Monday, September 25, 2006

Cryptonomicon & Monetary Theory (Part I)

I was joking when I said that I'd only read the chosen book if it was about monetary theory. So I was quite surprised when I found Cryptonomicon does indeed contain monetary theory throughout. Indeed, it jumps right into it with the description of the various banks settling their accounts on Fridays:

So ten minutes before closing time on Friday afternoon, the doors of many banks burst open and numerous pairs of coolies march in singing, like the curtain-raiser on a fucking Broadway musical, slam their huge boxes of tattered currency down, and demand silver in exchange.

The description of the coolies and the currencies, which occurs in the first five pages of the book, is in my opinion, the most colorful and interesting part I've read so far (I've read through page 700). The whole scene really came to life for me.

But I wonder about the last part. Did they really "demand silver" in exchange? Or did they just settle accounts and perhaps demand an accounting of silver reserves?

In order to contemplate that, we need to consider the evolution of money and to examine the state of China's monetary system in 1941.

Let's start with the evolution of money.

In the beginning, trade occurred using barter: some grain for some flint or some skins for some salt. Things were traded directly for each other.

Lumps of metal are also things that can be traded. Shiny metals were suitably rare (not too rare though) and coveted. Trade naturally evolved to frequently involve gold, silver, bronze and other metals since they had a high density of value and thus a great deal of value could be stored, carried, and transported relatively easy.

The next step in the evolution was quite varied as it took a long time for the more optimal solutions to be discovered and adopted. But the following concise excerpt gives a good overview:

It started with goldsmiths. As early bankers, they initially provided safekeeping services, making a profit from vault storage fees for gold and coins deposited with them. People would redeem their "deposit receipts" whenever they needed gold or coins to purchase something, and physically take the gold or coins to the seller who, in turn, would deposit them for safekeeping, often with the same banker. Everyone soon found that it was a lot easier simply to use the deposit receipts directly as a means of payment. These receipts, which became known as notes, were acceptable as money since whoever held them could go to the banker and exchange them for metallic money.

Then, bankers discovered that they could make loans merely by giving their promises to pay, or bank notes, to borrowers. In this way, banks began to create money. More notes could be issued than the gold and coin on hand because only a portion of the notes outstanding would be presented for payment at any one time. Enough metallic money had to be kept on hand, of course, to redeem whatever volume of notes was presented for payment.

While there is a risk when bankers loan out more money than they have in metallic money reserves, this risk is usually well worth it, both for the bankers, depositors, and borrowers. The banks' notes provided extra liquidity desperately needed in a system based on metallic money deposits. Investment and economic growth are greatly assisted by the extra liquidity.

There's generally little danger from the loan side because bankers generally only lend money to those who can put something up as a security deposit, for example, a farm or a piece of equipment. If the borrower defaults, the bank takes the assets put up for security and sells them to recoup the loan amount, and, so as long as the bankers were reasonably diligent, the downside is limited.

But of course nobody knows exactly what the volume of notes accompanied by the demand for the metallic money is going to be at any given time. Thus, there's a risk that the bank would be unable to meet the demand if they don't have adequate metallic reserves. If the bank can't meet the demand, word gets out, people panic, all of the notes become worthless (because there's no metallic money left to back them), and the banking and monetary system collapses. This is a big bummer!

Unfortunately, in a crisis (like when a world war is about to start), a run on the banks becomes much more likely. Everybody suddenly wants their tangible metallic money back and they rush into the bank with notes and try to withdraw it. Even if the banks happen to have adequate reserves, liquidity is sucked out of the system, which destroys the economy anyway.

So what is going on when the coolies are about to be run over by Shaftoe's vehicle? What was the monetary system like in China in 1941? It turns out that it was quite chaotic, but nowhere near collapse. It didn't collapse until well after World War II. Here's a brief excerpt that gives a flavor of what was going on:

After the Chinese government consolidated the currency in 1935, it forbade local banks and provinces from issuing their own banknotes, but this didn't stop communist banks, Japanese banks and warlords that were not under the political control of the Nationalist government from issuing their own banknotes.

After the consolidation of Chinese currencies in 1935, the southern provinces seceded monetarily. The Central Bank of Canton issued the Canton Dollar (CNDC) equal to 1.44 Chinese Dollars (or one old Tael). This continued to be used until the Japanese occupied Canton on October 31, 1938 and replaced the Canton Dollar with their own currency.

The Mexican Peso (Hai Kwan Tael) was used as a customs unit of account until February 1, 1930 when China introduced the Custom Gold Unit for the payment of customs. CGU Banknotes were 100% backed by US Dollars and were convertible at the rate of 1 US Dollar equal to 2.5 CGU. The gold standard was abandoned on November 3, 1935. As the inflation accelerated, the government introduced Custom Gold Units (CNU) for general use in China. Originally, these had been used for paying import duties and were equal to 20 Yuan, but after 1945 they were used to fuel the Chinese inflation. After the war, the Chinese government kept Taiwan and northeastern China as separate currency areas within the China.

So, the bottom line is that in 1941 the monetary system in China was still workable, if chaotic.

Therefore, it seems unlikely to me that the Cryptonomicon coolies would actually have been demanding silver for their banknotes (other than small amounts to achieve some balance). It seems to me more likely that they would have simply been trading banknotes to help settle accounts. If they had actually been demanding silver, that would essentially have started a run on the banks and the whole thing would have fallen apart. I don't think the apocalyptic description on page 4 by Stephenson quite matches reality:

This is an ultimate settling of accounts before the whole Eastern Hemisphere catches fire. The millions of promises printed on those slips of bumwad will all be kept or broken in the next ten minutes; actual pieces of silver and gold will move, or they won't. It is some kind of fiduciary Judgement Day.

Of course Cryptonomicon is fiction, so perhaps the rules of banking from our universe don't apply.


Blogger Peter Burnet said...

Nor the rules of history. It seems to be hard for modern writers to write about the late '30s without painting a picture of one and all awash in a sense of forboding that the world was about to blow up and there was nothing they could do to stop it. Of course most of them didn't see it that way, which is arguably one reason why it blew up.

In fairness, the few political quips in the conversations among Turing, Rudy and Waterhouse are more authentic that way.

5:27 AM  
Anonymous Anonymous said...

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Blogger David said...

Although the day the US pulled out of Shanghai probably was a little sobering.

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