The Complications of Easy Money

vivekAn Indian writer dives deep into the history of money and concludes that government interventions rarely end well

Although he is not by formal training an economist – and perhaps because he is not – Vivek Kaul has established a reputation as a provocative, clear-voiced economic commentator for Firstpost and other publications in India. One article about Kaul’s recently published history, “Easy Money: Evolution of Money from Robinson Crusoe to the First World War,” paid Kaul the compliment of being “readable.” In response, Kaul explained that he devotes considerable study to “break things down. If a child cannot understand what I am writing, it is pointless.”
Though perhaps understandable to the younger population, Kaul’s extensively researched, 300-page volume speaks to a very different, highly educated audience. He delves into the origins and evolution of monetary systems and finds in them pointed, cautionary lessons for the central bankers who manage the modern-day money supply and for policymakers concerned about the risks and stability of financial systems.
“One of the lessons from history is that money printing has never really ended well,” Kaul says in this recent interview conducted by Dr. Nupur Pavan Bang of the Insurance Information Bureau of India. “It has inevitably led to disaster. We don’t seem to have learned that lesson at all.”

Why is “Easy Money” your title?
I use the term ‘Easy Money’ in the context of money being created out of thin air by kings, queens, rulers, dictators, general secretaries and politicians. The practice was regularly resorted to by kings of Rome and has been abused ever since. As the Roman Empire spread, it needed more and more money to keep its huge army all over the world going. But gold and silver could not be created out of thin air. Also, as Romans grew richer, luxury and showing off became an important part of their lives. This also increased the demand for precious metals. This meant more plunder of the territories Rome had captured in battle. But plunder could not generate gold and silver beyond a point. Hence, the Roman kings resorted to debasement.
How did debasement work?
A metal like copper was mixed with the gold or silver in coins, while keeping their face value the same. So let’s say a coin which had a face value of 100 cents had silver worth 100 cents in it. After it was debased, it only had 80 cents worth of silver in it. The remaining 20 cents was pocketed by the ruler debasing the currency. Once the Romans started this, the rulers who followed also debased various forms of money regularly. And that is a practice that has continued to this day. These days, governments print paper money and pump it into the financial system by buying government bonds. Actually, most of this money is created digitally and resides in bank accounts, but “printing paper money” is a simple way to explain this.
How and where has that history repeated?
Governments at various points in history have worked toward destroying money and the financial system. The Romans under Nero were the first to do it systematically by lowering the silver content in the Denarius coin. The Mongols, Chinese, Spaniards, French, Americans and Germans followed, at various points of time. When gold and silver were money, the governments destroyed money by debasing it, i.e., lowering the content of precious metals in the coins they issued. When paper currency replaced precious metals as money, the governments destroyed it simply by printing more and more of it.
Today, in the U.K., for example, the government does not print money on its own. It sells securities to the central bank, which prints money to buy them. This started with the Bank of England being tricked into lending endless money to the government in the late 1790s by Prime Minister William Pitt. This allowed the government to borrow as much money from the Bank of England as it wanted to, without having to get clearance from the Parliament. Governments all over the world continue with this practice of borrowing unlimited amounts from their respective central banks. The practice has only increased over the last few years, since the advent of the financial crisis.
The first volume of your planned trilogy covers “from Robinson Crusoe to the First World War”. Do you think some earlier practices like barter were actually better?
Not at all. In fact, if barter was better, we would have probably stayed with it, and money and the financial system wouldn’t have evolved. Barter had two fundamental problems. The first was the mutual coincidence of wants. I have some eggs and I want to exchange them for salt. So, I need to find someone who has salt and, at the same time, wants to exchange it for eggs. What if the person who has the salt does not want eggs, and wants sugar instead? To complete the transaction, I need to find someone who has sugar and is ready to exchange it for eggs. A simple, straightforward transaction could become fairly complicated.
In a barter system that has four goods to be exchanged, there are six ratios of exchange. But imagine a situation where there are 1,000 goods to be exchanged under a barter system. There will be 499,500 exchange rates.
And the second problem with barter?
Indivisibility. Let us say I have a potter’s wheel and want to exchange it for some basic necessities like eggs, salt and wheat. One way would be to find someone who has these three things and is ready to do an exchange. If I am unable to find such a person, then barter does not work for me. That demonstrates the utility of money.
The evolution of the concept of money, where a standardized commodity could be used as a medium of exchange, did away with the problems of barter. Also, money allowed people to specialize in things they were good at. People can work in areas they feel they are most suited to without having to worry about how to go about getting the other things that they might require to live a decent life. This specialization, in turn, leads to discovery and invention. The concept of money is at the heart of human progress.
You write that gold, which historically backed the value of coins or currency, “is valuable, because it is useless”. Can you explain this oxymoron?
