Money has functions four:
a medium, a measure, a standard, a store
This famous couplet sums up what money or currency is. Money is the measure of value, medium of exchange, the standard of value and a store of value. From the time of the Vedas till the present day, whatever humanity chose to use as money, whether they are Cows or Bitcoins, they did so because the commodity so chosen could perform the above four functions, some to a larger and some to a smaller measure.
It is interesting to notice what was used as Money down the ages:
Cattle
The oldest form of currency was cattle. The Upanishads mention Cows with their horns adorned with gold coins being given to Brahmins at the end of the sacrifice. It is continued to this day, as a payment for conducting the funeral rites, though the priest seeks a cash equivalent of the cow, preferably as a UPI transfer! Dowries were paid in India, till recently, in cows and other livestock.
Ancient Roman records show that fines were paid using sheep, goats, and oxen.
Cowrie Shells & Primitive Metal Currencies
The early Chinese societies used Cowrie shells from mollusks living in the shallow waters of the Pacific and Indian oceans as money. Later the Chinese started having replicas of these Cowrie shells in metals. These were the primitive metal currencies known to man. The Chinese were also using weapons and tools as a means of exchange. Sometimes, these weapons were made as bronze miniatures so that they were not required to lug spears, daggers, and arrows to the market. Sooner, the sharp edges on these weapons gave way to handier shapes and round coins were born.
Leather & Animal Pelts
In the cold countries of Europe, furs, pelts, and skin of deer were used as money.One foot square deer hide decorated with cloth on all four sides was used as promissory notes by traders.
Early stamped metal coins
Outside China, the first coins were made in small lumps of silver and gold stamped with the images of gods or kings as proof of authenticity. In the ancient city of Lydia, now part of Turkey, the earliest samples of stamped coins were found. They were made in silver and gold, unlike the Chinese ones which were made in copper and bronze.
Spices & Salt
The Arab traders who used to ply their trade in spices between India and Europe used spices to settle a debt. It was said that in those days a handful of spices could buy a house in Amsterdam. This led to the Europeans wanting to find a sea route to India, the land of spices and as we all know the rest is history. Ancient Romans used Salt as a legal tender. Legal Tender is when the law of the land approves settlement of debt with that commodity. A creditor could not refuse to accept ’Salt’ if a debtor offered to settle his debt through the payment of salt in Ancient Rome.
Paper money
The Chinese were the first to make money with paper, by 800 A.D. They continued with paper currency till the 15th century. However, this led to its proliferation. Any commodity that is too easily available could not gain ‘General Acceptance’, an essential attribute of money. Sooner it was abandoned and metal stamped coins alone remained as money. What we call paper money these days are made from cotton and linen and they have a feel that is hard to replicate using paper. The process is so complicated that most small countries do not have the manufacturing facilities and skills to make their own currencies. For example, Indian security presses in Nashik and Mysore print currencies for Nepal, Sri Lanka and the Maldives and many other smaller nations.
As the use of money gained popularity, people were looking for ways to make it easier to use. Gold and Silver ingots were heavy. Highwaymen could waylay the carriers and rob them. There was neither security nor convenience.
In pre-medieval Europe, during the time of the crusades, there rose an organization of elite Christian soldiers, called the Knights Templars. They played a major role in the defeat of Muslim invaders like Salahuddin. They set up castles everywhere in Europe and operated with impunity. They were pan-European and did not submit to the dictates of the kings, a kind of state with state—the medieval equivalent of the Pakistani Army. They very soon diversified into the business of safe deposit vaults for the rich. They took deposits of gold and silver in one Templar and gave a receipt that could be used to withdraw like quantities of gold and silver from another. They also issued Letters of Credit for those who went on pilgrimage to Jerusalem on the basis of gold and silver deposited with them. They were the first bankers.
In Medieval Europe, the use of precious metals, gold coins, in particular, had become prevalent. Goldsmiths were minting gold coins in standardized size and purity which made it easier to transact as people no longer needed to weigh the amount of gold they traded-in. Goldsmiths were regarded as trustworthy and having the means of securing huge quantities of precious metals in safe vaults.
