Macro Economics
What Makes a Currency?

Related Links
Discussion Boards

By FastMike
July 7, 2009

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

A long summer sojourn based on a true story for your amusement, a little history and opinion by FastMike.

"...A sufficient amount of coin to redeem these notes promptly on demand will be kept with the depositaries.... all depositors and collecting officers will receive them, enter them on their books, and pay them to public creditors as money....." -----Treasury Secretary Salmon P. Chase remarking on newly issued Greenbacks; August 1861

Begin Sojourn :

O'Keefe shuffled his way to the window and was astonished at what he saw. Across from him and a little further up was a long rail fence. Against it was a long row of stone wheels of various sizes. Some partially sunk into the tropical soil. Near the wheels were a large group of islanders who were looking toward the road.

"Some of those wheels look eight or nine feet tall! They must weigh tons!? Can that be?.. Decorated, feathered, tattooed islander?! He's obviously an important fellow....."

O'Keefe then sees the source of the singing and chanting.

A slow procession was coming up the path with one of those enormous stone wheels! But they weren't rolling it! At each call of cadence it was half pulled by rope and sled, and half lifted forward with a thick, tied, bundle of flexing, bamboo poles through the wheel's center hole. About a dozen men on either side, pulling rope or pushing on a the pole. Each forward lurch accompanied by a lively chant from the laboring choir. Each halt punctuated by the cadence caller.

They too were led by ‘an important looking fellow', all tattooed with a feathered crown. He had a tall staff, all feathered on top. Along side, two columns of singing women in parallel, tossing large colorful orchards from baskets they were holding. At the center of the columns, walking shyly, a beautiful, florally decorated young woman.

O'Keefe watched in fascination as stone took its' place. There was a cheer, happy greetings, sharing of food and beverage. After a long rest, some of the men sat in a circle, those two important looking fellows at the center. They began to argue with strange dramatic gestures.

Just then a man walked into the hut. "Ahhh! Sehr Gut!!! Gut!!! Sie sind wach!! Wir waren besorgt!! Sie muss hungar haben, ja?...... Verstehen??.... Sind Sie Deutch?? Ah Nein!.... Spanier??... Englander?..... Hollander?" O'Keefe replied, "American". "Ahhh glucklish! I speak good English. My name ist Karl. You've been unconscious since we found you. You must have had a difficult time, ja? You must be thirsty?.. and hungry!.... ja?" The arguing outside turned to shouting. O'Keefe stiffly turned toward Karl, "What are they trying to build?" Karl laughed, "Build? HA! Nein! I mean no! They're not building. They're bartering!"

"What for?" he asked. Karl smiled, realizing his guest was still groggy, "Ah, ja! A dowry. It's an important marriage. Two powerful clans. That's why they come to that bank". O'Keefe thought he was dreaming, "Bank? There's a bank here!? What're the wheels for?"

Karl looked puzzled, then rolled his eyes and laughed. "Ha, ja! I mean no! I forgot! I've become so used to it! Karl walked over to the window and motioned in the direction of the long row of stone wheels then clasped his hands behind his back and smiled. O'Keefe looked at him and then the wheels. "My friend! Those things you call ‘stone wheels'? Well, that is the money!".

It is a date unknown, October 1871, on the Yap island of Baleabaat, and sometimes adventurer, sometimes sailor, and full time fugitive, Captain David Dean O'Keefe, with utter disbelief, is watching the father of the bride pay up for his princess's big wedding with an eight foot diameter, two ton stone coin.

Karl sat O'Keefe at the desk, left for a while and then returned with a plate of tropical fruits, hot biscuits and a beverage which Karl called ‘spiced coconut arrack'.

Over lunch he explained that the strange coins were called Rai and were not simply stone, but a type of calcite, a very rare mineral in this region. Their values depended on size, gloss, age, decoration, history and many other ‘factors'. Some Rai even seemed to have a slight greenish glow in the dark! Some came from great distances. Even from other islands! The more Rai a clan had, the more influence and bargaining power they had.

"And they even have a place to deposit very large sums" quipped Karl.

He went on to explain that the Rai O'Keefe saw was a new deposit. Otherwise, the coins weren't often moved. The bank was a way to prove the owners had money in the bank. When accumulated debts had to be settled, after a little bargaining, it would then be a simple matter to ‘transfer ownership' without actually having to move the coin again.