That may sound oxymoronic, but it is not. Gold is highly malleable (it can be beaten into sheets), ductile (can be easily drawn into wires), and the best conductor of electricity. Despite these qualities, gold does not have many industrial uses like other metals have. This is primarily because there is very little of it around. Also, pure gold is as soft as putty, making it practically useless for all purposes that need metal.
Now, why am I making this point? It is important to understand that when commodities are used as money, they are taken away from their primary use. If rice or wheat is used as money for daily transactions and to preserve wealth, then there are lesser amounts of rice and wheat in the market for people to buy and eat. This, in turn, would mean higher prices of grains, which are staple food in large portions of the world. If a metal like iron is used as money, it is not available for its primary use.
Why is gold different?
Given the fact that it is extremely expensive, and that it does not have many industrial uses, the mere act of hoarding gold does not hurt anyone or infringe their rights. That “uselessness” also helps it to retain value.
Silver has lots of industrial uses. If one owns silver during a recession, chances are that the price of silver, and thus its purchasing power, would fall, because there would be less demand for silver for its industrial uses. The same would be true for metals like platinum and palladium which are also used for industrial purposes. Gold would not be impacted. As analyst Dylan Grice wrote in “A Minskian Roadmap to the Next Gold Mania“ (2009), “The price of gold will be unaffected by any decline in industrial demand because there is no industrial demand!” Hence, gold is useful because it is useless. This is paradoxical, but true.
What determines currency values now, and what causes them to crash, as was the case in the South East Asian crisis of 1997?
Paper currencies inherently do not have any value. What makes them money is the backing by the government that has issued them. Hence their designation as fiat currencies. One paper currency’s value vis-à-vis another to a very large extent depends on the economic strength of the issuing country. Before the South East Asian crisis, the Thai baht was pegged against the U.S. dollar: one dollar was worth 25 baht. Thailand’s central bank ensured that this rate did not vary. Hence, it sold dollars and bought baht when there was a surfeit of baht in the market and vice versa.
Once economic trouble broke out in Thailand’s and other regional currencies, investors exited them en masse. They exchanged baht for dollars to repatriate their money. In the normal scheme of things, with a surfeit of baht in the market, the value of the baht would have fallen. But the baht was pegged to the dollar. The Thai central bank kept intervening by selling dollars and buying baht. But it could not create dollars out of thin air. It ran out of dollars, and the peg snapped.
The baht was a piece of paper before the crisis. And it continued to be a piece of paper after the crisis. What changed was the economic perception people had of Thailand. As a result, the baht rapidly depreciated in value against the dollar.
What is the relevance today?
Central banks around the world have been on a money-printing spree since the late 2008. Between then and early February 2013, the U.S. Federal Reserve System expanded its balance sheet by 220%. The Bank of England did even better, at 350%. The European Central Bank came to the money-printing party a little late and expanded its balance sheet by around 98%. The Bank of Japan has been relatively subdued, increasing its balance sheet by 30% over the four-year period. But it is now printing a lot of money, planning to inject nearly $1.5 trillion into the Japanese money market by April 2015. This is huge, given that the size of the Japanese economy is $5 trillion.
One of the lessons from history is that money printing has never really ended well. It has inevitably led to disaster. But we don’t seem to have learned that lesson at all.
In a past interview, Dr. Ishrat Husain, former governor of the Central Bank of Pakistan, pointed out that if shareholders’ equity in a bank amounts to 8% of deposits, then 92% belongs to depositors, ang although excessive risks are taken with the depositors’ money, the upside gains are captured by the shareholders and managers. But, if they lose money, taxpayers have to bail them out. This “asymmetric relationship in incurring risk and appropriation of reward makes the financial sector more vulnerable to exogenous shocks.”
I totally agree with Dr Husain. I talk about this in some detail in “Easy Money.” Walter Bagehot, the great editor of The Economist, wrote in Lombard Street,“The main source of profitableness of established banking is the smallness of requisite capital.” This book was published in 1873. So things haven’t changed for more than a century. The low shareholders’ equity of banks makes the entire financial system very risky.
What would it take to mitigate that riskiness?
Anant Admati and Martin Hellwig explain this point beautifully in “The Bankers’ New Clothes” (2013).Let us say a bank has shareholders’ equity of 2%, as some had between 2007 and 2009. If the value of the assets falls by 1%, half of its equity is wiped out. The bank cannot issue any new equity. So what does the bank need to do, if it wants to move its shareholders’ equity back to 2%? If the bank has assets worth $100, its shareholders’ equity earlier stood at $2. If the value of these assets fell by 1%, the bank’s assets are now worth $99. Its equity is also down to $1. To increase shareholders’ equity back to 2%, assets must fall to $50 – meaning $49 worth of assets must be sold.
In times of trouble, a lot of banks need to do this, leading to a rapid fall in the value of their assets. This tells us that if banks have a little more equity, then they will need to sell a smaller amount of assets, which will make for a more stable financial system during times of trouble.
Therefore, shareholders’ equity in banks needs to go up. This is a no-brainer, the influence of Wall Street notwithstanding. 

