Massive analyses over millennia about “money” have created such noise that most societies fail to separate the compounding noises from what this human invention is about.
A simple example illustrates money’s crucial role. Say there are 1,000 rights to goods and services to be transferred now and in the future, be it domestically or across borders. In the absence of an agreed upon monetary yardstick there would be 499,500 possible relative prices to be haggled about, as each commodity and service would be priced in relation to every other when entering into a contractual agreement. With one common – trusted - yardstick, there would be 999 prices and that’s it.
Even for societies with small, relatively isolated populations with just 50 goods and services, there would be 1225 prices in the absence of an agreed upon measure. Once this society agrees on one item to serve as yardstick, there would be 49 prices. Briefly: Solid pricing information and simpler processes to make contracts require a stable unit of account. Today’s national currencies are not stable; rising 100% within months or few years, and dropping 50% over the next few, thus making contracts far more expensive to conclude. Yet contracts and trust in institutions sustaining them are the basic blocks of thriving commercial societies.
It is not surprising that at all times and everywhere, one of the first things societies invented and worked very hard to sustain was a trusted monetary yardstick. When its crucial role was forgotten – which is the case today - it has led to costly and at times devastating consequences, over the last century in particular. In this piece I’ll show what happened, how it weighs negatively on the US-China relationship, along with the remedy.
- Creating and Sustaining Monetary Yardsticks
In his Money Mischief (1952) Milton Friedman looked at the “stone money” of the Yaps on a small, relatively isolated island in Micronesia. At the end of the 19th century the tribe used stone wheels as both a yardstick for prices and as collateral, and the German colonial regime accepted them for paying taxes. When the locals refused the colonial authorities’ wanting to pay them with their currency, the authorities taxed the Yaps by painting black crosses on the stone wheels, indicating confiscation.
The Yaps could no longer use the stones either to pay taxes or as collateral. The impoverished Yaps then worked harder and the authorities compensated them by erasing the black crosses – an act that restored the tribe’s “currency” and collateral. Friedman concludes that these events show how important “illusions” can be in monetary matters.
Friedman was mistaken: the events had nothing to do with illusions; rather they reflected the locals’ profound understanding of what “money” is. The Yap’s stones were no simple rocks found on the island. They were in fact big, scarce lime-stones from islands hundreds of miles away, carving out the disks on the spot later. These yardsticks were thus in relatively fixed supply, and used both for pricing and as collateral, backed by intricate customs and traditions.
The Yap’s behavior should be familiar. “Modern” governments confiscate de facto too when suddenly pursuing devaluations. People respond to the impoverishment by working harder – leading to the occasional relationship economists call “Phillips Curve,” but which they, as Friedman, have attributed to “illusions.”
The responses are no mystery. The destabilization of age-old yardsticks makes societies poorer, unravels traditions, raises havoc about contracts and collateral, and brings about barter and chaos. The Yaps lost their knowledge of “one price,” and relapsed into bartering, a process that takes time and depends on negotiating powers, discovering what these powers are in the midst of the monetary chaos. It is no surprise that the term “barter” originates from Middle French “barater” – which means “to cheat.” The Yaps’ decision to work harder and “buy back” their traditional yardstick makes sense.
It is not surprising that every so called “primitive society,” of anthropologists’ research, had monetary yardsticks, and that in our days’ too “isolated tribes” – in prisons – promptly use cigarettes as yardstick. Although the Soviet Union had the ruble, scarce Marlboros served such a role in that large prison land too, together with scarce Levi jeans and US dollars.
It is rare to have a laboratory monetary experiment showing how such a cigarette yardstick is created and what happens when it is destroyed. But Richard Radford, a British soldier captured in 1942, and who spent the remaining war years as prisoner in war camps, recorded meticulously such an experiment.