Sooner, the merchants deposited their gold and silver with the goldsmiths who in turn issued them receipts, called ‘Claim Cheques’ those days. Any ‘Claim Check’ presented to the goldsmith had to be honoured with the return of gold that it claimed to represent on the face of it. These Claim Checks soon became currency as merchants settled debts of each by endorsing them in favour of the creditor. Sooner the goldsmiths found out that all Claim Checks were not presented back to them at one time and they could leverage the existing stock of gold to issue additional Claim Checks to those seeking loans for a price. These were not depositors but those who wanted temporary accommodation from these goldsmiths when they were short of money to settle their
debts. The origins of modern banking lie in this evolutionary step in depositories run by goldsmiths.
As a natural outcome, Merchant Banks began to emerge at the beginning of the Middle Ages, primarily to fund trade. Merchant banks provided loans to associations of individuals in exchange for shares in their venture—the seeds for a stock exchange were sown then and there.
The East India Company, which was an association of merchants of Britain, could raise money to send a huge fleet of well outfitted and stocked ships to India as a result. Individual merchants or a partnership of merchants could not bring in both the resources and the risk appetite that sending a fleet of ships to the east entailed. Many a merchant lost everything when his ship was destroyed after a storm in the sea or due to the actions of pirates.
The first modern bank to issue banknotes was the Bank of England set up in 1695. These banknotes were hand-written and contained the name of the payee and the bank’s cashier. They were issued to a person upon depositing money in the bank. Sooner, they were issuing banknotes in different denominations but the notes were still hand-written. These banknotes were always honoured when presented back to the bank without any consideration of how the holder acquired it from the original payee. The nature of the underlying transaction did not taint the banknote.
Later, when the law on negotiable instruments was passed and formalised, the custom followed by the Bank of England was incorporated in the law.
Later, when the law on negotiable instruments was passed and formalised, the custom followed by the Bank of England was incorporated in the law.
Thus the process of disintermediation between those who save and those who borrow had their origins in this goldsmith's evolution as ‘manufacturers of money’. Let us see these two aspects of modern banking in detail.
The two essential functions of Banks which makes them unique institutions are:
1. Disintermediation between savers and borrowers and the idea of interest
Lending for interest was considered usury by the early Jews and Christian people. Riba is considered against the teachings of Islam as well even to this day. The orthodoxy of the Catholic Church was waning in parts of Anglo-Saxon Europe with the birth of the Protestant movement of Church Reformation launched by Martin Luther in 1512. The economists started to define ‘Interest’ as remuneration to savers for postponing ‘current consumption’. With this rational explanation, the stigma against lending for interest wore off. Economic theorists started highlighting the need for savings ( or postponing current consumption) so that Investments could be funded without any inflationary effect on the economy. The role of banks in pooling savings as investible surpluses for the larger good of the economy was highlighted by economists like Pigou.
Disintermediation means ‘removing the distance between’. Banks, by removing the distance between savers and borrowers, served to concentrate capital for large investments so necessary for growth.
2. Banks as Manufacturers of Money
I recall this quote from my college years, “Banks are not only purveyors but manufacturers of money”. I forgot whose quote it was. Let us see how Banks manufacture money. I will explain the concept with a simplified example. Let us say a Bank with a share capital of Rs100/- starts accepting deposits. It collects an initial deposit of Rs.100 from savers. The banks are obliged to return cash to depositors whenever they ask for it. This is the uniqueness of banks when compared to other Non-Banking Financial Institutions ( NBFCs). However, nobody asks for all money at once. Suppose, the bank finds out that its depositors seek to withdraw not more than 10% of their deposits, it can use this Rs200/- ( 100 + 100 ) to create a commitment upon itself to provide loans to borrowers to the extent of Rs.1900/-. As the borrowers are also going to demand only 10% of the total loan committed to them, the Rs.190 in hand ( Rs.200 - Rs.10 set a side for the depositor) is enough to meet all claiming liquid cash from it. It therefore merely credits Rs.1900 in favour of borrowers and manages its cash flows to service both the depositor and borrowers. This Rs.1900/- when used to settle debts by the borrowers become additional deposits in the banking system. Thus when money supply accounting is done, the cash along with deposits of the banks is treated as comprising the money supply in the economy. In our example, the total money supply will be Rs.2000/-. You can see how the bank has created money out of thin air, as it were. This is the reason very strict supervision banks are required as opposed to other financial and business entities in an economy. The job is entrusted to the technocrats in the Central bank of the country which is a quasi-judicial institution. They have all powers to control the banking system of a country.