 The interview was first published by the Global Association for Risk Professionals on February 06th 2014 

Rupee debacle: UPA should stop blaming gold for screw up

goldVivek Kaul

How do I define history?” asked Alan Bennett in the play The History Boys, It’s just one f@#$%n’ thing after another”.
But this one thing after another has great lessons to offer in the days, weeks, months, years and centuries that follow, if one chooses to learn from it.
Finance minister P Chidambaram and other fire fighters who have been trying to save the Indian economy from sinking, can draw some lessons from the experience of the Mongols in the thirteenth and the fourteenth century.
The Mongol Empire at its peak, in the late 13th and early 14th century, had nearly 25 percent of the world’s population. The British Empire at its peak in the early 20th century covered a greater landmass of the world, but had only around 20 percent of its population. The primary reason for the same was the fact that the Mongols came to rule all of China, which Britain never did.
In 1260 AD, when Kublai Khan became King, there were a number of paper currencies in circulation in China. All these cur­rencies were called in and a new national currency was issued in 1262.
Initially, the Mongols went easy on printing money and the supply was limited. Also, as the use of money spread across a large country like China, there was significant demand for this new money. But from 1275 onwards, the money supply increased dramatically. Between 1275 and 1300, the money supply went up by 32 times.By 1330, the amount of money in supply was 140 times the money supply in 1275.
When money supply increases at a fast pace, the value of money falls and prices go up, as more money chases the same amount of goods. As the value of money falls, the government needs to print more money just to keep meeting its expenditure. This leads to the money supply going up even more, which leads to prices going up further and which, in turn, means more money printing. So the cycle works. That is what seems to have happened in case of Mongol-ruled China.
Gold and silver were prohibited to be used as money and paper money was of very little value as the various Mongol Kings printed more and more of it. Finally, the situation reached such a stage that people started using bamboo and wooden money. This was also prohibited in 1294.
What this tells us is that beyond a certain point the government cannot force its citizens to use something that is losing value as money, just because it deems it to be so. By the middle of the 14th century, the Mongols were compelled to abandon China, a country, they had totally ruined by running the printing press big time.
There is a huge lesson here for Chidambaram and others who have been trying to put a part of the blame on the fall of the rupee against the dollar because of our love for gold. The logic is that Indians are obsessed with buying gold. Since we produce almost no gold of our own, we have to import almost all of it. And every time we import gold we need dollars. This sends up the demand for dollars and drives down the value of the rupee.
This logic has been used to jack up the import duty on gold to 10%. 
But as Jim Rogers told the Mint in an interview “Indian politicians…suddenly blamed their problems on gold. The three largest imports to India are crude oil, gold and cooking oil. Since they can’t do anything about crude and vegetable oil, the politicians said India’s problems were because of gold, which, in my view, is totally outrageous. But like all politicians across the world, the Indians too needed a scapegoat.”
The question that no politician seems to be answering is, why have Indians really been buying gold, over the last few years? And the answer is ‘high’ inflation. As we saw in Mongol ruled China, it is very difficult to force people to use something that is losing value as money. And rupee has constantly been losing value because of high inflation.
High inflation has led to a situation where the purchasing power of the rupee has fallen dramatically over the last few years. And given that people have been moving their money into gold. As Dylan Grice writes in a newsletter titled 
On The Intrinsic Value Of Gold, And How Not To Be A Turkey “Now consider gold. In ten years’ time, gold bars will still be gold bars. In fifty years too. And in one hundred. In fact, gold bars held today will still be gold bars in a thousand years from now, and will have roughly the same purchasing power. Therefore, for the purpose of preserving real capital in the long run, gold has a property which is unique in comparison with everything else of which we know: the risk of a loss of purchasing power approaches zero as one goes further into the future. In other words, the risk of a permanent loss of purchasing power is negligible.”
And this is why people are buying gold in India. Gold is the symptom of the problem. Take inflation out of the equation and gold will stop being a problem, though Indians might still continue to buy gold as jewellery. But creating ‘inflation’ is central to the politics of the Congress led UPA. Now that does not mean that people need to suffer because of that? Especially the middle class. As M J Akbar 
put it in a column in The Times of India “Gold is the minor luxury that a confident economy purchases for its middle class. The cost of gold imports has become a problem only because the economy has imploded.”
Nevertheless people need to protect themselves against the inflationary policies of the government. “Historically, people have understood money’s intrinsic value when they have been forced to, when alternative monies have been rendered unfit for purpose by persistent debasement,” writes Grice.
In ancient times Kings used to mix a base metal like copper with gold or silver coins and keep the gold or silver for themselves. This was referred to as debasement. In modern day terminology, debasement is loss of purchasing power of money due to inflation.
Given this, people will continue to buy gold. The buying may not show up in the official numbers because a lot of gold will simply be smuggled in. 
A recent Bloomberg report quoted Haresh Soni, New Delhi-based chairman of the All India Gems & Jewellery Trade Federation as saying “Smuggling of gold will increase and the organized industry will be in disarray.”
And other than leading to a loss of revenue for the government, it might have other social consequences as well. As Akbar wrote in his column “If we are not careful we might be staring at 1963, when finance minister Morarji Desai imposed gold control to save foreign exchange. Desai, and a much-weakened prime minister, Jawaharlal Nehru, could issue orders and change laws but they could not thwart the Indian’s appetite for gold, even when he was in a much more abstemious mood half a century ago. All that happened in the 1960s was that the consumer turned to smugglers. From this emerged underworld icons like Haji Mastan, Kareem Lala and their heir, Dawood Ibrahim. India has paid a heavy price, including the whiplash of terrorism.”
Maybe the new Dawood Ibrahims and Haji Mastaans are just about starting up somewhere.
The piece originally appeared on on August 20, 2013

