Saturday, August 20, 2011

As the nature of the economy changes, the nature of money changes

Let's put history on fast forward. The feudal system dissolved. The trading empires arose, and soon in the great centers of trade like Florence and Genoa banking develops.

Government debt - and bankruptcy - are invented. ( See A History of Florence 1200-1575 for how Florence consolidated its government debt in 1343 and how the "Monte" - mountain of debt - dominated politics for decades.)

Philip II's Spain imports fleets of gold from the new world, squanders it in Habsburg dynastic wars, and then serially defaults on its debt starting in 1557.

The Dutch and then the English strengthen their empires with the invention of central banking, including the Bank of England in 1694, and careful management of a national debt.

Finance strengthens the sinews of war. Or destroys them. Spain disappears as a great power. England's Royal Navy comes to rule the waves.

France impoverishes itself with John Law's Bank disaster. The South Sea bubble causes wild swings of optimism and despair in England in 1720. Bank notes begin to circulate. Stock exchanges begin in coffee houses.

Alexander Hamilton transforms the future of the United States when he does a deal with Thomas Jefferson in 1790. He agrees southern states will get the new national capital, instead of the current location and his own home of New York City. In return Jefferson agrees the federal government will assume state revolutionary war debts and create a national debt. America would not just be a nation of yeoman farmers, as in Jefferson's vision. It would be a financial and industrial and military power. New York City eventually becomes the largest, richest city on the planet, while Washington D.C. remains a small empty southern town right up to the New Deal in the 1930s.

Inflation, sovereign default, credit booms and busts, vast wealth and sudden indigence come and go. Money becomes abstract, related to confidence, sovereign power, property, prudence and ideas of liberty.

The world starts becoming one interlinked, globalized economy. Money turns into an international system, most importantly the gold standard in the 19th century. Major currencies are linked together by strictly maintained values in gold. Movements of gold for settling international payments would inflate or deflate domestic economies, and increasingly causing outrage among farmers and workers. William Cullen Bryant's speech to the Democratic Party Convention in 1896 is the most famous example:

"Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests and the toilers everywhere, we will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold."

But that in a sense is just what happened well into the 1920s and 1930s. The first world war forced countries off the gold standard. The war caused immense inflation, as many governments simply printed money to pay obligations rather than raise taxes. Much of the gold reserves in the world also flowed to the safer USA.

Liaquat Ahamed tells the story in his book Lords of Finance: The Bankers Who Broke the World of how Winton Churchill disastrously put Britain back on the gold standard in 1925. It led to worsening mass unemployment and helped cause the general strike of 1926. Before long the whole world financial and trading system collapsed.

(I will have more to say about this political change later, in reference to Karl Polanyi's bookThe Great Transformation: The Political and Economic Origins of Our Time. Polanyi argues the gold standard soon became politically impossible after democracy meant populations would no longer accept the dislocation of deflation. The current monetary system became socially impossible.)

The interesting thing about the abortive restoration of the gold standard was the conviction among most Treasury officials, central bankers and economists that a return to the gold standard was both practically essential and morally necessary to restore the confidence of savers. ( Of course, inflation did ravage savers for much of the next seventy years.)

The gold standard meant governments could not interfere with or debase the currency. But economic aims alone are no longer sustainable in the twentieth century. The public will not accept the insecurity and volatility and u employment the link to gold apparently brings.

So governments loosen the system, effectively turning it into a dollar standard. Countries settle their accounts in US dollars (or in theory IMF special drawing rights). There is a residual link to gold, but it no longer automatically determines a country's money supply.

The Bretton Woods system of fixed exchange rates, as it is known, remains largely stable for thirty years. This is partly because international financial markets are hobbled. Capital flows are restricted, and exchange controls even apply to ordinary tourists in many countries. There are strict limits on how many pounds sterling a person can exchange for US dollars, for example. Currencies are not fully convertible.

But the Bretton Woods system breaks down in 1971 when Nixon breaks the dollar's link to gold. Currencies float freely, which helps countries adjust to the oil shocks of the 1970s and 1980s. Inflation breaks out. Currencies swing dramatically, despite international efforts like the Plaza accord in 1985.

Soon politicians want to use the monetary system for political ends again. The European Union links the DM, Franc and other currencies into an exchange-rate mechanism. It then evolves into a full-scale currency, the euro, in 1999 and its own banknotes in 2002. China links its currency to the US dollar. It purchases vast amounts of US treasury debt to keep the yuan's value from rising and its exports competitive.

And so to this week, when the euro is tearing itself apart and China is in an unsustainable boom. American consumers are overindebted and underspending. Markets are fragile. People are nervous. The monetary system is at the very heart of the problems.

Our ideas of money and the mechanisms and values money represent can upend society. And so we must be careful to neither stick to an outdated, rigid conception of money, nor allow it to be so flexible that soaring debt, sovereign default and depression are the result.

And here's the real point: our current problems - sovereign debt, recession, economic slowdown - are not just a matter of arithmetic. It is not just a matter of taxes and revenues and spending and credit and demand. It is not just a matter of the size of government.

It is a problem with our conception of money, its functions and limits and boundaries, just as so many times in the past.

As the nature of the economy changes, the nature of money changes. And vice versa.

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