FIAT MONEY AND FATE OF ECONOMIES
Mar 21 - 27, 2011
The Incas that were to be vanquished by the Spanish conquistadors in early sixteenth century appreciated only aesthetic value - not economic value - of precious metals like gold and silver. To them, gold was 'sweat of the sun' and silver 'tears of the moon'. Like a communist society, the Inca empire thought of 'labor' as the unit of value. They could not believe in the greed and keenness European nations showed for gold and silver. When imprisoned by the Spanish conquistadors led by Francisco Pizarro, the Incan emperor Atahualpa tried to secure his release by offering gold that could fill the entire room he was held at, in addition to silver twice the quantity of gold.
Niall Ferguson writes in his book The Ascent Of Money "The Incas could not understand the insatiable lust for gold and silver that seemed to grip Europeans.... The Incas could not appreciate that for Pizarro and his men silver was more than shiny, decorative metal. It could be made in to money: a unit of account, a store of value - portable power."
Potosi the silver-city of South Bolivia housed a 4,824 meters high Cerro Rico peak. With the discovery of Potosi silver wealth, a landmark in the history of world economy was reached. The Spaniards took away this wealth at the cost of uncountable human lives - the lives of miners who were forced to work in the mines of Cerro Rico. According to the monk Fray Antonio de la Calancha, every Peso coin minted cost the lives of ten Indians who died in the depths of the mines. Between 1556 and 1783, Spaniards mined 45,000 tons of silver that was transformed into bars and coins. Surprisingly, the sliver mountain could not help Spain in attaining a distinct economic and financial position.
Niall Ferguson writes "Cursed with an abundance of precious metal, mighty Spain failed to develop a sophisticated banking system, relying instead on the merchants of Antwerp for short-term cash advances against future silver deliveries. The idea that money was really about credit, not metal, never quite caught on in Madrid. Indeed, the Spanish crown ended up defaulting on all or parts of its debt no fewer than 14 times between 1557 and 1696.î
Known as one of the greatest innovations of the seventeenth century, the creation of Bank of England in London in 1694 gave impetus to the concepts of 'fractional reserve banking' and paper money. Established primarily with the object of financing government's war effort, the bank was subsequently given the status of the only bank allowed to operate as a joint-stock company. Still later, in 1742, the bank established a partial monopoly for printing currency notes. The issue of currency notes was, however, restricted by statute to the amount of securities (sterling pound 14 million in 1844) and unspecified amount of coin and bullion that varied according to England's balance of trade with the rest of the world. The conservative stance of the bank never allowed the stock of currency notes to exceed the amount of bullion held in reserve. The sacred principle was that a pound sterling should be convertible into a fixed and immutable quantity of gold according to the rate of three pounds, seventeen shillings and ten and a half pence per ounce of gold.
The trend of minimum currency printing adequately covered by securities and gold held continued till World War I. Those were the days of price stability, a fact admitted by the exponents of free market economy, a bit reluctantly though. Niall Ferguson writes "In 1924 John Maynard Keynes famously dismissed the gold standard as a 'barbarous relic'. But, the liberation of bank-created money from a precious metal anchor happened slowly. The gold standard had its advantages, no doubt. Exchange rate stability made for predictable pricing in trade and reduced transaction costs, while the long-run stability of prices acted as an anchor for inflation expectations."
The free market economist however hastened to believe that the British economy would have choked had the money supply been restricted to the quantity of gold coins and bullion held in the reserve account of the Bank of England. With the removal of restrictions on joint-stock banking in 1858, big commercial banks like the London & Westminster, the National Provincial, the Birmingham & Midland , Lloyds and Barclays took to the inevitable course of abundant credit money creation to give free market exponents a false sense of economic expansion and consumer wellbeing. Economic expansion and credit money supply are the two key expressions that carry the burden of so-called economic booms and busts. These expressions have seen the world economy rising to unprecedented heights one day and then coming down like a termite-eaten wooden house the other. Gone is the age of silver and gold. We now exist in paper-money era, technically known as fiat money system.
Fiat money system allows a simple piece of paper printed by the government to assume huge economic value with no intrinsic value at all. The 1945 Britton Woods system pegged the value of US dollar at $35 to an ounce of gold. Other world currencies were pegged to the US$. World central banks were entitled, and the US Federal Reserve was bound, to convert their stock of dollars, accumulated as a result of foreign trade, into gold. The unrestrained expansion of dollar resulting from an irrational urge to control world economy put the US in a tight corner when claims for conversion to gold started arising worldwide.
Encouraged by its formidable military strength, the US took the unilateral decision of abolishing the convertibility of dollar to gold in 1971. That was a bizarre economic decision that pushed the entire world economy into the grip of perennial inflation. Pakistan rupee had to undergo a massive devaluation of 131 percent. The economies were now free to print as much money as they liked without any gold or any other precious metal backing. The interest based economy and the fiat money system work in unison to fuel inflation. An interest charge adds to the cost of doing business and since interest has to be paid each year, the prices of goods and services keep on rising ad infinitum.
Besides governments' prerogative to throw as much fiat money into the economy as it may wish, the bank's unbridled power to create credit money adds another dimension to the inflationary economic model. Presently, our total bank deposits stand at around Rs5 trillion against the total issued currency of around Rs1.5 trillion. The corridor between the total real money ñ issued currency ñ and total bank deposits is represented by the credit money generated by the banking system. The conventional banking relies on its core business of accepting customer deposits and lending money to the various sectors of economy namely business, industry households, and consumers. It raises credit money by allowing loans to these sectors from the money it holds in the shape of customer deposits. The process of generating credit money through banking system has become so vital for the free market economic model that MBA students at Harvard Business School are trained by their professors to comprehend it through an act of simulation in the classroom.