 (Vivek Kaul is a writer. He tweets @kaul_vivek) 

I fear a Great Disorder

Dylan Grice is a strategist with Societe Generale and is based out of London. He is the  co-author of the French investment bank’s much-followed Popular Delusions analysis. “History is replete with Great Disorders in which social cohesion has been undermined by currency debasements. The multi-decade credit inflation can now be seen to have had similarly corrosive effects… I fear a Great Disorder,” he says. In this interview he speaks to Vivek Kaul.
What is debasement of currency?
Sometimes the most basic questions are the biggest ones! I’ll try to keep it as simple as possible by defining currency debasement as an increase in the supply of money which increases the purchasing power of whomever issues that money, by reducing purchasing power for everyone else.
And since when is it happening?
In the story of our civilisation, coins of a defined weight first appear at around at around 700BC. Around 400BC Aristophanes references inflation in his comedyThe Frogs, probably a reference to the currency debasement caused by the Peloponnesian war. So money debasement is as old as money itself. Traditionally, money debasement would involve issuers or traders ‘clipping’ tiny amounts of gold or silver from the coin, but still passing that coin on as though it was of a given weight. After a few rounds of clipping, your ounce of silver might only be worth nine tenths of an ounce of silver. Or maybe treasuries would mint gold or silver coins alloyed with base metals, again hoping that no one would notice. The intention was again to pass a coin containing less than an ounce of silver off as an ounce of silver and the effect would be an increase in the price level. Since more gold coins were needed to obtain a given amount of gold, more coins were also needed to buy given goods.
And why would people do this?
It’s important to understand that currency debasement is a mechanism for redistributing wealth. Anyone clipping coins kept the clippings for themselves and therefore secured an increase in their purchasing power. Any treasurer minting coins alloying gold or silver with copper or tin similarly benefitted because they now had more coins. Since the twentieth century the dominant circulating currency has been paper money and more recently, electronic money. Currency debasements have taken different shapes and forms this century – from the hyperinflations of central Europe following WW1 to the credit inflations of the 1920s or 2000s – but the fundamental principle has remained the same: the supply of money was increased in a way which redistributed societies’ wealth towards the issuer of the new money and away from everyone else.
What is the Cantillon effect?
Cantillon observed that when precious metals were imported into Spain and Europe from the New World in the sixteenth century causing a general price increase, the gold miners – the money creators, in other words – and those associated with them benefitted. When they spent their new found wealth on goods like meat, wine, or wool the prices of meat, wine and wool would rise as would the incomes of anyone involved in the production of those goods. For this group, money creation was highly beneficial.  The problems arise for other groups. Anyone not involved in the production of money or of the goods the newly produced money purchased, but who nevertheless consumed them – a journalist or a nurse, for example – would find that the prices of those goods had risen while their incomes hadn’t. In other words, their real incomes had declined. Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman’s allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter.
Why do governments debase money?
Governments usually raise revenue through taxation which has the benefit of being transparent and open. Everyone knows why they are poorer and by how much. They know who the perpetrator is, if you like. But raising money by simply creating it, debasing the existing currency stock is very different. For the government, the effect is the same. Whether printing money today, or clipping coin in the past, the debasement represents a real increase in government revenues and therefore purchasing power. But it’s better increasing in tax revenues because you can pretend you’re not actually raising taxes. You can hide what you’re doing. By printing one billion dollars, it now has one billion dollars more to spend without having to be open about what you’ve done. But we know that revenue cannotbe raised without someone somewhere paying. And here is the problem such an action creates: who pays?
Who pays?
