Tuesday, February 8, 2011

Currency driven growth : where are we headed to?

 

The on-going global '”Currency War” has its roots deep buried in the history of monetary system and the economic practices followed worldwide post Second World War. Men’s experiments with money loosely started from bartering during river valley civilizations and extends to the currently prevalent fiat money system. It started with a promise to solve trading problems, which barter system could not solve and has evolved into the cornerstone of modern economics, driving and determining country’s trade, economic prosperity and its relations with the world outside. This certainly imposes a necessity to think about (mis)use of this system as a weapon to fight power games while suffocating another country’s trades and simultaneously creating inflationary problems for your own people, which in long term may lead to a ‘currency bubble burst’ kind of scenario. Because historically in world economics everything that rises up so rapidly, simply crashes one day.

A bit of history

The earlier barter system was succeeded by commodity money in which the currency used to represent the value of the substance it is made of. So if you melt the coin, you don’t loose anything. It was followed by standardized money in which the value of currency exceeded that of the substance it was made of. The difference between the ‘real value’ of the money and the ‘market value’ kept on increasing. Then with the emergence of bills of exchange and banknotes, came the concept of ‘gold/silver’ backed currency or representative money which guaranteed that against that banknote a definite amount of gold/silver is kept in treasury, which can be redeemed by returning this banknote. This is the reason we see “I promise to pay bearer a sum of ….” statement signed by bank governor on our currencies. But soon the money became over valued, there was meagre amount of back up treasury maintained. The new thing was ‘fiat money’, backed up by a sovereign guarantee and not by other commodity.

Real Sector vs. Financial Sector

Real sector of an economy represents the aggregate demand and aggregate supply of goods and services in the economy. It has two major markets – production factor market and the output market.  While financial sector represents the system which supports real sector by providing financial services like banking, insurance, investment fund etc.

It has been found that finance sector leads the growth of real sector, which means a well developed finance sector will have a well developed economy. Adam Smith expressed the view that the high density of banks in the Scotland of his times was a crucial factor for the rapid development of the Scottish economy[1]. So the huge credit generation and money mobilisation by financial sector leads to the increased demand and supply in economy and hence to the real sector growth. This makes it a strong case for legitimised offshore bankingwith all its socio-economic evils.

 

Why do governments print so much of money and who regulates it?

We were amazed at the US declaration in 2008 to provide a USD 2.3 trillion economic stimulus with a ‘plan’ that out of that USD 1 trillion will be printed. the immediate question which came to mind was how? Is this just the sweet will of government to print the money and won’t it create the global and national intersectoral imbalances? The answer was actually given by US Treasury Secretary John Connally (after US moved away from gold backed currency) – “This is our currency and your problem”.

Not going into much details basically the developed countries print excessive amount of money to keep their imports of raw material cheaper while the developing countries want to keep their exports  of ready material cheaper in the international market. Main aim is to keep the currency undervalued. And both north and south are sort of in competition and trapped in a vicious cycle to print more and more of money causing huge fiscal deficits and ultimately PIIGS type of situation.

Another reason is to create demand in the economy by supplying money. Take example of welfare schemes like NREGA, the money given is without creation of productive assets and is with very meagre returns of investment.  This way developing countries try to stimulate growth. Developed countries resorts to this in times of crisis.

The money increase also inflates GDP growth figures, showing a perceived growth of economy.

Also when country’s foreign trade increases, it needs to print more of domestic currency to ‘manage’ the incoming foreign currencies.

 

They all seem to be good and desired advantages, any problems?

Obviously, that’s why this article is being written. The most visible problem is inflation. Because of supply demand mismatch of money the value of currency decreases and it leads to inflation with all its side effects. More you ‘manipulate’, more the poor people pay. So all people who are jealous of China, for its manipulative power can feel pity for her poor. Paul Krugman says about Chinese case that while an undervalued yuan helps the industrialist community, it is detrimental to the interests of poor.

In absence of balancing by market of goods and services, this printed money creates ‘false assets’ in the economy, mostly in terms of high real estate prices having a dead underlying  asset.

The other problem is unhealthy practices like the current Currency War. A nation will try all measures to keep its currency undervalued and print more currency in absence of any international guideline controlling printing of money.

This is an ever expanding phenomenon, soon there will be a time when Rs 100 notes will also be phased out because of their unviability as it happened recently with 50 paisa coin. We may imagine a global future where fiscal deficits of governments will be too high and so will be the tax rates, there will be no more chances of increase in the ‘real assets’ which are limited by nature’s limits to produce. Where more and more money will be generated but there will not be any takers for that, as fundamental system of economics is bootstrapped by availability of raw materials which can not be created beyond a limit. Globally and historically the “Stock Price bubble” has busted, the “real estate bubble” has busted, and the “Gold Bubble” is just waiting to be. On national level we have seen many countries going bankrupt e.g. PIIGS in recent times and may Afro-Asian countries in 90’s (including India), because of huge currency manipulation regimes along with their elephant size fiscal deficits. The boom-burst cycle is now believed to exist empirically.

Just think if the currency bubble ‘bursts’ and all legal-tenders(currencies) become completely (or almost) illegal and invalid or useless, would we back to Barter system? This may not happen in next 100 years but its bound to come. The time may be prolonged or US and China may lead a shortcut to the crisis. This is high time when global powers should come together under the premises of Bretton Woods Institutions(IMF specially) and devise binding methods to control this unhealthy and disastrous practice. The new currency should be backed by a real commodity, something more than a sovereign guarantee whose guarantee itself depends upon the international credit rating agencies.