On money and its value

Money (a good that acts as a medium of exchange in transactions, among other things) is the blood that flows through the veins of any capitalist economy. As Lord King proclaims in his book The End of Alchemy, money helps us to cope with an unknowable future by enabling us to hold a store of generalised purchasing power with which to buy goods and services that might not yet exist. A capitalist economy is inherently dynamic; after all, the innovation of economic agents is what drives its existence. Generally, the free market mechanism (using money) works to maximise sales of the goods that we feel maximise our utility, or satisfaction, with relation to their cost. Returning to King’s book, however (after reading it last year), I was struck by some of the examples the ex-Bank of England chief used to illustrate some key points about what gives money its value. Most notably, the example of the different Iraqi dinars used in two parts of Iraq before Saddam Hussein was deposed piqued my interest. Rather than trying to explain it better than Lord King did, I implore all the readers of this article to read about it in The End of Alchemy. The example, though, got me thinking – what backs the paper money of today, giving it value?

The easiest way for me to think about this was to ponder what has historically given money its value, and draw parallels with today. In the past, the widely-used gold standard meant that you could exchange your paper currency for a specific quantity of gold, essentially meaning the paper money was backed by the relevant authority’s gold reserves. Such a system was commonplace, used in both the UK and the USA. The last time we saw the pound or dollar being convertible on demand to gold (either directly or indirectly) was in the Bretton Woods system of the late 20th century, which collapsed in 1971, and it’s a relatively safe bet to say that we won’t see another gold standard anytime soon. We can see how gold is valuable, though; it can be used for a variety of things, from piping to jewellery. So, holding a quantity of gold means that we hold something of value, and exchanging a claim on this value for goods and services gives someone else a claim to that value. Perhaps, then, money must be backed with something valuable to the real economy.

What, of value, backs the paper money we use today? For one, an independent central bank (or an equivalent branch of government), present in much of the developed world today. History has shown us that central banks can, and have recently been successful in taming inflation (see below). This alleviates the probable fear that holding fiat money means rapidly decreasing purchasing power from one year to the next. Good governance, then, may give money its value. That may perhaps be why we are so quick to accept that what a central bank says is £5 is actually £5; we have confidence in the entity issuing the notes and can trust that it will continue to be worth roughly £5. This also explains why countries with questionable governance, such as Venezuela, are suffering such extreme bouts of hyperinflation (although it’s not the whole story). But is the backing of dependable monetary governance really “value”? We can’t build pipes or make jewellery with it. What we can do, however, is convince others to buy our goods and services with paper money, assuring them with reasonable certainty that the value of the money will not suddenly appreciate through a sharp bout of deflation. We trust our notes and coins to not rapidly appreciate or depreciate in value, and that’s why we make and receive payments when we do.

If trust is present, then, do we need a central bank or government to “back” the currency? History says no. Take a look back at the example above – in one part of Iraq whose currency was the so called “Swiss dinar”, there was no credible system of government or central bank, however the Swiss dinar broadly retained its value.  This proves by contradiction that we do not actually need any sort of centralised authority to give our fiat money its value. We can see, though, that we still need the trust that a centralised authority can instil.

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Source: Reproduced by moneyandbanking.com from Alesina and Summers, “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit and Banking, May 1993.

Concluding, then, it’s clear that our paper money isn’t backed by something as physically valuable as gold, and for the flexibility of our monetary policy’s sake, that’s probably a good thing in my opinion. What I would say here is that our fiat money, today, is backed by trust, namely trust that our money will broadly retain its value from one day to the next, and continue to be widely used in transactions. Can this be instilled by centralised government or a central bank? Definitely; we’ve seen that in the UK and the USA. Does it have to be? Iraq tells us no. Social cohesion and/or a record of money previously maintaining its value, among other things, could deliver the trust that is essential to preserve money as the lifeblood of a thriving capitalist economy. Such an arrangement connecting money and trust is fragile, yes, and it is scary to think of the impact on our economy should we lose our trust in money’s ability to retain its value. It is for this very reason that I believe that sound social institutions and governance are some of the most important prerequisites for a successful capitalist economy to form. Without them, people lose trust in money, and without money as we know it, we see the end of our brand of capitalism.

