February 7, 2012
Staff Picks: Paper Promises
Our economic lives could literally stop on a dime. All it would take is an agreement redefining what a dime is, or is worth, backed by or tied to. It's happened before, and The Economist's "Buttonwood" columnist Philip Coggan believes it will inevitably happen again as the great international play of creditors and debtors enters its next act.
Paper Promises: Debt, Money, and the New World Order (released today by PublicAffairs), identifies turning points in the history of economies, nations and international affairs by examining the relationships between creditors and debtors. And to do this, it is important for him to identify exactly what money is and has been, something that has changed throughout history as economies rise and fall. This makes for a fascinating story that clears the cobwebs of the past and brings us up to the present day. As he writes: "Given that mankind has been using money for thousands of years, it is perhaps surprising that money is still such a nebulous concept. ... Over time, money has been everything from precious metals through paper to entries on a computer screen. One writer defined it quite neatly: 'Money is the belief that someone will pay you back.'"
What constitutes money and how it is exchanged coincides neatly with the rise and fall of powers. Quoting John Kenneth Galbraith, the author notes that "If the history of commercial banking belongs to the Italians and of central banking to the British, that of paper money issued by a government belongs indubitably to the Americans." But regardless of what form money takes, it is when that "belief that someone will pay you back" is challenged that matters become especially delicate between debtors and their creditors, and the rules get rewritten. And it is a situation that looks increasingly likely today.
Throughout history, the most popular political reactions to unmanageable debt have been deflation and default—diluting the purity of coinage and devaluing currency to lessen the burden of debt, or simply refusing to pay it back. One great example of the former is Henry VIII, "known as 'old copper nose' because of his habit of adulterating silver coins, the base metal underneath showing through the wear." Similar tactics diluted the silver content of Roman coinage by "96 percent over the course of two centuries." But repaying debts in debased currency is probably preferable to the outright defaults of some monarchs, such as Philip IV of France:
Philip IV, who ruled from 1285 to 1314, borrowed heavily but forced his bankers into exile rather than repay them. Just to put icing on the gâteau, he then decreed that the principal on all other debts must be repaid to the crown. The result was the ruin of his main creditor, the Order of the Knights Templar.Of course, exiling your bankers is not an option when debt becomes international. Resolving debt is now a political issue dependent on international agreements. The gold standard was one such (and as the author explains, accidental) agreement, and worked quite well until it was abandoned in the attrition of the First World War. The Bretton Woods system—an agreement in the wake of World War II under which currencies were tied to the dollar and, because the US held 60 percent of the world's gold bullion, to gold through the dollar—was another. That system was the norm until 1971, when facing a crisis of confidence in the dollar the United States abandoned that agreement and decoupled the value of the dollar from gold.
Since then, currency exchange rates have "floated" on the foreign exchange market. This has increased capital flow, and the financial sector has exploded in size and wealth since. It has also allowed governments to run greater deficits because they can manipulate their currencies more easily. This is the story told in the second half of the book, a story of easy credit and asset bubbles. It is the story of modern finance and the brink of disaster it brought us to that's been covered so well in so many books of late, here told through the lens of the entire history of money and debt documented in the book's first half. It is a perspective that makes our current crisis look less unique, even as the author references research done in another recent book entitled This Time Is Different:
Carmen Reinhart and Kenneth Rogoff recount that sovereign default has occurred in a number of waves, starting with the Napoleonic Wars. In the 1840s cycle, nearly half the countries in the developed world were in default. There was a 1870s to 1890s wave, associated with falling commodity prices, and a 1930s to 1950s wave, linked to the Great Depression and the war.Between the Second World War and the current crisis, sovereign debt was almost always associated with the developing world, and the debate largely focused on how much of that debt should be forgiven for historical reasons or on humanitarian grounds. Today it is the developing world, largely China and the resource-rich nations of the Middle East, that acts as the creditor to developed, debtor nations—the United States the largest among them. But, as we're seeing in the news everyday now, it is Europe where the real worry is. (Just yesterday the Prime Minister of Romania resigned amidst growing protests over austerity measures there, and his was but the latest government to fall across Europe since the debt crisis began.) Essentially, the current relationship ultimately relies on faith in governments, which is wearing thin across the Western World.
Coggan brings us to this present moment in history with great skill and scholarship, and a steady, masterful hand. He explores the various aspects, implications and possible outcomes of this new paradigm, and believes that "the debt is unlikely to be repaid in real terms." "The Unholy Trinity" he sees coming down the road is inflation, stagnation, and default, with some sovereign defaults incredibly likely in the Eurozone, and countries that still control their own currencies like America and Britain "partially defaulting" in the sense that they depreciate the value of their currency to make their debts more manageable.
The ultimate solution, however, is where the "New World Order" in the book's subtitle comes in. This is "where the buck stops," or at least where it stops floating as it has since 1971. He believes the current arrangement of "floating exchange rates in the developed world and managed rates in the developing world" will come to an end. He sees the most likely outcome being a new agreement between China and the United Stated—the world's largest creditor and its largest debtor—in which the West agrees to a new system of capital controls as China allows it's currency to appreciate and America reigns in its national debt.
Nassim Nicholas Talb, the well-known author of The Black Swan, is quoted on the cover saying "This book stands way above anything written on the present economic crisis." I think there's a whole library's worth of brilliant books on the present crisis, and I wouldn't want to judge a peopled narrative like Andrew Ross Sorkin's Too Big to Fail against a history of currency and debt like Coggan's, or put up what I read as a character study (of both people and nations) like Michael Lewis's Boomerang against a modern financial history like Bethany Mclean and Joe Nocera's All the Devils Are Here. Coming from a company with a bookseller background, I have a firm belief in matching up the right reader with the right book, and would recommend different books to different people for different reasons. (And if you like this book, I would recommend picking up Menzie Chinn and Jeffry Frieden's Lost Decades, James Rickards' Currency Wars and Keith Roberts' Origins of Business, Money, and Markets to go along with it.)
All that said, I think Paper Promises is not only a great book, it is a great accomplishment—a brilliant work of financial history, an clear examination of the present moment, and a journalistic masterpiece all wrapped into one.