by Philip Coggan
PublicAffairs, 2012, 304 pp., $27.99
If you were to stop some average, sign-wielding Tea Party protesters and ask them about the state of the U.S. economy, they would likely throw up a clunky comparison to household economics: If you’re borrowing more than you’re earning, you will eventually drown in a sea of debt. The only way to get back on track is to spend less and start paying the debt back. It is fundamentally irresponsible to spend what we don’t have, so we must cut spending to reduce the debt.Philip Coggan’s Paper Promises is a de-vulgarization of this common Tea Party argument. No, he says, countries are not households, and the homespun analogy is particularly misleading when it comes to the United States, given its valuable privilege of issuing debt in its own currency. Besides, if life is indeed graded on a curve—and it is—the United States remains the best bet worldwide to park one’s savings. Even official downgrades of the U.S. credit rating after the debt ceiling standoff this past summer haven’t much affected borrowing costs. And if the dollar were to depreciate, America’s relatively very large domestic market ensures that the effect on our standard of living would be far from catastrophic.Nevertheless, Coggan argues, the history of the world financial system is best understood as an ongoing struggle between creditors and debtors, and the intuition of the Tea Party that a lot of debt is a bad thing should not be cavalierly dismissed. Shifts in the relative indebtedness of countries have historically presaged major shifts in the organization of the global financial system. Since World War II, the United States has been the lynchpin of the world’s economy. Though its relative position of strength started slipping in the mid- to late 1960s due to President Johnson’s deficit spending on Vietnam abroad and on the Great Society at home, it wasn’t until President Nixon ended the dollar’s convertibility into gold in the summer of 1971 that all hell started to break loose. With China ascendant and the U.S. debt binge showing no signs of ending, Coggan’s thesis is that we’re due for another systemic shift—and unlike the one after World War II, this time it won’t be the United States calling the shots.Money and DebtThe key to Coggan’s worldview is found in his understanding of the nature of money itself. Money serves three primary purposes: It is a store of value, a unit of account, and a medium of exchange.As a store of value, money lets us save (and invest), allowing us to buy more expensive things in the future. Without this ability, we would have to barter for everything in the present. That would greatly limit both the scope of our commercial activities and our ability to plan. Obviously, money is most useful in this function insofar as its value is predictable.1 In a barter economy, we would be forced to find relative value by pricing goods in terms of each other (“five oranges for two apples”). Money’s role as a unit of account enables us to far more readily assign relative value to goods based on a common reference point. And finally, as a medium of exchange, money facilitates transactions. If I make shoes and want a sweater and you make sweaters but need some wool, I don’t have to find a shepherd who needs shoes in order for us to do business. Money thus enables us to conceptualize wealth more easily, and thus to create it.Our understanding of money has shifted through the centuries. From the establishment of the gold standard until today, Coggan argues, humanity has struggled to find the optimum balance between money as a store of value and money as a medium of exchange. He illustrates the tension between these two views of money by retelling the story of John Law (1671–1729), the Scottish mathematician and gambler who founded what amounted to France’s first central bank and is acknowledged as an early practitioner of modern monetary economics. Though the Dutch Bank of Amsterdam predated Law’s Banque Generale by almost a century, the Dutch never hit upon the idea of actively managing the economy by modulating the money supply. Law did. Unfortunately for Law (and for France), this early experiment did not go so well.Law insisted that money’s sole purpose is to serve as a medium of exchange. “Money is not the value for which goods are exchanged”, he wrote, “but the value by which they are exchanged: The use of money is to buy goods. Silver, while money, is of no other use.” And indeed, at the time of his bank’s opening in 1716, hard money was in short supply in France. The profligate Louis XIV had just died, and the government was on the brink of bankruptcy. Law’s insight, that the economy was stagnant because there was insufficient money in circulation to facilitate commerce, was essentially correct.The Banque Generale started loaning out six million livres of capital, primarily to the French government, in the form of paper. The government decreed that this paper was legal tender, and started paying back its debts with it. The public, used to Louis’s unreliability as a debtor and his tendency to adulterate species currency, took to the new money with enthusiasm—Law’s paper was for a while valued higher than the hard money it represented. For his part, Law assured the public that each slip was convertible into specie at the rate indicated on its face, and