Thursday, 2 December 2010

Philippine paper money is reliable

John Mangun
Outside the Box
Business Mirror

If you have been reading this column long enough, then you are aware of the problems associated with “paper” money, fiat currency backed with nothing of intrinsic value. The French historian and philosopher Voltaire wrote, “Paper money eventually returns to its intrinsic value—zero.” Friedrich A. Hayek, an Austrian economist said, “Practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.”

However, paper money is a great economic invention. When the supply of currency in circulation is properly managed by a central bank, paper money is a very efficient and effective method of storing wealth and for using as a medium of exchange.

Paper money in circulation is like the lubricating oil in your car’s engine. If there is too little, the system seizes up and will not run. If there is too much, the system becomes overloaded and does not run well. The secret to managing the money supply is to make sure there is just the right amount. Too much money and there will be inflation because of the imbalance between the “value” of the money and the goods the money purchases.

If there is too small an amount in circulation, then the paper money competes with other commodities for value. For example, for many years after the Vietnam War, the US dollar was really the medium of exchange because the Vietnamese government oversupplied the economy with local currency, the dong. Because there was too many dong, that paper money lost value. However, the supply of dollars was constant and held value. Over time though, the amount of dollars in physical circulation became scare. Physical dollars became more and more valuable, creating price inflation for the goods the dollars bought.

It is not only the amount of paper money in the economic system that is important but what that paper money is being used for.

What is happening in the US now, for example, is that the Federal Reserve is printing trillions of dollars that is not being used for economic activity but is being used to pay for more government debt. That is not healthy for an economy.

One of the duties of a nation’s central bank is to keep the money supply in balance with the nation’s economic growth, even to anticipate future growth so as to not have too much or too little money in circulation.

Perhaps the best accomplishment of the Bangko Sentral ng Pilipinas (BSP) through the years has been the management of the money supply. The Philippine money supply has been allowed to expand during periods of strong economic growth and contract when too much paper money in circulation would have been harmful. At the time when the economy really started booming during the presidency of Fidel Ramos, the Philippines’ money supply grew by as much as 25 percent in a year. This is a huge increase that by conventional wisdom would have been crazy. But the economy needed that extra money then and it utilized all those additional pesos in circulation very well.

This year, the BSP is allowing the amount of currency in circulation to grow by about 8-9 percent.

As long as the money is being put to good use and, therefore, inflation is low, the BSP can properly put more and more money in the economic system to help grow economic activity.

Because of what has happened in the global economies, not only during the last two years but for the last two decades, we think of prices bubbles as bad. There is nothing necessarily wrong with price bubbles that pop as long as the increase in price is not based on buying through debt, with borrowed money.

The thing that killed the US stock market in the 1990s and the US housing market most recently is the prices that were artificially high because people used borrowed money. When the borrowing stops and prices go down, the loans still have to be repaid.

Look at the local stock market. After a two-year period of booming stock prices, suddenly this month prices have fallen significantly. Granted, if you invest in the local market, you may have lost money. Get a new stock market adviser because other investors got out weeks ago, now sitting with very large profits.

Yet because the rising stock prices that put the market at an historic high was paid for with cash not credit, we will see stock prices shoot up again very shortly.

More important, though, the way the economy handles cash-based price bubbles is an important indicator of the health of the economic system.

Billions of cash in pesos have been pulled from the stock market in the last weeks. What we have witnessed is how efficiently the economy has handled this excess liquid cash. While the stock market has been drained of large amounts of liquid cash, the government debt market has absorbed a portion of it. The benchmark 91-day Treasury-bills reached an historic low interest rate of 0.775 percent or 67.5 basis points lower than the previous record low of 1.48 percent last November 15, while the yield on the 182-day debt dropped by 33.3 basis points to a new low of 1.650 percent from 1.985 percent. Money easily went from one financial vehicle to another without any disruption to the economy.

Part of this is because these investments are cash, not debt based, and is easily transferable, and part of it is because the BSP has the right amount of paper money in the economic system.

The BSP has maintained prudent and sensible money supply policies through the years and the net result is that the Philippine Peso is reliable and credible paper currency.

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