Karl then changed the subject, "There's a good market in Europe for coconut, you know, but these islanders are difficult to deal with. They're reluctant to trade for our goods. Push them too hard and they'll push back. When you see one of those chaps angry, I assure you that you won't forget it! They'll accept jewelry, but are certainly no fools. They'll trade for saws, axes, nails and hardware, but want rifles and pistols. (We dare not do that). They're fascinated by the deck canon, but we've never fired it so they might not realize it's a weapon, at least I hope not."

"We should introduce ourselves. I'm Karl Steingeld. I'm in the coconut business. You can say that money really grows on trees here. And you? Your name, my friend?"

There was no reply. O'Keefe, just stared wide eyed toward the window fixated on the bride with her giggling attending maids.

"My friend? Are you not feeling well again? Perhaps more arrack, ja?"

Then without turning nor batting an eyelid, O'Keefe asked, "How often do you send for supplies?"

pause Sojourn.

One of my favorite memories of a visit to the Smithsonian was seeing one of those giant coins on exhibit. At first, I saw a humor in it. "Were they serious?!", I thought with a smile. I'm sure that most visitors must think the same. But that experience stuck in my mind like a thorn in a shoelace.

Was it really primitive or clumsy? Not if you were a Yap islander. That calcite was rare and desired. Used only for jewelry, decoration, and a status symbol. In the Caroline Islands Rai was as good as gold. And they had a system that used the coins efficiently. There were different units of coin. They extended credit, had banks, established covenants and settled debts. All without having to move the coins.

We think that a gold coin is worth much. But how far can you really get on a gold coin? If I were to challenge you, give you, say, five gold Eagles, that you're not allowed to exchange for cash, could you make your way home from a distant place? Just how much are those coins worth? Can you buy a burger and fries? Jump in a cab? You might, but don't expect much change. Get a hotel room? An airline ticket? Even if someone accepted it, you'd raise a heck of a lot of suspicion.

But take out a plastic card and the world is at your fingertips! Find an ATM. Get ‘advance cash'! Maybe do a little shopping on the way. Not only can you find your way home, but you can do so in first class comfort!

In fact, in recent years, I've seen the wider use of plastic where you wouldn't expect it. In convenience stores, coffee shops, taxi cabs. Even drive through fast food!! They might be debit cards, gift or pre- paid or credit. The point is that plastic is taking the place of pocket change. And plastic cards have familiar ranks : gold card, silver card, platinum card, rewards card, cash back, gift card.

Can it then be said that a plastic card is currency? Or does a plastic card represent currency?

Are people willing to pay a small premium to use plastic in place of cash? Or is using a card allowing the user to leverage cash (in other accounts), by not having to spend it daily?

Currencies do transform. The Euro was a relatively sudden transition. After the collapse of the Soviet Union, the Ruble had to be reinvented... and reissued. So too the Mexican Peso in the late 80's. The currency of this country has been through a more gradual ‘transformation'.

A national paper currency, the greenback, officially called a ‘U.S. Note', was first issued during the American Civil War. It was not intended be in use very long after that war. It was merely a stopgap. After that war, Washington unsuccessfully tried to ‘wind down' the greenback. President Grant's efforts to finally get the paper (and silver) out of the system and enforce a ‘gold only' standard was a key factor leading to the ‘Long Depression' (1873 - 1883).

But there's that subtle implication again : what makes a currency? The U.S. Note issued during the Civil War, was legal tender. It existed in parallel with gold and silver specie. What kept paper there was a post war boom. The west was being settled. Railroads were booming. The country was growing. There was a demand for currency. The greenback accidentally filled that gap. So for the first time in our short history, a national paper fiat currency had become an integral part of U.S. economy.

The Forth Coinage Act of 1873 required the government to purchase silver. The silver was then minted into coins, but those coins, the silver dollar, were ‘so large' as to be unwieldy. The government took its' cue from the Greenback and a paper representation, the Silver Certificate, was issued. Gold Certificates followed about 10 years later. So by the late 1880s, U.S. currency consisted of ‘U.S. Notes', Silver Certificates, Gold Certificates and gold and silver coins, not to mention a wide variety of private Banknotes.

The last addition to the paper currency and first issued in 1914 was the paper that we use today; our ‘true fiat' currency : the Federal Reserve Note.

The point being that through war, post war boom, depression, and prosperity, currency expanded from gold and silver specie into ‘asset backed paper' along side two paper fiat currencies. Imagine that! A gold and silver currency existing along side a fiat currency! And as you might expect, such a situation can create a bit of volatility in the economy.

