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BW Businessworld

Book Extract: In Money We Trust

Most ‘stuff’ is today bought not with notes and coins, but with cheques, debit and credit cards, and by electronic transfers drawn on interest- bearing bank deposits. Economists have long debated how to measure the amount of money in the economy

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The love of money is the root of all evil.’ /Timothy, 6:10 (King James Bible) ‘Evil is the root of all money.’ /Kiyotaki and Moore (2002)

In the United States I studied at Harvard as a Kennedy Scholar. Later in life, I was a member of the interviewing panel to select new scholars. One young man, who was studying theology at Oxford, entered the room and, obviously a little nervous, sat on the chair in front of a line of eminent figures. The chairman, a distinguished philosopher, started by asking, ‘Tell me, does god have much of a role in theology these days?’ The young man blinked and never recovered.

But it made me think that the question one should ask of economists is, ‘Does money have much of a role in economics these days?’

Money is misunderstood because it is so familiar, although not as familiar as many of us might wish. Its function in a capitalist economy is complex, and economists have struggled to understand it. It is not even easy to define because the word is used to mean different things: the notes and coins in our wallets, the value of our total wealth, sometimes even the power that wealth confers, as in ‘money talks’. Whatever it is, we seem to be in thrall to it. In his Epistle to Timothy, quoted above, St Paul put it more bluntly. The management of money, in rich and poor countries alike, has been dismal. Governments and central banks may talk about price stability, but they have rarely achieved it. During the 1970s, prices doubled in the United States in ten years and in Britain they doubled in five years. In November 1923, prices in Germany doubled in less than four days and GDP fell by over 15 per cent during the year. That experience helped to undermine the Weimar republic and contributed to the rise of Nazi totalitarianism. In the film Cabaret, set in Berlin in the 1930s, the MC at the Kit Kat Klub performs a song entitled ‘Money’, which includes the lines:

A mark, a yen, a buck, or a pound
Is all that makes the world go around

Yet in recent years, with central banks printing money like never before (albeit electronically rather than by churning out notes) and a world recovery still elusive, you could be forgiven for thinking that money doesn’t make the world go round. So what does money do? Why do we need it? And could it eventually disappear?

As governor of the Bank of England, I would sometimes visit schools to explain money, especially to the younger pupils. Bemused by the fact that I was actually paid for ‘hanging out with my friends’ (the only answer I could come up with to their question ‘What is a meeting?’), they were nonetheless certain about the value of money. I would hold up a £5 note and ask them what it was. ‘Money,’ they would scream. ‘Surely it’s just a piece of paper,’ I would reply, and make as if to tear it in two.

‘No, you mustn’t,’ they gasped, as I hesitated and asked them what the difference was between a piece of paper and the paper note in my hand. ‘Because you can buy stuff with it,’ they explained loudly. And so we went on to discuss the importance of making sure that the amount of stuff you could buy with my note didn’t change drastically from one year to the next.

They all got the idea that low and stable inflation was a good thing, and that whatever form money takes, it must satisfy two criteria. The first is that money must be accepted by anyone from whom one might wish to buy ‘stuff’ (the criterion of acceptability). The second is that there is a reasonable degree of predictability as to its value in a future transaction (the criterion of stability).

Most ‘stuff’ is today bought not with notes and coins, but with cheques, debit and credit cards, and by electronic transfers drawn on interest- bearing bank deposits. Economists have long debated how to measure the amount of money in the economy.

But since what is accepted as money changes over time with both technology and economic circumstances, the quest for a precise definition has little point. Some people prefer a narrow definition in which money comprises the notes and deposits issued only by the central bank or government. Others prefer a broad definition that includes deposits issued by private banks and accepted in transactions. Yet others would include unused overdraft facilities that can be spent at the borrower’s wish. In normal circumstances the amount of money available for the financing of transactions is better captured by a broad measure, although in a banking crisis, as we shall see, a narrower definition may be more appropriate.

When money satisfies the two criteria of acceptability and stability it can be used as a measuring rod for the value of spending, production and wealth. After the Normans conquered Britain in 1066, they put together an inventory of wealth – houses, cattle and agricultural land – in order to assess the taxable capacity of their new domain. Known as the Domesday Book, the survey (now available online) measured wealth in terms of pounds, shillings and pence, Anglo- Saxon monetary units still in use in my youth before the decimalization of Britain’s currency in 1971.5

The view that money is primarily an acceptable medium of exchange – a way to buy stuff – underpins the traditional interpretation of the history of money. Specialisation created the need for people to exchange their own production for that of others. Adam Smith’s division of labour did not start with his pin factory. It is as old as the hills, almost literally, with the early specialisation between hunters and cultivators, and the development of a bewildering variety of crafts and skills from early civilisation onwards. Smith described how ‘in a nation of hunters, if anyone has a talent for making bows and arrows better than his neighbours he will at first make presents of them, and in return get presents of their game’. A man who spends all day making arrows in order to swap them for meat gives up the possibility of hunting himself for the chance of sharing in a larger catch. To be willing to specialise, the hunter who turns arrow-maker has to be sure that his partner in trade will deliver the ‘present’ of meat.

