Are we entering another critical age of money?

September 23, 2015 14:22

Age of Innovation

Some 2600 years ago in the kingdom of Lydia, in what we know now as Anatolia Turkey, a momentous event in human history took place. An event that would have far reaching consequences and that continues to inform our behaviour and shape the societies that we live in, even in the modern day.

That event was the minting of the first coins, that could be used a common medium of exchange. Prior to this point trade and payment for goods and services was a haphazard affair. Deals were struck based on given weights / values of sought after commodities, such as gold and silver. However establishing the purity of these metals and therefore their value could delay transactions for long periods of time, making the whole process very cumbersome indeed.

The Lydian's first major innovation was to standardise these payments made in precious metals into a series of uniform tokens or coins. Which were of a fixed weights and purity. Their second great leap was to guarantee the quality of the currency through a series of royal stamps / hallmarks that became universally recognised and trusted. In doing so the world's first truly portable (in every sense) currency was born. Such was the success of this common currency that the name of its creator and guarantor lives on in our modern world.

Perhaps you have wondered how Croesus came to be so rich that his name became a by-word for untold wealth even today. Well now you know, he ruled the kingdom that invented money and with it international trade.

One of Croesus's gold coins from Lydia circa 550 BC

The age of specialisation

We have to wait for some 2250 years before we come across the second major development in the history of money ,which came about in late 17th century Europe, with the formation of the Bank of England. An institution that would over time become the benchmark for the world's Central Banks.

The formation of a bank was not ground breaking in itself. But the fact that this bank would act on behalf of the government and crown of England and within fifteen years for the whole of the newly formed Great Britain was.

Furthermore the Bank adopted and legitimised the new ideas around credit creation and fractional reserve banking, that had been developed first by Italians and then by the Dutch. As such it was the first and only institution allowed to issue bank notes in the country.

Indeed so successful was the bank that it took just 12 days for it to raise £1.2 million pounds for the government of the day. A feat which had been beyond the government and the crown prior to the formation of the bank. Of course this model of banking was subsequently rolled out around the globe often a result of an expansion in trade, which itself came about through the expansion of the British Empire.

The age of causation

If we fast forward another 277 years into the future, to America in 1971 to be exact. We come to our third critical development in the history of money. In this case the historic decision by the Nixon Government to completely abandon the "gold standard" and the Bretton Woods agreements on fixed exchange rates. Which had been agreed by the allied powers just prior to end of WW2.

The link between the value of the US Dollar and that of gold had become unsustainable thanks largely in part to the immense cost of the Vietnam War. The Dollar was allowed to float and effectively find its own level on world markets. A little over a year later in 1972 the IMM or International Monetary Market was launched in Chicago and soon after currency and interest rate contracts were traded on the exchange for the first time. Effectively launching the modern financial markets we know today.

Traders on the floor of the IMM exchange (source CME)

The age of experimentation

Once again we leap forward in time, in this instance to Japan at the end of the 21st century.

Having created a massive bubble in the 1980s, which burst spectacularly, the Japanese economy is suffering "a death by a thousand cuts" as the excesses of the bubble have left a legacy of corporate scandal and underperformance, which threatens to become a deflationary spiral. Or if you prefer a sort of economic black hole from which there may be no way back.

The Bank of Japan had maintained interest rates at or near zero since 1999 and yet the economy still showed no signs of lasting recovery. And so in an effort to reflate the economy the BOJ decided to implement unconventional monetary policies or QE.

On March the 19th 2001 the BOJ acted to flood the commercial banks with liquidity (cash) to promote lending and embarked upon a program of government bond purchases. Later on it would also buy equities, short term commercial paper and other assets. Ultimately the bank of Japan would become the biggest holder and the biggest buyer of Japanese Government debt. Culminating in the current QE program, announced on October 31st 2014, which committed the BOJ to spending 80 trillion Yen or approximately $660 bln dollars per annum on QE.

Even this gargantuan amount of money has not been able to stimulate the domestic economy or inflation in any lasting fashion. Ignoring Einstein's classic definition of insanity (that is doing the same thing over and over again and expecting a different result) the BOJ may well announce further QE at its meeting in October. But in doing so it risks locking the country into a perpetual spiral of low interest, rates falling prices and a weaker currency from which there may literally be no escape.

The chart below plots inflation rates in Japan since 2010: The Red area indicates deflation.

The Global Financial Crisis or GFC which blew up in 2007 and 2008 would ultimately see the Federal Reserve, the Bank of England and the European Central Bank (or ECB) embark on their own QE programs .The early adopters, the Fed and the Bank of England have curtailed their asset buying, whilst the ECB, a late comer to the party, is just over 6 months into its own 18 month plan.

The Age of Uncertainty

As has been well documented the Fed has not raised interest rates for almost a decade whilst in Japan interest rates have effectively been at zero for more than fifteen years . Borrowing cost have also been kept low in the UK, whilst in Switzerland ,Sweden and Denmark interest rates have gone negative. That is depositors must pay to keep their money in the bank and lenders effectively pay borrowers to take the money away. This is a nonsensical scenario but it demonstrates the bizarre circumstances that unconventional monetary policy can create. In effect an oversupply of money, an embarrassment of riches that would have made even Croesus blush.

The Federal Reserve chose not to raise sUS interest rates at its September meeting, citing concerns over the health of the global economy and the slowdown in China. However it seems unlikely that the situation in China and the Emerging Markets will improve any time soon. Data from the US and European economies is also patchy, with many indicators suggesting a loss of momentum, slowing demand and the persistence of deflationary pressures.

Economic Surprise Indices have turned lower in unison (source Deutsche Bank)

All of which raises the questions is the window within which interest rates could be raised closing? And perhaps more controversially, could the next moves in rates in the UK and the US be downward rather than up?

Both Goldman Sachs and Citigroup recently published notes explaining how the issues in China could be transmitted to developed western economies via the Emerging Markets. The Citi note calculated the chances of a recession as result of this, within the next two years, as being at 55%. The balance of probabilities (40%) was weighted towards a shallow, short lived technical recession .

But they also see a 15 % chance of something far worse, caused by a new financial crisis most likely emanating from China and or the Emerging Markets.

That begs the question in these circumstances what course of action would be open to central banks, who have inflated their balance sheets through bond buying and who already have zero interest rate policies in place?

Given the experience of Japan the answers, if there are any, are not going to be palatable ones.

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