When nature fails, it is the duty of sovereign to
help people who are suffering.
To handle such events,
sovereign require flexibility in monetary policy since it is a tool of
sovereign as per Jinxia school. This was the flexibility taken away from them
through the conventional view of money as propounded by Locke.
The story of Irish potato
famine is an example of disaster that can be compounded due to monetary
rigidity of the conventional view. For two consecutive years Ireland faced
famine. More than a million people died due to famine. The followers of
conventional view of money, at that time a majority in parliament, and
supported by editors of renowned magazine ‘Economist’, prevailed on the
Sovereign from providing any form of support to the Irish, who, by the way were
dependent on British for everything other than Farming.
(As you read this chapter and the
previous one, it is surprising to see the number challenges that Britain faced
due to conventional view of money and the associated monetary rigidity. If you
remember the book ‘Lords of Finance’, you could see how wrong was the BoE in
sticking to Gold Standard when the whole world was moving towards monetary
expansion as a means to kick-start growth. The English has been wrong multiple
times and the world had had to pay terrible price for their mistakes)
Chapter 10
While England in the 18th
century looked at value of money as a ‘Fact of nature’ and hence not to be
tampered with, money was viewed differently in different parts of the world at
different times.
For example, ancient Greeks
were concerned that people were putting money value as everything and
acquisition of money was overshadowing other human pursuits. The question of
‘How much money is enough?’, bothered the philosophers. As the famous story of
King Midas shows, Greeks considered the acquisition of wealth beyond one’s need
to be ludicrous.
Greeks also observed a
paradox about money. One need the help and support of other people to make money.
But the same money drive the person away from the people. Once a person has the
money, he no longer require the support of people who helped him in the money
making endeavor.
While Greeks were bothered
about limiting acquisition of money, their neighbors, Spartans, eliminated the
use of money altogether. Sparta was a highly militarized, regulated society.
They believed that if all other social institution are powerful enough, a
society did not need any money to survive. Similar sentiments were espoused by
Thomas Moore in his 16th century book ‘Utopia’.
Coming to modern era, Soviet
Communists followed the strategy of ‘Containment’ of money rather than its
elimination. Through this rigorous planning and widespread bureaucracy, Soviets
progressively reduced the opportunities to use money. The outcome was that
acquisition of money got one nowhere since there was hardly any opportunity to
use the same.
As mentioned earlier, there
is inherent contradiction of money. While you need society to support its
acquisition, you do not need society once you have money. How do you handle the
contradiction?
Chapter 11
While England was
experimenting with the conventional view of money, there were reformists in
different parts of the world, at different points in time, who came up with
different views of money.
One such reformer was John
Law, a Scotsman, who in 1705 wrote a treatise called ‘Money and trade
considered, with a proposal for supplying the nation with Money’.
Unlike Locke or Lowndes, Law
saw the role of money differently. As per him ‘money is not the value FOR which
the goods are exchanged, but the value BY which they are exchanged’. Money, in
his opinion, was just transferable credit.
If money is transferable
credit, determining the standard of abstract economic value should be the most
important question in economic policy for two reasons. One, standards should be
such as to ensure sufficient supply of money. Two, the standards also
determines the distribution of wealth between sovereign and eh subjects and
more importantly in a commercial economy, between the private debtors and
creditors.
For money to prime up the
economy, it should circulate. However, money will not circulate by itself since
people are safety conscious and will hoard money. Without circulation, money
ceases to generate wealth and income and this makes people anxious and they
hoard more. This becomes a vicious cycle.
Without appropriate
intervention, money cannot play the role of priming up economy.
What kind of intervention?
And who will intervene?
As per Law, the sovereign
issuer of money should have the authority to vary the supply of money to match
the needs of private commerce, public finance and balance between private
creditors and debtors. The monetary standard must allow discretion in issuance
of money. This immediately ruled out gold and precious metals as a standard.
So what could be the
standard?
In early 18th
century, France was a basket case. Not only it had a shortage of money, but the
crown was neck deep in unsustainable debt. The first challenge was to improve
the money supply. Law persuaded Regent to allow him to establish a General Bank
tasked with issuance of money. Initially the quantity of money issued was
linked to the availability of Gold and Silver (so called Gold Standard), but
over a period of time this linkage was broken. For the first time in history
(of the world) France had ‘Fiat’ money.
