The Monetary Causes of the Debt Crisis

On February 22, 2012, in economic theory, monetary policy, by Jon Lewis

Philip Coggan. Paper Promises: Debt, Money, and the New World Order. Public Affairs, 2012, pp. 294, $27.99 What is money? At first, it sounds like a simple question. But, as this thoughtful new book makes abundantly clear, the definitions of what money is, and what it should be in the future, are far more complex [...]

Philip Coggan. Paper Promises: Debt, Money, and the New World Order. Public Affairs, 2012, pp. 294, $27.99

What is money? At first, it sounds like a simple question. But, as this thoughtful new book makes abundantly clear, the definitions of what money is, and what it should be in the future, are far more complex than one might initially realize. In Paper Promises, Philip Coggan of The Economist forces the reader to think differently both about the nature of money and the concept of debt. “Modern money,” writes Coggan, “is debt and debt is money.” Throughout this engaging work, he successfully demonstrates how, throughout history, societal attitudes toward money and debt have changed and that they may be about to change once again.

The author contends that one can view all of economic history through the prism of a perennial contest between creditors and debtors, between those who lend money and those who borrow it. Anyone reading a newspaper these days knows all-too-well that much of the West is in debt. The battle between creditors and debtors aptly described by Coggan is being played out in front of our very eyes. Although some countries, like Greece, are in far more perilous shape than others, both the European Union and the United States face the looming prospects of increased sovereign debt and the possibility of default.

“As these debts become due,” writes the author, “rich creditors will be pitted against poor debtors; private-sector taxpayers against public-sector workers, young workers against the retired, domestic voters against foreign bondholders. It is impossible to forecast who will win each of these battles but one thing seems certain: not all these debts will be paid in full.” One of the book’s myriad takeaway lessons is that creditors will be disappointed. The breaking of these paper promises, as Coggan describes them, will result in economic turmoil akin to the end of the gold standard in the 1930s and of fixed exchange rates in the 1970s.

The book’s first chapter, entitled, “The Nature of Money” is a thought-provoking introduction to the concept of money. “For thousands of years,” writes Coggan, “the nature of money has been subject to change at the whim of those in power.” Indeed, the relationship between state power and money is nothing new. Coggan suggests, however, that something new did occur in eighteenth-century France, when John Law, a Scottish economist advising Louis XV, fathered modern monetary economics and attempted to redefine money. Law advised the French king that the way out of the country’s fiscal mess was to create a bank with the right to issue paper money, even if it were not backed by gold. This, recounts the author, led to an asset bubble in the form of land speculation in the Mississippi basin.

In a more theoretical section of the same chapter, the author delineates three uses of money. As a medium of exchange, money allows people to buy and sell goods and services without having to barter or ship bullion across great distances. He rightly notes that, with regard to the “media of exchange, paper and electronic money are much more useful than precious metals.” Money is also a unit of account, meaning that it expresses “the price of goods and services with relation to one denominator.” Finally, as a store of value, money allows one to save and not spend what one earns immediately. This facilitates investment. Coggan posits that, “the means of exchange and the store of value . . . lie at the heart of the struggle between creditors and debtors.” For the last forty years, he argues, the pendulum has swung toward loose money and money’s medium of exchange function. In other words, credit and money have expanded, benefitting debtors.

In Coggan’s estimation, our troubles began with the breakdown of the Bretton Woods system in the early 1970s, when the formal link between money and gold disappeared. “Paper money prevailed. Without a gold anchor, and without full capital controls, fixed exchange rates were not really feasible. Governments preferred the freedom to govern their own economies as they saw fit, using both monetary and fiscal policies to support demand.” According to Coggan, these governments and their central banks “overdid it, a process that culminated in the debt crisis of 2007 and 2008.” As he writes in the book’s introduction, the developed world financed their economies through debt.

Although Coggan tells a compelling story of how we got into our current debt crisis, it need not have ended up this way. The author certainly makes a strong case for the argument that the breakdown of the Bretton Woods system likely contributed to the vast increase of debt in the western world. Demography, fiscal policy, globalization, housing policy, and technology, however, also played dispositive roles in destabilizing the world economy. In my opinion, if voters throughout the past decade were more demanding that politicians in Washington adhere to a balanced budget and not engage in excessive spending, many of our current problems could have been avoided.

While Coggan accurately notes that the Clinton administration ran “a fairly conservative fiscal policy,” he seems to imply that the 1990s boom and budget surpluses were an anomaly in the post-Bretton Woods era, rather than part of a natural ebb and flow cycle in which politicians and bureaucrats alternatively acted fiscally responsibly and irresponsibly. After all, governments throughout history have made financial decisions that would prove, in retrospect, to have been significantly flawed.

One should not underestimate China’s potential to make financial, or political, mistakes that will inadvertently benefit the United States. Given the infeasibility of returning to a gold standard in an age of electronic money and instantaneous transfers, western countries are going to have to find a way to create a more stable fiscal and monetary system. If they do not, and the United States experiences a lost decade of anemic growth, then the world’s new monetary system may very well, as Coggan suggests, be made in China.

Due to his willingness to acknowledge readily that, “there are no easy answers in economics,” Coggan’s work stands apart. Paper Promises certainly doesn’t have all the answers; it, however, does force the reader to think differently about the nature of money and of debt. One need not agree with Coggan’s analysis of fiat money to appreciate that Paper Promises is an extremely thoughtful contribution to the ongoing debate about the financial crisis and our current debt problems.

Jon Lewis (c) 2012

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