How valuable is your money...??

If your wallet is somewhere near you jus take out a 100 rupee note(well if it s the last week of month even a 10 rupee note wud suffice :P). Just think of what all you will be able to do with this little piece of paper in your hand. You can just walk in to your nearby Potti Kadai for instance and can buy stuff worth 100 rupees . The shopkeeper simply accepts that piece of paper(yea trust me .. it is only a piece of paper..) in exchange to all the stuff which he provides you. But if you try to shop with the same piece of paper in some other country the shopkeeper will simply shoo you away. (Well if u wanna experiment this try payin an autorickshaw driver in chennai with sri lankan currency...observe wat he says and report back to me :P nd don complain if ur ears start bleeding) . Similarly one can't use Indian currency in Lanka. Well everyone knows this as a fact but why is that the piece of paper which is valuable in India worthless elsewhere?

Well if you look closely you can see the following promise note written out on the currency note 'I promise to pay the bearer the sum of one hundred rupees' signed by the honorary governor of RBI.(Probably all jobless people like poeple like me would have noticed this). So what is the significance of this statement and why is the governor of RBI has come down to the level of 'aam aadmi' and written out a promise note to us.

I was under an assumption that RBI would maintain a reserve in gold equivalent to the currency which it publishes. So suppose lets us say that somehow you lose faith in the RBI you can always go to the RBI and demand for gold. Well this sounds fair enough. The RBI gets to keep the real money and you will be having the representative paper money which is easy to carry around for trading.

Consider this scenario. Supposing if there is only 1 kilogram of gold in the RBI reserve. It can issue currency worth around 7500000 rupees only (yea thts the price for 1 kg of gold...for those who are specific about the exact gold price check it out here. esp for de ladies). Of course they can issue notes worth twice that value(i.e Rs 15000000)but it only means we are reducing the value of our currency by half.

With a little bit of googling I found out there is a name for this and it is called the gold standard. But thank god I did some googling. I found out some other startling facts. I always had assumed that this gold standard holds good even to this day. But I realized that this gold standard was dumped long back even before I was born. USA was the last country which had used this gold standard but it was abandoned in 1971 by Mr.President Nixon.

Before 1971 it was agreed through Brenton Woods system that all countries would maintain its reserves in US dollars (not in gold as I had previously assumed) and in USA every dollar would be backed by one dollar worth of gold (well atleast in theory) . The countries which would have its reserves in dollar would be able to exchange the US dollars to gold whenever it wished to.

To put it in plain terms let us suppose you had one hundred rupees with you before 1971 and wanted it change that cash to gold. What you should have done is, you should have walked upto the RBI and got US dollars equivalent to 100 rupees. Then you will have to go all the way to Washington DC to the Central Bank in USA and get gold worth that amount.(Phew tough job.. :P.). Lets imagine that each and everyone of us decides to do the same thing; suddenly the pressure on the US govt to give gold will increase and the system will collapse. This is precisely what happened before 1971 when some of the countries like France wanted to convert its dollar reserves to gold and US was in deep trouble because in reality it had only 22% percent of its dollars backed by gold.(Anyways there was never enough gold in this earth to back all the paper currencies in the world. So this system was bound to collapse.)

So one fine morning in 1971 Mr. President Nixon announced that the US dollars cannot be exchanged for gold. All the countries with which had dollar reserves woke up to the rude fact that all the reserves which it had built over the years are nothing but mere paper. If you look the current US dollar bill there will not be any promise note as we have it here.

US $1 bill

Note that it only says that the note is only a legal tender for all debts public and private. Nowhere in the note there is any promise made to return the bearer the sum of 1 dollar like in our case. (Note that after this incident countries started to maintain reserves in several foreign currencies commonly known as the forex reserves. Since there are several currencies in the reserve the value of the reserve would remain reasonably stable. Well I ll write about forex reserves in another blog. Now jus read on.)

So now we have ruled out the gold standard completely. That brings us back to square 1. What is the meaning of this peice of paper in your hand and does the governor's promise in our notes still hold good? If it is not gold standard there has to be something else which gives the value to the money.

Well the answer is "FIAT". What does this word remind you of? Cars which ruled the Indian roads in 1980s..?? (Cars which ruled Indain roads? Fiat??U mite never agree.. ;) U mite say Ambasador or Maruti 800 or may be even the contessa.. Since my dad owned a Fiat Premier Padmini (1985 model) I am giving this honour to fiat.. lol .. Anyway this is my space and I can write anything here) . But we are talking about a different FIAT here.

Well what exactly is this FIAT? This system declares all paper currency issued by the government as legal tender. So basically the 100 rupee note which you are holding in your hand is not backed by anything valuable but just by another bunch of papers signed by some government authority declaring it to be valuable.(Hmmm isnt it quite funny that we slog out day in and day out jus for these bunch of papers.)

Well then... What about the governor's promise in the note which you are holding in your hand? Does it still hold good? Well the governor's promise makes this piece of paper a legal bond. It is the Government's way of telling that it will accept taxes only in form of the currencies which it publishes. Since our government accepts it, everyone who is supposed to pay taxes to the government will accept these notes.

Note that this system will work only if the people of the country trust the value of the currency. The governor's promise is there in the note only for the sole purpose of instilling trust in the people. My God!! We are living in the Kaliyug and we are talking about a system which works purely on TRUST.Sounds creepy? Hmmm...

There is a reason why such a ridiculous system is put to use all over the world.This system establishes the paper currency as the common form of exchange for all forms of trade within the country.(Note that it is only within the country). If there isn't any common form of exchange then everyday trading would be almost impossible and comical. The price boards in your local vegetable markets will look something like this.

1kg Rice = .25 kg of potato

1kg potato = .5 kg of onion

1kg onion = o.2 kg chicken

and list will go on..

You should actually got to have some potato with you to buy rice. (You ll be in real trouble if you are a vegetarian and if u wanna buy some onion in this particular market.. :D). So paper currency is the saviour which helps us to do all the shopping even though they dont have a intrinsic value for themselves.

So ultimately what is the one thing which gives the value to the peice of paper which you are holding in your hand. It is TRUST. It is quite stange but it is a fact. It is only with this trust the entire world is functioning today. Hmmm.. Nambikai than Vazka.. So true...

PS: Please leave a comment if u read this post..