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.

 

 

Microfinance and its challenges

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Photo Credits: Jaimoen87 on WikiCommons License: Creative Commons Attribution-Share Alike 3.0 Unported

Microfinance in recent years has been touted as one of the most potentially effective poverty alleviation programs in the developing world. From the humid paddy fields of Bangladesh to the cluttered squalor of rural India, the bottom-up approach to economic development has indeed proved both efficient and successful in combating the wide variety of issues faced by those living in absolute poverty. Essentially, what this global game-changer is is an access path to financial services for those in poverty who lack many of the things that make people (or businesses) successful debtors (such as a verifiable credit history). This could help them lift themselves out of the poverty trap, for example by providing the funds to help them start start successful businesses. When Muhammad Yunus came up with the idea during a 1970s Bangladeshi famine, however, he had, by his own admission, never thought that the greed of man could turn his brainchild into just another failed poverty alleviation plan. Of course, in addition to this, there’s a variety of reasons why the programme doesn’t work perfectly, the most important of which I’ll go through in this article. Despite this though, it has to be said that despite its flaws, microfinance has “changed the game”, so to speak, and is by far one of the greatest ideas, in my opinion, in recent economic thought. With the right economic agents involved, it could still be a major warrior in the fight against absolute poverty in the developing world, however, it will need to surmount some obstacles first.

To provide some context, let’s take the perspective of Afghanistan, one of the poorest countries in the world. In Bamiyan, about 240 km northwest of the Afghan capital, Kabul, a field study microcredit initiative was put in place, whereby low-interest small-scale loans were provided to impoverished Afghans in the hope that they would spend the money in such a way that they were pulled out of the clutches of the poverty trap. Alas, even though a strong potato crop within the area would provide a promising source of growth for any business set up using microcredit funds, the funds were disappointingly used partly by the Afghans to finance consumption. While you might think of this as simply a strange Afghanism, such phenomena have been witnessed all across the developing world, and when one thinks about it, it makes quite a bit of sense. When you’re in that type of situation with barely enough funds to ensure your next meal, it’s natural that any injection  of cash would be used to ensure that you’re able to fund consumption of all your necessities. In addition to this, not everyone is an entrepreneur; not everyone possesses the set of skills to turn a theoretical business plan into a workable business model and not everyone is willing to take the risks that an entrepreneur takes. Hence, the notion of microcredit, and microfinance in general that everyone can become an entrepreneur is slightly flawed and something which has a large negative impact on the potential effectiveness of microfinance to pull people out of the poverty trap by facilitating entrepreneurship.

While the microfinance initiative aforementioned in Afghanistan was only a pilot study, another significant drawback of microfinance is its potential inability to secure the low interest rate loans that are so critical to its success. This is because many of the areas which microfinance targets are rural and therefore hard to reach. Actually reaching these areas both to administer loans and enforce their repayment would take a large investment in both physical and human capital, something which raises the cost of making loans and therefore (assuming microfinance firms are profit minded as well as socially conscious) increases the interest rate which these firms have to charge in order to generate their target return on investment. The loan sharks who charge exorbitant interest rates to impoverished rural dwellers suddenly now look not too different from the microfinance institutions themselves, with the two now differing in intention only (and perhaps a few percentage points on the sky-high interest rates offered). Although the economies of scale generated through lending to a group of people at once go some way towards mitigating this, even slightly lower interest rates than aforementioned would be hard to repay for individuals who often have irregular income flows and don’t earn all that much in the first place.

Even though the previous two points are entirely valid when looking at the viability of microfinance to meet its end objectives, the idea definitely still has some merit. Alas, when implemented in real life, it fell flat due to economic agents (namely firms) acting in their own self-interest. Of course, the firms I’m talking about are the large banks that to a large extent caused and amplified the huge negative impact of the 2008 financial crisis on the global economy. Banks have taken over the microfinance scene in recent years and charge rates of 100 percent or more to impoverished borrowers who obviously don’t have any chance of repaying loans at these huge interest rates. The idea that the majority of institutions offering microfinance facilities could be both socially and profit driven has therefore been shown to be untrue in reality, as these large banks seem to only desire profit above the social and economic betterment of their poor debtors. While regulation in disadvantaged areas remains tenuous at best and extremely difficult to implement, profit-driven institutions take advantage and reap massive profits at the expense of clients. Therefore, they represent a massive blockage to the road which microfinance could have taken to drastically reduce global poverty rates. It is hence my opinion that only once banks’ motives change, or banks are purged from the microfinance system altogether can microfinance continue to transform lives at the breakneck pace it once did.