Having attacked the first
problem of Money Supply, Law focused on the next problem of excessive debt. Law
convinced Regent to allow him to form a joint stock company and to award it the
rights to develop French North America. Holders of sovereign bonds were invited
to swap their debt claims on crown for equity share in the company.
The response was
overwhelming. Every one rushed in to buy the shares in the company. The company
expanded its operations and acquired many more companies and the share prices
started going thru the roof. Everyone was happy.
In 1719, company acquired the
rights collect Indirect taxes. Along with that it announced intention to buy up
entire sovereign debt by issuing a huge tranche of equity.
The Bank was minting Fiat
money, the company was reaping profits, the Sovereign debt was converted into
equity and the monetary standard was exclusively under the preview of
Sovereign. Law had achieved the impossible. A sort of Monetary Utopia as it
were.
What could go wrong?
There was one problem,
though. The entire edifice of the system was based on the ability of the
company to earn profits. By 1720, doubts began to creep in about the potential
losses of the company. The smart money began to sell off leading to a fall in
value of the equity. This led to collapse of economy. By December 1721, Law had
fled France.
What were the contribution of
Law? One, he believed in the power of money to spur the economy. Two, he
identified the inherent conflict between fixed value debt being serviced by
uncertain revenue flow. The simplest way to handle this was to convert the
fixed financial claims (debt) into variable claims (equity). By all criteria,
Law’s system should have been a success.
So why did it fail?
It failed because Law
believed in the authority of monarch to set the standards. Considering that
money was a social technology and was used by everyone in the land, it is
important that the standards were fair and transparent and socially acceptable.
However an arbitrary standard made by sovereign did not meet this criteria.
It was surprising because of
two reasons. One, about two centuries ago, in France itself, Nicholas Orasme
had made the same point that money was a social technology and should be
controlled by the community. This lesson was not heeded to. Second, the same
idea was prevalent in ancient Greece as early as 600 BC. To curb the monetary
excesses, Solon, a philosopher elected to the post of Chief Magistrate of
Athens, enacted a series of social reforms known as ‘Shaking off of Burden’.
Main among them was the cancellation of debts, not by diktat, but as a matter
of political compromise, making monetary decision more democratic. In addition
Solon abolished share cropping, introduced taxation by economic category rather
than class and guaranteed right to trial by Jury. Finally all these were
codified into a comprehensive body of Law.
How are Solon’s ideas
different from that of Law? Solon believed that the only compromise of
democratic politics can durably decide what is fair. The basis of the
compromise was the fundamental equality of the individual. By its nature money
permits social mobility and accumulation wealth and power. Any fixed standard
will become obsolete. So the state must always ensure that the architecture of
financial obligations must reflect fairness. Only democratic politics can
furnish such an evolving standard. And only Law – its debate, codification and
rules- can enact it.
Despite the presence of this
enlightened view in early Greece, the conventional view has gained ascendance
across the globe. Let us review the conventional understanding in some detail.
Chapter 12
In the aftermath of Lehman
crisis of 2007. Lawrence Summers was asked his view on why the crisis happened
and why the economists could not anticipate the same and take corrective
action. He told that the vast edifice of economics built during post war years
was virtually useless. However, the contributions of Walter Bagehot, Hyman
Minsky and Charles Kindleberger, helped the authorities in designing an
appropriate response to the crisis. And once crisis was handled and the system
stabilized, the lessons learned from another great economist, Keynes, helped to
kick-start the economy.
So who was Walter Bagehot?
What were his contributions that helped tide over the economic crisis of 2007?
At the beginning of 19th
Century, Overend, Gurney and Co (OGC) was one of the leading bill
brokering houses in England.
The original business of
company was pure broking. Merchants will bring their bills to OGC. OGC will
satisfy themselves with the credit potential of the merchant. Once satisfied,
they will deposit the bills with a London Bank in exchange of money, which they
will transfer to the merchant. OGC will collect small commission from either
parties to handle this exchange. OGC was playing the role of a broker.
Over a period of time, banks
started parking their excess funds with OGC. From being a broker, now OGC had
become a dealer.
Soon the company went
international and at one point in time was the largest Financial Services
company in the world turning in a profit of 200000 pounds over a turnover of 170
Million Pounds. The name of OGC had become synonymous with England’s credit
economy.