made truculent pronouncements that any banker who did not keep sufficient reserves should be put to death.Yet within three years, largely at the crown’s urging, there were more than 800 million livres worth of notes in circulation. Coggan argues that it was neglect for money’s store of value function that led to Law’s undoing. Had his paper money been issued more prudently, with at least a set fractional value of gold or silver backing each note, it might have worked as intended. Unfortunately, the unchecked extra liquidity ended up inflating a huge speculative bubble in a stock company. When the bubble popped and the public’s confidence shattered like brittle crystal, people started asking for the hard currency to which their paper entitled them. By 1720, the bank had suspended convertibility. Law barely escaped France with his life, eventually dying in poverty in Venice.The parable of John Law is useful shorthand for Coggan’s worldview—and he refers back to it repeatedly throughout the book. Fiat money is inextricably bound to the concept of debt. Unlike gold coin that, it is said, has intrinsic value, paper money is just a claim on wealth. Relying solely on the supply of precious metals to run your economy has serious downsides, as the supply of gold is arbitrarily related to the productivity and wealth being generated by any given economy. Why should a discovery of gold, for example, drive up your money supply? And why should an economy constrained by its supply of money not have more of it so that it can function at its fullest potential?But by severing the link between intrinsic value and money, money essentially becomes just a promise to pay. The desperate French crown, rather than waiting on an increase in economic activity to eventually deliver higher tax receipts, decided to simply print ever more money to service its debt. It basically transferred what it owed in gold and silver onto paper, which it promised to redeem if necessary. As long as the public believed this promise—when the government’s credibility remained intact, that is—everything functioned well. But by ignoring money’s role as a store of value, the French crown eventually undermined the public’s confidence in it, causing creditors to demand payment in something more reliable.A Standard Without GoldThe bulk of Paper Promises walks the reader through modern economic history with this tension—creditor versus debtor—deployed as an explanatory framework. We encounter William Jennings Bryan representing the over-indebted farmer against the big city financier and arguing passionately for an expansion of the money supply (“You shall not crucify mankind upon a cross of gold”). We see how the gold standard foundered after World War I due to the advent of mass social democracy and the breakdown of solidarity among the transnational elite. We witness John Maynard Keynes and Harry Dexter White wrangling over the design of the Bretton Woods accords after World War II, with Keynes arguing for debtor-country-friendly provisions in the new order. And we’re treated to a dizzying, though fairly satisfying, tour of the most recent financial crisis, encompassing both the banking crises attendant to the popping of the housing bubble as well as the sovereign debt crises plaguing the European Union.But while Coggan’s sweep of history is broad, he returns repeatedly to a key inflection point: Nixon’s unbinding of the dollar to gold in 1971. Under Bretton Woods, which was still in effect at the time, all the world’s currencies traded at set values to the dollar, which itself was pegged to gold at a price of $35/ounce. With the dollar unshackled, the system broke down. This had two important effects: It allowed countries to print unlimited amounts of paper money, since they no longer had to manage money supply in reference to a known quantity, and it once again allowed money to flow around the world unfettered, something that Bretton Woods forbade.That second effect is worth elaborating. You might recall from introductory economics a concept dubbed the “Impossible Trinity” of exchange rate policy. Stated simply, you can only have two of the following three outcomes at any one time: a fixed exchange rate, international capital mobility, and monetary policy independence. During the gold standard era, countries fixed their currencies to gold and allowed money to flow freely around the world. Currencies adjusted by means of painful, often pro-cyclical interest rate shifts that could induce nasty recessions domestically—a cost born mostly by the least well off. During Bretton Woods, with currencies pegged to the dollar (which itself was pegged to gold), countries opted instead to preserve monetary policy flexibility in order to fight inflation or recession at home. But in doing so, they risked opening themselves up to speculators, who would seek to exploit interest rate differentials between countries to make money. By curbing international capital flows, Bretton Woods allowed countries to both peg their currencies and to control domestic interest rates.The post-1971 era of free-floating rates allowed for both free capital flows and discretionary monetary policy, but with governments (especially the U.S. government) now unconstrained from running larger trade deficits as well. A very profitable financial sector sprung up to facilitate