Lets start from the very basic thing on which rests the entire world of economics and finance : Money. Do we really understand what money actually is ? Where it comes from ? what it signifies ? How did the concept of money evolve ? Who gets the power to print money?
To understand the complexity imagine that a new island has been discovered which is inhabited by people who still practice barter system. Now you are required to introduce currency system in this new economy. How will you go ahead with it? Who will issue the money , in what quantity and to whom?
So lets come back to the definition of money. Money can be any object ( notes, coins, metals, gems etc. ) which can be used as means of exchange of goods and services. It is a store of value i.e. its ownership signifies a valuable work or service which u have provided for someone. .
In ancient times as we know most of the trade was done using barter system. People would meet at a market place and exchange various goods or services in lieu of goods or services provided by others. Now this method had its own limitations. If you had wheat grains and wanted to exchange them for a piece of cloth , but the owner of cloth wanted rice instead there was no way that the transaction could have taken place... unless u happened to find someone who was willing to exchange rice for wheat. Obviously this was a quite an inconvenient method of transacting goods and services.
But since ancient times there have been objects such as precious metals ( gold, silver), fabrics ( silk) , gems, diamonds, pearls which are seen as desirable in almost all the communities. Their attractiveness comes from various reasons... be it the inherent shine or the ease with which gold can be cast into various objects, or the properties of diamond ( its hardness, Refractive index ) or just plain attractiveness. Their widespread acceptability enabled the owners to transact in almost any possible goods or service. And of course the various kings over the years introduced gold and silver coins as money in their economy.
But how did the use of paper currency came into existence? A piece of paper by itself is of hardly any value. Why are people all over the world willing to part with their valuable goods for a worthless piece of paper?
So again lets go back some 600-700 years into history. Suppose in a town you had a reputed goldsmith. This goldsmith created a vault in his house to safely secure his entire gold. Other people in town who had quite a significant amount of gold with them approached the goldsmith to safely secure their gold in the vault.The goldsmith agreed to do the same in exchange for a fee ( say grains, cloth , oil etc). A receipt would be issued by the goldsmith to people who had kept their gold with him. And voila !!! the very first ever form of paper money is born. Now the owners of the receipts can buy other goods using these very paper receipts. They don't need to physically exchange their gold. The ownership changes by the exchange of a receipt.
The total no of receipts in circulation would indicate the total amount of gold kept with the goldsmith. This is the very basic principle on which the Gold Standard of currency system used by various economies around the world was based on.
And as the Gold Smith slowly realized that most people never came back to retrieve their gold, and when they did, not all of them came back at the same time ;he sensed an opportunity to make some additional profit . He could lend the gold in his vault or even better write down additional receipts with an obligation to pay back, to people who were in need of funds. Of course slowly the people in the community saw the trick in the game and instead of paying a fees to the goldsmith started to demand a share of his earnings from lending activities. So our very own Goldsmith and his vault has given birth to the very first Private Bank.
Coming back to the now abolished gold standard of currency, nations such as USA and UK kept large quantities of gold with them and issued currency in the system was equivalent to the total gold with them. You could approach the central bank and exchange your dollar note for a certain quantity of gold. As more gold was found or acquired through conquests, trade etc more amount of notes could be printed.
But there were certain extreme situations such as wars which required a large amount of currency for the govt to be able to fund the purchase of soldiers and ammunition. As the total amount of currency was limited by the total amount of gold where will the additional money come from? So what the govt did was that it simply printed notes and gave them to the soldiers. These notes were accepted by soldiers simply based on the faith which they had in the govt. Over the years total currency in the system was much more than the total amount of gold with the central bank. And with time the gold standard was entirely abolished. The currency in the system would come to be known as Fiat Currency. The only way from which the currency currently being used gets its value is by a govt fiat ( Latin for 'let it be done') or order. The govt creates a law certifying that this currency should be accepted in lieu of goods and services and can be used to pay back debt. The only reason why your 1000 Rupee note is valid is because the govt has said so. You can not approach RBI and ask for a certain gold in lieu of it. You can exchange it only for notes and coins whose total value is Rs 1000.
Lets think about gold standard for a moment. There have been many advocates who say that the world should return back to gold standard and there is equal criticism for the same.
Ask yourself why should the entire worth of the economy be measured only by a quantity of metal which for some reason people find it to be attractive. Should not the wealth of a country be instead judged by the the kind of infrastructure it has ( buildings, bridges, dams, roads etc). As the economy improves in infrastructure and starts to produce a wide variety of goods and services shouldn't the quantity of money increase accordingly?
