a snapshot of our blog.

Well, even if we hadn’t noticed before, quite clearly we are quite concerned about money. And rather naturally, it bothers us that the present overwhelming emphasis on money as a value in itself, rather than its arguable origin as an efficient and just means of exchange, has led to the control banks have on our lives.

As George Monbiot pointed out in the article Murali referenced earlier, we humans have allowed ourselves to get into a situation where we, citizens of most of the world’s apparently civilised countries, are firmly under the control of banks and banking institutions, who exercise this control through their grip on almost every kind of transaction that governs our intercourse.

An easy way out of this dangerous situation is to have more than one entity do the job, and possibly allow competition between them, in order to enable the efficiency of the marketplace. However, it can’t have failed anyone’s attention that this is in fact how the US operated till recently, with the Fed (The US Federal Reserve) under Greenspan delegating authority for fiscal management to banks and money institutions (but not accountability, which seems to have irked POTUS no end, doubtless striking a chord with unhappy people around the world).

A more elegant solution appears on the face of it to be more complex, and that is to switch over to universal money, independent of national control and of the possibility of business manipulation. Most people will remember how George Soros punished the UK central bank, the Bank of England, for its lax management of the pound sterling relative to the European Exchange Rate Mechanism, in 1992.

There is a perception that this failure actually led to the stabilisation of exchange rates and removal of the specter of recession. Today, of course, this view will be seen to be overly generous, that in fact it merely led to a covering up of the continuing holes in economic and fiscal policy – a kind of grasshopper philosophy, or a belief in fool’s gold.

A core argument for universal money is its removal of a source of greed. Removing greed entirely is probably not possible, as it appears to be some kind of survival mechanism – perhaps atavistic – and is therefore possibly hard-coded into most humans. There are humans who survive without greed, but generally not with the same material lifestyle. Arguably then, it is the material lifestyle itself that causes greed, and then that infects all kinds of interpersonal transactions, eventually destroying money’s value proposition, as has just happened.

Unfortunately, this self-same material lifestyle is the key to modern economic well-being. Material needs are seen as essential to survival, and satisfaction of higher needs is a difficult or Utopian proposition, when the basic needs themselves cannot be met. Weaning away from it cannot be done in a day, unless it be a particularly horrific day, and any thinking person would surely much rather find some gentler way.

Similarly, the introduction of universal money, freed of its links to greed and manipulation, inherent in the concentration of control to a few good men, is not an easy task, not even to conceive, much less to execute.

However, unlike greed itself, or the consumptive material lifestyle, it does not have to be abolished from all of human existence overnight, in order to tread a different path. It can be tried in individual countries, especially in partially controlled economies, that are not already inextricably beholden to duplicitously free flows of money. Actually, fully controlled economies would be the easiest to begin with, except for one major stumbling block: control is already handed over to an elite few, who are then bound by greed no less and possibly as completely as our modern Princes.

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I don’t see any philosophical counter-arguments to a return to the basics. The explosion of ‘material’ creativity that characterises the Industrial and post-industrial age economies will probably not only continue, it will adopt ever higher standards of efficiency as a given, and it will be valued far greater than silly money-based patenting and copyrighting fancies can deliver.

Cultural change is such a ‘scientific’ affirmation of values. Perhaps that is one reason Mr Obama could win an election, with his oratorical command triumphing over rhetoric (I don’t mean the content entirely, but the delivery – that’s how it sounds, very important to reach out to a lot of people who aren’t learned enough to follow the arguments, some of which are doozies).

I always did find the idea of rocket scientists generating algorithms and processes to turn blobs of money into thundering snowballs was a little nauseating.

1.  Consumption.  Our system of capital accumulation is based on ever increasing consumption – consumerism.  The more consumers consume, the more firms produce, and that results in economic growth.  Give consumers cheap credit and they will willingly consume themselves into oblivion.

