The Evolution of Money

by David Orrell

  By November of that year, the price of gold had reached $100. Soon after, the Bretton Woods currency system ended, and exchange rates between major currencies were allowed to float freely, unburdened by the effects of Newtonian gravity, like astronauts in space.

  Money 5.0

  The Nixon shock effectively transformed the dollar, and every other currency linked to it, into fiat money. In one of its magnetic reversals that happen only once or twice a millennium, money had completed a switch from being based on scarce supplies of metal to being based on the word of the state. However, because all the components of the machine were kept in place, it didn’t appear from the outside as though anything had changed. Unlike John Law, Nixon had made sure that the bankers were onboard. And as Galbraith noted, language was carefully controlled: “Men did not speak of the final abandonment of the gold standard. Instead it was said that the gold window had been closed. No one could get much excited about the closing of a window.”26 So the new system was superficially the same as the old one. The only difference—which no one liked to draw attention to in case it harmed the stability of the dollar—was that now there was no connection to gold. There was still plenty of gold in the vaults of Fort Knox or the Federal Reserve, but in theory it had nothing to do with the monetary system. The Federal Reserve was not renamed the “Public–Private Non-reserve,” which would have been more accurate, since the only “reserves” it can produce to back up its banknotes are bookkeeping credits on an electronic ledger.

  Of course, these changes had repercussions (including inflation which climbed to 11 percent in 1974). As nervousness was growing about the dollar, the International Monetary Fund (IMF) decided in 1969 to create its own reserve asset, known as special drawing rights (SDRs), which were handed out to members in proportion to quotas. Initially an SDR was valued at 0.888671 gram of gold, but this too was abandoned in 1973, and since then its value has been computed with reference to a basket of major currencies. Since an SDR can be swapped for hard currencies, it provides liquidity to the global banking system, even if it can’t be used to buy anything directly. As the IMF’s deputy managing director Min Zhu put it, “They are fake money, but they are a kind of fake money that can be real money.”27 SDRs have since played a growing role in the global economy, especially following the Great Financial Crisis (GFC) of 2007/2008.

  At the same time that money was losing its connection with precious metal, new forms of electronic money such as credit cards were emerging (box 5.2). The automated teller machine, or ATM, made it possible to use a bank card to withdraw money. In 1971, the NASDAQ was the first electronic stock market, allowing traders to buy and sell stocks using computers. The growth of this electronic system was enabled, and ensured, by the development of the Internet. It was only a matter of time before people were having their salaries deposited electronically, managing their finances online, and shopping at e-commerce outlets such as Amazon and eBay. Once again, money was going back to its virtual roots, as a score in a ledger, a digital record this time rather than cuneiforms.

  Box 5.2

  Paying with Plastic

  The first charge card, made out of cardboard, was introduced by Diners Club in 1950. The idea came to company founder Frank McNamara after he forgot his wallet while dining out in New York. The card allowed customers (mostly well-off businessmen) to purchase meals at the restaurants listed on the back and settle the bill at the end of the month. In 1961, Diners Club switched to a plastic card.

  Competition arrived only in the late 1950s, when American Express launched its charge card, and the Bank of America introduced the BankAmericard (renamed Visa in 1977). This last was a credit card, which meant the debt could be rolled over with an interest charge. In the 1960s, Barclays Bank in the United Kingdom joined in with its Barclaycard, and the City Bank of New York came up with the Everything Card, later renamed MasterCard. American Express introduced its gold card, which was soon copied by other issuers, showing that gold still held psychological appeal at least. The list of participating outlets no longer fit on the cards. In Nigeria, a 2014 scheme to give every citizen an ID card with an embedded MasterCard debit card and share biometric data with the firm was protested by local groups that said the branding was similar to the branding of people during the nineteenth-century slave trade.*

  Just as subatomic particles exert forces on each other by the exchange of transient, virtual particles, so shoppers exert forces on the economy using credit cards, which create pulses of virtual money that are annihilated when the monthly bill is paid. This virtual money adds up—the current total credit card debt in the United States amounts to more than $10 trillion. Processing the transactions is a complex task, and fees—which amount to 2 to 3 percent—are a major source of profit not just for the credit card companies, led by Visa and MasterCard, but for a range of intermediaries such as banks, payment processors, and clearinghouses.

  *Patrick Jenkins and Tom Braithwaite, “New Platforms Vie to Take Finance to the Masses,” Financial Times, January 29, 2015.

