In the last part we saw how the Gold Standard – the system whereby each country’s currency represented no more and no less than a share in the total stock of gold held by that country’s government – became unsustainable by the end of the 20th Century. In practice it had been unsustainable for a long time, perhaps from the very beginning, and the process of trying to sustain it had made a relatively small number of people very rich indeed.
We also saw how early attempts to leave the gold standard, by laying it to one side and going to the other extreme of printing ‘free money’, had mixed success: like a drug, a small amount administered in the right way for a short period of time could be very successful (e.g. the American Greenback), whilst in some cases the withdrawal symptoms could be severe (the Bradbury Pounds). Administered in too great a quantity or in the wrong way, the remedy could prove fatal for the patient (the French post-revolutionary Assignats).
The system which is in use across the world today, called ‘fiat currency’, is a sort of hybrid between the Gold Standard and ‘free money’. Despite how much we depend on it in our everyday lives, what it is and where it comes from is not often thought about, and is poorly understood – even, or perhaps especially so, amongst our political class. In this article, I shall do my best to explain it and lead into the next and final part of this short series, namely a proposal for how an independent Wales’s currency should work.
Things get a little technical in parts and there are some questions which are bound to crop up in some people’s minds: therefore, although I’ve striven to keep the main article to ~2000 words, there are three appendices: one on the Financial Crisis of 2008, one on house price inflation, and one on cryptocurrencies.
Supply and Demand
As I stated near the beginning of Part I, money can be anything at all so long as the people who use it agree on its value.
The most fundamental law of economics is that of supply and demand. Things become valuable when the demand for them exceeds the supply, and lose their value if the supply of them exceeds the demand. That fundamental law is as true of money as it is of coal, steel, bushels of grain or hog bellies.
The psychology of numbers
Prices are just numbers; a beer in Wrexham is worth the same as a beer in South Korea, even though in one place the price is 3 and in the other it’s 5,000 (in Pounds and Won, respectively). Even so when prices move they have a psychological effect on people. When they go down, people tend to spend less, because they put off purchases while they wait for the price to go lower still. When they go up, people tend to spend more, to buy the things they want before the price increases further. This remains true even if their own incomes are going up or down at the same rate.
I always think it’s a bit like daylight-saving time in summer. By putting the clocks forward in March so that what would have been eight o’clock at night is now nine o’clock, we haven’t made the day a minute longer. Yet psychologically, seeing daylight at nine o’clock in the evening makes us feel good, and more inclined to work later and/or go out and spend money. We’d get exactly the same benefit from getting out of bed an hour earlier, but that requires mental effort and fortitude.
It has to come from somewhere
Therefore the overriding aim of every government in the world that wants to see healthy economic conditions is that deflation should be avoided at all costs and that there should be real, but low, inflation: the consensus seems to be that inflation of around 2% per annum is the sweet spot. Any higher than this and people become discouraged from building up savings, since they perceive that their value will decrease and it’s better to spend the money now. They’re encouraged to borrow and spend instead, since they perceive that over time the value of the debt will become less. This ends in stalemate where people want to borrow money rather than invest it, but no-one wants to lend it to them; and in the absence of longer-term investment, productivity collapses – just as we saw in 1970s Britain.
Inflation of 2% means that every year, the amount of money available in the economy to spend on goods and services grows by 2% more than the amount of available goods and services themselves. Let’s get this over with: the money is created from out of thin air. One minute it’s not there, and then with a push of a button on a banker’s keyboard, it is there. In a modern economy, printed banknotes and physical coins make up just a tiny fraction (in the UK, around 3%) of the total amount of currency in circulation. Most of it is just numbers on screens. To create more, you just make the numbers a little bigger.
But how much of it to create? And how to get it out into the economy so that people can use it? And what happens when there’s too much of it out there?
Borrowing from no-one, with no-one to repay
I’ve heard it suggested by perfectly sensible people that this should be the government’s job. Every year, the government should review the previous year’s economic growth, figure out how much more money is needed, and create exactly that much. The new money could then be fed out into the economy, for example by using it to pay civil service salaries or to buy other goods and services required by the government. It would be very much as if the government were borrowing it, only it wouldn’t be borrowing it from anyone, exactly. And since there’d be no creditor to pay back, there’d be no debt.