But this unfettered consumption is not physically (ecologically) sustainable at a global level, and cheap credit is the source of economic bubble, that invariably burst periodically.  If 6.2 billion people start consuming like Americans, human ecological footprint and GHGs would increase 20 fold, forcing dramatic and disastrous climate changes.  So any solution to the global financial crisis must get us off  this path of consumerism.

2.  Investment.  Much wealth around the world is invested in real estate or financial instruments.  Even material wealth of gold, oil, and commodities is securitized and traded on financial markets.  These markets are fundamentally speculative.  Wealth is created and destroyed daily based on forecasts and future expectations.  There is no invisible hand or “rational actor” guiding speculation.  The elaborate professional investment guidance infrastructure (accounting statements, analysts, rating agencies) are ways of cleaning up the speculation, in an impossibly opaque system.  Financial values are only weakly linked to the production economy.  Ordinary individual cannot build a life on speculation or gambling, without enduring enormous stresses and risks.

Investment speculations are based on notion of earnings – surplus of revenues over costs. Many costs are externalized, so “earnings” are a problematic notion.  Labor wages and environmental costs are probably the most problematic.

3.  Labor (and wages). In information (and knowledge) work settings, the old notions of labor (physical work measured in pieces produced or time worked) simply fall apart.  Labor of a software programmer, consultant, bank officer, government clerk, hotel receptionist is only partly physical – and actual more intellectual, emotional, and social process. Paying for 8 hours of physical presence in an office does not guarantee quality and not even quantity of labor derived.  So historic wage systems are ill-suited to rewarding information/knowledge work. Efforts to incentivize workers with stock options are crude and have many intended consequences. Need to better understand what “work” means today, how to measure it, how to incentivize workers.

What sort of solutions would we need for this global financial crisis to address these challenges?

Bankers know how to create money out of thin air. In fact, banks are money factories. Banks exist to make money. You might think that banks are in business to provide services such as banking accounts and loans to their customers. It’s true that banks provide essential financial services. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money. Where does this money come from? It comes from customer deposits. In other words, it comes from the money you and I deposit into the bank.

Notice very carefully, banks “create” money. It’s not simply that banks “earn” profits when they provide bank services and loans. Banks actually “create” new money that did not exist before.

Here is an example of how banks create money. You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. The bank now can use your money to create loans.

Federal Reserve rules allow the bank to make five to six loans based on a deposit. Each loan creates an additional asset. We’ll stop at three loans, review the process, and add up how much money the bank has created, going by the rule that a bank can lend upto 90% of an asset.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 – $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

Money, Social Reformers and Revolutionaries:

Sooner or later, every social reformer or revolutionary gets the same idea. If it’s so simple, why not just keep on printing money. By getting enough notes to everyone, poverty can be eliminated and the good life can begin not just for a few but for all.

Does it work? Here are three examples.

(Extracts from “Money: Whence it came, where it went” by JK Galbraith)

