Paper Promises: Money, Debt and the New World Order

The paper money system is a matter of faith.

Paper Promises: Money, Debt and the New World Order
Philip Coggan
Allen Lane, 304pp, £20

"I wasn't worth a cent two years ago, and now I owe two millions of dollars." Attributed by Mark Twain to "a speculator in lands and mines" in The Gilded Age (1873), his satirical novel of post-civil-war America co-written with Charles Dudley Warner, it is an observation that applies in much of the western world. The incomes of most Americans have been stagnant, in real terms, for roughly 30 years and yet, in the run-up to the 2008 crash, millions were able to buy homes by loading up on debt that they had no prospect of repaying. Ireland and Spain enjoyed wild booms as a result of cheap credit extended to the construction and property industries, while in Britain, the political economy of New Labour was based on high house prices and not much else. Predicted by Nassim Nicholas Taleb, Nouriel Roubini and a handful of others, a bust was inevitable. But it seems that little has been learned since the crash and, as a consequence, a crisis that our leaders have never properly understood is now entering an even more dangerous phase.

One source of this intellectual deficit is denial of the past. Full of false starts and dawns that never came, history is a solvent of illusions and is for that reason hardly considered or else actively rejected by much of the political class. Yet we can only understand where we are if we know how we arrived here, a fact made perfectly clear in Philip Coggan's Paper Promises, the most illuminating account of the financial crisis to appear to date. Coggan begins his story where it should begin, with an exploration of the nature and origins of money - a more problematic subject than is commonly acknowledged. It has become a commonplace that many things can serve a monetary role: cowrie shells in ancient China and cigarettes in prisoner-of-war camps. The rise of paper money is less well understood, though it has a clear bearing on the present crisis.

First introduced by the 9th-century emperor Hien Tsung to deal with a shortage of copper, paper money was developed by the Mongols. Coggan describes the surprise of Marco Polo when he discovered that the grand khan of the Mongols paid his soldiers with paper currency, which for them had "the same value as if it were gold or silver". Answering the Venetian merchant's puzzlement, Coggan writes, "Paper clearly has no intrinsic value so why accept it as payment? The answer was that traders had little choice. The Mongol regime had decreed paper's use and theirs was not a government one defied. In a sense, then, the value of the paper was equivalent to the citizen's belief in the stability of the governing regime."

It is a highly pertinent observation, because, as Coggan goes on to show, the world monetary system has had much the same basis ever since Richard Nixon ended the dollar's convertibility to gold in 1971. Since then, the global monetary order has been based entirely on fiat currency - money that is created and managed by governments. Just as much as the paper issued by the grand khan, the dollar and the euro rest on faith in the regimes that underwrite them.

Contrary to the clamour for a return to a gold standard that can be heard on the Tea Party fringes of the American right, fiat currencies have been trusted for long periods even though their purchasing power tends to decline over time. However, fiat money runs into difficulty when - as with the euro and the US dollar, despite the relative strength the dollar is gaining from the eurozone crisis - the ruling regime comes to be seen as weak. In the last analysis, it is power that sustains any monetary system, including those that have been based on gold.

As Coggan notes, "The First World War destroyed the cosy arrangements that kept the gold standard in place." More than any mistakes in monetary policy, it was the geopolitical upheaval that followed the Great War that produced the Great Depression. Writing with a lucidity that enables him to convey deep insights without a trace of jargon, the author recounts the process through which Europe's old elites destroyed their own power, while the politicians who inherited the mess that ensued found themselves in "a world without ideas".

Democracy is more firmly rooted today, but with Europe's elites having once again lost the plot, it is not unreasonable to fear that some of the disasters of the 1930s will be repeated. Unfortunately, the debate about how to deal with the financial crisis has degenerated into a dispute between rival schools of economists, each convinced that it has the solution. Rightly, the latter-day Keynesians highlight the absurdity of imposing austerity when the economy is already burdened by high levels of debt - economic activity shrinks and the level of debt rises. But policies of the kind that John Maynard Keynes suggested in the 1930s, which worked well after the Second World War, are unlikely to be so effective in the current conditions. The role of the New Deal in ending the Depression is disputed, some historians maintaining - plausibly, I think - that it was the mass mobilisation of the United States during the Second World War, rather than any of Franklin D Roosevelt's economic initiatives, that was decisive. Even if it was the New Deal that began the recovery, the trick cannot be repeated today, when the US is no longer the world's industrial powerhouse.

The gargantuan levels of increased debt that the US has taken on since the start of the crisis have been sustainable only because so much of China's foreign reserves is locked in to the dollar. Economists will tell you that rational self-interest will prevent China from disrupting this relationship of mutual dependency. Chinese policy up to the present supports this view, but it would be foolhardy to count on Beijing financing America's borrowing indefinitely. A president who tilted the US further in the direction of protectionism could alter the situation sharply. Who knows what US policy will be like if the country ends up being led by a religiose ignoramus such as Mitt Romney or a witless buffoon such as Rick Perry?

However, we face problems that are far more serious than the inanities of US politics. As Coggan intimates towards the end of his thought-stirring book, the largest obstacles to "Keynesian" solutions are posed by demographics and resource limits. Borrowing your way out of debt works only if the present generation can dump its borrowings on the next one, restarting growth in the process. With the ageing of the developed world, the next generation will be smaller than the last, while the cost of energy will rise as emerging countries continue to industrialise.

Peak oil doesn't mean that there is no oil left, rather that the cost of what remains - in terms of the capital and energy expended in extracting it - is trending inexorably higher. Any pick-up in the global economy is likely to hit this energy constraint pretty quickly, but politicians and economists still seem to believe that we can somehow return to pre-crisis conditions. With awkward facts submerged in the loose talk about green growth, few are asking how the world is going to adapt to low growth as a permanent condition in the developed countries. Yet that is what is on the horizon.

John Gray is the New Statesman's lead book reviewer. His latest book is "The Immortalization Commission: Science and the Strange Quest to Cheat Death" (Allen Lane, £18.99)