Editor's note: This is an excerpt from Easy Money: Evolution of Money from Robinson Crusoe to the First World Warwritten by Vivek Kaul and published by Sage Response.
"How do I define history?" asked Alan Bennett in the play The History Boys, "It's just one fuckin' thing after another." But this one thing after another has great lessons to offer in the days, weeks, months, years, and centuries that follow.
Governments at various points of time in history have worked toward destroying money and the financial system. The Romans led by Nero were the first ones to do it systematically, by lowering the silver content in the Denarius coin. This was followed by the Mongols, the Chinese, the Spaniards, the French, the Americans, and the Germans 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 money replaced precious metals as money, the governments destroyed it by simply printing more and more of it.
Central banks around the world have been on a money-printing spree since the start of the financial crisis in late 2008. Between then and early February 2013, the Federal Reserve of the United States has expanded its balance sheet by 220 percent. The Bank of England has done even better at 350 percent. The European Central Bank came to the money printing party a little late in the day and has expanded its balance sheet by around 98 percent. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30 percent over the four-year period. But the Bank of Japan has also recently announced an unlimited money printing plan to get economic growth going again.
As we have seen throughout history money printing has never ended well. But the same mistake continues to be made.
In the system, as it has evolved, 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.
The regulations, as they stood, did not allow the Bank of England to make any advances to the government without the approval of the Parliament. This rule was bent now and then, and during the American War of Independence, the bank had made advances amounting to 150,000 to the government. Hence, a bill was sought by the bank to establish a limit on the amount that it could advance to the government. The bank also sought to be indemnified for the past advances it had made to the government.
Pitt saw this as a huge opportunity and he hurried the bill through the Parliament and managed to leave out the limiting cause. This allowed the government to borrow as much money from the Bank of England as it wanted to, without having to get a clearance from the Parliament. Governments all over the world still continue with this practice of borrowing unlimited amount of money from their respective central banks. The practice has only increased over the last few years, since the start of the financial crisis.
It was and remains easy for the government to obtain money by printing it, rather than taxing its citizens. F.P. Powers aptly put it when he said that money printing would always be "the first device thought of by a finance minister when a large quantity of money has to be raised at once."
It is important to understand here that money throughout history has had two objectives. As "currency," money is nothing more than a medium of exchange that facilitates trade and commerce. Over the short term almost anything can be used as a medium of exchange.
But money is also a store of value. The cycles of monetary debauchery (and economic collapse that follows) happen when money devolves into a mere currency and nothing more. As economist Jeff Nielson told me over an e-mail conversation "Once that happens we have theft-by-dilution where more and more money is printed. Those producing the 'money' (i.e. currency) get fabulously wealthy from their crime-at the expense of impoverishing the masses and completely hollowing-out/destroying the broader economy."
The trouble is that when money works both as a store of value and as a medium of exchange (like gold/silver coins and bullion, or paper money backed by gold/silver), at times there have been major problems of facilitating trade and economic growth. In the last few years of the 19th century, the United States and Great Britain suffered from economic stagnation, when gold and paper money backed by gold was the primary form of money. The same thing happened in Great Britain after the First World War.
Another lesson from history is that there has been a close link between the development of banking and the paper money system as it stands today. Merchants started depositing their gold and silver coins and bullion with goldsmiths in Britain and bankers in Italy and other parts of continental Europe, as we saw in the book.
The bankers/goldsmiths issued paper receipts against these deposits. These receipts could be presented and gold/silver coins and bullion could be withdrawn.
Some of the bankers/goldsmiths developed a reputation of being honest. This led to merchants who had accounts with these banks simply transferring the deposit receipts of these banks when they had to pay one another. And so, these receipts started functioning as "paper" money.
Soon, some banker/goldsmith somewhere figured out that all the depositors did not comeback on the same day demanding their coins and bullion back. Hence, the coins and bullion could be loaned out in the meanwhile to those in need and a fee could be charged for it. Over a period of time, some banker must have figured out that instead of lending out the gold and silver coins and bullion, fake deposit receipts could be printed and lent out as money.
The more money a banker lent out by printing fake deposit receipts, the more was the money he made by charging a fee for the loan. The deposit receipts were fake because there was no gold/silver backing them.
The learning from this modus operandi was that the lesser the capital the bank had, the greater was the return that it made on that capital. As Walter Bagehot, the great editor of The Economist once put it, "the main source of profitableness of established banking is the smallness of requisite capital."
This is a lesson that has stayed with banks to this day. Recent financial innovations like securitization, collateralized debt obligations, and credit default swaps are an extension of this lesson and have helped banks to maintain a lower capital on their books.
Earlier, banks had to maintain the loans they gave out on their books for the entire tenure of the loan. These innovations allowed banks to get rid of the loans from their books and maintain a lower capital and thus generate higher returns. They were also a major reason behind the current financial crisis. Even now the situation doesn't seem to have improved much on this front.
(Reprinted with permission)
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Updated Date: Dec 21, 2014 01:16:35 IST