In 1836 and 1857, England
faced credit crises due to overheated economy. The 1857 crisis brought a
significant regulatory change that had significant impact on OGC.
Since 1825, the broking
houses had enjoyed access to loans from BoE in times of crisis. On analyzing
the crisis of 1857, one of the reasons identified was a tendency to rashness
among the bill brokers. It was also found that lion’s share of Bank’s emergency
lending was going to Brokers rather than other banks. It was felt that
emergency funding was encouraging speculation. So in 1858, BoE ended bill
broker’s access to BoE lending.
The above development,
instead of discouraging riskier investments had the opposite effect on OGC. The
firm’s portfolio was filled with speculative, long-term and high risk
investments (called ‘Junk Bonds’ in modern finance parlance). In addition, the
second generation of OGC started delegating much of the oversight job to
professional managers.
The combination of above
proved disastrous. The annual profit of 200000 turned to a loss of 500000. The
new managers attempted to regain profitability by taking riskier, long-term
bets funded by short term deposits from banks (asset liability mismatch)
By 1865 the situation had
become desperate. New capital was required. OGC went in for an IPO and off
loaded their problems on the public. Late in the year Bank rate was raised to
8%. There was anxiety and despondency everywhere.
In early 1866 an unrelated
brokerage firm of ‘Overend and Watson’ went into default. The illiterate
public assumed relationship and started withdrawing their deposits. In two
months 2.5 Million worth of deposits moved out of OGC.
On 9th May, the
company made an appeal to BoE for emergency support. This was immediately
turned down and in the afternoon of 9th of May the company suspended
payments.
The economy tanked. There
were runs on all the banks in the country. Only BoE was available to honor the
bills which they did at hefty interest of 9%. To tide over the crisis, the bank
resorted to printing new currency.
While the crisis was handled
over a period of time, it took almost three years for the economy to rebound.
The questions were: How did
this crisis happen? What were the causative factors? How could it have been
prevented? What are the lessons for the future?
These were the question
analyzed by Walter Bagehot, the then editor of the journal Economist. He
published a book in 1873, titled ‘Lombard Street, or, a description of the
money market’.
The two distinguishing
features of this small book were as follows. One, it started explicitly from
money, banking and finance, which he saw as the governing technology of modern
economic system. The second was his insistence that the theory should be
constructed to fit the reality of the monetary economy rather than the other
way round.
The first finding of the book
was that the money was not gold and silver (commodity medium of exchange), but
it is transferable credit. Fundamentally different factors explain the demand
for transferable credit as against the commodity. Meeting the demands of
commodities can be easily done by ensuring a sufficient supply of the metal.
But TC is different. In addition to volume, its demand also depends on the
creditworthiness of the issuer and on the liquidity of the liability. Both
these are determined by the level of trust on the economic system. As per him,
credit is an opinion generated by circumstances and one needs an insight into
its history, politics and psychology of the economy. None of these can be
learned though mathematical formula.
This change in understanding
called for alternate policies to handle crisis and recession. The first step
was to understand that the obligations of sovereign are more creditworthy than
the rest. Since BoE controlled all the banks and they in turn controlled the
brokers, the central bank had become the ‘Lender of the last resort’.
While central bank was
essential element in the modern monetary system, it did not have a properly
articulated monetary policy. The first prescription made by Bagehot was that Central
Banks role as a ‘lender of last resort should be made a statutory
responsibility. As per Bagehot, ‘In times of panic, the Bank must advance
freely and vigorously to the public out of its reserve’.
The second rule proposed by
Bagehot was that in its roles as lender of last resort, the bank should not try
to make nice distinctions between who is insolvent and who is illiquid. It
should lend on all banking securities and as largely as public asked. The goal
was to ward off alarm. The way to cause alarm is to refuse someone who has good
security to offer.
But if public knows that
there is a lender of last resort, wont it cause excessive speculation? To
handle this Bagehot recommended that the emergency lending should be made at a
high rate of interest.
Bagehot’s idea did not get
much traction since the classical view of money was very entrenched. Chapter 13
addresses these in detail.
Chapter 13
Classical economists
considered money as a commodity. Private credit instruments were just
substitutes for money and had value only if gold or silver was available to
redeem them.