1. “Paper was similarly to serve the Soviets in and after the Russian Revolution. By 1920, around 85 per cent of the state budget was being met by the manufacture of paper money. In that year or not long after, a Harvard graduate student in economics visited the Soviet Union. In accordance with counsel of similar adventurers of the time he took in his pockets a pad of toilet paper. On a densely crowded streetcar in Moscow one day he felt the hand of a thief in his hip pocket. He noted with amusement and satisfaction that it was the pocket that contained not his money but the toilet paper. The latter the pick-pocket deftly remove. Only later did the young scholar come to realize that the gentle produce that was stolen was more valuable than the packet of notes in the other pocket. In the aftermath of the Revolution the Soviet Union, like the other Communist states, became a stern defender of stable prices and hard money. But the Russians, no less than the Americans or the French, owe their revolution to paper.
2. Not that the use of paper money is a guarantee of revolutionary success. In 1913, in the old Spanish town of Chihuahua City, Pancho Villa was carrying out his engaging combination of banditry and social reform. Soldiers were cleaning the streets, land was being given to the peons, children were being put in schools and Villa was printing money by the square yard. This money could not be exchanged for any better asset. It promised nothing. It was sustained by no residue of prestige or esteem. It was abundant. Its only claim to worth was Pancho Villa’s signature. He gave this money to whosever seemed to be in need or anyone else who struck his fancy. It did not bring him success, although he did, without question, enjoy a measure of popularity while it lasted. But the United States army pursued him; more orderly men intervened to persuade him to retire to a hacienda in Durango. There, a decade later, when he was suspected by some to be contemplating another foray into banditry, social reform and monetary policy, he was assassinated.”
3. “By the mid thirties there was also in existence an advanced demonstration of the Keynesian system. This was the economic policy of Adolf Hitler and the Third Reich. It involved large-scale borrowing for public expenditures, and at first this was principally for civilian works – railroads, canals and the Autobahnen. The result was a far more effective attack on unemployment than in any other industrial country. By 1935, German unemployment was minimal. ‘Hitler had already found how to cure unemployment before Keynes was finished explaining why it occurred.(17) In 1936, as prices and wages came under upward pressure, Hitler took the further step of combining an expansive employment policy with comprehensive price controls.

The Nazi economic policy, it should be noted, was an ad hoc response to what seemed over-riding circumstance. The unemployment position was desperate. So money was borrowed and people put to work. When rising wages and prices threatened stability, a price ceiling was imposed. Although there had been much discussion of such policy in pre-Hitler Germany, it seems doubtful if it was highly influential. Hitler and his cohorts were not a bookish lot. Nevertheless the elimination of unemployment in Germany during the Great Depression without inflation – and with initial reliance on essentially civilian activities – was a signal accomplishment. It has rarely been praised and not much remarked. The notion that Hitler could do no good extends to his economics as it does, more plausibly, to all else.”

(extracts from Glyn Davies: A history of money from ancient times to the present day)

The invention of banking preceded that of coinage. Banking originated in Ancient Mesopotamia where the royal palaces and temples provided secure places for the safe-keeping of grain and other commodities. Receipts came to be used for transfers not only to the original depositors but also to third parties.

…After the fall of the Roman Empire banking was forgotten and had to be re-invented much later.

…Banking re-emerged in Europe at about the time of the Crusades. In Italian city states such as Rome, Venice and Genoa, and in the fairs of medieval France, the need to transfer sums of money for trading purposes led to the development of financial services including bills of exchange. Although it is possible that such bills had been used by the Arabs in the eighth century and the Jews in the tenth, the first for which definite evidence exists was a contract issued in Genoa in 1156.

The Crusades gave a great stimulus to banking because payments for supplies, equipment, allies, ransoms etc. required safe and speedy means of transferring vast resources of cash. Consequently the Knights of the Temple and the Hospitallers began to provide some banking services such as those already being developed in some of the Italian city states.

Paper Money

The first proper European banknotes were issued by Stockholms Banco, a predecessor of the Bank of Sweden, in 1660, although the bank ran out of coins to redeem its notes in 1664 and ceased operating in that year.

Until Louis XIV, banknotes were issued by small creditors, had limited circulation, and were not backed by the authority of the state. Economist John Law helped establish banknotes as formal currency, backed by capital consisting of French government bills and government accepted notes.

John Law

(from the Wiki article on John Law)

John Law (usually pronounced Jean Lass by contemporary French) (bap. 21 April 1671 – 21 March 1729) was a Scottish economist who believed that money was only a means of exchange that did not constitute wealth in itself, and that national wealth depended on trade. He is said to be the father of finance, responsible for the adoption or use of paper money or bills in the world today.

Law was a gambler and a brilliant mental calculator, and was known to win card games by mentally calculating the odds. An expert in statistics, he was the originator of economic theories, including two major ideas: the ‘Scarcity Theory of Value‘ and the ‘Real bills doctrine‘.

