Thursday, May 1, 2014

Once Upon A Time… Money Fairytales

Sit down, and let me tell you a tale of intrigue and tragedy. Long, long, ago humankind emerged from the dark primordial swamp of hunter-gatherer subsistence living and began the first primitive marketplace. Attempting to barter and exchange goods with one another, they soon discovered there was not a complete “coincidence of wants” – i.e. the leatherworker desired bread, but the bread maker desired bricks from the stonemason for a new oven not a sling from the leatherworker.

And so, as the story goes, money was born. Perhaps money may have started as the baker’s IOUs (since everyone wanted bread and would accept his “credit”), but eventually pure gold & silver became the best store of value and means of exchange and everyone lived happily ever after… at least until banks came along.

Those with extra money after meeting their needs wanted safekeeping for their gold and silver hoards and so banks were created to safely store their wealth. To make more money, the banks started lending out the gold (or receipts to gold) with interest to others who needed it. Not satisfied, the greedy bankers then began lending out more than they held in deposits, and so fractional reserve banking took over, inflating the money supply, causing inflation, and triggering economic crises.

Meanwhile, governments joined in by progressively devaluing the pure gold coins by debasement (reducing the gold content-to-price ratio) and seigniorage (dictating that the face value of their coins exceed the underlying precious metal value). Eventually, governments ditched the firm anchor of gold altogether and launched the world down the perilous path of un-backed “fiat” money, printing our way to hyperinflation and economic disaster. 

And so we await the knight in shining gold and silver armor to rescue our doomed civilization from the clutch of fiat-printing central bank dragons.

It’s a great story … for a novel. It is also largely fictional. Unfortunately, when fairy tales become economic history textbooks, much trouble enters the land.

Historians will tell you a much different story: one of circulating credit based initially around agrarian calendars; of sophisticated banking systems and credit clearinghouses enabling trade across continents; and of State-based monetary systems dating back into the early Mesopotamian valley civilizations over two thousand years BC. Throughout history, money has been credit, and for a very long time, most money has been State money enabled by some form of taxation. Whether inscribed and encased in clay or etched into wooden tally sticks, records of creditors and debtors have been recorded for thousands of years, and have functioned as the backbone of commerce and as a means of States to provision resources to themselves.

For those raised on the view that gold-backed money and 100% reserve banking equals “happily ever after”, it is important to know that such a system has rarely if ever actually existed in the real world. There is much evidence to the contrary. And even if one isn’t persuaded from history, we can at least agree that our present monetary systems are definitively State-based, backed by taxation, and have no link to gold. They require no borrowing from the population or from abroad, and so we cannot understand their function through the prism of gold-based or gold-convertible currencies. 

Before we pine for a golden "ever after", let’s first understand first how our current system works so we can operate it correctly, and cast off the confused policies that make nations pretend they live under imaginary constraints of a bygone and somewhat fictional era. Then we can deal with the real constraints head on.

State Money & Not State Money

So money as we know it is sovereign State money. A national currency is exactly that – the nation has a monopoly on the ability to issue its own currency. Our money is the thing we use to measure wealth, value goods and services, and account for transactions between buyers & sellers. Examples include the US dollar, the British Pound, Swiss Franc, the Canadian, New Zealand and Australian Dollars, the Japanese Yen and the Chinese Yuan Renminbi. Countries that operate this way have more flexibility than those who don’t.

Note that some countries have given up their sovereign currency. In Europe, the Deutsche Mark, French Franc, Italian Lira, Spanish Peseta, Dutch Gulden, etc. were surrendered (what were they thinking!) in order to share a currency that each country no longer issued (the Euro). Other countries use another nation’s currency or they issue their own currency but promise to keep its value in line with another currency that is viewed as stronger than theirs. A number of Central American countries do this with the US Dollar and some Pacific islands use the New Zealand Dollar. These countries all limit the range of policy options available to their citizens by removing or limiting the freedom they would otherwise possess as a currency-issuing sovereign State.

More reading on the history of State money