Origin of paper money

During the early day of human civilization, Barter was the system of trade. There was a basic flaw in this system. E.g. I have 100 kg of rice which I can exchange for a one room house. But if the counter party, who has a one room house, wants wheat, then there is a problem. Either I have to search for a person in need of 100 kg rice in exchange for a house or find some method in which exchange takes place. This resulted in the introduction of common mode of payment in the form of common currency. People could exchange this common currency for goods/ services. The next question was what will be the common currency. The currency should be a commodity, equally divisible, equally valuable to everyone and its value shouldn’t change depending on who owns it. 

Over a period of time, gold was the commodity which suited everyone and it became the common currency all over the world. 

As civilization developed, banks were created where people deposited there gold. The banks gave this gold as loans and earned profit and returned it in the form of interest to depositors. This was a very efficient system of monetary usage. But as economies evolved, they faced a problem of boom-and-bust business cycles primarily in the US which was a capitalist system of society. 

Let’s look at how things happened in the early part of the 20^th century. As banks gave loans, business developed, more so due to the industrial revolution. At a particular period of time, the supply of goods/ services exceeded the demand. The entrepreneurs defaulted on their loans i.e. they could not return the gold resulting in losses for the banks indirectly affecting the depositors. Due to this people spent less resulting in a reduction in the GDP. As the scenario changed slowly, demand picked up and demand exceeded supply. The industries started working well again and the economy flourished. 

The central bankers were thinking of a solution to avoid the boom-and-bust business cycles. The solution was to have perennial flow of money into the system so that businesses would have inflow of money for business and consumers to would have it at a cheap rate so that they can spend more. But this was not possible in case of gold since it cannot be manufactured artificially. Paper money was the answer to this problem. Paper money could be printed to keep the flow of money into the economy at cheap rates. Thus they introduced paper money equivalent to an ounce of gold which could be printed. 

This excess liquidity and flow of money into the system resulted in inflation and the money found its way into the stock market, assets like housing and agricultural commodities. Speculation made the asset prices go northwards creating a bubble and we had the Great Depression of the 1930s. The socialists and the communists blamed capitalism for this depression and problems the world over. Ironically, the reason paper money was created was to stop the recessionary cycles but this resulted in capitalism system taking a beating. 

To overcome this problem, the gold standard was overthrown and we had the common reserve currency in the form of the US Dollar at bretton woods in 1940s. This was done under the stewardship of the two great economists of the time, John Maynard Keynes and White Dexter. 

A similar thing has come to haunt us since last year, 2008, after the housing bubble in the US crashed and along with it, big banks such as Lehman brothers which went bankrupt and some others which had to be saved by government intervention. Ben Bernanke, the present Federal Reserve Chairman, was on the board of the federal reserve when free market defender Alan Greenspan as the Federal Reserve Chairman, reduced the interest rates at an all time low for the same reason as before 1930s, to try and stop the recessionary cycles by free flow of money into the economy. 

However the present crisis isn’t due to availability of easy money only. The Complex Derivatives which were described as “financial weapons of mass destruction” by legendary investor Warren Buffet also played a major role in the crisis. They were directly responsible for the Systemic failure due to the exposure of major investment banks and other financial institutions such as hedge funds, pension funds among others to these toxic derivatives. 

The concept of securitization i.e. Originate-to-Distribute (OTD) means transfer of risk from those who cannot afford to those who can afford. The concept is valid and it is a very good financial innovation but its implementation has not been truthful. Loopholes in the laws and regulations or rather the lack of regulation have been exploited and they were bound to fail. 

Both these attributes responsible for the crisis i.e. easy money and derivatives can easily be reigned in if there is political will and prudent policymakers like Dr. YV Reddy, the Governor of RBI who at the cost of being called a conservative and old fashioned, did not allow Indian banks to trade in these type of exotic financial instruments. 

Thus there is talk now of going back on the gold standard or the Special drawing rights (SDRs) by the International Monetary fund (IMF) as the World’s Reserve Currency. The US will obviously object to this and try to use its political and monetary clout over the smaller and emerging nations and thwart it from happening.

This however seems the right time to have a change in the world system of currency.