ECONOMICS:The ability to print more money with minimal constraint is proving all important, writes CHARLIE FELL

THE WHEEL is widely recognised as the most important invention of primitive agrarian societies but it is perhaps the introduction of money that set our ancestors on the path to the modern world. Indeed, the need for money is so strong that it has been invented by almost every society beyond the most primitive with the notable exception of the Incas in South America.

The earliest recorded use of money has been traced to ancient Mesopotamia some 4,500 years ago. Our ancestors used all sorts of objects as money at different times – the list includes beads, ivory, leather, oxen, rice, salt and even vodka. Commodity money evolved from cattle and grain toward shells and then bronze and ultimately to silver and gold. The large scale of issuance of gold coin began under King Croesus in ancient Lydia, now part of western Turkey 2,500 years ago.

Commodity money however, proved impractical for widespread commercial transactions. As trade and economic activity began to expand in Europe during the 15th century, the need for more efficient money became apparent. The difficulties were overcome through the introduction of “representative” paper money – a type of money that has no intrinsic value but represents something of worth.

Warehouses accepted deposits of silver and gold and issued paper receipts in return. These paper receipts, which were fully backed by the precious metals in the warehouse, began to circulate as money. The convenience of carrying paper money as opposed to the bulkier silver or gold coins enhanced efficiency and trade flourished. The deposit banks soon realised that the holders of the paper receipts would not all simultaneously redeem the gold deposited with them and, consequently, they needed only to hold a reserve of gold that enabled them to meet the normal demands for redemption. The concept of fractional reserve banking was born and first introduced by the Swedish Riksbank in the late-1600s.

Representative money posed its own problems as the discovery of precious metals was sporadic and shortages created immense deflationary pressures. Indeed, the Wizard of Oz is a parable about money reform in late 19th century America when presidential candidate William Jennings Bryan declared that “you shall not crucify mankind upon a cross of gold”. The yellow brick road could prove unkind and adherence to the Gold Standard contributed greatly to the economic misery endured by the US in the 1930s.

Fast forward to today and representative money has given way to fiat money – a medium of exchange that has no intrinsic value whatsoever but for the fact that it has been decreed as legal tender. The ability to tap the printing presses with minimal constraint is proving all important in the current environment as, one-by-one, central banks across the world have accepted that the risk of deflation is material and have adopted the unconventional path of quantitative easing or the direct purchase of government bonds with newly-created central bank reserves.

The US Federal Reserve announced just last week that it intends to monetise $300 billion of the Treasurys debt over the next six months with maturities ranging from three to 10 years.

It also announced that it will purchase an extra $750 billion (€556 billion) of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac, which brings its cumulative purchases to $1.25 trillion this year, and intends to buy a further $100 billion in agency debt. Desperate times require desperate measures.

The announcement caught the markets off guard. Treasuries rallied furiously with the yield on the 10-year Treasury bond dropping more than half a percentage point to 2.5 per cent, the sharpest fall since the crash of 1987.

The US dollar suffered its largest weekly loss in more than 25 years while the price of gold jumped from $884 before the announcement to $967 and held on to most of its gains through the remainder of the week. Meanwhile, stocks registered their second consecutive week of gains.

The Fed will do all in its power to prevent deflation but the Treasury purchases are not that large and especially when one considers that the recycling of money into the US from China and elsewhere has stalled. The traditional money multiplier has collapsed as both borrowers and lenders hoard cash. The velocity of money or the rate at which money circulates through the economy has dropped considerably due to an increase in money demand. Traditional monetary policy transmission mechanisms are simply not working.

The deflationary pressures facing the US are clear. The Fed acknowledges this fact and “sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term”.

Quantitative easing has been adopted in response but it remains to be seen whether it will prove sufficient. The next step could well be explicit ceilings for long-term interest rates and perhaps even negative interest rates on bank reserves. A repeat of the 1930s just won’t be allowed to happen.