The scenario that is being described here, has happened many times in past world history. It is nothing new. It is a possibility. Understanding it is important. Because it is painful. To talk from an economist point of view always sounds like a robot talking, so inhuman. But to understand some concepts we have to take non-partial look.
I am sorry I have to do this. I have to stop the story, and take a big tour. We will first try to understand some concepts we have discussed, and then come back to our story. I hope you find the journey interesting.
What is Money? What is that we understand by the term money? Do you think the notes you carry around in your pockets is money? Do you think the zeros you have in your bank is money? So so wrong. They are not money. They are just "currency". They are simple "papers". And if you are using the 'plastic money', then you only have the notion of money. It is ridiculous to think that we slog 24 hours a day, so that at the end of the month somebody gives us few slips of paper, wherein some body simply promises us to pay us that much of money. Just like our Rich Man, a promissor. It is hard to explain now, hope you catch the concept later on. There is a whole band of economist, intellectuals who band this as the "Greatest Swindle of the Man-kind".
Let’s begin, where it all began. Let us begin by understanding how the trade began.
Deep in the pre-historic ages, there might have been two individuals who were good at something. One may have been good in hunting and other good in fruit gathering. So, in the pitch darkness, when they came back to their caves, they shared their produce with each other. This was Barter. You give me this much; I will give you this much. We may assume, if the hunter dint get any hunt for the day, he may have manage some other way, or borrow some fruits from his friend or friend will give the hunter out of sympathy and friendship. This is a simple transaction.
As the time progressed and the communities increased, the sympathy level would have come down. Because people not knowing each other that well. Therefore, producing was crucial. It was the livelihood. Something you did for living. But how do you know how much Oranges does it require to buy the deer meat or the meat of a wild boar. Certainly, hunting these would have involved different levels of difficulty. How do you also know what the value of Orange is when it is off season? Certainly, the value of fruits would have changed from season to season. There is a big problem fixing the price, when transactions with added complexities are involved. They needed a common cause. That common cause is what is called as Money.
Money had its own intrinsic worth. It would on any day, come rain or shine, summer or winter, stand on its own. It could buy its owner its value of goods, no matter the time or day. Money was pure.
Money was also money because everyone in the society agreed that it had value. Humans have experimented with wide range of money. They differed from conch shells, stones, wooden sticks, bones to metals like gold, silver, copper etc. We will use only gold in the discussion for the sake of ease.
Now let us assume a society of 100 people, where 1 gold coin buys you the goods worth 1 gold coin. Let us assume they transact once every month. Therefore, the turnover [the GDP] of the society will be [100 people x 12 months=] 1200 gold coins per year. This will be the same, no matter what the progress made by the society. If we change one variable, say one transaction per day. Then the GDP becomes [100 people x 365 days=] 36,500 Gold coins. We can see, there is an intrinsic "brake" in this type of dealing. You cannot go too fast, no matter how many deer you have hunted, or what amount of bumper crop you have produced. This "brake" has been the big weakness of the "Gold Standard".
What is Gold Standard? Simply, it means every economic unit of money, is backed up by equal amount of economic value. 1 gold coin = 1 gold coin. [This is carrying the meaning to little extreme but understanding is useful]
To progress, societies either needed more people to deal with or transact more and more frequently. Both of which had limitations. The clever way to by pass this "brake" and increase the GDP was as follows. To illustrate, simply, make two unit of economic money equal to one gold coin. If we take this example, then the achievable GDP of the society doubles overnight. [2times x 100people x 365 days = 73,000 gold coins]. This meant more transactions and more wealth. People would be happier. This process, of increasing the value on an economic unit, while maintaining/ decreasing the value of economic value, is similar to "inflation". [The term Inflation would be understood much better when included under the discussion on banking]
Now let us progress into the future, and bring in the interesting character of Angel and the Devil. The Banker. Bankers were originally goldsmiths. To be a banker in the earliest days needed only one qualification, to have a "Locker". In the earliest days, people would come to the Banker-goldsmith, who was a person of highest integrity, to keep their valuables with him, namely gold and gold coins. In return, the Banker would give them a promissory note for that particular value. With the permission of the "Depositors" the banker would lend the gold and gold coins to the needy. Thus the banker earned his living. In the earliest days, it was the necessity of the “depositors" to keep their belongings safe. But competition would soon arise, for the "depositors" valuables. Bankers started offering, an incentive called as "Interest" whenever a depositor deposited the money with them.