Resume sojourn :

O'Keefe recovered and worked for the merchants. But the epiphany he experienced was not forgotten. He used his earnings to purchase stone cutting tools and a few weapons. He needed a few ‘local' entrepreneurs. With the plan he had in mind, money would be no object. O'Keefe promise Rai that wasn't in a bank. It didn't yet exist. In exchange for their labor, O'Keefe gave them nothing more than a promise. With iron hammers and hardened steel chisels and saws, he would have to carve out quite a living for himself.

Pause sojourn

Consumer credit took root during the ‘roaring twenties'. New technologies and assembly lines created a flood of consumer goods. There was a problem though. The velocity of production of consumer goods, like autos, greatly exceeded the velocity at which consumers could save and purchase goods. Consumer credit closed that gap. Consumer credit kept people employed, factories running and ‘expanded' consumer purchasing power.

There's no need to give the history of credit. It suffices to say that consumer credit was meant to be a stopgap. Credit kept the economic wheel rolling, so to say. Let's fast forward a bit and note the evolution credit went through.....

In modern fractional reserve banking, commercial banks are allowed to create money, under the regulation of the Federal Reserve System. The (very simple, ideal situation ) works like this:

You put $100 Federal Reserve Notes (FRNs) in a demand deposit account. The bank enters $100 FRNs on their books and keeps $20 of your FRNs in reserve. The bank lends out the other $80 FRNs. The bank gives you an $80 IOU in your account and you'll never know the difference. That IOU is called Commercial Bank Money (CBM) and is dependent on the deposited FRNs. Commercial Bank Money exists only on the books. There's no physical representation of it.

The most interesting part is that CBM inflates the money supply. How? There's that legally created $80 CBM, in your account plus the $80 that the bank returned to circulation by loaning out. Nifty, huh? The bank keeps $20 FRNs in reserve to meet, say, cheque book demands.

Now suppose that, the person who received the $80, deposits it in the same bank. The process would repeat. The bank would record the $80 deposit, put 20%, i.e., $16, in reserve and lend the $64 dollars. If this process is repeated say 10 times the money supply will have inflated by $357 of CBM plus $357 of money loaned out.

So in reality, the economy has two currencies : the Federal Reserve currency, and a dependent Commercial Bank currency. But you'll never, ever see a Commercial Bank Note. It does exist, but only in the bank's ledgers.

Resume sojourn:

At first, getting to the quarries at a place called Palau, was difficult. Small rafts on rough seas. A gauntlet of hostile islanders, tropical downpours, dense jungle and a biblical plague of insects. But O'Keefe persisted. The best they could make and transport back were smaller denominations of yar or reng. But it was enough seed money to trade for coconut which he would then trade for equipment from the merchants. Slowly, with much effort, he traded and saved enough to buy a used Chinese junk. Now he could sail to the quarry with more workers and then back with more newly minted Rai, much quicker and in greater quantity.

Pause sojourn:

Say what you may about fractional reserve banking, it was certainly an orderly way to offer credit. Gramm-Leach-Bliley totally undermined that orderly credit market. Traditional banking simply couldn't compete with the growth of non bank lenders. Mortgage applicants had the choice of paying points, putting up collateral, documenting income, or simply going with a non bank lender and getting really easy terms. That's a no brainer, if you ask me. But still, how was that possible? How could non bank lenders create so much more credit?

Let's make a simple comparison to put it some perspective : With a traditional 20% reserve the lender could lever up his money 5 to 1. The Shadow Bank leverage tossed around in the press ranged from 30 to 40 to 1. This would be the equivalent of only keeping a 3.3% to 2.5% in reserve for every dollar on deposit.

If a traditional bank were to leverage 40 to 1; i.e. (that means with a 2.5% reserve), and the same process were applied on a $100 deposit, then by the 10th iteration, over each $872 of loans and IOUs are created. The money supply would have then increased by the sum of the IOUs and the money loaned out.

There was one heck of a lot of credit out there, and smack in the middle of an economic boom, and an easy Fed stance. Like the Greenback, easy credit was at the right place, at the right time. By 2007, the shadow banking system was estimated to have had $10 trillion in ‘assets', about the same amount of ‘assets' held by the traditional banks at the time.

At that peak, there were two competing credit markets, one "traditional" and the other unregulated. They existed in parallel, just as the variety of currencies of the early 20th century, or the two Rai of Baleabaat, Yap.

In fact, to offer some empirical evidence that two systems did indeed exist, recall that several non traditional lenders had to apply to become bank holding companies, in order to be ‘rescued'. GMAC and American Express for examples. There was so much said about the ‘great bank rescue'. But many of the banks that needed rescue, had to become banks first!?