It’s a very appealing idea; and it’s not difficult to imagine that it could actually work. Unfortunately it has two unsurmountable flaws. Firstly, no government ever has the necessary information to hand for it to be able to estimate the growth of the economy with that much precision. We’re all used to the economic growth figures reported in the media being revised upwards or downwards, sometimes substantially, as new information comes through. Accurate information may not come in for several quarters, or even years. Yet the tolerances are tight: when the target is ~2% inflation, with an absolute lower bound that deflation must be avoided, there is not much room for error, and yet errors there’d be bound to be. Each one would have serious consequences as inflation surged forwards or the economy sputtered into a deflationary spiral.
The second flaw is that no-one seriously believes any government, given the right to create money on demand, would limit itself to creating what was justified. In real life, even the most prudent governments would end up borrowing debt-free money like drunken sailors. That’s just life. With no limit on supply (and no mechanism for taking money back out of the economy in times of inflation) the money they borrowed would end up worthless, like French Assignats or (from more recent history where this has happened), Weimar marks, Zimbabwean dollars or Venezuelan bolivars.
In June 2018 a Citizens’ Initiative (a public referendum of the type allowed under Swiss Law) was put forward in Switzerland, to the effect that Switzerland should adopt this system. Despite the (perhaps surprising) support of the Financial Times and widespread lobbying from international campaigning organisations such as Positive Money, the measure was defeated by 76% to 24%
The wisdom of crowds
Fiat currencies avoid these risks by leaving it to markets to decide how much money should be created – or indeed destroyed – from day to day. When people or businesses feel that money is tight, they go to banks to borrow it. The banks create the money, lend it to their customers, and in doing so the total amount of money in the economy increases. When people or businesses have surplus money on their hands, but have debt to repay, then they go back to the banks to pay their debts off. When the debt is paid off the money is destroyed, leaving the economy forever, and the money supply contracts. The individual decisions of millions of individuals from day to day form a consensus of how much money there really ought to be circulating in the economy.
The Central Bank’s role is to regulate this process by setting interest rates, so as to keep inflation as close as possible to its target. If inflation is too high, indicating that there is too much money chasing too few goods and services, then rates are raised to encourage people to pay loans back rather than borrow, or (if they do not have loans) to place their money into savings accounts. Likewise, if deflation threatens, then rates are lowered to encourage borrowing and discourage saving, and so increase the money supply.
Note that in general (certainly most ‘advanced’ countries), governments cannot borrow from banks directly: rather, they issue bonds, as was described in the previous part of this series. Banks will sometimes buy these bonds to hold within their own reserves, but most are sold to individuals, insurance and pension companies, or to other governments for reasons which will be explained in the final Part.
All this debt! Who gets the interest?
The banks do, obviously. It’s how they’re remunerated for the service they provide in distributing the money through the economy. Note well that the interest is all the banks get from all this created money – at no point do they get to keep it, since once the loans have been paid back the money does not go into their coffers but leaves the economy altogether. It’s almost, though not quite, as though the commercial banks were borrowing the money from the Central Bank when they issue loans, and paying it back when the loans are repaid.
The banks’ profits, once they have met their costs, are distributed to their shareholders. For Central Banks – which regulate this process and receive the bulk of the revenues from it – that almost always means the government. The Bank of England, though founded as a private joint-stock company in 1694, has been nationalised since 1946; immediately prior to nationalisation its £14.6 million of assets were owned by 17,000 different shareholders.
The idea that the world’s central banks are still owned and controlled by secretive private families such as the Rothschilds is categorically untrue. In fact, the only countries in the world with privately-owned central banks are Japan, Switzerland, Greece, Belgium, South Africa and Turkey. In all these cases the banks are publicly-traded companies, with anyone able to buy and sell shares in them but with strict government regulations over how much dividend can be paid out to shareholders. The only significant individual shareholding in any central bank is the ~5% stake in Switzerland’s central bank, worth around $25 million, held by a German businessman named Theo Siegert. Two other countries, Italy and the USA, have their central banks owned by networks of other banks, but again operating under strict regulation.
Commercial banks operate as commercial companies with shareholders. Since in general they produce reliable dividend income, their shares form a large part of the main stockmarket index in most countries and therefore feature strongly in the investment portfolios behind most peoples’ pension and life insurance policies. It’s a fair bet than any retired person reading this, if they have any sort of private or company pension supplementing the minimal state pension, is living off the profits of commercial banks.
Checks and balances
If all of the above sounds like banks have a license to print as much money as they want, then nothing could be further from the truth. Commercial banks operate under strict rules that the total value of their loans cannot exceed a certain proportion of their own assets (i.e. the bank’s own wealth, not including its customers’ deposits – in practice, the money that has been invested by shareholders plus the returns that have been gained on it from the bank’s own investing).
