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History of Money (Part II) | Currencies, banking and crises

In the initial years, the notes and coins were backed by the commodities such as gold, silver etc. This meant that volume and value of currency circulated were based on the value of gold/silver reserves held by the authorities which were mainly central banks 

March 01, 2021 / 02:39 PM IST

In the previous piece, we discussed how money evolved from being a commodity to today’s notes and coins. This piece discusses how this evolution shaped the monetary and banking systems.

In the initial years, the notes and coins were backed by the commodities such as gold, silver etc. This meant that volume and value of currency circulated based on the value of gold/silver reserves held by the authorities which were mainly central banks.

The Gold Standard

This backing policy had two purposes. First, it kept a check on volume of issuance as currency could expand only in case new reserves were found. Second, to infuse confidence in the currency as people could exchange notes with gold/silver. Accordingly, monetary systems of different countries were called as silver standard, gold standard (GS) and even bi-metallic standards in case both silver and gold were used as reserves. Overtime, GS became the most popular system due to higher scarcity and mystic aura.

The commodity backed currency meant that exchange rates of different countries were based on price of gold. Say, if the United States priced a unit of gold at $1 and the United Kingdom priced similar unit at £2, the exchange rate between the two countries will be $1 = £2.

Close

The purpose of central banks was to maintain this parity of fixed exchange rate. Most of the time, system was self-adjusting. If the economy faced a trade deficit, a chain of reaction led to capital outflows and decline in domestic money supply. This led to lower inflation which made economy competitive leading to rise in exports and adjustment in trade finance.

The GS worked well till beginning of the 20th century with stable inflation conditions and was also seen as a symbol of first phase of financial globalisation. The first crack came in WWI, when countries gave up GS as they had to spend to finance the war and the system was restored post-war.

The second crack came during the Great Depression which started in the US and spread across the world because of the GS. The crisis led to capital outflows and in order to maintain parity, the central bank increased interest rates followed by decline of domestic economic activity. A crisis required a central bank to ease policy but the GS-enabled constraints led to opposite policies and a global depression. The countries which first abandoned the GS (the UK) also recovered quickly from the depression.

$35 per ounce

In 1944, the leading policymakers assembled in Bretton Woods (BW) to discuss several matters on international economics, including a new international exchange rate system. They agreed on a quasi GS, where only the US Dollar was fixed to gold ($35 per ounce) and all the members were fixed to the USD, affirming the economy’s numero uno status in the world.

This status was not for free as the constraints of GS now applied to US alone and was required to maintain adequate gold reserves. However, the country was unable to maintain adequate gold reserves pushing the USD to become overvalued hitting exports. US Presidents kept trying to keep the BW system going but situation kept worsening. Finally, in 1971 US President Richard Nixon ended the BW agreement leading to a complete breakdown of international monetary system.

Exchange rate systems

Post-1971, countries moved to multiple exchange rate systems. The economies also faced high inflation after 1970s due to both inflationary policies and the oil shock. The countries where inflation remained a problem or wanted to control exchange rates, adopted fixed exchange rates where the domestic currency was pegged to a stable currency, such as USD. The countries which could lower inflation eventually moved to flexible exchange rates. Some other countries which wished to follow a middle path by allowing currency to be broadly flexible but intervene only in case of high volatility, adopted managed float system, such as India. European countries moved to an extreme form of fixed exchange system by adopting a common currency, the Euro.

Economists soon began to think about the effectiveness of macroeconomic policies under these different arrangements. Robert Mundell and Marcus Fleming explained that under fixed exchange rate systems, fiscal policy was more effective whereas monetary policy was more operative under a flexible exchange rate systems. These findings were crucial to this new thinking that central banks should just target inflation and allow exchange rates to be determined in markets. In 1989, the Reserve Bank of New Zealand pioneered the inflation targeting framework which became the new gold standard for the international monetary system.

3-6-3 Rule

In all these years since BW, countries have increasingly moved to a fiat currency system. The currencies were no more backed by gold, but by domestic government bonds and foreign exchange reserves. Developed countries mostly had currencies backed by government bonds. Whereas developing ones maintained a combination of domestic bonds and foreign exchange reserves so that they could intervene in case of excessive volatility.

The banking system also changed significantly during these period.

Till BW, banking was broadly stable and governments also had large control over the financial system. Banks were seen following the ‘3-6-3 Rule’ which meant banks mobilised deposits at 3 percent, lend at 6 percent and then play golf at 3 PM!

Post-BW, just like exchange rates, even financial and banking systems became more market driven. The interest rates became highly dynamic and changed every second implying the 3-6-3 Rule was thrown out of the window. The banks began to protect themselves from interest rate risks leading to development of several derivative products which created their own volatility.

The period post-BW is also seen as beginning of the second phase of financial globalisation. Like the previous phase, this one too faced a severe crisis. The increased competition and globalisation had led banks to take higher risks in this phase. The financial crises had become more frequent in this phase but none were really as severe and mostly limited to emerging markets. This fed the usual ‘this time is different’ kind of overconfidence in policymakers and bankers.

Banks and governments

Where does India fit in all this long history? Part I discussed the pre-RBI history of coinage and banknotes in India. In 1935, the currency issuance business shifted from Paper Currency Act to the newly created Reserve Bank of India, which became the region’s central bank.

The RBI’s preamble clearly stated the importance of currency management: “to regulate the issue of Bank notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.” The coinage minting business remained with the government.

Post-independence, the RBI was nationalised and its functions were made in sync with the government’s five year plans. The banknotes were initially printed in the government-owned press in Nashik. Overtime, the RBI built its own printing facilities in Mysore and Salboni.

Post-bank nationalisation in 1969, the Indian banking system became one of the central pillars of the government’s socialist agenda. The banks were increasingly milked to push government’s policies and loan melas. Just like banks in other countries, the Indian banking system was doing badly by the end of 1980s. In 1991, the government woke up to a larger crises leading to several policy changes. The fixed exchange rate system gave way to managed floating system and licences were given to new private sector banks. By early 2000s, India was riding a tiger with GDP growth touching 8-9 percent levels and record private investment. After remaining closed to the world for most part of its history, Indian confidence was matching with the global exuberance.

Monetary destinies

However, global and Indian growth crashed with the 2008 financial crisis. The crisis not just shook this overconfidence, but also exposed deep fault lines. The highly-regarded US financial system became the epicentre of the crisis. The crisis spilled over across the world via the three channels of trade, finance and confidence.

The crisis changed and questioned several things around world economy. One such question was whether governments should dominate and control our monetary destinies?

Satoshi Nakomoto not only asked this question, but also answered it via his landmark article pushing an idea called Bitcoin. We discuss this in the third and final part of this series.

(This is the second in a three-part series on the evolution of money. The third part will be published on March 4.)
Amol Agrawal is faculty at Ahmedabad University. Views are personal.
first published: Mar 1, 2021 02:39 pm

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