The nature of mankind has been to explore new frontiers and dive into uncharted territories in search of a paradise. The inherent urge to improve upon the status quo has been the making of a quintessential human. Trade is the most remarkable consequence of humanity. The movement of goods, services, culture, technology, and everything material across civilization from ancient times to the present modern world is the linchpin that holds globalization. Our advances are made possible due to this movement but the world has never been a fairy tale story and it needed an enabler or an incentive. Any trade of any form is enabled only when both buyer and the seller perceive value in what they are receiving. The old barter system was not a simple exchange of material but it was an exchange of value. It is a natural tendency of humans to seek value in what he receives. In order to normalize the value across materials, a currency in the form of metal and later paper was introduced which accelerated the growth of trade and the development of humanity along with it. Thus, money became the bedrock of everything that defines the history of an unprecedented species which will dominate the planet for millennia.
Money has been the locus of pivotal events across history. A strong object of lust, many powerful kings, ministers, and nobles have fallen to the dictum of money. Wars, conquests, bloodshed, and atrocities are waged just to obtain or preserve wealth. The idea of money as a physical personification of evil is pervasive in general discussions and philosophical arguments. Despite every criticism that is hurled over money, I marveled at the ability of money to retain the collective confidence of humanity for several centuries.
In the past lies the answers to our future.
PART - 1: ORIGINS OF MONEY
In order to qualify as money, it had to fulfill three essential requirements:
a) Medium of exchange
b) Unit of account
c) Store of value
Nothing can be called money unless and until it qualifies these three requirements.
There is no evidence to date that the barter system existed in any form in the early civilizations. The novel money arrived in the form of commodity money. This form of money had value because of the object it was made. The Mesopotamian civilization used Shekel which was a unit of weight having a mass of 160 grams of barley. This system eventually morphed into representative money. This form of money had value because of the underlying object the receipt, document, or note is supposed to represent. Many merchants of gold and silver provided a note stating the value of the object which could be reimbursable by that particular note. This note gradually became a means of payment or money. This form of money which was backed by a representative amount of objects, mostly gold or silver replaced the exchange of commodity itself. This led to the introduction of the gold standard. This monetary system fixes a paper note in circulation as a medium of exchange backed by a convertible amount of gold.
During the second world war, several governments across the world abandoned the gold standards and geared toward printing money to service the costs of war but they printed in such exorbitant amounts that lead to hyperinflation. This caused a decrease in the value of the currency note. To put this into perspective, people had to drag a wheelbarrow full of money to buy a loaf of bread. The economies including the rich industrialized allied nations were devastated. In order to maintain a western economic order, the Bretton woods conference was convened in 1944 in the United States of America. This was an attempt to create an open market and give rise to globalized trade. One of the major agreements of that conference was to move towards an adjustably pegged foreign exchange market. In accordance with the agreement, major economies had their currency pegged to the US dollar which was further pegged to gold standards because the USA had the highest gold reserves at the time. In this way, the US Dollar became the dominant currency.
After almost three decades of the Bretton wood conference, the United States of America was facing a double blow of inflation and recession, commonly known as stagflation for various reasons from the oil shock to the Vietnam war. This caused a run on gold reserves and high deficits making the promise of an exchange rate difficult. In 1971, President Nixon announced that he will no longer redeem gold in exchange for dollars. The following decades were filled with numerous rise and fall in the economy. This separation was momentous because of the fact that the world currencies were not pegged to any physical asset but to the confidence of citizens in the paper money brought upon by the government. This paved way for the rise of the Modern Monetary Theory.
PART - 2: CREATION OF MONEY
The central bank decides a reserve of money that the commercial banks have to keep with them, prints the money accordingly, and commercial banks give out loans from the pool of deposits and money as received from the central bank.
There are three myths in the statement.
Commercial banks collect deposits and provide loans from that borrowing.
Central banks decide the amount of broad money in the system.
Money is created by the central bank.
The process of money creation in the modern days is the opposite and the reverse of popular belief.
Commercial banks collect deposits from the people and provide loans to the people. Commercial banks earn interest on loans and pay interest to the depositors. Commercial banks are obligated to provide a sum equal to the amount requested by the depositor at the time of withdrawal. In order to safeguard the interests of the depositors, the commercial banks are mandated to put a reserve amount of money with the central banks in order to service the withdrawal requests. This is known as the fractional reserve banking system which is based on the realization that the withdrawals will not happen at the same time. In case the number of depositors increases to an extent that the banks have to increase their reserve, the commercial banks can ask for extra reserve from another commercial bank or from the central bank at an interest rate. This is the mechanics of present banking.
When a person makes a request for a loan, the banks conduct a profitability analysis of the venture. Based on this analysis, the banks provide money to the person. Commercial banks credit the loan amount to the person. The amount that gets credited returns back to the commercial banks in the form of a new deposit from another person who earns that money from the creditor. This becomes new deposits to the banks. Since the deposits have increased, commercial banks have to increase their reserves and ask for the aid of the central bank. The commercial banks print the money and supply it to commercial banks. Commercial banks with an increased reserve amount can accommodate more loans and deposits and the cycle continues. A detailed explanation is provided in the document "Money creation in the modern economy". To know more, download a document released by the Bank of England titled," Money creation in the modern world".
Therefore, the act of lending by the commercial bank is the source of money creation. Debt creates money. 97% of the money is in the form of bank deposits.
The following chart is a stunning visualization of the money that exists in the world in a different forms.
PART - 3: DERIVATIVE TIME BOMB
The definition of a derivative is financial security or contract between two or more parties in which one party assumes the risk of the other party at a premium due to the fluctuation in the underlying asset. The essence of derivatives is that one party will bet against the happening or non-happening of the event against which there will be a payoff in the event of happening or non-happening of the event. It is a zero-sum game with one winner and one loser. The speculative nature of the derivatives market has been a grave concern among various economists. The problem with the derivatives market is the heavily levered commercial banks that have hedged their positions in order to increase their profitability in the era of low-interest rates. The great recession of 2008 is a precedent of a gamble gone south. If the commercial bank default, the source of money creation in itself will vanish and further create problems for the world economy. The explosion of the derivative time bomb will lead to severe avalanches that the world may not be prepared to face.