Now, somebody smart enough to safe guard the money was smart enough to use it. It would not have taken long for the Banker to see, that depositors "Save" the money. That is, they do not use part of it. And from Banker's point of view, they are not "Withdrawn". So, no matter the circumstance, there was some money always with the banker. To illustrate, if the Banker had 1000 gold coins as deposit, and banker thinks 900 gold coins will not be withdrawn within a month, Banker can lend 900 gold coins easily for a month. Up until here, we are safe [gold standard]. But it is another practice that led to something more useful as well as devious.
The amounts loaned out were put back in as a deposit, and were used for further loans. For example, if 900 gold coins were lent out to 9 people at 100 coins each and each of these "debtors" put back 50 coins for safekeeping until required. The banker, had [9people x 50 coins=] 450 coins more to lend. He could lend 100 coins each to 4 more people. From the simple 1000 gold coins in deposit, by using the "credit" based system of accounting, the Banker increased the "Money Supply" to [1000+900+450+....=]2350 coins. From just 1000 gold coins, an extra 1350 coins were created, with no increase in the "Redeemable Economic Value". In other words, 1350 coins of value were created out of thin air. Just like magic. This created "Inflation". This method of banking is also called "Fractional Reserve Banking", because the actual reserves with the Bankers are just a tiny fraction of the 'money' lent out.
All the people are happy because the increase in the money supply has improved the standard of living. They "think" they are now richer because last summer they had 25 gold coins and this summer they have 50 gold coins. Now let us assume the angel, the much blessed, magician banker continues his magic trick for years. Now, on books of record there are so much money created [including the drafts, negotiable instruments, promissory notes etc] that the "Money Supply" increases enormously. We must realize, increase in money supply is a spiraling effect. More money supply, leads to much more money supply. The cycle does not end. It would end only if no new money was created using the Credit based system.
But does the paddy field's yield, for example, match up with the pace of growth in money supply. Unfortunately not, the real world grows much slower than else. [That is why you will see the financial sector or any other sector without "brakes" like software growing faster than say agriculture, in an inflationary climate. Simply, because people have more money- don’t know what to do and this leads to a situation where there is more to invest in companies, stocks, real estate, cars, vacations, parties etc. You see everyone opening a company or producing a film. Or giving Rs100 for a coffee which is worth only Rs5. You see rich becoming richer. The stock market booms. Real estate goes sky high. Credit cards are everywhere. Loans are a joke. Cars and obnoxious wealth populate. People are simply rich, with no Jesus idea what to with the money. Or are they really "Rich". Even our Rich Man was rich. Back to the story.]
But does the paddy field's yield, for example, match up with the pace of growth in money supply. Unfortunately not, the real world grows much slower than else. In effect, this means the production of paddy remains same but the money supply has increased a lot. Therefore by simple demand-supply economics, the price of the paddy goes up. Why, because just like coffee, people are ready to give Rs40 for a rice that is worth Rs20. The commodity price increases. All the real world prices increases, because they cannot increase the production at the same pace as the money supply. Don’t forget, Money supply is a spiraling effect. [There is a common mis-perception that increase in prices is inflation. Actually, increase in prices is the 'result' of inflation. Many economists call this "increase in prices" theory as cheating. That is because; any government can control the prices of commodities to a large extent. Take the case of onion imports or petroleum imports. Back to story]
It is not long then that Money supply has grown to such an extent that, even the simplest commodity cost HUGE sums of money. You may have to carry a truck load of "currencies" to buy a bagful of necessities. It is surely cheaper, to burn the money than pay for gas. It would be easier to sleep on the Currencies than buy a mattress.
From the conventional point of view, the money has lost value. How? For example, a cup of coffee that cost Rs5 now would cost say Rs100. So therefore [Rs5 yesterday = Rs100 Today]. This gives us another impact of inflation, and sometimes considered [wrongly] as the definition of inflation.
Not to mention, there will be a class of society, which will be caught totally off guard. They would never have imagined, what they bought for Rs10 would be Rs30, in just a few days.
The worst part of the story is that there is no end in sight. It is just spiral effect. In this environment, billionaires will be middle class, may be even lower. Why? Because even the simplest thing can cost Trillions!!! These are the facts. In 1913 Germany, a pair of shoe would cost 13 marks. By 1923, the same pair of shoes cost about 32 Trillion Marks!!!! [32,000,000,000,000 marks for a shoe!]