On 9 April 1694 John Law fought a duel.. over the affections of Elizabeth Villiers.. was tried and found guilty of murder and sentenced to death.. but he managed to escape to the continent.

….Law urged the establishment of a national bank to create and increase instruments of credit, and the issue of banknotes backed by land, gold, or silver.

In May 1716 the Banque Générale Privée (“General Private Bank”), which developed the use of paper money was set up by Law. It was a private bank, but three quarters of the capital consisted of government bills and government accepted notes. In August 1717, he bought the Mississippi Company, to help the French colony in Louisiana…In the same year Law floated the Mississippi Company as a joint stock trading company called the Compagnie d’Occident which was granted a trade monopoly of the West Indies and North America…

The system however encouraged speculation in shares in ‘The Company of the Indies’ (the shares becoming a sort of paper currency) and inflation. The system was based on Law trading shares in the Mississippi Company in return for government debt. The Banque Royale was created by default as a result of Law attaining the majority of the government issued notes (debt). It effectively became the Central bank of France. In 1720 the bank and company were united and Law was appointed Controller General of Finances to attract capital.

Law’s pioneering note-issuing bank was extremely successful until it collapsed and caused an economic crisis in France and across Europe.

Law exaggerated the wealth of Louisiana with an effective marketing scheme, which led to wild speculation on the shares of the company in 1719. In February 1720 it was valued for a very high future cash flow at 10,000 livres. Shares rose from 500 livres in 1719 to as much as 18,000 livres in the first half of 1720, but by the summer of 1720, there was a sudden decline in confidence, leading to a 97 per cent decline in market capitalization by 1721. Predictably, the ‘bubble’ burst at the end of 1720, when opponents of the financier attempted en masse to convert their notes into specie.

By that time, creditors were “counseled the application of Law’s notes to the most ignoble purpose paper can be put to.”

By the end of 1720 Orleans dismissed Law, who then fled from France.

(Extracts from “Money: Whence it came, where it went” by JK Galbraith)

Metal was an inconvenient thing to accept, weigh, divide, assess as to quality in powder or chunks, although more convenient in this regard than cattle. Accordingly, from the earliest known times and more likely somewhat before, metal was made into coins of predetermined weight. This innovation is attributed by Herodotus to the kings of Lydia, presumably in the latter part of the eighth century B.C.

It seems possible, based on references in the Hindu epics, that coins, including decimal division, were, in fact, in use in India some hundreds of years earlier.
Debasement of Roman Coinage

As early as 540 B.C., Polycrates of Samos is said to have cheated the Spartans with coins of simulated gold.

With the passage of time and depending on the financial needs of rulers, their capacity for resisting temptation, which was generally modest, and the private development of the speculative arts, coinage had a highly reliable tendency to get worse. The Greeks, notably the Athenians, seem to have resisted debasement out of a rather clear understanding that this was a short-run and self-defeating expedient and that honesty was, at a minimum, good commercial policy. After the division of the Roman Empire and the reassertion of Greek influence at Constantinople the bezant was for several centuries the world symbol of sound money, everywhere as acceptable as the gold it contained.

By contrast, the history of the highly developed coinage of Rome itself, as legend has sufficiently established, was one of steady debasement, beginning, it is commonly supposed, in consequence of the financial pressures of the Punic Wars. In time, this had the effect of converting the empire from a gold and silver to a copper monetary standard. By the time of Aurelian the basic silver coin was around 95 per cent copper. Later its silver content was brought down to 2 per cent. In time it would be asserted that the debauchment of the currency caused the downfall of Rome.

This historiography – the tendency to attach vast adverse consequences to monetary behaviour of which the observer happens to disapprove – is one which we will find frequently to recur. It should, needless to say, be regarded with the utmost suspicion.

