Saturday, July 21, 2012

Currency Indispensability

Doing away with the currency system will not help solve the problem of inequitable distribution of natural resources


The past five years have seen several crank “anti-currency” cults surfacing. For example, a group called the Zeitgeist Movement, which is a break-away from a similar group called the Venus Project, makes a lot of noise while propagating its crank theories online as well as releasing propaganda films. Zeitgeist means “spirit of the times” in German. The movement is supposedly in response to a popular feeling that the world’s natural resources are inequitably divided and exploited in an unsustainable fashion. The movement aims to change this.
The “solution” is unreal. The Zeitgeist movement promotes a science-fictional, communistic “resource-based economy” (RBE). Currency will be abolished in the RBE. Global banks of computers will track all natural resources and allocate them according to respective needs. There will be an averaged allocation of food calories, fuel supplies, electricity, etc. This will be done in sustainable fashion so that nobody suffers and the ecological balance remains stable.
It can’t be done of course. To start with, there is no way to redistribute resources without violence. The top 50 per cent of global population controls close to 80 per cent of resources and of course, there are national divisions. Ergo, you’d have to kill a lot of people before you can redistribute.
Even if resources were somehow redistributed peacefully, the computer programmers would possess immense undemocratic powers. Even if the computer programmers were all deeply altruistic, such a system could still be gamed for profit by citizens.
Somebody may choose to have lots of children (or perhaps, keep lots of pets) so as to control resources allocated to minors. This can only be prevented by curtailing basic human rights.
Even if everybody voluntarily accepted family planning, simple transactions would still be impossibly cumbersome without currency. Suppose one person, A, hates chocolates and is willing to forego his allocated chocolate ration. But A wants a haircut every fortnight, whereas the RBE allocates a haircut once every month. Suppose another person, B, is a hairdresser, who wants to own a racing bicycle. In a currency-based economy, neither A or B have problems. A doesn’t buy chocolates and has as many haircuts as he likes and can afford. B charges for haircuts, and saves up to buy the cycle he wants. In an RBE, A has to trade his chocolate ration for haircuts; B has to trade hair-cuts for a bike. Setting exchange rate for such barters is difficult.
This is a simple example of why currency was invented. It is a common denominator between dissimilar goods and services. A currency doesn’t need intrinsic value. It is useful only because people use it as a medium of exchange. No nation backs its currency with bullion anymore. The printed text on a currency note contains a promise to redeem it for a given value. As an economy gets more complex, the need for a common denominator (currency) increases because there are a wider array of dissimilar goods and services available. While the cultists claim to represent the spirit of the times, they are actually a very fringe minority. The real spirit of the times is a proliferation of new currencies.
Virtual transactions
In the past five years, many virtual currencies have come into existence on the Internet. As the online economy has grown in size and popularity, so have the number of virtual currencies. Think of it this way. You pay your local shopkeeper in rupees for goods produced by a Chinese subsidiary of an American company because it’s most convenient for both of you. In theory, you could pay in dollars or Yuan, but it would be more cumbersome.
Similarly, in online economies, it makes sense to use a local, virtual currency rather than convert each transaction from various national currencies. For example, the social networking giant, Facebook uses a virtual currency called the FB Credit on its site. This trades at around a current rate of 10 FBC =1USD$. Facebook has over 900 million users spread across the world. They could all, in theory, use FB credits. It also has affiliate sites, which accept FB credits. Many websites use other currencies such as the open-source Bitcoin or ducats, etc.
These currencies are exchanged online for real goods and services with quantifiable costs. A very common transaction for instance, involves paying for movies and music downloads in a virtual currency. Advertisers and online market researchers also offer virtual credits to people who click through ads, or fill up surveys. Quite a few real-world services such as bed-sitter rentals, car-maintenance services, etc, can also be paid for in virtual currency if you’re hooked into the right online circuits.
Virtual currencies are also directly, formally, convertible (both ways) into national currencies such as the dollar, yen, euro, won, etc. Assets denominated in virtual currency can be auctioned on websites like eBay for national currencies. Exchanges like Singapore’s First-meta Exchange specialise in this.
The number of goods and services that can be bought using virtual currencies is increasing. The complexity of transactions is growing as well. But there are, as yet, no virtual central banks managing virtual interest rates, or controlling virtual money supply.
Obviously a real world currency and economy needs more “management” since the real world is far more complex than the online world with a much larger inventory of goods, services and trading interactions.
But virtual economies are already quite complex and at the same time provide a useful model. As online economies have evolved, it has become apparent that the measure of control required for maintaining a successful currency is less than most central bankers would have us believe.
In the real world as well, central bankers also have less control than they used to, due to the increasing integration of the world economy. In an open economy, it’s impossible to simultaneously control exchange rates, money supply and interest rates – this is sometimes called the Impossible Trinity.
If a central bank wishes to manage its interest rate, or money supply, it must accept fluctuations in the exchange rate. Unless it’s an absolutely closed economy like North Korea, the exchange rate will change to reflect central bank action. The price of domestic goods and services will also change. Excessive controls may lead to developing of black market currency rates.
Monetary policy is a powerful tool. But it is not a cure-all. Economies with big policy issues and structural imbalances cannot solve their problems by just changing interest rates or money supply. India has run into this situation over past three years.
GDP growth has slipped slower while inflation has remained high and the rupee has also gotten weaker as the trade balance has gotten worse. This has placed the RBI in a bind. If it drops rates, inflation will certainly rise. But growth may not rise even if rates are cut because growth depends to a large extent on fiscal policy. The government has been absolutely paralysed on the policy front in recent years.
So the RBI has decided not to touch either money supply or policy rates in the latest credit policy. At the same time, the Chinese have cut rates, the Europeans have eased money supply with a big bailout for Spain’s banks, and the US has eased money supply.
This comparative situation is probably bad for India’s economic growth, which means it could be bad for equity investors. It is bad for debt investors too. It means that in the short run at least, expectations of returns from the stock market drop. There is one possible situation where holding rates unchanged could turn out to be beneficial. It leaves room for cuts in an emergency if there’s a sudden currency collapse in Europe.
Over the next six months, if growth slows even further, there will be a point where inflation will start coming down. The economy will then stage some sort of recovery. Before that, we’re likely to see quite a lot more pain. It will also be interesting to see the direction in which exchange rates go. I suspect that the USD will get quite a bit stronger versus the rupee before the exchange rate trends play out.