 

 

Why central banks should target 4% inflation

Photo by Remy Steinegger

It is October 29, 1929 , also known as Black Tuesday. The Great Depression, one of the largest economic downturns in history, has just begun. Unbeknownst to the everyday man and woman, this will last a backbreaking decade, during which these everyday people will see their dreams slashed in the face of lower wages. That is, if they even find a job in the first place; unemployment will reach almost 25% in America at the height of the depression in 1933. During this time, it’s obvious that we will start looking to policymakers for solutions to this problem, however, even they have been silenced by the lunacy of the gold standard: there are no solutions in the pipeline.

Time for a voyage into the future. 1990, specifically – New Zealand. The Reserve Bank of New Zealand has just introduced a pioneering measure that will shake up monetary policy: the inflation target. They say they target a rate of price increase of 0 to 2%. Fast forward 22 years, and on the 25 January 2012, Ben Bernanke, the chairman of the most famous central bank in the world, the Federal Reserve, has introduced a 2% inflation target. Nowadays, the magic “2” is the norm, with central banks from the Bank of England to the Bank of Japan adopting the target. The problem? Well, there’s more than one, but the most arresting drawback is that we’re veering into very dangerous territory should we be even slightly amiss in meeting these targets.

Say we undershoot from our inflation target. That can happen, right? People make mistakes – even big, bad central bankers. If prices, therefore, appreciate by only 1% a year, that’s not too bad. But say we adjust the degree of error even more, and then we’re veering dangerously into deflationary territory – a nightmarish decrease in prices. In both my opinion and the opinion of many others, deflation is far worse than even high levels of inflation. This is because a deflationary slump in an economy causes people to think twice about purchasing goods and services, reducing demand for these goods and services, decreasing their prices to levels lower than they already are. Intuitively, this causes job layoffs as the reduction in demand causes a corresponding reduction in corporate revenue, and so the freshly unemployed aren’t very likely to buy non-essentials like a bottle of Coke or a packet of gum, let alone a new house. The ensuing vicious downward price spiral amidst a plethora of redundancies has historically been extremely difficult to get out of; deflation can batter an economy like nothing else. Where do we look for an example of this? Back to the past, that’s right – the Great Depression, where prices plummeted and redundancies soared due to a collapsing banking sector.

Moreover, recessions happen. We can’t prevent all of them, and it’s a fact of life that the average person is overwhelmingly likely to experience at least one or two in their lifetimes, if not many more. It’s how a central bank deals with the recession that defines how strong and robust their monetary policy is, and when you can only decrease interest rates by a small amount, then you’ve got a problem. Take the Bank of England. Interest rates currently sit at staggeringly low levels: 0.5%, to be precise. Let’s assume they meet their inflation target of 2%, and so the nominal interest rate (the interest rate when we don’t take into account inflation) will be 2.5%. Now, let’s hypothesise that they increase their inflation target to 4% and meet it (I know, I’m optimistic about their abilities). Now we have a wiggle room of a whole 4.5% should we face a recession, so we have a greater chance of stimulating the economy and getting it back on track. Even taking into account that central banks may not meet these targets, it’s logical to believe that they’ll at least achieve a higher inflation rate than before, and so regardless of the scenario, the overwhelming likelihood is that we’ll have more chance of beating back a recession than before.

Finally, we need to lend the companies that are the backbone of our economy a hand in being able to dish out nominal wage increases. Again, let’s take a scenario whereby we have higher inflation, say 3% (due to central banks undershooting the 4% inflation target) and the nominal wages of not very productive employees operating in, for example, McDonalds rise by 2%. In reality, they’ve still got 1% less purchasing power than they did before, however McDonalds’ 2% rise in wages keeps them happy and satiated; they won’t go on strike or resign or do all the things that corporations fear so much. Say we had a much lower inflation rate, perhaps 1%. Now, McDonalds is in hot water because they can only increase wages by a small, small amount, risking the ire of its employees. If the inflation rate went even lower, then we have even more of a problem; McDonalds cannot hand out relatively large nominal wage increases, as if they were to do so, their costs would increase, therefore enabling a reduction in profits. So now we have annoyed corporations, annoyed employees and perhaps an economy on the verge of recession, with very little room to alter interest rates when we enter one. All because of those dastardly low inflation rates.

Since 1990, the inflation target has become one of the key symbols of monetary policy and central banking. We need to increase it; I think it’s time to change this symbol for the better.

Do you?

Shrey Srivastava, 16