Until D-Day, in June 1944, prices in terms of cigarettes were stable. Although their supply varied randomly from one week to the next, the Shop – the POW’s variation of a bank – issued paper certificates worth “one cigarette,” which were accepted at par with physical cigarettes. The Shop was a bank – only unlike fractional banking, it backed its paper money 100%. There could be no “fractional banking” in these camps since prisoners had short horizons expecting to be dispersed as soon as the Allies freed them.
In August 1944 the supplies of both cigarettes and parcels of food were suddenly diminished. The prisoners promptly got rid of the paper certificates, and physical cigarettes became the sole yardstick and medium of exchange. The Shop’s certificates could still be exchanged, but only for types of food that prisoners did not want, and whose inventories accumulated in the Shop.
For a while the Shop decided to give “pricing guidance” for “popular” goods which it did not have in its inventory; suggesting they should not deviate by more than 5% from past patterns. Its guidance and appeals to “morality” had no impact. Exchanges quickly took place at “unauthorized” higher prices for the valuable items, whereas the “unpopular” items accumulated in the Shop’s inventories – a primitive version of QE.
With the number of cigarettes and food items becoming uncertain, the organized economy of the camp dissolved into obscure pricing chaos and bartering, within which relative prices depended on momentary negotiating powers. The paper money lost all its value and became the subject of jokes, thus disappearing from circulation.
Other behavior patterns emerged that appear uncomfortably familiar. The Medical Officer wanted to impose rationing and price controls, stating that otherwise health issues would multiply. The prisoners did not heed to his advice. “Activist” prisoners advanced theories blaming “speculators” for deflation, chaos and the disappearing of the Shop too. They rehashed Medieval ideas of “just prices” – by which they meant that prices had to equal the prices they were used to before the supply of parcels and of cigarettes became uncertain and blind to the fact that trust evaporates when people disperse and horizons shorten. This situation lasted until April 12, when the 30th U.S. Infantry Division freed the camp.
Similar sequences of events took place on grand scales in post-WWII Germany between 1945 and 1948, though clearly the problems and solutions to create and sustain a new yardstick were more complex.
Germany was impoverished after WWII: 20 percent of its housing was destroyed; food production per capita in 1947 was about half of its 1938-level; industrial output in 1947 was one-third its 1938 level, and a large percentage of Germany’s working-age men were dead. The Reichsmark had no value: It stopped circulating, as happened to paper certificates in the POW camp. Cigarettes and soluble coffee became the currencies of the day. City dwellers bartered in the countryside, exchanging household items for food and coal.
The finance minister, Ludwig Erhard’s 1948 stabilization plan restored order when he stabilized the currency, abolished price controls and lowered taxes drastically. These steps set the basis for the “German miracle,” fueled up to 1961 by 12 million mostly well-trained, disciplined young penniless immigrants too; the success obviously related to the fact that countries have longer horizons than camps.
Next I show what happens when societies go in reverse and destroy their yardsticks.
II. Do Not Play Politics with Units of Account
The UK experienced both deflation and high unemployment after Winston Churchill, Chancellor of the Exchequer, decided to re-link the pound sterling in 1925 to the price of gold at its pre-WWI parity, in spite of the fact that the price level doubled during WWI, and the pound fell by 60 percent. Unfortunately, Churchill realized his mistake too late.
The abrupt political upward repricing – disregarding settled exchange rates at new levels following the war – brought predictable deflation, reduced exports and increased unemployment. The severe impacts of WWI were compounded as contracts signed in what parties thought were stable exchange rates when the war was finished suddenly saw the terms altered. In other words, those who entered into agreements hadn’t anticipated Churchill’s mistake.
Churchill admitted that this decision was his biggest blunder ever. In 1931 England reversed the 1925 error; abandoning the gold standard and devaluing the “pound sterling” (so called since the “pound” was once backed by a pound of silver). By then, after much upheaval, observers believed that new theories and government policies were needed to stabilize societies. Though Keynes’ General Theory intended to propose solutions for the lasting English malaise, the book deals with a closed economy where exchange rates and yardsticks make no appearance – the “general” in the title notwithstanding.