Smith explained that ‘when the division of labour first began to take place, this power of exchanging must frequently have been very much clogged and embarrassed in its operations.’ He was referring to the absence of what economists call a ‘double coincidence of wants’: the hunter wants arrows and the arrowmaker wants meat. Without that double coincidence, exchange cannot take place through barter. If the arrowmaker wants corn, and the farmer who grows the corn wants meat, then only a sequence of bilateral transactions will satisfy their wants.

Since the transactions are separated in time, and probably space, some medium of exchange – money – enters the picture to allow people to engage in their desired trades.

The history of money is, in this view, the story of how we evolved as social animals, trading with each other. It starts with the use as money of commodities – grain and cattle in Egypt and Mesopotamia as early as 9000 BC. Many other commodities, ranging from cowrie shells in Asia to salt in Africa, were deployed as money. It is, of course, costly to hold stocks of commodities with a useful value; salt kept as money cannot be used to preserve meat. Nevertheless, commodities continued to function as money until relatively modern times.

Adam Smith wrote about how commodities like ‘dried cod at Newfoundland; tobacco in virginia; sugar in some of our West india colonies’ had been used as money and how there was even ‘a village in Scotland where it is not uncommon . . . for a workman to carry nails instead of money to the baker’s shop or the alehouse’. Commodities that had an intrinsic value were used in communities where trust, either in others or in a social convention such as a monetary token, was limited. In the early days of the penal colony of New South Wales, managed by the British Navy, rum was commonly in use as money, and, during the Second World War, cigarettes were used as money in prisoner- of- war camps.

The cost and inconvenience of using such commodities led to the emergence of precious metals as the dominant form of money. Metals were first used in transactions in ancient Mesopotamia and Egypt, while metal coins originated in China and the Middle East and were in use no later than the fourth century BC. By 250 BC, standardised coins minted from gold, silver and bronze were widespread throughout the Mediterranean world. Governments played an important role in regulating the size and weight of coins. Minted by the authorities, and carrying an emblem denoting official authorisation, coins were by far the most convenient form of money. Officially minted coins were supposed to overcome the problem of counterfeits and of the need to weigh precious metals before they could be used in a transaction – the need to protect the physical object used as money has always been essential to its acceptability. Adam Smith’s close friend, the chemist Joseph Black, said that while teaching at the University of Edinburgh, where students paid the professors in advance, he was ‘obliged to weigh [coins] when strange students come, there being a very large number who bring light guineas, so that I should be defrauded of many pounds every year if I did not act in self- defence against this class of students’. Counterfeiting continues today – indeed, coins are counterfeited more often than banknotes. The use of standardised coinage was a big step forward.

Technology, however, did not stand still. As the English economist David Ricardo wrote in 1816:
The introduction of the precious metals for the purposes of money may with truth be considered as one of the most important steps towards the improvement of commerce, and the arts of civilised life; but it is no less true that, with the advancement of knowledge and science, we discover that it would be another improvement to banish them again from the employment, to which, during a less enlightened period, they had been so advantageously applied.

The drawback of using precious metals as money had been evident since at least the sixteenth century when the first European voyages across the Atlantic led to the discovery of gold and, especially, silver mines in the Americas. The resulting imports of the two metals into Europe produced a dramatic fall in their prices – by around two- thirds. So in terms of gold and silver, the prices of commodities and goods rose sharply. This was the first truly European great inflation. Prices increased by a factor of six or so over the sixteenth century as a whole. That experience demonstrated vividly that, whatever form money took, abrupt changes in its supply could undermine the stability of its value.

Even more convenient than coin is, of course, paper money, which has for a long time dominated our monetary system. The earliest banknotes appeared in China in the seventh century ad. Later banknotes from the Ming dynasty in China were made from the bark of mulberry trees – the paper is still soft to the touch today. The penalty for counterfeiting was death – as advertised on the notes themselves. If not backed by gold or some other commodity, paper money is what is known as a pure ‘fiat currency’ – it has no intrinsic value and, crucially, cannot be exchanged for gold or any other valuable commodity at the central bank. It is useful only insofar as other people accept it at face value in exchange for goods and services, and its value depends upon the trust people have in it. The earliest western experiment with paper money was conducted in the United States – not the new post- revolutionary nation, but the pre- revolutionary colonies on the eastern seaboard.

Before American independence, the creation of money was the prerogative of the British government. Thus prevented from minting their own coins, the colonists rightly complained of a lack of money to support commerce. Whatever gold and silver existed in the colonies (sadly there were no gold or silver mines to provide a new supply) rapidly flowed out to pay for a regular excess of imports over exports to England, which resulted from trade restrictions imposed by the mother country. As a consequence, barter systems and commodity monies, such as tobacco, became the main method of exchange in the colonial economies.