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Thursday, 25 September 2008

Economics of Money and Inflation in Historical Perspective

Money! It is around which today’s world revolves. But have you ever thought of how money is defined? We all know that a dollar note is considered as money, but say if someone from outer space comes here and asks what is this money? How would you explain to him what money is? In short how would it be defined? Well there are quite a number of definitions that tend to satisfy the cause and more importantly the type of money used in today’s world. Some of the definitions are:

                “Money is a commonly accepted medium of exchange in commerce.”

                “Money is a legal tender used as a medium of exchange in commerce.”

                “Money is what money does.”

                The official currency issued by a government or national bank

Unlike money inflation is a relatively new phenomenon. Inflation is defined as persistent increase in general price level. In layman terms, if prices of goods of general use persistently increases over one accounting period this percentage increase is called inflation. Just to give you a little insight on inflation, there are two main types of inflation.

One is demand-pull-inflation. In this situation inflation occurs because of difference between the demand of certain commodities and their supply. Say for example; demand for milk and bread increases drastically due to some reason and supply cannot be increased immediately. This will cause prices to increase as well and not only of the milk and bread but all those things that are directly related to milk and bread, thus generally price of almost everything. This is demand-pull inflation.

Second type is supply-push-inflation. In this situation the supply of certain essential commodities contracts suddenly due to certain circumstances, therefore prices would go high because of unmet demand. For example, there is certain country that produces wheat. Its share in global market for wheat is 15%. It is struck by famine during certain year causing wheat production to be almost zero. This would cause the global prices of wheat to rocket-up, because the supply contracted and the therefore demand cannot be met. Take another situation which is closer to today’s world. If United States of America invades Iran for one thing or another. Iran being second largest producer of oil will not be able to export oil to the global market, creating huge shortage of oil. This shortage of oil would kick the prices upwards; making prices of everything go up as oil effects everything else as well. These would be supply-push-inflation as supply contraction would push the prices up.

For centuries man has been using gold and silver coins to fulfil his commerce needs. What is different in gold and silver compared to the modern currency? Since the beginning of time gold and silver or their coins for that matter have their own intrinsic value. Whether they owe this to their chemical properties, physical properties or whatever, it is beyond the scope of this article. But the bottom-line is that gold and silver hold some intrinsic value. Although the respective governments used to put their stamp on those coins, but still it was gold. It could be easily trader with any item anywhere around the world, irrespective of the stamp. Unlike today’s currency notes which need to be exchanged to buy stuff from the foreign countries. Then gold and silver are not perishable. Implying if you bury gold for a thousand years, it would still remain gold when you take it out and not decrease in value by even an ounce.  But at the same time they had their own drawbacks like transportation was difficult and hectic task and security of them was also a problem.

To overcome these disadvantages of gold and silver, some private businessmen came up with a business idea. What they did was to open a shop where they would store gold of people and in return issue a receipt to them confirming that the holder has got so and so amount of gold with the issuer of that receipt. They called this institute a bank and the receipt later came to be known as bank notes. These receipts and gold were inter-changeable and thus equally good for commerce. The scheme because of its usefulness attracted many among people and use of bank notes became more and more common. This popularity of these bank notes made many businessmen to venture in this field. Up until this point everything seems good as the banks provide security to the gold of people and they in turn use bank’s receipts to do the commerce. There is no problem of inflation being faced either. All through the only time things start to get bad is when centuries old human attribute of greed comes into play. According to history not much time after the establishment of bank, greed destroyed fortunes of many people. The bankers when realised that people who have got deposits with them don’t really come to check or collect their gold and are content using receipts, started giving out fake receipts or vanish away with all gold that they have. These fake receipts were the ones which did not have any gold at their back. Therefore, when somehow this news came to the depositors they rushed to the bank to check if their gold was there or not and thus world saw crowds outside of banks. The banks closed because they could not exchange receipts for the gold as they didn’t have the gold of the amount of receipts they had given out. Thus the term, ‘run at the bank’.

Later the authority of issuing those receipts was transferred to the central banks and Federal Reserve in case of US. Most of these institutes are owned by the government apart from US, where Federal Reserve is a private institute as well that makes and follows its own policies. Another bit of information about it is that American presidents for decades had been opposing the establishment of such an institute as a central bank, but finally federal reserve act was passed through senate when most of the senators were on vacation and only a handful were available in senate. Such an important institute was enacted in a single day without consent of more than half of the senators, which had been vehemently opposed for decades. The central bank was for the purpose of providing security to the depositors in case any bank defaults.

During 1930s a couple of really interesting events happened in America. A law was passed making it illegal for people to have possession of gold with them and many were prosecuted and imprisoned on ignoring this law. Therefore whole economy was shifted to paper money, although it was still gold backed. Then there was great recession in the American economy. Thirdly, American currency was devalued by Federal Reserve. Meaning amount of gold at the back of every American dollar was reduced without any reason given to its stake holders who were forced to use that paper money by law. Overnight Federal Reserve which has currency issuing authority removed certain amount of gold at the back of not only new American dollars but also the existing ones. What it caused was sky-rocketing inflation. Before this adventurism with paper money concept of inflation was non-existent, although only in those societies who were not using paper money or were still fully gold backed. This concept was called partial gold standards. Whether this drastic change in economy prolonged recession period or was the cause of recession itself is still debatable and subject of many conspiracy theories as well along with enactment of the very same institute. To deny everything that these theorists say would also be wrong because where there is smoke, there has to be some sort of fire. Therefore, I believe until some clear logical explanation is given for the said step these theories would continues to roam around. If of course, there is some explanation behind this.

