Islands in the stream
Why has the recovery from the financial crisis of 2008 been so slow? To answer that question, it helps to reflect on two items in the newly opened Citi Money Gallery at London’s British Museum. The first is a photograph of a two-tonne carved stone which once served as money on the Pacific island of Yap. The second is the exhibit of counterfeit notes and coins.
Yap’s use of big rocks as currency poses some obvious problems, but the carved stones, known as rai or fei, did not actually pass from owner to owner. Possession was merely noted down by inscriptions. The economist Milton Friedman wrote an elegant paper about the Yap arrangement in 1991, explaining that the system worked because of the Yap residents’ “unquestioned belief” in it.
Friedman realised that modern monetary systems are also faith-based. The faith used to reside in the value of gold and silver, whether minted in coins or held in central bank vaults and represented by paper. Now people are asked to believe in the value of a currency which is almost entirely intangible and which can be created and destroyed by the fiat of central banks.
For a monetary system to continue working, the authorities, whether tribal leaders or central bankers, must defend the monetary faith. In Yap, the currency system was inextricably woven into the complex net of tribal social relations. The rai were trusted as long as – and because – the whole society worked as a unit. The modern system of fiat money and ample credit needs more active support. The authorities must ensure that the financial intermediaries that keep the accounts are trustworthy. Also, they should prevent sharp variations in the value of money (the quantity of stuff which a set sum of dollars or euros can buy).
For the most part, modern societies do these tasks very well. Even after the crisis, the “dematerialised” monetary system has not broken down. However, the crisis experience points to a serious problem: there has been too much tolerance for monetary manipulation. Consider the Money Gallery’s display of counterfeit coins and bills. The exhibit’s curator told me it was one of the most popular. That is hardly surprising; there is something compelling about trying to turn dross into gold, whether though Roman slugs or Bernard Madoff’s Ponzi scheme.
Illegality adds a frisson to the appeal, but legal money creation is also tremendously popular. The pertinent example came ahead of the 2008 crisis. For many years the financial system was allowed to create more funds than the economy needed. The new cash was used to bid up the prices of equities, bonds, houses, oil and other financial assets. Simultaneously, it amounted to a devaluation of money because more dollars or euros were needed to buy the same stuff.
If the monetary faith were pure, the distortion would have been considered sacrilege. Instead, most consumers, companies, savers, borrowers, politicians, central bankers, investment bankers and retail bankers were delighted. They wanted to get in on the game. As in Yap, today’s monetary system is woven into the fabric of society, but the contemporary social fabric has been weakened by the easy acceptance of money that was economically counterfeit.
The enthusiasm for this flimsy money is ultimately antisocial, and lies behind the current disarray of the financial and monetary system. The sequence of financial bubble, financial crisis and desperate financial policies has produced a widespread loss of confidence, and faith, which explains why the economy has been so slow to recover. Economic commitments are avoided because the financial system is distrusted.
A Yappite economist would explain that the official monetary response to the crisis has weakened belief. While financial institutions have not been allowed to fail, neither have they been reformed. They are still widely considered untrustworthy, as the latest uproar over the manipulation of the Libor system makes clear.
Worse, the mix of huge government deficits, irrationally low policy interest rates and abundant money creation amounts to the fiat money equivalent of bringing boatloads of rai onto to the island in the hope that more money will encourage more spending. The technique may work for a while, but the positive effects of such policies – cash-in-hand or stone-at-hand – will be neutralised by realisation that the value of monetary tokens has become more uncertain.
The social fabric behind the monetary system needs to be strengthened. So-called primitive societies such as that of Yap would probably begin with a ritual purification – a few sacrifices, the appointment of untainted high priests of money and a solemn commitment from all to restore the status of rai.
It is not hard to think of equivalents in advanced economies. More bankers could be forced to sacrifice pay and prestige; regulators and central bankers could be chosen for their passionate commitment to financial stability; and politicians could be obliged to swear opposition to all sorts of monetary excess. We should all learn from the stones of Yap.