Fiat money is a wonderful thing is it not? Truly one of the more useful developments in society since humans first learned to think / speak, that one can put in a day’s work and be rewarded with a piece of paper, which can itself be exchanged for something as marvelous as a punnet of strawberries or a Fender Jazz Bass.
So easy, right? And not a large wheel-barrowful of paper as citizens would have needed in the Weimar Republic, but a small scrap that is literally like Monopoly paper. (The 500 euro ($632) note, at approximately 404 pounds, is coincidentally exactly one week’s average gross salary for workers in the UK in 2011. Just think, all that purchasing power contained in a piece of paper measuring 160 x 82 mm! And in Bangladesh that note would be 60 percent of average annual salary…).
The public could be forgiven for wondering where the money comes from. Originally, that is. What is backing up the value implicit in a bank note?
The orthodox answer can be found in any textbook on economics of course. Ultimately the central bank backs up the value of paper money, with its "promise to pay the bearer on demand the sum of…" but of course since currencies came off the gold standard this promise to pay isn’t in the form of equivalent assets of intrinsic value, like gold, but just more of the same paper money.
But what is the central bank? An arm of the government. The Bank of England, the Federal Reserve, even the European Central Bank with its jurisdiction across multiple national boundaries, are not private institutions in the way that a fruit ‘n’ veg stall or Microsoft are privately owned. They are branches of the government (or governments).
Right now we have the ECB lending money to banks, who in turn lend (some of) it to governments. A very handy circle of money that provides (unarguably much needed) term liquidity to banks but also enables them to have funding power to purchase sovereign debt, which the banks use as collateral for their borrowing at the ECB.
We have the ECB’s own “bond-buying” program, handy for sovereign authorities that see their borrowing being financed by an institution that is, ultimately, a creation of their own (there is a big difference between a private institution and an “independent” one).
The circle is more obvious with the explicit quantitative easingprogram in the U.S. and UK. The Bank of England holds over 30 percent of the UK government bond market as part of its quantitative easing (QE) operations and there is talk of increasing this number.
At what point should we start to worry that that number is too high, that we have a branch of government lending to the government? 40 percent? 50 percent? 100 percent? The longer QE goes on and the more people keep talking about increasing it, the more one might start to worry about diminishing value of money and demanding more of it for the same work rate.
Because it has no more intrinsic value than Monopoly money, fiat money retains its value only because of confidence. As central banks print more and more money, all else being equal, its real value must decline. That explains partly the desire of the German government to enforce public sector spending controls as the price of saving the euro. Otherwise a blanket bailout without cuts in spending would just be a road to inflationary ruin.
But is there something more at stake here than just an orthodox macroeconomic argument about inflation? Does the ability to keep printing money without any real control or discipline, creating a circular flow of money in which one branch of government lends to another branch of government, undermine confidence in the concept of paper money itself?
And does it amount to a hidden tax on the private sector's purchasing power? The value of what one earns today will not be what it was in a year’s time, it will be lower. If we take QE and “bond buying” to its ultimate conclusion, that could be a lot lower. And then we might indeed need a wheelbarrow, virtually loaded onto our debit cards of course, when we go out to buy those strawberries …
----------------------------------------------------------------------------------------The author is Professor Moorad Choudhry, Treasurer, Corporate Banking Division, Royal Bank of Scotland.
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