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The Telegraph
Since 1st March, 1999
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- Low growth and a lack of jobs are haunting the West

Currency issue is an immensely profitable industry. A well managed currency commands a market value that is a multiple of its cost. A 500-rupee note costs no more than a few paise to manufacture; the rate of return on its production is close to 50,000 per cent. Currency production is so profitable that it would attract too many entrepreneurs. If they put out too much currency, its value would decline; in other words, there would be inflation. Inflation brings losses to those who hold currency; they would be better off if they held anything else, such as gold. So inflation beyond a point can cause a flight from currency. So currency issuers have to be moderate in their greed. It is impossible to limit their greed. So governments eliminate competition and become monopoly issuers of currency.

Coins can be stolen. They are also difficult to carry around beyond a point. Early on, governments tried to solve this problem by using valuable, malleable and durable commodities to make coins. They settled on three minerals — copper, silver and gold. But their scarcity fluctuated as new reserves were found and exhausted; the fluctuations caused long cycles of inflation and deflation. To overcome this instability, governments invented paper currency, whose supply they monopolized and controlled.

Paper currency can be stolen, burnt or washed away; it would be convenient if cash could be parked in a safe place. Someone could make a business of storing it for others for a fee. But soon people found a better alternative. If the safekeepers could lend out the cash, they would earn interest, which they could share with the depositors. This business was called banking.

Once people got used to keeping money in banks, they kept only a fraction of their money in cash, and withdrew money only occasionally from banks. While they withdrew money, others would be depositing it; if as much money was being deposited as withdrawn, banks would not have to keep any cash. They could lend it all out. So banks started lending out most of their deposits.

It happened once in a while that people came to withdraw more money than to deposit, and a bank ran out of money. If depositors heard that a bank had run out of cash, they would all run to the bank to get out what they could before the owner ran away. Seeing them run, depositors of other banks would also panic, and run to withdraw their deposits. These episodes of infectious running came to be known as bank runs. When the depositors found that the banker had run away, they would break his bench or table in rage. This rupture of the bench was transformed into bankruptcy.

Bank runs were extremely disruptive. They suddenly made depositors poor, and sent some of them into bankruptcy. And if they could not pay their debts, their creditors too went bankrupt. Thus bankruptcies could bring business to a halt, sometimes for years. To prevent such catastrophes, governments created central banks. They tried to stop banks from being too foolish, made them keep minimum cash reserves, and in return lent them cash when they were afflicted by bank runs.

If there are governments, there will be a multiplicity of currencies. Anyone who wants to buy, sell, borrow or lend abroad will need another currency than his own. This can be easily organized in currency exchanges. But if one currency is more stable than another or interest rates are higher in one country than in another, people will want to transfer their money to the better country. They will buy that country’s currency and sell their own; the exchange rate of their currency will fall. The government of the worse country would not like that at all; it would worsen the government’s reputation and reduce the demand for its currency. So governments of worse countries place restrictions on their citizens’ foreign exchange transactions; they are known as exchange control. The strictest form of exchange control is one in which the government gives itself a monopoly of holdings of foreign currency and sells it to its citizens at fixed exchange rates subject to detailed conditions.

If governments hold all foreign exchange and regulate all transactions in it, they are in a good position to fix the exchange rate. But if two governments cannot agree on the exchange rate between their currencies, there can be a currency war. Especially when there is a world slump and shortage of demand, it is in every country’s interest to push down the exchange rate of its own currency, so that its goods become cheaper abroad and foreign goods become expensive in that country. The way to do it is to buy gold or foreign currencies, so that their value goes up relatively to its currency. But if all countries try to do it, none of them can be sure to win. So currency wars are usually indecisive.

After much bitter experience, governments of the world decided to abandon currency wars after World War II, and appointed a policeman, named International Monetary Fund, in 1945. Every country declared its exchange rate in terms of gold to the IMF, and to stick to it; in return, it could introduce as draconian exchange controls as it liked. Then in 1971, the biggest country, the United States of America, suddenly said it would not maintain its exchange rate in terms of gold: it went off the gold standard. There soon followed the Yom Kippur war in between Israel on the one side and Egypt and Syria on the other; it led Arab countries to impose an embargo on export of oil. The price of crude suddenly quadrupled from $3 to $12 a barrel; the sharp rise sent the balances of payments of many oil importing countries into deficit. The deficits were far bigger than what they could borrow from IMF and elsewhere, so they were forced to stop trying to fix exchange rates. Thus the world entered a period of floating currencies.

The exchange rate of floating currency was no longer fixed by its government. So it needed no gold foreign exchange reserves. Industrial countries soon realized this, and stopped accumulating reserves; some liquidated reserves entirely. But governments cannot do without a religion. So they replaced the pursuit of external stability by internal stability; their central banks pursued price stability by means of monetary policy.

However, old ghosts continued to haunt us. The industrial world is suffering from low growth and high unemployment. In the circumstances, it would be of advantage to an industrial country to devalue. They cannot do this the old way since they no longer fix exchange rates; but they can induce devaluation by means of expansionary policies such as reducing interest rates and running fiscal deficits. This is what the US and the European Union are doing. They do see that like competitive devaluation of old, their present policies are also beggar-thy-neighbour policies. But for domestic reasons, they see no alternative. So they continue what they are doing, and meet periodically to look for an alternative. They meet so often that to save paper, media have abbreviated their meetings to G8 and G20.

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