Centuries ago, a famous Spanish poet warned how powerful money was. Many things have changed since those famous verses were written, but the important role of money in society and in human life has not been one of them. Among the countless things that have changed since Quevedo’s time is… the money itself. Back then, the value of coins was related to the metal with which they were minted, while today, 50 years after the death of the gold standard, trust is the only thing that justifies the value of money.
Pablo Duarte, senior analyst at the Flossbach von Storch Institute, reflects on what exactly ended money as it was known until 1971. Until that year, the US government guaranteed that if you raised $35, you could exchange it for a ounce of gold, thereby fixing the value of the US currency. Last Thursday, an ounce of gold was worth 1,816 dollars, thus evidencing an undeniable reality: money is worth less, much less, than before 1971.
For Duarte, the gold standard died when it became uncomfortable for the US government. Underfunded and immersed in the Vietnam War, he found raising debt or taxes unpopular. The solution was to increase the money in circulation and for the central bank to finance the government, but the gold standard acted as a corset by needing more metal to print more money. The solution was to remove that particular corset.
This brought consequences. “The first thing is a loss of currency value. The second thing to notice is an increase in speculative bubbles. In the history of financial markets there have been bubbles for centuries, such as the tulip bubble or the Louisiana Company bubble. There have been all kinds of things, but the common denominator in them is the devaluation of the currency”, recapitulates the analyst.
However, not even the long-awaited gold standard for some was far from infallible. Already in the ancient Roman Empire, some emperors had the habit of lowering the value of their currency by putting less metal in it or mixing gold with other less noble materials to mint more and finance their wars or whims. In essence, the foundation of money has always boiled down to the same thing and this remains unchanged.
“We are talking about a monetary system based on trust. Because the bills themselves are of little use. They work based on the trust that they will be accepted by other people in exchange for goods or services. With gold it has a value, but also gold can be manipulated. Even the gold standard system is somewhat based on trust. In the confidence that whoever decides how much gold to offer in exchange for the currency is not going to change that figure from one day to the next,” asserts Duarte.
Bankers or wizards?
Year 2020. A pandemic like no one remembers has paralyzed life as we knew it. In the midst of the tragedy that millions of people around the world are experiencing, the economy is frozen as hitherto unthinkable lockdowns are applied. Central banks step up and commit to supporting the economy. The GDP collapses, but the quantity of money increases enormously.
The percentages and figures vary, but history repeats itself almost everywhere in the world. In the case of the Eurosystem, the balance sheet of the European central banks grew by 2.32 trillion euros, rising 50% in 2020 to a total of 6.97 trillion. In the Federal Reserve, the increase in the balance was 3.16 trillion dollars. An increase of 76% in one year, until setting the balance at 7.33 billion dollars.
The historic fattening of the central bank balance sheet meant that 2020 was the year in which the most money was created in five decades. According to data from the IMF, the sum of the debts of households, non-financial companies and governments worldwide reached 28 trillion dollars, leaving the total at 226 trillion, or what was the same, 256 % of world GDP. But even in this there are classes. Specifically, according to the IMF, 90% of the increase in debt in 2020 occurred in advanced economies and China. Those who were able to turn to their central banks.
Sources with knowledge of monetary matters who remain anonymous remind us of the high price that injecting too much money can have. These sources say that in the 1960s and 1970s, in some Latin American countries, central banks were required by law to pay public deficits through monetary expansion. “When Keynesian monetary policy was abandoned and it was thought that you cannot continually expand monetary policy and finance government deficits forever, it is because it was a game that sooner or later exploded. People lost confidence in that currency because they knew that currency was losing value in the face of the continued printing of money by the central bank to finance government deficits,” they maintain.
The aforementioned sources say that this lesson was learned through hyperinflation. Although, they point out: “If you are thinking that the quantitative easing measures carried out by the Fed or the ECB are exactly this, you are right, what happens is that the governments of Latin America do not have the credibility or have the hard currency such as the dollar, the euro or the yen. These are such solid coins that they can afford it. There has been a lot of discussion about whether the advanced economies are making the same mistakes that the emerging economies made in the 1970s, but the truth is that the emerging economies did not enjoy the credibility that the advanced economies have”, reflect these sources, before recommending caution when talking about 2020 in terms of monetary policy given the exceptionality of the year.