this newfound capital freedom, and the printing presses of the world’s largest economies provided them with lots of liquidity to move around the world in search of the highest returns. Coggan posits that this excess mobile global liquidity—the cause of crises in developing countries in the 1980s and 1990s—has finally started complicating things in the advanced West. Like in Law’s time, too much worthless paper is chasing too little “real” wealth, defined, simply enough, as goods and services people are willing to buy. No country’s economy can cope for very long with those kinds of capital influxes, which instead of being put to productive uses are far more often to be found inflating asset bubbles and leaving ruin in their wake.And there’s a further vexing detail: China never followed the world’s lead and is still resolving the Impossible Trinity in the old-fashioned Bretton Woods way—by pegging the renminbi to the dollar at an artificially low rate and instituting severe capital controls. It’s doing this as part of a conscious policy to industrialize and modernize its massive rural population by choosing to become a net exporter of manufactured goods. Had it not instituted capital controls, speculators would have bid up its currency long ago, undermining its competitive edge. But they can’t, so China gets to run persistent trade surpluses. These trade surpluses are in turn a kind of turbocharger on the ill effects of unmoored paper money. Not only is there too much of it sloshing around, but China’s economy is also acting as a giant fire-hose in redirecting it back to its largest trading partner, the United States.End of the LineCoggan cites Nixon’s chair of the Council of Economic Advisers, Herbert Stein, as famously saying, “If something cannot go on forever, it will stop.” He elaborates:In the last forty years, the world has been more successful at creating claims on wealth than it has at creating wealth itself. The economy has grown, but asset prices have risen faster, and debts have risen faster still. Debtors, from speculative homebuyers to leading governments, have made promises to pay that they are unlikely to meet in full. Creditors who are counting on those debts to be repaid in full will be disappointed.Coggan is fairly cautious in predicting the final outcome of this unraveling. The process by which the world’s creditors and debtors are reconciled will not come about overnight. A new financial world order is probably at least a decade or so away. After all, England was not completely eclipsed by the United States for at least a quarter century after the end of the First World War. He does seems fairly certain, however, that the next several years will not be fun, with balance eventually being restored through some combination of “inflation, stagnation and default.” And though debtors will not have it easy, creditors will not forget these lessons either. China in particular, if it stays on top, is not likely to embrace any sort of new system that allows for the kinds of free financial flows that have characterized the global economy since 1971.Is Coggan’s analysis correct? He admits to being influenced by Austrian school ideas, many of which yield important insights. There clearly have been vast misallocations of resources, and it seems obvious that this is due to large sums of money rushing into and out of economies, often wreaking havoc as they move through. But though Coggan repeatedly bemoans this modern process of money creation “out of thin air”, he’s equally quick to point out that a return to the gold standard is a non-starter. He even points to the ongoing meltdown in Greece for an example of how untenable it might be in today’s world of representative democracies. So if artificially limiting currency creation is not in the offing, and if humanity has proven itself incapable of finding the “right” level of money for any given situation, perhaps capital controls are the only way forward. The Chinese may have figured this one out already.One might argue that Coggan is premature in his gloom. However bad the situation may seem, the United States is still a vibrant, dynamic and productive economy. Just because a ton of money was misinvested in housing and other speculative nonproductive assets does not mean that still betting on America is a bad idea. After all, America’s debts were almost paid off at the turn of the millennium, and as Tyler Cowen argues elsewhere in this issue, there are signs that America could become a very successful net exporter sooner than later.But forecasting the future is a mug’s game. Whether Coggan is right or wrong on the specifics, Paper Promises is thought-provoking and engaging. Not since John Kenneth Galbraith’s Money: Whence It Came, Where It Went has an author presented so accessible a panoptic view of monetary economics. In doing so, Coggan has ably illuminated a point that Tea Party activists intuitively grasp, even if they are confused about causes—that excessive debt, rooted ultimately in a misunderstanding of what money is and can be, could be our undoing. By providing an economically literate framework with which to discuss these issues, he has provided a must-read, at least for non-economists (if not economists too), in complicated times. 1See George Tavlas, “The Money Man”, The American Interest (November/December 2011).