Central banks operate under similarly strict rules, including the requirement to maintain large reserves of wealth in forms other than the nation’s own currency – principally gold, which is still an important part of the financial system, and foreign currency: often in the form of bonds issued by other country’s governments.
In fact this subject: the relationship between money supply, central bank reserves, and exchange rates – and how all of this impacts upon the real economy, affecting imports, exports, prices and wages – will be the principal topic of the next and final part of this series. At that point it will hopefully become clear why this subject is so directly relevant to the prosperity of an independent Wales.
Appendix I – What happened in 2008?
If I’m arguing that the fiat currency system is better than the alternatives, how do I account for everything that went horribly wrong in 2008? The short answer is that the crisis wasn’t caused by the fact that banks were creating too much money according to the rules they’d been given– inflation remained under 3% for the whole time. The problem was that when it was created it was being lent to the wrong sort of people – essentially those who lacked the means to repay it. Remember that the whole thing blew up out of “subprime” mortgages, namely mortgages to people to whom an old fashioned bank manager like Captain Mainwaring would never have lent a penny. Without doubt this was partly motivated by greed, but also by political pressure: in the US in particular, the Clinton government had strongly incentivised banks to lend more money to impoverished people, particularly those from ethnic minorities. There was also the constant need to increase money supply to stave off the threat of deflation, and this meant that money had to be created and lent out even when there was a dearth of good-quality applicants to lend it to.
This leads directly to the next point…
Appendix II – Why have house prices soared?
What has gone wrong with the housing and mortgage system, so that housing has become unaffordable for so many people?
Essentially, the marching orders given to the banks by the government (certainly in the UK and US, and I believe elsewhere too) are that they must keep deflation at bay at all costs, especially where it might affect wages. Yet in real terms, all sorts of things have got much cheaper over the last few years: pretty much any sort of manufactured goods (because of the growth of China), pretty much any sort of labour-intensive service (because of mass immigration), and many sorts of more highly-skilled professional services (because of business process automation). In the face of that, money supply has had to increase at an unprecedentedly high rate to keep inflation positive, and all of this excess money has ended up chasing the few assets for which supply has not increased at the same rate as everything else – namely land and houses. It’s not so much that houses have got more expensive, but that a glut of money has led to it becoming less valuable relative to them. This could have been ameliorated had the government increased the supply of housing on a massive scale – as happened in the 1920s, for example, when house prices dropped significantly over the decade even as the quantity and quality of the housing stock increased – but instead politicians have come up with misguided schemes like ‘Help to Buy’ which further stimulate demand whilst doing nothing to help supply, and so make the problem far worse.
In my view, neither of these problems arise from the way that money is generated and distributed, but rather from excessive government interference with the system coupled with failure to either control immigration or invest sufficiently in infrastructure, especially housing. If the Labour government that had been in power for 11 years by 2008 had borrowed money for this purpose, things may have worked out quite well. Instead, they simultaneously invited in a huge tide of immigrants (confident that they’d gratefully vote Labour once they were here), while borrowing huge amounts of money to spend on expanding the public sector without doing anything to reform it or improve its productivity. It’s not a great surprise, then, that the modern Labour party’s core vote consists of immigrants and well-paid middle-class public sector employees, while its traditional supporters in the industrial heartlands of Wales, Scotland and Northern England have been wholly neglected.
Appendix III – Cryptocurrencies
Where does Bitcoin and other ‘cryptocurrencies’ fit into all of this? From where do they derive their value?
Like any other asset, the value of cryptocurrencies lies in the excess of demand over supply. Although Bitcoins (to use these as an example) are the purest form of ‘blips on a screen’ rather than representing physical wealth, the algorithm that generates them has been very cleverly designed in such a way that, as more and more of them are ‘mined’ – a process which consists essentially of solving very complex mathematical ‘puzzles’ – the harder it becomes to mine further coins. The more coins there are in circulation, the harder the puzzles get.
Even though computers themselves continue to become more and more powerful over time (and it’s possible to buy computers with designs that are highly optimised specifically for mining Bitcoins), the difficulty of mining new Bitcoins continues to outstrip them. Hence, while there’s no absolute limit on the amount of Bitcoins that may ultimately be mined, the expense of doing so means that there is a practical upper bound on the rate at which the supply of them can grow, and this prevents them from becoming over-abundant and therefore worthless.
It’s anyone’s guess what role cryptocurrencies will play in the world’s financial system in future, but it’s hard to imagine that they won’t play any role at all. It’s much better, though, to think of them in terms of a replacement for gold bullion – something with limited supply, that’s kept in the Central Bank reserves – than as a replacement for the currencies that we use in everyday transactions.