Wednesday, May 18, 2011

Funny Money

Funny Money by Sauvik Chakraverti, Apr 7, 2007, 12.00am IST Times of India

Inflation is not new. In my teens, Coca-Cola was 40 paise, a pack of Wills cost a buck and petrol sold at three rupees a litre. A beer was five bucks. 

This inflation has nothing to do with either the demand or the supply of the articles of everyday consumption. 

Rather, inflation is a disease that afflicts money, being but a gradual and continuous erosion of currency value. 

Since the government is the monopoly issuer of our money, we know who the culprit is. The game that politicians and central bankers play is best understood by a parable from Ken Schooland's charming The Adventures of Jonathan Gullible. 

In the story, the people use an inconvertible government paper money called 'kayns', named after John Maynard Keynes, the economist who designed today's world monetary system after centuries of the international gold standard. 

This particular parable tells of a circus coming to town. A big tent is set up and the people gain entry by paying 10 kayns per head. 

Once inside, the show commences, with the ringmaster, every once in a while, picking one member of the audience and showering him with 1,000 kayns. 

When Jonathan remarks that the game is odd, he is told that this circus is a standing institution: it passes by every month, and all the townspeople play the game hoping they will receive 1,000 kayns someday. 

This is 'the kayns conspiracy'. The crucial thing to note is not that the game is a fraud — 'attempting to purchase public affection through gratuitous alienations of the public revenue' â” but that the money used to play the game is fictitious too. 

One can perhaps feel sorry for those who worship Mammon, but what can one say of those who chase this 'funny munny'? Mankind's collective ignorance regarding the most important regulator of the market economy, money, is truly astounding. 

And the education cess will only pay the salaries of armies of Keynesians employed in government universities. This is in addition to the battalions of Marxists already there. Catch-44. 

What is extremely important for the layman to understand is that, since real goods and services are exchanged for this 'legal tender' funny munny, inflation has losers and gainers. 

The gainers are those who get to spend the kayns first — the personnel of the government, their contractors and those cronies who get generous loans from banks. The losers are savers and the poor, who earn eroded money on a daily basis. 
There is thus a 'transfer of real wealth' that occurs alongside creeping monetary inflation, with savers and daily wage-earners losing the most. 

Further, the statistical indices used to 'measure' inflation give a false picture of a 'price level' that is rising uniformly. 

In reality, there are zillions of prices and these move up and down in a totally uncertain world. There is no price level. 

Cellphone and computer prices, for example, are falling steadily. Stock markets and real estate values, on the other hand, are rising much faster than the statistic suggests. 

Wherever the new money (and the new credit) goes, there the price effects are most strongly felt. Again, because inflation affects some prices more than others, the effects are differently felt, and some people gain while others lose. 

This is why inflation continues — because those who produce it, the kayns conspirators, gain anyway. The solution to inflation is essentially a legal one as the existing system is based on legal fiction and fraud. 

When we pick up a Rs 100 note, we see a 'promise to pay' signed by the central banker emblazoned upon it. Under the rule of law, he must redeem his notes on demand. 

This is what prime minister Robert Peel attempted to achieve through his Act of 1844, but he made a crucial error in leaving out bank demand deposits. 

A banker can increase the money supply by making a loan and opening a current account in the borrower's name with that 'money' in it. 

Bankers therefore created so much deposit money (to finance the railway boom) that the currency principle which lay at the heart of Peel's Act became unworkable, and had to be repeatedly suspended — until it was finally abandoned. 

This failure to apply good law to money and banking lies at the root of modern-day inflation, whose only cause is excessive creation of money and credit. 

A recent study of legal history reveals that, long before legislation was invented, Roman and Continental law always recognised the vital difference between a demand deposit (which is placed in the banker's custody for safekeeping) and a term deposit (which is a loan to the banker for a stipulated period). 

These two kinds of deposits were governed by two different contracts. In the first, the private banker was compelled to keep money deposited with him for safekeeping constantly available to the depositor, without being able to lend out any portion of it — a 100 per cent reserve. 

In the latter case, the banker could loan out the money, and was only bound to return it with interest at the end of the contracted term. 

Under such legal principles we can have free, competitive, private banking and sound money without central banks and their fraudulent fractional reserve system. Currency notes will always be convertible, and all depositors will be secure. 

Inflation and boom-bust business cycles will never recur. The poor will steadily accumulate capital. Prices will keep on falling. 

The writer is an economist.