By way of conclusion, they state: “You cannot create production by decree. The backup of money is the real production of the economy. You can see it in relative terms of the exchange rate, of one currency versus another. If suddenly Mexico starts to grow a lot, triple that of the US, because they do everything right and many reforms are implemented, what one would expect is a strengthening of the peso against the dollar. Because that economy grows more and, if it is perceived to be sustainable, then that currency will be gaining strength. Strictly speaking the value of a currency is backed by something real, we are not magicians. It is not enough to print money to be richer”.
money and water
At first glance, money and water have little to do with it, despite how easily both can sometimes slip through your fingers. They have more similarities metaphorically. Water is necessary for human life. We use it in virtually every facet of the economy, but too much of it can end up drowning us. For its part, money is necessary for the human economy, we use it in practically all facets of it, and the question is whether an excess of money printing can end up drowning a country.
“There are countries in which, when taking control, the president dismisses the central bank and puts whoever he wants. So it happens that he forces the central bank to print. What that dictator will be able to do more than president is to force the central bank to print money, but he will not be able to force the world to buy his exports, nor can he tell the world how much he is going to lend his debt. No matter how dictator you are, you can’t force them to lend you money. He can control his nationals, but people will tend to take money out of that country. We have already seen this movie several times. If what you mean is that advanced countries are playing with fire by printing money, giving transfers to people and financing governments, you are right. It is a dangerous game. It definitely is”, comment the anonymous sources about it.
Doubts about the value of money have been causing a search for alternatives. For example, with a discourse based on its decentralization and a limited number of units, specifically 21 million, bitcoin has achieved great popularity until the disaster that occurred this week. “The dollar is sustainable because there is really no alternative to it. In recent times we have begun to see an attempt at competition, this aspect of innovation is very positive, but we are light years away from seeing something alternative to the dollar. In the case of bitcoin, it does not meet any of the three characteristics of a currency in use, that is, being a unit of value, being able to be used for transactions and being a store of value. Its volatility means that it can hardly be considered a reserve of value”, says Pablo Duarte.
“At the Flossbach von Storch Institute we have a price-to-wealth index. The consumer price indices are published by the different statistical units of the countries. Everything that is not there you do not have. It is very interesting to consider the wealth index. Although consumer inflation was stable and low, the inflation of the prices of wealth, an index in which there are real estate, shares, vintage cars, works of art, valuable wines, assets with which it is sought to maintain value, this It’s going up crazy. In Spain, between 2014 and 2019, the prices of these assets increased by 23%, ”says the analyst.
“The big dilemma in all of this is what kind of institution, rule or mechanism would allow us to have a monetary system that does not degrade into what it has always been degrading. There has always been someone who has benefited from the system, the elite, the king, the duke, whoever. The question is how to create a system that is stable in terms of the institutional framework to base the value. If you want a really stable system, you should not be able to set the amount of money supply in a discretionary way”, concludes Duarte.
Metaphors aside, there is a big difference between money and water. If someone wanders in the desert, he wishes he had a bottle of water instead of a ticket, because water does have intrinsic value.
In an article entitled “Digital innovation and the future of money”, the director general of the Bank for International Settlements (BIS), Agustín Carstens, speaks about the digital evolution of central bank money. The one that seems will be the next step.
“Money is evolving and has been for thousands of years. To avoid the volatility and costs of money scarcity, societies adopted trust claims for more stable money. However, they also learned the hard way that commercial banks and governments have an incentive to overissue, which erodes confidence in those credits and harms economies and society. As exemplified by the Bank of Mexico, the current independent central bank, with a monopoly on the issuance of banknotes and a mandate for monetary stability, has evolved based on trial and error”, it starts.
After talking about the innovations that the alliance between private banking and public banking has brought about, Carstens continues. “Many digital innovations are learning from the lessons of the past that drove the evolution of our current system. Cryptocurrencies, such as bitcoin, may be scarce, but this has led to the same volatility and costs as other types of money. The move to stablecoins seems like a repeat of history, both in terms of the need for a claim to stabilize money, and how those claims can be undermined. An alternative to the failed digital money types of yesterday could be central bank digital currency.” In closing, Carstens says, “We need to innovate what money can do, not try to reinvent it. Money will continue to evolve and that evolution must be based on trust.”
Judging by the lines written by the director general of the BIS, the arrival of digital currencies issued by central banks will not change the backing that money has always had: trust. If they fail to generate it, this type of money will fail.
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Trust economy: how money and water are alike
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