This period when the money supply is very very high, and increasing at a very sharp rate [because of compounding effect] and when the prices double almost every week [a day] is called "Hyper inflationary" period. This phenomenon is called "Hyper-Inflation".
Let’s get back to the village of the Rich Man. Now, since the Rich Man's Promissory notes have been used by the Merchants among themselves to trade, the notes become equivalent to money. Now, the Rich Man has printed out so much of Promissory notes, that actual amount of Gold in the entire village is just a tiny fraction of the "Money supply". [Fractional Reserve] That is why Rich Man can never hope to buy back the entire Promissory notes with the gold. But, he still has one way of protecting his loyal Merchants. Rich Man simply prints out more Promissory notes, to cover for the short fall. For Example, if one promissory note promising 100 coins is worth only 80 coins in the eyes of trades’ people, then Rich Man will simply print another Promissory note for the shortfall of 20coins. It does not take long to realize this is a spiral effect, just like our tour above. More the Rich Man prints the notes, more the value decreases, and more he has to print again to keep the sum of the notes equivalent to 100. What will result is hyperinflation. Rich Man, will end up giving 32 trillion coins for a shoe, which initially cost just 12 coins.
There is a widespread poverty during these times. Not to say, things are expensive. The 'Notes' by themselves have no meaning or intrinsic worth. The Poor Merchant and his family who worked hard, for number of years, to save some coins/notes, now find even the simple necessities out of reach. He would be lucky if the hard earned money could buy his family enough bread and medicines.
[So, what is the value of the money we carry around, and for which we struggle and slog day and night. The Money retains its value as long as there is value for it in the market. If the value goes down, naturally the employers will give more 'money'(salary) just to compensate. And we end up thinking, we have become richer. This is where, in my opinion, the jobs in "non-brake" industries like Financial sector, software, BPOs, Call centers etc [Especially BPOs and Call centers] carry biggest risk. When the time comes, we are very much incapable to translating our knowledge and experiences into "real world" production.]
:) Falkor
Rich Man's Story:http://surff.blogspot.com/2005_11_20_archive.html
First published: http://surff.blogspot.com/2005/11/rich-mans-story-part-5.html
I am sorry I have to do this. I have to stop the story, and take a big tour. We will first try to understand some concepts we have discussed, and then come back to our story. I hope you find the journey interesting.
What is Money? What is that we understand by the term money? Do you think the notes you carry around in your pockets is money? Do you think the zeros you have in your bank is money? So so wrong. They are not money. They are just "currency". They are simple "papers". And if you are using the 'plastic money', then you only have the notion of money. It is ridiculous to think that we slog 24 hours a day, so that at the end of the month somebody gives us few slips of paper, wherein some body simply promises us to pay us that much of money. Just like our Rich Man, a promissor. It is hard to explain now, hope you catch the concept later on. There is a whole band of economist, intellectuals who band this as the "Greatest Swindle of the Man-kind".
Let’s begin, where it all began. Let us begin by understanding how the trade began.
Deep in the pre-historic ages, there might have been two individuals who were good at something. One may have been good in hunting and other good in fruit gathering. So, in the pitch darkness, when they came back to their caves, they shared their produce with each other. This was Barter. You give me this much; I will give you this much. We may assume, if the hunter dint get any hunt for the day, he may have manage some other way, or borrow some fruits from his friend or friend will give the hunter out of sympathy and friendship. This is a simple transaction.
As the time progressed and the communities increased, the sympathy level would have come down. Because people not knowing each other that well. Therefore, producing was crucial. It was the livelihood. Something you did for living. But how do you know how much Oranges does it require to buy the deer meat or the meat of a wild boar. Certainly, hunting these would have involved different levels of difficulty. How do you also know what the value of Orange is when it is off season? Certainly, the value of fruits would have changed from season to season. There is a big problem fixing the price, when transactions with added complexities are involved. They needed a common cause. That common cause is what is called as Money.
Money had its own intrinsic worth. It would on any day, come rain or shine, summer or winter, stand on its own. It could buy its owner its value of goods, no matter the time or day. Money was pure.
Money was also money because everyone in the society agreed that it had value. Humans have experimented with wide range of money. They differed from conch shells, stones, wooden sticks, bones to metals like gold, silver, copper etc. We will use only gold in the discussion for the sake of ease.
