By Pater Tenebrarum
A Major Crisis
Last week Jayant Bhandari related the story of the overnight ban of certain banknotes in India under cover of "stamping out corruption" (see Gold Price Skyrockets In India after Currency Ban Part 1 and Part 2 for the details).
Banned 500 rupee banknotes
The problem is inter alia that the sudden ban of these banknotes has hit the Indian economy quite hard, given that 97% of all transactions in the country are cash-based. Not only that, it has certainly created fresh avenues for corruption - which should have been expected (whether it will succeed in its aim of stamping out other types of corruption remains to be seen - we doubt it).
Moreover, the poorest of the poor are suffering the most on account of the ban, not least because the promised replacement of the banned banknotes is apparently hitting major logistical snags and may take much longer than thought.
Readers interested in this story may want to listen to an interview Jayant has recently given to Maurice Jackson of "Proven and Probable," which we have embedded below. A quick note on errata: at 1:45 and 1:57, Jayant says "2,000 dollars" - he obviously meant to say "2,000 rupees."
Further updates on the still developing situation can be expected soon.
Consider it a Warning
We would note on this occasion that although what India's citizens are facing these days may seem a remote danger to most Westerners, it does demonstrate an important point: state-issued paper currency exists only at the sufferance of the State. It can be made worthless by decree.
As we pointed out in "Why Does Fiat Money Seemingly Work?," the main reason why irredeemable paper money is accepted at all are not only legal tender laws which enforce its use as a means of payment, but primarily the fact that the State insists that its fiat currency be used for the payment of taxes. This is what creates a secondary market demand for fiat money, without which it could probably not exist.
Surprisingly, the concept is not really a modern one - it was tested in Great Britain for a considerable stretch of time with the tally sticks system. Although that particular system ultimately failed (just as every currently extant paper currency eventually will), it did show the way to governments. It was indeed possible to do more than merely usurp the production of gold and silver coins.
So obviously, governments do have considerable influence on what is used as the means of final payment in the economy. What governments have been unable to do though is to effectively "demonetize" the money previously chosen by the market - namely gold. Governments may well be able to make the possession of gold illegal, but they cannot possibly destroy the metal's monetary qualities by decree.
Gold - the market-chosen money. No agreements, convocations or force were needed - people adopted gold voluntarily as a money commodity all over the world, after a long period of trial and error with a variety of monies.
When Nixon was persuaded to abandon the gold exchange standard in favor of a pure fiat dollar, many monetarists (one of whom was advising him on the move) and other mainstream economists were convinced that gold prices would decline from the $35 fixed exchange rate to something like $6 per ounce, reflecting its value as an industrial commodity.
In other words, they reckoned that the act of officially "demonetizing" gold would erase all monetary demand for it. As is often the case with predictions agreed on by a majority of economists, this turned out to be rather wildly mistaken.
Another prediction by mainstream economists gone rather spectacularly wrong. Monetary demand for gold not only failed to disappear, it actually grew rather significantly.
What has just happened in India clearly demonstrates that the nature of state-issued fiat money must be taken into account when considering what to do about the rapaciousness of increasingly desperate and technically insolvent governments.
If one wants to safeguard one's cash holdings against the potential failure of the fractionally reserved banking system or against arbitrary wealth confiscation - such as has inter alia been advocated by the IMF (see "Is a Large wealth Grab in its Way" for the sordid details on this) - one has to keep this important detail in mind.
Withdrawing deposit money in the form of cash currency is only an effective strategy as long as governments don't do what India's government has just done. And one should definitely never make the mistake of underestimating the lengths to which governments are prepared to go under the cover of "emergency."
In the course of the 20th century alone, we have seen such a wide range of government depredations with respect to money, that one has to be extraordinarily naïve to believe repeat performances are no longer possible.
What has happened in India should be seen as a clear warning. State-issued cash currency may not be affected by bank insolvencies and "bail-ins," but it is by no means safe. By contrast, gold simply cannot be devalued by government decree.