The answer is that no one knows who or by how much. Most people are completely unaware that they are even being taxed. Keynes said that inflation redistributed wealth arbitrarily and in a way in which “not one man in a million is able to diagnose.” All people see is that they are suffering a decline in their own purchasing power. They can’t afford to buy the things they used to buy. They know something is wrong but they don’t know why. And they don’t who to blame. They don’t know who the perpetrator of this wrong they’re suffering is, so the group dynamic unleashes suspicion and speculation just like it does in Agatha Christies novels.
Could you explain that in detail?
Unfortunately, things being more complex in the real world than in whodunit novels, the group finds someone to blame. But there does seem to be a coincidence of past currency debasements with past social debasements in which society looks for an enemy to blame for its problems. History is replete with Great Disorders in which social cohesion has been undermined by currency debasements. The multi-decade credit inflation can now be seen to have had similarly corrosive effects. Yet central banks continue down the same route. The writing is on the wall. Further debasement of money will cause further debasement of society. I fear a Great Disorder.
Can you give us an example?
In medieval Europe, for example, the seventeenth century currency debasements coincided with the peak in witch trials. During the French (and Russian revolutions), rapidly debased currency coincided with the revolution’s transition from a representative movement to one which becomes bloody and self-consuming. The hyperinflations in Central Europe after WW1, most infamously in Weimar Germany but also in Austria and Hungary saw societies turning viciously on their Jewish communities. In Zimbabwe more recently, the white farmers were made scapegoats for the country’s ills and in Venezueala today, Chavez blames “profiteers” variously defined.
What sort of great disorder do you expect to play out in the days and years to come?
Although what we’ve seen in the last few decades has been an unprecedented credit inflation, which is a different type of currency debasement to the monetisations of the past or quantitative easing of today, today’s problems have the hallmarks of past inflations. So we see Cantillon redistributions in the very sudden increase in wealth inequality which has favoured those closest to the money creation (the financial sector and anyone with access to cheap credit). Everyone else has suffered. Median US household incomes have stagnated during the past twenty years while there is a record number of US households on foodstamps.
That’s a fair point…
We also see the in-group trust turn to suspicion as societies look for someone to blame. The 99% blame the 1%, the 1% blame the 47%, the public sector blame the private sector, and private sector blames the public sector. In the Eurozone the Northern Europeans blame the Southern Europeans, Germans blame Greeks, Greeks blame bankers. In Spain, the Catalans blame the Castillians and want independence. Meanwhile in China, popular anger seems to be deliberately directed by the Party towards the Japanese. So everywhere you look, everyone is blaming everyone else for the overall malaise. But that malaise is really just a consequence of the various credit inflations each of those societies experienced. The US, China, Spain, Greece etc all experienced one way or another, quite extreme credit inflations. In all of this I just think we’re seeing the usual debasement of society we might expect following a currency debasement.
But the money printing isn’t stopping…
The central banks’ solution to these problems is to print more money. But I think this solution is actually the problem. I understand why they’re doing it, and I appreciate what a difficult situation they find themselves in. But since these problems have been cause by their past currency debasement – asset price inflation engineered by credit inflation – I don’t see why another round of more traditional currency debasement is going to heal anything. I hope I’m wrong by the way, but I’m worried that this is the beginning of a Great Disorder in which social frictions increase. I’m concerned that distrust deepens both within societies and between them and inflation ultimately becomes uncontrollable. Obviously, financial markets reflect an environment like this, the financial analogue to less trust being higher yield. So I think the historically low yields we see today in bond, equity and real estate markets will go much higher. Of course, that implies their prices go much lower.
A shorter version of the interview appeared in the Daily News and Analysis on November 12, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])