This’ll be difficult, but it’s worth it – ideas like this one don’t come about all too often.

What caused the demise of Lehman Brothers?

Till date, the biggest bankruptcy ever seen in US history is the crash of Lehman Brothers. The former fourth largest investment bank in the world filed for Chapter 11 Protection with more than $639 billion in assets 7 years ago. Images adorning the hallowed newspaper sheets in the days after its September 15, 2008 collapse were of its dejected employees leaving the company buildings, never to be seen again. However, opinions differ as to what actually caused this gargantuan crash. In truth, it is an amalgamation of many different factors that led to the collapse of the gigantic investment bank. Continue reading “What caused the demise of Lehman Brothers?”

Should the Federal Reserve raise interest rates?

Photo by Dan Smith, License: CC by 2.5

Note: If you want to gain a basic grounding into government policy and its effects on currency, please read my previous article on the aforementioned subject.

Within the sphere of economics and economic thought, the discussion which has overwhelmingly prevailed, above others, is that of whether the Federal Reserve, the central bank of the United States, should raise interest rates or not. At the current moment, the tide seems to have shifted towards a tightening of rates, however, the opposition towards an interest rate rise is still unyielding. Economic scholars, who believe that an interest rate hike is the right way to go, assert that the hike will boost job growth through an increase in both opportunity and actual cost of automation, and that it will boost consumer spending, according to the Keynesian model. However, proponents of keeping rates stable argue that a hike would send financial markets into turmoil, perhaps even worse than their late August plunge. Funnily enough, the one minim that both sides agree on is that whatever happens, a Fed rate hike would change the global economic landscape forever. However, in this article, the case for raising interest rates will be argued, as that is precisely what I firmly agree should happen. Continue reading “Should the Federal Reserve raise interest rates?”

The surge of Amazon: What makes it so incredible?

Photo by Steve Jurvetson, Licence: CC by 2.0

Amazon, quite simply, is an American e-commerce company that has erupted onto the global market in recent years, with its share price rocketing and customer base booming. Its founder Jeff Bezos has ensured that his brainchild has continued to be relevant in an ever changing market, and, as of today, Amazon not only survives, but thrives. Although other companies such as Alibaba have seen a rapidly depreciating share price, Amazon makes sure that its profits continue to soar and that it takes up an ever increasing market share, in a market that should be positively brimming with competition and fresh faces. It does this through a simple but ingenious business model, which has ensured itself a steadily growing base of regular users, who are willing to spend disposable income on items sold and marketed by Amazon. Continue reading “The surge of Amazon: What makes it so incredible?”

How I think we can solve the problem of poverty in India

It is clear to see from the past few years that India’s economy has been surging. With their economy now being classified as the fastest growing economy in the world today, it would look like everything is good in this country of 1.2 billion. However, what the Indian underclass will tell you is a story that is starkly different from what Indian businessmen such as Ratan Tata will say. The problem of poverty in India is a dark stain on the face of humanity, with Indian labourers frequently toiling 10 or even 12 hours a day, for little or no reward. For too long has bureaucratic red tape covered up the real problem, which is that a greater proportions of Indians need to be above the UN poverty line. To do this, we need progressive and constructive solutions, some of which I am trying to provide here. Continue reading “How I think we can solve the problem of poverty in India”

Why oil prices will go lower from here

The dramatic markdown in oil prices in the years of 2014 and 2015 has gotten everyone talking. On one side, there are those who say that oil is simply too big a component of our lives for prices to remain this low, and on the other there are those who believe that a combination of supply-side and demand-side factors will make sure that oil prices will stay at the current level, and perhaps even go lower. I tend to agree more with the latter, as a plethora of conditions are required for oil prices to go up, and, as of now, none of them are being met, and perhaps will not be for the foreseeable future. The first reason why oil prices will go lower from here is a reduction in global demand. Continue reading “Why oil prices will go lower from here”

Lessons learnt from a 15 year old’s voyage into the financial markets

Having traded the financial markets in my holidays, and having made a little over five figures in that time, I feel that not only have I found a gratifying pastime, but also that my knowledge about financial markets has been vastly increased, from many mornings spent watching Bloomberg on a TV screen. The gains have been marvellous, the losses not so much. My general knowledge of global events and their repercussions to the markets has also increased. Above all, however, the most salient thing is that a sound base of knowledge has been built for, hopefully, a lifetime of trading on the financial markets. Many lessons have been learnt from experience, incipiently to ignore the brunt of what the news says. Continue reading “Lessons learnt from a 15 year old’s voyage into the financial markets”