The changing world of money
The ability of states to effectively create money and get away with it boosted the ability of governments to spend. However, Quantitative easing and digital money could change all this.
Money is the root of all evil, some say. Others accept that money makes the economic world go round. The investor has some money and wants to keep it safe, but also wants to earn a return. That may require holding it as a longer-term deposit to get a better rate of interest, or taking considerably more risk and buying shares or properties. There needs to be sufficient money to pay wages and buy goods and services to maintain good levels of employment and allow decent living standards. Governments and Central Banks agonise over how much money there is, how much is needed and how taxation should be used to influence the distribution of the money in circulation.
The traditional idea of money in an advanced country is based on a state-issued monopoly currency, and a highly-regulated banking system which holds deposits in the currency and offers loans in it. When we abandoned the gold standard we came to rely on individual central banks and governments making wise decisions about how much money to allow in circulation, to keep its value. If they allowed too much the internal value of the money fell through price inflation, and the external value fell through currency depreciation against other fiat currencies.
Inflation vs jobs
Governments also wrestled with the fact that the amount of money and credit has an impact on the performance of the economy, influencing how many jobs can be sustained and how much output created. Sometimes the wish to keep inflation down conflicted with the wish to see more employment and activity. Commercial banks create money and credit under the surveillance of the Central Bank. The Central Bank intervenes to increase or reduce the pace of money and credit creation, by shifting official interest rates and by buying or selling government bonds. If it thinks too much credit is available it can raise the rates trying to deter people from borrowing, and it can sell more government bonds to mop up money that would otherwise be available to banks to lend on.
In the late 1980s in Japan – and at the end of the last decade in the US and Europe – the monopoly currency systems produced banking crashes. The authorities decided to discipline the commercial banks for past excessive lending, greatly reducing their capacity to create enough money and credit. This in turn led to recession. Rather than fix the commercial banks quickly or allow them more scope to lend, the authorities decided they would create more money directly themselves, and inject it into markets by buying up government debt.
This policy of quantitative easing has become a regular part of Japanese life for many years, and played an important part in the recent economic history of the US, UK and the Euro area. It had limited success. It drove up asset prices, by paying ever higher prices to buy the government bonds. This in turn persuaded investors to sell their bonds and buy shares and properties, pushing their prices up. Some of the money found its way into the banking system, facilitating more lending and transactions. Because money and credit creating by commercial banks was impaired it did not prove to have much impact on the general price level. The inflation it generated was mainly confined to asset prices.
The ability of states to effectively create money and get away with it boosted the ability of governments to spend. They can borrow so cheaply and effectively cancel some of the debt by buying it back, permitting them to spend more. In turn, it in led to a few doubts about the nature of money. More doubts have been created by technology with the evolution of much more digital money replacing cash. It has long been the case that most money takes the form of an entry in a bank ledger. Most people hold the bulk of their money as a current account and deposit account balance with their bank, with only a small amount of their money held in the form of physical banknotes. This process is accelerating as many more people now pay for items through their mobile phone or credit or debit card.
Governments have started to undermine cash as a means of payment as they fear some people use cash to escape taxes or break other laws. In Sweden parts of the public sector refuse to accept cash payments. In India the government withdrew the two largest denomination banknotes from circulation, to force their owners to declare their wealth and hold it in a new form, preferably as bank deposit, so it can be taxed and accounted for.
China is now working on a new digital currency or payment system, to modernise the yuan. The attraction to the Chinese state is obvious. If they can get Chinese people to undertake all their transactions digitally under an approved state system, the state will have greater intelligence about what people are doing, and a means to regulate or control them. The money the state creates and allows in your account could be repossessed by the state if they dislike your conduct.
The rise of crytpo
In the US, the tech giants are working on digital payments, whilst the credit card companies and banks already dominate the market for holding money and paying for transactions without using cash. The Fed is at the moment engaged on an exercise of rethinking how it controls money and the commercial banks. The President thinks the Fed has been too tough, not allowing enough cash and credit to circulate to generate even more jobs and incomes. The Fed worries that the US economy is close to the point where more looseness might generate inflation rather than more activity.
Quantitative easing and digital money have undermined the traditional prudent thoughts of some in the mainstream, who are now looking for a replacement approach. Some say the Japanese experience shows you can loosen a lot more without causing inflation. Others look at Argentina and Turkey for a reminder that even in this modern digital world governments and central banks can overdo the money creation and end up with a nasty inflation.
All eyes are on the Fed this week. There seems to be enough money around to sustain the current expansion. Will they stand up to the President who says otherwise? Many market commentators and investors seem to want more money and even lower interest rates, as this formula has buoyed financial assets over the last decade. This puts them on the side of a President who they often criticise for his tweets against the Fed.
For more information please get in touch 020 3504 8307 or email us at email@example.com
John Redwood is Chief Global Strategist at Charles Stanley &Co. Limited, which is authorised and regulated by the Financial Conduct Authority.