There are three major
differences between the classical economists and Bagehot.
First is on the use of
monetary policy in crisis. Classical economists believed that since3 money is a
commodity, the BoE’s role is limited. BoE should protect its assets and raise
lending rate. As per Bagehot, since trust and confidence are low in a crisis,
Central Bank had a unique ability to restore confidence by playing the role of
lender of last resort.
Second difference is on the
cause of and ways to handle recession. As per classical economists, recession
is caused due to lack of supply which in turn cause lack of demand. The way to
handle recession is by producing more and increasing supply, the so called
‘supply side economics’. As per Bagehot, recession was caused by lack of money.
When economy fell into recession, the demand for money, unlike that of
commodities, increases. So the correct way to handle a recession is by
increasing money supply.
The third difference between
Classical Economists and Bagehot related to the role of Money. As per classical
view, money is just a medium of exchange facilitating the exchange of
commodities. The economic value belong to the commodities being transferred and
hence money can simply be ignored in this analysis
As per Keynes, realistic view
of money should consider both fiscal and monetary policies. In the real world
there is no guarantee that supply will equal demand since people can and do
hoard money. Proactive policy to boost demand is by ensuring that sufficient
sovereign money is available to meet the demand during the crisis. In addition,
if private sector is unable to spend, government should us its money to
kick-start economy. Keynes ideas seemed to have caught on in the aftermath of 2nd
world war.
From the ‘moneyless’ view of
classical school evolved the modern orthodox economics. By focusing on the
production and consumption, economics ignored money altogether. From the
practitioners of Bagehot school, evolved the discipline of finance – a
framework for understanding money, banks and finance.
There you have it!!. The
reason for the crash of 2008. There was no integrating framework between
economics and finance. Those who knew economics did not understand finance and
those who knew finance did not understand economy.
Chapter 14
In the year 2007, the world
faced a major economic crisis. Northern Rock (NR) is a leading bank in the UK.
The business of the bank is to provide long-term mortgage loans. The deposits
of the bank consisted of short term CASA deposits. Assets (long term mortgage
loans) were backed by Short term liabilities.
This was a classic ‘Asset
Liability mismatch’.
At the first whiff of an
impending crisis, depositors started withdrawing their deposits. This created a
liquidity crisis for NR. The bank approached BoE for liquidity support.
Central Bank providing
liquidity support to banks at time of crisis was a practice followed by the
central bank ever since Bagehot recommended the approach. BoE agreed to provide
liquidity support to NR. However, the crisis did not end there.
In case of a bank, the assets
are the loans that it makes and the liability is its deposits. In normal
scenario, value of Assets should be higher than that of liabilities, the
difference being the equity capital of the bank.
In the case of NR, it was
found that many of the loans that it had made were defaulted and the bank was
in a situation where the value of assets were less than the liabilities. The
equity capital had completely eroded.
NR was in the verge of
bankruptcy unless government intervened. This was a novel situation without any
precedent. While central bank providing liquidity support to handle the
liquidity risk was normal response, this was different. No one knew how to
handle credit risk.
The best option would have
been to let NR fail due to its mismanagement. However, government was worried
about the wider impact of allowing the bank to go bankrupt. So after a lot of
thought, the government decided to nationalize Northern Rock.
While the general public did
not understand the full significance of this move, the smart money was quick to
realize the magnitude of the problem. In one shot, by nationalizing a bank,
the tax payer was owning the cost of mismanagement leaving the employees, the
bond holder and the shareholder off the hook.
This was a recipe for
disaster. World learned some lessons from this move of the British Government.
So when Bear Sterns faced similar issue in the US, government did not
intervene. It was left to another private bank, J P Morgan, to buy out Bear
Sterns.
Almost immediately the US
Government faced the next crisis. Lehman brothers also faced the same issue as
was faced by NR and Bear Sterns. The US Government did not intervene and
allowed Lehman Brothers to declare Bankruptcy.
The crisis did not end there.
One by one, major banks and other financial intermediaries started approaching
the Government for bailout. Soon world saw an embarrassing spectacle of US
Government providing credit (equity) support for some huge banks and insurance
companies (AIG).
Similar drama was getting
played out in other countries as well. Almost 17 countries in the world spend
close to 14 Trillion to prop up the loss making banks.