Gresham’s Law

In the ancient and medieval world the coins of different jurisdictions converted at the major trading cities. If there were any disposition to accept coin on faith, it was inevitably the bad coins that were proffered, the good ones that were retained. Out of this precaution came, in 1558, the enduring observation of Sir Thomas Gresham, previously made by Oresme and Copernicus and reflected in the hoarding of the good Roman coin, that bad money always drives out good. It is perhaps the only economic law that has never been challenged, and for the reason that there has never been a serious exception. Human nature may be an infinitely variant thing. But it has constants. One is that, given a choice, people keep what is best for themselves, i.e., for those whom they love the most.”

Central to both ends of the spectrum has been one word: “Derivatives”. Nobody seems to understand exactly what it means. Nobody knows the real total value of derivatives afloat in the financial system. Some, perhaps, would prefer not to, under the mistaken impression that some ostriches always survive.

What many are doing, however, is to look furiously to the past. Is 1929 the model and 1933 the solution? Or is it 1987, 1993, or even 2002, that hold the key? Is Keynes now the resurrected king, or is Friedman only on a short time-out? Is the situation really so serious, so out of control, that there is no answer from the past, and that therefore we have no option but to innovate completely afresh?

Many are now willing to lend their names and opinions to the view. “Black Swan” is a term one hears with increasing frequency. On Essential Values itself, there has been more than one post that tends towards this persuasion.

In this specific and following few posts, I make no attempt to take either of the two sides. Instead, I want to go back in time and take a short trip through history. For, while this may turn out to be the worst financial crisis ever, it is certainly not the first financial crisis ever. There have been innumerable in the past. In chronological sequence, they are paralleled by the evolution of money to the form we deal with today. Perhaps it is in the history of money that we can find some direction.

(Most of the material that follows is easily available on the Net. I have a particular liking for John Kenneth Galbraith’s writings, and the quotations have been referenced).

It’s your statement ” ..it seems to me that money is in fact precisely that, an equitable replacement for barter” – that I would like to focus on. The rest can wait.

Money as we know it – in the form of instruments such as notes, checks, deposit receipts, etc- is not an equitable replacement for barter. According to me, this is absolutely fundamental. The whole economic edifice rests on the assumption that not everyone will demand redemption at the same time on the basis of the “I promise to pay ..” in the humble currency note.

Your unused airtime is an asset you own, but transferring it to me is not the equivalent of money exchanges between banks. Banks are exchanging money, not primary assets. Similarly, mortgages on housing owned by a lending institution are also assets. Transferring a mortgage from one lender to another would be the equivalent of exchanging unused airtime. It’s only when marketable derivative bonds get created out of mortgages by slicing them into tranches and packaging the tranches as bonds, as happened over the past 10 years, that we start getting into territory that’s similar to exchange of money between banks. Then we need to go back to the origins of modern money to understand how and why a crash can and did happen.

I think it’s possible to show that derivatives are an almost exact equivalent of the first few large issues of currency notes – in particular as pioneered by John Law in 1716 – but for this to be explained we first need to get past understanding the origin of modern money. Shockingly, I don’t think the history of money is part of a modern MBA curriculum, when so many graduates are going to end up managing money in one role or another.

If it’s OK with everyone, I’d like to cobble together a cut-and-paste to explain this. It might be a little long for a mail, so a document can be created if that’s the preferred option. Might run to 2-3 pages. Since I will not be the author, for the most part, I can promise it will be entertaining!

In the process, I hope to show also that (a) greed is an inescapable reality in human behaviour; and that (b) the history of money can be seen, from one perspective, as partly the history of management of greed.

Then we can get back to the 21st century!

1. Your proposal is to replace currency notes by ‘e-cash’. To a large extent I see this as an increasing trend. For example, when I pay my credit card bill off my Internet-enabled banking account, a lot of paper has gotten saved, including the currency notes that were not required when i used my credit card.
   

   Correct. Material savings, and a green move too, potentially.

2. In the ultimate analysis, you would like to replace all currency notes by e-cash.

Totally.