What the financial system had been calling innovation was not much more than using the Gramm-Leach-Bliley as a loophole to work the system and literally create money, and wealth, that shouldn't or couldn't have existed based on traditional lending standards. Not unlike Mr. O'Keefe's Rai.

Resume Sojourn :

O'Keefe's coconut business grew in leaps and bounds. The colonial minded Europeans stubbornly refused trade on Islander's terms. O'Keefe had no such pride. Before long he had a lock on a calcite quarry, a small fleet of junks and a trade route to Hong Kong. He learned the languages, fitted and paid his crews well, respected the traditions of the islanders, sparing no expense doing so. He leased a coconut palm rich island and eventually controlled 2/3 of the Caroline Islands coconut trade. The Chinese considered him a Taipan. The Yapese considered him a chieftain. And the flamboyant O'Keefe considered himself a "king", and purchased the island of Terang for his castle. He lived like a king. Had feasts like a king. This one time castaway's empire was worth millions!! And it was said that when he threw a party his hearty laughter could be heard echoing across the bay.

Pause sojourn :

So to the point, (for which I had to Shanghai you, reader, half way around the world to make) :

In an economy that was so heavily dependent on credit availability, where credit had become a virtual currency that the sudden loss of credit availability is tantamount to a severe currency deflation.

Further, that unregulated system had grown so large, that combined global efforts have only marginally restored normalcy to credit availability. They stopped the ‘free fall' but with an effort that was expected to revive the system. That fact alone should ‘deflate' any inflation arguments. (Pun intended).

When I read or hear about the "coming inflation" I recall the feeling I had the first time I saw a Rai. I have to chuckle. What could possibly be supporting prices, I don't know. Perhaps prices don't reflect deflation as quickly on the consumer level. Perhaps inventories can't be restocked at profitable prices, and supply is constrained. Perhaps with higher populations in areas, prices of consumer basics deflate more slowly?

It's a fact, though, that home values have declined dramatically and continue to do so; That mortgages and equity loans continue to default. It's a fact that auto sale are at levels so low, companies have been pushed to the point of bankruptcy. It's a fact that job losses are still mounting. It's a fact that credit is still constrained especially in that all important mortgage market.

In short, there's been a lot of ‘wealth destruction'.

I'm not an expert, nor do I spend hours researching for subtle indications of a turn around. At best I try to glean clean facts from the noise, and there's a heck of a lot of negative noise as well as positive.

But history shows, as in the long depression or the great depression, when the banking system is damaged, long deflationary recessions of varying degrees, result.

Conclude Sojourn :

King O'Keefe was troubled by conscience. He had left a wife and child in Savannah, Georgia, decades before. He did support her over the years. (as he did with his ‘other' wives and children on Baleabaat and Terang). He was in his seventies, and decided to return home. So in May of 1901, His Majesty, King David Dean O'Keefe boarded his flagship schooner, the Santa Cruz and set sail for Savannah.

Some months later a merchant ship stopped over in Apra Harbor, Guam. A marine corps surgeon recorded that this ship had found a man clinging to wreck in the South Pacific. The said survivor managed to tell them that his ship broke up in a typhoon, and gave a strange name, called himself a King!?... lived on Terang?!... before he died. They laid his remains to rest on Guam.

As the news gradually spread, the people of the Carolines refused to believe it. His medicine was too strong. They believed he secreted himself away on Terang to escape his enemies. And it was there that he spent his final days there and that his spirit still resides there. King O'Keefe, the stranger who respected their ways and yet brought them into a new age is still with them.

And although King O'Keefe is still a famous historic figure in the Carolines, it should be noted that in the years following his death, his non traditional Rai became less valuable than the traditional Rai. But the story of his legendary exploits are as valuable today, as they ever were.

Your rock ‘n rai Fool,

Notes :

1)There's quite a debate about money supply. For an interesting take on a method of determining ‘a count', so to say, follow this link to a 2007 article.

Also a more detailed "simple" description of Fractional Reserve Banking.

2) To see the composition of the money supply from 1914 until 1941 follow this link and scroll down a bit (It's PDF format.)

3) Some very nice photos of Yap and a Rai bank, and a brief biography of his majesty, King O'Keefe.

4) Lastly, the New York Times obit�[PDF]. Notice the age discrepancy.

5) OH!!! The Greenback, A.K.A ‘United States Note' which was to be withdrawn after the civil war, was finally removed from circulation in............ 1971!?