Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:
twitter
Facebook
Wordpress

November
Sun Mon Tue Wed Thu Fri Sat
   
9
     
2016
Months
Nov
2015
Months

Powered by Blosxom

Wed, 09 Nov 2016

It is not money but credit that makes the world go round

After the Indian government withdrew most of the Indian currency notes from circulation last night, there has been a fear that this would be so disruptive that the economy would just go off the cliff. I think this fear is totally misplaced. Contrary to what some economists might tell us, money does not make the world go round. We finance people know that the world actually runs on credit. Economists tend to think that credit is what you use when you run out of money. Nothing could be further from the truth. In reality, money is what you use when your credit has run out. I work for my employer on credit, my newspaper vendor sells me newspaper on credit, companies buy raw material on credit and sell their products on credit. If you find somebody having difficulty doing any of these transactions on credit, you can be sure that that somebody is a whisker away from bankruptcy.

Yes, today you will not be able to go to your neighbourhood grocery store and buy anything with the 500 rupee note in your wallet. But if you cannot buy whatever you like on credit from the same neighbourhood grocery store, then you have a very serious problem on your hand; a problem that will not go away when the banks reopen tomorrow. If you really find yourself in that position, you should be very worried and you should drop everything that you are doing, and work slowly and painstakingly on rebuilding your credit. For in a capitalist society, if you have lost your credit, you have lost everything.

So, yes, the Indian economy will be fine even though it is denuded of most of its currency for the next few days. Apart from the few people who are travelling (other than your credit card, you have no credit amidst strangers), it will not even be too inconvenient for the vast majority of people. I have no first hand knowledge of the black economy and would be reluctant to comment on that, but I suspect that this too runs more on credit than on cash. It might be premature to conclude that the economy would suffer from a fall in demand due to disruption of the black economy.

If you want historical evidence on how the world copes with disruptions to money supply, I would recommend an excellent article early this year by the Bank of England on how Ireland coped with a six month long bank strike in the 1970s. Or you could look at the experience from 19th century US in the wake of frequent bank failures and how cities and towns rebuilt their economy on alternative credit networks. Or you could read Niklas Blanchard on complementary currencies.

Posted at 11:24 on Wed, 09 Nov 2016     4 comments     permanent link

Comments...

Mitul SJ wrote on Wed, 09 Nov 2016 17:14

Re: It is not money but credit that makes the world go round

Prof. quite a timely write-up!!!

To add more I guess laborers and other folks who have cash and need to get things or pay will have to line up in quite inconvenient way. What the creditors will take undue advantage no one knows of people in coming time??? Also Govt wants to imbibe or instill cashless mode of payment for most of us, in a sense, as a habit, with the move made.

About the credit as you mentioned, Telecom carriers and other companies have already started sending messages to install their e-payment systems/apps, guess we all can see where things are heading or will be. Poor citizens like farmers, laborers are stuck in the mess unless things are sorted out for them in smooth manner. As only 12% of money which is circulated in the system (excl 500 and 1000 notes)

Banks would have liquidity for sure, for an ordinary citizen they will line up day in day out for the deposits. As well-to-do people they have credit cards, debit cards, EFTs at their quick disposal. They won't be that much affected.

Also to further add for the credit argument it also affects pricing of commodities and other regular items. Also some say ease of inflation will be there with black economy fading away. Plus it was the black economy which somewhat helped India during the crisis else we all would have ended up like Western countries. So I agree with what you wrote: "that this too runs more on credit than on cash." Perhaps that might have set the ball somewhat rolling back then. As currently people would be running out of high denominated cash notes which counts to 88% buying things would be cumbersome in times ahead esp large sum ones. And if people have cash crunch then buying on credit increases prices (for the money inflow foregone today for future basic TVM concept) so inflation cooling down that's questionable.

Grocery stores selling FMCG, Durables and other products...how people will co-operate??? they only know. Perhaps there is more to see beyond credit. Faith in people & in system and how people behave and how they all interact in general.

Today itself, a taxi driver would not accept high denominated cash note (which still can be deposited by him given the time frame) from passengers how can the credit puzzle be answered in that case for the ride service taken & suppose you pay that person in other denominations the credibility shoots up or is normal? That's kind of something weird if given a thought.. As people's behavior cannot be ascertained just like that or from looking into the history on the basis credibility or otherwise, even though you might be person who maintains a good credit to others.

Thanks for the article and the links!!!

Pratik Maru wrote on Thu, 17 Nov 2016 20:14

Re: It is not money but credit that makes the world go round

Hello Sir,

I got redirected to your post from Twitter, and honestly I was thinking that I would be able to read some real insightful analysis among all this noise.

I couldn't help but notice that article is too short on depth and has conveniently ignored various other aspects. One thing, which I found completely missing is details/analysis on credit cycle. I will try to explain my point below with the help of an example.

You are certainly right, when you say lot of day to day trade happens over credit, but what I think you have completely ignored is that credit keeps on rolling, only if you are in capacity to pay earlier dues. No small shopkeeper or big raw material supplier will provide you goods on credit, if you are in no position to pay earlier debts.

So for example, if I am suppose to buy a packet of detergent from nearby grocery store worth 100 INR, this guy won't be credit of new 100, if I am not clearing my old debt. Since this grocery store owner won't have any cash in hand, he won't be able to pay to manufacturer of detergent, and in turn manufacturer won't be able to pay to raw material supplier, and hence put brakes to complete business/consumption cycle.

Would like to know your view points on this.

Regards Pratik