3. I don’t see how the replacement of currency notes by e-cash changes the functions of a bank in any way whatsoever. Whether the bank is the telco or the telco the bank makes no difference to the basic function.
   

   This follows an ongoing policy. The KYC norms set in motion a couple of years ago, for instance, are designed to perfectly exclude most Indians from having bank accounts, since they are unable to furnish the documentation necessary to open one.

   The problem is the regulatory framework. There is no point legalising the sale of widgets if the manufacture and possession of widgets is illegal. All actions on m-currency right now specifically legalise its use only through scheduled banks. As my figures on the current branch network show, this amounts to an exclusionary right/privilege, instead of an empowering enablement for India’s illiterate majority.

4. Banks are much more than loan-giving organizations, according to my understanding. In fact, without currency notes (whether paper or ecash) to process in the form of deposits or withdrawals, a bank has no meaning.

OK. We agree, apparently, although I hadn’t actually considered eliminating banks entirely.


5. Currency notes – or e-cash – are not replacements for barter. A currency note is a promise to pay by a bank. A promise to pay became legally accepted tender for conducting commerce because of the reputation of a bank for solidity. In his “Money, Whence It Came, Where It Went”, John Kenneth Galbraith explains this in brilliant and entertaining detail.

I haven’t read Galbraith’s book, but it seems to me that money is in fact precisely that, an equitable replacement for barter. The problem with money arises when it becomes in itself an object of accumulation. A rich man has real wheat, a poor one doesn’t, but money by itself, whether paper or e-cash, won’t feed anyone. All it does is set up ‘money’ as a ‘value’.


6. According to me, from the purely economic standpoint, it is not at all clear if black money is a problem in terms of reducing economic efficiency. There are several arguments for the theory that it may in fact increase economic efficiency. Black money is a legal and moral problem, the extent of which depends on the culture one lives in.

Legal? As Talleyrand famously said, treason is a matter of dates, and so is black money, sez I. If cash is not black in Dubai, but is in India, then we must examine our legal framework, and our consciences, too, to know why our tax framework is designed to create a billion criminals. If Dubai, without any ‘material’ income (no oil, etc) can do without income tax, then why should we care whether the US can’t?


7. A simple calculation will show that black money has the effect of converting a progressive income tax into a quasi-consumption tax, because of untaxed savings in the form of black money, and the fact that the higher the income the greater the potential to save, even as consumption increases.
8. There is more than sufficient empirical evidence to show that consumption taxes or flat taxes increase disparities between rich and poor. Making money, whether notes or ecash, more widely available is not going to change this.
9. It may well be possible – this is the central argument of free marketers – that economic growth is always greater in a consumption tax or a flat tax regime, and that lower taxes catalyze entrepreneurship and innovation.

You’ve lost me here. Are we therefore agreed that a flat tax (well, I didn’t say it needs to be flat, merely that it be the tax of choice) is better than direct taxation? I only ask because I had earlier thought you were arguing contra my submission.
As far as your point about disparities increasing, was this empirical evidence collected from either-or situations, or a blend? One of the points in my argument for e-cash was that it is better suited for an illiterate populace. Removing direct taxes from the equation would be a positive intervention to its universal introduction (and replacement of paper currency, within a short time-frame).
Banks already hardly ever exchange notes between themselves, they use e-money. Why shouldn’t we? But it is illegal for me to transfer my paid airtime to you, because (and solely because) no bank is involved. Logically, and by extensio ad absurdum, it should be illegal for me to hand you Rs 10 (a token guaranteed by the Reserve Bank of India only, not State Bank of India or any other Indian bank) for any reason whatsoever.


10. Hence the ideology of ‘greed is good’. I hope I’ve understood you correctly, and you likewise my comments. How does ecash help to manage greed any better than currency notes?

I don’t think that e-cash directly addresses greed, but it certainly removes (or diminishes) an object of greed from the equation. Is this argument fallacious, do you think?