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Business News/ Opinion / Columns/  Democracies and central banks haven’t found what they’re after
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Democracies and central banks haven’t found what they’re after

Fiat money overprinted as hardship relief isn’t solving people’s problems and a corrective is in order

Photo: AFPPremium
Photo: AFP

In 2012, I interviewed the economist Russell Napier. In the four years since the financial crisis of 2008 had broken out, Western central banks had printed a lot of money in order to prevent an economic depression. Being younger and more naive, I had asked Napier if he saw the fiat money system as it exists surviving, to which he replied: “The history of the fiat currency system is really the history of democracy." In the fiat money system, paper money is not backed by any commodity, as has largely been the case historically.

Before World War I broke out, the world largely ran on the classical gold standard, with paper money worth a certain amount of gold. This ensured that governments couldn’t create money out of thin air by printing it because once people came to know of it, they would exchange money for gold and there was only so much of this metal to go around.

During that War, many governments suspended the gold standard in order to print enough money to fund war efforts. But when they tried to go back to the gold standard, it created even more pain for people who were already suffering from the ravages of war.

As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “Workers, many of whom had become politically aware in the trenches of World War I, organized to demand for some form of protection against economic adversity." But the gold standard limited government options, forcing politicians to change track. By abandoning the gold standard, they could gain the power to print an endless amount of money.

This power has survived to this day. When the 2008 financial crisis broke out, Western central banks printed a huge amount of money. Something similar happened when the covid pandemic began to spread. Many governments gave printed money directly to people. In that sense, fiat money and democracy, where politicians and government- backed central banks must be seen to be doing things to alleviate the economic hardships of people, go hand in hand.

The idea is that with more money floating around in the financial system, interest rates will come down, people will borrow and spend, companies will borrow and expand, and jobs will be created. This will help the economy.

Such thinking stems from an incorrect understanding of how banking works. Most writing in economics textbooks tells us that banks borrow deposits to give loans. This isn’t true. A 2014 bulletin of the Bank of England says that a bank giving out a home loan “does not typically do so by giving" the borrower “thousands of pounds worth of banknotes". It credits the loan-taker’s bank account with a deposit equal to the size of the home loan.

David Orrell explains this in Quantum Economics, where he says that when a bank lends money, “it doesn’t scrape together the amount by borrowing it from its clients’ savings accounts—it just makes it up by entering it in their computer system."

Hence, a bank creates a deposit of the same amount as the loan in the bank account of the individual taking the loan. In the process, it creates new money. While the loan is an asset for the bank, the deposit made is a liability. The money given as a loan will ultimately be spent and thus move out of the account of the person taking the loan.

Now every asset needs a balancing liability. When the money taken out as a loan moves out, the asset and liability don’t match. To fill this gap, banks need deposits from savers.

As an article titled The Truth About Banks published by the International Monetary Fund (IMF) points out: “Once purchases have been made [using loans] and sellers deposit the money, they become savers… but this saving is an accounting consequence."

This dynamic ensures that banks don’t give loans just because interest rates are low. As Josh Ryan-Collins et al write in Where Does Money Come From?: “The primary determinant of how much [banks] lend is not interest rates, but confidence that the loan will be repaid." This explains why all the money printing carried out by central banks in the Western world hasn’t led to growth in lending to businesses, something that creates sustainable jobs. In the US, for example, commercial and industrial loans, as of May 2020, stood at $3.03 trillion. By November, they had contracted by a fifth to $2.4 trillion.

Also, a lot of money has found its way into stocks and real estate, leading to a rapid increase in their prices—or asset price inflation. From July to September, home prices in the US went up by close to 20% over last year’s figures, something almost never seen before.

Clearly, the policy of central banks to print money so as to revive growth isn’t working in the desired direction. As the IMF article states: “If the funds are used to support relatively unproductive economic activity, it will give rise to… asset price inflation and less additional output." This is precisely what’s happening. Large sums of money have been going into unproductive economic activities like real-estate speculation.

How can central banks correct for this phenomenon? For starters, their primary focus on consumer price inflation as a target needs to be expanded and measures of asset price inflation need to be built in.

Vivek Kaul is the author of ‘Bad Money’.

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Published: 28 Dec 2021, 09:38 PM IST
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