But by the 1930s, hyperinflation in Germany, Austria, and Hungary during the 1920s destroyed their own yardsticks, wiped out the savings of middle- and lower-class citizens, devastated Europe’s financial markets, leaving governments as the main financial intermediary. The US did not serve as model for monetary policy or society either as a sequence of policy mistakes compounded following the 1929 stock market decline of about 30 percent: The tariff legislation (Smooth-Hawley, 1930), bad monetary policy decisions (1931), and a sharp increase in tax rates (1932, when the rate on top incomes rose from 25 percent to 63 percent, the estate tax doubled and corporate taxes rose by about 15 percent). These changes, some anticipated, led to a significant drop in the price level, increased the value of outstanding debts (of companies that did not go under), and a large number of bank failures (some 10,000 overall during that Great Depression).
Instead of attempts to restore domestic and international yardsticks for contracts within and across borders, the US devalued the dollar against gold to $35 per ounce from $20.67 in 1933, having first confiscated all gold from its citizens at the $20.67 – not a confidence-inspiring policy.
It was only with the Bretton Woods system after WWII that domestic and international yardsticks got fixed. Western currencies were linked one to one another and anchored in a US dollar defined as 1/35th of a gold ounce. But the new agreement left out two clauses that would have been necessary for this system’s long-term survival. The clauses were related to letting a country occasionally adjust its exchange rate downward following a disastrous event, and to penalize countries which, through domestic policies (such as explicitly or implicitly preventing domestic financial markets from developing, and subsidized their exports instead), had constant large balance of payment surpluses. The absence of these two clauses doomed the agreement, once Western countries ran out of “good luck” covering for compounding policy mistakes.
The mistakes were the U.S.’s increased spending on the badly managed Vietnam War and pursuing costly domestic programs without raising taxes. The US dollar became overvalued; having been anchored in expectations of more disciplined policies. Instead of a one-time repricing of the dollar in terms of gold and negotiating with trading partners – restoring clauses left out of the Bretton Woods agreement and correcting domestic policy mistakes – President Nixon declared in his televised 15 August, 1971 TV speech that the US was unilaterally abandoning the Bretton Woods system. The President stated that the main reason for this step was that the American dollar was a “hostage in the hands of international speculators.” Having abandoned the international yardstick, inflation, high interest rates, price and wage controls, recession were all on their way – variations on the POW and German experiences on far grander scales.
In Changing Fortunes (1992, co-authored with T. Gyohten), Paul Volcker pointed out that the Western world then shifted without much thought or debate to the floating exchange rate system accompanied by a vastly increased financial sector we still live with. This system led to the use of hundreds of trillions in derivatives that in the absence of the yardstick were needed to stabilize the value of domestic and international contracts. This adjustment made contracts more expensive to conclude and also led to significant misallocation of talents, employing too many brains in finance.
The absence of a yardstick and an international agreement to back it also shed light on the US having constant twin deficits – and for China, among others, to accumulate surpluses. With China gradually relinquishing its fully centralized model of society, it kept its exchange rate with the US relatively stable since 1995 (varying in the 15% range and since 2008 by 5%). During this transition, the US dollar was still the best anchor to let China redirect its massively mismatched talent and resources without dispensing of its one party model of society and dispersing power domestically too fast by deepening its financial markets. This political balancing policy meant that while redeploying its massive labor force toward exports, China accumulated massive surpluses purchasing US Treasuries (putting them in its “national mattress” - its central bank).
If the US, Western Europe, Japan, and China agreed to a renewed Bretton Woods regime, including the dropped clauses in the initial one, such imbalance would come to a good end. China would pursue policies encouraging domestic entrepreneurship and consumption faster, and the US would pursue more disciplined fiscal and monetary policies, and commercial societies around the world would regain their footing.