After the Second World War, the Breton woods system was formed. According to this system all of the world currencies were to be pegged to US Dollar, while US Dollar was still pegged to gold (gold standard). Dollar was made exchangeable with gold. While US promised to redeem the dollar in gold to other central banks. Trade imbalances were corrected by gold exchanges or loan from IMF. Breton woods agreement signed in 1944 gave the world two more institutions viz. International Monetary fund (IMF) and International Bank for Reconstruction and Development (IBRD) also known as World Bank. The charter of these financial institutions says that no country should be allowed to revert to gold standards and they use every possible mean to ensure that sometimes even using the American military muscle. Therefore in a way the whole of the world was made dependent on the United States of America and its dollar. 

In 1971, American economy was in recession because of heavy American involvement in the Vietnam War. With war expenses sky high and not enough gold to with US Government for to make dollars, the government thought of revoking the gold standards altogether. What did do? What were the implications? Well, for starter it reduced the value of banknotes to just printed pieces of paper. Then the government could technically print any amount of paper as was required and use it. This certainly solved the problem of government not having enough money for their war. But as later the economist came to know that this leads to drastic inflation. Why? Because that piece of paper now no longer has any intrinsic value and is just a ‘legal tender’ which do. As for the rest of the world, it already was not gold backed rather fixed with US dollar in accordance with Breton woods agreement. United States unilaterally came out of this agreement and whole world had to bear the consequences of fiat currency. Previously dollar was fixed to an ounce of gold, after Nixon reneged Breton woods in 1971 it was no longer fixed to gold, something measurable, it was only fixed to printing press of Federal Reserve System of US. The economist agree that decade of 1970s was the worst after 1930s in terms of economic performance. Although oil crisis was the reason behind this as is popularly thought, but the fact remains that oil crisis just added fuel to fire which was already there.

This crisis was stabilized by creating demand for US dollar in international market. An agreement was reached with Saudi Arabia according to which oil could only be sold in dollars and in return US would support “house of Saud” Saudi royal family. After this other OPEC countries followed suit and accept oil payments only in dollars, therefore every country in the world needed US dollars to purchase oil and therefore made dollar a de-facto global currency.

So how does this inflation happen? Well as explained earlier, inflation is persistent increase in general price level. Therefore when more money is printed to take care of expenses more of this money enters the economy, demand for goods increases. As people would have more money they would demand more as well. When they would demand more, prices of goods would increase. The money that is in circulation now does not have any intrinsic value therefore prices of goods vary according to prices of gold, which in turn depends upon its demand and secondly the amount of money in circulation in the economy. More recently in the past couple of years, United States is again engaged in a series of endless wars the so-called “War on Terror”. Keeping other things aside these wars have grown really expensive for American economy which is finding it had to finance this war. They can borrow money from Federal Reserve which runs the printing press but they already are under a debt of billions if not trillions of dollars to this Federal Reserve. The pitifulness of the situation can be judged by the fact that now US government is borrowing money from Saudi Arabia and China at lesser interest so that it doesn’t have to borrow from Federal Reserve which lends at higher interest rates. What this does it that it further weakens already dismal situation of US economy. The state of US economy is directly related to value of US dollar. Therefore meaning that as US economy further weaken so does the dollar, as does the dollar weakens prices of goods that have some intrinsic value increases including oil. When oil prices increase in nominal terms it further increases the prices of other commodities especially food items. When all these prices increase US economy further weakens and the vicious cycle goes on. The inflation that is being observed these days is in nominal terms only and not much in real term, although wages have been decreasing in real terms.

I tend to believe no matter how desperate be a situation, there always is a solution to it. The solution being hard to come up with or not is a separate matter and depends on the particular situation. In my opinion a possible and only solution to this problem is reverting back to gold standards and if not gold other commodities can be used for the purpose of trade, those commodities that have their own intrinsic value and is not just a printed piece of paper. These commodities can be silver, Iron, Wheat, Rice or oil. It might seem old thing to you but it is the only possible remedy to the curse of inflation, fiat paper money was a bad idea. Gold standards would close down the printing press of the government and give some real value to the money of people and make wealth of people independent of those sitting in the government, thus more secure. At the same time it also makes economies of countries independent of US hegemony when their currencies are linked to some other real commodity instead of US Dollar. What right does the government has to erode the hard earned money of people whenever they want? Or what right does the person sitting in Wall Street has to devalue the hard earned wealth of a person sitting in Africa? Therefore, the gold standard would make people and nations more independent of their government’s policies or US hegemony respectively. It would give them more authority over their own wealth and it would get the world rid of the curse of inflation.

3 comments:

Ammar - Ed said...

great post boy..very astute understanding of the current financial syndrome..we sorely need the gold standard back and end the wanton speculative trading that has screwed with too many people's lives now..
keep at it.. let people know..

Insouciant said...

Though the federal reserves is a private entity yet it never can make policy that is totally isolated with the U.S government. It is the Congress that passes money bills for federal reserves and hence Federal Reserves keeps its policies at par with the wishes of the contemporary government.

Muhammad Shemyal Nisar said...

I never said anything like Federal Reserve is going against the government or anybody else. All I did here was to tell how this system works without going into who is good and who is bad.

Secondly, this money bill did not give money from Federal Reserve to the banks. It took money from US Treasury and gave it to the banks. which I must mention was the tax payers money which went to the banks.