From being a ‘Lender of last
resort’, the Central Bank was morphing to ‘Loss bearer of the last resort’. The
impact of this was predictable. Around the world banks have grown in size,
reduced their capital buffer, made riskier loans and decreased the liquidity of
their assets. Tax payer end up bearing 100% of the downside while the bond
holder and employees get the 100% benefit of any upside.
In earlier times, tax payers
used to be the same as bond holder of banks and hence the idea of bailing out
the banks would not have been contentions. However, in modern times, two
factors undermined the relationship between tax payer and bond holder. One was
the class divide between wealthy bond holders(who were a minority) and others
who were majority. Second was the internationalization of high finance. The tax
payers of one country were footing the bill of bank recapitalization that
was benefiting foreign bond holders.
If taxpayer having to bear
the credit risk of banks were bad enough, worst was yet to come. The period
from 1980s had seen technology significantly impacting the market for debt.
Initially debt was an agreement between a bank and the borrower. The loan
remained on the books of the bank as an asset and on the borrower’s books as a
liability. However, the decade starting 80s saw the debt markets exploding in
the US. Corporates were bypassing banks and issuing debt instruments directly
to investors.
The years following the 90s
saw technology supported financial intermediation. The nature of debt markets
started undergoing significant changes. The debt instruments started moving
from the Originator through various intermediaries, changing form at each
intermediary, till it reached the final owner, a money market mutual fund
(MMF).
For example, let us say that
a bank issuing a loan. Traditionally, this loan would reside in the books of
the bank. In the new paradigm, the bank immediately sold off the loan to a
financial intermediary. The loan no longer existed in the books of the bank.
The intermediary will package different loans from different issuers
(Securitization), create an asset backed security (called, Collateralized Debt
Obligation, CDO) and sell it to a money market mutual fund (MMF).
The end investor will buy
units of the MMF. Now the money will start its reverse journey, finally
reaching the bank, with intermediaries taking their commissions.
The biggest problem was that
in the entire cycle, somewhere the liquidity risk became hazy. On the one hand
there was a long-term , illiquid asset, the original loan created by the
bank. At the other end of the cycle was the MMF promising short term cash
withdrawals. Strip off the intermediaries, this was a classic ‘Asset Liability
Mismatch’, with its attendant liquidity risk and the inevitable credit
risk.
Except, there was one
catch...
None of the above risks were
in the formal banking system. The moment it sold the loan to an intermediary,
the loan had miraculously disappeared from the Banking System. When the crisis
stuck, government was faced with the choice of bailing out the ‘Shadow Banking
System’. In the 6 weeks between 10 September and 22 October 2008, the balance
sheet of US Fed doubled and that of the BoE more than tripled.
The next chapter discusses
the sovereign’s response to the crisis and the role of the regulators.
Chapter 15
Since the Grand Monetary
Settlement between ‘Money Interest’ and Sovereign tilted in favour of the
former leading to its misuse and the crisis of 2007, regulatory reforms (known
as Basel Reforms) have been taking shape in the Bank for International
Settlements (www.bis.org), based at Basel,
Switzerland.
The first reform initiated by
BIS was a directive requiring the banks to hold more capital and more liquid
assets in their portfolio (Capital Adequacy Norms). This acts as a tax on the
banks, thus discouraging excessive lending.
(Note: It is not clear how
this will work since, as we saw in the previous chapter, none of the loans were
in the books of the bank)
However, experts are skeptical
of the efficacy of the regulatory norms. Reasons vary. First is the scale of
the problem. The potential social costs of operating the monetary system as it
is currently configured is simply too large to be discouraged through the
system. The social costs include cost of lost GDP, of mass unemployment, and of
lost capacity. It is impossible to recover these costs from the defaulting
banks.
Second reason why taxation
would work is the networked nature of banking system. While the banking system
is international in nature, the legal jurisdiction is still national. Even if
taxes have to be levied as per the rules, there is no multi-national political
authority that can enforce the norms.
Third reason for the
skepticism on the ability of the regulatory system to control excesses is the
innovative nature of the emergent financial system that can easily circumvent
the regulations. Actually the conventional regulations proved
counter-productive in the aftermath of the 2008 crisis. Forcing banks to raise
the capital ratios reduced the availability of capital at the precise time that
it was needed.