Frequently, banks run into liquidity pressures when the cash inflow from borrowers does not match with the cash outflow to depositors and they go the Central Bank of the country ( RBI in our case) which acts as ’the lender of last resort’ and provides liquidity to banks, but at a price. In India, it is called ‘Repo Rate’. Currently, the repo rate is 4.40 %, the lowest in my memory.
Accounting for money supply, therefore, takes into account the balances in current, savings and fixed deposits with banks along with cash and cash equibvalents in circulation. With our economy close to 3 trillion dollars, and bank deposits close to 142 lakh crores, RBI keeps around 23 lakh crores in circulation, roughly 16% of bank deposits ( See Appendix I ). Countries like Sweden have reduced the requirement for printed money to below 1% of Bank deposits as everybody uses electronic mode of payment and cash payments are minuscule.
(India is a pioneer in this area, but elaborating on it will be a digression. A separate blog post is required to do justice to the wonderful payment infrastructure we have put in in the form of UPI, which is called by many commentators as the ‘Rolls Royce’ of all payment settlement systems. More on it in a later post).
The rise of Gold Standard
Gold has always been treasured by all cultures. The pyramids of Egypt built 5000 years back have tombs in which the pharaohs were buried adorned in gold. Even the aborigines of Australia valued gold. In the history of the world, it is estimated that around 200,000 Mts of gold have been mined. Its supply has dwindled so much and the cost of extraction gone up so much, it is not remunerative to mine in most places even where some gold is available. Gold had advantages over other commodities. It could be standardized for purity and weight, it was precious and available in sufficient quantities for the requirements of economies unto the 20th century, and did not deteriorate in value when kept in storage for long periods of time. Thus gold enjoyed “General Acceptance” to perform all functions of being a medium of exchange, the measure of value, standard and a store of value.
In the early and high middle ages, the currency used throughout the Mediterranean and mainland Europe was the Bezant , the gold coin of the Byzantine empire. With the collapse of the Byzantine empire, Bezant went out of favour. Silver took its place and silver coins were in circulation as the standard. This period extended even up to the founding of the United States in the 1770s. However, in 1717, Sir Issac Newton, who was then the master of the Royal Mint, put Britain on the gold standard. He established a new mint ratio between gold and silver and paved the way for the elimination of silver as a standard.
There were three different types of gold standards. The gold specie, the gold bullion and the gold exchange. To have a gold specie standard, a gold coin must be in circulation, upon which the value of all other bills and coins were based. Gold Bullion standard is when the currency in circulation is backed either partially or fully by the availability of gold with the Central Bank. Bullion means gold melted in mints and kept as ingots. Fort Knox in the USA was supposed to hold the largest reserve of gold in ingots. The Full Gold standard ended by 1913, before the start of World War I. However, many countries followed the gold exchange standard whereby they measured the value of their currencies in gold and used it to equate in terms of other currencies following a similar gold standard. The external value of the currencies expressed in gold paved the way for easy and reliable conversion rates.
However, the evolution of economic theories of value and the role of money supply in handling business cycles, lead to countries giving up the gold standard.
The evolution of theories of value and the demise of Gold Standard
The early economic theorists identified Land,Labour, Capital, and Organization as the four factors of production. The land referred to all-natural resources that the land offered , whether it was for farming or mining of metals. Labour of tradesmen with skills and diligence was considered a value enhancer and hence another factor of production. Capital, like a pool of monetary resources necessary to harness the other factors of production and organisation, as the managerial ability or
entrepreneurship to run the whole show, were next to two in the order of importance.