Now let us assume a society of 100 people, where 1 gold coin buys you the goods worth 1 gold coin. Let us assume they transact once every month. Therefore, the turnover [the GDP] of the society will be [100 people x 12 months=] 1200 gold coins per year. This will be the same, no matter what the progress made by the society. If we change one variable, say one transaction per day. Then the GDP becomes [100 people x 365 days=] 36,500 Gold coins. We can see, there is an intrinsic "brake" in this type of dealing. You cannot go too fast, no matter how many deer you have hunted, or what amount of bumper crop you have produced. This "brake" has been the big weakness of the "Gold Standard".
What is Gold Standard? Simply, it means every economic unit of money, is backed up by equal amount of economic value. 1 gold coin = 1 gold coin. [This is carrying the meaning to little extreme but understanding is useful]
To progress, societies either needed more people to deal with or transact more and more frequently. Both of which had limitations. The clever way to by pass this "brake" and increase the GDP was as follows. To illustrate, simply, make two unit of economic money equal to one gold coin. If we take this example, then the achievable GDP of the society doubles overnight. [2times x 100people x 365 days = 73,000 gold coins]. This meant more transactions and more wealth. People would be happier. This process, of increasing the value on an economic unit, while maintaining/ decreasing the value of economic value, is similar to "inflation". [The term Inflation would be understood much better when included under the discussion on banking]
Now let us progress into the future, and bring in the interesting character of Angel and the Devil. The Banker. Bankers were originally goldsmiths. To be a banker in the earliest days needed only one qualification, to have a "Locker". In the earliest days, people would come to the Banker-goldsmith, who was a person of highest integrity, to keep their valuables with him, namely gold and gold coins. In return, the Banker would give them a promissory note for that particular value. With the permission of the "Depositors" the banker would lend the gold and gold coins to the needy. Thus the banker earned his living. In the earliest days, it was the necessity of the “depositors" to keep their belongings safe. But competition would soon arise, for the "depositors" valuables. Bankers started offering, an incentive called as "Interest" whenever a depositor deposited the money with them.
Now, somebody smart enough to safe guard the money was smart enough to use it. It would not have taken long for the Banker to see, that depositors "Save" the money. That is, they do not use part of it. And from Banker's point of view, they are not "Withdrawn". So, no matter the circumstance, there was some money always with the banker. To illustrate, if the Banker had 1000 gold coins as deposit, and banker thinks 900 gold coins will not be withdrawn within a month, Banker can lend 900 gold coins easily for a month. Up until here, we are safe [gold standard]. But it is another practice that led to something more useful as well as devious.
The amounts loaned out were put back in as a deposit, and were used for further loans. For example, if 900 gold coins were lent out to 9 people at 100 coins each and each of these "debtors" put back 50 coins for safekeeping until required. The banker, had [9people x 50 coins=] 450 coins more to lend. He could lend 100 coins each to 4 more people. From the simple 1000 gold coins in deposit, by using the "credit" based system of accounting, the Banker increased the "Money Supply" to [1000+900+450+....=]2350 coins. From just 1000 gold coins, an extra 1350 coins were created, with no increase in the "Redeemable Economic Value". In other words, 1350 coins of value were created out of thin air. Just like magic. This created "Inflation". This method of banking is also called "Fractional Reserve Banking", because the actual reserves with the Bankers are just a tiny fraction of the 'money' lent out.
All the people are happy because the increase in the money supply has improved the standard of living. They "think" they are now richer because last summer they had 25 gold coins and this summer they have 50 gold coins. Now let us assume the angel, the much blessed, magician banker continues his magic trick for years. Now, on books of record there are so much money created [including the drafts, negotiable instruments, promissory notes etc] that the "Money Supply" increases enormously. We must realize, increase in money supply is a spiraling effect. More money supply, leads to much more money supply. The cycle does not end. It would end only if no new money was created using the Credit based system.
