MONEY, BANKS, BUBBLES AND CRISES

MONEY, BANKS, BUBBLES

AND CRISES

Money makes the world go round. In order to trade, dealers must
use a recognised and acceptable form of money and this then
enables goods and services to be exchanged and incomes to be paid.
The need to use money and yet safeguard its use led to the first
banks, and the subsequent creative manipulation of other people’s
money has since given rise to the modern, massive, international
financial industry.
In general, the growth of banking and the resulting globalisation
of finance has accompanied the increasing wealth of nations, but it
has been a roller-coaster ride at times. On occasions, too much
money has been loaned out – only to be followed by recriminations
all round when creditors, in the attempt to get their money back,
close down banks and sell off the businesses they supported. Money
is essential to conduct trade; it requires the growth of financial
specialists, and there arises, therefore, the occasional irresponsible
use and abuse of financial power. It is to these issues that the study
of economics must now turn.THE NATURE OF MONEY
Money is a unique commodity that is only as good as other people
think it is. The notes and coins that you have in your pocket may
look pretty tangible and appear valuable to you but, first, most
money in the world does not have any physical form at all (it exists
only as a matter of computer record on bank balance sheets) and
© 2004 Tony Cleaver
second the value of any currency is only determined in exchange –
and if someone else won’t accept it, it’s worthless.
A Medium
Money is first and foremost a MEDIUM OF EXCHANGE. It thus
facilitates the circular flow of national income and output described
in Chapter 4 and, indeed, without money far less trade and income
growth would be possible. Money allows each of us to specialise in
our chosen profession, exchange our labour for money income and
then trade this for any and all commodities that we may choose to
buy in the market economy. Without money we are reduced to
BARTER – perhaps swapping work for payment in goods and then
attempting to pass off whatever we are given for something else we
want from another. Successful barter is very rare since it requires a
double coincidence of wants (we can strike a deal only if you’ve got
exactly what I want and I’ve got exactly what you want). The transactions
costs involved in everyone trying to trade in this way are so
huge that it inhibits any economic growth for society above subsistence
level. Everyone would wear out shoe leather trying to go
around bargaining for an acceptable deal, trades agreed in one place
would vary with others elsewhere and perishable commodities like
essential foodstuffs would deteriorate in the process. Agreeing to an
acceptable medium of exchange obviates all this.
What is an acceptable medium? It used to be gold. Something
that everyone valued intrinsically for itself, which could be verified
for its purity, could be measured out in fine, divisible units, easily
carried and which did not deteriorate. It thus possessed most of the
ideal QUALITIES OF MONEY. Key to its use as money was its acceptability
across cultures – all round the world, people valued gold as
a precious asset.
Due to its success as a form of exchange, gold in fact became
too scarce.With trade made profitable for payment in gold, production
increased, trade expanded and merchants plied the world.
But with insufficient gold to support the increase in world output
the price of gold must rise and the prices of all other goods and
services must correspondingly fall (deflation). The use of other
precious metals (principally silver) was thus resorted to. This gave
rise to the first quarrels over EXCHANGE RATES – the price at which
© 2004 Tony Cleaver
one currency could exchange for another – but markets grew up to
deal with this.
Note however an important distinction: the first monies therefore
differ from today’s by possessing an INTRINSIC VALUE. Gold and silver
had a street value for themselves, based on their usefulness in
jewellery and craftwork. This carried advantages and disadvantages. It
guaranteed the acceptability of precious metals – thus ensuring they
could function as a medium of exchange – but it also meant that world
money supplies were susceptible to a steady deflationary drain as
these metals were pressed into service as raw materials in the industry
of fine craftsmanship (i.e. as gold and silver were slowly taken out of
the money supply, that which remained in circulation went up in
value. All other goods must go down in price, therefore).
The invention of paper money avoided this problem. The use of
coins – standardised units of precious metal – predates the Roman
Empire but we have to thank the medieval goldsmiths in London
for the invention of a paper promise to gold or silver. A promise to
pay the bearer on demand the sum of ten pounds of sterling silver
is the origin of the UK ten pound note. The promise is still there on
banknotes today – but the paper itself has little intrinsic value and
the promise now cannot be claimed. It is not backed by any precious
metal. It is thus FIAT MONEY: its value is declared by fiat, by the
central authorities.
In fact today, in the twenty-first century, we have a world monetary
system that Friedman calls unprecedented in that no major
currency has any link to a commodity and nor is there a commitment
anywhere to restoring such a link. Throughout history, he
argues, the only times that governments departed from basing their
currencies on some recognised and accepted commodity (such as the
GOLD STANDARD) were either very short-lived or disastrous, or both.
The reason for this claim is that if there is no physical limit to
the money supply imposed by, say, the amount of gold or silver that
can be mined then there is always the temptation to issue more
paper promises – banknotes – by whomsoever holds the licence to
print money. And there is no quicker way to undermine a market
society that to debase its currency, as hyperinflations throughout
history have proved (see Box 5.1). Once people lose confidence in
the money supply then, unless a ready alternative is available, it
becomes impossible to trade.
© 2004 Tony Cleaver
At the beginning of the twentieth century the world monetary
system operated with all main currencies fixed to a given gold price.
The First World War impoverished Europe, most countries came off
the gold standard and in the case of Germany hyperinflation ensued
since it was unable to pay reparations without printing money.
After the Second World War, under the Bretton Woods agreement
in 1944, all world currencies operated a dollar standard (Box 5.2).
That is, they fixed their currencies in terms of the US dollar and
this in turn was fixed to the price of gold – and this system lasted
right up until 1971 when the system broke down. Since then there
has been no anchor to world money.
Confidence has wobbled at times, though so far the international
financial system has avoided disaster. The 1970s, as explained in
Chapter 4, were times of abnormal inflation and the debt crisis of
the 1980s brought real fear that the world’s system of banking
Box 5.1 The German hyperinflation, 1923
The economic consequences of the peace negotiated at the end
of the First World War proved to be disastrous for Germany. The
victorious nations in the conflict demanded that Germany pay
reparations for the costs imposed on, particularly, French soil.
But Germany was an impoverished country and could only pay
the massive sums demanded of it by printing banknotes. The
more it did so, the more the value of these notes fell and the
more, inevitably, were demanded. And so Germany printed more
and more and more. Eventually, the banknotes became almost
worthless – in the domestic economy people were paid in suitcase
loads of cash which they desperately tried to exchange for
anything of intrinsic value before the notes devalued even
further. Hyperinflations – where prices increase by hundreds and
thousands of per cent – destroy people’s confidence in currency,
make market exchanges impossible and thus provoke economic
collapse. In Germany’s case, the economic and political chaos
created in 1923 led to a vacuum that would later be filled by a
nationalist strongman who would only lead his country into an
even greater trauma.
© 2004 Tony Cleaver
would come crashing down but these difficulties were overcome
despite calls from some critics to bring back the gold standard.
Indeed, the mythical attachment to a gold anchor is neither necessary
nor sufficient to guarantee the success of paper money. There
is only one guiding rule. It is financial discipline imposed by central
banks and governments over the long term and the subsequent
confidence that this instils in the public that ensures that a given
banknote is accepted as ‘good as gold’.