It was Adam Smith who identified labour as more important than land and its resources. This was the prevalent view until the dawn of the 20th Century. An entire political movement shook the whole of Europe and led to the overthrow of the Tsarist regime on the basis of Karl Marx’s Labour Theory of value. He propagated that capital as the villain of the piece, appropriated all
addition to value and prophesied that the resulting overproduction would lead to such a massive crash that a dictatorship of the labor class would be inevitable. The instrument of markets and free trade unbridled by any govt intervention was believed to result in the creation and distribution of wealth. However, World War I ( 1914-1918) and the Great Depression of the 1920s in the USA compelled the monetary authorities to rethink the utility of gold standard, that of pegging the supply of money to the stock of gold. War compelled the governments to free their purse strings and this meant that the Central Bank of the country could not be held hostage to the constraint imposed by the availability of gold. Still, so complete was the belief in the anchorage in gold of their currencies, the conservative money managers running the treasuries were quite unwilling to open up the floodgates and pump money into govt coffers to assist the war efforts.
The USA at the end of the First World War had become the most powerful country in the world. But the recession of 1929 devastated the country. The classical economists believed that economies will always move towards equilibrium as supply created its own demand ( Say’s law). It was not that periodic instabilities leading to the closure of business, the attendant financial instabilities and run on banks were not noticed. They even noticed that periods of the boom were followed by periods of busts and vice versa, but only there was no prescription by way of a solution. The 1929 depression brought the USA to its knees; business after the business failed, the stock market crashed, asset values came crashing down and put banks under pressure. There were widespread runs on banks. Unemployment and the resulting loss of incomes drove consumption down further leading to further closure of a business.
At this time, John Maynard Keynes, the most important economist of the 20th Century came out with his “The General Theory of Employment, Interest, and Money”. It was a breath of fresh air. The limited thinking of classical economics was projected in the large canvas of Macroeconomics with startling new insights. He saw the whole economic system as an interplay of aggregate demand and aggregate supply and he put forward the view that govt spending on increasing the productive capacity of the nation as the antidote to the flailing aggregate demand which was at the heart of any recession. He prescribed governments to boost spending on infrastructure projects to prop up flagging aggregate demand during times of downward phases of the business cycle. He put forward the concept of multiplier-effect whereby that expansion in the economy could be several times the govt’s initial trust through investments. Economics was never the same again. The methods used by classical economists looked very inadequate to understand the economic expansion the world was experiencing as a result of the industrial revolution, the birth of nation-states, the spread of education and the growth in the middle-class population of professionals and industrial workers. In fact, the recommendation of classical economists was entirely based on a theory that the rational self-interest of the man will by itself take care of all vicissitudes of the economy and their only policy prescription was laissez-faire, or unhindered free trade. There was no place for government intervention.
Roosevelt as the president of the United States was faced with mounting failures of banks in the aftermath of the 1929 depression. The only way to stop the failure of banks was to pump money into the system and he could do so only if the money supply was freed from the availability of gold with Fort Knox. Most of his advisors advised him to stick it out with the gold standard; they said that things would tide over eventually. There was one advisor by the name George Warren who advised Roosevelt to abandon the gold standard. As an agricultural economist, he was already of the opinion that US agriculture was being harmed by the gold standard. As Keynes famously said, "The difficulty lies not in the new ideas but in escaping from the old ones''. Luckily, Roosevelt listened to him and took the US off the gold standard and this is cited as one major reason for the USA surviving the Great Depression. Not only did he abandon the gold standard, but he also followed JM Keynes prescription of splurging govt money on road projects, the money raised through the issue of Treasury Bonds—money created out of thin air!! American Federal Reserve was created just in 1911 and was a conservative institution. When I had been to the USA some years back, I traveled on the road that connected Atlanta to Memphis; I was told huge road networks like those were made during the time of Roosevelt when there were hardly any cars to justify the investment in that kind of road infrastructure.
