A Sweet Exchange

The practical reason for the switch turned out to be a current chronic shortage of Rs 1 coins, but the idea of getting back money in the form of candy is intriguing nonetheless. For this piece of candy lies at the intersection of two conceptual streams – cash and kind, abstract and concrete, impersonal and visceral. It reminded me that money is not just a commercial abstraction, but a measure of purchasing power as well as a vessel for our economic hopes.

Broken Promises

If you look carefully at any currency note, you will see that it promises to pay you the face amount. For example, Indian currency says, “I promise to pay the bearer the sum of X Rupees,” and is signed by the governor of the Reserve Bank of India. U.S. currency bears a similar legend. In effect the currency is an IOU from the government to pay you…but what?

Obviously the promise is meaningful only if the payment is in kind, not in the same paper currency as the IOU. Yet governments today do not fix the value of the currency in gold, as many used to. Furthermore, the promise to pay a certain value in kind, usually in gold, has been repeatedly broken during most of history by governments either through step-devaluations or, more insidiously, through inflation.
The Rupee, like most currencies around the world, has had its historical ups and downs. Historians trace the Rupee, which pre-dates British times, to the Afghan Sher Shah Suri who ruled India from 1540-1545 AD and issued the coin under the name Rupiya. The Mughal silver Rupee was part of a trimetallic currency system, which also included gold Mohurs and copper Dams. The word Rupee derives from the Sanskrit Rupyakam, which means coins of silver. Unlike many of the world’s major currencies, which were based on gold, the Rupee was always a silver-based currency and remained so until the middle of the 20th Century. Consequently, it was subject to the great global devaluation of silver that occurred between 1770 and 1850.

The practice of devaluing currency by fiat goes back in history at least to ancient Greece. The Greeks appear to have pioneered currency devaluations; documented cases include Dionysius of Syracuse and the Delos Temple in the 4th Cent. B.C. The reason was usually to pay for profligate spending habits, often to fund wars. The typical method was to melt, dilute and reissue coins with less gold than before. Such “one-time” devaluations, which have continued ever since, are effectively partial defaults by the government.

But currencies tend to gradually drop in buying power even in the absence of major devaluations, because of inflation. Recently, I purchased a small Indian copper coin dated 1928, issued in India by the British Raj, decorated with King Edward’s bust and denominated in the astonishingly small denomination of 1/12th of an Anna, which in turn was 1/16th of a Rupee. In 1928, one could purchase a peppermint candy for two Pies, as the coin was called then. One Anna would buy you a breakfast of idlis, 13/4 Annas a royal meal of pooris and potatoes. A shirt cost 1 Rupee, 8 Annas, and a lower middle class family could live comfortably on Rs. 30 per month. The equivalent inflation over the intervening eight decades works out to just under 6% per annum.

The actual historical devaluation of the Rupee occurred in fits and starts. Since independence, there were two major devaluations of the Rupee, corresponding to financial crises in 1966 (after India’s war with Pakistan) and 1991, when India faced a total depletion of its foreign exchange reserves. Between 1970 and 2000, the rupee devalued by approximately a factor of 6 relative to the U.S. Dollar.

The Disease of Inflation

As high as 6% inflation sounds, the experience of many countries has been far worse. Once inflation reaches double digits, it tends to be self-perpetuating, leading to a spiral of devaluation that is hard to stop. One of the most spectacular episodes of hyperinflation in history occurred in Germany, in the aftermath of World-War-I. By 1923, hyperinflation was rampant, and German Reichmarks were denominated in the trillions! A well-known photograph from this period shows a German woman shoveling bundles of currency notes into a stove, because it was cheaper to burn currency than to buy firewood. By the time it was controlled in late 1923, hyperinflation in Germany had destroyed the public’s confidence in government, and ultimately contributed to the rise of fascism and the Nazis.

India has not had a hyperinflationary episode, at least since its unification under British colonial rule in the 1860s. On the other hand, the periods both before and after independence included several episodes of stagnant growth and low productivity, resulting in a gradual erosion of the Rupee in terms of purchasing power. Since 1990, India has been growing rapidly, and it has become a challenge to control inflation in the face of high rates of growth. As an expanding superpower, India’s interdependence on the rest of the world has grown, and its vulnerability to hiccups in global inflation and growth have increased.

Until September, India had been facing perhaps the most serious threat of inflation in the past two decades. Domestic inflation, which recently reached 12.5%, was fueled by the rise in prices of petroleum, grains and cooking oil, and base metals. The combination of unprecedented growth in emerging market economies led by China and India, and loose monetary policy around the world led by the United States Federal Reserve stimulated global demand and strained the availability of natural and agricultural commodities.

Bitter-sweet pills

I walked away from the store, candy tucked in my mouth, reflecting that the lessons on inflation from history were anything but sweet. Economic chaos due to unchecked inflation often brought down governments, set back growth, destroyed investment confidence, and kept real interest rates high, slowing down growth. The only tool available to fight inflation is a painful tightening of monetary policy, and if necessary, fiscal spending. The government must dampen price growth by raising interest rates, or by otherwise tightening lending requirements. Unfortunately, this must be done even if the inflation is largely imported, as is the case in India today.

It is always expedient to feed rather than fight inflation. When the Reserve Bank of India imposed tightened its fiscal policy over the summer, there was extensive criticism that the monetary belt-tightening was unnecessary. Governments have a strong incentive to cave in to populist demands.

However, as it happens, global inflation is retreating on its own, because the bubble that created it has been pricked decisively. The dramatic market events around the world in September have changed economic prospects almost overnight. The failure of major financial institutions has just about ensured that a developed markets recession is underway.

The resulting global credit crunch will affect India, along with China and the rest of the emerging markets. The “decoupling” that people assumed would allow emerging markets to keep growing regardless of what happens in the developed world looks increasingly like a pipe dream. In today’s shrinking global economy, the fear of inflation is already being replaced by talk of deflation, recession and even a long-lasting Japan-style depression. Don’t be surprised if pundits are soon calling for currency to be sprayed from helicopters once again.

No matter what happens, we should remain hopeful that our grandchildren won’t have to accept a piece of candy instead of Rs. 540 in change when they make a supermarket purchase in India.

Dr. Arvind Rajan is an executive at Prudential Financial, Inc. His views do not necessarily reflect those of the company.