Now when the govt has the power to print as much money as it wants , what stops it from doing so? The first answer that comes to mind is 'inflation'. The argument goes that as more people will be having more amount of money, and with quantity of goods and services remaining the same, money will loose its purchasing power. But shouldn't that be the case only when the govt is printing money and giving it to public by simply distributing it or by raising govt officers' salaries , as there has been no actual increase in the economic activity.
Instead suppose that the govt wants to build a new highway, dam or wants to fund some other infrastructure project. In this case why cant the govt simply print more notes and give it to the people who are contributing in improving the overall infrastructure. This money will be in turn be used by people to purchase further goods and services thus creating a demand in the economy and fueling the process of economic growth. The increased amount of money would be representative of the increased wealth of the economy. After all its a service being done by the infrastructure builders for the collective benefit of the society and govt being representative of the society issues a receipt saying that "in future we will be willing to provide goods and services in exchange for the work you do for us". And the newly printed money acts as that receipt. As we know most of govt financing comes from selling govt bonds and securities. And when the earnings from Taxes, duties and services provided to public don't match the expenses you have Fiscal Deficit. Also when the govt fails to pay back the money it has borrowed from the market you have the problem of ever increasing govt debt. The issue I am trying to raise is that is it really necessary for the govt to always borrow money to finance its operations? And if that is the case hasn't the quantity of Rupee in the economy actually increased since independence? I am not talking about increased money velocity ( the speed with which money changes hands in the economy ) but the actual quantity of Notes and Coins in circulation . Which situations require and enable the govt to print money?
It is the job of RBI to oversee that the quantity of money is sufficient for the economic activity being carried out. It needs to ensure that inflation is kept in check and with increasing globalization also have to worry about the exchange rates. Central banks all over the worlds use various instruments such as Interest Rates, Repo and Revers Repo rate, CRR etc to fine tune the process of economic growth.
Lets look at the premium currency being used in international trade today i.e the American Dollar. For some reason after the second world war which i still haven't quite been able to figure out dollar came to be accepted as the currency for international today. It was most probably due to the rapid industrialization in US economy and the faith that traders and nations around the world had in US govt and in the stability of its economy. And once dollar got that recognition it was virtually free lunch for the US govt. It could simply print money and buy it to shop around the world for goods and services. And it actually did. I firmly believe that the unique position which Dollar enjoys in world economy is one of the primary reasons for rise of US as a superpower in the last century. In fact there is so much of excess dollar in world economy that if all the countries poured their dollar reserves in the US economy it would simply crash and possibly the wold economy as a result. In fact when China was facing threat of US sanctions it actually threatened to sell all US Govt Securities in the forex market which would crash the US Dollar.
Almost all the developing economies want to build a big stash of Dollars to be able to fund their imports. They do this either by increasing their exports or by seeking FDI (Foreign Direct Investment). Quite frankly i find the entire system quite ridiculous. The Indian Govt cant pay for the oil it imports using its own currency 'coz it's not 'acceptable'. I ask why not? Just as you can go and take a dollar and use it to buy American goods so can you use the Indian Rupee to buy goods from Indian Firms and economy. But then this is how the world economy works. Only dollar and some other currencies such as Pound,Euro, Yen etc. are used in world trade because of the view that nations and economy to whom these currencies belong are 'stable'. Just take a look at the fiscal deficit of US govt currently at 12% of GDP. Go through the figures of its public and private debt. The debt has gone on increasing since 2nd world war. How is it any different from a country such as India, UK, Spain etc? Of course i am no economic expert and don't understand entirely as to what leads to the acceptance of a particular currency for international trade. Perhaps the most important reason would be the size of economy and US economy being the largest commands that influence over international trade. Dollar securities are considered to be most liquid and everyone is willing to accept them in exchange for goods and services. But isn't this just a chicken and egg situation? We are asking why dollar is the currency for international trade. And the reason given is that it's most widely accepted and dollar securities are most liquid. But the reason why dollar securities are most liquid is 'coz dollar is the most widely used international currency.
In fact China has recently raised questions on the status of Dollar as words reserve currency. It wants the world to look for alternative solutions such as SDR's ( Special Drawing Rights ) which are a basket of major international currencies ( dollar, Pound, euro , yen etc.) issued by IMF . The procedure as to how this can be done is as of now not quite understood by me. One important step would be to create a market for SDR's by world organizations by giving investors attractive returns on buying SDR securities. The battle is on and we can only wait and watch if dollar can hold on to the privelaged status it enjoys in world economy at the moment.