  All of this activity was dwarfed, however, by the massive growth in currency trading that occurred after currencies were free to float against one another. In one sense, currency trading is the most pure form of economic activity in that it only involves money—no actual goods change hands. It is unbounded by time zones or geographical location, is highly liquid and leveraged, and—like the financial equivalent of a superconductor—is mostly untroubled by regulatory friction or resistance. Average turnover on a typical day is now about $4 trillion, which compares to an annual world GDP of $71 trillion. Much of the trading is carried out by high-frequency automated computer algorithms. This frenetic, twenty-four-hour, globalized activity is driven not so much by news or information but by the actions of other traders and investment firms that not only follow and react to one another but, as shown by a U.S. Department of Justice investigation, sometimes collude to rig prices.28

  Because floating currencies are linked through the markets, which quickly exploit and remove any opportunity for arbitrage, a change in the exchange rate between any two currencies, say the yen and the dollar, is quickly reflected in other exchange rates, such as the yen versus the pound. However, the fact that currencies are linked in this way does not mean that they are driven to equilibrium, only that their motions are closely coupled, so shocks or fluctuations immediately propagate through the system. Rather than accurately reflecting economic “fundamentals,” the market is mostly reacting to itself. This feedback means that, like turbulent flow, price changes are characterized by sudden spikes of intense volatility.

  As in other financial makets, much trading in currencies is done not through spot transactions but through derivatives such as options (contracts to buy or sell at a particular date and price). As discussed in more detail later in the chapter, complex derivatives can be used to bet on anything from stock prices to mortgage defaults. The nominal value of all such derivatives—that is, the amount potentially at risk—has been estimated at $1.2 quadrillion.29

  On the surface at least, central banks are still responsible for managing the money supply. According to the conventional picture, as discussed in box 4.2, the “fractional reserve” system means that deposits from the central bank are multiplied, through the private banking system, by an amount set by the reserve requirements.30 However, as the Bank of England noted in a recent paper, this is misleading, because it makes it seem that the central bank initiates the process and is in total control of the money supply. In most countries, there is no formal reserve requirement, and banks are free to lend as much as they want. “In normal times,” therefore, “the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”31 To back up their loans, banks do want to hold some central bank money, on which they pay interest at a rate set by what is known as the interbank interest rate—the rate at which banks lend to one another. The central bank controls this rate by, fo
r example, using made-up funds to buy bonds on the open market from preferred suppliers—which adds reserve money to the system, thus making it cheaper—or by selling those bonds—which does the reverse. So money creation is the job of banks, and the central bank’s main lever of control—apart from emergency measures such as quantitative easing—is limited to tinkering with the interbank interest rate.

  As Adair Turner notes: “Economic textbooks and academic papers typically describe how banks take deposits from savers and lend the money on to borrowers. But as a description of what banks actually do this is severely inadequate. In fact they create credit money and purchasing power. The consequences of this are profound: the amount of private credit and money that they can create is potentially infinite.”32 In other words, while we usually think of the money for a bank’s loans being generated by the deposits of its customers, that is really the wrong way around. Instead, the money in the system is created in the first place when the bank makes a loan. The money supply is therefore almost completely detached from the physical actions of minting coins or printing banknotes and is only indirectly influenced by government policy. In fact, in countries like the United States and the United Kingdom, currency in the tangible form of coins or notes makes up only around 3 percent of the total money supply.33 Since the entire economy is funded by these interest-bearing loans, it has been estimated that about half the cost of everything we buy can be traced back to interest payments.34 Turner adds: “To a quite striking extent, the role of banks in creating credit, money and purchasing power, was written out of the script of modern macro-economics.” More on this in chapter 7.

  Because this bookkeeping money is created when a loan is made to businesses or individuals, and destroyed when the loan is repaid, the money supply is like a bathtub full of water with both the tap on (money creation) and the plug out (money destruction). The amount a bank can lend is limited by the interest rate it needs to pay the central bank for reserves and regulations that loosely tie it to government policy, but the real source of money is not the government but private banks. The government has to borrow money from a central bank and pay interest on the loan like everyone else. This helps counteract the impulse to print money with abandon, but as discussed later it is a rather expensive approach. Even were the government to run a surplus, it cannot pay off the debt, because it is exactly those securities that back the debt and therefore the money supply.

  Governments are therefore supposed to be in deficit, as neochartalists such as L. Randall Wray point out, because they need to supply citizens with money (which puts the lie to austerity politicians who compare national budgets with household budgets).35 It is hard to grow the economy if there isn’t enough money in circulation to buy more goods and services.36 And if the government does not borrow the extra money by issuing bonds, then it has to come from somewhere else—the private sector or other countries—and usually at a higher rate of interest. So there is always a trade-off between public and private borrowing. Of course, this is not to say that governments should attempt to artificially boost GDP by borrowing even more money—debt helps to fuel short-term growth but is not in itself sufficient for long-term growth, because what counts in the end is how the money is used.