The earlier theories of Land and labour being the source of wealth was called to question when the new countries in Africa, as tribal societies, failed to capitalize on their abundant natural resources and India with abundant labour had just around 2% Growth ( called the Hindu Rate of Growth !) while countries like South Korea, Japan, Taiwan , Hongkong and Taiwan boomed. The economists reasoned the phenomenon of these 'Asian Tigers’ to the investment in human capital in these countries. Disciplined and educated workforce along with investment in physical infrastructure, none of which could have been done on a large scale without abandoning the gold standard, were given as the reason. Slowly the obsession with the gold standard was wearing off. President Nixon finally removed all linkage of the value of dollars to gold in 1970. With England and the USA abandoning the gold standard, it was just a matter of time that the whole world followed suit. In fact, carrying gold in the vaults of the central banks of countries was considered an unnecessary cost and when the UK wanted to get rid of its gold reserves in one go, the World Gold Council panicked and requested the govt of UK to do it in staggered manner as otherwise, the value of gold would crash to the detriment of world gold trade. The only recent example of gold coming to some rescue, to my mind, is the recent 500 million transaction by Venezuela, a bankrupt country, which imported essential goods from China in exchange for its gold reserves.
The last nail on the gold standard's coffin came in the 1980s and 1990s when Douglass North ( Nobel Laureate for economics in 1993) established in his monumental works the primacy of Institutions. He defined institutions as the ‘humanly devised constraints that shape human interaction”. These constraints are the “rules of the game”, and appear in both formal and informal guises, he said.
North's institutions are not only those built with brick and mortar. His ‘institutions’ included the society's codes, customs, and traditions— for example, it is not possible in India to ply slave trade or practice ruthless labour policies like China did where the culture accepts totalitarianism.
Douglas North identifies property rights—both physical and intellectual property— as an institution essential for economic growth. He traces the emergence of property rights in England to the year 1668 when the crown was made subservient to the Parliament. Before then, the monarch could take away the resources, like everything, by default, belonged to the king.
We know from experience that in India that govt-run businesses were a disaster and deepened our poverty, but well-run institutions, like the Election Commission, RBI, SEBI, TRAI, IRDA, ISRO, NCERT, NCAER, IITs, IIMs, ICMR ( in these days of Coronavirus ! ) help set the rules of the game and help in the fostering of economic growth. Before SEBI was born, Stock Exchanges in India were a closed club of some wealthy brokers, hardly anybody from the general public invested in them. Now around 12,000 crores of SIP flows into stock markets from our middle classes each month. Institutions are not just restricted to the government sector. The companies run by TATAs, Mahindras, Birlas or Reliance are no less 'institutions' than those run by Govt. Ambani’s foresight of investing in Mobile data and the execution of that vision has been a boon to our country in the past decade. GST rollout would have not been possible without the mobile network rolled out by Reliance.
What India sorely lacks is institutional capacity in local governance—of road traffic, municipal planning, etc. Bangalore traffic, probably destroys 10% of the wealth that Bangalore produces! When wealth is destroyed by "Bad institutions", the poor bear the brunt as the costs are transferred are always transferred down the economic pecking order.
What India sorely lacks is institutional capacity in local governance—of road traffic, municipal planning, etc. Bangalore traffic, probably destroys 10% of the wealth that Bangalore produces! When wealth is destroyed by "Bad institutions", the poor bear the brunt as the costs are transferred are always transferred down the economic pecking order.
It is the institutional capacity in the government and private sector that sets apart a developed country from a developing one. A country like Pakistan lacks precisely this; the only institution they developed was the army. We had the good fortune of having Nehru, a great builder of institutions at the helm for a good 17 years post-independence and they had none. In fact, the Pakistani army is a dysfunctional institution that eats into the vitals of that country; it runs factories, bakeries, farms, real estate entities and even units manufacturing ice cream, apart from its internal security and foreign policies! Douglas North also explained in his works how “Bad” institutions hamper economic growth and social progress.
