This article is a continuation of my previous thoughts; probably this title suited it more. In the first article I tried to argue how the value of the currency is linked to the nation’s productivity. In this article we would explore the currency issue further and link it with the basic economic framework of today.
Let’s first explore as to how the credit is created and how money supply can lead to growth or bust and finally how we are sitting on a pile of trash. A borrower deposits 100 rupees with a bank, the bank is expected to maintain a cash reserve ratio of 10% which essentially means that he can keep 10 rupees and lend out the 90. This 90 again finds its way into the banking system and again 9 rupees is held back and 81 rupees are lent out (ofcourse assuming there is sufficient demand for that liquidity) and as this process goes on the 100 rupees of deposit becomes 1000 rupees in credit. This is called magic in common banter and money multiplier in economic talk. Now if the demand for credit is greater than this credit of 1000 rupees the Central Bank follows an accommodative monetary policy and supplies some more cash into the banking system. Had the country been following a gold standard the Central Bank would have been restricted in the amount of cash it could infuse thus restricting this growth. However since the human demand is infinitum, the key to success of this “Non Collateralized Monetary Policy” and I will come back on this term is for the Central Bank to pull out the liquidity if the demands are unjustified, which brings me to the second point… What does one means by unjustified demand….
The term unjustified demand in my opinion is any demand which would lead to investments that end up generating insufficient cash flows. Ofcourse in a capitalistic economy where risk taking is at the core and failures are part of life there are bound to be unprofitable investments and so that is why the “interest rates should be what they should be”, the cost of money should correspond to the risk in the investment but in any case if the overall risk of non-profitable investments increase in a certain sector the Central Bank has the tools i.e. adjusted risk weightages of loans given in that sector to deal with it and if this risk increases on an overall macro level the Central Bank should stop providing that extra liquidity or should even pull it out by adjusting the interest rates or changing SLR or CRR ratios. High interest rates act as a deterrent for risky investments as the cost of failure is higher and so my first issue with the current setup is that the interest rates have been so low for so long that it has inevitably turned the whole world into a casino.
Before I link this with the fiscal and Current account aspects let me quickly explain what I meant by “Non Collateralized Monetary Policy”…. Now when the bank issues loans against the deposits it basically issues cheques. So let’s say it has 100 rupees in it’s vaults, the bank can issue a cheque worth 90 rupees and give it to someone in form of loan. The collateral for that 90 rupees is the 100 rupees kept in the bank vaults. In a similar way the currency note or the cash number in your bank account that you are holding is a cheque that the “Great Central Bank” is issued you, but considering the amount of money supply in the economy what is the collateral held by these Central Banks…. Well China holds over 1 trillion dollar resevers in form of dollars so let’s see what reserves the US central bank holds whose dollars China is holding as collateral….
Ready……….. Nothing!!! The world is holding cheques issued by a bank that has no collateral to back it…… Blind following the Blind, well maybe not in every case and this we would explore a little later but anyways as the countries start realizing this more they would move towards hard assets from paper assets and so the commodity bull market of last 10 years has still some distance to go.
I just realized the article would probably become huge if I bring in the next point which is linking today’s monetary policy with the 2 critical components in economics Fiscal spending and Current Account. So with this thought till next time……………. Maybe in this case I should have changed the title :)