Digital wallets are fast catching up

The rapid adoption of digital wallets in India has not come as a surprise to many people. In a recent study by the Boston Consulting Group, the significant disruption caused by digital payment systems was clearly evident. As the figure below illustrates, in the two years since FY17, digital payment systems have captured a 17% market share of the 32 billion transactions in FY19. While the wide adoption of digital wallets is here to stay, it is interesting to pause and reflect on how reached this stage.

How did we get here

Several centuries ago, trade primarily happened through barter. But as the range of goods traded increased, the need for an easily transportable and divisible medium of exchange and store of value was strongly felt. Enter gold and silver into the picture. As the minting technology developed, slowly gold & silver coins were widely adopted as a medium of exchange.

As a further development on this, very soon ‘fiat’ currency entered the scene. A ‘fiat’ currency is a paper that is ‘decreed’ by the government to be convertible into gold at a certain exchange rate. For example, an ounce of gold was decreed to be equivalent to 20 US dollars. As more formal economic systems began to develop, this payment system of using ‘fiat’ money backed by gold reserves (called the gold standard) was widely adopted.

The gold standard

A country that uses the gold standard sets a fixed price for gold in terms of its paper currency (fiat currency) and buys and sells gold at that price. The gold standard is not used anywhere in the world right now. But understanding the history of the gold standard helps us better appreciate how far we have evolved. Despite all this talk of technological progress, conceptually in an uncanny way, the new age cryptocurrencies are somewhat similar to the currencies operating under the gold standard. Let’s see how.

As mentioned above, when a financial system is on the gold standard, the amount of money in circulation is limited by the total gold supply in that country. This acts as an excellent check on excess money being put into circulation (as is happening now across the world). This was the main benefit of the gold standard. On the flip side, if followed too strictly the gold standard was not flexible enough to accommodate tough economic conditions and could lead to economic instability.

England was the first country to officially adopt the gold standard in 1821. By 1871, the gold standard began to be adopted widely across Europe starting with Germany in 1871. The US was one of the last major nations to adopt the gold standard.

The gold standard worked very well for all the countries during the period 1871-1914. However, with the outbreak of World War I in 1914, chinks began to appear in the global financial system. In order to finance the war effort, most of the nations needed more money which they were not able to raise due to the limitations on money supply imposed by the gold standard. Clearly, there was a great need for a monetary standard which was more flexible. On the top of the difficulties imposed by the war, the stock market crash in 1929 and the subsequent Great Depression further exacerbated the situation.

At this point, there were two options for a country following the gold standard – 1) increase interest rates so that people are discouraged from converting their fiat currency into gold 2) devalue the fiat currency so that for the same amount of gold more fiat currency can be put into circulation. The first option was clearly not palatable to most industrialised countries who were trying to export their way out of the economic distress brought on by the war (as higher interest rates cause currencies to appreciate). The US devalued the dollar from 25$ per ounce of gold to 35$ per ounce. This led to a lot of gold being converted into US dollars and soon the US was holding 75% of the available global gold reserves. This also led to the US dollar gradually being accepted as a global reserve currency.

The Bretton Woods Agreement

This situation continued till the end of World War II when a new arrangement called the “Bretton Woods Agreement’ came into effect. Under the Bretton Woods agreement, all currencies would be valued relative to the US dollar at prices which are commensurate with their relative economic strengths. The US dollar would be the only fiat currency that would be convertible into gold at 35$ per ounce. Now the link between gold and the international monetary system was more indirect.

Post World War II, in the 1960s, the US economy began to run a trade deficit. This coupled with its involvement in the Vietnam War started to drain its gold reserves. As the US dollar began to lose its relative competitiveness, some European countries like France and Belgium began to convert their US dollar reserves into gold. The last straw in this chain came through in 1971, when Britain demanded that US settle its trade bills in gold and not in US dollars. At this point, the US announced that the US dollar would no longer be convertible into gold. The last link between gold and the global monetary system was finally broken.

The global financial system then entered a world of freely/partially floating exchange rates and money supply was no longer restricted by the amount of gold available. Central banks could effectively increase money supply by printing more money (they just had to run the printing presses for longer times!, that simple).

Back to the present

The outcome of this flexible monetary system is the ‘supposedly’ increased ability of a central bank to counter-cyclically keep an economy in a balanced state. But as noted above, when the money supply is no longer restricted by a tangible asset base, other evils follow. Now there is a growing clamour for financial systems based on crypto-currencies in because cryptocurrencies are limited in supply. As they say, life comes back a full circle.


** Author name – Vijay Sarathi