If only, Nehru and Indira had corrected their blind distrust of private sector, we would have our own Hyundai, Toyota, etc.
Well-run institutions, at all levels—Federal, Provincial or city/town are important for "Wealth of Nations". After this has been established with enough empirical evidence, it was but natural that Gold lost its importance. There was no reason to peg currencies and their supply in the economy to gold. The Central Bank Governor’s solemn promise to pay the bearer a sum of … was enough. Thus currency backed by Govt fiat replaced currency backed by gold. The last to give up the gold standard was Switzerland; they did it in the year 2000.
There was also another significant development in economic theory in the 1960's —the works of Milton Friedman, in the area of monetary theory. He disputed the Kenesian ideas of Govt proactive spending and said that merely by modulating the flow of money in the economy it was possible to stabilize growth and avoid financial crises.
Based on the Indian experience, I can say, it is the Govt’s spending policies ( Fiscal policies) and the monetary policies of the Reserve Bank of India, together decide the fate of our economy. Just imagine, the kind of monetary loosening ( Quantitative Easing, as they call it) that Govt’s and Central Banks are doing across the world to fight the recession fears in the wake of Coronavirus shut down; it would not have been possible at all in the days of the gold standard. The USA president just signed a bill to provide a 2 Trillion Dollar push, our own Modi will have to think upwards of 10 lakh crore fiscal expansion if our banks and businesses do not fail. Besides, we have to literally drop money from helicopters if our migrant labour is to be saved from starvation. Times are extremely challenging for Central Bankers all across the world. They will have to handle the backlash of inflation in the aftermath of this monetary loosening.
But one question is still unanswered. It is alright for the diktat of a govt to run within a country. Why should a Srilankan in his country accept Indian Rupee in settlement of debt? Indian Currency or for that matter no currency, save for the exception of the currency of the USA has what is known as “General Acceptance '' across all countries. To a limited extent other currencies like Euro, British Pound and Yen are also accepted as world currencies, but none can match the stature of the US dollar as people all over the world have faith in the American institutions, the judicial system and its checks and balance. Chinese currency can never be widely accepted as a world currency as its institutions are suspect and non-transparent, its judicial system not independent and there are no checks and balances on the activities of President XI. We all use the “promise to pay’ of the American treasury to settle dues across the world. America need not produce anything, it does preciously little actually—just pumping more dollars into the world’s currency markets is enough, the world is ready to gobble it. Remember, a 100 dollar note by the USA is just what it says—a claim on the resources that the USA has to offer. The entire world seeks something or the other from the USA and hence it is okay to accept the US dollar in return for export to any third country. When this bubble will burst , it is hard to imagine, burst it will, as it is against the natural order of things. A black swan event like this virus outbreak could end the eminence of the dollar if America is devastated by the virus more than other countries.
So what happens if a country runs out of foreign exchange reserves in the form of dollars ( typically American Treasury bonds ). The country will not be able to buy the next consignment of petrol as we were in 1990. Barter is the only option. I recall the days when the USSR collapsed in the early 1990s. I was working in a Fertilizer company of the TATAs. USSR was a big importer of low-grade South Indian tea under the Rupee-Rouble agreement signed between the USSR and. India. The rouble was artificially set equal to about 70 Indian rupees to our detriment under that agreement. With the USSR falling there was no value for Rouble. Gorbachev’s government did not have dollars to pay for our tea exports. We also had no market for the low-grade tea in dollar paying countries. It was decided that one TATA company would import Muriate of Potash ( MOP) a fertilizer and another company would export tea and settle accounts between themselves. It did not work out for too long, because of the dread of Russian mafia controlling the ports of the Black Sea, which is another story.
Appendix I
Money supply as per RBI released data as of March 13th, 2020.
M3 is called broad money and the amounts are Rupees in Crores. The
currency with the public is just 23 lakh crores, while the bank deposits are
around 142 lakh crores. RBI has some gold , but is treated as part of reserve and not as money supply.
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