But does the paddy field's yield, for example, match up with the pace of growth in money supply. Unfortunately not, the real world grows much slower than else. [That is why you will see the financial sector or any other sector without "brakes" like software growing faster than say agriculture, in an inflationary climate. Simply, because people have more money- don’t know what to do and this leads to a situation where there is more to invest in companies, stocks, real estate, cars, vacations, parties etc. You see everyone opening a company or producing a film. Or giving Rs100 for a coffee which is worth only Rs5. You see rich becoming richer. The stock market booms. Real estate goes sky high. Credit cards are everywhere. Loans are a joke. Cars and obnoxious wealth populate. People are simply rich, with no Jesus idea what to with the money. Or are they really "Rich". Even our Rich Man was rich. Back to the story.]
But does the paddy field's yield, for example, match up with the pace of growth in money supply. Unfortunately not, the real world grows much slower than else. In effect, this means the production of paddy remains same but the money supply has increased a lot. Therefore by simple demand-supply economics, the price of the paddy goes up. Why, because just like coffee, people are ready to give Rs40 for a rice that is worth Rs20. The commodity price increases. All the real world prices increases, because they cannot increase the production at the same pace as the money supply. Don’t forget, Money supply is a spiraling effect. [There is a common mis-perception that increase in prices is inflation. Actually, increase in prices is the 'result' of inflation. Many economists call this "increase in prices" theory as cheating. That is because; any government can control the prices of commodities to a large extent. Take the case of onion imports or petroleum imports. Back to story]
It is not long then that Money supply has grown to such an extent that, even the simplest commodity cost HUGE sums of money. You may have to carry a truck load of "currencies" to buy a bagful of necessities. It is surely cheaper, to burn the money than pay for gas. It would be easier to sleep on the Currencies than buy a mattress.
From the conventional point of view, the money has lost value. How? For example, a cup of coffee that cost Rs5 now would cost say Rs100. So therefore [Rs5 yesterday = Rs100 Today]. This gives us another impact of inflation, and sometimes considered [wrongly] as the definition of inflation.
Not to mention, there will be a class of society, which will be caught totally off guard. They would never have imagined, what they bought for Rs10 would be Rs30, in just a few days.
The worst part of the story is that there is no end in sight. It is just spiral effect. In this environment, billionaires will be middle class, may be even lower. Why? Because even the simplest thing can cost Trillions!!! These are the facts. In 1913 Germany, a pair of shoe would cost 13 marks. By 1923, the same pair of shoes cost about 32 Trillion Marks!!!! [32,000,000,000,000 marks for a shoe!]
This period when the money supply is very very high, and increasing at a very sharp rate [because of compounding effect] and when the prices double almost every week [a day] is called "Hyper inflationary" period. This phenomenon is called "Hyper-Inflation".
Let’s get back to the village of the Rich Man. Now, since the Rich Man's Promissory notes have been used by the Merchants among themselves to trade, the notes become equivalent to money. Now, the Rich Man has printed out so much of Promissory notes, that actual amount of Gold in the entire village is just a tiny fraction of the "Money supply". [Fractional Reserve] That is why Rich Man can never hope to buy back the entire Promissory notes with the gold. But, he still has one way of protecting his loyal Merchants. Rich Man simply prints out more Promissory notes, to cover for the short fall. For Example, if one promissory note promising 100 coins is worth only 80 coins in the eyes of trades’ people, then Rich Man will simply print another Promissory note for the shortfall of 20coins. It does not take long to realize this is a spiral effect, just like our tour above. More the Rich Man prints the notes, more the value decreases, and more he has to print again to keep the sum of the notes equivalent to 100. What will result is hyperinflation. Rich Man, will end up giving 32 trillion coins for a shoe, which initially cost just 12 coins.
There is a widespread poverty during these times. Not to say, things are expensive. The 'Notes' by themselves have no meaning or intrinsic worth. The Poor Merchant and his family who worked hard, for number of years, to save some coins/notes, now find even the simple necessities out of reach. He would be lucky if the hard earned money could buy his family enough bread and medicines.
[So, what is the value of the money we carry around, and for which we struggle and slog day and night. The Money retains its value as long as there is value for it in the market. If the value goes down, naturally the employers will give more 'money'(salary) just to compensate. And we end up thinking, we have become richer. This is where, in my opinion, the jobs in "non-brake" industries like Financial sector, software, BPOs, Call centers etc [Especially BPOs and Call centers] carry biggest risk. When the time comes, we are very much incapable to translating our knowledge and experiences into "real world" production.]
:) Falkor
Rich Man's Story:http://surff.blogspot.com/2005_11_20_archive.html
First published: http://surff.blogspot.com/2005/11/rich-mans-story-part-5.html
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