Here it is worth pointing out
that regulations put in place around the great depression of 1929, including
the Glass-Steagall act and the McFadden act went a long way in ensuring long
term stability of banking system in the US. It was the relaxation of these
controls in the 90s that led to the excesses that created crisis of 2007-08.
The question is, if the tax
regulations are ineffective, what are the alternatives?
The Volker committee in the
US and the committee headed by John Vickers in the UK, both of which were set
up to look in the financial sector reform in the aftermath of 2008 crisis,
recommended the segregation of the retail (deposits and payments) and wholesale
(market based) activities of the banks. However, these reforms have not brought
about desirable level of Financial Stability.
Why?
As per the author, the
‘Social Technology’ perspective of money could provide some answers.
Money issued by Sovereign
will work since Sovereign has the political authority. Private money will
become prominent only when sovereign loses confidence of its citizens. A
critical prerequisite for sustainability of monetary society (Financial
Stability) is a safety valve of a variable monetary standard. So long as
citizens permit the sovereign a discretionary power to re-calibrate the
financial distribution of risks by adjusting the standards when it becomes
unfair, Sovereign money can work.
The problem is that in the
modern world, all the money in circulation is issued by the Sovereign. Banks
also issue money. So how do banks promise to deliver both stability and freedom
that is the promise of money? As per theory, this is done by ‘Liquidity
Transformation’, by transforming liquid, short-term deposits into illiquid,
long-term loans. Note that no actual transformation takes place. The assets
still remain illiquid and long –term and liabilities still remain liquid and
short-term. The mirage of transformation is achieved through synchronization of
payments in and out of the balance sheet of the bank.
When things are going fine,
this will work. But as soon as crisis of confidences hits the system, banks
cannot handle the increase in withdrawals since the carefully constructed
balance of cash flow is no longer applicable. That is the reason why banks need
Sovereign backing and authority, which the Great Monetary Settlement was to
have provided.
Global banking’s current
structure generates an unjust distribution of risks. The losses are socialized
– tax payer funded bailouts cover the losses – while gains are reaped by banks
and their investors.
Two options are suggested to
handle the skewed risk-reward ratio mentioned above. First would be to
privatize all the risks – restructure the system so that investors bear all the
costs and reap all the rewards.
Problem with the above
approach is that the conversion of debt to equity would leave economy totally
at the mercy of market forces, leaving sovereign unable to intervene in times
of crisis. Money would no longer be a tool of government.
Second option would be to
redesign the financial system to socialize the risk and rewards. What UK did
with Northern Rock (Bank Nationalization) is the template for this
approach. The problem with this approach is that instead of becoming a
tool of the government, money would become the government. All benefits of
decentralized decision making in finance would be gone.
It should be noted that the
first option was similar to what John Law did in France. This was the spirit of
the recommendation of both Volker and Vickers. US Economist Robert Schiller has
long advocated the issuance of bonds that pay interest linked to GDP. This is
another approach where investors bear the risk as well as the reward.
The traditional view of money
provides three principles for the reform of banking system.
First, design policies that
will shift more of the risks and costs to the investors.
Second, since money is a tool
for organizing the society and only authority with the political legitimacy is
the sovereign, any redesign must maximize room for monetary policy. Monetary
tools should have the escape vale of flexible monetary standard.
Finally, set as few rules as
possible to supervise the financial sector and police them rigorously. This can
be done by restricting sovereign’s support for a limited range of banking
activities.
As per the proposal by
American Economist Irwing Fisher, any deposit that could be withdrawn or used
to make payment on demand must be backed by Sovereign money, and banks which
offer such deposits will be permitted do no other business. This is the concept
of ‘Payment Bank’. Any other activity by the bank will neither enjoy sovereign
support nor suffer sovereign supervision.
There are two advantages to
the suggestions made by Fisher. One, the financial risk will be circumscribed.
A clear distinction between ‘narrow banking’ and other banking activities will
eliminate moral hazard from the system. Second, this will also preserve
monetary policy and money’s integration with the society. The rules for narrow
banks would be few but draconian.
Most of the issues in the
current century are due to incorrect configuration of money and banking. And
the same, correctly configured will take us out of the morass and make the
world great again.