  Since the dollar is the global reserve currency, the United States also has to run a trade deficit to supply currency to the rest of the world. As Federal Reserve governor Marriner Eccles explained to Congress in 1941, “If there were no debts in our money system, there wouldn’t be any money.”37 Whether the country needs quite so much debt is less obvious: since the Nixon shock in 1971, its credit card has developed an impressive balance, with the ratio of federal debt to GDP roughly tripling from 35 percent to 103 percent. Private debt, which is of greater concern (as will be discussed in chapter 7), has followed a similar trajectory, going from 144 percent to 367 percent of GDP.38

  Aftershock

  Of course, these developments that began in the 1970s did raise the question: If the U.S. dollar, which was still the main reserve currency for the global economy, was not backed by gold, then what was it backed by? Perhaps it was backed by the seal (or electronic equivalent) of the government. But if governments were now free in principle to produce as much electronic money as they wanted, and only had indirect control over the money supply anyway, then how much was the seal worth?

  One alternative was to say it was backed with oil instead of gold, which is essentially what happened in the early 1970s when OPEC countries agreed to price their product in dollars. The fact that countries needed dollar reserves to pay their fuel bills certainly supported the currency; but the value of oil is a slippery quantity that lacks the reassuring (if largely psychological) stability of precious metal. Or perhaps dollars were backed by military force—which would help to explain all those U.S. military bases in far-flung destinations around the world.

  Today, the term “virtual currency” is usually reserved for cybercurrencies, but (and this hasn’t quite sunk in yet) even traditional forms of money such as the U.S. dollar have now gone virtual. This was illustrated in a 60 Minutes interview with Ben Bernanke in 2009. When asked whether it was “tax money that the Fed is spending,” Bernanke replied: “It’s not tax money … we simply use the computer to mark up the size of the account.”39 No wonder personal and sovereign debt in many rich countries is at record highs, when money itself has lost any sense of tangible reality. Just as music lovers are rediscovering the tactile experience of playing vinyl records, and studies show that we recall text better when it is read from a physical book than a screen, so money seems less real when it exists only on a computer and payments are made using contactless terminals. It seems bizarre to think that less than a century ago gold and silver coins were a regular part of everyday commerce.

  In the 1990s, the trend toward virtualization accelerated with the spread of complex new financial derivatives such as the credit default swap (CDS) and collateralized debt obligation (CDO). The CDO allowed banks and financial intermediaries to bundle up large numbers of loans, such as mortgages, and divide them up into tranches with different risk levels. The CDOs could then be sold off to other institutions, so a mortgage on a house in California might be held by a bank in Germany. Mortgages were no longer an arrangement between a person and his or her local bank but were a commodity that was passed between a large number of brokers and intermediaries. The CDS, meanwhile, was a kind of insurance against default. If a bank lent a company some money, then the bank could insure its loan by taking out a CDS. Alternatively, it could take out a CDS as a bet that another company would go bust. These derivatives were traded over the counter rather than in public exchanges, so there was little transparency. A consequence of these developments was that banks had many ways to reduce their perceived exposure to risk. This meant they could lend out even more money, boosting the money supply in a manner very similar to John Law’s scheme in eighteenth-century France. And like Law’s scheme, it revealed one of the dangers in virtual money, which is that its validity rests on the authority and stability of its issuer—and private banks proved to be no better equipped for this role than was the French monarchy.

  While financial innovations had appeared to reduce risk, all they had done was to conceal it, by making the system more complicated and opaque.40 And instead of helping to safeguard the value of the currency as at the start of the gold standard, the private-banking sector had been using it for rampant and uncontrolled speculation. The collapse of these schemes meant that the banks had to be rescued by the public sector. In the United States, 4.5 percent of GDP was spent on recapitalizing banks, an amount almost equivalent to its massive defense budget. The United Kingdom spent 8.8 percent, and Ireland 40 percent (about eighty times its defense budget). This went rather beyond Walter Bagehot’s idea of the lender as last resort, since the problem was not one of bank liquidity but of solvency—the loans were no good. The Bank of England’s public–private template made sense when the private sector supported the cr
edit of the state but not when it needed to be rescued by the state during the Great Financial Crisis.

  The GFC can be seen as a kind of delayed aftershock from the Nixon shock, and the reverberations continue to the present day. Money had switched to a virtual phase, and—surprised by its new power—the first thing it did was blow up a giant multidecade global credit bubble, which the crisis only partly deflated. Just as the GFC revealed problems in the fiat currency system, it also exposed the flaws in our economic theories of the financial system. Risk models used by credit-rating agencies to price instruments such as CDOs were based on the “gold standard” theories of neoclassical economics, which assumed that price changes were random perturbations to an underlying equilibrium. They therefore failed to take into account the unstable nature of the monetary system or the possibility of a general financial crash (when equilibrium is not a useful concept). As discussed further in chapter 6, the implications were felt especially keenly in the eurozone, where the fledgling euro currency proved to be both an asset and a liability.