Themes > Current Issues
13.01.2005
The Changing Colours of Money
Jayati Ghosh
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.
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.
© MACROSCAN 2005