The Descent of money and the Destruction of purchasing power – Part – I By Dr. Bobby Srinivasan and Dr. Sudhakar Balachandran

January 13, 2015 | Posted by bobbysrinivasan << back to blog

Older text books in economics will claim that one of the properties of money is the ‘store of value’. Now, this claim is not correct and out of date as well. The new adage should be ‘money is an instrument of public policy’. Why one may ask? Recent data shows that the central banks around the world have pumped in nearly 10 trillion dollars of fiat money since the sub-prime crisis of 2008. Now the question is where did all these money go and why has it not helped the global economic growth? Did the money find its way into speculation and non-productive activities? Has it gone to pay off old debts? The bubbles in the stock, commodity and real estate prices are they due to this fiat money? This is the topic of discussion between a student and his economics professor.

Student: Professor, I have read in the economics text books that money is used for among other things, transaction and speculative purposes. Now where is all the excess money gone since the global economic growth is rare. Japan, Euro zone countries are currently in deflation. Chinese economy is slowing down. Thus economy thanks to QE has just recovered.

Professor: This is a difficult question which requires a comprehensive answer. Besides, I am also guessing. First, understand that inflation arises when the supply of money is not enough when the demand for it exceeds supply. Inflation can also arise by creating artificial scarcity and also through legislation to curb demand. As it stands the amount of money created in the last 7 to 8 years is just too much. This should have caused high inflation which it did not. The just conclude quantitative easing in the US has added nearly US $ 4 trillion to the global economy. To top it all, the US Federal Reserve brought down the discount rate, the rate at which commercial banks can borrow from the central bank to zero. This must have increased the money supply horrendously. Next, Japan through the policy of abenomics named after its Prime Minister Abe has pumped in trillions of Yen into their economy. His intention was to pump in unlimited amounts of money into the economy, until the rate of inflation picks up to at least 2 percent. Currently the inflation rate in Japan is negative and this is pushing the economy into deflation. Similarly the euro zone is deciding on Jan 22, 2014 as to how much money they need to pump into the euro zone economies to pull out of a potential deflation. Milton Friedman, a nobel price economist through a detailed study in the US, established that pumping money into the economy without productivity will eventually result in a high inflation over a period of time. On the other hand, Paul Krugman, another nobel price economist claims that by not pumping enough money into the economy when the recession is prevailing in the country will lead to a serious deflation. His argument currently holds good because even after pumping US $ 4 trillion which is nearly 20 percent of US GDP the ugly inflation has not shown its head. On the other hand the US third quarter GDP has gone up by 5 percent. So you see, I am not able to give you an unequivocal answer to your question.

Student: Professor, look at India, year after year we are incurring budget deficits of 4 to 6 percent. Our inflation rate has always remained stubbornly high. Only recently we saw the CPI and WPI come down drastically. There is a debate going on between the Finance Ministry and the RBI regarding future repo rates. What should be the relevant policy?

Professor: I will address it in the next blog. Meanwhile hold on to your question.

Student: Thanks Professor.

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