| There
are several myths about economics that have proved to
be very hard to dislodge, despite theoretical proof
and empirical evidence that directly contradict them.
One such myth is that governments can control money
supply. There is the related myth that this money supply
that the government can control is then responsible
for creating inflation, based on the simplistic notion
that too much money chasing too few goods will cause
prices to rise.
The
reality is that as economies grow more sophisticated
in terms of the spread of finance, it is always possible
for new types of liquidity, or ''quasi-money'' to emerge,
and so it is actually impossible for governments to
control the actual money supply. Rather, the level of
money supply is determined by the workings of the system,
by the level of economic activity, the prices at which
goods and services are traded. So this is one clear
case where demand creates supply.
This emerges from the peculiar feature of money, which
is that it essentially exists only between human minds.
It is - and has historically been - a social creation
based entirely on trust. In the past it was trust conferred
by the ruler - whether king or state. But increasingly,
it is the case that new forms of money or quasi-money
emerge, either to meet certain kinds of demand or simply
because financial innovation creates new possibilities
for liquidity.
Thus, credit card transactions, bills of exchange, IOUs,
hire purchase agreements, all involve the creation of
liquidity. There have been situations in which share
certificates have been treated as liquidity. In financial
markets, the emergence of futures trading and derivatives
has created very complex webs of liquidity creation.
What has been true nationally is also true internationally
speaking, as world financial markets have created their
own liquidity whenever required. In the 1970s, the Eurocurrency
markets emerged, at least partly as a response to controls
on credit creation in the United States.
And now, there are even newer forms of liquidity which
tend to dwarf conventional money in terms of sheer volume.
According to the London Economist magazine, frequent
flyer miles are being accumulated at a rate which makes
them the single largest global currency, with more spread
than the US dollar!
It is estimated that by the end of 2004, around 14 trillion
frequent flyer miles had been accumulated worldwide.
They can be earned not only through air travel but also
through credit card payments, which now account for
around half of all the miles that are being accumulated.
These miles can be redeemed for free flights or upgrades
at any where between 1 US cent and 10 US cents per mile,
or transferred to credit card accounts at an average
rate of 2 US cents per mile. Using the mid-point of
this range gives an estimate of the global stock of
frequent flyer miles of more than $700 billion.
This is more than all the US dollar notes and coins
in circulation. Of course, there is still much more
dollar holding in banks, etc. But clearly frequent flyer
miles are now more than dollar base money, or M0. And
increasingly they are not only a medium of exchange
(being converted into free flights, extra credit card
purchases and so on), but also a store of value. And
they are treated as such by all those engaged in the
business of air travel, not just companies and their
employees, but also both beneficiaries of the system
and those for whom this is a future liability.
With money taking so many complex forms, many of which
are near impossible to regulate, it is strange to still
hear economists and even Finance Ministers talking about
regulating money supply. More than just strange, it
is actually alarming when these translate into attempts
to reduce money supply on the grounds of controlling
inflation, even when other economic conditions do not
warrant it.
In India at the moment, for example, there is talk of
the possibility of introducing restrictive domestic
credit policies, simply because external reserves held
by the Reserve Bank of India are going up and therefore
base money would increase. The irony is that currently
commercial banks in India are flush with funds which
they are placing in government securities because of
insufficient demand for bank credit from prime borrowers.
This is happening even as agriculture and the small
scale sector are starved of funds and the in throes
of major crisis. Putting curbs on domestic credit in
such a situation would simply further increase the travails
of small borrowers and have a depressing effect in the
economy.
And in any case all this would have no effect on the
actual money supply, that is, all the liquidity in the
economy, since that is something that emerges from the
combination of economic activity and prices that are
generated in the system. The sooner our government realises
this basic truth, the more likely it is that we will
get economic policies that correspond at least slightly
to a desirable alternative.
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